SEC Proposes New Exemption Rules For Smaller Funds And Advisers

Nov 29 2010 | 8:28am ET

By John Brunjes, Genna Garver and Arthur Don of Greenberg Traurig -- On November 19, the Securities and Exchange Commission proposed new rules and rule amendments under the Investment Advisers Act of 1940, as amended to implement certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Proposed Rules, among other things, would implement new exemptions from the registration requirements of the Advisers Act for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. The Proposed Rules would also address reporting and record-keeping by those exempt advisers and clarify the meaning of certain terms included in the Dodd-Frank Act’s exemption for certain foreign private advisers. 

We are pleased to provide this summary of the Proposed Rules and their effect on these important exemptions established under the Dodd-Frank Act. The full text of the Proposed Rules is set forth in Release No. IA-3110 and Release No. IA-3111, each dated November 19, 2010 (the “Proposing Releases”):

• IA-3110: Rules Implementing Amendments to the Investment Advisers Act of 1940
• IA-3111: Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers

Background

With Congress recognizing the increasing role of private investment funds, and hedge funds in particular, to the global economy, Title IV of the Dodd-Frank Act, the “Private Fund Investment Advisers Registration Act of 2010” (the “Registration Act”), significantly expanded the reach of SEC inspection and enforcement authority over advisers to these and other private funds by, among other things, repealing as of July 21, 2011 the “private adviser exemption” contained in Section 203(b)(3) of the Advisers Act. This exemption, in many ways the cornerstone on which the private investment funds industry has grown over the decades, afforded an exemption from SEC registration under the Advisers Act for advisers with fewer than fifteen clients (and assuming other conditions were satisfied). By eliminating this key exemption, the Registration Act gives effect to the perceived need for better information gathering and greater transparency with regard to fund investment advisers, the nature of their advisory activities, and the types of securities they hold. The availability of the private adviser exemption hinges on the term “clients,” which is defined in a way that allows each fund advised by the investment adviser to be counted as a single client for purposes of reaching the fewer than 15 client limit — without having to look through and count the number of the fund's underlying investors. 

The Registration Act creates new sections of the Advisers Act and directs the SEC to adopt rules under three narrow exemptions from registration for advisers to certain types of private funds:

• New Section 203(l) of the Advisers Act provides an exemption for an adviser that advises solely one or more “venture capital funds;”
• New Section 203(m) of the Advisers Act instructs the SEC to exempt any adviser that acts solely as an adviser to private funds and has assets under management (“AUM”) in the United States of less than $150 million; and
• Restated Section 203(b)(3) of the Advisers Act provides an exemption for non-U.S. advisers with less than $25 million in aggregate AUM from U.S. clients and private fund investors, and fewer than 15 such clients and investors. 

Congress also directed the SEC to define by rule the term “venture capital fund” and authorized the SEC to require advisers relying on new Sections 203(l) and 203(m) of the Advisers Act (referred to as “Exempt Reporting Advisers”) to maintain such records (with authority to examine), and to submit such reports as the SEC determines necessary or appropriate in the public interest.   

While this GT Alert addresses the preliminary scope of the Proposed Rules, other provisions of the Registration Act create exemptions from registration under the Advisers Act for advisers to licensed SBICs, and provide an exclusion for certain family offices from the definition of “investment adviser” under the Advisers Act. Our October article, SEC Proposes Family Office Definition, discusses the proposed rule defining “family office” as announced in SEC Release No. IA-3098, dated October 12, 2010.

‘Venture Capital Funds’ Defined

Proposed Rule 203(l)-1 would define the term “venture capital fund” for purposes of Section 203(l) of the Advisers Act as any private fund that:

• Represents to investors and potential investors that it is a venture capital fund;
• Owns solely: (i) equity securities (as such term is defined in Proposed Rule 203(l)-1) issued by one or more qualifying portfolio companies, and at least 80% of the equity securities of each qualifying portfolio company owned by the fund was acquired directly from the qualifying portfolio company; and (ii) cash and cash equivalents and U.S. Treasuries with a remaining maturity of sixty days or less;
• With respect to each qualifying portfolio company, either directly or indirectly through each investment adviser not registered under the Advisers Act in reliance on Section 203(l) thereof: (i) has an arrangement whereby the fund or the investment adviser offers to provide, and if accepted, does so provide, significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company; or (ii) controls the qualifying portfolio company;
• Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15% of the private fund’s aggregate capital contributions and uncalled committed capital (meaning, any commitment pursuant to which a person is obligated to acquire an interest in, or make capital contributions to, the private fund), and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days;
• Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and
• Is not registered under Section 8 of the Investment Company Act of 1940, as amended (“Investment Company Act”), and has not elected to be treated as a business development company pursuant to Section 54 of the Investment Company Act.

