Investment Advisers Should Start Planning Registration Based On SEC Proposed Rules
As 2011 begins, investment advisers need to analyze whether they will need to register as an investment adviser with the Securities and Exchange Commission (SEC) or a state securities authority. While final rules have not yet been adopted, the SEC recently proposed several rules to clarify the new exemptions from registration in the Investment Advisers Act of 1940 (the “Advisers Act”) that were added by the Dodd-Frank Wall Street Reform Protection Act (the “Dodd-Frank Act”). The proposed rules would define the new exemptions in the Advisers Act for investment advisers that (1) only advise private funds and have less than $150 million in assets under management (AUM) in the United States or (2) only advise venture capital funds. The proposed rules would also clarify the filings that those exempt investment advisers must make with the SEC and the mechanics of transitioning to state registration, if applicable. In addition, the SEC proposed to intensify disclosure relating to private funds in Part 1A of Form ADV and to change the methodology of computing of AUM. Finally, the SEC proposed to amend its recently adopted “pay-to-play” rule to, among other things, conform it to changes resulting from the Dodd-Frank Act. The proposed rules are subject to a 45-day comment period.
Exemption for Advisers Only to Private Funds with Less Than $150 Million in AUM
The Dodd-Frank Act added new Section 203(m) to the Advisers Act, which requires the SEC to adopt a rule exempting investment advisers that only advise private funds and have less than $150 million in AUM in the United States (the “$150 Million Exemption”). Section 203(m) also requires investment advisers exempted by the $150 Million Exemption to maintain the records and make annual or other reports as the SEC determines is necessary or appropriate for the public interest or for the protection of investors. The proposed rules would clarify several issues relating to the exemption, including the impact of non-United States activities, the method of calculating AUM and the reporting that is required.
Would having a managed account that is located outside of the United States prohibit an adviser from using the $150 Million Exemption?
The answer depends on the adviser’s principal place of business. An investment adviser with a principal place of business located in the United States would not be permitted to have any clients that are not private funds irrespective of whether the client is a United States person. An investment adviser with a principal place of business outside of the United States would be disqualified from using the $150 Million Exemption due to having a managed account client only if that client is a United States person. A “United States person” is defined generally as a “U.S. person” pursuant to Regulation S under the Securities Act of 1933 (the “Securities Act”).
What would AUM in the United States include?
The proposed rule would compute AUM in the United States differently for advisers with a principal place of business in the United States than for those with a principal place of business outside the United States. Investment advisers with a principal place of business in the United States would be required to include the “regulatory” AUM (as defined below) of all of its private funds even if some of the AUM is managed from a non-U.S. branch office. Advisers with a principal place of business outside of the United States that have a place of business in the United States would only be required to include assets managed from a place of business in the United States. Investment advisers that have no place of business in the United States would be able to use the $150 Million Exemption regardless of the number of United States investors in any private fund that they manage or advise or the assets attributable to those investors.
What reports would an adviser relying on the $150 Million Exemption have to file with the SEC?
An adviser relying on the $150 Million Exemption would be required to file a partial Form ADV Part 1A as set forth below under “Required Filings for Exempt Reporting Advisers.” No other reports were contemplated by the proposed rules.
How would an investment adviser transition to registered status when its regulatory AUM exceeds $150 million?
An investment adviser to private funds using the $150 Million Exemption would be required to measure its regulatory AUM as of the end of each calendar quarter. If the adviser’s regulatory AUM as of the end of any calendar quarter were to equal or exceed $150 million, it would be required to register with the SEC. If the formerly exempt investment adviser had filed all reports that it was required to file on Form ADV, it would have one quarter after crossing the threshold to register with the SEC.
Would an investment adviser be subject to examination by the SEC if it is using the $150 Million Exemption?
