07.21.2010

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Updates

On June 30, 2010, the House of Representatives approved the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Financial Reform Act, a comprehensive and expansive set of financial reforms widely thought to be the toughest changes to financial regulation in the United States since the Great Depression.  The Senate approved the Financial Reform Act on July 15, 2010, and President Obama signed it into law on July 21, 2010.  The Financial Reform Act implements a wide array of financial and regulatory reforms, including many that will directly impact private funds and their advisers, such as new registration and reporting requirements and changes to the definition of “accredited investor” under Regulation D.  This Update provides highlights of the Financial Reform Act relevant to private funds and their advisers and offers practical advice.

Registration of Investment Advisers to Private Funds Required

The Financial Reform Act will have a significant impact on advisers to many private funds by requiring their registration under the Investment Advisers Act of 1940 within one year following enactment, through the elimination of the “private adviser exemption” currently in Section 203(b)(3) of the Investment Advisers Act (commonly known as the “15 client” exemption).  The Financial Reform Act defines a “private fund” as an issuer that would be an “investment company” under
Section 3(a) of the Investment Company Act of 1940, but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.

Previously, many investment advisers to private funds relied on the 15 client exemption to avoid registration under the Investment Advisers Act and the many reporting and other obligations imposed on registered advisers.  Now registration will be required for these advisers unless they qualify for one or more of the limited exemptions described below.  Investment advisers required to register will need to comply with a host of regulatory obligations under the Investment Advisers Act, including rules relating to client asset custody, recordkeeping, advisory contracts, performance fees, ethics, personal trading policies, investment and financial reporting and advertising.  These obligations will significantly increase the administrative burdens of these advisers.  Although the registration requirement will take effect one year after the date of enactment of the Financial Reform Act, investment advisers may voluntarily register before the effective date.

Certain Investment Advisers Exempt From Registration.  Importantly, the Financial Reform Act exempts from registration investment advisers to venture capital funds, private funds with less than $150 million in assets under management, family offices, small business investment companies and foreign private advisers.

    • Venture Capital Fund Advisers:  The Financial Reform Act does not define “venture capital fund” but instead directs the Securities and Exchange Commission to issue final rules within one year to define the term.  There is speculation that the SEC will define the term based on the size of the fund or the fund’s business strategy of investing only in small or startup businesses.
    • Private Funds Under $150 Million:  Because assets under management will include all private funds for which investment advice is provided, and because this threshold will need to be satisfied continuously, it is expected that relatively few middle market private funds will be able to avoid registration under this exemption.
    • Family Offices:  The Financial Reform Act does not define “family office” but instead directs the SEC to define the term in a manner that is consistent with its prior guidance on the subject and that recognizes the range of organizational structures and management arrangements customarily employed by family offices.
    • Small Business Investment Company Advisers:  Small business investment company advisers that are exempt from the Financial Reform Act’s registration requirements include those advisers that advise only (i) small business investment companies licensed under the Small Business Investment Act of 1958, (ii) entities that have received a notice to proceed to qualify for a license from the Small Business Administration, or (iii) applicants related to one or more licensed small business investment companies that have applied for another license.
    • Foreign Private Advisers:  The new limited exemption for “foreign private advisers” applies to any adviser that (i) has no place of business in the United States, (ii) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser, (iii) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million, or such higher amount as the SEC may determine appropriate, and (iv) neither holds itself out generally to the public in the United States as an investment adviser nor acts as an investment adviser to any registered investment company under the Investment Advisers Act or company electing to be a business development company under the Investment Advisers Act (without withdrawing its election). 
    • Non-Fund Advisers:  Advisers to clients that are not “funds” will be exempt from registration if the adviser has less than $100 million in assets under management. 

Practical Tip

Future SEC Rulemaking May Determine the Applicability of the Registration Requirements to You.  Because the final rules defining the term “venture capital fund” have not yet been determined, private fund advisers should consult their attorneys while continuing to monitor changes and developments in the SEC’s rulemaking process, as these definitions will affect whether a private fund is subject to the new registration requirements under the Financial Reform Act.  Perkins Coie will be monitoring this rulemaking procedure closely and will be considering comments to the SEC’s proposed regulations implementing this and other provisions of the Financial Reform Act.

