Certain Impacts of the Dodd-Frank Wall Street Reform and Consumer Protection Act on Investment Advisers¹
 
August 27, 2010
 
James S. "Jay" Crenshaw- Orlando
Scott R. MacLeod- Orlando

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”). This alert summarizes noteworthy impacts of the Act on the investment management community in general. However, each client should review the Act as a whole, and Holland & Knight can help you to identify aspects of the legislation, including those not discussed here, that may be relevant to your specific business.

Unless otherwise stated, any changes in law discussed here are generally not effective until July 21, 2011.

1. Exemptions Under the Act

You will no longer be exempt from registration under the Advisers Act simply by means of having, inter alia, fewer than 15 clients (i.e., the federal de minimis exemption has been eliminated).²

• The Act now provides only much narrower registration exemptions (as discussed below).
• If you previously relied on the de minimis exemption, you may need to register with your home state(s) or the SEC.
• Advisers in states such as Connecticut, which currently exempts advisers from Connecticut registration that were eligible for SEC registration (but claimed the federal de minimis exemption), must now re-evaluate their exemption status in such states to the extent they are not required to register with the SEC under the new thresholds. (For more information on SEC or state registration, including the new thresholds, see section 2 below.)

Advisers with aggregate assets under management (AUM) of less than $150M in the United States, whose sole clients are private funds, may remain exempt from SEC registration.

• If you manage any separate accounts in addition to private funds, you are not eligible for this exemption.
• Once your aggregate AUM is greater than or equal to $150M, you must register with the SEC. (See section 2 below).
• Advisers not required to register pursuant to this exemption are still subject to certain record keeping and filing obligations to be determined by the SEC.
• Exempt advisers must continue to evaluate the registration laws of any state where they have a place of business to ensure compliance with, or exemption from, such state laws.

Non-U.S. advisers will generally be required to register with the SEC unless they qualify for a very narrow “Foreign Private Advisers” exemption.

• A “foreign private adviser” means any adviser that: (1) has no place of business in the United States; (2) has less than $25M in assets under management³ “attributable” to U.S. clients and to investors in such adviser’s private funds; (3) has fewer than 15 clients and investors in the U.S.⁴; and (4) does not hold itself out generally to the public in the United States as an investment adviser nor act as an adviser to any registered investment company or business development company (BDC).
• Non-U.S. advisers solely to private funds with aggregate AUM of less than $150M may still claim that registration exemption (discussed more fully above).

“Family offices” or advisers solely to one or more “venture capital funds” are exempted from SEC registration.⁵

• The SEC is required to develop definitions for “venture capital funds” and “family offices” through rulemaking within a year of the Act’s adoption; very narrow definitions are expected.
• Advisers solely to one or more “venture capital funds” will still be subject to certain record keeping and filing obligations to be determined by the SEC.

2. New AUM Thresholds for SEC/State Registration⁶

U.S. Advisers That Do Not Solely Advise Private Funds. If you are an adviser to at least one separately managed account (i.e., if you are not an adviser solely to “private funds”), the following new registration requirements and thresholds apply:⁷

• If you have AUM in excess of $100M, then you must register with the SEC (even if you only have one account/client).
• If you have AUM of $25M to $100M⁸ and are not required to be registered, or, if registered, would not be subject to examination in your home state(s), then you: (i) may register with the SEC if your AUM is at least $25M; and (ii) must register with the SEC if your AUM is $30M or more.
• If you have AUM of $25M to $100M and are required to be registered, and, if registered, would be subject to examination, in your home state(s), then you must: (i) deregister with the SEC (to the extent applicable); and (ii) register in your home state(s).⁹
• If you have AUM of less than $25M, then you are not eligible for SEC registration and must either be: (i) registered in any state where you have a place of business; or (ii) able to claim an exemption in each state where you have a place of business.

