Introduction
The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Act) has a wide-ranging scope, and contains provisions which will impact private equity, financial and other businesses in a number of ways. Title IV of the Act deals with the Investment Advisers Act of 1940 as amended (Advisers Act) and makes significant changes in the way in which advisers to private funds are treated under the Advisers Act.
The material below summarizes the impact of Title IV of the Act on U.S.-based advisers to and managers of private equity funds.
Executive Summary
The role of general partners and other managers of private equity, venture capital and hedge funds usually involves investment advisory activity. A significant number of advisers to private funds have relied on the exemption from the registration requirements of the Advisers Act which is currently generally available to an adviser with fewer than 15 clients in the United States (Old Private Adviser Exemption). The Act eliminates the Old Private Adviser Exemption effective July 21, 2011.
The Act contains several new exemptions, two of which may be of particular interest to advisers to private equity funds. There is a new exemption for advisers solely to private funds where the total amount of assets under management (AUM) in the United States is less than $150 million (Private Fund Exemption), and a new exemption for advisers solely to venture capital funds (Venture Capital Exemption). The Act also includes important new recordkeeping and reporting requirements for private fund managers.
The Securities and Exchange Commission (SEC) will prepare and adopt regulations implementing these new statutory provisions. (It is also possible that states will make changes in their approach to the regulation of investment advisers during this period in response to the Act.)
Managers of private equity funds should assess the impact of the Act, and begin planning for the transition to these new rules.
Action Items
During the transition period, before these new provisions of the Advisers Act become effective on July 21, 2011, the SEC will conduct a rulemaking proceeding. The SEC will publish proposed rules and provide the opportunity to comment on those proposals as part of this proceeding. The SEC reviews the comments it receives, and many times makes changes in the final rules directly in response to these comments. The SEC is anticipating a very active comment process for the new Advisers Act rules, and has already discussed procedures for participation in this process, including the possibility of meeting with SEC staff members.
Managers of private funds may wish to monitor the upcoming rulemaking proceeding. In addition, it may be in the interest of managers to comment on proposed rules that will impact their operations, and some managers may wish to participate more actively. In the meantime, private fund managers should consider the following steps.
Determine the impact of the Act on your federal and state registration status as an investment adviser. The Act may require that you register as an investment adviser under the Advisers Act. In addition, if you are already registered under the Advisers Act, you may need to shift to state registration. If you are not currently registered under the Advisers Act, and the Act will require you to register, begin planning now. Registration will require that you:
- Make certain publicly available filings.
- Update those filings annually, and amend them in the interim if certain changes take place.
- Provide specified information to clients.
- Comply with regulatory provisions relating to compensation.
- Have specified compliance programs and a compliance officer.
- Comply with privacy and custody provisions.
- Comply with provisions concerning paid solicitors.
- Maintain specified books and records (including e-mail).
In addition, upon registration you will become subject to the SEC’s compliance examination program. If you currently are registered at the federal level, but as a result of the Act will need to shift to state registration, begin planning now to make the required filings and any required regulatory changes. Determine if compliance with the Act will entail operational or structural changes in your business.
For example, the new Private Fund Exemption requires that a manager/adviser provide advice solely to private funds, and the new Venture Capital Exemption is available to a manager/adviser solely to venture capital funds. If a manager/adviser does not currently meet the “solely” requirement, it may be possible to restructure its operations to comply before the new rules take effect on July 21, 2011.
In addition, if you will be required to register, and you manage a fund which is exempt from registration under Investment Company Act of 1940 as amended (Investment Company Act) section 3(c)(1), the 100 or less holders fund (C1 fund), the investors in that fund will need to be Qualified Clients if you receive “performance compensation.” Not all C1 funds are currently structured to comply with this requirement.[1] Fees calculated as a share of capital gains or capital appreciation are considered performance compensation. The typical “carried interest” based on the return on the investment portfolio is performance compensation.
If you manage a private fund, regardless of your registration status, you should monitor the SEC requirements for reports concerning these funds, and prepare to comply with those requirements.
