The Effect of Dodd-Frank on Hedge Fund Managers
On July 15, 2010, Congress passed the Dodd-Frank Wall Street Reform and Consumer Protection Act, H.R. 4173 2010 (“Dodd-Frank”). Shortly thereafter, on July 21, 2010, President Obama signed Dodd-Frank into law, ushering in arguably the most sweeping financial regulatory overhaul since the Great Depression. Included within Dodd-Frank is the Private Fund Investment Advisors Registration Act of 2010 (“Act”), which significantly impacts the registration requirements of both domestic and foreign hedge fund advisors. Specifically, the Act requires certain unregistered investment advisors to register with the Securities and Exchange Commission (“SEC”) under the Investment Advisors Act of 1940, as amended (“Advisors Act”). Most notably, the Act eliminates the “private advisor exemption,” which exempts from registration advisors to private funds who: (1) have less than 15 clients during the preceding 12 months, (2) do not hold themselves out to the public as investment advisors, and (3) do not advise registered funds or business development companies subject to the Investment Company Act of 1940, as amended (“Investment Company Act”). Further, the Act also significantly impacts the reporting, disclosure, and record keeping requirements of investment advisors. Finally, the Act permits the SEC to promulgate rules to require advisors to take steps to safeguard client assets over which they have custody, including requiring verification of such assets by an independent public accountant.
Below is our analysis of the areas of the Act expected to most impact hedge fund advisors.
Hedge Fund Registration Requirements
Private Advisor Exemption
The Act eliminates the private advisor exemption from section 203(b)(3) of the Advisors Act, as described above. Removing the private advisor exemption will effectively require most private fund advisors to register under the Advisors Act, subject to the assets under management threshold detailed below. Advisors will either need to register with the SEC or, in many cases, with a state securities regulator. Currently, no investment advisor who is regulated or required to be regulated by a state regulator may register with the SEC unless the advisor has assets under management of not less than $25 million or advises a registered fund. The Act also limits the existing exemption under Section 203(b)(6) of the Advisors Act available to investment advisors registered with the Commodity Futures Trading Commission (“CFTC”). If the business of a private fund investment advisor that is registered with the CFTC as a commodity trading advisor becomes predominately the provision of securities-related advice, then the investment advisor will also have to register with the SEC under the Advisors Act.
Assets Under Management (“AUM”) Threshold
The Act adjusts the jurisdictional boundaries between federal and state regulation of investment advisors. Investment advisors acting solely as advisors to private funds and with AUM in the United States of less than $150 million will be exempted from federal registration with the SEC (previously, the AUM threshold for federal registration was $30 million). The Act defines “private funds” as those funds that would be an investment company but for the respective exemptions contained under Sections 3(c)1 and 3(c)7 of the Investment Company Act.
An investment advisor with clients other than private funds — such as an advisor with separate accounts — will not be subject to federal registration if the advisor has less than $100 million in assets under management and registers with the state in which it maintains its principal place of business and principal office. However, if an advisor otherwise would be required to register with 15 or more states as a result of not registering with the SEC, then the advisor will be allowed to register with the SEC. Advisors that are exempt from federal registration under this exemption will still be subject to certain disclosure and recordkeeping requirements.
The change in the AUM threshold will likely raise issues regarding the capacity and resources of already overburdened states to regulate what might be a significantly increased number of hedge fund advisors. Published estimates state that approximately 4,000 federally registered advisors would be required to switch to state registration, representing an approximately 28% increase in the number of state registered advisors.
Mid-sized Private Fund Advisors
The SEC will take into account the size, governance and investment strategy of mid-sized private funds to determine if they pose systemic risk and provide separate registration and examination procedures for their advisors. “Mid-sized” private fund is not expressly defined in the Act and will presumably be defined by the SEC.
Venture Capital Funds
Under the Act, advisors to venture capital funds are exempt from the registration requirements. The Act tasks the SEC to define “venture capital fund” within one year after enactment. The Act also provides that within one year of enactment the SEC will issue regulations requiring venture capital fund advisors to maintain books and records and provide the SEC with annual reports or other reports the SEC determines “necessary and appropriate” in the public interest and for the protection of investors.
