President Obama has signed into law the Private Fund Investment Advisers Registration Act of 2010 (the "Act") as part of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act, which enacts sweeping changes to the U.S. financial regulatory system intended to address both the causes of the recent financial crisis and other perceived gaps in U.S. financial regulation. The Act establishes a new investment adviser registration regime for managers of hedge funds and private equity funds and certain foreign advisers. It also alters the allocation of federal and state oversight responsibilities and changes certain investor eligibility criteria under the federal securities laws.
Below, we cover how the legislation impacts you (you can jump to each section by clicking on the bulleted item of interest to you, or scroll down to read the entire document):
The Act eliminates the "private adviser" exemption under the Investment Advisers Act of 1940 (the "Advisers Act"), which is the exemption that most hedge fund and private equity fund managers rely on to avoid registering as an investment adviser with the SEC. This exemption was based primarily on the number of clients an adviser had. Now, all hedge fund and private equity fund managers who manage private funds aggregating $150 million or more in assets will be subject to SEC investment adviser registration, unless another exemption is available—making mandatory what was previously a voluntary registration regime for most U.S.-based fund managers. Important exemptions and qualifications include:
The Act authorizes the SEC to require venture capital fund managers and managers of funds with less than $150 million in total assets—which are exempt from registration—to maintain such records and file such reports that the SEC deems necessary or appropriate in the public interest or for the protection of investors.
Foreign Private Advisers. A foreign private adviser is exempt if it (a) has no place of business in the U.S.; (b) has fewer than 15 clients and fund investors in the U.S.; (c) has less than $25 million (or such higher amount as the SEC may deem appropriate) in aggregate assets under management attributable to U.S. clients and fund investors; and (d) neither holds itself out generally in the U.S. as an investment adviser nor acts as an investment adviser to any registered investment company or business development company.
Many non-U.S. managers are not registered with the SEC in reliance on the private adviser exemption but manage funds with more than $25 million of assets from U.S. investors. The Act's new registration requirements will impact these managers; however, it is possible that the SEC may increase the $25 million threshold to a higher amount (e.g., $150 million in the case of foreign fund managers and/or $100 million in the case of foreign separate account managers) to apply a uniform and consistent registration threshold to both U.S. and non-U.S. managers. The SEC may also, as it has done in the past, adopt a lighter regulatory scheme for non-U.S. based managers to avoid imposing duplicative and potentially onerous regulatory requirements on managers whose home country supervisory authorities may subject them to regulatory oversight.
Family Offices. Although the Act gives the SEC authority to define the term "family office" for purposes of its exclusion from the definition of investment adviser under the Advisers Act, the Act requires the SEC to adopt rules that are consistent with previous SEC exemptive orders and that take into account the "range of organizational, management and employment structures and arrangements employed by family offices." In addition, the Act requires that the SEC grandfather certain specified family office related investment activities engaged in prior to January 1, 2010, and previously exempt from SEC registration.
For hedge and private equity fund advisers subject to SEC registration, the Act would authorize the SEC to impose substantial new recordkeeping and reporting requirements. The Act would treat all records and reports of a private fund that a registered investment adviser manages as the records and reports of the adviser itself and thus subject to examination by the SEC. The Act would also require registered hedge and private equity fund advisers to participate in systemic risk reporting to the newly established Financial Stability Oversight Council (the "Council). Specifically, fund advisers will be required to maintain records and provide the SEC with reports (which will be made available to the Council) concerning assets under management and the use of leverage, counterparty credit risk exposure, trading and investment positions, valuation policies and practices, types of assets held, side letters with certain fund investors, trading practices and other information necessary for an assessment of systemic risk.
Funds must maintain these records for as long as the SEC deems necessary, and the records may be subject to periodic or special examinations by the SEC. All record submissions to the SEC or the Council will be kept confidential (except with respect to disclosures to Congress, other government agencies or pursuant to court order) and are exempt from Freedom of Information Act disclosure. The Act attempts to strike a balance between the regulators' need to assess systemic risk and the fund advisers' need to keep their proprietary information confidential.
Mid-Size Fund Managers. The Act directs the SEC to consider the systemic risk posed by advisers to mid-size private funds based on the size, governance and investment strategy of such funds, and to establish appropriate (and presumably less burdensome) registration and examination procedures for advisers to such funds that are commensurate with the level of systemic risk they posed.
For managers with any separately managed account clients (either alone or in conjunction with the management of any private investment funds), the Act substantially modifies the applicable SEC registration thresholds. The new registration thresholds (inclusive of fund assets as well as separate account assets under management) are:
Any manager exempt from SEC registration should review state law to determine whether or not it is subject to any state investment adviser registration requirement. The change in the federal registration threshold raises issues about the capacity and resources of the states to regulate and examine what is expected to be a significantly increased number of state-registered investment advisers. Also, the applicability of the new registration regime to private equity fund managers will likely present new challenges to both federal and state regulators who may not be as familiar with the private equity business model.
Accredited Investors. The Act also adjusts the "accredited investor" standardfor individual investors in all private placement transactions, including private placements of hedge and private equity funds. SEC rules presently define accredited investors to include natural persons with income in each of the two most recent years in excess of $200,000 (or $300,000 for a couple) or with a net worth of $1 million either individually or jointly with the person's spouse (the "Net Worth Test"). The Act mandates that the Net Worth Test for all private placements shall exclude the value of the person's primary residence. The Act also mandates that the SEC review the entire accredited investor definition as it applies to natural persons every four years and authorizes the SEC to enact rules modifying the definition as appropriate in the public interest and to protect investors, but it freezes the Net Worth Test at $1 million, exclusive of the equity in an individual's primary residence, for the first fours years after enactment.
