12.07.2010

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Updates

On November 19, 2010, the Securities and Exchange Commission released two companion releases proposing new rules related to registration requirements for investment advisers to private funds, including hedge funds, private equity funds and other pooled investment vehicles.  The proposed new rules and rule amendments would exempt from registration advisers to mid-sized private funds, clarify operation of the new foreign private adviser exemption, define the term “venture capital fund," provide for the transition of smaller advisers from federal to state registration, and establish reporting requirements for certain private fund advisers.  Taken together, the releases are significant steps in the SEC’s implementation of the Private Fund Investment Advisers Registration Act of 2010, or the Private Advisers Act, and shed much-anticipated light on how the SEC will approach the regulation of private fund advisers.

The Private Advisers Act is part of the Dodd-Frank Wall Street Reform and Consumer Protection Act, or the Financial Reform Act, which was signed into law on July 21, 2010.  It requires investment advisers to most private funds to register with the SEC by July 21, 2011 on Form ADV under Section 203 of the Investment Advisers Act of 1940.

The Exemption Release

One of the SEC's companion releasesproposes new rules under the Investment Advisers Act that would

  • implement the exemption from registration provided by the Private Advisers Act, and provide related definitions, for advisers to “mid-sized” private funds with less than $150 million in assets under management, or AUM, in the  United States;
  • clarify the meaning of certain terms included in the registration exemption under the Private Advisers Act for foreign private fund advisers; and
  • define the term “venture capital fund.”

The Implementing Release

The second release proposes new rules and rule amendments under the Investment Advisers Act that, among other things, would establish

  • new AUM thresholds for SEC registration, which “will require a significant number of advisers currently registered with the SEC to withdraw . . . and to switch to registration with one or more state securities authorities”; and

  • the reporting requirements for advisers to mid-sized private funds and venture capital funds.

Registration Requirements

Pre-Financial Reform Act Exceptions. 

Prior to the enactment of the Private Advisers Act, advisers to private funds avoided registering with the SEC by relying on the exception afforded by Section 203(b)(3) of the Investment Advisers Act.  This exception allowed a private fund adviser to avoid registration as long as the adviser (i) had fewer than 15 clients during the course of any rolling 12-month period, (ii) did not hold itself out generally to the public as an investment adviser, and (iii) did not serve as investment adviser to a registered investment company.

Post-Financial Reform Act Exemptions.  The Private Advisers Act repeals the former provisions of Section 203(b)(3) and establishes in their place a narrow framework of conditional exemptions from registration for certain private fund advisers, including, among others:

  • “mid-sized” advisers with less than $150 million in AUM in the United States that solely advise private funds;
  • foreign advisers (i) with less than $25 million aggregate AUM attributable to U.S. clients and investors (or a higher amount that the SEC deems appropriate by rule), (ii) with no place of business in the United States, (iii) that, during the course of any rolling 12-month period, have fewer than 15 total U.S. clients and investors in the private fund(s) under management, and (iv) that do not hold themselves out to the U.S. public as investment advisers; and
  • advisers that solely advise venture capital funds, as distinguished from private equity funds.

Mid-Sized Private Fund Adviser Exemption

In its exemption release, the SEC seeks to address interpretive questions raised by the provisions of the Private Advisers Act that create a carve-out from registration for advisers to mid-sized private funds.

  • Solely Private Funds.  As proposed, advisers eligible for the exemption may only advise U.S. private funds, including private funds that invest in other private funds.  There is no restriction on the number of private funds under an adviser’s management, “provided the aggregate value of the adviser’s private fund assets is less than $150 million.”
  • Foreign Advisers.  A foreign adviser may take advantage of the exemption to the extent that all of the adviser’s U.S. clients are qualifying private funds.
  • AUM Calculation.  To be eligible for the proposed exemption, an adviser would have to aggregate the value of all private fund assets it manages in the United States on a quarterly basis to determine if it remains below the $150-million threshold.  AUM would be calculated by reference to Form ADV, under which the SEC has proposed a uniform method of calculating AUM.  The new formula would include the following types of private fund adviser assets:
    • proprietary assets, if any;
    • assets managed without receipt of compensation;
    • assets of non-U.S. clients; and
    • uncalled capital commitments.
  • Assets in the United States.  All of an adviser’s AUM would be deemed to be “in the United States” for purposes of the mid-sized private fund adviser exemption if the adviser’s principal office and place of business is in the United States.  A foreign adviser—whose principal office and place of business are presumably outside of the United States—need only count the assets of its clients that are residents of the United States to calculate the $150-million threshold.

Practical Tip

  • How does the SEC define "United States"?  The SEC proposes that the new rules under the Private Advisers Act generally incorporate the definition of “U.S. person” and “United States” set forth in Regulation S under the Securities Act of 1933, except that a U.S. person also includes any discretionary or similar account held for the benefit of a person in the United States by a non-U.S. dealer or by a fiduciary of an investment adviser relying on the exemption.  In determining an adviser’s principal office and place of business, the SEC will look to the location where the adviser controls, or has ultimate responsibility for, the management of private fund assets, even though day-to-day management of certain assets may take place at another location.