Foreign Private Advisors
The Act exempts foreign registered advisors from the registration requirements in limited circumstances. To qualify for exemption, the Act requires that a foreign advisor (1) has no place of business in the U.S., (2) has, in total, fewer than 15 clients and investors in the U.S. in private funds advised by the advisor, (3) has less than $25 million (or such higher amount as the SEC may deem appropriate) in AUM attributable to clients and investors domiciled in the U.S. in private funds advised by the advisor, and (4) neither holds itself out generally to the public in the U.S. as an investment advisor, nor acts as an investment advisor to any investment company registered under the Investment Company Act or a company that has elected to do a business development company pursuant to section 54 of the Investment Company Act, and has not withdrawn its election.
The Act exempts family offices from investment advisor registration, consistent with the previous exemptive policy of the Act. However, the Act’s definition of “family office” is subject to an SEC ruling. The Act instructs the SEC to define “family offices” consistently with past family office exemptions, taking into account the family office’s organizational, management, and employment structures.
Definition of “Client”
The Act maintains the current definition of “client,” which includes only persons or entities that have a “direct advisory relationship” with the advisor. It also prohibits the SEC from including in the definition of client an investor in a private fund managed by an investment advisor if such private fund has entered into an advisory contract with such advisor. (In 2005, the SEC redefined client to allow itself to “look through” to hedge fund investors and count them as clients for purposes of the private advisor exemption, thus requiring many hedge funds to register with the SEC by the February 28, 2006 deadline. However, later in 2006, a federal district court reversed the SEC’s foregoing definition of client in Goldstein v. SEC, declaring that only Congress could alter the definition of client.)
Recordkeeping and Reporting Requirements
The Act requires investment advisors to private funds to maintain certain records and reports. Advisors must maintain, for each private fund advised by the investment advisor, records of AUM, the use of leverage (including off-balance-sheet leverage), counterparty credit risk exposure, trading and investment positions, valuation policies and practices, types of assets held, side arrangements or side letters, trading practices, and such other information as the SEC might deem important.
The Act provides the SEC with broad authority to require investment advisors to maintain records and submit reports to the SEC with regard to private funds. This broad authority seeks generally to enable the SEC, in conjunction with the newly created Financial Stability Oversight Council (“Council”), to supervise systemic risk related to hedge funds. The Act requires the SEC to consult with the Council when determining which records an investment advisor is required to maintain and which reports they are required to file. The Act states that the SEC will conduct periodic inspections of the records of private funds maintained by an investment advisor registered under the Act and that the SEC will establish the schedule for such inspections. The Act also allows the SEC to conduct spot-inspections when it deems it “necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.”
Adjusting the Accredited Investor Standard
The Act also revises the definition of “accredited investor,” as set forth in Regulation D of the Securities Act of 1933. The SEC is required to adjust any net worth standard for an accredited investor as set forth in Regulation D so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1 million, excluding the value of the primary residence of such natural person. This changes the previous net worth standard that allowed inclusion of an investor’s primary residence. The Act specifies that the SEC can review the definition of “accredited investor” as it applies to natural persons to decide if the requirements of the definition should be adjusted or modified to protect investors and for the public interest. Despite the one-year transition rule under the Act, the staff of the SEC has stated that this revision will take effect immediately. The Act directs the SEC not to further adjust the $1 million net worth standard for a period of four years following enactment of the Act, but tasks the SEC to undertake a review of the standard as a whole and make such other changes as it deems appropriate.
Absent further guidance from the SEC, however, it is our belief that the new definition of “accredited investors” only applies to (1) new investors in private funds and (2) existing investors in private funds that make additional capital contributions. We do not currently believe that advisors need to recertify existing investors in private funds, unless such investors make additional capital contributions.
Adjusting the Qualified Client Standard
The Act directs the SEC to review the “qualified client” standard that arises from Section 205(e) of the Advisors Act and is detailed in Rule 205-3. The SEC is to adjust the standard within one year of the Act’s enactment to adjust the standard for inflation. The SEC shall then undertake subsequent reviews of the qualified client standard not less frequently than every five years.
In addition to the foregoing changes, due to the increase of overall financial industry regulation and SEC power, advisors should be prepared to invest significantly more staff time preparing for an SEC audit. It is recommended that advisors conduct mock audits, periodic internal compliance review, and designate a contact person to control the inspection. In addition, advisors should closely observe record keeping requirements. If the SEC requests information from advisors, the information should be produced quickly in order to reduce the time SEC has to observe problems during a waiting period. Lastly, advisors should update and simplify their compliance manuals.
The Act will become effective one year after its enactment, but advisors will be able to register with the SEC anytime during this one-year transition period under the Advisors Act. However, due to the substantial discretion and rulemaking authority that the Act vests in the SEC, the Act’s full impact likely will not be known for some time.