For purposes of Proposed Rule 203(l)-1, the term “qualifying portfolio company” means any company that:

• At the time of any investment by the private fund, is not publicly traded (as such term is defined in Proposed Rule 203(l)-1) and does not control, is not controlled by or under common control with another company, directly or indirectly, that is publicly traded;
• Does not borrow or issue debt obligations, directly or indirectly, in connection with the private fund’s investment in such company;
• Does not redeem, exchange or repurchase any securities of the company, or distribute to pre-existing security holders cash or other company assets, directly or indirectly, in connection with the private fund’s investment in such company; and
• Is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by Investment Company Act Rule 3a-7, or a commodity pool.

A non-U.S. adviser would be able to rely on the exemption from SEC registration as established in Section 203(l) only if all of its clients, whether U.S. or non-U.S., are “venture capital funds” as defined above.  As a venture capital fund is a type of “private fund” as defined in the Registration Act, any non-U.S. advisers to such funds whose securities are offered only outside the United States other than in reliance on sections 3(c)(1) or 3(c)(7) of the Investment Company Act would be ineligible for this Section 203(l) exemption. 

Proposed Rule 203(l)-1 would also grandfather within its exemptive scope any adviser to a pre existing venture capital fund that:

• Has represented to investors and potential investors at the time of the offering of the private fund’s securities that it is a venture capital fund;
• Prior to December 31, 2010, has sold securities to one or more investors that are not related persons, of any investment adviser of the private fund; and
• Does not sell any securities to (including accepting any committed capital from) any person after July 21, 2011.

Advisers to venture capital funds that meet definitional elements set forth above and are able to take advantage of the exemption from SEC registration afforded by Section 203(l) will still be required to maintain such records and provide to the SEC such annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors.  The reporting requirements are discussed in greater detail below. 

Advisers to venture capital funds that do not meet the definition set forth above and who are subject to the jurisdiction of the SEC would need to register with the SEC unless another exemption or exclusion from SEC registration is available.  Since many venture capital funds have AUM of less than $150 million, advisers to those funds may qualify for the new private fund adviser exemption discussed below.  With some exceptions, an adviser with less than $25 million in AUM is not subject to regulation by the SEC, but would potentially be subject to regulation by the securities regulator in each state where it maintains a place of business or where during the preceding twelve month period it had more than five clients.

Private Fund Adviser Exemption

The Registration Act requires the SEC to provide an exemption from registration to any investment adviser that acts solely as an adviser to private funds and has AUM in the United States of less than $150 million.  “Private fund” for this purpose is defined in new Section 202(a)(29) of the Advisers Act as an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act, but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act.  Proposed Rule 203(m)-1 would provide the exemption, which the SEC refers to as the “Private Fund Adviser Exemption,” and address several interpretive questions raised by Section 203(m).

Proposed Rule 203(m)-1 would provide that an investment adviser with a principal office and place of business in the United States is exempt from the requirement to register under Section 203 of the Advisers Act if the investment adviser:

• Acts solely as an investment adviser to one or more qualifying private funds; and
• Manages private fund assets (meaning, AUM attributable to a qualifying private fund) of less than $150 million, calculated as the total value of such assets as of the end of each calendar quarter.

For purposes of Proposed Rule 203(m)-1, the term “principal office and place of business” would mean the executive office of the investment adviser from which the officers, partners, or managers of the investment adviser direct, control, and coordinate the activities of the investment adviser.  For purposes of Proposed Rule 203(m)-1, the term “qualifying private fund” means any private fund that is not registered under Section 8 of the Investment Company Act and has not elected to be treated as a business development company pursuant to Section 54 of the Investment Company Act.  In the case of an adviser with a principal office and place of business in the United States, all of the qualifying private fund assets would be considered to be AUM in the United States even if the adviser has offices outside the United States. 

For an investment adviser with its principal office and place of business outside of the United States, Proposed Rule 203(m)-1 would provide an exemption from the requirement to register under Section 203 of the Advisers Act if:

• The investment adviser has no client that is a United States person except for one or more qualifying private funds; and
• All assets managed by the investment adviser from a place of business in the United States are solely attributable to private fund assets (meaning, AUM attributable to a qualifying private fund), the total value of which is less than $150 million, calculated as the total value of such assets as of the end of each calendar quarter. 

