On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act1 (the “Act”), a comprehensive bill constituting a sweeping overhaul of the regulatory framework of the U.S. financial sector. In this article we analyze the implications of the Act for non-U.S. advisers to investment funds whose clients include U.S. persons, with a particular focus on Title IV of the Act, the “Private Fund Investment Advisers Registration Act of 2010.” For such advisers, the most significant change brought about by the Act is the elimination of the current “private adviser” exemption under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). While the newly enacted Act still provides various exemptions from registration as an investment adviser with the U.S. Securities and Exchange Commission (the “SEC”) under the Advisers Act, including one for certain foreign fund advisers, these exemptions are much more restrictive than the private adviser exemption which is available under current law.
In practice, the Act is likely to require most non-U.S. advisers to private funds who currently have U.S. investors or who intend to raise significant funds in the United States to apply for SEC registration and comply with the substantial regulatory requirements applicable to investment advisers registered under the Advisers Act.
The primary statute regulating the provision of investment advisory services in the United States is 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. advisers have broadly relied upon the so-called “private adviser” exemption, which currently exempts from registration any adviser who:
- has had fewer than 15 U.S. clients in the preceding 12 months;
- does not hold itself out generally to the public as an investment adviser; and
- 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 for purposes of qualifying under the private adviser exemption, the adviser is generally able to treat each fund that it advises as a separate client and is not required to “look through” the fund and count the number of individual U.S. investors therein as clients.
To date, the private adviser exemption has allowed non-U.S. advisers broad flexibility to accept subscriptions from U.S. investors for their funds without being required to register as investment advisers under the Advisers Act. Once implemented, the provisions of the Act are likely to substantially reduce this flexibility.
New Registration Requirements
The Act eliminates the private adviser exemption by striking Section 203(b)(3) from the Advisers Act. As a result, a large number of private fund advisers who have previously relied on the private adviser exemption will now be required to register as investment advisers with the SEC, unless they qualify for another exemption.
The most relevant exemption for non-U.S. advisers introduced by the Act is the one available to “foreign private advisers.” The term “foreign private adviser” is defined to include any investment adviser who:
- has no place of business in the United States;
- has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser;
- has aggregate assets under management (“AUM”) 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 (or a higher amount if the SEC deems appropriate); and
- neither holds itself out to the public in the United States as an investment adviser, nor acts as an investment adviser to an investment company or business development company.
The Act defines a “private fund” as an issuer that would be an “investment company” under the 1940 Act but for its reliance on the exemptions provided by Sections 3(c)(1) or 3(c)(7) of the 1940 Act.
The foreign private adviser exemption is non-exclusive, however, and a non-U.S. adviser not falling within its scope may still be able to avail itself of other exemptions available under the Act. These include exemptions for advisers to “venture capital funds” (to be defined by the SEC no later than July 21, 2011), advisers that provide advice solely to private funds and have less than $150 million in aggregate AUM in the United States, advisers that provide advice solely to “small business investment companies”, and commodity trading advisers that manage a private fund and are registered with the Commodity Futures Trading Commission. Finally, the Act exempts “family offices” from the definition of an “investment adviser”. While the term is not defined in the Act (nor does the Act set a date by which the SEC is required to set such definition), the Act provides guidelines for the application of this exemption to bring it in line with the SEC’s existing exemptive policy for family offices.
Currently, non-U.S. advisers are generally able to avoid SEC registration as investment advisers by, among other things, limiting the number of their U.S. clients to fewer than 15. Because no look-through provision or AUM test applies to the private adviser exemption, currently a manager can have up to 14 U.S. clients (in addition to non-U.S. clients), and each U.S. “client” can itself be a fund with multiple U.S. investors. Furthermore, AUM attributable to U.S. investors in such funds is not a factor considered by the private adviser exemption, so a non-U.S. manager is able to manage funds with substantial AUM without thereby being subject to SEC oversight.
Notably, a discussion draft of the Private Fund Investment Adviser Registration Act released by House Representative Paul E. Kanjorski in October 2009 (the “2009 Draft”) essentially maintained the private adviser exemption in its current form for non-U.S. investment advisers.2 The final version of the legislation, however, sharply limits the availability of exemptive relief for non-U.S. investment advisers, thus signaling a radical departure from historical practice.
The Act departs from the current approach by requiring a non-U.S. adviser seeking to avail itself of the foreign private adviser exemption to limit the aggregate number of its U.S. clients and U.S. investors in private funds advised by the adviser to no more than 14 and the aggregate AUM of those U.S. clients and investors to less than $25 million. In so doing, the Act essentially introduces a “look-through” approach to U.S. investors in private funds which mirrors the client-counting methodology that the SEC previously attempted to adopt by rulemaking but which was overturned by the U.S. Court of Appeals for the District of Columbia Circuit in Goldstein v. SEC.3 Thus, under the new statutory language, investment advisers will be required to look through “private funds” they advise (i.e., funds that rely on the exemptions provided by Sections 3(c)(1) or 3(c)(7) of the 1940 Act) and count U.S. investors therein and their respective AUM against the exemption’s thresholds.