Elimination of the Old Private Adviser Exemption
The Advisers Act contains registration requirements and an extensive set of regulatory and compliance provisions which apply to a registered investment adviser. The Old Private Adviser Exemption provides an exception to these registration requirements, and as a result, to the other provisions of the Act that come along with registration. The Old Private Adviser Exemption is available to an adviser who:
- During the past 12 months had fewer than 15 clients;
- Does not hold itself out to the public generally as an investment adviser; and
- Does not advise a fund which is registered under the Investment Company Act or a business development company.
Under current interpretations, each private fund is generally treated as one client for purposes of the 14-client limit, so an adviser can manage up to 14 funds under the Old Private Adviser Exemption. The Act eliminates the Old Private Adviser Exemption effective July 21, 2011. Accordingly, if you are currently relying on the Old Private Adviser Exemption at the federal level, you need to determine if another exemption is available. If another exemption is not available, you need to determine if you are eligible for federal registration. You should also review your state adviser registration status.
New Private Fund Exemption
The Act creates an exemption for investment advisers solely to private funds where the AUM in the United States is less than $150 million. Private funds for this purpose are C1 funds, and funds exempt from registration under the Investment Company Act pursuant to Section 3(c)(7), Qualified Purchaser funds. If this exemption is available, then it does not matter how many private funds the manager advises, so long as the aggregate “AUM in the U.S.” is less than $150 million, and the manager only advises private funds.
The Act does not state how to calculate the amount of AUM. This calculation will probably involve a determination of fair market value rather than cost, and accordingly could present issues in the case of hard-to-value assets or changing asset values. Issues in this regard could also arise as a result of uncalled investor commitments, and in other situations. For example, the Act does not state what constitutes AUM “in the U.S.” This concept will probably be based on assets attributable to U.S. investors, where assets are held by an offshore fund outside the United States.
Advisory activity other than to a private fund would prevent an adviser from using this exemption. For example, advising “managed accounts” would probably fall outside the “solely to private funds” requirement. In addition, complex issues may arise in determining whether certain types of offshore fund structures fall within the solely to private funds requirement. In the absence of guidance from the SEC to the contrary, investment advisory activity outside the United States which does not involve U.S. investors, could be taken into account in determining compliance with the solely to private funds requirement of this new exemption. Issues may also arise in the case of certain fund of funds structures. These questions should be dealt with in the upcoming SEC rulemaking proceeding.
The SEC is authorized to require advisers to private funds to comply with reporting requirements and maintain specified records. So managers of private funds that are exempt from the registration provisions of the Advisers Act by virtue of this new exemption, may still need to file reports with the SEC.
New Venture Capital Exemption
The Act also includes a new exemption for advisors who solely manage venture capital funds. The SEC is required to issue a rule defining the term venture capital fund by July 21, 2011.
The legislative history indicates that the term “venture capital fund” was intended to include investment vehicles which invest in start-ups and small businesses, and which do not rely on leverage. There was a separate exemption in the Senate bill for advisers to private equity funds which was intended to deal with funds that invested in larger operating businesses, rather than start-ups. The private equity fund exemption is not contained in the final Act, and it is unclear whether the SEC will include the private equity fund concept in the new regulation defining the term venture capital fund.
The SEC’s rulemaking proceeding to define venture capital fund will determine the extent to which the venture capital fund concept will also include characteristics generally associated with private equity funds.[2] Many people expect that the SEC will propose a narrow definition of the term venture capital fund.
If this exemption is available, then it does not matter how many venture capital funds a manager advises or the total amount of AUM in those funds. Advisory activity which involves advice other than to a venture capital fund would prevent an adviser from using this exemption. As a result, the rulemaking proceeding to determine the definition of venture capital fund is very important.
In the absence of guidance from the SEC to the contrary, investment advisory activity outside the United States which does not involve U.S. investors could be taken into account in determining compliance with the “solely to venture capital funds” requirement of this new exemption.
