Monday, July 18, 2011

SEC Adopts Final Rules Implementing New Reporting, Recordkeeping and Custody Obligations

On June 22, 2011, the Securities and Exchange Commission (the “SEC”) adopted final rules to implement certain provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”).1 Among other things, the final rules (i) amend Form ADV to require additional disclosure by advisors; (ii) modify the definition of “hedge fund” to narrow the use of the term in the categorization of funds; (iii) implement a new uniform method for calculating assets under management (“AUM”); and (iv) amend the custody and disclosure requirements for advisers registered under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).

Title IV of the Dodd-Frank Act (“Title IV”) introduces various new reporting requirements for registered investment advisers. Currently, an investment adviser registered with the SEC must (i) submit registration forms – Form ADV Parts 1 and 2 – with the SEC; (ii) submit to each advisory client and prospective client a written disclosure statement that complies with Form ADV Part 2; (iii) comply with various detailed policies and maintain certain detailed records; and (iv) appoint an individual responsible for administering the adviser’s policies and procedures.

A. Form ADV

Under Title IV, Form ADV has been amended to require additional disclosure by advisers about their advisory and business relationships as well as their portfolios. Of particular note, Item 7.B.(1) of Schedule D requires detailed information about individual funds advised by the investment adviser to be disclosed, which would be made publicly available. The final rules expand the information that advisers must report to the SEC about the funds they advise. An adviser must complete a separate Schedule D for each “private fund” that the adviser manages.2 Information an adviser is required to report in Section 7.B.(1) will include (i) the name of the fund; (ii) the state or country in which the fund is organized; (iii) whether the fund is a master fund or a fund of funds; (iv) the regulatory status of the fund, such as exemptions from the Investment Company Act on which the fund relies; (v) the type of investment strategy the fund employs;3 (vi) whether the fund invests in securities of registered investment companies; (vii) the gross asset value of the fund; (viii) the minimum amount that investors are required to invest; (ix) the approximate number of beneficial owners of the fund (including related persons); (x) information about the fund’s gatekeepers, including administrators and auditors; and (xi) the extent to which clients of the adviser are solicited to invest, and have invested, in the fund.

The final rules also make modifications to clarify the definition of the term “hedge fund” in order to narrow the broad use of the term in an effort to more appropriately categorize funds. The definition of “hedge fund” no longer includes funds categorized as “securitized asset funds,” and the definition of “securitized asset fund” is no longer used in reference to “hedge funds.” Clause (a) of the “hedge fund” definition also was modified to relate only to fees or allocations that may be paid to an investment adviser (or its related persons) rather than accrued or allocated to them. Clause (a) was modified further so that hedge funds, in calculating performance fees or allocations, may not take into account unrealized gains solely for the purpose of reducing such fees or allocations to reflect net unrealized gain. Lastly, clause (c) was modified to provide an exception for short selling that hedges currency exposure or manages duration.

The final rules also include a new uniform method for calculating AUM that would be used to determine eligibility for exemptions and registration thresholds. In general, the adopted amendments eliminate adviser discretion that would have enabled advisers to opt in or out of federal or state regulation. Under the new method, advisers must count several classes of assets that currently may be excluded, such as proprietary assets, assets managed without receiving compensation, and assets of foreign clients. As such, Part 1A of Form ADV is amended to refer to an adviser’s AUM as “regulatory AUM.”4 Advisers also must include accrued but unpaid liabilities, uncalled capital commitments and the value of any private fund over which continuous and regular supervisory or management services are exercised, regardless of the nature of the assets held by the fund.5 Additionally, advisers must value all assets at fair value, rather than on a cost basis.

B. Custody, Recordkeeping, and Disclosure

The final rules amend Item 9 of Form ADV to require each registered adviser to indicate “the total number of persons that act as qualified custodians for the adviser’s clients in connection with the advisory services the adviser provides to its clients” to provide a more complete view of an adviser’s custodial practices. Advisers with custody of client funds must maintain those assets with a qualified custodian, and must know both the identity and number of qualified custodians that maintain said assets. The final rules also correct a drafting error in Item 9.A., which now requires advisers to exclude from Item 9.A., and to report in Item 9.B., client assets for which custody is attributed to the adviser as a result of custody by a related person. The client assets reported in Item 9.A. should only be those over which the adviser has physical, rather than constructive, custody.

Title IV requires the SEC to conduct periodic inspections of records of private funds maintained by registered investment advisers. Furthermore, Title IV grants the SEC broad power to conduct additional examinations at any time and from time to time as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk. Registered investment advisers must make available to the SEC “any copies or extracts from such records as may be prepared without undue effort, expense, or delay, as the [SEC] or its representatives may reasonably request.” The SEC is required to make these documents available to the Financial Stability Oversight Council, and to report annually to Congress on its use of the information collected. The costs incurred by the maintenance and reporting of such documents could prove significant for investment advisers.

Title IV further dilutes the ability of investment advisers to keep client information confidential by amending the disclosure requirements of Section 210 of the Advisers Act. Prior to the Dodd-Frank Act, Section 210(c) stated that no provision of the Advisers Act could be construed to require or authorize the SEC to require an investment adviser to disclose the identity, investments, or affairs of its clients unless such disclosure was “necessary or appropriate in a particular proceeding or investigation having as its object the enforcement of a provision or provisions of [the Advisers Act].” Title IV expands that carve-out to enable the SEC to require disclosure of such information “for the purposes of assessment of potential systemic risk.” Exempt reporting advisers also will be subject to the public disclosure requirements of Section 210.


  • The full text of the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173, is available at http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=111_cong_bills&docid=f:h4173enr.txt.pdf.



  • In the event there are multiple advisers to a single fund, only one adviser must report the information for the fund. Further, an adviser managing a master-feeder arrangement may submit a single Section 7.B.(1) on behalf of the master fund and all feeder funds if each fund would report substantially similar information.



  • The adviser may select from seven broad categories, including: (i) hedge fund; (ii) liquidity fund; (iii) private equity fund; (iv) real estate fund; (v) securitized asset fund; (vi) venture capital fund; and (vii) other private fund.



  • This amendment is meant to distinguish between Part 1A and Part 2 of Form ADV.



  • Calculating AUM on a gross, rather than a net, basis is designed to prevent advisers from utilizing highly leveraged positions to avoid federal registration and systematic risk reporting.



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