As we have reported in recent briefings, on December 11, 2009 the United States House of Representatives (the “House”) passed its version of comprehensive financial regulatory reform, The Wall Street Reform and Consumer Protection Act of 2009 (the “Wall Street Reform Act”). This briefing summarizes the component of the Wall Street Reform Act that would require most investment advisers to hedge funds, private equity funds and other private funds (“private fund advisers”) to register as investment advisers under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), entitled the Private Fund Investment Advisers Registration Act of 2009 (the “Registration Act”). The Registration Act is the latest in a series of legislative efforts to subject private fund advisers and/or private funds to federal regulation.1 What is significant, however, is that unlike these previous efforts, the Registration Act has actually passed one chamber of the Congress. While the Registration Act represents the full House’s view on these issues, it will have to be reconciled with whatever legislation finally is passed by the United States Senate, which has been reported to be in the process of producing its own version of comprehensive financial regulatory reform legislation.
Interestingly, the Registration Act requires registration only of private fund advisers, and not the private funds themselves (such as by imposing some form of registration under the Investment Company Act of 1940, as previous bills have proposed).2 The Registration Act, however, requires private fund advisers to maintain records and provide reports regarding certain aspects of the activities of the private funds they manage. Another interesting aspect of the Registration Act is that the legislation sets a comparatively high threshold for requiring registration with the Securities and Exchange Commission (the “SEC”), in that private fund advisers with less than $150 million in assets under management would not be eligible to register under the Registration Act (although the Registration Act does contain a provision that may have the effect of requiring advisers to “midsize private funds” to register under state law or, alternatively, the Advisers Act).3 Other proposed bills have set lower minimum assets under management thresholds for registration to be required.4 Additionally, unlike other legislative proposals,5 the Registration Act does not provide an exemption from registration for “family offices.”
Elimination of “Private Adviser Exemption” for Private Fund Advisers. The Registration Act eliminates the exemption from registration upon which many private fund advisers rely, the so-called “private adviser exemption” of Advisers Act Section 203(b)(3). Under Section 203(b)(3), an investment adviser is exempt from registration as such if it has had fewer than 15 clients during the preceding 12 months, does not hold itself out to the public generally as an investment adviser, and does not advise any registered investment company or business development company. The Registration Act eliminates this exemption for private fund advisers. Subject to certain exceptions discussed below, the Registration Act requires investment advisers to “private funds”, as defined, and other advisers now relying on the exemption to register as investment advisers with the SEC under the Advisers Act (“registered advisers”).
Definition of “Private Fund”. The Registration Act defines “private fund” as any investment fund that (i) relies on either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, as amended, to avoid having to register under that act, and (ii) is organized under the laws of the U.S. or a U.S. state, or has 10% or more of its securities owned by U.S. persons.
Registration and Examination of Advisers to “Mid-Size Private Funds”. In prescribing regulations to require the registration and examination of registered advisers to “mid-sized private funds,” the Registration Act requires the SEC to take into account the “size, governance, and investment strategy of such funds to determine whether they pose a systemic risk, and [to] provide for registration and examination procedures which reflect the level of systemic risk posed by such funds.” The Registration Act does not define the term “mid-size private funds,” and how this might relate to the $150 million threshold for mandatory registration discussed in this briefing. However, the Registration Act amends the Advisers Act to add a provision regarding the treatment of certain “mid-sized investment advisers” (which is not defined). This provision requires investment advisers with more than $25 million in assets under management to be subject to either state registration and examination, or if no state in which the investment adviser is registered conducts an examination, such investment adviser will be required to register with the SEC. The effect of this provision appears to be to require investment advisers (including private fund advisers) with more than $25 million but less than $150 million in assets under management to either register under state law or register under the Advisers Act.
Exemptions from Registration
The Registration Act exempts the following categories of private fund advisers from the registration requirement:
Smaller Advisers: Private fund advisers that have less than $150 million in assets under management are exempt from registration. Such smaller private fund advisers would instead be subject to the regulatory jurisdiction of state securities laws, and could be required to register as investment advisers in one or more states unless an exemption from registration under state law is available.
Venture Capital Advisers: Advisers of venture capital funds are exempt from registration. The Registration Act does not define the term “venture capital fund,” although the Registration Act requires the SEC to establish a definition of the term for purposes of this exemption.
Small Business Investment Company Advisers: Advisers of small business investment companies regulated by the Small Business Administration are exempt from registration.
Foreign Private Advisers: Foreign private advisers are exempt from registration. The term “foreign private adviser” is defined to mean an investment adviser that (i) has no U.S. place of business, (ii) has fewer than 15 U.S. clients and U.S. investors in private funds that it advises the during the preceding 12 months, (iii) has assets under management attributable to U.S. clients and U.S. investors in private funds that it advises of less than $25 million (or such higher amount as the SEC may prescribe), and (iv) does not hold itself out generally to the U.S. public as an investment adviser or act as an investment adviser to a registered investment company or a business development company.
