On July 15, 2010, the U.S. Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, which includes the Private Fund Investment Advisers Registration Act of 2010 (the “Registration Act”).  Like earlier versions of the legislation passed by the House of Representatives and the Senate, the Registration Act will (1) require registration with the Securities and Exchange Commission (SEC) under the Investment Advisers Act of 1940 (“Advisers Act”) by many investment advisers that are currently exempt from registration, (2) require many other investment advisers currently registered with the SEC to transition to state registration, and (3) broaden reporting requirements for investment advisers to private funds.  The above adviser registration provisions will also apply to many non-U.S. advisers.

Most of the requirements of the Registration Act will not become effective until one year after its enactment.

Registration

The Registration Act will require certain investment advisers to register under the Advisers Act by eliminating exemptions upon which those investment advisers commonly rely.  Under current law, an investment adviser that (i) has fewer than 15 clients in any 12-month period, (ii) is not an investment adviser to a registered investment company or a business development company and (iii) does not hold itself out as an “investment adviser” is exempt from registration under the Advisers Act.  Most managers of hedge funds and private equity funds that are not currently registered rely on this exemption. Under the Registration Act, this exemption will be eliminated. It will be replaced with a narrow exemption (described below) for non-U.S. investment advisers.

In addition, the Registration Act will eliminate exemptions for investment advisers that offer advice only within a single state if one of their clients is a “private fund.”  The Registration Act will also eliminate the exemption for advisers to private funds that are registered as commodity trading advisors with the Commodity Futures Trading Commission if they subsequently become engaged predominantly in the provision of securities-related advice.  Private funds are defined under the Registration Act to include funds that would be an investment company under the Investment Company Act of 1940 (the “Company Act”) if it were not for the exceptions provided by Section 3(c)(1) or 3(c)(7) of the Company Act.  This definition captures most hedge and private equity funds.

The Registration Act will, however, exempt, or require the SEC to promulgate a rule to exempt, the following investment advisers from registration: (1) investment advisers whose sole clients are venture capital funds (as such term is defined by the SEC) (the “Venture Capital Exemption”), (2) investment advisers whose sole clients are private funds and will have total assets under management (AUM) in the United States of less than $150 million (the “$150 Million Exemption”)[1], and (3) investment advisers who provide investment advice solely to licensed small business investment companies (unless registered as a business development company).  Investment advisers relying on the Venture Capital Exemption or the $150 Million Exemption will be subject to record retention requirements and will be required to provide such reports as are required by the SEC.  The proposed exemption for advisers to private equity funds, which was included in the version of the Registration Act originally passed by the Senate, was eliminated in the reconciliation process.

The Registration Act will also exclude family offices from the definition of investment adviser.  The SEC will be required to develop a definition of “family office,” which recognizes the range of family office types and is consistent with past practice and specified grandfathering provisions.

Limited Exemption for Non-U.S. Investment Advisers

The Registration Act provides an exemption for non-U.S. investment advisers that will be available only to advisers that (1) have no place of business in the United States, (2) have less than $25 million in AUM related to clients or investors located in the United States or such higher amount as the SEC sets by rule, (3) have fewer than 15 clients and investors in private funds in the United States and (4) do not hold themselves out generally to the public in the United States as an investment adviser.[2] The requirement to count U.S. investors in offshore funds toward the “fewer than 15” test will make this exemption much more limited that the exemption available to many foreign fund managers under current law. While it seems likely that the SEC will continue the application of its “Unibanco” principles, which generally excuse non-U.S. registrants from complying with most regulatory requirements in their dealings with their non-U.S. clients, some adjustment of these principles with respect to offshore funds is to be expected.

Amendment of Threshold for Federal Registration

Current law generally prohibits an investment adviser from registering with the SEC unless it has at least $25 million of assets under management. The Registration Act creates an additional intermediate barrier to registration for certain investment advisers in the $25 million to $100 million range. Specifically, it prohibits an investment adviser from registering with the SEC if the adviser (1) is required to be registered as an investment adviser with the securities commissioner of the state in which it maintains its principal office and place of business and, if registered would be subject to examination by that state commissioner, agency or office, and (2) has AUM of $25 million[3] to $100 million (or a higher amount as may be set by the SEC), unless the investment adviser is an adviser to an investment company registered under the Company Act, or a company which has elected to be a business development company pursuant to the Company Act, and has not withdrawn the election.  If an investment adviser would be required to register with 15 or more states, then the adviser may, instead, elect to register with the SEC under section 203 of the Advisers Act.

