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SEC Adopts Rule Requiring Registration of Hedge Fund Advisers

December 30, 2004

On December 2, 2004, the Securities and Exchange Commission (SEC) adopted Rule 203(b)(3)-2 and amended several related rules (collectively, the Final Rule) under the Investment Advisers Act of 1940, as amended (the Advisers Act). The Final Rule requires certain hedge fund advisers and fund-of-fund advisers to register with the SEC and become subject to the Advisers Act. The adopting release is available at http://www.sec.gov/rules/final/ia-2333.pdf. The SEC believes the Final Rule will deter fraud, deny individuals with a history of disciplinary problems the ability to become advisers, establish compliance controls and enhance investor confidence in the growing hedge fund industry. There are ongoing legal challenges to the SEC's jurisdiction to adopt the Final Rule.

Effective Date for Compliance
The Final Rule becomes effective February 10, 2005 (except for the amendments to the Form ADV, which become effective January 10, 2005). All advisers who will be required to register under the Final Rule must be in compliance by February 1, 2006. On or before February 1, 2006, each adviser must: (i) designate a chief compliance officer by the date of registration; (ii) adopt compliance policies and procedures; and (iii) adopt a code of ethics. After registration, such advisers will be subject to the full scope of the Advisers Act and the regulations thereunder, including regulations pertaining to custody of client assets, soliciting new investors, charging performance fees, recordkeeping and proxy voting.

Registration Requirements
The Advisers Act exempts an adviser from registration if it (i) has had 14 or fewer clients during the preceding 12 months; (ii) does not hold itself out to the general public as an investment adviser; and (iii) does not act as an adviser to a registered investment company. For purposes of determining whether such exemption is available, the Final Rule requires advisers who provide investment advice to "private funds" to count each investor in a private fund as a client, rather than count the "private fund" as a single client.

The Final Rule defines a "private fund" as a company that:

• is exempt from registration as an investment company under Section
  3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act);
• permits investors to redeem their investments in the fund within two years of purchase; and
• offers its equity interests in the fund based on the "investment advisory skills, ability or expertise of the adviser."

By limiting the scope to companies which are exempt from registration under Section
3(c)(1) or 3(c)(7) of the Investment Company Act, this definition was designed to include most hedge funds and exclude most businesses, insurance companies, broker-dealers and banks. Also, the two-year redemption test would include most hedge funds as they are currently structured, since they generally offer investors liquidity at least annually, and would exclude most private equity or venture capital funds since they generally require investors to invest for terms longer than two years. Additionally, since investors are deemed to rely on the adviser's skills and expertise, this test prevents investment advisers, in particular hedge funds, from circumventing registration by delegating the advisory function to subadvisers or by establishing a "manager of managers' structure."

The Final Rule does not change Rule 230A-1 of the Advisers Act, which provides that investment advisers with less than $25 million in assets under management are not required to register unless they also advise a registered investment company. Advisers managing between $25 million and $30 million would be eligible, but not required, to register with the SEC.

Exceptions from Definition of "Private Fund"
Exceptions to Two-Year Redemption Test. The two-year redemption test in the definition of "private fund" permits a fund to offer redemption rights within two years of the investment under extraordinary circumstances without being considered a private fund. Such extraordinary circumstances may permit early redemptions (i) if continuing to hold the investment would result in a materially adverse tax or regulatory outcome; (ii) if continuing to hold the investment would become impractical or illegal; or (iii) if key personnel at the fund die, become disabled, or cease to be involved in the management of the fund. The redemption test also does not restrict the general partner or adviser from initiating distributions payable to all owners or a class of owners. In addition, the redemption test provides an exception for interests acquired through reinvestment of distributed capital gains or income.

Exception for Offshore Fund Advisers. Generally, an offshore adviser to an offshore private fund that makes a public securities offering outside the United States where the fund is regulated as a public investment company under the laws of another country is not considered a "private fund." However, Rule 203(b)(3)-2(c) requires offshore advisers to offshore private funds to register with the SEC if such adviser has 15 or more investors who are residents¹ in the United States (regardless of the amount of assets the adviser has under management). In such a case, the offshore adviser will only be subject to the provisions of the Advisers Act prohibiting fraud in connection with their dealings with its U.S. investors; most of the substantive provisions of the Advisers Act such as the compliance rules, custody rules or the proxy rules will not apply to the offshore advisers' activities with the fund or its non-U.S. investors.

Related Rule Amendments

1. Look Through for Fund-of-Funds. Rule 203(b)(3)-1 has been amended to clarify that hedge fund advisers must "look through" a fund-of-funds investor and count each investor in that fund-of-funds as a client.
2. Performance Fees Grandfathered. The SEC added a grandfathering provision to Rule 205-3 to allow newly-registered hedge fund advisers to continue to charge performance fees to their pre-February 10, 2005 investors, even those which are not "qualified clients."² This grandfathering provision would allow such pre-February 10, 2005 investors to maintain their interests in the fund and permit such investors to make additional investments in the fund. However, such investors are not permitted to invest in a new fund or a new account. This amendment to Rule 205-3 provides transitional relief for the investment advisers who are required by the rule to register.
3. Use of Historical Performance and Recordkeeping Requirements. The SEC has adopted two amendments to Rule 204-2 concerning an adviser's recordkeeping requirements. The first amendment exempts a newly registered hedge fund adviser from complying with a requirement that advisers maintain specific records to support claims of historical performance regarding any accounts managed by the adviser and would require that the adviser retain the records that the adviser actually has supporting such performance claims.³ The second amendment requires that the adviser maintain records of the private funds for which the adviser acts as an investment adviser and for which the adviser, or related person, acts as general partner, managing member or in a similar capacity. Advisers are required to provide the SEC with access to those records.
4. Extension of Time for Distribution of Financials. For fund-of-funds only, the Final Rule amends Rule 206(4)-2 by extending the deadline for which a registered adviser must deliver to investors the annual audited financial statements of a fund-of-funds it advises from 120 days to 180 days after the completion of the fiscal year-end of the fund. This recognizes that the fund must first receive audited financial statements from its portfolio funds.
5. Changes to Form ADV. Part 1A, Item 7 and Schedule D, Item 7 have been revised to identify investment advisers to "private funds" and to require them to identify the names of such funds, the approximate percentage of their clients invested in each such fund, the minimum investment requirement for each such fund and the current value of the assets of each such fund. The changes will be effective for all filings, including amendments made by advisers who are already registered, made on or after March 8, 2005.

Footnotes:
1.  An investor's residency status is only determined at the time of the investment in the private fund, and subsequent relocations would not change the investor's status.

2.  Generally, a "qualified client" is a person who, at the time of making an investment, has a net worth (together with their spouse) of more than $1.5 million or has at least $750,000 of assets under the management with the fund's adviser.

3.  In general, advisers that provide performance history to investors are required to retain records substantiating that performance for five years after the last use of such performance history.

For more information please contact the following Thelen LLP attorneys: 

E. Ann Gill, Esq.
Phone: 212.603.2412
agill@thelenreid.com

©2004 Thelen LLP. This client alert is presented as an information service to clients and friends. Please recognize that the information is general in nature and must not be relied upon as legal advice. The author, or your Thelen attorney contact, would be happy to discuss with you the information in this article and its application to your specific situation. We welcome your comments and suggestions.

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