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Comment: Impact in UK and Europe of SEC’s proposal to register hedge fund investment advisers

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William Yonge, Peter Malyshev and John Sullivan of the US law firm McDermott, Will & Emery examine the impact of the SEC’s proposals on non-US based advisers.


William Yonge, Peter Malyshev and John Sullivan of the US law firm McDermott, Will & Emery examine the impact of the SEC’s proposals on non-US based advisers.

Many investment advisers to hedge funds, private equity funds and other investment funds currently qualify for exemption from the registration as an investment adviser under the Investment Advisers Act of 1940 (Advisers Act).

The U.S. Securities and Exchange Commission (SEC) recently proposed a rule that would narrow one important exemption, and if adopted, the rule would require SEC registration of many currently unregistered investment advisers, including non-U.S. based investment managers of non-U.S. domiciled hedge funds and funds of hedge funds who will likely be regulated already in their local country.

For example, a UK based investment manager is required to be authorised and regulated by the UK Financial Services Authority (the “FSA”) (even if such manager has only a single client).

For clarity the U.S. term ‘investment adviser’ includes, discretionary investment managers, as commonly used in UK and Europe.

Following a heated debate on July 14, 2004 the SEC by a 3-2 vote proposed for comment a new Rule 203(b)(3)-2 under the Advisers Act (See 17 CFR Parts 275 and 279, SEC Release No. IA-2266, Registration Under the Advisers Act of Certain Hedge Fund Advisers, published July 28, 2004 (Proposed Rule). Comments to the Proposed Rule were due in by September 15, 2004.

After the SEC reviews the comments (which are currently publicly available at (, it will consider changes and could issue a final rule soon thereafter.

Five industry groups opposed to the proposals have written to the SEC requesting a 45 day extension of the comment period, to October 28, 2004. Signatories include the Managed Funds Association, the main U.S. hedge fund trade group; the Alternative Investment Management Association, the main international hedge fund trade group; the International Swaps and Derivatives Association; the Futures Industry Association; and the Chamber of Commerce. Some commentators have even questioned whether the SEC has power to alter the existing rules as proposed.

The Current Rules

Under the current rules, an investment adviser qualifies for exemption from SEC registration if it: (i) advises fewer than 15 clients during the preceding 12 months; and (ii) does not hold itself out publicly as an investment adviser. Currently, Rule 203(b)(3)-1(a)(2)(i) permits many corporations, general partnerships, limited partnerships, limited liability companies, trusts or other legal organizations to be counted as a single “client”. Furthermore, an investment adviser is permitted to count an investment fund as a single client for Advisers Act purposes if the adviser gives securities trading advice based on the fund’s investment goals rather than on the goals of any particular investor in the fund. In the case of a non-U.S. based adviser the current rule is applied so that the limit on number of clients applies only to U.S. clients.

It is worth noting an important distinction in the application of SEC rules in this context between U.S. advisers and non-U.S. advisers.  In short a U.S. adviser who has 15 or more clients and has:

* USD 30 million or more under management is required to register at the federal level with the SEC;
* between USD 25 and USD 30 million under management may choose between registration with the regulator in its local State or with the SEC. In practice nearly all advisers in the category choose SEC registration;
* less than USD 25 million under management, is required to register with the regulator in its local State only.
In the case of non-U.S. advisers, these thresholds do not apply in the first place since by definition a non-U.S. adviser will not have its principal office or place of business in the U.S. and therefore would be required to register with SEC.

The Proposed Rule

The Proposed Rule applies to “private funds,” which will be defined to encompass most hedge funds and funds of hedge funds by including any company that relies on Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (1940 Act) for exemption from 1940 Act registration.

These exclusions are relied upon by most hedge funds and funds of hedge funds to avoid registration with the SEC, and are commonly called “100-Person Fund” and “Qualified Purchaser Fund” exclusions. The funds covered by the Proposed Rule also include funds that permit investors to redeem their ownership interests in the fund within two years of purchasing such interests, and are marketed based on ongoing investment advisory skills, ability or expertise of investment adviser.

The reference to the two-year lock-up period requirement is intended to distinguish, for registration purposes, managers of venture capital funds, private equity funds and other similar funds that require investors to make long-term commitments of capital, from managers of hedge funds and funds of hedge funds that permit investors to redeem their capital more frequently.

Interestingly, Europe is seeing some hedge funds being set up with three and even five year lock-ups. Managers of such funds would not be subject to SEC registration under the Proposed Rule.

