O Exchange Commission (SEC), by a 3-2 Prior to the adoption of Rule - - PDF document

Investment Management Alert

November 2004

SEC Adopts Requirement that Hedge Fund Advisers Register Under Investment Advisers Act

O

n October 26, 2004, the Securities and Exchange Commission (“SEC”), by a 3-2 vote, adopted Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (“Advisers Act”). The new rule, which will become effective on February 1, 2006, is a substantial change to the Advisers Act and will require advisers to certain private investment pools, commonly referred to as “hedge funds,” to register with the SEC as investment advisers. Essentially, Rule 203(b)(3)-2 requires hedge fund advisers to “look through” the fund and count each investor in the fund as a single client. Advisers having more than 14 clients will be required to register with the SEC, and thus be subject to all of the requirements applicable to registered investment advisers. The SEC stated that the rule was adopted substantially as it was proposed in July 2004, with no substantial changes from the proposed rule. The SEC also adopted certain conforming and transitional amendments.

Purpose

According to the SEC, the purpose of requiring hedge fund advisers to register as investment advisers is to provide investors in hedge funds the protections afforded by the Advisers Act, and to enhance the SEC’s ability to protect our nation’s securities markets.

Background

Prior to the adoption of Rule 203(b)(3)-2, many hedge fund advisers availed themselves of the “private adviser” exemption to registration under the Advisers Act (i.e., Rule 203(b)(3)). Section 203(b)(3) of the Advisers Act provides a registration exemption for advisers that have had 14 or fewer clients during the preceding 12 months and that do not hold themselves out generally to the public as investment advisers. Rule 203(b) (3)-1 enabled an adviser serving as a general partner or investment adviser to a limited partnership or other entity holding investment securities to count the entity as one client for purposes of the private adviser exemption if, among other things, the advice provided to the entity is based on the investment objectives of the entity rather than those of the various limited partners, shareholders, members, or other equity

• wners. Prior to the adoption of Rule 203(b)(3)-2,

the SEC had taken the position that when an adviser manages a group of client accounts on the basis of the investment objectives of the pool, it would be appropriate to view the pool, rather than each participant in the pool, as the client.

G

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com

L

Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

New Rule 203(b)(3)-2

Counting Investors of Private Funds Under new Rule 203(b)(3)-2, investment advisers to “private funds” can no longer count such funds as single clients. New Rule 203(b)(3)-2 will require investment advisers to “look through” the “private funds” they advise, by counting each

• wner of a private fund as a client for purposes of

determining the availability of the private adviser exemption of Section 203(b)(3) of the Advisers

• Act. As a result, an adviser to a “private fund” may

no longer rely on the private adviser exemption if the adviser, during the course of the preceding 12 months, advised a private fund that had more than 14 investors. In addition, any individual clients advised directly by the adviser would be counted together with the investors in any private fund advised by such adviser when determining such adviser’s total number of clients. Definition of Private Investment Fund New Rule 203(b)(3)-2 defines a “private fund” by reference to three characteristics shared by a substantial majority of hedge funds. First, the private fund would be limited to a company that would be subject to regulation under the Investment Company Act of 1940 (“Investment Company Act”) but for the exception provided in either section 3(c)(1) or section 3(c)(7) of such

• Act. Second, a company is a private fund only if it

permits investors to redeem their interests in the fund within two years of purchasing them (which would encompass most hedge funds, since most allow for withdrawal or redemption of an investment prior to two years after making such investment). Third, interests in a private fund are based on the ongoing investment advisory skills, ability or expertise of the investment adviser. Thus, most hedge funds (but not most private equity or venture capital funds) would be considered “private funds” for purposes of the new rule and thus, the investment adviser would have to count each investor as a client for purposes of the private adviser exemption. Funds that have lock-ups that apply for two years

• r longer (with an exemption permitted for

“extraordinary circumstances”) would not be considered “private funds,” will not be subject to new Rule 203(b)(3)-2, and could continue to rely

• n the prior rule to count the fund as a single
• client. The two year limit on redemption or

withdrawal applies to new investors (and additional investments made by existing investors) beginning

• n

the compliance effective date

• f

February 1, 2006. Non - U.S. Investment Advisers New Rule 203(b)(3)-2 contains special provisions for advisers located outside the United States designed to limit the extraterritorial application of the Advisers Act to offshore advisers to offshore funds that have U.S. investors.

