23 March 2018
Industry veterans will remember the 2004 attempt of the U.S. Securities and Exchange Commission (the “SEC”) to regulate fund managers. At that time, the SEC attempted to alter the rules investment advisers to funds were required to use to count clients. This represented the SEC’s indirect attempt to deprive fund managers of the ability to rely on the so-called “Private Adviser Exemption” for investment advisers with fewer than 15 clients. Much to the relief of the funds industry, the U.S. Court of Appeals for the District of Columbia found that the SEC had exceeded its authority and nullified the new rule in a case styled Goldstein v. Securities & Exchange Commission.
As a result of the numerous scandals involving funds and investment advisers, there is a renewed effort to regulate fund managers. This time, the U.S. Congress is leading the charge. As such, there is little likelihood that the funds industry will get a last-minute judicial reprieve as it did in 2004. Under the current legislative proposals, rather than manipulating the manner in which clients are counted for purposes of the Private Adviser Exemption, the U.S. Investment Advisers Act of 1940 (the “Advisers Act”) would be amended to eliminate the Private Adviser Exemption in its entirety.
On December 11, 2009, the full U.S. House of Representatives passed The Wall Street Reform and Consumer Protection Act of 2009. On May 20, 2010, the full Senate passed The Restoring American Financial Stability Act. The versions of the legislation passed by the House of Representatives and Senate have been referred to Conference Committee where differences between the two proposals will be resolved prior to submitting final legislation to President Obama for signature. Based on the most recent reports, it is anticipated that the a final version of the amendments to the Advisers Act will be approved by both houses of Congress and signed by President Obama prior to the 4th of July Congressional recess. Once final legislation is enacted, implementation of the amendments to the Advisers Act will require a SEC rulemaking proceeding. It is anticipated that the SEC rulemaking proceeding will be completed within 12 months and the amendments to the Advisers Act will, therefore, be effective by mid-2011.
Non-U.S. funds managers should be aware that it is a stated purpose of these legislative proposals to expand the number of non-U.S. funds that are subject to registration with and regulation by the SEC.
The Current Private Adviser Exemption
Under current law, and until the effective date of the proposed amendments to the Advisers Act discussed in greater detail below, Advisers Act Section 203(b)(3) provides an exemption from registration for investment advisers with a limited number of clients. Advisers Act Section 203(b)(3) states, in relevant part, that the registration requirements of the Advisers Act will not apply to:
Any investment adviser who during the course of the preceding 12 months has had fewer than 15 clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any investment company….
Again under current rules, fund managers are generally allowed to treat a fund as a single client, as opposed to each of the individual investors in the fund being treated as a separate client. Under Advisers Act Rule 203(b)(3)-1, any trust or other legal organization such as a corporation, limited partnership, limited liability company or their non-U.S. equivalents can be treated as a single client so long as the fund manager provides investment advice based on the investment objectives of the legal organization rather than the individual investment objectives of its shareholders, partners, members or beneficiaries. The ability to count a fund, as opposed to fund investors, as clients has allowed nearly all fund managers of privately-placed funds to avoid regulation under the Advisers Act.
Further, under current Advisers Act Rule 203(b)(3)-1(b)(5), any fund manager that advises multiple funds and maintains its principal place of business outside the U.S. is required to count only “U.S. resident clients” against the 15-client limitation. Although Advisers Act Rule 203(b)(3)-1(b)(5) uses the term “U.S. resident client”, that term is not specifically defined in the Advisers Act or the rules promulgated thereunder. The most recent guidance the SEC has provided as to the meaning of “U.S. resident client” under the Advisers Act can be found in an SEC adopting release for the proposed hedge fund registration rule that was struck down in the Goldstein decision.
In the adopting release, the SEC acknowledged that there was no adequate definition of “U.S. resident client” under the Advisers Act and that this definition should be the subject of a future rulemaking proceeding. However, the SEC went on to say that until such a rulemaking was undertaken, it would not object if the status of a client as a “U.S. resident client” were determined as follows:
- A natural person will be a U.S. resident client if their permanent residence is in the U.S.;
- A corporation or other business entity (including a business trust) will be a U.S. resident client if the business entity’s principal office and place of business is located in the U.S.;
- A personal trust or estate will be a U.S. resident client if any of the trust’s trustees or the estate’s executors or administrators is a natural person whose principal residence is in the U.S. or a business entity organized under the laws of the U.S. or whose principal office or place of business is located in the U.S.; and
- In the case of any discretionary or non-discretionary managed account, the status of the person or persons for whose benefit the amount is held.
The significance of the current definition of a “U.S. Resident Client” will become apparent when we discuss the definition of a “Foreign Private Adviser” below.
The Proposed Amendments
Both The Wall Street Reform and Consumer Protection Act of 2009 and The Restoring American Financial Stability Act will amend the Advisers Act to, among other things, eliminate the Private Adviser Exemption. Both of these proposals will replace the current exemption based on the number of clients with an exemption based on the amount of assets under management (“AUM”). Both of the proposals will also create new exemptions for a “Foreign Private Fund Adviser.” The definition of Foreign Private Fund Adviser will be discussed in greater detail below.
