A. Mid-Sized Advisers
The Dodd-Frank Act generally shifts the burden of regulating investment advisers with assets under management below $100 million to the states.2 Nonetheless, certain advisers with assets under management between $25 million and $100 million ("Mid-Sized Advisers") will be required to register with the SEC under certain circumstances, including if the adviser (i) advises a registered investment company; (ii) advises a business development company; or (iii) is required to register with 15 or more states. Alternatively, pursuant to the SEC's final rules implementing the Dodd-Frank Act's amendments to the Advisers Act, a Mid-Sized Adviser will be required to register with the SEC if it is not subject to registration or examinations in the state where it maintains its principal office and place of business. In practice, this means that Mid-Sized Advisers located in Minnesota, New York and Wyoming must register with the SEC.3 In addition, Mid-Sized Advisers in other states that are exempt from registration under a state's investment adviser statute will also be required to register with the SEC.4 A Mid-Sized Adviser that manages only qualifying private funds may be able to rely on the Private Fund Adviser Exemption (see discussion below).
B. Calculating Regulatory Assets Under Management
The SEC also revised its instructions to Part 1A of Form ADV to implement a uniform method for calculating an adviser's "regulatory assets under management" for purposes of SEC registration, reporting on Form ADV and various exemptions from SEC registration. Generally, advisers must calculate their regulatory assets under management according to the current market value of their assets as measured within 90 days prior to the date of filing their Form ADV. Advisers must also calculate their regulatory assets under management on a gross basis (i.e. without deducting any outstanding indebtedness or other accrued but unpaid liabilities).
The SEC's rules also provide more specific instructions with respect to calculating regulatory assets under management for advisers to private funds. Private fund advisers must now include in their regulatory assets under management (i) the market value of any private fund over which they exercise continuous and regular supervisory or management services, and (ii) the amount of any uncalled capital commitments. In a footnote to the final rules, the SEC stated that it expects advisers to use the same accounting method to determine the fair value of their regulatory assets under management as they use for financial reporting purposes. For example, if an adviser calculated a fund's gross asset values in accordance with U.S. GAAP, then such method could be used for SEC reporting purposes.
C. Exempt Reporting Advisers
The Dodd-Frank Act empowered the SEC to require investment advisers relying on the Private Fund Adviser Exemption and the Venture Capital Fund Exemption (collectively, "Exempt Reporting Advisers") to adhere to certain recordkeeping and reporting requirements. Under the final rules, Exempt Reporting Advisers must report on Form ADV within 60 days of relying on either of these specific exemptions from registration, provided that Exempt Reporting Advisers must submit their initial Form ADV no later than March 30, 2012. More specifically, Exempt Reporting Advisers will be required to disclose information about their regulatory assets under management; organization; and ownership and control. They will also be required to report on their disciplinary history as well as the disciplinary history of their employees. In addition, Exempt Reporting Advisers that advise private funds will be required to provide information for each private fund they advise, including the private fund's size and investment strategy. The SEC stated that it would address applicable recordkeeping requirements for Exempt Reporting Advisers in a forthcoming rule release.
D. Amendments to Form ADV
In response to concerns raised by commenters, the SEC's final rules contain several modifications to the initially proposed amendments to Form ADV. With respect to private fund reporting by registered advisers and Exempt Reporting Advisers, the SEC did not adopt the proposed amendments that would have required Exempt Reporting Advisers (i) to disclose each private fund's net assets; (ii) to report private fund assets and liabilities by class and categorization in the fair value hierarchy established under GAAP; and (iii) to specify the percentage of each fund owned by particular types of beneficial owners. The SEC also revised Part A of Section 7.B.(1) to clarify the definition of "hedge fund." Similarly the SEC revised Part B of Part 7.B.(1) to clarify the instructions and to protect the confidentiality of third parties that value of a private fund's assets on behalf of the adviser.
With respect to custody of client assets, the SEC adopted several clarifications urged by commenters. The SEC clarified Item 9 of Form ADV to specify that Item 9 asks whether an adviser or its related person has custody of funds and securities of clients that are not registered investment companies. The SEC also clarified that for purposes of Item 9.B. and 9.C. an adviser must include funds and securities of which a related person has custody in connection with advisory services the adviser provides to clients.
E. Pay-to-Play Rule
The SEC adopted the amendments to the pay-to-play rule largely as proposed, but expanded the category of "regulated persons" excepted from the rule's prohibition on advisers paying third parties to solicit government entities. Specifically, registered municipal advisors are now regulated persons under the rule.
