US investment adviser registration: A summary for offshore hedge fund advisers

Jennifer L Nye, Partner, Katten Muchin Rosenman Cornish LLP, outlines the latest SEC rules with regard to offshore hedge fund advisers.

Offshore adviser registration is imminent

At this point, it is widely known that the US Securities and Exchange Commission (SEC) has issued new rules requiring certain hedge fund advisers, including advisers who have their place of business located outside of the United States (offshore advisers) to register with the SEC as advisers pursuant to the US Investment Advisers Act of 1940, as amended.

While the hedge fund industry continues to speculate as to whether the new rule will be scaled back or eliminated as a result of legal challenges or the recent change in leadership at the SEC, the current reality is that offshore advisers who advise US based hedge funds with more than 14 investors, or offshore hedge funds with more than 14 US investors, had to be registered with the SEC before 1 February 2006.

We have prepared the following concise summary to assist offshore advisers to hedge funds with evaluating the impact of the rule on their businesses.

Applicability of rule to offshore hedge fund advisers

Who needs to register?
An offshore adviser to hedge funds will need to register as an investment adviser with the SEC if:

US Funds -- The offshore adviser provides advisory services to one or more US-based 'private funds' with more than 14 investors or to other US resident clients; and/or

Offshore funds - The offshore adviser provides advisory services to one or more offshore 'private funds' with more than 14 US residents as investors.

The SEC has defined 'private fund' to cover most hedge funds. Specifically, the rule defines a 'private fund' as any company that: (a) would be an investment company under the US Investment Act of 1940, as amended, but for Section 3(c)(1) or 3(c)(7); (b) has less than a two-year lock up period; and (c) offers interests based on the investment advisory skills, ability or expertise of the investment manager.

Exceptions
Two-year lock-up - Offshore advisers will not be subject to the rule (i.e. have to register with the SEC) if they only provide advisory services to hedge funds that have two-year lock-up periods.

Offshore public funds - Offshore advisers will not be subject to the rule if they only provide services to offshore, publicly offered funds. The SEC has excluded from the definition of 'private fund' any company that (a) has its principle office and place of business outside of the United States, (b) makes a public offering of its securities in a country other than the United States; and (c) is regulated as a public investment company under the laws of a country other than the United States.

Practical effect of SEC registration

Offshore hedge fund clients only -- limited applicability of Advisers Act
An offshore adviser registered with the SEC who provides services to hedge funds (and not to US resident clients) will only be required to comply with the following sections of the Advisers Act and SEC rules under the Advisers Act:

Registration -- procedures for registration and amendment requirements (section 203)

Recordkeeping -- requirement to maintain certain books and records (section 204)

Code of ethics -- no requirement to have a code of ethics, but must retain its access persons' personal securities reports (Rule 204A-1)

SEC exams -- allowing for periodic examinations and sweeps by the SC (Section 204)

Anti-fraud provisions -- the general anti-fraud provisions of the Advisers Act (Sections 206(1) and 206(2))

Us hedge fund clients -- full applicability of Advisers Act
An offshore adviser registered with the SEC who provides services to US based hedge funds with more than 14investors (or to other types of US resident clients) will be subject to all applicable provisions of the Advisers Act and SEC rules under the Advisers Act. Together with the provisions mentioned above, these include the following:

Code of ethics -- requiring a written code of ethics addressing conflicts of interest and insider trading (section 204A)

Advisory contracts -- requirements for content of advisory agreements and restrictions on charging performance fees (section 205)

Advertising rule -- requirements for and restrictions on content of advertising materials (section 206(4)-1)

Custody rule -- restrictions relating to cash payments to solicitors (Rule 206(4)-3)

Proxy voting -- requiring written proxy voting policies and procedures (Rule 206(4)-6)

Compliance program rule - requiring written policies and procedures and Chief Compliance Officer (Rule 206(4)-7)

Conclusion - Few options for Offshore Advisers

Unfortunately, the options available to offshore advisers to hedge funds that market to US residents are limited under the rule. Absent making significant business changes to avoid registration (i.e. instituting a two-year lock-up or limiting activities to advising publicly offered and regulated investment companies), offshore advisers providing services to offshore hedge funds with more than 14 US investors and/or US hedge funds with more than 14 investors, must register with the SEC.

As noted above, it is possible to limit the impact of SEC registration by advising only offshore private funds. As a practical matter, this approach would require an offshore adviser who currently advises US-based funds to terminate its relationship with the US funds and, if desired and/or necessary, restructure its offshore funds to accommodate US investors.

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