On July 21, 2010, President Obama signed into law the much-anticipated Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). Although important on several fronts, the Dodd-Frank Act will be of particular interest to private fund managers because it includes the Private Fund Investment Advisers Act of 2010 (the "Registration Act"), which significantly reshapes the current rules regarding the registration of private fund managers with and their regulation by the SEC. Most notably, the Registration Act eliminates the private adviser exemption to the registration requirement of the Investment Advisers Act of 1940 (the "Advisers Act") commonly used by private fund managers and replaces it with a number of new, but more narrowly applicable, exemptions. As a result, many private fund managers that are currently exempt from registration will be required to register with the SEC.
The Registration Act provides exemptions to the registration requirement for the following types of advisers:
advisers to "venture capital funds";
advisers to private funds if the adviser has less than $150 million in assets under management in the United States;
advisers to small business investment companies;
certain foreign private advisers; and
The details of these new exemptions are discussed below.
The Registration Act also transfers regulatory responsibility for certain mid-sized investment advisers from the SEC to the states by increasing the minimum assets under management threshold required for eligibility for federal registration, heightens the recordkeeping and reporting requirements applicable to investment advisers of private funds (including some that are exempt from the Advisers Act registration requirement), and amends the definitions of "accredited investor" and "qualified client" in ways that will limit some investors’ ability to invest in private funds.
The majority of the Registration Act provisions take effect one year from the date of enactment, meaning that private fund advisers subject to the new requirements must be registered and meet the applicable recordkeeping and reporting requirements by July 21, 2011. Private fund advisers may register voluntarily during the one year transition period.
This memo provides an overview of those provisions of the Registration Act that are most likely to directly affect private fund managers.
Investment Adviser Registration
Currently, the Advisers Act requires the registration of investment advisers and subjects them to certain ongoing regulations. "Investment adviser" means any person who, for compensation, engages in the business of advising others as to the value of securities or as to the advisability of investing in, purchasing, or selling securities.1 Absent an exemption from registration under the Advisers Act, a private fund manager is required to register with the SEC and comply with a variety of recordkeeping and reporting obligations. The Registration Act significantly alters the universe of private fund managers required to register under the Advisers Act.
Elimination of Private Adviser Exemption
The Registration Act eliminates the current version of Section 203(b)(3) of the Advisers Act (the "private adviser exemption"), which exempted from registration advisers that, during the preceding twelve months, (a) had fewer than 15 clients and (b) neither held themselves out to the public as an investment adviser nor (c) acted as investment adviser to (i) any investment company registered under the Investment Company Act of 1940, as amended (the "Investment Company Act") or (ii) any entity electing to be treated as a business development company under the Investment Company Act. Most managers of private investment funds have been able to take advantage of this exemption because the funds they manage, rather than the investors in those funds, are considered to be their "clients" for purposes of the 15 client limitation and because those funds are usually exempt from registration as investment companies. The elimination of the private adviser exemption will now require many of these advisers to private funds to register with the SEC unless they can rely on another exemption from registration. Moreover, because the private adviser exemption has also historically served as the basis for many fund managers’ exemption from state investment adviser registration requirements, many fund managers that remain exempt from federal registration under the new regime will now be required to register at the state level.
Exemptions from Registration
Although the Registration Act eliminates the private adviser exemption, it creates several new exemptions from SEC registration.
1. Advisers to Venture Capital Funds
The first new exemption under the Registration Act provides an exemption from registration for investment advisers that solely advise one or more venture capital funds. The term "venture capital fund" is undefined, but the SEC is required to define the term within one year after the law’s enactment. Although fund managers that solely advise venture capital funds are exempt from registration, the Registration Act grants the SEC broad authority to require such fund managers to maintain records and provide to the SEC annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors.
