Friday, February 12, 2010

House Passes Private Fund Investment Adviser Registration Act: Implications for non-U.S. Managers

At the close of 2009, the U.S. House of Representatives passed the Wall Street Reform and Consumer Protection Act of 2009 (the "House Bill"), a broad financial reform bill that includes an amended version of the Private Fund Investment Adviser Registration Act of 2009 introduced in October 2009 as H.R. 3818. If enacted, the House Bill would require advisers to hedge funds and other private funds to register with the U.S. Securities and Exchange Commission (the “SEC”) and impose certain recordkeeping and regulatory disclosure requirements.

In this article we analyze the implications of the House Bill for non-U.S. fund managers whose clients include U.S. persons. We suggest that while the House Bill provides various exemptions from registration, including one for certain foreign fund managers, these exemptions are much more restrictive than the currently available “private adviser” exemption. In practice, the House Bill is likely to force most non-U.S. managers with U.S. investors to apply for SEC registration and comply with the regulatory requirements for registered investment advisers.

Background
The primary statute regulating the provision of investment advisory services in the United States is the Investment Advisers Act of 1940, as amended (the “Advisers Act”), which requires all investment advisers, unless exempted, to register with the SEC and comply with certain recordkeeping, regulatory reporting and disclosure rules, while also subjecting them to inspection and examination by the SEC staff.

Thus far, non-U.S. managers have broadly relied upon the so-called “private adviser exemption” which exempts from registration any adviser who (i) has had fewer than 15 U.S. clients in the preceding 12 months; (ii) does not hold itself out generally to the public as an investment adviser; and (iii) does not act as an investment adviser to any “investment company,” as defined in the Investment Company Act of 1940, as amended (the “1940 Act”). When counting the number of U.S. clients, the adviser was generally able to treat each fund that it advised as a separate client, and was not required to "look through" the fund and count the number of U.S. investors in that fund as the adviser's clients. The private adviser exemption allows non-U.S. managers broad flexibility to accept subscriptions from U.S. investors for their funds without subjecting such managers to the Advisers Act requirements. Under the House Bill, this flexibility would be substantially reduced.

New Registration Requirements
The House Bill would amend Section 203 of the Advisers Act to remove the private adviser exemption. As a result, many private fund advisers, such as hedge fund and private equity fund managers, would be required to register as investment advisers with the SEC unless they qualify for another exemption.

The House Bill introduces a new exemption from registration for “foreign private fund advisers”. The term “foreign private fund adviser” would be defined to include any investment adviser who: (i) has no place of business in the United States; (ii) during the preceding 12 months has had (x) fewer than 15 clients and investors in the United States in private funds advised by the investment adviser, and (y) assets under management (“AUM”) attributable to clients and investors in the United States in private funds advised by the investment adviser of less than $25 million (or a higher amount if the SEC deems appropriate); and (iii) does not hold itself out to the public in the United States as an investment adviser, or act as an investment adviser to an investment company or business development company.

Additional exemptions would be provided for advisers to “venture capital funds” (as that term may be defined by the SEC) and advisers that provide advice solely to “private funds” and have less than $150 million in aggregate AUM in the United States (the “small private adviser exemption”). A private fund would be defined as a fund which would be considered an investment company but for its reliance on the exemptions provided by Sections 3(c)(1) or 3(c)(7) of the 1940 Act.

Discussion,
Currently, non-U.S. managers are able to avoid SEC registration as investment advisers by limiting the number of their U.S. clients to fewer than 15. Since no look-through provisions or AUM test applies, a manager can currently have up to 14 U.S. clients (in addition to any non-U.S. clients), and these clients can themselves be funds with multiple U.S. investors. Because AUM attributable to U.S. investors in such funds are currently not considered, a non-U.S. manager is able to manage very large funds which have U.S. investors without being subject to SEC oversight.