Reporting

A registered investment adviser to a private fund will be subject to additional reporting, recordkeeping and disclosure requirements to the SEC and other third parties.  The Registration Act provides the SEC with broad authority to require registered advisers to maintain records, which will be subject to inspection, and file reports to the SEC as are “necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council …” (the “Council”) and to provide the Council and other entities that have responsibility for systemic risk the contents of those reports.  Those records and reports will include a description of (1) the amount of AUM, (2) the use of leverage (including off-balance sheet leverage), (3) counterparty credit risk exposure, (4) trading and investment positions, (5) valuation policies and practices of the fund, (6) types of assets held, (7) side arrangements or side letters, whereby certain advisers receive more favorable rights or entitlements, (8) trading practices, and (9) any other information that the SEC in consultation with the Council deems to be “necessary or appropriate in the public interest for the protection of investors or for the assessment of systemic risk…”  The SEC will also be allowed to require different reports for different classes of private fund advisers.  The SEC will be permitted to share the information it collects with the Council, but the SEC will not be compelled to disclose any report or information in the Registration Act to the public.

A registered investment adviser to a private fund will also be required to maintain records of any private fund that it advises, as provided in rules to be established by the SEC, and make the records of those private funds available for inspection by the SEC.  The SEC will also be permitted to conduct sweep examinations of registered investment advisers to assess perceived systemic risks.  The SEC will, however, be required to provide for registration and examination procedures that reflect the level of systemic risk presented by a particular private fund based on the size, governance and investment strategy of a particular fund.

The SEC will also have the authority to require certain investment advisers that are not registered with the SEC to file reports.  As stated above, investment advisers using the Venture Capital Exemption or the $150 Million Exemption will be required to file reports, the contents of which are not specified by the Registration Act.  Also, Section 204(b)(5) of the Advisers Act, as amended by the Registration Act, obligates the SEC to promulgate rules to require “each investment adviser to a private fund to file reports containing such information as the [SEC]… deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.”  Unlike other sections of the Registration Act, the scope of this subsection is not limited to registered investment advisers.

Adjustment of Accredited Investor Standard and Qualified Client Standard

The Registration Act requires the SEC to (1) adjust the net worth accredited investor standard for natural persons (currently more than $1 million either individually or jointly with spouse) to exclude the value of the person’s primary residence immediately upon passage, (2) increase the $1 million net worth standard after the fourth anniversary of passage of the Registration Act, (3) review the definition of “accredited investor” as it relates to natural persons, and (4) subsequently review the accredited investor standard (under Rule 215 under Regulation A under the Securities Act of 1933) as it applies to natural persons every four years.

The Registration Act also requires the SEC to adjust the “qualified client” standard in Rule 205-3 for inflation by the first anniversary of the Registration Act.  The SEC will also be required to adjust the qualified client standard every five years thereafter.

Custody

The Registration Act will also require registered investment advisers to take steps to safeguard client assets (as opposed to funds and securities), including verification with an independent public accountant.  Given the SEC’s changes to its custody rule under the Advisers Act, it is unclear whether this provision will result in changes to currently applicable custody requirements. 

Studies

The Registration Act will also require the SEC to conduct studies regarding (1) the feasibility, costs and benefits of real time reporting of short positions either publicly or to the SEC and the Financial Industry Regulatory Authority, Inc., including through the consolidated tape, (2) the current state of short selling, with emphasis on failures to deliver related thereto, (3) the financial thresholds or other criteria to qualify as an accredited investors, (4) the formation of a self-regulatory organization for private funds and (5) the compliance costs of the SEC’s custody rule under the Advisers Act.

Conclusion

Although the changes imposed by the Registration Act will not take effect for one year, unregistered investment advisers to private funds should consider devoting resources to their compliance practices now.  In particular, investment advisers that will be required to register with the SEC should consider: (1) appointing or determining who will serve in the role of chief compliance officer; (2) reviewing existing disclosure documents to determine what additional disclosures will be required upon registration; (3) conducting a compliance risk assessment; and (4) reviewing and revising, as necessary, existing compliance policies and procedures to ensure that required compliance mechanisms are in place (including proxy voting, codes of ethics, custody and information security policies).

In addition, many investment advisers will be required to transition to state regulation because of the amendments to the SEC registration thresholds for advisers that would be subject to a state registration regime.  Investment advisers that are currently registered with the SEC but have less than $100 million in AUM should begin to examine the differences between state and SEC rules, including relevant securities examination requirements.  Advisers that will transition to state registration should also consider beginning the registration process with the appropriate state in advance of the one-year transition period in order to avoid likely processing backlogs.

[1] It is unclear from the text of the Registration Act whether a “fund of one” would satisfy the requirements for a private fund for the purposes of the $150 Million Exemption.

[2] This exemption does not apply to non-U.S. advisers to registered investment companies or business development companies.

[3] The existing threshold for registration with the SEC as an investment adviser of $25 million will continue to apply.