  

Trap for the Unwary

Fund Advisers May Become Subject to State Regulation.  Even if exempt from registration under the Investment Advisers Act, fund advisers may be subject to state regulation through reforms in the Financial Reform Act.  Specifically, the Financial Reform Act changes the threshold for exclusive federal jurisdiction of registered investment advisers.  Prior to the Financial Reform Act, registered advisers with less than $25 million of assets under management were subject exclusively to state securities regulation, registered advisers with more than $25 million but less than $30 million of assets under management could choose between state and federal regulation, and registered advisers with $30 million or more of assets under management were subject exclusively to federal regulation.  The Financial Reform Act raises this threshold for federal regulation to $100 million.  Now, investment advisers with less than $100 million of assets under management will be subject to exclusive state regulation unless the investment adviser (i) is an adviser to an investment company registered under the Investment Company Act or (ii) advises a company that elected to be a business development company pursuant to Section 54 of the Investment Company Act and has not withdrawn such election.  This change is expected to result in a 25% to 30% increase in the number of advisers subject to state regulation.  Upon enactment of the Financial Reform Act, funds subject to state regulation should consult their attorneys to ascertain the nature of the specific state compliance obligations to which they will be subject.

It is not clear how investment advisers with assets under management of between $25 million and $100 million who are currently registered under the Investment Advisers Act will be treated under the Financial Reform Act.  Absent the inclusion of a grandfather provision addressing the issue in the final legislation, it appears that the change in the threshold will require advisers who have already registered to deregister with the SEC.


Performance-Based Compensation of Private Equity Fund Advisers Limited, Subject to Certain Exceptions

Section 205(a)(1) of the Investment Advisers Act prohibits registered advisers from receiving compensation based on a share of the capital gains on, or capital appreciation of, client funds (e.g., carried interest) unless one or more exceptions apply.  These exceptions generally fall into two categories:  (i) exceptions based on the type of compensation arrangement and (ii) exceptions based on the type of investors in the fund.  Historically, advisers to private equity funds who were exempt from registration were not subject to these limitations.  Following enactment of the Financial Reform Act, limitations on carried interest compensation, coupled with the likelihood of higher taxation of carried interest, may cause fund sponsors to consider restructuring their
performance-based fee arrangements.  Private equity firms required to register under the Investment Advisers Act will need to satisfy at least one of these exceptions to continue to receive carried interest on the profits of the funds they manage.

Exceptions Based on the Type of Compensation.  Section 205(b) of the Investment Advisers Act specifically permits registered advisers to structure performance-based compensation as follows:

    • the adviser’s compensation may be based on a percentage of the total assets in the client’s account, determined as of a specified date or dates or averaged over a defined period
      (i.e., asset-based fees); or
    • the adviser’s compensation may be based on a percentage of the total assets in the client’s account, averaged over a defined period, with the percentage increasing or decreasing proportionately with the investment performance of the fund over such period relative to the performance of an appropriate index of securities prices or other measure of investment performance permitted under SEC regulations (i.e., fulcrum fees).

Exceptions Based on the Type of Investors.  For private equity firms that do not structure their performance-based compensation using asset-based fees or fulcrum fees, Section 205(b) and Rule 205-3 of the Investment Advisers Act allow registered advisers to receive performance-based compensation (regardless of structure) from the following types of investors:

    • funds exempt from registration under Section 3(c)(7) of the Investment Company Act, that is funds whose investors all qualify as “Qualified Purchasers” under the Investment Company Act;
    • “Qualified Clients” or investors who have at least $750,000 in assets under management with the adviser or whose net worth equals or exceeds $1.5 million (note that, with respect to registered investment companies and private funds exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act, the adviser must “look through” the fund and determine whether each investor satisfies the Qualified Client exemption to take carried interest with respect to such investor);
    • business development companies, provided the compensation does not exceed 20% of the realized capital gains on the funds of the business development company; and
    • persons who are not residents of the United States.

Trap for the Unwary

Section 3(c)(1) Funds Need to Determine the “Qualified Client” Status of Their Investors.  General partners of “3(c)(1)” funds may not continue to charge carried interest to limited partners who do not meet the thresholds set forth in the definition of  “Qualified Clients” unless another exemption is available (e.g., limited partners who are not residents of the United States).  Registered advisers to private funds that previously relied on the exemption from registration under Section 3(c)(1) of the Investment Company Act should consult their attorneys to determine whether their performance-based fee arrangements qualify for one of the exemptions to Section 205(a)(1) of the Investment Advisers Act.

