Recent regulatory reform legislation and rulemaking in the US portend sweeping revisions to the overall US regulation of financial services, including private fund sponsors.
In their current form, these regulations would not only affect US fund sponsors, but would also impact their European peers, in certain cases to a significant degree. Recently proposed and approved, regulations include: (i) mandatory registration of private investment advisers (both US and non-US) with the US Securities and Exchange Commission (the SEC), (ii) the taxation of so-called “carried interests” at increased rates and (iii) the restriction of campaign contributions and related payments to elected officials by investment advisers holding public pension plan assets.
The Dodd-Frank Wall Street Reform and Consumer Protection Act
On 21 July 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the US Dodd-Frank Act) was signed into law. The Dodd-Frank Act includes the Private Fund Investment Advisers Registration Act of 2010 (the Registration Act), which substantially amends the registration and compliance requirements under the Investment Adviser Act of 1940 (the Advisers Act) for investment advisers to private funds.
Most private fund sponsors with assets under management of US $150 million or more (other than “venture capital” sponsors) will be required to register as investment advisers with the SEC. Sponsors falling below that threshold will need to register as investment advisers under applicable state law (unless state-specific exemptions apply). The Registration Act will also require non-US sponsors of private funds (whether organised in the US or elsewhere)to register with the SEC if they have US $25 million or more in assets under management attributable to US clients.
Many private fund advisers have relied on the “private adviser” exemption from US registration set forth in Section 203(b)(3) of the Advisers Act being an adviser that (i) does not hold itself out generally to the public as an investment adviser, (ii) has had fewer than 15 clients during the preceding 12-month period and (iii) does not act as an investment adviser to any registered investment company or business development company). The Registration Act simply eliminates the “private adviser“ exemption. As a result, most private fund advisers will be required to register with the SEC as an “investment adviser” under the Advisers Act, unless one of the remaining exemptions applies.
A surprising feature of the Registration Act will require a substantial number of non US investment advisers to non US finds to register with the SEC. The Registration Act provides a limited exemption for “foreign private advisers”, being any adviser that:
- Has no place of business in the US;
- Has, in total, fewer than 15 US clients and US investors in private funds advised by the adviser;
- Has less than US $25 million in aggregate assets under management attributable to US clients and to investors in the adviser’s private funds. The SEC may increase this threshold through rulemaking; and
- Neither holds itself out generally to the public in the US as an investment adviser, nor acts as an adviser to any registered investment company or business development company.
The impact of SEC registration on investment advisers is significant, and requires, among other things, the following:
- The establishment of a formal compliance policy;
- A chief compliance officer to monitor compliance with the firm’s policies;
- Higher level of disclosure of information, such as portfolio company valuations; and
- Regular inspections by the SEC.
The Registration Act also provides for additional rulemaking periods following the enactment of the Registration Act. It is unclear at this point whether the SEC will adopt rules that could exempt certain European private fund advisers from regulation under the Registration Act if such advisers are already subject to regulation under the potential European AIFM directive. Although the provisions of the Registration Act do not become effective until one year from its date of enactment, European private fund advisers who wish to continue to manage funds or raise funds with US investors should consider the impact on their businesses of potential SEC registration.
Carried Interest Tax
Under current US law, a person providing services to or for the benefit of a partnership may receive a “profits interest” or “carried interest” in the partnership that generally results in the participant being taxed at the rates applicable to the income and gains from the underlying investments of the partnership, which in many cases can include a significant amount of capital gain and thus a lower tax rate.
The American Jobs and Closing Tax Loopholes Act of 2010 contains a number of revenue raising provisions, including one (the Carried Interest Provision) that would have increased the rate of tax applicable to income attributable ”carried interests”. While the bill containing the Carried Interest Provision failed to pass a procedural vote in the US Senate on 24 June 2010, and no further action is currently pending, the reintroduction of the Carried Interest Provision in the future is likely. Under the most recent version of the Carried Interest Provision, in general, 75 per cent of an individual’s carried interest income (including gains from the sale of an investment services partnership interest) would be treated as ordinary income beginning on 1 January 2011. Fifty per cent of an individual’s income attributable to gains made by the partnership on assets held for at least 5 years would be treated as ordinary income, and 50 per cent of an individual’s gain from sale of an investment services partnership interest held by such individual for at least five years is attributable to underlying partnership assets held for at least five years, including the goodwill of the partnership, would be treated as ordinary income.