The term “United States person” means any person that is a “U.S. person” as defined in Regulation S of the Securities Act of 1933, as amended (“Securities Act”), except that any discretionary account or similar account that is held for the benefit of a United States person by a dealer or other professional fiduciary is a United States person if the dealer or professional fiduciary is a related person of the investment adviser relying on this exemption and is not organized, incorporated, or (if an individual) resident in the United States.  As a result, an adviser could not rely on the Proposed Rule 203(m)-1 exemption if it established discretionary accounts for the benefit of U.S. clients with an offshore affiliate that would then delegate the actual management of the account back to the adviser. 

A non-U.S. adviser would only need to count private fund assets it manages from a place of business in the United States towards the $150 million asset limit and would not lose the exemption as a result of managing assets from outside the United States. For this purpose, the term “place of business” would mean as it is currently defined in Advisers Act Rule 222-1: an office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.  

Proposed Rule 203(m)-l includes a transition period for advisers that cease to be exempt from registration under Section 203(m) of the Advisers Act due to having $150 million or more in private fund assets.  Specifically, the SEC will not assert a violation of the requirement to register under Section 203 of the Advisers Act with respect to the calendar quarter period immediately following the calendar quarter end date that the investment adviser ceases to be so exempt; provided that such adviser has complied with all applicable SEC reporting requirements.

Similar to advisers to venture capital funds, advisers to private funds who fall within the scope of this new Private Fund Adviser Exemption from SEC registration under Section 203(m) are subject to the SEC reporting requirements discussed below.  Advisers to private funds that do not qualify for this exemption and who are subject to the jurisdiction of the SEC would need to register with the SEC, unless another exemption or exclusion from SEC registration is available. 

SEC Reporting For Exempt Reporting Advisers

To implement new Sections 203(l) and 203(m), Proposed Rule 204-4 of the Advisers Act would require these Exempt Reporting Advisers to submit, and to periodically update, reports to the SEC.  The SEC has proposed that these advisers complete a limited subset of items on Form ADV and file the information electronically through the publicly-available Investment Adviser Registration Depository (“IARD”) using the same process as SEC registered investment advisers.  The SEC also proposed amendments to Form ADV to permit the form to serve as a reporting, as well as a registration, form and to specify the seven items of Form ADV Part 1 that Exempt Reporting Advisers must complete.

In justifying the use of Form ADV for this purpose, the SEC stated in its Proposing Release that using Form ADV avoids the expense and delay of developing a new form and also permits Exempt Reporting Advisers to satisfy both state and SEC requirements with a single electronic filing. The Proposed Rule would require Exempt Reporting Advisers to complete the following items in Part 1A of Form ADV:

• Item 1 (Identifying Information);
• Item 2.C. (SEC Reporting by Exempt Reporting Advisers);
• Item 3 (Form of Organization);
• Item 6 (Other Business Activities);
• Item 7 (Financial Industry Affiliations and Private Fund Reporting);
• Item 10 (Control Persons); and
• Item 11(Disclosure Information).

The Proposed Rules sets forth the type of information the SEC will require under Item 7 of Form ADV for these Exempt Reporting Advisers:

• basic organizational and operational information about the funds the adviser manages, such as information about the amount of assets held by the fund, the types of investors in the fund, and the adviser's services to the fund; and
• information concerning five types of service providers that generally perform important roles as “gatekeepers” for private funds (i.e., auditors, prime brokers, custodians, administrators and marketers).

In addition, Exempt Reporting Advisers would have to complete corresponding sections of Schedules A (Direct Owners and Executive Officers), B (Indirect Owners), C (Amendments to Schedules A and B), and D (Additional Information regarding Certain Items in Part 1A). The Proposed Rule would not require Exempt Reporting Advisers to prepare and file a client brochure (Form ADV Part 2). 

Proposed Rule 204-1(a) would require an Exempt Reporting Adviser, like a registered adviser, to amend its reports on Form ADV at least annually and to file an amendment to its when it ceases to be an Exempt Reporting Adviser.  The Proposed Rule provides a thirty-day grace period after the July 21, 2011 effective date of the Dodd-Frank Act by which time each Exempt Reporting Adviser must file its initial Form ADV. In its Proposing Release the SEC noted that may need to delay the reporting deadline if the IARD system is unable to accept such filings by that time.

Foreign Private Advisers Exemption 

The Registration Act eliminates the “private adviser exemption” from registration under Section 203(b) of the Advisers Act and, for certain foreign private advisers, replaces it with a limited exemption.  New Section 202(a)(30) of the Advisers Act defines “foreign private adviser” as an investment adviser that has:

• no place of business in the United States;
• in total, fewer than fifteen clients (with an investment fund and its investors each counting as one client) in the United States;
• aggregate AUM attributable to clients (including both investment funds and their investors) in the United States of less than $25 million, or such higher amount as the SEC may deem appropriate; and neither:
• holds itself out generally to the public in the United States as an investment adviser;
• acts as an investment adviser to any investment company registered under the Investment Company Act; nor
• acts as a company that has elected to be a business development company pursuant to the Investment Company Act and has not withdrawn its election.