II. Exemptions from Registration
As noted in our earlier Dodd-Frank Newsletter (available here), the Dodd-Frank Act repealed the "private adviser exemption" thereby extending Advisers Act registration to many private fund advisers absent another available exemption. The Dodd-Frank also created several new exemptions from SEC registration for investment advisers, which are summarized below:
A. Venture Capital Fund Exemption
The SEC recently adopted rules defining the term "venture capital fund" for purposes of the new exemption from registration added to the Advisers Act by the Dodd-Frank Act, which exempts advisers that advise only venture capital funds from SEC registration (the "Venture Capital Fund Exemption"). Rule 203(l)-1 defines a "venture capital fund" as a private fund5 that:
(i) holds, immediately after the acquisition of any asset (other than qualifying investments or short-term holdings), no more than 20% of the fund's capital commitments in non-qualifying investments (other than short-term holdings6);
(ii) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15% of the fund's capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days;
(iii) does not provide investors redemption rights except in "extraordinary circumstances" but that entitles investors generally to receive pro rata distributions;
(iv) represents itself as pursuing a venture capital strategy to its investors and potential investors7;
(v) is not registered as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act") and has not elected to be treated as a business development company.
In its final rule, the SEC expanded the scope of the Venture Capital Fund Exemption in response to several comments it received with respect to the proposed rule. In particular, the SEC eliminated the 20% limit for secondary market transactions that it originally included in the proposed rule and instead adopted a broader 20% limit for assets that are "non-qualifying investments."8 A venture capital fund would be required under the final rules to measure its compliance with the 20% limit on non-qualifying investments at the time any non-qualifying investment is made, based on the non-qualifying investments then held in the fund's portfolio. The final rules permit the adviser to allocate its non-qualifying investments up to the 20% limit in its discretion, including investments outside of the strict parameters of a fund's qualifying investments. In practice, this would allow venture capital funds to invest a portion of their capital in debt or publicly offered securities, provided that they adhere to the 20% limit for non-qualifying investments at the time each non-qualifying investment is made.
The SEC's final rule includes a grandfathering provision for any private fund that: (i) represented to investors and prospective investors at the time the fund offered its securities that it pursues a venture capital strategy; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including accepting any capital commitments from, any person after July 21, 2011 (the "Grandfathering Provision").9
The SEC's final rule also contains a note indicating that an adviser may treat any non-U.S. fund that is not offered in the United States, but that would be a private fund if the issuer were to conduct a private offering in the United States, as a "private fund." As such, a non-U.S. fund could be deemed a "venture capital fund" for purposes of the Venture Capital Fund Exemption, provided that the non-U.S. fund meets all of the requirements of such exemption. However, an adviser relying on the Venture Capital Fund Exemption with respect to any non-U.S. fund would be required under the final rule to treat such "private fund" as such under the Advisers Act for all purposes (e.g., reporting by Exempt Reporting Advisers).
In light of these final rules, investment advisers to venture capital funds should review the terms of all fund offering documents to determine whether such terms would disqualify the adviser from relying on the Venture Capital Fund Exemption. For example, an adviser should review whether a fund's strategy is consistent with a venture capital strategy and further, whether a fund's offering documents comply with the Venture Capital Fund Exemption's limits on (i) non-qualifying investments, (ii) borrowing and (iii) redemption rights.
B. Advisers to Private Funds With Less than $150 Million in AUM
As more fully discussed in our earlier Dodd-Frank Newsletter (available here), the Dodd-Frank Act also added a new exemption for advisers to qualifying private funds with less than $150 million in assets under management (the "Private Fund Adviser Exemption"). The final rule would limit the Private Fund Adviser Exemption to those advising "private funds" as defined in the Advisers Act.10 Accordingly, an adviser managing one separate account would not be eligible for the Private Fund Adviser Exemption, while an adviser with an unlimited number of private fund clients would be eligible for the Private Fund Adviser Exemption, provided that the aggregate value of the assets of the private funds is less than $150 million (using the "regulatory assets under management" criteria described above). However, in response to comments to its proposed rule, the SEC revised the rule to permit an adviser to treat as a private fund any fund that qualifies for another exclusion from the definition of "investment company" under the Investment Company Act (e.g., section 3(c)(5)(C) for certain real estate funds) in addition to the exclusions provided by section 3(c)(1) or section 3(c)(7) thereunder. Accordingly, an adviser may rely on the Private Fund Adviser Exemption if it advises a fund that qualifies for more than one exclusion from the definition of "investment company" under the Investment Company Act as long as such fund also qualifies under section 3(c)(1) or 3(c)(7) thereunder ("qualifying private funds"). An adviser relying on this provision, however, must treat the fund as a private fund under the Advisers Act and the rules thereunder for all purposes (e.g., reporting on Form ADV, which requires advisers to report certain information about the private funds they manage).
