Simon Firth of Wilmer Cutler Pickering Hale and Dorr LLP examines the ramifications of this week's SEC vote in favour of proposals for registration of hedge fund advisers.
On Wednesday 14th July 2004 the five members of the US Securities and Exchange Commission ("SEC") voted by a majority of 3:2 in favour of requiring investment advisers to "private funds" to register as investment advisers under the US Investment Advisers Act of 1940 (the "Advisers Act") where, on a look through basis, the adviser has more than 14 clients. The proposed rule has not yet been released but can be expected to be published within the next few days.
The SEC's press release states that the proposed rule would contain special provisions for advisers located outside the United States designed to limit the extra-territorial application of the Advisers Act to offshore advisers to offshore funds that have US investors.
The division within the Commission reflects polarised views expressed since the staff of the SEC recommended registration of hedge fund advisers in its report on hedge funds (the "Report") to the Commission last autumn.
The ramifications of the proposal are considered below.
Rationale of the SEC
The Commission's staff estimate that approximately 40 to 50 per cent of all (US) hedge fund advisers are currently registered with the Commission. The rationale of the SEC in seeking registration of all hedge fund advisers is evidenced by the fact that that the proposed rule would permit the Commission to:
* collect and provide to the public basic information about hedge funds and hedge fund advisers, including the number of hedge funds operating in the United States, the amount of assets, and the identity of their advisers;
* examine hedge fund advisers to identify compliance problems early and deter questionable practices. If fraud does occur, examinations offer a chance to discover it early and limit the harm to investors;
* require all hedge fund advisers to adopt basic compliance controls to prevent violation of the federal securities law;
* improve disclosures made to prospective and current hedge fund investors; and
* prevent felons or individuals with other serious disciplinary records from managing hedge funds.
The New Rule and related amendments
Under the current law, a US investment adviser with fewer than 15 clients does not need to register under the Advisers Act provided it does not hold itself out as providing investment advisory services and does not advise a fund registered under the Investment Company Act of 1940 (the "1940 Act"). For these purposes one fund generally counts as one client, irrespective of the number of investors in the client fund. As Chairman Donaldson pointed out, that could mean that a hedge fund adviser with 14 fund clients, each with 499 or fewer investors (that number being the maximum permitted to avoid registration under the US Securities Exchange Act of 1934) could have almost 14,000 ultimate "clients" without needing to be registered under the Advisers Act. Accordingly new Rule 203(b)(3) - 2 (the "New Rule") is proposed:
"to require an adviser to a private fund to look through the fund and count each investor towards the 14 client limit."
The SEC will define a private fund by reference to three characteristics adhered to by virtually all hedge funds and which they believe distinguish hedge funds from other private pooled investment vehicles, such as venture capital funds and private equity funds.
A "private fund" would be one that:
* would be an investment company but for the exceptions in Sections 3(c)(1) or 3(c)(7) of the 1940 Act;
* permits owners to redeem their ownership interest within two years of purchase; and
* is offered based on the investment advisory skills, ability or expertise of the investment adviser.
The statutory references in the first bullet are respectively to funds which have no more than 100 beneficial owners and is not offered to the public, or whose investors are exclusively "qualified purchasers" for the purposes of the 1940 Act.
The New Rule would not, however, attempt to define hedge funds by reference to their investment strategy, their trading frequency or their fee structures, nor would it change the minimum assets under management, USD 25 million, that an adviser must have in order to be eligible to register with the Commission. Hedge fund advisers that manage less than USD 25 million would not need to register with the Commission.
In addition to the New Rule, the SEC recommend three rule amendments that would accommodate hedge fund advisers as they transition to registration.
Record keeping: The first of these rule amendments would amend the SEC's record-keeping rule that requires advisers to keep certain records if they advertise their performance track record. The amendment would let hedge fund advisers continue marketing their performance history for their pre-registration period even if they did not have all the required records from that period.
Performance fees: Normally registered advisers can charge performance fees only to qualified clients (defined in "Consequences of registration" below), but the amendment would allow existing investors to stay in their hedge funds and continue paying performance fees even if they are not qualified clients.
Custody: The third amendment would make it simpler for funds of hedge funds to comply with the SEC's adviser custody rule. Currently an adviser to a fund can provide custody account information to investors by distributing the funds audited financial statements within 120 days of its fiscal year end. However, because funds of hedge funds often cannot finish their own audits until the underlying funds have completed theirs, the SEC proposes to extend that deadline to 180 days.