The SEC has the authority to examine any investment adviser (regardless of its registered status) other than investment advisers that are exempt from registration under 203(b) of the Advisers Act, such as “foreign private advisers” or registered commodity trading advisors that do not predominantly provide advice as to securities. As the $150 Million Exemption is located in Section 203(m) of the Advisers Act, the SEC will have examination authority over investment advisers exempt under the $150 Million Exemption. From the staff’s statements in the open meeting proposing the rules, however, it seems that its focus would be on cause examinations instead of routine examinations.
Foreign Private Advisers
The Dodd-Frank Act added an exemption from SEC registration in Section 203(b)(3) for “foreign private advisers.” “Foreign private advisers” are defined as investment 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.
How would a foreign private adviser determine how many clients in the United States it has?
The number of clients would be determined in a similar manner to the counting of clients for the current “fewer than 15 clients” exemption. The only differences are that clients for which an adviser receives no compensation would be required to be counted and that private funds that have investors that are counted for the separate investor test below would not be required to be counted as a client. A potential foreign private adviser would generally only be required to count clients that are “U.S. persons,” as defined under Regulation S under the Securities Act.
Who would be counted as investors in the United States?
The proposed rules would look to whether a person would be included in determining the number of beneficial owners in Section 3(c)(1) of the Investment Company Act of 1940 (the “Company Act”) or whether outstanding securities are owned exclusively by qualified purchasers under Section 3(c)(7) of the Company Act (including applicable look-throughs) in order to determine who would be an investor, subject to several exceptions and clarifications. First, knowledgeable employees would be counted as investors for purposes of the foreign private adviser determination. Second, any beneficial owner of outstanding short-term paper would also be counted as an investor. Third, any investors in a feeder fund formed for the purpose of investing in a master fund advised by a potential foreign private adviser would be required to be counted. Finally, any person holding an interest through a nominee arrangement or total return swap would be required to be counted as an investor. According to the SEC’s previous guidance for 3(c)(1) and 3(c)(7) exclusions, a potential foreign private adviser would generally only be required to count investors that are “U.S. persons,” as defined under Regulation S under the Securities Act.
What if a client or investor was not in the United States at the time of investment or of becoming a client, but subsequently moves to the United States?
A client or investor that moves to the United States subsequent to his or her becoming an investor or client would not be counted toward the above limit.
How are the $25 million in AUM determined?
The AUM attributable to United States clients and investors would be measured using regulatory AUM as defined below.
What is a place of business in the United States?
A “place of business” would be defined as “an office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.” The place of business is deemed to be in the United States if it is located in the United States of America, its territories and possessions, any state of the United States or the District of Columbia.
Advisers to Venture Capital Funds
The Dodd-Frank Act added new Section 203(l) to the Advisers Act, which will exempt investment advisers that only advise “venture capital funds” (as defined by the SEC) from the registration requirements of the Advisers Act (the “Venture Capital Exemption”). Section 203(l) will require investment advisers exempted by the Venture Capital Exemption to maintain the records and make annual or other reports as the SEC will determine is necessary or appropriate for the public interest or for the protection of investors.
How would the proposed rules define a “venture capital fund?”
“Venture capital funds” would be defined as any private fund that (1) represents to its investors that it is a venture capital fund, (2) owns solely equity securities issued by one or more qualifying portfolio companies (defined below), cash or cash equivalents and U.S. Treasury securities with a remaining maturity of 60 days or less; (3) acquired at least 80 percent of those equity securities of a qualifying portfolio company directly from the issuer, (4) either (a) controls its qualifying portfolio company or (b) has an arrangement whereby the fund or the relevant adviser has offered to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company and would provide the guidance and counsel if its offer were accepted, (5) does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the private fund’s aggregate capital contributions and commitments, (6) limits any such borrowing, indebtedness or guarantees to a term of 120 days on a nonrenewable basis, (7) does not permit its holders to withdraw or redeem their securities except in extraordinary circumstances and (8) is not registered as an investment company under Section 8 of the Company Act and has not elected to be treated as a business development company. Most private equity funds would fail to satisfy one or more of the elements of the venture capital definition.