U.S. Advisers Solely to Private Funds. If you are an adviser solely to private funds (i.e., hedge funds, real estate funds that hold securities, private equity funds, etc.) and are not an adviser solely to “venture capital funds,”¹⁰ then the following new registration requirements and thresholds apply:

• If you are an adviser solely to “private funds” and your aggregate AUM is equal to or greater than $150M, then you must register with the SEC (even if you advise only one fund).
• If you are an adviser solely to “private funds” and your aggregate AUM is less than $150M, then you are not required to register with the SEC.¹¹ It is currently unclear whether such advisers may optionally elect to register, or stay registered, with the SEC even if their AUMs exceed certain threshold levels (e.g., a private fund adviser that has an aggregate AUM in excess of $100M). Additionally, the following apply to private fund advisers with AUMs less than $150M: (1) they must continue to evaluate registration laws of any state where they have a place of business to ensure compliance with, or exemption from, such state laws; and (2) they are still subject to certain record keeping and filing obligations to be determined by the SEC. Such recordkeeping and filing obligations may be applicable to all advisers exempt from SEC registration hereunder, including advisers solely to private funds with aggregate AUMs of less than $25M.

Non-U.S. Advisers. If you are a non-U.S. adviser, you must register with the SEC (even if you have only one U.S. client or investor) unless you satisfy the “foreign private adviser” exemption,¹² which means, inter alia, you have less than $25M in assets under management “attributable” to U.S. clients and to U.S. investors in any private funds, whether domiciled inside or outside the United States.

Important Note on When to Begin Implementing. If, as a result of the unavailability of any registration exemptions or any of the new AUM registration thresholds discussed herein, any adviser needs to: (1) register with the SEC; (2) register with any state(s); and/or (3) de-register with the SEC, such adviser should seek to implement any of the foregoing actions well in advance of the July 21, 2011, effective date, preferably beginning in the fall of 2010.

3. Investor/Client Certifications

If you advise a private fund exempt under Regulation D of the Securities Act of 1933,¹³ you need to amend immediately the “accredited investor” certification/description in the fund’s offering documents.

• The Act now requires that the value of a natural person’s primary residence be excluded when determining such person’s net worth under the “Accredited Investor” determination.
• For now, this change seems to apply prospectively (e.g., only to new investors or additional subscriptions from existing investors) and not retroactively (e.g., no need to analyze and expel any existing investors).
• There is no grandfathering provision for funds formed prior to the Act.
• This change is effective immediately and requires your prompt attention.¹⁴

If you are a registered investment adviser and charge performance fees/allocations to any client (i.e., a private fund), you will need to amend the “qualified client” certification obtained from each client/fund investor.¹⁵

• The Act requires the SEC to adjust the “qualified client” dollar thresholds for inflation within a year of the Act’s adoption and every five years thereafter.
• Registered advisers charging performance fees to private funds exempt under Section 3(c)(7) of the Investment Company Act of 1940 generally need not amend their subscription agreements.¹⁶

4. Miscellaneous Impacts on Certain Advisers

Additional Reporting Requirements for Registered Investment Advisers

• The Act provides the SEC with authority to require registered advisers to maintain records and file reports to the SEC (and to provide certain regulatory bodies the contents of such reports).¹⁷
• Such reports will include a description of the amount of AUM; the use of leverage, including off-balance sheet leverage; counterparty credit risk exposure; trading and investment positions; valuation policies and procedures; types of assets held; side letters; trading practices; and any other information that the SEC deems to be “necessary or appropriate.”

Custody. The Act will also require registered investment advisers to take steps to safeguard client assets, including verification with an independent public accountant.¹⁸

The “Volcker” Rule. The Act substantially restricts proprietary trading activities by “banking entities”¹⁹ and generally prohibits such entities from sponsoring or acquiring any equity, partnership or other ownership interest in a hedge fund, private equity fund or similar entity.

“Bad Boy” Provisions. The “Bad Boy” (issuer disqualification) provisions,²⁰ which previously only applied to Rule 505 Regulation D offerings, will likely now also apply to Regulation D Rule 506 offerings. The SEC has one year from the Act’s enactment date to issue rules regarding such Bad Boy provisions and their applicability to Rule 506 private offerings.