As applied to non-U.S. advisers, the Private Fund Adviser Exemption would permit an adviser to avoid registration as long as all of the adviser's clients that are U.S. persons are qualifying private funds. A non-U.S. adviser would only need to count the private fund assets it manages at a place of business in the United States toward the $150 million threshold of the Private Fund Adviser Exemption. Accordingly, a non-U.S. adviser that did not manage assets from a U.S. office could manage private funds with an unlimited amount of U.S. investor assets and still qualify for the Private Fund Adviser Exemption.
The SEC's final rule also requires advisers relying on the Private Fund Adviser Exemption to calculate their private fund assets annually in connection with their annual updating amendments to Form ADV, rather than quarterly as proposed. An adviser that reports on its annual updating amendment that it has $150 million or more of private fund assets under management that previously qualified for the Private Fund Adviser Exemption (and complied with all SEC reporting requirements applicable to Exempt Reporting Advisers) may continue to rely on the Private Fund Adviser Exemption up to 90 days after filing the annual updating amendment during the adviser's transition to becoming an SEC-registered adviser. Accordingly, short term fluctuations in fund asset values would not cause a fund manager to lose eligibility for the Private Fund Adviser Exemption as long as such manager was able to stay below the $150 million threshold when it filed its annual updating amendment.
C. Foreign Private Advisers
The Dodd-Frank Act also added a new exemption from SEC registration under the Advisers Act for any investment adviser that (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients in the United States 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; and (iv) does not hold itself out generally to the public in the United States as an investment adviser (the "Foreign Private Adviser Exemption"). The SEC adopted, substantially as proposed, a new rule which defines certain terms contained in the Foreign Private Adviser Exemption. The new rule clarifies that an adviser is not required to count a person as an investor for purposes of the Foreign Private Adviser Exemption if the adviser counts such person as a client of the adviser. As such, a person that is a client of the adviser as well as an investor in a private fund advised by the adviser would only be counted once.
The SEC also revised its treatment of beneficial owners who are "knowledgeable employees" with respect to the private fund, and certain other persons related to such employees (collectively, "knowledgeable employees"). In its proposal, the SEC would have included knowledgeable employees within the definition of "investor;" however, several commenters disagreed with this approach, stating that including such knowledgeable employees in the definition of investor conflicted with previous SEC policy. In consideration of these comments, the SEC's final rule will exclude knowledgeable employees from the definition of "investor" for purposes of the Foreign Private Adviser Exemption.
III. Family Office Exemption
On June 22, 2011, the SEC adopted the rules defining the "family office exclusion" added to the Advisers Act by the Dodd-Frank Act. Advisers that qualify as a family office are excluded from the definition of an investment adviser under the Advisers Act and are exempt from all registration and reporting requirements thereunder. Specifically, the SEC's rule defines the term "family office" and sets forth the specific elements of the family office exclusion. Though the SEC significantly expanded the scope of the exemption from its original proposal (click here to view a Client Alert we prepared summarizing the proposed rule), the SEC did not incorporate several comments it received into the final rule, particularly those urging that the SEC apply the exclusion to multi-family offices.
Generally, the SEC expanded the family office exclusion by enlarging the concept of "family member" in the final rule. First, the SEC allowed a family office to include as "family members" all lineal descendants of a common ancestor; provided, however, that there can be no more than 10 generations removed from the youngest generation of family members. In practice, this would allow an adviser to designate a common ancestor and in turn, determine the family members who can be advised by the family office. Further, a family office would be free to choose new common ancestors as older generations pass away. In addition, the SEC expanded the definition of family member to include former spouses and adopted, foster and stepchildren.
The SEC also expanded the concept of who is a key employee of the family office. Under the rule, a family office (the "First Family Office") can provide investment advice to any key employee of the First Family Office, including any person who is a key employee of an affiliated family office (the "Affiliated Family Office"). While the rule would not allow the First Family Office to provide advice to any employees of any Affiliated Family Office, it would allow the First Family Office to provide investment advice to a key employee of an Affiliated Family Office, provided that the Affiliated Family Office is (i) wholly-owned by family clients of the First Family Office, (ii) is controlled by family members of First Family Office (or controlled by family entities affiliated with the First Family Office), and (iii) has no clients other than family clients of the First Family Office. In addition, the SEC also extended the period during which a family office may continue to provide investment advice to non-family clients who receive assets through an involuntary transfer such as a bequest from 4 months to 1 year.
As a result of this rule, some existing family offices may need to restructure their operations to rely on the rule's exclusion from registration, or seek exemptive relief from the SEC. In particular, a family office may not qualify for the exclusion if it also advises non-family or non-key employee clients. A family office that cannot meet the requirements of the family office exclusion will be required to register with the SEC as an investment adviser by March 30, 2012, unless the family office qualifies for another exemption from SEC registration.
