Jay B Gould and Robert B Robbins of Pillsbury Winthrop Shaw Pittman LLP examine the implications of the SEC's 'no-action' letter to the ABA.
On August 10, 2006, the staff of the Division of Investment Management of the Securities and Exchange Commission issued a "no-action" letter to the American Bar Association's Subcommittee on Private Investment Entities to provide guidance to the hedge fund industry following the decision of the U.S. Court of Appeals for District of Columbia Circuit in June 2006, Goldstein v. SEC.
The Goldstein decision had vacated Rule 203(b)(3)-2 and its related amendments (the "Hedge Fund Rule") under the Investment Advisers Act of 1940, the intent and effect of which had been to require the registration of a substantial number of investment advisers to hedge funds. The SEC did not appeal the ruling and, as of August 7, 2006, the Court decision became final.
The Court decision not only rejected the SEC's approach that each investor in a hedge fund should be counted as a client instead of the fund itself, but it also vacated all of the other SEC rulemaking that accompanied the Hedge Fund Rule.
The Division's issuance of the August 10 no-action letter was intended to provide guidance to the industry as a result of this broader Court ruling. Industry observers should also be aware that on July 25, 2006, SEC Chairman Cox, in testimony before the Senate Committee on Banking, Housing, and Urban Affairs, stated that the SEC intended to adopt immediate temporary rules to address the uncertainty caused by the Court decision with respect to many of these same matters.
It is unclear at this point whether the SEC will adopt such temporary emergency rules, or will rely only on a Division no-action position to address the Court action, although given the limited nature of the relief provided in the no-action letter, additional regulatory action should be expected.
Offshore Advisers The Hedge Fund Rule had provided relief to offshore advisers with no place of business in the U.S. by permitting them to treat their offshore funds as exempt from most provisions of the Advisers Act. For offshore advisers that decide to remain registered with the SEC, the Court decision may have had the affect of subjecting all of the offshore adviser's clients to all of the substantive provisions of the Advisers Act. The no-action letter provides that the substantive provisions of the Advisers Act do not apply to the offshore adviser's non-U.S. clients, except as they would have under the Hedge Fund Rule.
Records Supporting Performance The books and records rule under the Advisers Act, Rule 204-2, requires an adviser to keep certain records that "form the basis for or demonstrate the calculation of the performance or rate of return." The Hedge Fund Rule created an exception to this requirement so that the records to support the performance of a private fund or other account for any period prior to February 10, 2005, was not required to be maintained. The no-action letter provides that hedge fund advisers may still rely on this exception to Rule 204-2.
Performance-Based Compensation The Hedge Fund Rule provided that certain investors in hedge funds who did not meet the definition of "qualified client" in Rule 205-3 of the Advisers Act could be "grandfathered" for purposes of charging such clients a performance fee or incentive allocation if the investors had been investors in the fund before February 10, 2006. To the extent a hedge fund adviser were to stay registered with the SEC and not mandatorily redeem investors who do not meet the definition of "qualified client," such advisers would not be permitted to charge these clients a performance fee. The no-action letter provides that the grandfathering provisions of the Hedge Fund Rule will continue to apply to the clients who do not meet this higher investment standard.
Custody Rule Rule 206(4)-2 under the Advisers Act, (the "Custody Rule"), requires hedge fund advisers, in most cases, to deliver annual audited financial statements to investors within 120 days of the end of the fiscal year. The Hedge Fund Rule provided an exception to this requirement for funds of funds due to the impractical nature of obtaining audits from all of the underlying funds, completing an audit for a fund of funds, and delivering the audited financials to investors within 120 days. The no-action letter provides that a fund of funds may continue to rely on the exception that was adopted in the Hedge Fund Rule and deliver annual audited financial statements within 180 days of the end of the fund of fund's fiscal year.
Registration Withdrawal The no-action letter provides that a hedge fund adviser may withdraw from SEC registration and not face enforcement action if during the time the adviser was registered, it held itself out generally to the public as a registered adviser and had more than 14 clients while it was registered. In order to rely on this Division relief, an adviser must no longer hold itself out as an adviser, have no more than 14 clients (counting each fund as a single client), and withdraw its registration by February 1, 2007. Additionally, to the extent an adviser withdraws from registration before February 1, 2007, it will not be required to provide the information required in a balance sheet when it files its Form ADV-W, the SEC form pursuant to which investment advisers de-register with the SEC.
The SEC also provided additional guidance that was not requested by the ABA Subcommittee in the following areas.
Form ADV The Division indicated that it is in the process of revising Form ADV to remove information with respect to private funds, but will provide information on the SEC website regarding how to complete Form ADV while these revisions are being made. The Division also warned hedge fund advisers that the books and records that advisers are required to keep on behalf of private funds must be made available to SEC examiners if requested. An adviser may not evade this requirement by designating certain books and records as those of a private fund and attempt to place such records outside the reach of the SEC.
Certainly, this is not the last word from the SEC in its attempt to regulate hedge funds and their advisers, nor is it likely the last volley from the industry