Dodd-Frank Act Implications for Investment Advisers to Private Funds (PDF-231kb)
Dodd-Frank Act Implications for Investment Advisers to Private Funds Authors: Jay B. Gould
The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) will significantly change the regulatory regime governing investment advisers, particularly investment advisers to private funds, such as hedge funds and private equity funds. The primary purpose of the new rules and requirements is to “fill the regulatory gap,” by requiring advisers to private funds to register as investment advisers with the Securities and Exchange Commission (SEC) or state securities regulators, unless an exemption applies, and provide information about their activities to the SEC.
Currently, advisers with $25 million or more of assets under management may register with the SEC. However, under the Dodd-Frank Act, advisers with assets under management of $100 million or more will be required to register as investment advisers with the SEC, unless an exemption applies (see below). An adviser with assets under management of less than $100 million and that is subject to state regulation will generally be required to register as an investment adviser with the state regulator(s) of the state(s) in which such adviser is located. By increasing the threshold for SEC registration to $100 million, the Dodd-Frank Act will allow the SEC to focus its time and resources on large advisers, which presumably present a greater systemic risk to the U.S. economy than small to mid-sized advisers.
Exemptions from SEC Registration
Currently, a large number of investment advisers are not registered with the SEC in reliance upon the “private adviser exemption,” under Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act). The “private adviser exemption” generally exempts an adviser from the registration requirements if it has had fewer than 15 clients during the preceding 12-month period, does not hold itself out as an investment adviser and does not advise registered investment companies or business development companies. The Dodd-Frank Act will eliminate this exemption, which will require many unregistered advisers to register with the SEC, unless another exemption applies.
Although the Dodd-Frank Act will eliminate the “private adviser exemption,” it will create several new exemptions from the registration requirements for advisers to private funds. A private fund is generally defined as an investment company that is exempt from the registration requirements of the Investment Company Act of 1940 (Investment Company Act), in reliance upon Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act.
- Mid-Sized Private Fund Advisers. Advisers with less than $150 million of assets under management in the United States and that only advise private funds will be exempt from the registration requirements of the Advisers Act. However, the SEC may (i) require such advisers to maintain such records and make such reports as the SEC by rulemaking determines is necessary or appropriate in the public interest and to protect investors, and (ii) implement registration and examination procedures for such advisers, which would take into account the size, governance, investment strategy and level of systemic risk posed by such advisers.
- Venture Capital Fund Advisers. Advisers to “venture capital funds” will be exempt from the registration requirements of the Advisers Act. To qualify for this exemption, an adviser may only advise venture capital funds. The SEC may require such advisers to maintain certain records and reports, if the SEC determines that such reporting and recordkeeping requirements are necessary or appropriate in the public interest or for the protection of investors. The SEC has not yet defined the term “venture capital funds,” but must issue a definition within one year of enactment of the Dodd-Frank Act.
- Foreign Private Advisers. “Foreign private advisers” will be exempt from the registration requirements of the Advisers Act. Under the Dodd-Frank Act, an adviser qualifies as a “foreign private adviser” if it (i) has no place of business in the United States, (ii) has fewer than 15 U.S. clients and investors in private funds advised by the adviser, (iii) has less than $25 million (or such higher amount as the SEC may determine by rulemaking) of aggregate assets under management attributable to U.S. clients and investors in private funds advised by the adviser, (iv) does not hold itself out as an investment adviser in the United States, and (v) does not advise any registered investment company or business development company.
- Family Offices. “Family offices” will be excepted from the definition of “investment adviser,” and will generally not be subject to the requirements of the Advisers Act, including the registration requirements. However, the term “family offices” has not yet been defined by the SEC and currently there is no deadline by which the SEC must define the term.
- Commodity Trading Advisers. Any adviser that is registered with the Commodity Futures Trading Commission as a commodity trading adviser will be exempt from the registration requirements under the Advisers Act, provided that such adviser does not predominantly provide advice with respect to securities.
- Small Business Investment Companies. Any adviser that solely advises small business investment companies will be exempt from the registration requirements under the Advisers Act.