For any non-U.S. fund manager that fails to meet the definition of a Foreign Private Fund Adviser, they will be subject to the same rules as are applicable to U.S. fund managers. Under The Wall Street Reform and Consumer Protection Act of 2009, a fund manager would be required to register with the SEC under the Advisers Act if they advise one or more funds with $150 million or more in AUM. The Restoring American Financial Stability Act would set the registration threshold at $100 million.
Registration under the Advisers Act would require fund managers to file a Form ADV, together with annual updates, with the SEC. The Form ADV, which includes information on structure, ownership and the amount of AUM, is publicly available on the SEC’s website in an electronically searchable format. Registration under the Advisers Act will also subject fund managers to other regulatory requirements, including, without limitation, requirements to appoint a chief compliance officer, adopt a Code of Ethics and other policies and procedures required by the SEC and comply with the SEC’s newly-enhanced custody rules. Registered fund managers will also be subject to periodic SEC examinations and be required to comply with SEC mandated recordkeeping requirements. With regard to SEC examinations and record keeping requirements, you should be aware that the records of the underlying funds advised by a registered fund manager would also generally be subject to such examination and record keeping requirements.
Definition of Foreign Private Fund Adviser
A Foreign Private Fund Adviser is defined as any investment adviser who (i) has no place of business in the U.S., (ii) has fewer than 15 U.S. clients, (iii) has less than $25 million in AUM attributable to clients in the U.S. and (iv) does not hold itself out generally to the U.S. public as an investment adviser. It is significant to note that under the proposed definition of Foreign Private Fund Adviser, a fund manager that has any place of business in the U.S. will automatically fail the test. This differs from current rules under which the operative test is the fund manager’s principal place of business.
However, perhaps the most significant aspect of the definition of Foreign Private Fund Adviser is the phrase “attributable to clients in the U.S.” Neither of the legislative proposals attempts to define the phrase “attributable to clients in the U.S.” Rather, both proposals leave the definition of that phrase to a future SEC rulemaking proceeding. Although we cannot state with any certainty how the SEC will ultimately define the term “attributable to clients in the U.S.,” it seems likely that the SEC will adopt a new set of rules for determining the status of U.S. clients in a way that expands the number of non-U.S. fund managers that are subject to registration with and regulation by the SEC. For example, the SEC may adopt look through rules that would determine U.S. status:
- In the case of a corporation or other business entity, by reference to the status of its officers, directors and/or owners (rather than its principal office and place of business);
- In the case of personal trust, by references to the status of its settlors and/or beneficiary(ies) in addition to, or rather than, its trustee(s); and
- In the case of managed accounts, by reference to the status of the account manager(s) in addition to the account owners.
Additionally, the SEC could adopt attribution rules that would require all of the assets of a fund to be treated as attributable to clients in the U.S. if a specified percentage of the fund interests were beneficially owned by U.S. investors.
Potential Exemption for Venture Capital and Private Equity Funds
The Wall Street Reform and Consumer Protection Act contains a provision that would exempt advisers to Venture Capital Funds while The Restoring American Financial Stability Act would exempt advisers to both Venture Capital and Private Equity Funds. However, neither of the legislative proposals attempts to define the terms Venture Capital Fund nor Private Equity Fund. Again, the definition of these terms is left to a future SEC rulemaking proceeding.
In the past, the SEC has found it difficult to develop functional definitions based on a fund’s investment strategy. As such, fund managers should not assume that the eventual definitions of Venture Capital Fund and Private Equity Fund adopted by the SEC would mirror how such funds are typically defined by industry professionals. It should also be noted that a fund manager who advises both a venture capital or private equity fund and a hedge fund would not be permitted to rely on the exemption with regard to its activities on behalf of the hedge fund.
State Law Regulation
It should also be noted that The Restoring American Financial Stability Act passed by the Senate raises the threshold for firms that are permitted to register with the SEC to $100 million. If this aspect of the Senate proposal becomes law, fund managers, including non-U.S. fund managers, will need to more carefully consider whether they will become subject to regulation under the laws of the various states in which their U.S. investors reside.
Both The Wall Street Reform and Consumer Protection Act and The Restoring American Financial Stability Act remain legislative proposals as of the date of this article and neither has yet become law. Each of the House of Representatives and the Senate have passed differing versions of the legislation and both versions have been referred to a House/Senate Conference Committee where differences between the two proposals, such as the treatment of Private Equity Funds and the threshold for registration, will be resolved.
As indicated above, both proposals also require subsequent SEC rulemaking proceedings to define important terms and phrases such as the definition of “Venture Capital Fund” and “attributable to clients in the U.S.” These SEC rulemaking proceedings will have a profound impact on the scope and application of the new law.
Despite remaining questions about the details of the legislation and subsequent SEC rulemaking proceedings, it appears almost certain that the Advisers Act will be amended to delete the current Private Adviser Exemption and that its application will be expanded to include non-U.S. fund managers. As such, non-U.S. fund managers with a significant amount of U.S. investment should carefully consider whether they might become subject to registration with and regulation by the SEC. If registration and regulation appear likely, fund managers should begin planning how they will adapt to new regulatory requirements applicable to SEC registered Investment Advisers. Finally, even if a particular fund manager does not meet the threshold for SEC registration and regulation, additional consideration will be warranted to determine whether such a fund manager may be subject to regulation under the laws of the various states in which its U.S. investors reside.