By: Edward G. Eisert and Carolyn A. Jayne
I. Introduction.
On November 10, 2009, Senate Banking Committee Chairman Christopher Dodd introduced his discussion draft of the "Restoring American Financial Stability Act of 2009” (“RAFSA”). This draft of more than 1,100 pages in length consolidates the various components of the Administration’s regulatory reform proposals. Set forth below is an overview of those provisions of RAFSA that most directly affect investment advisers to funds that rely upon the exemptions from registration set forth in Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act of 1940 (collectively, “Private Funds”) and that materially differ from the provisions of HR 3818, the “Private Fund Investment Advisers Registration Act of 2009,” which would require certain private fund managers to register with and be regulated by the SEC, and HR 3817, the “Investor Protection Act of 2009,” passed by the House Financial Services Committee on October 27, 2009 and November 4, 2009, respectively. (For more information about the RAFSA in general, see K&L Gates alert Senator Dodd Releases Financial Reform Proposal: The Restoring American Financial Stability Act of 2009. For a discussion of the Obama Administration’s proposed legislation, see K&L Gates alert The Obama Administration’s Proposal for the Registration of Investment Advisers to Private Investment Funds: The Private Fund Investment Advisers Registration Act of 2009.)
A. Title IV of RAFSA - “Regulation of Advisers to Hedge Funds and Others.”
Private Equity Funds. Title IV provides a new exemption from registration for advisers to “Private Equity Funds,” a term to be defined by the SEC within six months after the enactment of the Act. Within the same time frame, the SEC also will be required to issue final rules regarding records to be maintained by such advisers and reports to be provided by such advisers to the SEC.
Venture Capital Funds and Family Offices. In addition, Title IV: (i) provides an exemption from registration for advisers to “Venture Capital Funds,” a term to be defined by the SEC within six months after the enactment of RAFSA; and (ii) provides a new exclusion from the definition of “investment adviser” under the Investment Advisers Act of 1940 (the “Advisers Act”) for a “Family Office,” a term to be defined by the SEC. Title IV does not include an exemption for midsized private funds (i.e., funds that have “assets under management in the United States of less than $150,000,000”) and does not impose any recordkeeping and reporting obligations on Venture Capital Funds as does HR 3818.
Financial Thresholds for Registration of an Adviser Under the Advisers Act and for an Accredited Investor. Also, RAFSA raises to $100 million the threshold for non-exempted investment advisers to be required to register with the SEC.
Title IV directs the SEC to increase the “financial threshold for an accredited investor,” as defined in Regulation D under the Securities Act of 1933, as amended, in an amount determined to be “appropriate and in the public interest, in light of price inflation . . .” and to adjust such threshold no less frequently than once every five years to “reflect the percentage increase in the cost of living.”
Independent Custodian. Title IV authorizes the SEC to promulgate rules requiring registered investment advisers to use an independent custodian to hold client assets.
Reports and Records. Title IV excludes a provision in HR 3818 requiring registered investment advisers to provide reports, records and other documents to “investors, prospective investors, counterparties, and creditors” as the SEC may prescribe as “necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.” At the same time, Title IV increases the required information to be filed in such records or reports to include valuation methodologies of the fund, types of assets held and side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors. However, off-balance sheet leverage, required to be filed with the SEC under HR 3818, is not required to be filed under Title IV. Title IV requires the SEC to report annually to Congress regarding how it has used the data collected thereunder “to monitor the markets for the protection of investors and the integrity of the markets.” Title IV also contemplates an agreement of confidentiality when information is provided to Congress.
Studies and Reports to Congress. Lastly, Title IV directs the Comptroller General of the United States to conduct studies and submit reports to Congress on three subjects: (i) the appropriate criteria for determining financial thresholds or other criteria needed to qualify as an “accredited investor” and eligibility to invest in “hedge funds (within one year of the enactment of RAFSA)”; (ii) the feasibility of forming a self-regulatory organization to oversee “hedge funds, private equity funds, and venture capital funds (within one year of the enactment of RAFSA)”; and (iii) the state of short selling in the stock market, with particular attention to the impact of recent rule changes and the incidence of the failure to deliver shares sold short (within two years of the enactment of RAFSA).
B. Title IX of RAFSA - “Investor Protections and Improvements to the Regulation of Securities.”
Fiduciary Standards of Broker-Dealers Providing Investment Advice. Title IX takes a different approach than HR 3817, the “Investor Protection Act,” to the issue presented by investment advisers and broker-dealers currently being subject to somewhat different duties to clients. As amended, HR 3817 provides that brokers, dealers, and advisers shall have the duty “to act in the best interest of the customer without regard to [compensation]” and that the standard of conduct for brokers and dealers “shall be no less stringent than” the standard for advisers under the Advisers Act. HR 3817 would retain the broker-dealer exclusion from the definition of investment adviser.
