October 11, 2022

Exempt Reporting Advisers and SEC Scrutiny

Holland & Knight Alert
Stacy Byrd Thomas | Amanda Barbour Fantauzzo | Bradley M. Van Buren

Highlights

  • Increasing numbers of small, mid-size and large exempt reporting advisers (ERA) in the investment adviser community have drawn the interest of the U.S. Securities and Exchange Commission's (SEC) Division of Enforcement.
  • ERAs are required to file with the SEC by providing basic identifying information, details about the size of any funds they advise on and other business interests they and their affiliates have, among other details.
  • Considering the possibility of heightened scrutiny by the SEC, current and aspiring ERAs should be knowledgeable about applicable filing and compliance requirements, as well as topics of interest to the Division of Enforcement, to avoid violating federal and state regulations.

Exempt reporting advisers (ERA) have become a topic of interest for the U.S. Securities and Exchange Commission's (SEC) Division of Enforcement due in large part to their growing popularity among the investment adviser community. Given the likely prospect of heightened scrutiny, current and aspiring ERAs should be aware of applicable filing and compliance requirements, as well as topics of interest to the SEC's Division of Enforcement, to avoid running afoul of federal and state regulations.

What Is an Exempt Reporting Adviser?

Investment advisers must register with either federal or state securities authorities, depending on the amount of assets under management. "Small advisers," with less than $25 million in regulatory assets under management (RAUM), and "mid-sized advisers," with $25 million to $110 million in RAUM, generally may only register with state securities authorities. "Large advisers," with more than $110 million in RAUM, must register with the SEC unless they fall under the Private Fund Adviser Exemption or Venture Capital Adviser Exemption to registration, each of which was created under the Dodd-Frank Act as amendments to the Investment Advisers Act of 1940, as amended (Advisers Act).

The Private Fund Adviser Exemption is available to advisers based in the U.S. who solely manage private funds and have less than $150 million in RAUM. A "private fund" is an issuer of securities that would be an "investment company" but for the exceptions in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended (Investment Company Act) — that is, an investment fund limited to no more than 100 accredited investors or investors who are both accredited investors and qualified purchasers, respectively. The Venture Capital Adviser Exemption is available to investment advisers who solely advise venture capital funds. A "venture capital fund," as defined in the Advisers Act, is a private fund that 1) invests no more than 20 percent of its total capital in assets other than "qualifying investments"1 and short-term holdings;2 2) does not incur leverage in excess of 15 percent of its aggregate capital contributions and uncalled committed capital, and any such leverage is for a nonrenewable term of no longer than 120 calendar days; 3) does not offer its investors liquidity rights except in extraordinary circumstances; 4) is not registered under the Investment Company Act; 5) has not elected to be treated as a business development company; and 6) represents that it pursues a venture capital strategy.

Investment advisers who meet either the Private Fund Adviser Exemption or the Venture Capital Adviser Exemption are known as ERAs. ERAs are not subject to the same federal or state registration procedures as other investment advisers, but must still register with and report to securities regulators and satisfy certain compliance requirements.

Federal Registration

An ERA is required to file with the SEC and does so by completing and filing Form ADV, which is the same registration document submitted by registered investment advisers (RIA). However, instead of completing the entire form, ERAs complete only certain items in Part 1A, along with corresponding schedules. These items disclose, among other things, basic identifying information about the ERA (e.g., its legal name, principal office and place of business), details about the size of any private funds it advises, other business interests of the ERA and its affiliates, and disciplinary history of the ERA and its employees.3 In particular, an ERA must identify "control persons" who directly or indirectly control it.

Form ADV generally is electronically filed, and the information provided on it is available to the public on the Investment Adviser Registration Depository, operated by the Financial Industry Regulatory Authority. An ERA must complete and file Form ADV with the SEC (and pay associated filing fees) within 60 days of the date on which the investment adviser commences an advisory relationship with its first fund. Form ADV must be updated at least annually within 90 days of the ERA's fiscal year end and more frequently following certain material developments as described in the instructions to Form ADV. ERAs relying on the Private Fund Adviser Exemption must include any updates to their valuation of the private fund assets under management to determine whether the exemption is still applicable. If an ERA determines that it no longer manages less than $150 million in RAUM as of Dec. 31, it must file an application for registration as an RIA with the SEC by June 30.

State Registration

Generally, states require ERAs that have a place of business in state to make additional filings, pay fees and report to state securities authorities when filing or amending their Form ADV. Although specific state requirements vary, as a general rule, Advisers Act Rule 222-1(a) defines the term "place of business" as an office or other location held out to the public as a location in which the investment adviser regularly provides investment advisory services or solicits, meets with or otherwise communicates with clients. These "notice filings" may be accomplished by the ERA selecting the relevant states on Item 2.C of Part 1A of Form ADV, which will automatically send the form to those states. It is important for the ERA to determine whether it is subject to notice filing requirements in individual states.

Advisers who are exempt from investment adviser registration with the SEC must still comply with applicable state law. Many states have adopted exemptions that are similar to the federal exemptions for venture capital advisers and private fund advisers. However, in certain cases, state law will have additional requirements (e.g., "qualified client" status for private fund advisers). An ERA should check with the state in which it conducts investment advisory activities to determine whether there is a state exemption and what, if any, compliance requirements exist at that level.