It should also be noted that it is unclear from the language of the Act whether the adviser must count its U.S. clients and investors only during a particular period or whether all its U.S. clients and investors since the beginning of its business must be counted. Although the 2009 Draft followed the current adviser exemption and applied the counting test over a moving 12-month period, the Act does not include any such specification. Therefore, it is possible that instead of considering the number of U.S. clients and investors the non-U.S. adviser has from time to time during any 12-month period, the SEC might consider whether the adviser ever had 15 or more U.S. clients and investors since the inception of its business.
It is also unclear how investors will be counted in the event that a non-U.S. adviser is advising a single investor participating in multiple funds sponsored by the same adviser, a trust with multiple beneficiaries, or an investment made through a joint account.
The Act also leaves largely undefined what it means to have “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.” Since the fundamental regulatory motivation underlying the Act is the protection of U.S. investors and financial markets, it is likely that the SEC will interpret the expression broadly in order to more closely regulate non-U.S. advisers whose business may have a material impact on U.S. investors or markets.
This and other provisions will likely be clarified through SEC rulemaking required to be completed by July 21, 2011. Because of the broad authority granted to the SEC, the actual impact of the Act will remain uncertain until the underlying rules and regulations are put into place.
However, unless another exemption is available, it is now apparent that a non-U.S. adviser will be required to register with the SEC if it meets any of the following criteria:
- it has more than 14 clients and investors in the United States in one or more private funds it manages;
- $25 million or more of the assets in the private funds it manages consist of assets attributable to one or more clients and investors in the United States; or
- 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.
In practice, unless the SEC significantly increases the $25 million AUM threshold discussed above, the new foreign private adviser exemption will provide extremely limited relief from SEC registration requirements and will severely limit the ability of non-U.S. advisers to raise significant funds in the United States without first registering as investment advisers with the SEC.
Registration with the SEC4
In order to register on a timely basis, a non-U.S. adviser subject to the registration requirement must file Form ADV with the SEC by July 21, 2011, and update the form annually. In addition, as a registered adviser it must, among other things, maintain books and records, implement compliance programs and maintain a code of ethics and insider trading policies and procedures.
Further, if the non-U.S. adviser has custody of client funds or securities, it generally 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 least once each calendar year, unless the fund it manages is subject to an annual financial statement audit prepared in accordance with generally accepted accounting principles 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.5
Finally, a registered adviser needs to ensure compliance with the additional reporting requirements introduced by the Act. Section 404 of the Act entitles the SEC to require a registered investment adviser to maintain records and file reports regarding the private funds it advises, including, at a minimum, 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) valuation policies and practices; (vi) types of assets held; (vii) side arrangements or side letters; (viii) trading practices; and (ix) any other information the SEC determines is necessary and appropriate for the protection of investors or the assessment of systemic risk.
Further information on the Act is available at: http://curtis-ifg.blogspot.com/.
In sum, the Act is expected to have a profound impact on many non-U.S. advisers that advise U.S. or non-U.S. private funds with U.S. investors or raise capital in the United States. Unless such advisers are able to qualify for the narrow foreign private adviser exemption or avail themselves of another exemption, they will 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 is likely to result in additional administrative and compliance costs for the adviser which, by some estimates, could exceed several hundred thousand dollars for complex hedge fund structures.
A non-U.S. adviser newly subject to registration with the SEC as an investment adviser under the Advisers Act must comply with the new requirements by July 21, 2011. To achieve registration by the deadline, advisers will likely have to file their applications significantly in advance.
1The Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, 111th Cong. (2010). Available at: http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.
2The Act includes large portions of the 2009 Draft. For further detail, please see: http://curtis-ifg.blogspot.com/2009/10/congressman-proposes-private-fund.html.
3Goldstein v. S.E.C., 451 F.3d 873, Fed. Sec. L. Rep. (CCH) P 93890 (D.C. Cir. 2006). In Goldstein, the D.C. Circuit rejected the SEC’s attempt to treat each investor in a private fund, rather than the fund itself, as an adviser’s “client” for purposes of the Advisers Act.
4For a detailed discussion on the procedure for registration as an investment adviser with the SEC and the requirements applicable to registered advisers please contact Carl A. Ruggiero or Victor L. Zimmermann.5For a detailed discussion regarding the current SEC custody rules please see “Amended Custody And Recordkeeping Rules To Become Effective On March 12, 2010” at: http://curtis-ifg.blogspot.com/2010/03/curtis-client-alert-amended-custody-and.html.