SEC Issues Final Rules on Registration of Investment Advisers to Hedge Funds
 
December 9, 2004
 
Scott R. MacLeod- Orlando

On December 2, 2004, the Securities and Exchange Commission (SEC) issued its final new rule and rule amendments under the Investment Advisers Act of 1940 (the Advisers Act) requiring advisers to certain hedge funds to register with the SEC in accordance with the new amendments by February 1, 2006. The following is a summary of the new rule and amendments.

Background

Investment advisers registered under the Advisers Act are subject to certain regulatory requirements, including: maintenance of certain business records, delivery of a disclosure statement to clients and satisfaction of fiduciary duties to clients. The Act, however, provides a private adviser exemption from registration to advisers who (i) have fewer than 15 clients; (ii) do not hold themselves out to the public as an investment adviser; and (iii) do not advise any registered investment companies. Advisers are also exempt from registration if they have less than $25 million of assets under management. In 1985, the SEC adopted a safe harbor that permitted advisers to count each hedge fund as a single client. As a result, investment advisers could advise hundreds of clients and manage very large amounts of client assets indirectly through hedge funds without registering with the SEC. Under the new rule, the SEC has eliminated the safe harbor by requiring that advisers “look through” the funds to count the underlying investors towards the 15-client test for purposes of the private adviser exemption.

The New Rule

Under the new Rule 203(b)(3)-2 of the Advisers Act, investment advisers must count each owner of a “private fund” towards the 15-client test of the private adviser exemption of the Act. If the total number of an adviser’s individual clients and investors in its private funds is 15 or more in a 12-month period, then the adviser cannot avail itself of the private adviser exemption and must register with the SEC.

Counting “Clients”

The new rule requires investment advisers to count each owner of a private fund towards the 15-client threshold. Accordingly, each shareholder, limited partner, member or beneficiary of a private fund will be deemed a “client.” An adviser, however, can exclude itself as well as certain knowledgeable advisory personnel who are “qualified clients” that may be charged a performance fee.

The adviser must also “look through” and count the owners of any fund of funds that is itself a “private fund.” An offshore hedge fund adviser must also “look through” each private fund it advises, regardless of the fund’s location, and count each underlying U.S. owner to determine if it has 15 or more clients who are resident in the U.S. The determination of whether an investor is a U.S. client or a non-U.S. client can be made at the time of the investment, and the adviser is not required to alter its count if a non-U.S. client subsequently relocates to the U.S.

Assets Under Management

The new rule does not alter the minimum threshold of assets under management required for U.S. advisers to register with the SEC. U.S. advisers who have less than $25 million of assets under management will continue to be exempt from SEC registration under the Advisers Act even if they have 15 or more “clients” under the new rule, but they must follow state law regarding their registration status. Offshore advisers must register with the SEC if they have 15 or more clients who are resident in the U.S., regardless of the amount of assets they have under management.

The SEC made an important clarification that such a counting method was not intended to amend advisers’ methods of counting for other purposes. Specifically, the “look through” requirements will not pertain to purposes of applying the national “de minimis” standard for state adviser registration.

Definition of “Private Fund”

In adopting the new rule, the SEC was specifically concerned about hedge funds and did not intend for advisers to “look through” every organization that they advise. Consequently, the new rule uses the term “private fund” to identify the specific legal entities that advisers must “look through” to count their clients. A “private fund” is an entity that satisfies all of the following characteristics:

• The fund is exempt from the definition of “investment company” under the Investment Company Act of 1940 under either section 3(c)(1) or 3(c)(7) of such Act.
  
• The fund permits investors to redeem their interests in the fund within two years of their investment (although the rule permits funds to offer redemption rights under extraordinary circumstances and provide interests acquired through reinvestment of distributed capital gains or income without being considered a private fund).
  
• The fund’s interests are offered based on the investment advisory skills, ability or expertise of an investment adviser.

The new rule also includes an exception to the definition of “private fund” for an offshore company that makes a public offering of its securities outside the U.S. and is regulated as a public investment company under the laws of the foreign country where such securities are authorized for sale.

Rule Amendments

Recordkeeping Rule

The SEC has adopted two amendments to the adviser recordkeeping rule.

First, hedge fund advisers that are required to register with the SEC under the new rule will be allowed to market their performance for periods prior to their registration, even if they have not maintained the necessary documentation to satisfy existing rules.

Second, the books and records of a registered investment adviser will be required to include records of the private funds for which it acts as an investment adviser, general partner, managing member or in a similar capacity.

Performance Fee Rule

Existing rules under the Advisers Act prohibit a hedge fund from charging performance fees to investors unless they are “qualified clients” (i.e., have a net worth of more than $1.5 million or at least $750,000 assets under management with the adviser). In an effort to avoid disrupting existing arrangements with hedge fund advisers required to register under the new rule, the SEC has added grandfathering provisions to the performance fee rule that allow advisers to charge performance fees that would otherwise be prohibited.

Custody Rule

The SEC has amended the custody rule under the Advisers Act to afford advisers to funds of hedge funds additional time to complete audit work for distributing audited fund financial statements. The amendment extends the distribution deadline from 120 to 180 days from the fund’s fiscal year-end. In order to qualify for the extension, the fund of funds must invest at least 10 percent of its assets in other unrelated, pooled investment vehicles.

Form ADV

The SEC also adopted amendments to the Form ADV, which will require advisers to “private funds” to identify themselves as hedge fund advisers.

The Investment Adviser Registration Depository (IARD) filing system will incorporate the amendments made to Form ADV on March 8, 2005, and registered advisers amending their Form ADV after such date will be required to respond to the revised item. Advisers who have not amended their Form ADV prior to February 1, 2006, must in any event amend their Form ADV to respond to the revised item by such date.

Offshore Advisers of Offshore Funds

The SEC adopted special provisions under the new rule intended to limit the extraterritorial application of the Advisers Act to offshore advisers to offshore funds with U.S. clients. An offshore adviser to an offshore fund would not be subject to the compliance, custody and proxy voting rules under the Advisers Act with respect to such fund though such an adviser would be required to (i) register with the SEC if after looking through its private funds it determined it had 15 or more U.S. clients; (ii) keep certain books and records; and (iii) remain subject to SEC examinations.

Compliance

Hedge fund advisers are required to comply with the new rule and new amendments by February 1, 2006. Consequently, by such date, each adviser required to register under the new rule must have secured an effective registration and complied with all applicable rules, including, among other things:

• adoption of policies to prevent misuse of material nonpublic information
• adoption of policies to ensure securities are voted in the best interest of the client
• adoption of a code of ethics for the adviser’s supervised persons
• designation of a chief compliance officer
• compliance with the custody rules under the Advisers Act

To view a copy of the new rule and amendments, see www.sec.gov/rules/final/ia-2333.pdf.

For more information, e-mail Scott R. MacLeod scott.macleod@hklaw.com, or call toll free, 1-888-688-8500.

This Investment Management Alert is a summary for general information and discussion only. It is not a complete analysis of the matters presented and may not be relied upon as legal advice which may often turn on specific facts. Readers should seek legal advice before acting with regard to the matters mentioned herein.