An earlier Senate version of the Dodd-Frank Act applied this exemption to advisers of venture capital funds and private equity funds, but the separate private equity fund exemption was removed from the final version of the bill. Since there is no commonly accepted definition of "venture capital fund," it is unclear how the SEC will draft a definition that clearly exempts only managers of funds that are usually thought of by industry professionals as "venture capital funds." Although the removal of private equity funds from the exemption makes it clear that Congress intended to exclude managers of "buyout", "mezzanine" and other types of private equity funds from the exemption, the blurring of the lines between the private equity and venture capital industries will make defining the term "venture capital" a difficult task.
2. Advisers to Private Funds
The second new exemption under the Registration Act directs the SEC to provide an exemption from registration for any investment adviser to "private funds" if such investment adviser acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million. A private fund, for purposes of the Registration Act, is any entity that would be required to register with the SEC as an investment company but for Section 3(c)(1) (i.e., privately-offered funds with fewer than 100 investors) or Section 3(c)(7) (i.e., privately-offered funds where all investors are qualified purchasers) of the Investment Company Act. Although exempt from registration, the Registration Act still requires the SEC to require this category of exempted advisers to maintain records and provide to the SEC annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors. Note that the exemption’s requirement that the adviser act "solely" as an adviser to private funds will render it unavailable to advisers that advise private funds as well as other types of clients.
The precise scope of this exemption remains unclear largely because the Registration Act requires SEC rulemaking to establish it. We hope that the rules will clarify certain interpretive issued raised by this exemption, many of which stem from the failure to define the phrase "assets under management in the United States." For example, it is unclear whether this means $150 million of U.S. investor money, $150 million held in a U.S.-domiciled fund regardless of investors’ domicile, or just assets managed from an office in the U.S. Also, while it is probably safe to assume that "assets under management" include unfunded capital commitments to a fund still making new investments, it unclear whether and to what extent assets under management will be deemed to fluctuate as portfolio company valuations change or as a fund’s unfunded commitments become less available for new investment. The Registration Act does not specify a timeline for the SEC’s rulemaking.
3. Advisers to Small Business Investment Companies
The third new exemption from SEC registration is for advisers to small business investment companies ("SBICs"), which are generally funds that are licensed by, and receive financing from, the Small Business Administration under the Small Business Investment Act of 1958. This exemption applies to advisers that only advise SBICs (and, in certain cases, entities that have applied for or are in the process of obtaining an SBIC license). The requirement that the adviser "solely" manage SBICs may prohibit many SBIC managers from relying on this exemption, because many of them also manage entities that are not licensed as SBICs. For example, it appears that a manager of a so-called "drop-down" SBIC fund would not be able to rely on this exemption. This may be true even if the adviser could qualify for exemption by relying on the private adviser or venture capital exemptions for its non-SBIC assets under management. Hopefully the SEC will clarify these questions in its regulations.
4. Foreign Private Advisers
The Registration Act also provides an exemption from registration to any "foreign private adviser," which is defined as any adviser that (1) has no place of business in the United States; (2) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser; (3) has less than $25 million aggregate assets under management attributable to clients and investors in the United States in private funds advised by the investment adviser (or such higher amount as the SEC may, by rule, deem appropriate); (4) does not hold itself out generally to the public in the United States as an investment adviser; and (5) does not act as an investment adviser to any investment company registered under the Investment Company Act or to any business development company. Unlike the former private adviser exemption, the Registration Act makes clear that in calculating the number of clients for purposes of determining whether an adviser is a "foreign private adviser," the adviser must look through the private funds it advises to count the number of investors in the United States in such private funds.
Most foreign private advisers previously relied on the private advisers exemption to exempt them from registering with the SEC. The elimination of this exemption and the limited definition of "foreign private advisers" means that many more non-U.S. advisers will be required to register with the SEC.
One interpretive issue that is likely to arise from this exemption stems from the fact that the definition of "foreign private adviser" does not provide a timeframe for calculating the number of clients and investors for purposes of the 15-client and investor limit. As a result, it is unclear whether only current U.S. clients are counted, or whether former U.S. clients must be included as well. This issue could be addressed by SEC rulemaking.