What is a qualifying portfolio company?
A “qualifying portfolio company” would be defined as a company that (1) is not publicly traded or affiliated with a company that is publicly traded, (2) does not borrow or directly or indirectly issue debt obligations in connection with the venture capital fund’s investment, (3) does not redeem, exchange or repurchase any securities of the company or distribute to pre-existing security holders cash or other company assets, directly or indirectly, in connection with the venture capital fund’s investment and (4) is not an investment company, a private fund, a commodity pool or an issuer of asset-backed securities that would be an investment company were it not for Rule 3a-7 under the Company Act. The proposing release clarifies that the use of capital of the investment would need to be for operating and business expansion capital and not for purchases of securities.
What are extraordinary events allowing for redemption?
A venture capital fund would be allowed to permit an investor to withdraw from the fund for foreseeable but unexpected circumstances, such as changes in the law or corporate events such as mergers. The venture capital fund would also be permitted to exclude investors from participation in some funds’ investments, such as due to a change in tax laws or other regulatory changes, without requiring registration. Venture capital funds are also permitted to conduct pro rata distributions.
If a venture capital fund has held itself out as a venture capital fund, but would not satisfy the above definitional requirements, would its related investment adviser be able to use the Venture Capital Exemption?
The proposed rules would grandfather certain investment funds that would not satisfy all of the requirements of the “venture capital fund” definition. The grandfathered funds would include any private fund that has represented to investors and potential investors at the time of the offering that it is a venture capital fund, commenced its offering to unaffiliated investors prior to December 31, 2010, and does not sell any securities to, nor accept any additional committed capital from, any person after July 21, 2011.
TRANSITION TO STATE REGISTRATION FOR MANY ADVISERS WITH LESS THAN $100 MILLION IN AUM AND REQUIRED TO BE REGISTERED WITH, AND EXAMINED BY, A STATE SECURITIES AUTHORITY
Current law generally prohibits an investment adviser from registering with the SEC unless it has at least $25 million of assets under management. The Dodd-Frank Act creates an additional intermediate barrier to registration for any investment adviser that (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 and (2) has AUM of $25 million 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 that has elected to be a business development company pursuant to the Company Act and has not withdrawn the election. The proposed rules clarify several questions left unanswered by the changes to the Dodd-Frank Act regarding the logistics of transitioning to state registration and the applicability of a higher AUM threshold.
When would an investment adviser be required to transition from federal to state registration?
All SEC-registered investment advisers would be required to file an amendment to their Form ADVs no later than August 20, 2011 (30 days after the expiration of the transition date under Form ADV), reporting the market value of their regulatory AUM determined within 30 days of the filing (the “Transition ADV”). If the adviser has less than the required amount of assets under management as of the date of such filing, the registrant will be required to file Form ADV-W withdrawing its registration with the SEC no later than October 19, 2011 (60 days after the required filing of the above amendment to Form ADV).
An investment adviser’s regulatory AUM may fluctuate above and below $100 million on a regular basis. Would an investment adviser have to register and deregister multiple times a year?
No, other than as set forth above for the Transition ADV, an SEC-registered investment adviser is required to measure its regulatory AUM after its annual updating amendment to its Form ADV. If an adviser’s regulatory AUM decreases during the year, it would not be required to transition from SEC to state registration until its next annual updating amendment. Other than for the Transition Form ADV, the proposed rules would require transition from SEC registration to state registration within 180 days as under the current rule.
The Dodd-Frank Act allowed the SEC to adopt a higher threshold for transition to state registration. Did the SEC increase the registration threshold to allow for a range of AUM that permits voluntary registration?
No, the proposed rule did not include an intermediate AUM range for voluntary registration, but, instead, relies on the annual measurement of regulatory AUM only.
If an investment adviser with less than $100 million in regulatory AUM is able to take advantage of an exemption under a state investment adviser statute or its related regulations, would the investment adviser escape registration at both the state and federal levels?