 

Recordkeeping and Reporting Obligations of Private Equity Fund Advisers

Advisers of private funds that are required under the Financial Reform Act to register with the SEC will be subject to new reporting and recordkeeping requirements.  The SEC is authorized to require registered investment advisers to maintain records and to file reports as the SEC deems necessary or appropriate in the public interest and for the protection of investors, taking into account fund size, governance, investment strategy, risk and other factors.  Governmental bodies, such as the Board of Governors of the Federal Reserve System or the Financial Stability Oversight Council, will assess these “systemic risk” factors.  The Oversight Council is a new ten-voting-member council chaired by the Treasury Secretary and charged with identifying and monitoring systemic risks to the financial markets.

Information Fund Advisers Must Maintain Is Expansive.  All records that fund advisers must maintain will be subject to periodic and special examination by the SEC, and may be subject to filing requirements as well.  The types of records that fund advisers must maintain and make available for SEC inspection (and possible filing with the SEC) include information on the following:

    • amount of assets under management and use of leverage, including off-balance sheet leverage;
    • counterparty credit risk exposure;
    • trading and investment positions;
    • trading practices;
    • valuation policies and practices of the fund;
    • types of assets held;
    • side arrangements or side letters whereby certain investors in a fund obtain more favorable rights or entitlements than other investors; and
    • other information that the SEC, in consultation with the Oversight Council, determines to be necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

By comparison, registered investment advisers currently are subject to comprehensive recordkeeping requirements as well as restrictions on the location of the records and the length of time that the records must be maintained.  Categories of records that registered investment advisers must keep under current rules include financial and corporate records, written communications, advertisements and performance information, client disclosures, records relating to referral fees and portfolio management services, codes of ethics and records relating to compliance policies and procedures.

Even private funds exempt from registration under the Investment Advisers Act must maintain these records and provide to the SEC any annual or other reports the SEC determines necessary or appropriate in the public interest or for the protection of investors.

SEC Still Must Determine Specific Rules Regarding Recordkeeping and Reporting.  The final rules regarding record maintenance and reports by registered private equity advisers have not yet been determined, and the Financial Reform Act contains no timeline over which the SEC is required to issue these rules.  Although the specific details of these final rules are yet uncertain, the Financial Reform Act provides the SEC with the authority to establish different reporting requirements for different classes of fund advisers based on the type or size of the private funds they advise.

Private Funds May Request Confidential Treatment.  To the extent any “proprietary information” of a private fund is contained in reports required to be filed with the SEC, the Financial Reform Act provides for protections from public disclosure under the Freedom of Information Act.  The term “proprietary information” is defined to include sensitive, nonpublic information regarding: (i) the investment or trading strategies of the investment adviser; (ii) analytical or research methodologies; (iii) trading data; (iv) computer hardware or software containing intellectual property; and (v) any additional information that the SEC determines to be proprietary.  Client identities may not be protected under the Investment Advisers Act as the Financial Reform Act allows the SEC to require disclosure of client identities and investments to assess the potential for systemic risk.

Practical Tip

Begin Implementing “Best Practices” in Advance of Future SEC Rulemaking.  Because the final rules regarding specific recordkeeping and reporting requirements (and the extent to which advisers will be subject to these requirements) have not yet been determined, private fund advisers should consult their attorneys and begin to implement “best practices” while continuing to monitor changes and developments in the SEC’s rulemaking process, as these rules will affect what, if any, recordkeeping and reporting requirements will apply.


Accredited Investor Definition for Individuals Changed

The Financial Reform Act revises certain portions of the “accredited investor” definition regarding individuals participating in private placements.  Prior to enactment of the Financial Reform Act, an individual was an accredited investor if he or she had a net worth, either individually or jointly with his or her spouse, in excess of $1 million, with “net worth” defined as total assets (including home and personal property) minus total liabilities (including mortgage obligations).  Effective immediately, and for the next four years, the net worth threshold for individuals remains $1 million, but with “net worth” now defined as total assets other than the value of the investor’s primary residence minus total liabilities.

SEC May Periodically Modify the Accredited Investor Definition.  The SEC is authorized to adjust the individual accredited investor thresholds that do not relate to net worth, such as the “net income test” (currently defined to mean an individual with income in excess of $200,000, or joint income with his or her spouse in excess of $300,000, in each of the last two calendar years and reasonably expected in the current calendar year).  Beginning in four years and again every four years thereafter, the SEC is authorized to review the individual accredited investor definition and modify the definition as appropriate for the protection of investors, in the public interest and in light of economic conditions.