5. Family Offices
Although not an exemption from registration, the Registration Act excludes "family offices" from the definition of investment adviser. As a result, family offices are not subject to registration and regulation as an investment adviser under the Advisers Act. However, the Registration Act does not define the term "family office." Instead, it requires the SEC to define the term, provided, however, that the SEC’s definition must:
be consistent with the SEC’s previous regulatory relief granted for family offices;
recognize the range of organizational, management and employment structures and arrangements employed by family offices; and
not exclude certain persons (as set forth in detail in the Registration Act) from the definition of the term "family office" who were not registered or required to be registered under the Advisers Act on January 1, 2010 (the "grandfathering" requirement).
Unlike the requirement for defining "venture capital fund," the Registration Act does not specify a date by which the SEC must provide a definition for "family offices." Thus, uncertainty may arise under this exclusion if the SEC fails to define the term "family office" prior to the elimination of the private adviser exemption (which will become effective one year from the date of enactment of the Dodd-Frank Act). In addition, grandfathered entities will be deemed to be investment advisers for purposes of the general anti-fraud provisions of the Advisers Act.
Raising the Federal Registration Minimum Assets Under Management Threshold
The Advisers Act splits regulatory responsibility for investment advisers between the federal and state level such that advisers, unless otherwise exempt from registration, must register with the SEC or with the state securities commissions, but not with both. Currently, the Advisers Act generally requires advisers to have at least $25 million in assets under management in order to be eligible for SEC registration, and SEC registration is mandatory for advisers managing at least $30 million (unless an exemption from registration applies). The Registration Act, however, raises the minimum assets under management threshold required for eligibility for federal investment adviser registration. Once the Registration Act provisions become effective, advisers will be subject to federal versus state regulation as follows:
Assets Under Management
Federal versus State Registration/Regulation
More than $100 million2
- Federal registration is required absent an exemption from registration (e.g., venture capital, private fund, SBIC, etc.).
- Advisers with more than $100 million in assets under management that are exempt from federal registration will nonetheless be required to register at the state level if there is no applicable state exemption.3 In this situation, the adviser may elect to register with the SEC, rather than register at the state level.
$25 million - $100 million
- Federal registration is prohibited if the adviser is required to be registered at the state level and is subject to examination as an investment adviser in the state in which it maintains its principal office and place of business. If the adviser is not subject to such state registration and examination, then it must register with the SEC absent an exemption from registration.
- An adviser with assets under management from $25 - $100 million may elect federal registration if it would be required to register with 15 or more states.
Less than $25 million
- Federal registration is prohibited (unless certain exceptions4 apply), and in such cases state registration is required absent a state exemption from registration.
- Advisers to registered investment companies must register federally with the SEC regardless of the amount of assets under management.
As a result of the Registration Act’s increase in the minimum assets under management threshold, the number of investment advisers under state supervision is expected to increase significantly, and state agencies will likely take over the regulation of a larger percentage of mid-sized advisers. One issue that is likely to arise, based on the increased minimum threshold, is whether an adviser that is currently registered with the SEC because it satisfies the $25 million assets under management threshold will be required to deregister if it no longer qualifies under the $100 million threshold.
The effect of this increased threshold for federal registration is that fund managers that are prohibited from registering with the SEC will be forced to comply with state registration requirements in all of the states where they are transacting business as an investment adviser. In most cases, state blue sky laws, rules, regulations and policies governing investment advisers are disparate and non-uniform, and the state registration requirements are more burdensome than the SEC’s requirements. Although the Registration Act allows mid-sized advisers that would have to register in more than 15 states to register at the federal (as opposed to the state) level, an adviser that is required to register at the state level will likely face substantial additional expense, time and potential problems in attempting to comply with the applicable state laws, particularly if the adviser is required to register with several states.
Changes to the "Accredited Investor" and "Qualified Client" Suitability Standards
Accredited Investor Net Worth Standard5
Regulation D of the Securities Act uses the term "accredited investor" to provide a dollar-based threshold for determining investor suitability in certain private offerings. These offerings, if made to accredited investors, may be exempt from registration under the Securities Act. As a result, the definition of “accredited investor” is extremely important.