As is the case with exempt advisers to private funds, the SEC has the power to require the filing of reports with the SEC concerning venture capital funds managed.
New SBIC Exemption
The Act exempts from the federal investment adviser registration requirements advisers who only advise:
- Small business investment companies that are licensed under the Small Business Investment Act of 1958 (Small Business Companies).
- Entities that have received notice from the SBA to proceed to qualify for a license.
- Applicants that are affiliated with one or more Small Business Companies that have applied for another license which application remains pending.
The Act excludes advisers who are business development companies from this exemption.
New Family Office Exemption
The Act exempts from the definition of “investment adviser” any family office adviser. This new exemption will eliminate the need for advisers to family offices to obtain individual exemptive orders, so long as the advisor fits within the parameters of the new provision.
The SEC is directed to define “family office” in a manner consistent with previous SEC exemptive orders, taking into account the range of organizational, management and employment structures used by family offices, and a grandfather clause contained in the Act. (A family office adviser falling within the grandfather clause will still be subject to the antifraud provisions of Sections 206(1), (2) and (4) of the Advisers Act.)
Intrastate Exemption
The Advisers Act provides an exemption from the registration requirements for an investment advisor all of whose clients are residents of the state within which the adviser maintains its primary office or place of business, and who does not furnish advice or issue analysis or reports concerning securities listed or admitted to trading privileges on any national securities exchange. The Act revises the intrastate exemption so that it will no longer be available to an adviser to a private fund.[3]
Registration
Registration under the Advisers Act involves the filing of a Form ADV. After SEC review, which is generally a review for compliance with the requirements of the form itself, the ADV is made effective. The ADV is publicly available and the filing process is electronic. The ADV is required to be updated annually, and amended in the case of certain specified events.[4] Registration under the Advisers Act subjects the manager/adviser to a comprehensive and detailed regulatory structure.[5] The Advisers Act also contains provisions which require certain clauses be included in advisory contracts, and registered advisers are required to provide certain information to advisory clients and potential advisory clients.
The Advisers Act requires that registered advisers have specified compliance procedures, a code of ethics, and a compliance officer. The Advisers Act requires the maintenance of extensive books and records, including e-mail, and contains provisions with respect to the privacy of information concerning advisory clients and the custody of client assets. The Advisers Act also contains provisions dealing with various specific aspects of the business and operations of a registered adviser including advertising.
Registration also subjects the manager/adviser to the SEC compliance examination program. In a compliance examination, members of the SEC staff present an extensive list of materials which need to be assembled for review, including e-mail. The SEC staff member often comes onsite to review materials and conduct interviews. The examination is often followed by a letter from the SEC indicating areas of noncompliance which need to be corrected by the manager/adviser.
Reports
Registered Advisers
Registered advisers are required to maintain extensive records. These records are subject to review and examination by the SEC. The Act adds a new requirement to these books and records provisions. The Act requires registered advisers to maintain records and make reports to the SEC concerning private funds managed by the adviser. The new records and reports required to be maintained or filed for each private fund advised by a registered investment adviser include all of the following:
- The amount of AUM and use of leverage, including off-balance-sheet leverage.
- Counterparty credit risk exposure.
- Trading and investment positions.
- Valuation policies and practices of the fund.
- Types of assets held.
- Side arrangements or side letters, in which some investors get more favorable rights or entitlements than other investors.
- Trading practices.
- Other information specified by the SEC.
The Act treats these materials as records of the adviser for regulatory purposes. Under the Act, records of private funds maintained by a registered investment adviser are subject to periodic, special, and other examination by the SEC at any time. The Act requires the SEC to conduct periodic examinations of records of private funds maintained by a registered adviser.
The Act requires these records to be maintained for such periods of time as the SEC may require. It remains to be seen whether the SEC will require a separate time period for the maintenance of these records, or use the time periods in the current records maintenance rule. The Act requires the SEC to adopt rules to implement these new requirements. The Act does not contain any specific time for the completion of this aspect of the SEC’s rulemaking under the Advisers Act.