Potential Limitations on Mandatory Arbitration. The SEC may adopt rules and regulations restricting or prohibiting the use of mandatory arbitration agreements by advisers.

5. Impacts on Funds/Advisers as Participants in Certain Financial Instruments

Derivatives/Swap Regulation

• If you buy commodities and are subject to percentage limitations, you will need to include any swaps (i.e., non-securities-based swaps, including interest rate swaps) that now must be registered and/or regulated under the Commodity Exchange Act when determining compliance with such limitations.²¹
• If you are involved with swaps in the OTC derivatives markets,²² you may be subject to new regulations under the Act as a “major swap participant” (e.g., over-the-counter (OTC) swap dealers and certain large OTC swap participants); and/or certain of your OTC derivative transactions may be subject to federal regulation.
• The Act appears to require applicable regulators to issue interim rules, within 90 days after the Act’s enactment, regarding the reporting of pre-enactment swaps, which were not accepted for clearing.
• Any swap entered into before the Act’s enactment date that has not expired after July 21, 2010, must be reported by a date not later than 30 days after the of such interim final rules or such other period as may be determined by the relevant regulator.

Asset-Backed Securities. Within 270 days, certain federal agencies (e.g., the SEC) are required to jointly issue regulations requiring the person securitizing an asset-backed security to retain (without hedging) 5 percent or more of the credit risk of the securitized assets collateralizing the asset backed security that are not qualified residential mortgages.

Municipal Securities. Advisers to municipalities must generally be registered under the Securities Exchange Act of 1934 to solicit services or provide advice. Registered investment advisers that provide advice to municipalities or on municipal securities won’t need to register, but certain of their activities will be subject to regulation.

Securities Lending. The Act makes it unlawful to effect, accept or facilitate a transaction involving a loan or borrowing of securities in contravention of SEC rules. Within two years, the Act requires the SEC to promulgate rules designed to raise the transparency of information available to investors with respect to the loan or borrowing of securities.

Shorting and Arbitrage. The SEC may adopt further reporting rules and restrictions on such activities pursuant to the Act.

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¹ This material is intended to be informational only and does not constitute legal or tax advice regarding any specific situation; it may also be considered attorney advertising under court rules of certain jurisdictions. This list is by no means intended to be exhaustive. Please also note that this alert generally does not address any non-U.S. requirements. As required by U.S. Treasury Regulations, this communication is not intended to be used, and it cannot be used, for the purpose of avoiding penalties under U.S. federal tax laws.

² Previously, an investment adviser with fewer than 15 clients (with each fund counting as a single client) in any 12-month period that did not hold itself out to the public or act as an investment adviser to a registered investment company or business development company (BDC) was exempt from registration under the Investment Advisers Act of 1940 (the “Advisers Act”). Many investment advisers to private funds relied on this exemption to avoid registration under the Advisers Act.

³ Or such higher amounts as the SEC may determine.

⁴ When determining if a non-U.S. adviser has fewer than 15 clients, it must not only count separate accounts and/or the number of private funds it advises, but also the number of investors in any such fund. Accordingly, most non-U.S. advisers with substantial U.S. business activities will be required to SEC register and will not be eligible for the very limited “foreign private adviser” exemption.

⁵ The proposed exemption for advisers to private equity funds, which was included in the version of the Act originally passed by the U.S. Senate, was eliminated from the Act in the reconciliation process.

⁶ Advisers seeking to register as investment advisers generally prefer to federally register with the SEC to, among other things, qualify as a federally covered advisers, which pre-empts them from state regulation (excluding anti-fraud and certain notice filings). However, the Advisers Act retains certain AUM thresholds for advisers to even be eligible for SEC registration. Before and after the Act, the permitted AUM threshold for SEC investment adviser registration was/is $25M (with registration required at $30M). Although the Act retains the $25M permitted threshold, it essentially increases the amount to $100M for an adviser that is: (1) required to be registered in the state in which it maintains its principal office and place of business; and (2) subject to examination by such state. Such a provision essentially delegates to one or more states (as opposed to the SEC) the burden of regulating such “mid-sized” investment advisers (i.e., ones with AUMs of $25M to $100M).