These changes would exclude certain previously qualified individual investors from investing in hedge and private equity funds—in particular, funds with fewer than 100 investors that rely on the Section 3(c)(1) exemption from registration under the Investment Company Act of 1940 ("3(c)(1) Funds").
Qualified Clients. The Act also subjects the current qualified client threshold of $1.5 million net worth to mandatory inflation adjustments within one year after enactment and every five years thereafter. This is relevant to the existing rule promulgated by the SEC exempting arrangements with "qualified client" investors from the Advisers Act prohibition on charging performance fees. Unlike the SEC's optional authority to modify the accredited investor definition every four years, the inflation adjustments to the qualified client threshold are mandatory and the SEC will implement them by order without notice or rulemaking, and they may significantly curtail the availability of hedge and private equity fund products (3(c)(1) Funds in particular) with carried interests or other performance fees with respect to investors who do not meet the adjusted qualified client threshold.
Proprietary Trading. Section 619 of the broader Dodd-Frank Act, commonly referred to as the "Volcker Rule," amends the Bank Holding Company Act of 1956 to prohibit banks from (i) engaging in proprietary trading activities, and (ii) investing in hedge funds and private equity funds, and acting as sponsor to those funds (e.g. serving as general partner, managing member or otherwise controlling the management of a fund). These prohibitions are subject to a number of important exceptions. Activities that are excluded from the proprietary trading ban include U.S Government and agency securities trading; underwriting and market-making; risk-mitigating hedging; agency transactions on behalf of customers; and certain activities engaged in by regulated insurance companies and certain non-U.S. institutions. Nevertheless, the applicable regulatory agencies may impose restrictions and limitations on such excluded activities in the future even though they are permitted under the rule.
As a result of these provisions, many bank proprietary trading desks may spin off or otherwise depart to start their own hedge funds or join other fund groups, which could create opportunities for existing fund managers that are able to scale up and absorb the additional personnel. Further, the reduction in bank trading activity will likely remove some liquidity (and competition) from the marketplace.
Hedge and Private Equity Fund Prohibition. The Volcker Rule also contains important exceptions to the ban on investing in or sponsoring hedge and private equity funds, provided that these permitted investments do not involve a "material conflict of interest" or cause a bank to have "material exposure…to high risk assets or high risk trading strategies." A major exception to the ban permits banks to organize and offer hedge and private equity funds if (i) the fund is organized and offered in connection with the bank's provision of "bona fide trust, fiduciary, or investment advisor services" to customers of the bank with respect to those services, and (ii) the bank's ownership in the fund is limited to a "de minimus investment." This means that a bank can provide seed capital or other de minimus funding provided that (i) it actively seeks outside investors to dilute its interest and otherwise reduces its interest to no more than 3% of the fund's total ownership interests within one year of the fund's establishment, and (ii) the interest is "immaterial" and in any event does not exceed 3% of the bank's Tier 1 (core) capital.
As a result of the new prohibitions, many banks may have to divest a substantial portion of their ownership stakes in hedge and private equity funds in the future. Fund managers should review the applicable governing documents (and side letters) to determine whether any consent or disclosure obligations are triggered, or whether they can take any actions to facilitate the sale and transfer of fund interests currently held by bank investors.
Nonbank Financial Companies. The Volcker Rule also subjects certain large nonbank financial companies supervised by the Fed to certain capital requirements and quantitative limits on their proprietary trading and fund investing/sponsoring activities. The Fed will issue rules regarding these capital requirements and quantitative limits.
Implementation Period for Compliance. The Volcker Rule is not self-implementing. The rule requires that the Council study the rule and make recommendations within six months to implement it. The federal regulatory agencies will then have nine months to adopt final regulations implementing the rule's provisions, taking into consideration the Council's recommendations. There will be a long transition period thereafter for banks to comply. The final regulations implementing the Volcker Rule will take effect within two years of enactment; thereafter, banks have two more years to divest their non-complying assets/activities, subject to the Fed's authority to grant extensions for up to three one-year periods, and a one-time, five-year extension with respect to the divestiture of interests in certain illiquid funds. Accordingly, the Fed and other applicable regulatory agencies will define the contours of the Volcker Rule and the implementation details for many of its provisions as the rule takes effect in the coming years.
The Act in its final form does not appear to legislate drastic changes to the actual day-to-day operations of most hedge fund managers, many of whom are already registered with the SEC. For managers who previously relied on the private adviser exemption, the Act allows a one-year transition period for compliance with the new registration requirements. Smaller managers (i.e., fund only managers with less than $150 million in assets and other managers with less than $100 million in assets) should consider if they will now be subject to state registration. Larger managers will have to cope with the increased transparency associated with SEC registration and systemic risk reporting.
Hedge fund managers with an institutional compliance infrastructure should be better prepared to deal with SEC regulation, but the degree and scope of the new regulatory burden will be determined largely by how the SEC implements its new rulemaking authority regarding the Act's new examination, recordkeeping and reporting provisions. The Act may have more onerous consequences for private equity fund managers and foreign advisers not generally familiar with SEC regulation, though the scope of the related regulatory burden will also depend on the SEC's new rulemaking and examination initiatives for those entities.
Copyright © 2010 Herrick, Feinstein LLP. The Hedge and Private Equity Fund Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.