Effects of New Rule 203(b)(3)-2

Amount of Assets Under Management The new rule does not alter the minimum assets under management that an investment adviser must have in order to be eligible to register with the

• SEC. Thus, hedge fund advisers with assets under

management of less than $25 million will generally not be eligible for SEC registration, unless they also advise a company registered under the Investment Company Act, or qualify for registration under one

G

• f the SEC’s exemptive rules. Advisers with

between $25 and $30 million of assets under management will be eligible, but not required to register with the SEC. Advisers with more than $30 million of assets under management must register with the SEC, unless an exemption is available. State Registration Requirements The adoption of Rule 203(b)(3)-2 does not directly alter state investment adviser registration

• requirements. Thus, unregistered hedge fund

advisers, particularly advisers with assets under management of less than $25 million, must be aware of applicable state registration requirements. It is possible that the states will seek to adopt rules similar to Rule 203(b)(3)-2, which might require hedge fund advisers not registered with the SEC to register in those states.

Effects of Registration

Regulatory Compliance Registration under the Advisers Act will not prohibit hedge fund advisers from implementing any particular investment strategies, nor will it require or prohibit specific investments. However, advisers required to register will be subject to all regulations applicable to registered investment advisers (rather than only the anti-fraud provisions, which apply to all investment advisers, whether or not registered with the SEC). Applicable oversight will include SEC inspection and reporting, books and records requirements, compliance policy requirements, advertising restrictions, custody rules, disclosure requirements, the proxy voting rule, the code of ethics rule and limitations on accepting performance fees from clients other than “qualified clients” (as defined in Rule 205-3 of the Advisers Act). The rule as adopted, however, permits the acceptance of performance fees from investors that were invested in a fund prior to the adoption of the rule, even if such investors are not qualified clients.

Suggested Action Steps

Unregistered fund managers that are affected by new Rule 206(b)(3)-2 must register with the Commission, and comply with the various new regulatory requirements that will be applicable to

• them. This involves preparing and filing

Form ADV, which is available

• n

the SEC’s Internet Website at www.sec.gov/ divisions/ investment/ iard/ iastuff.shtl. In addition, unregistered fund managers will need to have in place all of the compliance programs and procedures applicable to registered fund managers by the time they register. Such compliance includes having designated a Chief Compliance Officer, the person with primary responsibility for administering the firm’s compliance policies and procedures, and having in place comprehensive compliance policies and procedures tailored to the business of the

• adviser. The effort involved and cost of compliance

will vary depending on the complexity of the adviser’s business. Although the compliance effective date is not until February 1, 2006, the registration and compliance process will likely involve a substantial effort and take several months. The requirements

• f the Advisers Act are complex. Affected fund

managers should consult counsel experienced with these matters. We work closely with our clients to put in place a comprehensive system to comply with the requirements of the Advisers Act, while

G

minimizing the regulatory burden on their business. Affected fund managers are urged to start as soon as possible so that they are compliant in time and ready for inspection and examination by the Commission.

Conclusion

Rule 203(b)(3)-2 will require many hedge fund advisers to register with the SEC as investment advisers, and require them to comply with the regulatory framework of the Advisers Act. Lowenstein Sandler’s Investment Management Group is available at all times to discuss the substantial filings, procedures and policies that will be required as a result of the adoption of this new

• rule. We will continue to publish guidance, and we

plan to present to our clients and friends a program detailing the implications of the new Rule 203(b)(3)-2 and its regulatory requirements in early 2005, so that registration and compliance may be effected in advance of the compliance effective date. Lowenstein Sandler’s Investment Management Group will continue to monitor and report on developments regarding the regulation of hedge funds, investment advisers and enforcement actions against them. The text of the final rule is not yet available, and the foregoing is based upon the releases of the SEC and statements made during the SEC’s meeting discussing the adoption of the final rules. If you have any questions regarding this, or any investment management issue, contact a member of the Investment Management Group at 973.597.2500.

Investment Management Group

Co-Chairs: Allen B. Levithan, alevithan@ lowenstein.com Robert G. Minion, rminion@ lowenstein.com Partners: Steven J. Tsimbinos, stsimbinos@ lowenstein.com John L. Berger, jberger@ lowenstein.com Andrew E. Graw, agraw@ lowenstein.com Michael N. Gooen, mgooen@ lowenstein.com Counsel: Paul W. Hartzel, phartzel@ lowenstein.com Brian A. Silikovitz, bsilikovitz@ lowenstein.com Douglas N. Bernstein, dbernstein@ lowenstein.com Liwayway A. Reilly, lreilly@ lowenstein.com Associates: Marie T. DeFalco, mdefalco@ lowenstein.com Elaine M. Hughes, ehughes@ lowenstein.com Mark A. Dorfman, mdorfman@ lowenstein.com Scott H. Moss, smoss@ lowenstein.com Steven P. Kirberger, skirberger@ lowenstein.com Javier Cuebas, jcuebas@ lowenstein.com Erik W. Johnson, ejohnson@ lowenstein.com Mario V. Hernandez, mhernandez@ lowenstein.com

G