Tuesday, August 31, 2004
Hedge Fund Compliance - Advisers Act Revisions
A Compliance Guide to the Investment Advisers Act of 1940 --->By Elizabeth M. Schubert, McDermott Will & Emery LLP Monday, August 30, 2004 1:14:53 PM ET
Introduction: The SEC’s Proposed Regulation
This article is the first in a series developed to provide guidance for investment advisers to hedge funds on complying with regulations recently proposed by the Securities and Exchange Commission, which, if adopted, will require the investment advisers to most hedge funds to register with the SEC. Under the Investment Advisers Act of 1940, registered investment advisers generally are subject to more stringent compliance rules than those that apply to unregistered investment advisers. This series of articles will present the proposed regulations and the requirements of registration with each article addressing a specific aspect of compliance with the Advisers Act. Use of defined terms, statutory references and acronyms, while at times unavoidable, will be kept to a minimum. This first article will introduce and explain the proposed rule, identify the affected parties, the terms for transition and present in general terms what it means to be a registered investment adviser. Future articles will focus more specifically on the mechanics of registration, ongoing compliance and reporting requirements to the SEC and the standards that must be met by the registered investment adviser in its relationship with its investors and clients.
The Advisers Act applies to all investment advisers, however, the Advisers Act applies more restrictive compliance standards to investment advisers that are required to register with the SEC. Investment advisers to many hedge funds currently qualify for exemption from registration and the related requirements because current rules do not apply to an investment adviser that has advised fewer than 15 clients during the preceding 12 months. For purposes of calculating the number of clients, the current rule counts as a single client each corporation, general partnership, limited partnership, limited liability company, trust or other legal organization advised by an investment adviser regardless of the number of investors in the entity. As an example, under current regulations an adviser that advises three limited partnerships with 20 investors each has only three clients, the three limited partnerships, and therefore qualifies for exemption from registration.
The proposed rule would change the exemption as it applies to hedge funds and require investment advisers to count each investor (each limited partner, member, shareholder, etc.) as a single client. In the previous example, if the proposed rule takes effect, the adviser would have 60 clients—each of the 20 investors in the three limited partnerships—and therefore would not qualify for the exemption and would be required to register with the SEC. The proposed rule applies only to “private funds” a term that has been carefully crafted to encompass most hedge funds.
The proposed rule would not apply to a fund that did not permit its investors to redeem any portion of their ownership interests within two years of the purchase of such interests. This carve-out is devised to exclude most managers of venture capital funds, private equity funds and other similar funds that require investors to make long-term (in excess of two years) commitments of capital, but also may exempt a hedge fund that imposes a two-year lock-up on its investors. The rule would not apply to investment advisers with less than US$25 million in assets under management. Compliance is voluntary for investment advisers with between US$25 and US$30 million in assets under management. The proposed rule would not apply most of the substantive provisions of the Advisers Act to non-U.S. clients of a foreign investment adviser.
Registration of an investment adviser will have a significant effect on the adviser’s relationship with the SEC and with its clients. Once registered, advisers will be subject to many additional SEC rules that impose ongoing compliance obligations and fiduciary standards. These include the filing of registration forms with the SEC (which must be kept current at all times); maintenance of books and records, adoption of policies and procedures designed to prevent violation of the Advisers Act; and the designation of a chief compliance officer. Registration also will subject advisers to extensive, on-site inspection by the SEC, which may occur as frequently as every two years.
Once registered, the relationship between advisers and their clients will change significantly, as well. Advisers will be subject to specific rules governing client assets held in the custody of the adviser, and they also will be required to provide written disclosures to prospective and existing clients. Registration also will change the management fees charged by many hedge funds by permitting performance fees to be charged only to “qualified clients” that have a net worth of at least US$1.5 million or have at least US$750,000 of assets under management with the adviser. To the extent that a hedge fund takes on new clients that do not meet these financial tests, these clients cannot be charged performance fees.
In addition to the compliance requirements under federal securities laws, most registered advisers also must comply with state Blue Sky laws applicable to advisers and their representatives. This generally will entail notice-registration in states where advisers are headquartered and engage in more than occasional marketing activities. If an adviser has less than US$25 million of assets under management, it must only register with the relevant state and cannot register with the SEC.
The SEC has provided for the transition of previously unregistered private funds to the new regulations. Specifically, the SEC proposes to require new registrants to retain their investment record and performance information relating to the period prior to registration but would excuse them from SEC record-keeping rules for that period. Once registered, a hedge fund would be obliged to comply with the record-keeping rules going forward. In addition, hedge funds that would not be permitted to charge performance fees to new investors that do not meet certain minimum net worth tests would be permitted to maintain existing fee arrangements with persons who invested in a hedge fund prior to registration.
The proposed rule currently is subject to comment and review by the public. The comment and review period ends on Sept. 15, at which time, the SEC will review the comments it has received and prepare its final rule. Since the rule is a priority for SEC Chairman William Donaldson, adoption of a final rule is very likely and may happen by the end of this year. The next article in this series will focus on how to register as an investment adviser.