IV. Adjustments to "Qualified Client" Test
A. Increase in Dollar Amount Thresholds in Rule 205-3
The SEC recently issued an order that implements the Dodd-Frank Act's adjustment for inflation of the two dollar amount tests in Rule 205-3 under the Advisers Act, which permits an investment adviser to charge certain qualifying clients a performance fee which would otherwise be prohibited under such Act.11 Under this rule, an adviser may charge performance fees if, among others, the client has at least $750,000 under the management of such adviser immediately after entering into the advisory contract (the "AUM Test") or if the adviser reasonably believes the client has a net worth of more than $1,500,000 at the time the contract is entered into (the "Net Worth Test"). The SEC has not revised the dollar amount thresholds contained in the AUM Test and the Net Worth Test since 1998.
The Dodd-Frank Act amended section 205(e) of the Advisers Act to require the SEC to adjust the dollar amount thresholds in the AUM Test and the Net Worth Test in Rule 205-3 promulgated under section 205(e) of the Advisers Act for inflation by July 21, 2011 and every five years thereafter. In its order, the SEC revised the dollar amount threshold in the AUM Test from $750,000 to $1,000,000 and in the Net Worth Test from $1,500,000 to $2,000,000. These new dollar amount thresholds will be effective as of September 19, 2011. These new dollar amount thresholds will particularly impact registered investment advisers managing private funds relying on the section 3(c)(1) exemption under the Investment Company Act by raising the bar of investor eligibility (assuming that such funds are charging performance fees to investors).
B. Other Proposed Amendments to Rule 205-3
In connection with its notice of intent to raise the dollar amount thresholds in Rule 205-3, the SEC also proposed three other significant amendments to Rule 205-3. These proposed rules would (i) require the SEC to adjust the dollar thresholds in the AUM Test and the Net Worth Test every five years; (ii) exclude the value of a natural person's primary residence for purposes of the Net Worth Test (similar to other Dodd Frank provisions and related SEC rules amending the definition of "accredited investor" under Regulation D of the Securities Act of 1933); and (iii) implement transition rules allowing investment advisers to maintain existing performance fee arrangements that complied with Rule 205-3 as in effect when the client entered into the advisory contract or that were entered into before the adviser registered with the SEC.
January 1, 2012:
February 14, 2012:
March 30, 2012:
June 28, 2012:
Copyright © 2011 Herrick, Feinstein LLP. This Dodd-Frank Newsletter 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.
1 The SEC's final rules are substantially similar to its proposed rules. See our previous Dodd-Frank Newsletter available here for a more detailed explanation of the SEC's rules.
2 In its final rules, the SEC revised Item 2.A. of Form ADV to adopt a "buffer" for advisers with close to $100 million in regulatory assets under management. A registered adviser that is filing its annual updating amendment may continue to be registered with the SEC if its has regulatory assets under management of $90 million or more.
4 Under the SEC's revised instructions to Form ADV, a Mid-Sized Adviser is not "required to be registered" with the state securities authority of the state where it maintains its principal office and place of business, if such adviser is (i) exempt from registration with that state, or (ii) excluded from the definition of "investment adviser" in that state. Accordingly, such Mid-Sized Advisers would be required to register with the SEC.
5 Under the Dodd-Frank Act, a "private fund" is defined as a fund that would be required to register as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act") but for the exemptions in section 3(c)(1) or section 3(c)(7) thereunder.
6 The SEC's final rule modified the definition of "short-term holdings" to include shares of money market funds that are regulated under rule 2a-7 under the Investment Company Act.
7 The SEC relaxed the "holding out" criterion of the Venture Capital Fund Exemption to permit a qualifying fund whose name does not include the words "venture capital" to qualify for the Venture Capital Exemption as long as such fund's strategy is not inconsistent with pursing a venture capital strategy.
8 Under the final rule, qualifying investments are generally equity securities that are directly acquired by a the private fund from a qualifying portfolio company and certain equity securities exchanged by the fund for the directly acquired securities.
9 Similar to qualifying funds under the Venture Capital Fund Exemption, a fund relying on the Grandfathering Provision may meet the requirements of the Venture Capital Fund Exemption even if the grandfathered fund's name does not use the words "venture capital" as long as such fund's strategy is not inconsistent with pursuing a venture capital fund strategy.
10 See footnote 5.
11 Rule 205-3 provides that the prohibition on advisers charging performance based compensation to clients contained in Section 205(a)(1) of the Advisers Act shall not apply in the case of persons who are "qualified clients" under the Rule. Under paragraph (b) of the Rule, each investor in a private fund that charges performance fees is considered a client for purposes of the Rule.