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Nov 3 2009 | 12:01am ET
By Genna Garver, John Brunjes, and Cheri Hoff of Bracewell & Giuliani -- On Oct. 27 the Private Fund Investment Advisers Registration Act of 2009 (H.R. 3818) moved one step closer to becoming law with the 67-1 approval of the U.S. House of Representatives Committee on Financial Services (the "Bill").
The purpose of the Bill, sponsored by Rep. Paul Kanjorski (D-PA), Chairman of the House Financial Services Committee’s Capital Markets Subcommittee, is to authorize the collection of information regarding capital to assess systemic risk and to increase investor protection. To that end, the Bill would eliminate the "private adviser exemption" from SEC registration under the Investment Advisers Act of 1940, as amended ("Advisers Act"), for advisers with fewer than 15 clients, upon which most private funds advisers currently rely (with each fund counting as one client). Requiring registration consequently would subject private fund advisers to the Advisers Act's record-keeping requirements, Form ADV reporting and investor protection requirements, including without limitation, safeguarding client assets and adopting written compliance policies and procedures. Not to be overlooked, the Bill also would provide broad authority for the SEC to impose additional record-keeping and reporting requirements on private fund advisers with respect to information on the funds they manage.
Although the Committee's press release described the Bill, in part, as leveling the playing field for investment advisers, the text of the Bill and the Committee's markup session discussion clearly profess a different desire—one that would scale regulatory obligations for different classes of investment advisers. Notwithstanding the elimination of the private adviser exemption, the Bill would preserve an exemption from SEC registration for some private fund advisers, which, in turn, would alleviate their compliance with the Advisers Act requirements for registered advisers. On a more limited basis, the Bill also would exempt certain classes of unregistered private fund advisers from the SEC's authority to require record keeping and reporting with respect to the funds they manage.
Which funds would benefit from this uneven playing field? We identify below the different types of private funds singled out for special treatment by the Committee and divine from the discussion surrounding the mark-up session of the Bill the rationale for scaled regulatory obligations.
Venture Capital Funds
If enacted as approved by the Committee, the Bill would exempt from registration advisers to "venture capital funds," as such term is to be defined by the SEC. However, advisers to such funds would 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 rationale for this exemption, according to Rep. Kanjorski, centers on Form D, which is used by issuers of securities, including private funds, to perfect a Securities Act safe harbor for private securities offerings by reporting information regarding their capital fundraising. According to Rep. Kanjorski, Form D, as reconstituted effective March 2009 to require greater disclosure, requires disclosure of the same type of information that SEC adviser registration would make available to a systemic risk regulator—information regarding private fund capital—making duplicative disclosure unnecessary.
One obvious problem with this rationale is that all U.S. private funds must report information regarding their capital fundraising on Form D, not just venture capital funds. If all private funds must report on Form D, why should venture capital advisers be exempt from SEC registration while advisers to other private funds must register? Because, according to Rep. Kanjorski, venture capital fund advisers worked closely with the SEC to reconstitute Form D in 2008.
When Rep. Jeb Hensarling (R-TX) questioned this special treatment for venture capital fund advisers, Rep. Kanjorski responded that while there were no individual hedge funds that he could point to in the recent economic collapse, the withdrawal of funds from various entities that the hedge funds were responsible for exasperated the problem. He added that unlike venture capital fund advisers, exempting hedge fund advisers from registration would render the bill ineffective given the size and sophistication of hedge funds.
Advisers to Small Funds (AUM of less than $150 million)
As a result of bipartisan compromise, the Bill also would exempt from registration advisers to private funds with assets under management ("AUM") in the U.S. of less than $150 million. Like advisers to venture capital funds, advisers to such small funds would be required to maintain such records and provide to the SEC such reports as deemed necessary or appropriate in the public interest or for the protection of investors.
In support of this exemption, Rep. Gary C. Peters (D-MI) argued that a one-size-fits-all regulatory regime would be overly burdensome on advisers to small funds that do not pose significant systemic risk because they are neither heavily leveraged nor a source of liquidity to the market. Rep. Peters also stressed that SEC resources should not be expended on smaller funds.
Rep. Kanjorski voiced concern that a small fund exemption would just create another loophole. He added that the SEC is anticipating the average cost of registration to be only in the $5,000-$15,000 range, which should not be overly burdensome for most advisers. Acknowledging Rep. Peters concern that SEC resources should not be expended on these small funds, Rep. Kanjorski argued in favor of state regulation of such funds, rather than an exemption from federal registration. Rep. Kanjorski also noted that he is anticipating, upon completion of a study to analyze the additional burden on the SEC from increased registrations, a proposal to raise the threshold for SEC jurisdiction of investment advisers from $30 million to $100 million. The Bill as approved by the Committee, however, would not increase the $30 million threshold.
Advisers to mid-sized funds — those being larger than $150 million in AUM — would not be exempt from registration or fund record keeping and reporting. The Bill does direct the SEC, when prescribing rules and regulations to carry out the Bill's requirements, to take into account the funds' size, governance, and investment strategies to determine whether they pose systemic risk. The SEC also would be required to provide registration and examination procedures with respect to mid-sized fund advisers that reflect their level of systemic risk.
Under the Bill, Small Business Investment Companies ("SBICs") licensed with the U.S. Small Business Administration ("SBA") would be exempt from all registration and reporting requirements. Rep. Shelley Moore Capito (R-WV), who offered the exemption, stated that the intention of the exemption is to avoid dual regulation of the advisers to these funds. A specialized type of private fund where the United States Treasury, acting through SBA, is a special limited partner of the fund, SBICs are already registered with, and thoroughly regulated by, the SBA. This oversight starts often times before the fund adviser commences operations, with the managers of the SBIC going through a rigorous pre-application screening process and interviews with SBA staff. Once licensed as an SBIC, the SBA is deeply involved with the investment process and has the authority to replace SBIC management teams as well as place the fund into receivership for statutory or regulatory violations including non-compliance with capital and leverage ratios. Giving further support for this exemption, the average size of SBICs is $50 million and the total capital available under the SBA's program is currently capped at $3 billion.
Commodities Trading Advisors
Although advisers to SBICs would be exempt from the registration and reporting requirements to avoid dual regulation, in a bizarre twist the Bill would limit the current exemption from registration for advisers registered with, and regulated by, the Commodity Futures Trading Commission ("CFTC") as commodity trading advisors to the extent such advisers act as private fund advisers.
Rep. Frank D. Lucas (R-OK) argued to preserve the current limited exemption to avoid dual registration and noted the substantial efforts underway to harmonize the regulatory regimes of the CFTC and the SEC, which includes a provision in the Bill which calls for harmonizing reports filed with both regulators. In response, Rep. Kanjorski emphasized that preserving the SEC registration exemption for commodity trading advisors would give the SEC an incomplete repository of capital information and make Bill less effective. The Committee, however, did commit to revisit this issue as they work through the Bill process.
As the Bill moves to the House floor, additional exemptions still may be approved and others eliminated. If the Bill becomes law, the SEC most likely will have broad discretion to define both the different classes of investment advisers and their scaled regulatory obligations.
Genna Garver, John Brunjes and Cheri Hoff are in the Private Investment Funds Group of Bracewell & Giuliani, LLP, representing hedge funds, private equity funds and venture capitalists in connection with fund formation and operations issues and illiquid investment transactions, with particular emphasis on advising private domestic and offshore capital pools and their stakeholders. John is head of the Fund Formation practice and a member of the Board of Directors of the Connecticut Hedge Fund Association.
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