Notwithstanding the absence of an explicit increase in taxation of European fund sponsors, the Carried Interest Provision could indirectly affect European fund sponsors in several ways, including increasing the tax rate on employees of European fund sponsors who are located in US satellite offices, or who are US citizens living and working outside the US for European fund sponsors. Similarly, European citizens working for US fund sponsors could be affected by a reorganization of the compensation structures of those sponsors in their efforts to ameliorate the effects of any carried interest tax legislation on their US partners.
On 30 June 2010, the SEC voted to approve a new rule to regulate campaign contributions and related payments to elected US state and local officials by investment advisers in order to influence awarding contracts for management of public pension plan assets (the Pay-to-Play Rule). The Pay-to-Play Rule, as approved, would apply to any investment adviser (US or non-US) registered with the SEC and any investment adviser exempt from registration under section 203(b)(3) of the Advisers Act (in other words, any adviser not holding itself out to the public as an investment adviser that had fewer than 15 clients during the last 12 months). Given the broad Advisers Act registration requirements of the Registration Act on non-US investment advisers discussed above, the Pay-to-Play Rule can be expected to apply to a substantial number of non-US advisers to non-US funds. The Pay-to-Play Rule’s restrictions on campaign contributions are as follows:
- Direct Contributions: Investment advisers and certain of their executives and employees are prohibited from making political contributions to an elected official (or a candidate for an elected position) who is in a position to select (or influence the selection of) the investment adviser to receive a contract to manage public pension plan assets; if such a contribution is made, then that adviser is banned from providing advisory services for compensation to pension plans, either directly or through a fund, for two years.
- Solicitation of Contributions: Investment advisers and certain of their executives and employees are prohibited from soliciting or coordinating (i) campaign contributions from others to an elected official who is in a position to influence the selection of the investment adviser (or to a candidate for a position that can influence the selection of the adviser) and (ii) payments from others to political parties in the state or locality where the investment adviser is seeking business, if that conduct would violate the rule if the adviser made the payments or contributions to it directly. • Third-Party Solicitors: Investment advisers are prohibited from paying a third party agent to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or registered broker-dealer subject to similar pay-to-play restrictions.
- Third-Party Solicitors: Investment advisers are prohibited from paying a third party agent to solicit a government client on behalf of the investment adviser, unless that third party is an SEC-registered investment adviser or registered broker-dealer subject to similar pay-to-play restrictions.
Very limited exemptions from the restrictions on campaign contributions apply: (i) up to US $350 per election per candidate if the contributor is entitled to vote for the candidate, and (ii) an exemption of up to US $150 per election per candidate if the contributor is not entitled to vote for the candidate..
The Pay-to-Play Rule becomes effective on 13 September 2010, and compliance with the rule’s provisions are required within six months of the effective date, with the exception of compliance with the third-party ban, which is required one year after the effective date. European fund sponsors with US public pension plan investors will be subject to the Pay-to-Play Rule. While many European fund sponsors and their executives and employees may be unlikely to make US political contributions, they should consider developing and implementing policies to ensure that their executives and employees do not make prohibited campaign contributions that could result in a ban on investments by such pension plan investors in their funds for a significant period.
While the effects of the recently proposed regulatory reform legislation and rulemaking in the US will not be immediate, the regulations already approved and in their currently proposed form are ambitious in their reach to encompass non-US sponsors, and could have significant ramifications for European fund sponsors in the future. European fund sponsors that have US offices or operations, or that manage assets of US investors, should begin to consider the effects of these regulations on their structures and internal policies and recordkeeping and reporting procedures.