⁷ The registration requirements and thresholds discussed under this first subheading of section 2 of this alert would also not apply to an adviser that is: (1) a “family office” or an adviser solely to “venture capital funds”; or (2) not eligible for any other remaining exemptions to registration under the Advisers Act.

⁸ The SEC may, in the alternative, determine higher amounts in excess of $25M to $100M.

⁹ Registration in any given state will not pre-empt an adviser from the potential registration requirements of any other state where an adviser does business. However, to alleviate undue hardship to an adviser needing to register in numerous states due to this provision, the Act permits such adviser to register with the SEC where such adviser would otherwise be required to register with 15 or more states.

¹⁰ See section 1: “Family offices” or advisers solely to one or more “venture capital funds” are exempted from SEC registration.

¹¹ See section 1: Advisers with aggregate assets under management (AUM) of less than $150M in the United States, whose sole clients are private funds, may remain exempt from SEC registration.

¹² See section 1: Non-U.S. advisers will generally be required to register with the SEC unless they qualify for a very narrow “Foreign Private Advisers” exemption.

¹³ Such funds generally rely on Regulation D Rule 506 of the Securities Act of 1933 to sell fund interests without having to register the sale of such interests. Rule 506 generally requires investors to be “accredited” in order to purchase interests in funds relying on such exemption. A natural person is generally considered to be accredited if he/she: (1) has $200,000 in annual income (or $300,000 jointly with a spouse); or (2) a net worth of $1M.

¹⁴ For additional information, please see Holland & Knight’s July 23, 1010 alert, “Dodd-Frank Revisions to Definition of “Accredited Investor” Immediately Go Into Effect: Prompt Action Required.”

¹⁵ Registered investment advisers may only charge performance fees to “qualified clients,” generally defined to mean: non-U.S. persons; ultra sophisticated investors (i.e., qualified purchasers); or any person with $750K in AUM with an adviser or a net worth of $1.5M.

¹⁶ Private funds exempt under Section 3(c)(7) may only be offered to “qualified purchasers,” as defined under the Company Act, which are automatically deemed to be “qualified clients” under the Advisers Act.

¹⁷ The SEC may share information it collects with the newly created Financial Stability Oversight Council, but the SEC will not be compelled to disclose any such report, or information contained therein, to the public.

¹⁸ Given the SEC’s recent changes to the custody rule under the Advisers Act, it is unclear whether this provision will result in any changes to currently applicable custody requirements.

¹⁹ Under Section 13 of the Act, a “banking entity” generally means: (1) an insured depository institution; (2) any company that controls an insured depository institution; (3) any entity treated as a bank holding company under the Bank Holding Company Act; and (4) any subsidiary or affiliate of any of the foregoing entities.

²⁰ Bad Boy provisions disqualify any issuer or promoter from relying upon Regulation D if such person: (1) has been previously convicted of a felony or misdemeanor in connection with the purchase or sale of any security or in connection with a false filing with the SEC; or (2) is barred from association with regulated entities or from engaging in the business of securities, insurance or banking, or in savings association or credit union activities due to fraud, manipulation or deception.

²¹ For example, advisers that are reliant on the Commodity Pool Operator (CPO) exemption under Rule 4.13(a)(3) of the Commodity Exchange Act must not allow: (i) the aggregate net notional value of any fund’s commodity positions to exceed 100 percent of the liquidation value of such fund’s assets; or (ii) the aggregate initial margin and premiums required to establish any fund’s commodity positions to exceed 5 percent of the liquidation value of such fund’s assets. If you cannot comply with your percentage limitations, you will need to register with the CFTC.

²² The Act creates new clearing and exchange trading requirements, capital and margin requirements, various reporting and recordkeeping requirements, and position limits.

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