Foreign Private Adviser Exemption

The SEC has proposed the following definitions for purposes of the exemption from registration established by the Private Advisers Act for foreign advisers to private funds:

    • “Client.”  Carrying over much of the safe harbor currently afforded foreign advisers, the SEC’s proposed rules would allow a foreign private fund adviser to treat a natural person as a single client including
      • that person’s minor children, regardless of whether they live in the same principal residence;
      • any relative, spouse or relative of the spouse of the person who lives in same principal residence; and
      • all accounts and all trusts whose only primary beneficiaries are the person and/or any of his or her minor children, spouse or relatives living at the same principal residence.
    Similarly, the proposed rules would permit foreign advisers to treat as a single client
    • a corporation, general partnership, limited partnership, limited liability company, trust or other legal organization to which the adviser provides investment advice based on the organization’s investment objectives; and
    • two or more legal organizations that have identical shareholders, partners, limited partners, members or beneficiaries.
  • “Investor.”  The term “investor” is not currently defined under the Investment Advisers Act.  The new definition proposed by the SEC is meant to prevent foreign advisers from attempting to avail themselves of the foreign private adviser exemption by establishing intermediate accounts through which investors may access a private fund and not be counted for purposes of the exemption.  The proposed rule defines an investor as any person who would be included in determining
    • whether the limit of 100 beneficial owners is met for purposes of the exemption from registration with the SEC for certain private funds provided by Section 3(c)(1) of the Investment Company Act of 1940;
    • whether the outstanding securities of a private fund are owned exclusively by qualified purchasers (generally those entities and individuals with at least $5 million in investments) as provided by Section 3(c)(7) of the Investment Company Act.
    The proposed definition of investor for purposes of the foreign private adviser exemption also includes beneficial owners who are “knowledgeable employees” of a private fund and beneficial owners of “short-term paper,” as defined by Section 2(a)(38) of the Investment Company Act, issued by the private fund, even though such investors would not otherwise be deemed beneficial owners or qualified purchasers under Section 3 of the Investment Company Act.

Venture Capital Fund Exemption

The Private Advisers Act directs the SEC to define the term “venture capital fund” for purposes of the new registration exemption under Section 203(b)(3) of the Investment Advisers Act, no later than July 21, 2011.  Ahead of schedule, the SEC's exemption release does just that.  Read our November 23, 2010 Update.

Federal vs. State Registration

The Financial Reform Act imposes new thresholds of eligibility for federal registration for all investment advisers, including advisers to private funds, which will become effective July 21, 2011. Generally under the amended registration requirements, an adviser

  • must register with the SEC if it has $100 million or more in AUM (or a higher amount that the SEC deems appropriate by rule);
  • must register with the securities regulator of the state(s) in which it maintains a principal office or place of business if it has between $25 million and $100 million in AUM (or such different amounts as the SEC may deem appropriate by rule); and
  • is not required to register with any state or the SEC if it has less than $25 million in AUM.  Advisers that are required to register with a state may not register with the SEC unless the adviser would be required to register with 15 or more states, in which case the adviser may register with the SEC.

Transition to State Registration.   The SEC will not adopt grandfathering rules with respect to the new AUM registration thresholds.  Approximately 4,000 advisers currently registered with the SEC under the lower pre-Financial Reform Act AUM thresholds will be required to withdraw from SEC registration and re-register with the appropriate state securities regulator(s) by October 19, 2011.  The SEC has proposed new Rule 203A-5 under the Investment Advisers Act, which would establish the steps for advisers with less than $100 million in AUM, including any private fund advisers currently registered with the SEC, to follow to transition to state registration.

Trap for the Unwary
  • An adviser’s mistaken belief that it does not have to register with the SEC is no defense.  The SEC’s November 19 rule releases propose to rescind the safe harbor from federal registration currently provided under the Investment Advisers Act for an adviser registered with “the state securities authority of the state . . . based on a reasonable belief that it is prohibited from registering with the SEC because it does not have sufficient assets under management.”

Practical Tip

  • Even federally registered advisers may still have to comply with certain state registration requirements.  Advisers that are registered with the SEC are not required to register with any state, except that a state may license, register or otherwise qualify an investment adviser representative who has a place of business located in that state and meets certain threshold requirements.  The North American Securities Administrators Association provides information about state investment adviser laws and how to contact state securities regulators at www.nasaa.org.

Reporting Requirements for Exempt Private Fund Advisers

Although advisers to venture capital funds and mid-sized private funds are exempt from SEC registration, the Private Advisers Act nonetheless requires that these exempt advisers maintain and furnish to the SEC any annual or other reports that the SEC determines to be necessary or appropriate in the public interest or for the protection of investors.  In its implementing release, the SEC explains that in light of this increased responsibility for oversight of private funds, it is proposing to require an adviser to venture capital funds and mid-sized private funds to electronically file with the SEC, on amended Form ADV, information about its operations, including, among other topics:

  • the form of the adviser's organization and identity of its control persons, if any;

  • the adviser’s other business activities and financial industry affiliations; and

  • any conflicts between the interests of the adviser and the private funds it advises, and how those conflicts of interests are addressed.

Practical Tip

  • Form ADV is the Uniform Application for Investment Adviser Registration under the Investment Advisers Act.  The SEC proposes to re-title the form to reflect that it will also serve as a Report by Exempt Reporting Advisers.  The public would be able to view private fund advisers’ most recent Form ADV filings through the Investment Adviser Public Disclosure System, which is accessible at www.adviserinfo.sec.gov.

SEC Requests for Comments

Both of the SEC’s November 19 companion rule releases solicit a wide variety of comments on the proposed new rules and rule amendments.  Advisers to all types of private funds, and especially to venture capital and mid-sized funds, may want to consider submitting comments to the SEC for its consideration in adopting any final rulemaking.  Comments are due to the SEC on or about the first week of January 2011.

Additional Information

This update is only intended to provide a summary of the SEC's proposed rules.  You can read the full text of the SEC's releases at http://www.sec.gov/rules/proposed/2010/ia-3111.pdf and http://www.sec.gov/rules/proposed/2010/ia-3110.pdf.  


© 2010 Perkins Coie LLP


 

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