No, investment advisers that are exempt from state registration in the state of their principal place of business would not be “required to register” with that state’s securities authority and, therefore, would be required to register with the SEC unless an exemption from registration is otherwise available. Also, a state-exempt investment adviser would not be able to voluntarily register with the state securities authorities to avoid registration with the SEC.
If an investment adviser is not required to register with a state securities authority because of an exemption, would an investment adviser only be required to register with the SEC once it has $25 million in regulatory AUM or would it be able to take advantage of the $5 million buffer and register at the $30 million in AUM level?
In almost every state, an investment adviser would be required to register once it has $25 million in regulatory AUM. The proposed rules would eliminate the $5 million buffer and, therefore, require the registration of a state-exempt investment adviser with the SEC if the adviser has more than $25 million in regulatory AUM unless an exemption from registration is otherwise available.
How would an investment adviser be able to determine if a state inspects the investment advisers that are registered with it?
The SEC stated that it will correspond with each state securities commissioner or similar official and request advice as to whether investment advisers registered in that state would be subject to inspection. The SEC will then incorporate the responses into the Investment Advisers Registration Depository system.
CHANGES TO AUM CALCULATION
Several of the proposed rules require determinations of an investment adviser’s “regulatory AUM.” Regulatory AUM is a new term used to indicate the AUM of an investment adviser as determined in accordance with specified instructions to Part 1A of Form ADV (rather than for purposes of Part 2A of Form ADV). The calculation of regulatory AUM in the instructions to Part 1A of Form ADV is similar to previous versions, with a few changes for private funds and discretionary assets. Under both the current and proposed AUM definition, “AUM” is defined as the value of securities portfolios with respect to which the investment adviser provides continuous and regular supervisory or management services. The new regulatory AUM definition changes the accounts to be counted as “securities portfolios” and the value of those securities portfolios. To review the definition of regulatory AUM, see instruction 5.F. available here.
How would the proposed changes to Form ADV change the accounts that are determined to be “securities portfolios?”
The current definition of AUM allows, but does not require, investment advisers to include securities portfolios that are (1) proprietary and family assets, (2) assets managed without compensation and (3) assets of clients who are not United States persons. The proposed Form ADV would require investment advisers to include those securities portfolios. The proposed Form ADV would also require investment advisers to include all of the assets of private funds as a securities portfolio regardless of the nature of those assets and include any uncalled capital commitments in that securities portfolio.
How would the proposed changes to Form ADV change the calculation of the value of the regulatory AUM?
As with the previous AUM calculation, an adviser would be required to calculate the AUM based on the current market value of the assets determined within 90 days of the filing of the relevant Form ADV. The proposed Form ADV would define a private fund’s AUM to be the current market value (or fair value) of the private fund’s assets.
Would the assets be reduced for liabilities or debt?
No, the previous AUM calculation stated that securities purchased on margin should not be deducted. The proposed Form ADV would expand the exclusion to prohibit an adviser from subtracting any outstanding indebtedness and other accrued but unpaid liabilities that remain in a client’s account and are managed by the adviser.