Invoking its authority under Section 211(a) of the Advisers Act to define technical, trade, and other terms used in the Advisers Act, the SEC issued Proposing Rule 202(a)(30)-1 to define certain terms in Section 202(a)(30) for use by advisers seeking to avail themselves of the foreign private adviser exemption, including the terms “investor,” “in the United States,” “place of business,” and “assets under management.”  Proposed Rule 202(a)(30)-1 would also include the safe harbor rules and many of the client counting rules that appear in Rule 203(b)(3)-1 of the Advisers Act with respect to the current private adviser exemption that will remain in effect until the July 21, 2011 effective date of the Dodd-Frank Act. 

Proposed Rule 202(a)(30)-1 includes a non-exclusive safe harbor for determining who may be deemed a single client for purposes of Section 202(a)(30) of the Advisers Act with respect to both natural persons and certain entities.  The following would be deemed to be a single client for purposes of Section 202(a)(30):

• A natural person, and any minor child of the natural person; any relative, spouse, or relative of the spouse of the natural person who has the same principal residence; all accounts of which the natural person and/or the persons referred to in this bullet are the only primary beneficiaries; and all trusts of which the natural person and/or the persons referred to in this bullet are the only primary beneficiaries; and
• A corporation, general partnership, limited partnership, limited liability company, trust (other than a trust referred to in the first bullet), or other legal organization (any of which are referred to hereinafter as a “legal organization”) to which the adviser provides investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which are referred to hereinafter as an “owner”); and two or more legal organizations referred to in this bullet that have identical owners.

For purposes of Proposed Rule 202(a)(30)-1 client counting, the following additional rules apply:

• holds itself out generally to the public in the United States as an investment adviser;
• The adviser must count an owner as a client if it provides investment advisory services to the owner separate and apart from the investment advisory services it provides to the legal organization; provided, however, that the determination that an owner is a client will not affect the applicability of these client counting rules with regard to any other owner;
• The adviser is not required to count an owner as a client solely because it, on behalf of the legal organization, offers, promotes, or sells interests in the legal organization to the owner, or reports periodically to the owners as a group solely with respect to the performance of or plans for the legal organization’s assets or similar matters;
• A limited partnership or limited liability company is a client of any general partner, managing member or other person acting as investment adviser to the partnership or limited liability company; and
• The adviser is not required to count a private fund as a client if it counts any investor in that private fund as an investor in the United States in that private fund.

In a footnote in its Proposing Release the SEC stated that if a client relationship involving multiple persons does not fall within Proposed Rule 202(a)(30)-1, the question of whether the relationship may appropriately be treated as a single “client” must be determined on the basis of the facts and circumstances involved. 

Proposed Rule 202(a)(30)-1 provides the following clarifying definitions for purposes of Section 202(a)(30) of the Advisers Act.  The term “investor” means any person that would be included in determining the number of beneficial owners of the outstanding securities of a private fund under Section 3(c)(1) of the Investment Company Act, or whether the outstanding securities of a private fund are owned exclusively by qualified purchasers under Section 3(c)(7) of Investment Company Act, except that any of the following persons is also an investor:

• Any beneficial owner of the private fund that pursuant to Investment Company Act Rule 3c-5 would not be included in the above determinations under Section 3(c)(1) and 3(c)(7) of the Investment Company Act; and
• Any beneficial owner of any outstanding short-term paper, as defined in Section 2(a)(38) of the Investment Company Act, issued by the private fund. (Note, advisers may treat as a single investor any person that is an investor in two or more private funds it advises.)

To avoid double-counting, the adviser would be able to treat as a single investor any person that is an investor in two or more private funds advised by the adviser. 

The term “in the United States” means with respect to:

• Any client or investor, any person that is a U.S. person as defined in Regulation S of the Securities Act, except that any discretionary account or similar account that is held for the benefit of a person in the United States by a dealer or other professional fiduciary is in the United States if the dealer or professional fiduciary is a related person of the investment adviser relying on this exemption and is not organized, incorporated, or (if an individual) resident in the United States.  A person that is in the United States may be treated as not being in the United States if such person was not in the United States at the time of becoming a client or, in the case of an investor in a private fund, at the time the investor acquires the securities issued by the fund;
• Any place of business, or the public, the term “in the United States” as defined in Regulation S of the Securities Act.