Under current law, a natural person qualifies as an accredited investor if at the time of the offering the investor (1) has an individual net worth, or joint net worth with the investor’s spouse, that exceeds $1 million, which net worth calculation may include the value of the investor’s primary residence, or (2) had an individual income in excess of $200,000 in each of the two most recent years or joint income with the investor’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. The Registration Act revises the definition of "accredited investor" to exclude the value of a natural person’s primary residence in determining whether the investor satisfies the $1 million net worth test. This revision is effective immediately upon enactment of the Dodd-Frank Act.
In addition to the immediate change to the calculation of net worth, the Registration Act authorizes further study and future adjustments by the SEC to the definition of accredited investor. On the fourth anniversary of the Dodd-Frank Act, and every four years thereafter, the SEC must review the accredited investor definition as it applies to natural persons and determine if any adjustments are necessary "for the protection of investors, in the public interest, and in light of the economy." The SEC is prohibited, however, from adjusting the $1 million net worth test for the first four years following enactment of the Dodd-Frank Act.
Qualified Clients and Performance-Based Compensation
Section 205(a)(1) of the Advisers Act generally prohibits any investment adviser, unless exempt from registration pursuant to Section 203(b) of the Advisers Act, from entering into, extending, renewing or performing under any investment advisory contract if the contract provides for compensation based on a percentage of the capital gains or appreciation in a client’s account. The performance fee prohibition does not apply to contracts with Section 3(c)(7) investment companies or contracts with "qualified clients" (defined below). Although the Registration Act does not revise this general prohibition on performance-based compensation or the definition of "qualified client," the elimination of the private advisers exemption means that private fund managers that now will be required to register with the SEC will be subject to this prohibition on performance fees unless an exemption applies. This is a particularly important issue since private fund managers generally receive additional distributions in the form of carried interest, which the SEC likely will argue is performance-based compensation. As a result, private fund managers that are registered or required to register will need to ensure that fund investors are limited to qualified purchasers or qualified clients.
The performance fee prohibition does not apply to contracts with investment funds that are exempt from registration under the Investment Company Act pursuant to Section 3(c)(7) thereof (i.e., investment companies in which all investors are "qualified purchasers," which generally include natural persons with at least $5 million in investments and entities with at least $25 million in investments). Rule 205-3 also exempts from this performance fee prohibition contracts with "qualified clients." The term "qualified client" is defined as (1) a natural person or legal entity that immediately after entering into the contract has at least $750,000 under management with the adviser; (2) a natural person who, or a legal entity that, the investment adviser reasonably believes, immediately prior to the establishment of the investment advisory relationship, has a net worth of at least $1.5 million at the time the contract is entered into or is a "qualified purchaser" (as defined above) at the time the contract is entered into; or (3) specified knowledgeable employees6 of the investment adviser. Rule 205-3 requires a look-through from the fund to the investors in the fund if the fund is relying on the Section 3(c)(1) exemption from the Investment Company Act, or if the fund is an investment company registered under the Investment Company Act or a business development company. Accordingly, investment advisers to private funds using the Section 3(c)(1) exemption will need to take a closer look at the fund’s investors to make sure that each is a qualified client. In addition, private fund managers will want to ensure that the fund’s subscription documents contain certain representations and warranties from fund investors relating to their status as qualified clients.
As noted above, the Registration Act does not change the definition of qualified client. However, the Registration Act does require that if the SEC uses a dollar amount test to determine who is a "qualified client" (as it does now), the SEC must, within one year of the law’s enactment and every five years thereafter, adjust such dollar amount for the effects of inflation. It is unclear how the SEC will treat private fund advisers that were previously exempt from registration under the Advisers Act and had entered into advisory contracts with non-qualified clients where the adviser receives performance-based compensation. It seems likely that the SEC will provide some type of transition rule that will allow private advisers to continue receiving performance-based compensation under advisory contracts entered into when the adviser was exempt from registration, particularly when withdrawal is not permitted, but this type of grandfathering provision will depend on SEC rulemaking.