Compliance Requirements and Recent SEC Actions

ERAs are not subject to some of the Advisers Act provisions regarding registration or recordkeeping that apply to RIAs. However, ERAs have fiduciary responsibilities to their clients and must abide by certain other compliance requirements applicable to all investment advisers, including anti-fraud rules and pay-to-play provisions. Some of the compliance requirements applicable to ERAs are summarized below:

Anti-Fraud Requirements: It is unlawful for any investment adviser, whether an ERA or RIA, to use any device, scheme or artifice in order to defraud a client or a prospective client. Investment advisers must also refrain from engaging in any transaction, practice or course of business that operates as a fraud or deceit upon a client or a prospective client. Examples of practices that run afoul of the anti-fraud rules include promising clients a guaranteed return from an equity investment or making false statements about the ERA's investment history. Advisers Act Rule 206(4)-8 (Antifraud Rule) makes it a fraudulent, deceptive, or manipulative act or practice for any investment adviser, whether an ERA or RIA, to make any untrue statement of material fact or omit a material fact such that a statement to an investor or potential investor becomes misleading or otherwise engages in any act, practice or course of business that is fraudulent, deceptive or manipulative with respect to any investor or prospective investor.

Since March 2022, there have been five SEC enforcement actions brought against ERAs citing the Antifraud Rule: two involving the disclosure surrounding and the calculation of management fees; two involving loans and cash transfers between an ERA's various funds that the SEC alleged to be unauthorized and undisclosed; and one involving the failure to audit financial statements where the fund documents provided for annual audits. The recent SEC enforcement actions indicate that the SEC's Enforcement Division will scrutinize investment advisers — whether registered or not — when it comes to compliance with their fiduciary obligations.

Pay-to-Play Requirements: ERAs are subject to Advisers Act Rule 206(4)-5, which prohibits certain investment advisers from engaging in pay-to-play practices (i.e., being compensated for investment advisory services to a government entity or an official after making political contributions to the same). Rule 206(4)-5 imposes three main conditions on ERAs. First, investment advisers and their associates are subject to a two-year "cooling-off" period after making a contribution to an official of a government entity before the adviser can receive compensation for providing advice to the government entity. Second, investment advisers are not allowed to use third-party solicitors who themselves are not subject to pay-to-play restrictions. Finally, investment advisers may not solicit or coordinate campaign contributions from others for officials of a government entity to which the adviser provides or is seeking to provide services.

Since March 2022, there have been three SEC enforcement actions against ERAs involving political contributions made by employees of fund managers to certain public officials occupying positions within government entities that were already invested in the managers' funds. As with the Antifraud Rule, it seems compliance with the pay-to-play rules is also a focus of the SEC's Division of Enforcement in its audits of ERAs.

Anti-Money Laundering Requirements: U.S. investment advisers, including ERAs, are subject to the rules promulgated by the Office of Foreign Asset Control (OFAC) of the U.S. Department of the Treasury, which prohibits investment advisers from doing business with individuals and entities on OFAC's list of "Specially Designated Nationals and Blocked Persons." Investment advisers must ensure that they do not accept those individuals or entities as clients and must notify OFAC of any suspect clients or transactions. Compliance with OFAC is most often accomplished by ERAs and RIAs by establishing and maintaining robust anti-money laundering policies and procedures.

Protecting Investor Privacy: ERAs and RIAs are both subject to rules promulgated under the Gramm-Leach-Bliley Act, including Regulation S-P, that govern maintenance of investors' personal information. Unlike RIAs, which are subject to privacy rules issued by the SEC, ERAs are subject to privacy rules issued by the Federal Trade Commission (FTC). The FTC privacy rules require ERAs to "develop, implement and maintain a comprehensive information security program that is written in one or more readily accessible parts." In particular, ERAs must identify reasonably foreseeable risks to the security, confidentiality and integrity of customer information; design and implement information safeguards; test and monitor these safeguards; and make adjustments as needed. Additionally, one or more employees must be appointed to coordinate the program.

Generally, ERAs are required to send initial privacy notices to investors along with standard fund documents describing their privacy policies and procedures. In addition, ERAs must send investors annual privacy disclosures, except when the ERA: 1) only shares investors' nonpublic personal information with unaffiliated third parties that do not require an opt-out right be provided to investors under the Fixing America's Surface Transportation Act (FAST Act); and 2) has not changed its privacy policies and procedures since its last privacy disclosure. Under the FAST Act, opt-out rights do not need to be provided to investors when information is shared: 1) with insurance rate advisory organizations, ratings agencies, consumer agencies, attorneys, accountants, auditors and others determining industry standards; 2) with unaffiliated third parties providing services for or on behalf of the ERA; or 3) for the purpose of fraud prevention or to comply with federal, state or local laws.

Conclusion and Considerations

As evidenced by the rules and restrictions described in this article, as well as the recent SEC enforcement actions against ERAs, "exempt reporting adviser" is somewhat of a misnomer. Although RIAs may have more onerous registration and reporting requirements, there are many regulatory pitfalls for ERAs at both the federal and state level. The SEC's focus on ERAs has recently become clear. As the SEC continues to focus on investment advisers, it is likely that we will see more ERAs being caught by the SEC's scrutiny. Thus, it is crucial for ERAs to clearly understand the obligations applicable to ERAs, strictly adhere to them and precisely follow the terms of the ERA's agreements (such as the determination of management fees).

Notes

1 As defined in 17 C.F.R. Section 275.203(l)-1.

2 As defined in 17 C.F.R. Section 275.203(l)-1.

3 In May 2022, the SEC issued proposed rules under the Adviser Act that, if adopted, would require advisers, including ERAs, that consider environmental, social or governance factors (ESG) as part of one or more of their significant investment strategies to report on Part 1A of Form ADV additional information about those strategies.


Information contained in this alert is for the general education and knowledge of our readers. It is not designed to be, and should not be used as, the sole source of information when analyzing and resolving a legal problem, and it should not be substituted for legal advice, which relies on a specific factual analysis. Moreover, the laws of each jurisdiction are different and are constantly changing. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. If you have specific questions regarding a particular fact situation, we urge you to consult the authors of this publication, your Holland & Knight representative or other competent legal counsel.


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