Collection of Systemic Risk and Other Data
Records and Reports of Private Funds – Registered Advisers. The Registration Act gives the SEC broad power to require registered advisers to maintain such records and file such reports regarding the private funds advised by such registered advisers “as are necessary or appropriate in the public interest and for the protection of investors or for the assessment of system risk” as the SEC determines in consultation with the Board of Governors of the Federal Reserve System. Such records and reports will include, at a minimum, the amount of assets under management, the use of leverage (including off-balance sheet exposures), counterparty credit risk exposures, trading and investment positions, and trading practices. The records and reports of any private fund managed by a registered adviser would be considered to be the records and reports of the registered adviser for regulatory purposes, and would be subject to examination by the SEC.
Records and Reports of Private Funds – Unregistered Advisers. Importantly, the Registration Act also permits the SEC to require reporting from private fund advisers who are not registered advisers (e.g., private fund advisers with less than $150 million under management and advisers to venture capital funds) as the SEC determines to be necessary, “taking into account the public interest and potential to contribute to systemic risk.”
Different Reporting Requirements for Different Classes of Private Fund Advisers. The Registration Act also allows the SEC to set different reporting requirements for different classes of private fund advisers, whether or not they are registered advisers, based on the particular types or sizes of the private funds managed by such advisers.
Information Sharing, Disclosure and Confidentiality. The Registration Act requires the SEC to make available to the Board of Governors of the Federal Reserve System, and any other relevant governmental or regulatory entity having systemic risk responsibility, copies of all reports and documents filed with the SEC by a registered adviser as the Federal Reserve or such other entity “may consider necessary for the purpose of assessing the systemic risk of a private fund.” Such information will be kept confidential in a manner consistent with the SEC’s existing confidentiality guidelines, and third parties may not compel the SEC to disclose such information.
Private fund advisers should also note that registered advisers will be required to provide such other reports and documents to investors, prospective investors, counterparties, and creditors of any private fund as the SEC may by regulation “prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.” The SEC may not compel a private fund adviser to disclose proprietary information to third parties such as counterparties and creditors.
Recordkeeping and Other Compliance Requirements Generally. In addition to maintaining and submitting the records and reports that may be required specifically by the Registration Act, it is important to remember that a private fund adviser that is registered under the Advisers Act is required to comply with all requirements applicable to registered investment advisers generally, including but not limited to the implementation of certain required policies and procedures, codes of ethics and insider trading/confidentiality policies, compliance with custody procedures6, Form ADV, disclosure and recordkeeping requirements, and submitting to periodic examinations by SEC staff.
Adjustments of Qualified Client Standard for Inflation
Under the Advisers Act, registered investment advisers are able to charge a performance-based fee only to investors in funds and clients who are “qualified clients.” The term “qualified client” generally includes persons with at least $750,000 under the registered adviser’s management, or persons with a net worth of more than $1,500,000, among other persons. The Registration Act requires the SEC to periodically adjust for inflation the net worth and/or asset-based qualifications applicable to “qualified clients.” Such adjustment will occur not later than one year after the enactment of the Registration Act and then every five years thereafter.
Clarification of Rulemaking Authority
The Registration Act clarifies that the SEC has rulemaking authority to issue, amend and rescind such regulations and orders as are necessary or appropriate to the SEC’s exercise of its authority in implementing the Registration Act, including in particular, classifying and different requirements for private fund advisers and private funds based upon their size, scope, business model, compensation scheme, potential to create or increase systemic risk. The SEC also is permitted to ascribe different meanings to terms used in the Registration Act, including the term “client” (although, interestingly, the SEC is not permitted to change the definition of the term “client” to include an investor in a private fund).
Annual Fee Assessments
The Wall Street Reform Act contains a provision requiring the SEC to establish regulations to collect fees from registered advisers to help recover the cost of SEC staff inspections and examinations of registered advisers. These fees would be payable upon registration and each fiscal year thereafter. In setting these fees, the SEC is required to consider various factors, such as the investment adviser’s size and the number and type of its clients.
Private fund advisers that are subject to the Registration Act would be required to register no later than one year after the date of the enactment of the Registration Act. By this effective date, the registered adviser would be required to comply with all provisions of the Advisers Act applicable to registered investment advisers, including implementation of all required policies and procedures. Private fund advisers would be free to register prior to this effective date under current registration rules and procedures, but would be required to comply with any other requirements (such as reporting requirements) as and when such requirements take effect.