November 11, 2004
At its meeting on October 26, 2004, the SEC voted to adopt new rules that will subject certain hedge fund advisers to regulation under the Investment Advisers Act of 1940. New Advisers Act Rule 203(b)(3)-2 (and amendments to related rules) will require investment advisers to count the owners of "private funds" as clients for purposes of determining whether the adviser had fewer than 15 clients during the preceding 12 months, a threshold that triggers registration under the Act. Investment advisers subject to the new Rule will be required to register by February 1, 2006.
In the past, investment advisers generally treated a private fund (regardless of how many investors participated in it) as a single client. The definition of "private fund" is expected to include most hedge funds, but not private equity funds. The new Rule will also have special provisions for offshore advisers that are intended to limit application of the Advisers Act to offshore funds with U.S. investors.
The SEC is expected to release details of the new Rule in the next few weeks, although the Rule is expected to be substantially as proposed by the SEC in July. The following is a brief summary of the proposed Rule and related amendments. Further details of the Rule as adopted will be provided as soon as they are available from the SEC.
Background
Under the Advisers Act, only a registered investment adviser is permitted to use the mails or otherwise engage in interstate commerce in connection with its business. There are various exceptions, including an exception for advisers with fewer than 15 clients during the preceding 12 months who do not hold themselves out to the general public as investment advisers or act as advisers to registered investment companies or business development companies.
An investment adviser that is subject to state regulations is not required to register unless it has more than $25 million in assets under management or is an adviser to a registered investment company.
Proposed Rule
Number of Clients of Private Fund. The proposed Rule requires investment advisers to count owners of private funds as clients rather than treating the fund as a single client.
Definition of Private Fund. Under the proposed Rule, "private fund" is defined as a company that (i) would be subject to regulation under the Investment Company Act of 1940, as amended, but for the exceptions in Sections 3(c)(1) and 3(c)(7), (ii) permits investors to redeem their investments in the fund within two years of purchasing them and (iii) offers its equity interests based on the investment advisory skills, ability or expertise of the adviser. This test was designed to include most hedge fund advisers, but to exclude persons that advise private equity funds, venture capital funds, real estate funds and other funds that require investors to make long term capital commitments.
Hedge Funds; Funds of Hedge Funds. Under the proposed Rule, investment advisers may not count a private fund as a single client. In addition, advisers to such funds in which a registered investment company invests are required to count the investors in the registered fund as clients. This special provision was intended to keep an adviser from advising as many as 14 mutual funds (and thousands of investors) while avoiding registration.
Offshore Advisers. The proposed Rule would require offshore advisers to count U.S. investors in offshore funds as clients for purposes of determining if they had fewer than 15 clients in the preceding 12 months. A exception is included for offshore funds that make a public offering offshore and are regulated as a public investment company by the laws of another country, regardless of how many U.S. investors that they have. In addition, while offshore advisers to offshore private funds are required to register if they have 15 or more U.S. clients and are subject to the provisions of the Advisers Act prohibiting fraud in connection with their dealings with their U.S. clients, most of the substantive provisions of the Advisers Act will not apply to the adviser's activities with the fund or its non-U.S. clients. These provisions are intended generally to restrict the application of the Advisers Act to advisers' activities with U.S. clients.
Divestitures Not Required. Generally, registered investment advisers may only charge performance fees to investors that place at least $750,000 under management with the adviser or have a net worth of $1.5 million. Hedge fund investors in funds with advisers that are required to register under the proposed Rule will not be required to divest existing interests in a fund if they do not meet these requirements and may add to an existing account. Such investors would not be permitted to invest in a new fund or a new account, however.
Record Keeping; Custody; Form ADV. The related rules changes include relief from record keeping requirements for advisers required to register under the Rule and an extension of the period for distributing audited financial statements for hedge funds. Changes in Form ADV are proposed to identify hedge fund advisers, among other things.
Effect of Registration. If an adviser is required to register it will become subject to numerous regulatory measures including limits on performance fees, insider trading, custody and proxy voting.
For more information please contact the following Thelen LLP attorneys:
Louis A. Bevilacqua
Tel: 202.508.4281
lbevilacqua@thelenreid.com
E. Ann Gill
Tel: 212.603.2412
agill@thelenreid.com
Philip W. Peters
Tel: 415.369.7009
pwpeters@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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