In contrast, Title IX would eliminate from the definition of “investment adviser” in the Advisers Act the categorical exception for a broker or dealer (without regard to whether any advice it provides is “incidental to the conduct of his business as a broker or dealer . . . ”). Title IX then would amend Section 206 of the Advisers Act to grant the SEC authority by rule to exempt any person or transaction, or any class of persons or transactions, from the prohibition under Section 206(3) thereof regarding principal transactions, if the SEC determines that such exemption is “for the protection of investors; and the adviser provides investors with adequate protections against conflicts of interest or principal transactions that are not in the best interests of the investors.”
Title IX also provides that “[n]othing in [Section 205 of the Advisers Act, which regulates the terms of investment advisory contracts] prohibits an investment adviser from entering into an investment advisory relationship that provides for the payment of an asset management fee or a commission.”
Lastly, Title IX would provide that it would be unlawful for an adviser “to fail to disclose to any client or prospective client any material limitation on the range of investment products about which the investment advisor gives advice . . . .”
Regulatory Oversight of Broker-Dealers. RAFSA also takes a different approach than HR 3817 to the oversight of certain advisers and broker-dealers. Currently, HR 3817 authorizes FINRA to oversee any investment adviser who has any legal or financial connection with a registered broker-dealer (although HFSC Chairman Frank has declared his intention to oppose this last-minute amendment to HR 3817 when presented to the full House). In contrast, by eliminating the exception for brokers or dealers under the definition of “investment adviser,” RAFSA appears to subject both advisers and broker-dealers to oversight by the SEC under the Advisers Act. In addition, as mentioned above, Title IV would require the Comptroller General to conduct a study of the feasibility of forming a self-regulatory organization to oversee hedge funds, private equity funds and venture capital funds.
II. Analysis.
A. The Definition of a “Hedge Fund.”
There is no statutory definition of a “hedge fund” and, as commonly used, the term “hedge funds” refers to private funds that follow a broad range of different investment strategies and employ leverage to greatly different degrees. If RAFSA is enacted in its present form, exemptions from registration will be provided to “venture capital funds” and “private equity funds” only. As a result of these provisions, and references to “hedge funds” in RAFSA, it appears that, by process of elimination, all other Private Funds might be deemed to be “hedge funds” unless the SEC also defines that term. Because of blurring of the lines between the hedge fund, private equity fund and other private fund industries, it is likely that the SEC will have difficulty in defining these terms and, accordingly, there is the not insignificant risk that the SEC will err on the side of overinclusiveness in requiring adviser registration.
B. Expanded Jurisdiction of State Regulation of Advisers.
If enacted in its present form, investment advisers that do not advise Venture Capital Funds or Private Equity Funds, would not come within one of the other narrow exemptions from registration under the Advisers Act, and have assets under management of less than $100 million would not be eligible to register with the SEC. Such advisers would be subject to regulation under the laws of the states in which they do business and, consequently, if they do business in more than one state might incur increased costs and be subject to increased regulatory burdens.
C. Treatment of Non-U.S. Domiciled Private Funds and Advisers.
Although much of the exemption provided for “foreign private advisers” is identical in both RAFSA and HR 3818, RAFSA includes one key revision to the definition of “foreign private adviser.” HR 3818 provides that a foreign private adviser must have fewer than 15 clients in the U.S. “during the preceding 12 months.” RAFSA provides no time frame for such calculation. Theoretically, non-U.S. domiciled advisers would be unable to rely upon this exemption under RAFSA after they have an aggregate of 15 U.S. clients over an unlimited period of time, regardless of whether such clients remain active clients.
RAFSA also modifies the definition of “Private Fund” in a manner that potentially is beneficial to U.S. and non-U.S. domiciled advisers to certain non-U.S. funds. RAFSA defines a “Private Fund” to be a fund that relies upon either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 and “either - (i) is organized or otherwise created under the laws of the United States or of a State; or (ii) has 10 percent or more of its outstanding securities owned by U.S. persons.” HR 3818 defines “Private Fund” to be any fund that relies upon either of those exemptions. Thus, RAFSA provides a limited exception from the definition of “Private Fund” for a fund organized in a non-U.S. jurisdiction if only a small percentage of its interests is held by “United States persons.”
Under RAFSA, non-U.S. domiciled advisers also would benefit to the same extent as U.S. domiciled advisers from the new exemptions from registration for advisers to “venture capital funds” and “private equity funds.”
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