More than a month after adopting new provisions under the Investment Advisers Act of 1940 (the "Advisers Act") in a 3-2 split vote, the Securities and Exchange Commission ("SEC") released the final rule and rule amendments that will require most hedge fund advisers to register with the SEC. [fn1] Advisers affected by the new requirements must register and have all policies and procedures in place by February 1, 2006.
Impact on Private Adviser Exemption
As a general rule of course, absent an exemption, investment advisers must register with the SEC. [fn2] Many hedge fund advisers use the "private adviser exemption" provided by Section 203(b)(3) of the Advisers Act. Under the private adviser exemption, an investment adviser is exempt from registration requirements if it: (i) had 14 or fewer clients during the preceding 12 months; (ii) does not hold itself out generally to the public as an investment adviser; and (iii) is not an adviser to any registered investment company. [fn3] The recently adopted rule and amendments are designed to make the private adviser exemption unavailable to most hedge fund advisers.
Counting Clients
Before new Rule 203(b)(3)-2, a legal entity that received investment advice based on its investment objectives rather than an investor's individual investment objectives could be counted as one client for the purpose of determining whether the adviser qualified for the private adviser exemption. A hedge fund adviser could count each hedge fund as a single client, regardless of the number of investors that held a beneficial interest in the fund. Under the new rule, advisers must now look through certain entities, including most hedge funds, and count each beneficial owner of the entity as a client. [fn4] Therefore, an investment adviser must now count each shareholder, limited partner, member or beneficiary of a private fund with certain characteristics (hereinafter, a "private fund") towards the 14 or fewer client threshold of the private adviser exemption.
Fund-of-Funds
The new Rule 203(b)(3)-2 also addresses the SEC's concern with hedge funds that use a fund-of-funds structure. The fund-of-funds structure, in the SEC's opinion, has made hedge funds more broadly available to investors. Typically, hedge funds are offered to institutional investors; however, a growing number of smaller investors (e.g., non-institutional investors) have been able to invest in hedge funds indirectly via a fund of hedge funds. [fn5] Under the new rule, the adviser of an underlying hedge fund must look through the "top tier" fund, regardless of whether the fund is a registered or a private fund, and count its investors as clients.
Offshore Advisers
The SEC extended the look-through requirements to apply to non-U.S. advisers. Regardless of the private fund's location, non-U.S. advisers must now look through a private fund (as defined under the new rule and discussed below) that it advises and count investors who are U.S. residents as clients. The SEC provided guidance for determining when an investor should be considered a U.S. resident. In the Adopting Release, the SEC stated that an adviser may look: (i) in the case of individuals, to their residence; (ii) in the case of corporations and other business entities, to their principal office and place of business; (iii) in the case of personal trusts and estates, to the rules set forth in Regulation S; and (iv) in the case of discretionary or non-discretionary accounts managed by another adviser, to the location of the person for whose benefit the account is held. The key time-period for the analysis of whether an investor is a U.S. resident is the time of investment in the private fund.
Offshore Funds
A fund that: (i) maintains its principal office and place of business outside the U.S., (ii) makes a public offering of its securities outside the U.S., and (iii) is regulated as a public investment company under the laws of another country is exempt from the definition of "private fund." Non-U.S. advisers to such offshore public funds are not required to register with the SEC. An offshore adviser to an offshore private fund may treat the fund as its client for most purposes of the Advisers Act. Unless an offshore adviser to an offshore private fund qualifies for an exemption (i.e., the private adviser exemption), the offshore adviser will be required to register with the SEC and to maintain certain books and records, and will be subject to SEC examinations. However, other substantive requirements under the Advisers Act rules will not apply, such as the rules relating to compliance, custody, and proxy voting. A registered offshore adviser will not be required to adopt a code of ethics, but will be required to preserve its access persons' personal securities reports.
Definition of "Private Fund"
The new rule adds the definition of "private fund," which is tailored to require a look-through of hedge funds, but not other types of unregistered investment products, such as private equity funds or venture capital funds. The definition focuses on three characteristics shared by most hedge funds. As defined in Rule 203(b)(3)-2(d)(1), a private fund is a company:
- that would be subject to the requirements of the Investment Company Act of 1940 (the "1940 Act"), but for the exception provided in either Section 3(c)(1) or Section 3(c)(7) of the 1940 Act; [fn6]
- that permits investors to redeem their interests in the fund within two years of purchasing them; and
- in which interests are offered based on the ongoing investment advisory skills, ability or expertise of the adviser.
The new rule adds a caveat that a company is not a private fund if it permits its investors to redeem their interests within two years of purchase if:
- events were found to be extraordinary, after reasonable inquiry; and
- interests were acquired through reinvestment of distributed capital gains or income.