The Proposed Rule would require investment advisers to “look through” a private fund and count each beneficial owner of an equity interest in a “private fund” as a “client” for purposes of determining the availability of the private adviser exemption of Section 203(b).

If the adviser has 15 or more U.S. clients on this basis and has USD 25 million or more assets under management, SEC registration will be required. The SEC limited the extra-territorial application of the Proposed Rule by requiring non-U.S. based advisers of non-U.S. private funds to “look through” only to U.S. investors.

Therefore, a UK investment manager who manages the assets of only one hedge fund with 15 or more U.S. investors would, under the Proposed Rule, be required to register with the SEC (regardless of how much assets under management they have).

Also, under the Proposed Rule, in the context of a hedge fund with fund-of-funds-investors, a UK investment manager of one hedge fund will be required to look through each fund-of-funds-investor to the underlying investors in the fund of funds, counting all U.S. investors in the fund of funds as its U.S. clients.

Lighter regime for non-U.S. advisers

Furthermore non-U.S. advisers would not be required to count non-U.S. investors in offshore funds they advise as clients and generally would not be required to count as clients any non-U.S. investors who, subsequent to investing in a fund, move to the U.S.

In addition, a non-U.S. adviser will not be required to look through and count as clients any U.S. investors in publicly offered, registered offshore funds they advise (e.g., investment vehicles such as UCITS). However, this exemption will not apply to domestic U.S. advisers of offshore funds.

The Ongoing Compliance Burden

Although all advisers, whether or not required to be registered with the SEC, are subject to the Advisers Act’s anti-fraud and anti-manipulation provisions, advisers subject to SEC registration are generally required to comply with many additional requirements and rules, including: filing with the SEC Form ADV Part 1 that publicly identifies the adviser and distributing to clients Form ADV Part II which must describe potential conflicts of interest of adviser; maintenance of specified books and records; the custody of clients’ securities and funds and periodic reporting related thereto; the disclosure of regulatory and administrative actions; the compliance and the code of ethics rules requiring advisers to adopt extensive policies and procedures detailing advisers’ internal controls; and restrictions on performance fees.

For example, under Rule 205-3 of the Advisers Act, registered advisers may only charge “performance fees” (i.e., fees based on fund’s capital gains or appreciation) to “qualified clients” that have net worth of at least USD 1.5 million USD or have at least USD 750,000 of assets under management with the adviser.

Since it is typical for the adviser of a hedge fund to charge a performance fee, a consequence of this rule will be to increase the minimum threshold for investment in a 100 Person Fund from the accredited investor standard to the qualified client standard.

As with all SEC registration statements and disclosure materials, investment advisers must keep their disclosures current at all times. Investment advisers are also subject to on-site inspection by the SEC, which can occur as frequently as every two years.

In the case of UK advisers who are SEC registered, it is the practice of the SEC to liaise with the adviser’s own home regulator, the FSA, first and for the SEC and FSA to visit the adviser jointly.

However, a non-U.S. adviser that is required to register under the Advisers Act because of the existence of U.S. investors in an offshore fund it manages will be subject only to the anti-fraud provisions of the Advisers Act and will not be required additionally to comply with various rules under the Advisers Act such as those relating to books and records, custody and compliance.

If a non-U.S. based adviser has an office in the U.S., it is no longer in the SEC’s view an offshore adviser, and must fully comply with the Advisers Act. There are additional rules for non-U.S. advisers who have an office in the U.S. specifically organised to deal with U.S. clients.

Transitional Provisions or ‘Grandfathering’

The SEC has provided a transitional mechanism for the regulation of private funds not previously registered with the SEC. Existing hedge funds that charge performance fees will be permitted to maintain existing fee arrangements with persons who had already invested prior to the adviser’s registration under the Proposed Rule.

The SEC proposes to allow new registrants to retain their investment “track record” and performance information relating to the period prior to registration and would excuse them from SEC recordkeeping rules to the extent that those performance records do not meet the requirements of Rule 204(2). Once registered, a private fund must keep documentation supporting performance claims and comply with the recordkeeping rule going forward.

If the Proposed Rule is adopted, the SEC estimates that between 690 and 1,260 advisers will be required to register with the SEC, which will significantly increase the SEC’s oversight of currently unregistered hedge fund advisers and the regulatory compliance burden of such hedge fund advisers.

It remains to be seen whether the SEC can be persuaded either not to proceed with the Proposed Rule at all or to carve out from the Proposed Rule non-U.S. advisers of non-U.S. hedge funds who are regulated by a competent regulator in their home country.

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