Practical Tip

Private  Offering Documents May Need Updating.  Private funds and other issuers currently raising capital through a private placement offering should consult their attorneys to revise their subscription documents to incorporate the new net worth test for individual accredited investors and ensure these updated subscription documents are used with prospective investors.  Even if a potential investor is currently a limited partner in an existing fund, it will need to meet the criteria to participate in the new fund.  If the adviser to the private fund must register under the Investment Advisers Act, the subscription documents should incorporate the “Qualified Client” test as well.


Volcker Rule Imposes New Restrictions on Hedge Funds and Private Equity Funds by Banking Institutions

The Financial Reform Act contains a number of provisions first proposed by Paul A. Volcker, the former Federal Reserve chairman, restricting the ability of banks from engaging in proprietary trading, that is, trading for their own accounts.  The Volcker rule aims to minimize the ability of banks to use low cost, federally insured deposits for high risk investments.  The Financial Reform Act adopted significant portions of the Volcker rule which will affect both hedge fund and private equity fund advisers, as well as other financial market participants.

Terminology Is Important to Understanding the Volcker Rule.  Key definitions in the Financial Reform Act’s implementation of the Volcker rule include:

    • Hedge fund” or “private equity fund” means an issuer that would be an investment company, as defined in the Investment Company Act, but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act, or other similar funds as the Federal Reserve, the SEC or the Commodities Futures Trading Commission may, by rule, determine.
    • Banking entities” are institutions whose deposits are federally insured, thrifts, any company that controls or is under common control with these types of institutions or thrifts and any entity considered a bank holding company under the
      International Banking Act of 1978.
    • Sponsoring” a fund means to (i) serve as the general partner, managing member or trustee of the fund; (ii) select or control, in any manner, a majority of the management of the fund; or (iii) share with the fund the same name or a variation of the same name.
    • Illiquid funds” means a hedge fund or private equity fund that, as of May 1, 2010, was principally invested in illiquid assets, such as portfolio companies, real estate investments and venture capital investments and makes all investments consistent with a strategy to invest principally in illiquid assets.  The Financial Reform Act does not provide any additional guidance on what constitutes an illiquid asset.
    • Proprietary trading” means engaging as a principal for the trading account of a banking entity or nonbank financial company in any transaction to purchase or sell, or otherwise acquire or dispose of any security, any derivative, any contract of sale of a commodity for future delivery, any option on any of the foregoing or any other security or financial instrument that the Federal Reserve, the SEC or the Commodities Futures Trading Commission may determine.
    • Trading account” means any account used for acquiring or taking positions in securities and the types of instruments identified above principally for the purpose of selling in the near term (or otherwise with the intent to resell in order to profit from short-term price movements), and any such other accounts as the Federal Reserve, the SEC or the Commodities Futures Trading Commission may determine.

Banking Entities' Sponsorship of Hedge Funds and Private Equity Funds Is Restricted.  The Financial Reform Act does not prohibit a banking entity from organizing and offering hedge funds or private equity funds, nor does it prohibit a banking entity from serving as a general partner, managing member or trustee of such a fund, selecting or controlling a majority of the directors, trustees or management of such a fund or incurring any necessary expenses in connection with the foregoing.  However, the Financial Reform Act does impose restrictions on a banking entity’s ability to sponsor a hedge fund or private equity fund.  These restrictions require that the banking entity:

    • provide bona fide trust, fiduciary or investment advisory services;
    • organize and offer the fund only to its customers in connection with these services;
    • not acquire or retain any ownership in the fund except for the following investments:

(a)   investments made in any amount of the total ownership of the fund to establish the fund’s operations and to attract unaffiliated investors, and

(b)   “de minimis” investments, provided that the banking entity (i) actively seeks unaffiliated investors in order to dilute its initial investment, (ii) reduces its total investment in the fund (through redemption, sale or dilution) to no more than 3% of the total ownership of the fund within one year of the fund’s establishment, and (iii) has an investment in the fund that is deemed “immaterial” and in no case exceeds 3% of the banking entity’s Tier 1 capital;

    • comply, along with its affiliates, with the Sections 23A and 23B restrictions contained in the Federal Reserve Act;
    • not, directly or indirectly, guarantee or otherwise insure the obligations or performance of the fund;
    • not share the same name (or a variation thereof) as the fund for any purpose;
    • not allow its directors or employees to retain an equity interest in the fund, unless they directly provide investment advisory services;
    • inform investors, in writing, that the investors and not the banking entity will bear any losses in the fund; and
    • not acquire or retain hold any ownership interest in or sponsor a hedge fund or private equity fund that is solely outside the United States under Section 4(c)(9) or 4(c)(13) of the Bank Holding Company Act, unless a U.S.-organized banking entity directly or indirectly controls the banking entity and it does not offer or sell an ownership interest in the fund to a U.S. resident.