Unregistered Advisers
The Act gives the SEC the power to require managers of private equity funds to file reports with the SEC concerning the funds managed. This requirement is not limited to registered advisers. As a result, managers of private funds who are exempt from the registration requirements of the Advisers Act can still be required to provide information to the SEC concerning the private funds they manage. The upcoming SEC rulemaking proceeding is expected to deal with this issue, although the Act does not provide any specific deadline for completion of this aspect of the rulemaking. The Act also gives the SEC the power to conduct other examinations, perhaps in response to reports filed by unregistered advisers.
Mid-Sized Advisers
The Act also requires the SEC to take into account the size, governance and investment strategy of advisers to mid-sized private funds to determine whether they pose systemic risk when developing registration and examination procedures. The Act does not define what is meant by the term “advisers to mid-sized funds.” SEC rulemaking should clarify this point.
Confidentiality
The SEC is required to make available to the new Financial Stability Oversight Council (FSOC) all reports and documents, records, and information filed with or provided to the SEC by an adviser to a private fund. The purpose of these provisions is to provide access to information that is needed for systemic risk assessment. Information filed with the SEC that would otherwise be confidential is also required to be provided by the SEC to:
- Congress under a confidentiality agreement;
- Any other federal department, agency or SRO requesting information within the scope of its jurisdiction; or
- Pursuant to a court order in an action brought by the SEC or otherwise by the U.S. government.
The FSOC and any department, agency or SRO that obtains information or reports from the SEC will be subject to the same type of confidentiality as the SEC. These parties will also be exempt from the requirements of the Freedom of Information Act (FOIA) with respect to this type of information. FOIA requires federal agencies, including the SEC, to disclose to the public records requested in accordance with a specified procedure, unless those records are subject to an exemption.
Proprietary Information
“Proprietary information” of an investment adviser that is available to the SEC from a report required to be filed with the SEC will be subject to the same limitations on public disclosure as materials gathered during an SEC examination. Proprietary information is defined to include sensitive, non-public information regarding all of the following:
- An advisor’s investment or trading strategies.
- Analytical or research methodologies.
- Trading data, computer hardware or software containing intellectual property.
- Other information the SEC determines to be proprietary.
In addition, the Act expands the authority of the SEC to require advisers to disclose client information. Section 210(c) of the Advisers Act provides that the SEC cannot require an adviser to disclose the identity, investments or affairs of its clients, unless that disclosure is needed in an investigation or enforcement action. That Act changes Section 210(c) of the Advisers Act so that this type of information can also be required by the SEC for the purpose of determining systemic risk.
New $100 Million Federal Registration Threshold
Currently, the Advisers Act provides that registration is required at the federal level when AUM exceeds $30 million, unless an exemption is available. Federal registration is permitted when AUM exceeds $25 million. Federally registered advisers who are not exempt at the state level file at the state level under a simple notice filing procedure.
The Act raises the AUM threshold for federal investment adviser registration from $25 million to $100 million. An adviser with between $25 million and $100 million in AUM that is required to register as an adviser in the state where its main office is located, and is subject to examination by that state regulator, is no longer eligible to register as an adviser at the federal level – subject to certain existing exceptions and the exceptions mentioned in the next paragraph. Advisers that do not satisfy the $100 million federal threshold amount will generally be required to register at the state level, unless a state exemption is available.
The new $100 million threshold does not apply to an investment adviser to a registered investment company or a business development company, or an investment adviser that would be required to register with 15 or more states.
This new federal registration threshold could present compliance issues for advisers with less than $100 million in AUM who are currently registered at the federal level. For advisers below the $100 million federal registration threshold who are not eligible for a state exemption, registration at the state level could present a number of issues.
State registration is generally somewhat more complicated and time consuming than federal registration. In addition, state registration can entail requirements, such as bonding or net worth standards, not present at the federal level, and the simplified notice filing procedure for federally registered investment advisers generally is not available. In addition, registration in one state does not preempt the registration provisions of another state in which the adviser does business.