CHANGES TO FORM ADV FOR REGISTERED INVESTMENT ADVISERS AND EXEMPT REPORTING ADVISERS
Amendments to Form ADV Part 1A in General
In connection with the proposed new rules, the SEC is proposing to amend Part 1A of Form ADV to collect more information about private funds. The SEC proposes to reinstate the questions in Item 7 of Form ADV and Schedule D originally adopted in 2004 containing identifying information regarding investment limited partnerships (now private funds), including the name of the fund, its AUM and general partner. It also proposes to expand questions about private funds in Item 7 and Schedule D to inquire into—
- the state or country of organization of the private fund
- the directors, manager, trustee or general partner of the private fund
- the private fund identification number of the relevant private fund
- all of the exclusions from the definition under the Company Act for which the private fund qualifies
- the name(s) of the foreign financial regulatory authority with which the private fund is registered
- whether the private fund is a master fund, and the name and private fund identification number of the feeder funds and vice versa
- all of the above information regarding the feeder funds
- whether the fund is a fund of funds, and whether it invests in related private funds
- whether the private fund invests in securities of registered investment companies
- a description of the type of fund, e.g., hedge fund, liquidity fund, private equity fund
- the gross and net asset value of the private fund
- a breakdown of the asset and liability classes of a private fund, categorized by the fair value hierarchy established under U.S. GAAP (Level 1, Level 2 or Level 3)
- the minimum investment in the private fund
- the number of beneficial owners of the private fund
- the approximate percentage ownership in the private fund by funds of funds, non-U.S. persons and the investment adviser and its related persons
- a breakdown of the approximate percentage ownership by all investors by type of owner, including, but not limited to, individuals, broker-dealers, registered investment companies, pension plans and government entities
- whether the investment adviser is a subadviser, the fund that it subadvises and the name and SEC file number of other subadvisers to the fund
- whether the adviser relies on Regulation D, and the private fund’s Form D file number
- whether the investment adviser’s financial statements are subject to audit, information regarding the private fund’s auditor and registration status, and whether audited financial statements are distributed to clients
- whether the private fund uses a prime broker, and the name, Central Registration Depository (CRD) number and office location of the prime broker
- whether the prime broker acts as a qualified custodian
- the names, office location, related person status and CRD number of each custodian
- whether the private fund uses an administrator, and its office location, name, related person status
- whether the administrator sends account statements, and the portion of investors sent statements by the administrator
- the percentage of the private fund’s assets that are valued by a third party, and the name and location of the entity so valuing
- whether the private fund uses third parties to market the private fund’s securities, and the name, location, related person status and CRD number of such marketer and any Web sites that the marketer uses.
In addition, the SEC would expand information required from all investment advisers. New information would include, among other things—
- identifying information regarding registered representatives and employees
- a breakdown of the types of investments for which an investment adviser provides advice
- additional information regarding related persons
- whether any broker-dealers the adviser recommends are related persons
- whether all soft dollar benefits received from a broker-dealer comply with the safe harbor under Section 28(e) of the Securities Exchange Act of 1934 (the “Exchange Act”)
- a check box indicating whether the investment adviser has more than $1 billion in assets, for purposes of monitoring those investment advisers that may be subject to the excessive incentive compensation provisions of the Dodd-Frank Act.
A link to the proposed new Part 1A of Form ADV, is available here.
Required Filings for Exempt Reporting Advisers
Investment advisers taking advantage of the $150 Million Exemption or the Venture Capital Exemption (together “Exempt Reporting Advisers”) would be required to file a limited Form ADV 1A.
What information would be required to be included in Exempt Reporting Advisers’ reports on Form ADV?
An Exempt Reporting Adviser would be required to complete the following sections of Part 1A of Form ADV—
- identifying information (Item 1)
- a new section relating to Exempt Reporting Advisers containing a checkbox identifying whether the relevant Exempt Reporting Adviser is relying on the $150 Million Exemption or the Venture Capital Exemption and, if the $150 Million Exemption is checked, the amount of private fund assets the investment adviser manages (Item 2.C)
- information regarding the investment adviser’s form of organization (Item 3)
- other business activities of the investment adviser (Item 6)
- the reporting relating to private funds set forth above and affiliations with other entities in the financial industry (Item 7)
- information regarding control persons (Item 10)
- disclosure information regarding disciplinary and other events (Item 11)
- Schedules A, B, C or D of Part 1A.
Exempt Reporting Advisers would not be required to complete the remainder of the form or a brochure under Part 2A of Form ADV.
Would the information in a report filed by an Exempt Reporting Adviser be publicly available?
Yes, information in a report filed by an exempt reporting adviser would be publicly available just as other Form ADVs are.