In addition, regulators may restrict other activities related to fund sponsorship by banking entities as necessary to promote and protect the banking entity and U.S. financial stability.

Practical Tip

SEC May Implement Additional Restrictions on Fund Sponsorship by Banking Entities.  The Financial Reform Act gives the SEC and other financial regulatory bodies discretion to impose additional restrictions on fund sponsorship by banking entities, including implementing rules on diversification and capital requirements.  Advisers should consult their attorneys while closely monitoring any additional regulatory guidance and commentary to ascertain any additional restrictions to fund sponsorship.


Proprietary Trading by Banking Entities Is Restricted.  
While the Financial Reform Act restricts proprietary trading by banking entities, it does provide certain permitted trading exceptions to these restrictions, subject to any other state and federal regulations.  These permitted trading activities include:

    • purchasing and selling of U.S. government and agency securities;
    • instruments issued by Ginnie Mae, Fannie Mae, Freddie Mac, a Federal Home Loan Bank, the Federal Agriculture Mortgage Corporation or a Farm Credit System institution chartered under the Farm Credit Act of 1971;
    • market-making activities;
    • risk-mitigating hedging activities related to individual or aggregated positions designed to reduce risks to the banking entity in connection with its position;
    • order entry for customers;
    • investment in one or more small business investment companies, as defined in the Small Business Investment Act of 1958 and other investments designed to “promote the public welfare”;
    • qualified rehabilitation investments (e.g., historic sites);
    • investments by insurance companies that are regulated under state insurance law; and
    • proprietary trading by a banking entity solely outside the U.S., provided the banking entity is not controlled, directly or indirectly, by a banking entity organized in the U.S.

As with fund sponsorship restrictions, regulators may restrict other activities related to proprietary trading as necessary to promote and protect the banking entity and U.S. financial stability.

Trap for the Unwary

Nonbank Institutions Could Be Subject to Volcker Rule Restrictions if Classified as Supervised Nonbank Financial Institutions.  While the Financial Reform Act does not impose Volcker restrictions on nonbank institutions, it provides the Federal Reserve with the authority to classify certain companies substantially engaged in activities of a financial nature as “supervised nonbank financial institutions.”  Companies classified as “supervised nonbank financial institutions” may be subject to regulations developed by the Federal Reserve restricting their proprietary trading and investment in hedge funds and private equity funds.  Because the Federal Reserve and the Financial Reform Act provide little guidance on what companies will be classified as “supervised nonbank financial institutions” other than a nonbank financial company that is supervised by the Board of Governors of the Federal Reserve, the classification of companies as such and the Federal Reserve’s subsequent creation and enforcement of guidelines for these institutions should be closely examined. 


Volcker Rule Compliance Is Not Required Immediately.  The Financial Reform Act does not require compliance with the Volcker rule until the earlier of 12 months after issuance of final rules or two years from the date of the Volcker rule's enactment.  Within two years of the effective date of the Volcker Rule, banking entities and those nonbank financial institutions identified by the SEC as required to comply must move into compliance with the Volcker rule.  The Federal Reserve may grant up to three one-year extensions, if found not detrimental to the public interest, and up to a total of five years for illiquid funds so that they may fulfill contractual obligations in effect on May 1, 2010, or take any ownership interest in or provide capital to an illiquid fund.

Additional Changes to Carried Interest Taxation Expected

As a final note, many observers believe that Congress will continue to work on new legislation that will change the tax treatment of carried interest received by investment fund managers.  The House version of the American Jobs and Closing Tax Loopholes Act of 2010 would have taxed as regular income 75% of carried interest paid as compensation to private equity firms, hedge funds, venture capital funds and some real estate partnerships after 2012.  The House bill capped the percentage of carried interest compensation that would have been treated as capital gains at 25% and the remainder would presumably be taxed at the highest ordinary income rate, which is set to step up to 39.6% in 2011.  The Senate version of the bill would have treated 35% as capital gains, and would have exempted energy partnerships from any tax increase.  Although the American Jobs and Closing Tax Loopholes Act of 2010 failed in the Senate, most observers believe changes to the tax treatment of carried interest are likely to occur later this year.

Additional Information

This Update is only intended to provide a summary of the Dodd-Frank Wall Street Reform and Consumer Protection Act. 


 

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