24 February 2011

Dodd Frank Act: the exemptions


David Guin
Partner | US

The Dodd-Frank Wall Street Reform and Consumer Protection Act (‘Dodd-Frank Act’) was signed into law on 21 July 2010, Title IV of which amends the Investment Advisers Act of 1940 (‘Advisers Act’). On 19 November 2010 the U.S. Securities and Exchange Commission (‘SEC’) released proposed rules governing registration exemptions for certain advisers as provided in the Dodd-Frank Act (the ‘Proposed Rules’). The Proposed Rules were subject to comment, and the SEC is expected to publish finalized rules in the second quarter of 2011. The article below assumes that the contents of the Proposed Rules will be adopted.

The Dodd-Frank Act requires certain US and non-US private equity fund managers and advisers to register with the SEC by 21 July 2011. The entities affected by these regulations are investment advisers, being entities engaged in the business of advising (including managing others) on the value of securities or as to the advisability of investing in, purchasing or selling securities, for compensation (‘Adviser’).

The Advisers Act exempted from registration with the SEC (‘Private Adviser Exemption’) investment advisers with fewer than 15 US clients (where a fund was a client, as opposed to each investor in a fund). The Dodd-Frank Act replaces the Private Adviser Exemption with a ‘foreign private adviser’ exemption; while the Proposed Rules clarify some of the Dodd-Frank Act’s terms regarding foreign private advisers and exempts ‘exempt reporting advisers’ from registration (but not reporting) with the SEC. As the repeal of the Private Adviser Exemption has significant implications for non-US fund managers, it is crucial to determine whether one of the exemptions to the Dodd-Frank Act may apply.

Foreign Private Adviser

Under the Dodd-Frank Act, a ‘foreign private adviser’ is exempt from SEC registration and all SEC rules except (for transactions in the US) anti-fraud and pay-to-play rules. A ‘foreign private adviser’ is an Adviser which:

  • has no place of business in the US. The Proposed Rules define ‘place of business’ as (a) any office where the Adviser regularly provides advisory services, solicits, meets with, or otherwise communicates with clients; and (b) any location held out to the public as a place where the Adviser conducts these activities. This test is broader than the ‘principal office and place of business’ test in the Private Adviser Exemption. ‘US’ includes any US state, territory or possession and the District of Columbia.
  • has fewer than 15 in aggregate of clients in the US and investors in the US in private funds advised by the Adviser. Under the Proposed Rules ‘client’ is defined to avoid double-counting investors in funds with the relevant fund. The location of the potential client at the time of engaging the Adviser is relevant throughout the relationship, so that the Adviser is not penalised if a client that is initially determined not to be a ‘US Person’ later qualifies as such. The definition of US Person is broader than the current definition of ‘US clients’ under the Private Adviser Exemption, and is loosely based on the ‘Regulation S’ definition applicable to private funds.
  • has less than $25 million in aggregate assets under management (‘AUM’) from such clients and investors. Note that the SEC is proposing changes to the calculation of assets under management. For example, it suggests using the fair value of the assets rather than cost; and
  • does not hold itself out as an investment adviser to the US public.

Exempt Reporting Advisers

The Proposed Rules state that ‘exempt reporting advisers’ include (i) venture capital funds and (ii) private fund advisers with less than $150m AUM in the US. The advantage of qualifying as an exempt reporting adviser is the exemption from registration with the SEC. However, unlike the foreign private adviser exemption, the exempt reporting adviser would remain subject to reporting obligations, including filing parts of Form ADV (the uniform application for investment adviser registration) record-keeping requirements and SEC examinations. It would also be required to disclose basic organisational, operational and investment information about the fund, as well as data about the service providers to the private funds. Both types of exempt reporting adviser are detailed below.

Venture Capital Funds

A venture capital fund is defined in the Proposed Rules as a private fund which:

  • represents itself to investors as a venture capital fund;
  • invests in (i) equity securities of qualifying portfolio companies to provide operating or business expansion capital; (ii) US Treasury securities with a remaining maturity of 60 days or less; or (iii) cash or cash equivalents;
  • is not leveraged in connection with its investment activities;
  • offers to provide a significant degree of managerial assistance, or controls its portfolio companies;
  • does not offer redemption rights to its investors.

It is proposed that existing funds (ie, those with a final closing by 21 July 2011) which have represented themselves as venture capital funds will also generally come under this definition.

Private Fund Advisers with less than $150m AUM in the US

Under the Proposed Rules, in determining which assets come within the $150m limit, a non-US Adviser would need only to include assets managed from a place of business within the US. These proposed reporting requirements are substantially similar to those of a registered Adviser. The Adviser to a private fund may be required to maintain or provide reports about (among others things) the fund’s:

  • assets under management;
  • use of leverage, including off-balance sheet leverage;
  • counterparty credit risk exposure;
  • trading and investment practices;
  • valuation policies and procedures;
  • types of assets held;
  • side letters;
  • any other information that the SEC or the newly created Financial Stability Oversight Council deems to be ‘necessary or appropriate’.

Conclusion

The SEC requested and has received comments on its proposed rules giving effect to the new, more limited exemptions that will replace the current “Private Adviser Exemption” as mandated by the Dodd-Frank Act. These comments will be considered prior to the SEC releasing final rules during the second quarter and in all events prior to the effectiveness of the Dodd-Frank Act on 21 July 2011.

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