When would Exempt Reporting Advisers be required to file their limited reports on Form ADV?
Exempt Reporting Advisers will be required to file their initial reports within 30 days of July 21, 2011, i.e. August 20, 2011. After their initial filing, Exempt Reporting Advisers would report on an annual basis. An Exempt Reporting Adviser would also be required to update its Form ADVs if there is any change to the identification information, form of organization or disciplinary history or if there is a material change to its control person’s disclosure.
Did the SEC provide grandfathering provisions in the proposed rules?
Yes, the SEC added a transition rule for the maintenance of books and records relating to the performance of a private fund or other managed account prior to July 21, 2011, provided that the adviser was not registered with the SEC during the relevant periods. Advisers must, however, preserve any records that it already possesses. The SEC did not provide any grandfathering or transition rules for performance fees.
CHANGES TO PAY-TO-PLAY RULE
Effective as of September 13, 2011, the SEC’s pay to play rule, Rule 206(4)-5 under the Advisers Act (the “Pay-to-Play Rule”) will, among other things, prohibit registered investment advisers and investment advisers that are exempt as advisers to fewer than 15 clients from using any third party to solicit government entities unless the third party is registered as an investment adviser or broker-dealer and is subject to the same pay-to play-rules as subject investment advisers. Because of changes in regulation due to the Dodd-Frank Act, the SEC is proposing two changes to the Pay-to-Play Rule. First, the SEC is replacing the reference to the “fewer than 15 clients” exemption and replacing it with “foreign private advisers” and “Exempt Reporting Advisers.” Second, the Dodd-Frank Act introduced a new regime for “municipal advisers,” consisting of persons who solicit a municipal entity. Under the proposed rule, subject investment advisers would only be permitted to use third-party registered investment advisers and broker-dealers that are “regulated municipal advisers” under Section 15B of the Exchange Act.
Mary Schapiro, chairman of the SEC, stated that the SEC would try to expedite the adoption of the final rules in order to provide certainty for advisers that may have to register as investment advisers. Given the number of potential applicants, we recommend that investment advisers that believe that they will have to register based on the guidance in the proposed rules begin preparing for registration and reach out to counsel and service providers for assistance as soon as possible. We will keep you up to date as the rules progress through the regulatory process.
 Several places in the proposed rules incorporate the definition of “U.S. Person” under Regulation S under the Securities Act. The proposed rules, however, vary from the Regulation S definition in that discretionary accounts held by a related broker-dealer or fiduciary organized in the United States for the benefit of a United States person would be a United States person for the purposes of the proposed rules.
 The proposed rules, as in the counting rules for the â€œfewer than 15 clientsâ€ exemption, would count the following as one client: an entity receiving advice based on its investment objectives; two entities with the same owners; an an individual together with his or her minor children, cohabitating spouse or relatives and related trusts and accounts.
 The term as used is defined in Rule 3c-5 under the Company Act.
 Rule 222-1 under the Advisers Act.
 Cash equivalents are defined by Rule 2a51-1(b)(7)(i) under the Company Act.
 Under the proposed rules, venture capital funds that invest as a group would only satisfy the definition if each venture capital fund (or its adviser) offered (and, if accepted, provided) managerial assistance or exercised control.
 “Publicly traded” for this purpose would include companies that have a security listed or traded on an exchange outside of the United States.
 Note that the 90-day transition period contemplated by the proposed rules is shorter than the 180 days set forth in the current rules. Investment advisers that expect to have to transition to state registration may wish to dual-register with a state prior to July 21, 2011, in order to accommodate state investment adviser registration timelines and avoid gaps in registration.
 Wyoming does not have a statute that regulates investment advisers, so investment advisers located in that state must register with the SEC starting at dollar one.
 The U.S. Circuit Court of Appeals for the District of Columbia vacated Item 7B in Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir 2006).
David M. Billings
Simon W. Thomas
Ying Z. White