US legal firm Bryan Cave provides a summary of the final SEC rules covering the registration of hedge fund advisers in the USA.
On December 2, 2004, the Securities and Exchange Commission (the "SEC") adopted Rule 203(b)(3)-2 and related amendments (collectively, the "New Rules") under the Investment Advisers Act of 1940, as amended (the "Advisers Act").
The New Rules were adopted substantially as proposed and require most hedge fund managers to register as investment advisers with the SEC. Although the effective date for many of the provisions in the New Rules is February 10, 2005, all hedge fund managers must be in compliance with the New Rules (i.e., registered with the SEC) by February1, 2006. Below is a brief summary of the New Rules.
Under the prior regulatory framework, a hedge fund manager counted each hedge fund to which it provided investment advice as one client. The New Rules require advisers of "private funds" to look through the entities they manage to determine the number of clients to whom the adviser provides investment advisory services.
Any adviser with more than fourteen (14) clients (i.e., more than 14 investors) during the previous twelve (12) months and at least USD 30 million in assets under management would be required to register as an investment adviser with the SEC. The adviser need not count itself or the private fund as a client for such purposes. In the fund of hedge funds context, an adviser of a private fund in which a fund of hedge funds is an investor is required to look through and count each investor of such fund of hedge funds.
To ensure that the New Rules apply to hedge fund advisers and not to operators of other pooled investment vehicles (such as private equity and venture capital funds), the SEC defines a "private fund" as an entity that: (i) would qualify as an investment company under the Investment Company Act of 1940, as amended (the "Investment Company Act"), if not for the exemption in Section 3(c)(1) or 3(c)(7) of the Investment Company Act; (ii) permits investors to redeem their interests within two (2) years of purchase; and (iii) offers its interests based on the investment advisory skills, ability or expertise of the investment adviser. The SEC release adopting the New Rules states that the two (2) year redemption test does not apply to investments made prior to February 1, 2006.
Offshore advisers are required by the New Rules to look through the private funds they manage, whether or not such funds are located offshore, and count as clients those investors that are U.S. residents.
Any offshore adviser who has more than fourteen (14) U.S. resident investors (or other U.S. resident advisory clients) over the past twelve (12) months (without regard to the amount of assets under management) would generally have to register with the SEC. The determination as to whether an investor is a U.S. resident is made at the time of the investment in the private fund.
The New Rules include an exception to the definition of "private fund" for a company that has its principal office and place of business outside the U.S., is regulated as a public investment company under the laws of a country other than the U.S. and makes a public offering of its securities outside the U.S. in the same jurisdiction in which it is regulated as a public investment company.
Further, the New Rules permit an offshore adviser to an offshore private fund to treat the fund as its client for all purposes under the Advisers Act other than (i) when determining the availability of the private adviser exemption from registration and (ii) those provisions of the Advisers Act prohibiting fraud.
In addition, the New Rules modify the recordkeeping requirements of the Advisers Act and the rules promulgated thereunder to allow an adviser registered pursuant to the New Rules to market the performance of any account managed by such adviser for periods prior to its registration, even if it has not kept documentation required to support the performance of such account.
A registered investment adviser is generally prohibited from charging a client fees based upon capital gain or appreciation (i.e., performance fees) unless such client is a "qualified client" (i.e., a natural person or entity that has at least USD 750,000 under management with the adviser, has a net worth of more than USD 1,500,000 at the time of investment or is a "qualified purchaser" as defined in the Investment Company Act). The New Rules include a grandfathering provision to allow advisers registered pursuant to the New Rules to avoid disrupting existing fee arrangements with their current clients. Thus, the grandfathering provision allows existing investors of a Section 3(c)(1) fund that charges performance fees and that is managed by a newly-registered adviser to retain and add to their investments in such fund.
The New Rules amend the adviser custody rule to extend the audited financial statement delivery deadline for fund of hedge funds advisers from 120 days to 180 days from the pool's fiscal year-end in order to ensure that they are able to satisfy their obligation to deliver custody account information. In order to limit the extension of the delivery deadline to fund of hedge funds, the New Rules allow the extension only for private funds that invest at least ten (10) percent of their assets in other unrelated pooled investment vehicles.
Additionally, Form ADV has been amended to require advisers to "private funds" to identify themselves as hedge fund advisers. The Investment Adviser Registration Depository (IARD) filing system will incorporate the amendments made to Form ADV on March 8, 2005. All currently registered investment advisers must amend their Form ADV to respond to the revised disclosure item by February 1, 2006.
Registration with the SEC as an investment adviser entails full compliance with the Advisers Act and the rules promulgated thereunder, including, among other things, (i) the preparation and filing of Form ADV, (ii) the prohibition against charging performance fees to investors that do not qualify as "qualified clients," (iii) the adoption of written compliance procedures and the appointment of a chief compliance officer, (iv) the adoption of a written code of ethics, (v) certain disclosure requirements upon payment of a cash referral fee to third party placement agents, (vi) enhanced recordkeeping requirements, (vii) additional reporting and audit requirements if the adviser has custody of its client's assets and (viii) periodic inspections by the SEC.
Finally, in the open meeting adopting the New Rules on October 26, 2004, the SEC stated that it would form a task force responsible for assisting hedge fund managers in the technical aspects of registration and developing a risk-based inspection program for registered investment advisers. We will continue to monitor the situation and will provide you with more details as they become available.
This is only a brief summary of the New Rules and is prepared solely to familiarize you with the basic requirements of the New Rules. If you have any questions, please feel free to contact a member of the Bryan Cave Hedge Fund Team via www.bryancave.com