The term “place of business” would have the same meaning as in Advisers Act Rule 222-1(a), as noted previously in this Client Alert under the discussion of the Private Fund Adviser Exemption.

The term “assets under management” would mean the regulatory assets under management as determined under Form ADV.

An adviser relying on Proposed Rule 202(a)(30)-1 would not be deemed to be “holding out generally” to the public in the United States as an investment adviser solely because it participates in a non-public offering in the United States of securities issued by a private fund under the Securities Act.

* * *

Advisers relying on the exemptions under Sections 203(l), 203(m) or 203(b)(3) may be subject to registration by one or more state securities authorities. Advisers that that are subject to SEC jurisdiction and are neither registered with the SEC nor excepted from the federal definition of “investment adviser” in Section 202(a)(11) of the Advisers Act are technically still subject to state regulation and registration requirements. Accordingly, advisers relying on the registration exemptions under Sections 203(l), 203(m) or 203(b)(3) of the Advisers Act must consider the application of state registration requirements and exemptions thereto.  In addition, Exempt Reporting Advisers must also be ready to file their initial Form ADVs no later than August 20, 2011. 

For those advisers who are subject to the SEC jurisdiction and cannot take advantage of an exemption from SEC registration, the process of SEC registration and ongoing compliance is no small task. Unless the compliance dates are extended through rulemaking, advisers required to register with the SEC must be ready to file and be compliant with the Advisers Act on or before June 7, 2011, to ensure there is time for the SEC to declare the registration effective before July 21, 2011. 

The SEC has requested comments on the Proposed Rules, which must be received on or before 45 days after publication in Federal Register.  In the coming weeks we will be providing additional information regarding the Proposed Rules as well as additional rulemaking under the Dodd-Frank Act. 

About The Authors

John Brunjes, shareholder at Greenberg Traurig, is a transactional securities lawyer who handles a wide variety of investment, transactional and governance matters for private investment funds and their sponsors/managers, as well as for domestic and international institutional and individual investors placing capital into these funds. He is a member of the Board of Directors of the Connecticut Hedge Fund Association, and serves on the Connecticut Banking Commissioner’s Securities Advisory Council. He was an Assistant Attorney General in Connecticut from 1990-1995, during which time he led and settled one of the largest securities fraud investigations ever brought against a public accounting firm in connection with investor losses in a multi-billion dollar Ponzi scheme.

Genna Garver is an of counsel in the Corporate Securities Practice of Greenberg Traurig’s New York office. She represents financial institutions in a variety of transactional and regulatory matters with a focus on investment advisers, hedge funds and other private investment funds. Genna advises clients on formation and offering matters for domestic and offshore funds, mergers and acquisitions, securities regulation, SEC and state investment adviser registration and exemptions, the development and implementation of Advisers Act compliance programs and procedures, ongoing compliance matters, mock audits and regulatory examinations. She also has counseled banking clients on complex structuring and capital issues regarding M&A, risk capital matters, affiliated transactions, and securities lending agency transactions.

Arthur Don, shareholder at Greenberg Traurig, has more than 30 years of experience representing mutual funds, public investment companies, fund independent directors, investment advisers, private investment funds, private equity funds, real estate funds, broker-dealers and public companies in a variety of sophisticated securities transactions. His experience includes all aspects of investment company practice, from organizing new funds through acquisitions and mergers of funds. Arthur has represented issuers and underwriters in numerous public offerings. He also frequently advises independent directors on fiduciary duties, and advises clients on compliance policy issues.


In Depth

David Yarrow On Growing His Hedge Fund And Shooting The Animals And People Of Africa - As A Photographer

Jul 23 2014 | 6:44am ET

While he’s always been a photographer, recent expeditions to Iceland, Ethiopia...

Lifestyle

Einhorns Busts At WSOP, Finishes In 173rd

Jul 15 2014 | 10:48am ET

Greenlight Capital founder David Einhorn’s World Series of Poker won’t end at...

Guest Contributor

Common Risk Parity Misperceptions

Jul 16 2014 | 11:02am ET

Over the past few years, risk parity has become a component of most investors’...

 

Sponsored Content

    Northern Trust Helps Hedge Funds Navigate Derivatives Regulations

    Jul 8 2014 | 10:48am ET

    The surge in derivatives regulation is among the most complex challenges facing the financial services industry today. Northern Trust’s Joshua Satten recently spoke with FINalternatives to share insights into the challenges presented by new regulation and explore how the industry is responding. Read more…

Publisher's Note