- Intra-State Exemption. The Dodd-Frank Act will narrow the exemption for intra-state advisers. Currently, the intra-state adviser exemption exempts an adviser with clients that are all residents of the state in which the adviser maintains its principal office from the registration requirements under the Advisers Act. The exemption will be narrowed, as it will no longer be available to advisers to private funds.
Under the Dodd-Frank Act, the SEC has the power to create and implement broad recordkeeping and reporting requirements for advisers to private funds that are registered with the SEC. Advisers to private funds (i) will be required to maintain records regarding the private funds that they advise and make such records available to the SEC for inspection, and (ii) may be subject to future SEC filing requirements. Advisers to private funds will be required to maintain reports and records that include information regarding the private fund’s assets (including the amount and type of assets), use of leverage, counterparty risk exposure, trading and investment positions, valuation policies and practices, side letters, trading policies and practices and such other information that the SEC determines is necessary or appropriate in the public interest or to protect investors. The foregoing records and reports will generally apply to advisers that advise private funds; however, the SEC may implement different standards for different classes of private fund advisers, based on the size and type of private fund advised by the adviser. Further, advisers to mid-sized private funds or venture capital funds also may be subject to different recordkeeping and reporting standards as determined by the SEC. The Dodd-Frank Act will require the SEC to share reports and other documents that are filed with it with the Financial Stability Oversight Council.
Other Relevant Issues
- Volcker Rule. The Dodd-Frank Act includes what has been referred to as the “Volcker Rule,” which will restrict the activities of banking entities (e.g., insured depository institutions, companies that control insured depository institutions or are treated as bank holding companies, and the affiliates of any such entities, including private fund managers and broker-dealer subsidiaries) and certain nonbank financial companies. Under the Volcker Rule banking entities will generally be prohibited from sponsoring or investing in private funds, unless an exemption applies, and certain nonbank financial companies that sponsor or invest in private funds will be subject to additional capital requirements and quantitative limits if they do not comply with certain requirements under the Volcker Rule. For a more detailed discussion regarding the Volcker Rule, please see our Client Alert that specifically discusses the Volcker Rule.
- “Accredited Investor” Standard. Upon enactment of the Dodd-Frank Act, and for the following four-year period, the net worth threshold of $1 million dollars for an “accredited investor,” as defined under Rule 501(a)(5) of Regulation D of the Securities Act of 1933 will no longer include the investor’s primary residence. Following the four-year period after the date of enactment, and every four years thereafter, the SEC will be required to review the definition of the term “accredited investor,” as applied to natural persons, and may modify the definition as appropriate for the protection of investors, in the public interest and in light of the economy. Based on our conversations with the SEC staff, it appears that an existing investor in a private fund who does not satisfy the new “accredited investor” standard may remain in the private fund, as long as such investor does not make any additional capital contributions to the private fund (unless such investor subsequently satisfies the new standard). Accordingly, a private fund adviser should update its existing fund documents immediately to reflect the new “accredited investor” standard and to address the treatment of existing investors who do not satisfy the new “accredited investor” standard.
- “Qualified Client” Standard. Generally, advisers may only charge a performance or incentive-based fee to its investors that are “qualified clients” under Rule 205-3 of the Advisers Act. Under the Dodd-Frank Act, the SEC will be required to adjust for inflation the dollar thresholds (i.e., the $750,000 assets under management test and the $1.5 million net worth test) of the “qualified client” standard within one year of enactment of the Dodd-Frank Act and every five years thereafter. Unlike the net worth test for the “accredited investor” standard, the Dodd-Frank Act does not explicitly require that an investor’s primary residence be excluded from the net worth test for the “qualified client” standard. As an odd result, an investor could satisfy the “qualified client” standard, but not the “accredited investor” standard.
- Custody. Under the Dodd-Frank Act, the SEC will have the authority to establish rules under the Advisers Act to require all registered advisers with custody of client assets to take steps to safeguard such client assets. For example, the SEC may require advisers with custody of client assets to retain an independent public accountant to verify such assets.
- Transition Period. The provisions of the Dodd-Frank Act become effective one year after the date of the act’s enactment, unless otherwise specifically noted. During the one-year transition period, the SEC will promulgate new rules and regulations regarding the Dodd-Frank Act’s standards.
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