The foreign private fund exemption, as envisaged by the October 2009 version of the Private Fund Investment Adviser Registration Act of 2009, essentially mirrored the current private adviser exemption with regard to non-U.S. advisers. The House Bill departs from this approach by including "investors in the United States in private funds advised by such investment adviser" for the purpose of determining whether the 15-client or $25 million thresholds are met, effectively introducing a "look-through" approach to this test. As a result, unless another exemption is available, a non-U.S. adviser would be required to register with the SEC (i) if it has more than 14 investors in the United States in one or more non-U.S. private funds it manages; (ii) if $25 million or more of the assets in non-U.S. private funds it manages consist of assets attributable to one or more investors in the United States; or (iii) if it holds itself out to the U.S. public as an investment adviser or acts as an investment adviser to an investment company or business development company.

Following the amended definition of a foreign private fund adviser, the House Bill also contemplates “looking through” to the underlying investors of a private fund for the purpose of determining whether a non-U.S. adviser qualifies as a small private adviser; the exemption refers to AUM in the United States and not to “clients”. Consequently, non-U.S. advisers who manage private funds with AUM in the United States of $150 million or more would be required to register under the House Bill.

Registration with the SEC
In order to register, a non-U.S. manager must file Form ADV with the SEC and update the form annually. In addition, as a registered adviser it must maintain books and records in accordance with SEC rules. Further, if the non-U.S. manager has custody of client funds or securities it must arrange for an independent public accountant registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (the “PCAOB”), to perform a "surprise" inspection of the custody property at some time during the calendar year, unless the fund it manages is subject to an annual financial statement audit prepared in accordance with generally accepted accounting principles (“GAAP”) by a PCAOB Accountant, and the audited financial statements are distributed to the fund’s investors within 120 days of the fund’s fiscal year-end. Finally, the non-U.S. manager would need to ensure compliance with the additional reporting requirements introduced by the House Bill, as described below.

Additional Reporting Requirements
Under the House Bill, the SEC would be entitled to require a registered investment adviser to maintain records and file reports regarding the private funds it advises, including, for each such private fund: (i) the amount of AUM; (ii) the use of leverage (including off-balance sheet leverage); (iii) counterparty credit risk exposures; (iv) trading and investment positions; (v) trading practices; and (vi) any other information the SEC determines necessary or appropriate.

Although they will be exempt from Advisers Act registration, small private advisers and venture capital fund advisers will nevertheless be required to maintain records and provide the SEC with annual reports or other data the SEC deems necessary or appropriate.

Conclusions
The House Bill, if enacted in its current form, would have a profound impact on many non-U.S. managers that advise U.S. clients (including non-U.S. funds with U.S. investors). Unless they are able to qualify for the narrow foreign private fund adviser exemption or another available exemption, such managers would be required to register with the SEC as investment advisers and comply with the regulatory requirements of the Advisers Act. Registration as an investment adviser would likely result in additional administrative and compliance costs. According to Rep. Kanjorski (D-PA), the sponsor of H.R. 3818, the newly introduced reporting costs alone are expected to be in the range of $5,000 to $15,000 for most hedge funds. By some estimates, these costs could exceed several hundred thousand dollars for more complicated hedge funds.

The Senate's version of the Private Fund Investment Adviser Registration Act of 2009 was introduced by Senate Banking Committee Chairman Christopher Dodd (D-CT) in November 2009 as Title IV of the Restoring American Financial Services Act of 2009 (the "Senate Bill"). The investment adviser registration provisions in the Senate Bill essentially mirror those of the House Bill discussed above. Certain differences exist, however, including (i) an exemption for “private equity” fund advisers, as defined by the SEC; (ii) an exemption for single family offices, as defined by the SEC; and (iii) the exclusion of an offshore fund from the definition of a “private fund”. Additionally, the Senate Bill also provides that advisers with less than $100 million in AUM need not register with the SEC, but do need to register with state authorities in the state where the adviser maintains its principal office. Finally, the House Bill sets forth special considerations for advisers to mid-sized private funds, whereas the Senate Bill does not.

The Senate Banking Committee is likely to continue portions of its markup of the draft bills in early 2010. However, with the Senate focusing its debate on healthcare, it is unlikely that the full Senate will vote on the House Bill or Senate Bill until well into 2010.