Registration Process and Reporting by Registered Investment Advisers
Currently, in order to register with the SEC under the Advisers Act, a fund manager is required to file a Form ADV with the SEC, establish an account with the Investment Advisers Registration Depository, and pay certain set-up and annual fees. The Form ADV requires disclosure regarding the adviser’s business, including information regarding its clients and ownership, and information regarding the adviser’s fees, the services it offers, and any conflicts of interest applicable to the adviser. Some of the information provided is made publicly-available on an SEC website. The Registration Act does not make any revisions to the registration process.
Recordkeeping and Reporting
Under the Advisers Act, once the registration is accepted by the SEC, a registered investment adviser is subject to certain recordkeeping and reporting requirements, may be inspected from time to time by the SEC, and is required to maintain a code of ethics and other policies focused on complying with its fiduciary responsibilities, recordkeeping requirements and insider trading laws. The Registration Act, however, grants the SEC the authority to impose additional reporting and recordkeeping requirements on advisers to private funds that are required to register with the SEC, and in fact mandates that the SEC must require private fund advisers to report certain information for each private fund, including:
the amount of assets under management;
use of leverage (including off-balance sheet leverage);
counterparty credit risk exposures;
trading and investment positions;
valuation policies and practices of the fund;
types of assets held;
side arrangements or side letters;
trading practices of the fund; and
any other information the SEC (in consultation with the newly created Financial Stability Oversight Council) determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.
In addition, advisers to private funds that are exempt from SEC registration under the "venture capital funds" exemption or the "private fund advisers" exemption are subject to such recordkeeping and reporting requirements as the SEC determines necessary or appropriate in the public interest or for the protection of investors.
For more information on the registration process, recordkeeping requirements and other substantive compliance requirements for registered investment advisers, please contact us to request a copy of our detailed client memo titled "Investment Adviser Registration."
The Registration Act significantly alters the regulatory landscape for managers of private funds. Elimination of the private advisers exemption will result in the federal registration of most private fund managers. Once registered, these advisers will have to comply with extensive private fund reporting and recordkeeping requirements. The application of many of the new exemptions under the Registration Act will remain unclear until further defined pursuant to SEC rulemaking. We will continue to monitor regulatory developments and post updates to our website regarding any SEC rulemaking or interpretive guidance.
We welcome you to contact Haynes Lea at (704) 377-8304, Richard Starling at (704) 377-8394, Kelly Loving at (704) 377-8397, Jeffrey Hart at (919) 328-8801, Henry Riffe at (704) 377-8145, or Ashley Hedgecock at (704) 377-8163 with any questions you may have regarding the Registration Act and its implications.
1. Broker-dealers are excluded from the definition of investment adviser if the broker-dealer’s performance of advisory services is solely incidental to the conduct of its business as a broker or dealer and it receives no special compensation.
2. The $100 million threshold may be raised by SEC rulemaking.
3. Note that many state investment adviser registration laws have provisions exempting advisers that are exempt from federal registration by virtue of the federal private advisers exemption. These state exemptions are effectively eliminated by the Registration Act’s deletion of that federal exemption. On the other hand, most states exempt from registration advisers that have no place of business in the state and whose only clients are specified categories of institutional investors. In addition Section 222(d) of the Advisers Act prohibits states from requiring the registration of any investment adviser that has no place of business in the state and during the preceding 12 months has had fewer than six clients who are residents of the state.
4. Among other exceptions, Rule 203A-2 provides that investment advisers with less than $25 million in assets under management still may register with the SEC if they would otherwise be subject to registration in more than 30 states or if they are affiliated with, and have the same principal office and place of business as, an investment adviser registered with the SEC.
5. Note that while the accredited investor net worth standard does not have anything to do with the registration of private fund advisers, the revision to the net worth standard was included in the text of the Registration Act and is relevant because most funds do require investors to be accredited in order to invest in the fund. Accordingly, fund subscription documents will need to be revised to reflect the new accredited investor net worth test.
6. These can include an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser, or an employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions or duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company, for at least 12 months.