The SEC also recommends some minor changes to form ADV (see "Consequences of registration" below) in order to allow the Commission more easily to identify hedge fund advisers as such.
Impact on non-US hedge fund advisers
Private fund advisers located outside the United States ("Non-US Advisers") may be required to register under the Advisers Act when they have US persons as clients. However, the SEC is concerned that the New Rule should not apply inappropriately to offshore advisers. We understand that the New Rule will contain several provisions that would limit its extra-territorial reach to offshore advisers to offshore funds that have US investors, namely:-
* The New Rule would not require advisers to public investment companies to count as US clients those investors that move to the United States after they invest in a fund advised by the offshore adviser; and
* When offshore advisers to offshore private funds do have 15 or more US investors, and therefore have to register, the New Rule would limit the application of most provisions of the Advisers Act to those funds.
All the indications, therefore, are that, subject to those limitations, Non-US Advisers to offshore funds with 15 or more US clients will be required to register under the Advisers Act, assuming this outline proposal is finally adopted, but only in respect of funds with 15 or more US persons as investors. As indicated above, the Commission will add flesh to the bones of the requirement to look through to underlying investors in terms of how they are counted. Many Non-US Advisers, including in the UK, count ERISA investors and funds of funds as their clients, and may need to look through to the ultimate investors in those clients. This would require those investing funds of funds, for example, to divulge information as to their own client base to the underlying investee fund, which may trigger confidentiality issues between the fund of funds and the single fund into which it has invested.
It is to be seen how the look through counting is policed. Would it be sufficient for the Non-US Adviser simply to self-certify the number of US investors in any of his funds, and then effectively to opt in and out of compliance with the Advisers Act in respect of each fund?
There may also be scope for avoiding the "private fund" conditions, for example by limiting redemptions within two years of purchase. Also the position of advisers to non-US public funds such as EU UCITS is not clear, although in the generic sense they are not "private" funds.
Consequences of registration
The process of registration requires completion of a Form ADV which is in two parts, Part I requiring administrative information concerning the adviser, and Part II stipulating the provision of client facing information, such as the types of services provided, fees charged and disclosure of conflicts of interest. In addition, depending on the circumstances, SEC registered advisers may have to provide US state securities authorities with copies of documents filed with the SEC.
A significant issue for Non-US Advisers will be the requirement that performance fees may only be charged, under the Advisers Act, by registered advisers to "qualified clients" who are any of:-
* An investor with at least USD 750,000 under the management of the adviser; or
* An investor with a net worth of at least USD 1,500,000 at the time the contract is entered into; or
* A "qualified purchaser" for the purposes of the Advisers Act; or
* Certain affiliates and employees of the adviser.
In this context note the transitional "grandfathering" provisions (described in "The New Rule and related amendments") above relating to record keeping, performance fees and custody proposed by the SEC. However, it might be harder to attract new investment under these stricter controls.
Registration as an investment adviser requires on-going compliance with the SEC's rules, including on, for example, principal and agency cross transactions, advertising, assignment of the advisory contract, cash solicitation fees, custody, preparation of disclosure document (or brochure) describing the adviser's business practices and background, proxy voting and conflicts of interest. These and all other relevant issues need to be addressed by written compliance policies and procedures overseen by a compliance officer.
The debate over hedge fund adviser registration continues to generate heat and light. The divisions within the Commission itself also spread to influential policy makers and legislators, and there can be no guarantee that this proposal will be successfully promulgated during Donaldson's chairmanship, which some consider will end with the passing of the current Bush administration.
Nevertheless, Non-US Advisers should continue to lobby the SEC for exemption where they are subject, as in the UK, to adequate regulation and oversight already, for example in the guise of the UK Financial Services Authority. This was the principal recommendation made in the submission on the Report made by the Alternative Investment Management Association to the SEC earlier this year.
Wilmer Cutler Pickering Hale and Dorr LLP
15th July 2004
Tel + 44 20 7872 1036
Wilmer Cutler Pickering Hale and Dorr LLP, and international law firm, services the hedge fund community from its US, London and Berlin offices providing comprehensive fund formation, transactional and regulatory support and advice.