Many, but not all, states have exemptions similar to the Old Private Adviser Exemption. The Act does not change state law, but states may change their laws in response to the Act. In addition, the North American Securities Administrators Association may propose model rules which could be adopted by many states. A manager who is exempt from registration at the federal level still needs to check applicable state law to determine if a state exemption is available. It would be a good idea to monitor for changes in applicable state law in this regard.
Private Offerings
Accredited Investor Standard
Many private funds are offered under Regulation D. Regulation D provides an exemption from the securities registration requirement of the Securities Act of 1933, as amended. Most of these private fund offerings are limited to “accredited investors” under Regulation D.
Before the Act, a natural person was an accredited investor if (1) the person had an individual income in excess of $200,000 in each of the last two most recent years, or joint income with his or her spouse exceeding $300,000 in each of those years, and has a reasonable expectation of reaching the same income level in the current year; or (2) the person’s net worth, together with his or her spouse’s, exceeds $1 million at the time of investment. Before the Act, individuals could include the value of their primary residence in calculating net worth.
The Act changes the method of calculating net worth for purposes of determining “accredited investor” status under Regulation D. This change is effective immediately. As changed by the Act, an investor will not be able to include the value of his or her primary residence in calculating net worth under the net worth test for accredited investor status. In addition, debt secured by the primary residence may be excluded from the calculation, up to the value of the primary residence. The income test remains unchanged. This new standard would apply to new investors, and unless the SEC provides otherwise, to current investors making additional purchases.
Existing subscription documents should be reviewed and conformed to these new requirements.
The SEC may modify the new net worth test after four years.
Bad Boy Provisions
The Act also requires that the SEC change Rule 506 of Regulation D so that it will not be available to certain disqualified persons.
The SEC is required to adopt provisions similar to current Rule 262. Rule 262 applies to Rule 505, which is only available for offerings of less than $5 million. Rule 262 prohibits certain issuers from using Rule 505, including issuers that have been subject to an injunction or convicted of a felony or misdemeanor in connection with the purchase or sale of a security. So in effect, this change will make the types of disqualification provisions that currently apply to Rule 505 applicable to offerings under Rule 506 as well.
The SEC is also required to adopt provisions disqualifying a person subject to certain types of final orders by a state securities, banking or insurance authority, a federal banking agency, or the National Credit Union Administration.
McGuireWoods Private Equity Group
The Private Equity Practice Group at McGuireWoods LLP is dedicated to keeping clients advised of new legislative and business developments as they occur.
NOTES:
1. A Qualified Client is an advisory client which is a (i) natural person or an entity who has invested $750,000 with the adviser, (ii) natural person or an entity that has a net worth of not less than $1,500,000, or (iii) qualified purchaser. (The Act requires the SEC to adjust any dollar amount it uses for this Qualified Client definition for inflation not later than July 21, 2011 and every five years thereafter. Adjustments need to be made in multiples of $100,000.)
2. In a 2004 regulation intended to require registration of advisers to private funds, the SEC took the approach of exempting advisers to funds which did not allow redemptions for the first two years after investment. These regulations were invalidated in 2006 in a court proceeding and it is unclear whether the SEC will use the permitted investor redemption structure as a feature distinguishing venture capital funds.
3. The Act also provides a limited foreign private adviser exemption. This new exemption does not impact managers located in the U.S.
4. The ADV consists of Parts 1 and 2. Part 2 consists of detailed information concerning the business of the adviser which is required to be provided to new clients and offered to existing clients on an annual basis. The SEC recently adopted changes to the contents of Part 2 of Form ADV and to require that Part 2 be in “plain English” and that it be filed electronically, starting in 2011.
5. It is unclear when the general partner of a fund will also need to register as an investment adviser if the fund has a separate investment manager which registers as an investment adviser. This issue may be clarified in the upcoming SEC rulemaking.