Introduction: The SEC’s Proposed Regulation
This article is the first in a series developed to provide guidance for investment advisers to hedge funds on complying with regulations recently proposed by the Securities and Exchange Commission, which, if adopted, will require the investment advisers to most hedge funds to register with the SEC. Under the Investment Advisers Act of 1940, registered investment advisers generally are subject to more stringent compliance rules than those that apply to unregistered investment advisers. This series of articles will present the proposed regulations and the requirements of registration with each article addressing a specific aspect of compliance with the Advisers Act. Use of defined terms, statutory references and acronyms, while at times unavoidable, will be kept to a minimum. This first article will introduce and explain the proposed rule, identify the affected parties, the terms for transition and present in general terms what it means to be a registered investment adviser. Future articles will focus more specifically on the mechanics of registration, ongoing compliance and reporting requirements to the SEC and the standards that must be met by the registered investment adviser in its relationship with its investors and clients.
The Advisers Act applies to all investment advisers, however, the Advisers Act applies more restrictive compliance standards to investment advisers that are required to register with the SEC. Investment advisers to many hedge funds currently qualify for exemption from registration and the related requirements because current rules do not apply to an investment adviser that has advised fewer than 15 clients during the preceding 12 months. For purposes of calculating the number of clients, the current rule counts as a single client each corporation, general partnership, limited partnership, limited liability company, trust or other legal organization advised by an investment adviser regardless of the number of investors in the entity. As an example, under current regulations an adviser that advises three limited partnerships with 20 investors each has only three clients, the three limited partnerships, and therefore qualifies for exemption from registration.
The proposed rule would change the exemption as it applies to hedge funds and require investment advisers to count each investor (each limited partner, member, shareholder, etc.) as a single client. In the previous example, if the proposed rule takes effect, the adviser would have 60 clients—each of the 20 investors in the three limited partnerships—and therefore would not qualify for the exemption and would be required to register with the SEC. The proposed rule applies only to “private funds” a term that has been carefully crafted to encompass most hedge funds.
The proposed rule would not apply to a fund that did not permit its investors to redeem any portion of their ownership interests within two years of the purchase of such interests. This carve-out is devised to exclude most managers of venture capital funds, private equity funds and other similar funds that require investors to make long-term (in excess of two years) commitments of capital, but also may exempt a hedge fund that imposes a two-year lock-up on its investors. The rule would not apply to investment advisers with less than US$25 million in assets under management. Compliance is voluntary for investment advisers with between US$25 and US$30 million in assets under management. The proposed rule would not apply most of the substantive provisions of the Advisers Act to non-U.S. clients of a foreign investment adviser.
Registration of an investment adviser will have a significant effect on the adviser’s relationship with the SEC and with its clients. Once registered, advisers will be subject to many additional SEC rules that impose ongoing compliance obligations and fiduciary standards. These include the filing of registration forms with the SEC (which must be kept current at all times); maintenance of books and records, adoption of policies and procedures designed to prevent violation of the Advisers Act; and the designation of a chief compliance officer. Registration also will subject advisers to extensive, on-site inspection by the SEC, which may occur as frequently as every two years.
Once registered, the relationship between advisers and their clients will change significantly, as well. Advisers will be subject to specific rules governing client assets held in the custody of the adviser, and they also will be required to provide written disclosures to prospective and existing clients. Registration also will change the management fees charged by many hedge funds by permitting performance fees to be charged only to “qualified clients” that have a net worth of at least US$1.5 million or have at least US$750,000 of assets under management with the adviser. To the extent that a hedge fund takes on new clients that do not meet these financial tests, these clients cannot be charged performance fees.
In addition to the compliance requirements under federal securities laws, most registered advisers also must comply with state Blue Sky laws applicable to advisers and their representatives. This generally will entail notice-registration in states where advisers are headquartered and engage in more than occasional marketing activities. If an adviser has less than US$25 million of assets under management, it must only register with the relevant state and cannot register with the SEC.
The SEC has provided for the transition of previously unregistered private funds to the new regulations. Specifically, the SEC proposes to require new registrants to retain their investment record and performance information relating to the period prior to registration but would excuse them from SEC record-keeping rules for that period. Once registered, a hedge fund would be obliged to comply with the record-keeping rules going forward. In addition, hedge funds that would not be permitted to charge performance fees to new investors that do not meet certain minimum net worth tests would be permitted to maintain existing fee arrangements with persons who invested in a hedge fund prior to registration.
The proposed rule currently is subject to comment and review by the public. The comment and review period ends on Sept. 15, at which time, the SEC will review the comments it has received and prepare its final rule. Since the rule is a priority for SEC Chairman William Donaldson, adoption of a final rule is very likely and may happen by the end of this year. The next article in this series will focus on how to register as an investment adviser.
# posted by Tom @ 8:29 AM 