Private equity funds and venture capital funds typically would not satisfy the second condition, because such funds generally have longer lock-up periods, and thus would typically not be subject to a look-through for counting purposes.
Other Related Rule Changes
Performance Fees
Generally, a registered investment adviser may not charge a performance-based fee to investors who are not "qualified clients" (as defined under the Advisers Act). [fn7] Because some investors in a small number of hedge funds may not meet the qualified client requirements, the SEC adopted rule amendments "grandfathering" existing hedge fund investors to avoid disruption to current performance fee arrangements. Without the exemption, investors that did not meet the qualified client standards would be required to withdraw their investment from the fund once the adviser registered, or the adviser would not be permitted to charge a performance-based fee. The SEC also extended its grandfathering provision to other types of investment pools or separate accounts managed by hedge fund advisers. After the February 10, 2005 effective date, new investors in hedge funds must satisfy the qualified client requirements in order for the adviser to charge a performance-based fee.
Recordkeeping Requirements
After the amendments become effective, newly registered hedge fund advisers will be subject to recordkeeping requirements under the Advisers Act. Generally, a registered adviser must keep documentation supporting its performance track record for a period of five years after the performance information is last used. Because previously unregistered hedge fund advisers may not have maintained such records, the amended rule provides a transition period. Hedge fund advisers may continue to market their performance record for periods prior to February 10, 2005, even if they have not maintained the records required by the recordkeeping rule. Although hedge fund advisers have until February 1, 2006 to register, they must maintain the required records beginning February 10, 2005. After registering with the SEC, the hedge fund adviser must comply with the recordkeeping provisions going forward.
The amended rule also clarifies that the recordkeeping requirements include the records of private funds for which the adviser acts as a general partner, a managing member, or in a similar capacity.
Other Implications for Hedge Fund Advisers
The new rule and amendments have other implications for hedge fund advisers who will be required to register with the SEC. The new registrants will be subject to SEC oversight and inspections. Registered hedge fund advisers will be required to comply with all of the rules under the Advisers Act, including rules related to custody of pooled assets, proxy voting, and a code of ethics. Hedge fund advisers will be subject to the rule requiring registered advisers to develop a compliance program and to appoint a chief compliance officer. This means that hedge fund advisers will have to adopt policies and procedures designed to prevent violation of the Advisers Act. In addition to being subject to the Advisers Act regulatory regime, hedge fund advisers will be required to file Part I of Form ADV with the SEC, and to complete Part II of Form ADV and provide copies to their clients. And the ADV will have to publicly disclose certain (fairly limited) information about each private fund.
Compliance Dates
Affected hedge fund advisers may begin complying with the new rule and rule amendments as of their effective dates in early 2005; however, the hedge fund advisers have until February 1, 2006 to comply with the new requirements.
Footnotes
1: See Registration Under the Advisers Act of Certain Hedge Fund Advisers, Final Rule, Release No. IA-2333 (December 2, 2004) (the "Adopting Release").
2: See Section 203(a) of the Advisers Act [15 U.S.C. § 80b-3(a)]. See also Section 203A and Rule203A-1 [15 U.S.C. § 80b-3A and 17 C.F.R. § 275-203A-1]. An investment adviser that maintains its principal office and place of business in the United States must also have at least $25 million in assets under management to be eligible to register with the SEC.
3: Advisers that qualify for the private adviser exemption are still subject to the anti-fraud provisions of the federal securities laws. See, e.g., Section 206 of the Advisers Act [15 U.S.C. § 80b-6], Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder [15 U.S.C. § 78j(b) and 17 C.F.R. § 240-10b-5].
4: The Adopting Release clarifies that an investment adviser is not required to count itself or certain knowledgeable employees of the adviser who are "qualified clients" as a client of the private fund.
5: According to the Adopting Release, funds of hedge funds represent approximately 20% of hedge fund capital, and are the fastest growing source of capital for hedge funds today. See Adopting Release at p. 14.
6: Section 3(c)(1) of the 1940 Act [15 U.S.C. § 80a-3(c)(1)] excludes a fund from the definition of "investment company" if it has no more than 100 beneficial owners and does not make or propose to make a public offering of its securities. Section 3(c)(7) of the 1940 Act [15 U.S.C. § 80a-3(c)(7)] excludes a fund from the definition of "investment company" if, at the time of investment, its investors are "qualified purchasers" (as defined by the rule) and the fund does not make or propose to make a public offering of its securities.
7: See Rule 205-3(d)(1) [17 C.F.R. § 275.205-3(d)(1)].