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

G Investment Management Alert November 2004 SEC Adopts Requirement that Hedge Fund Advisers Register Under Investment Advisers Act n October 26, 2004, the Securities and Background O Exchange Commission (“SEC”), by a 3-2 Prior to the adoption of Rule 203(b)(3)-2, many vote, adopted Rule 203(b)(3)-2 under the hedge fund advisers availed themselves of the Investment Advisers Act of 1940 (“Advisers Act”). “private adviser” exemption to registration under The new rule, which will become effective on the Advisers Act ( i.e. , Rule 203(b)(3)). Section February 1, 2006, is a substantial change to the 203(b)(3) of the Advisers Act provides a Advisers Act and will require advisers to certain registration exemption for advisers that have had private investment pools, commonly referred to as 14 or fewer clients during the preceding 12 months “hedge funds,” to register with the SEC as and that do not hold themselves out generally to investment advisers. the public as investment advisers. Rule 203(b) (3)-1 enabled an adviser serving as a general Essentially, Rule 203(b)(3)-2 requires hedge fund partner or investment adviser to a limited advisers to “look through” the fund and count each partnership or other entity holding investment investor in the fund as a single client. Advisers securities to count the entity as one client for having more than 14 clients will be required to purposes of the private adviser exemption if, register with the SEC, and thus be subject to all of among other things, the advice provided to the the requirements applicable to registered entity is based on the investment objectives of the investment advisers. The SEC stated that the rule entity rather than those of the various limited was adopted substantially as it was proposed in July partners, shareholders, members, or other equity 2004, with no substantial changes from the owners. Prior to the adoption of Rule 203(b)(3)-2, proposed rule. The SEC also adopted certain the SEC had taken the position that when an conforming and transitional amendments. adviser manages a group of client accounts on the basis of the investment objectives of the pool, it Purpose would be appropriate to view the pool, rather than According to the SEC, the purpose of requiring each participant in the pool, as the client. 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. 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. L Roseland, New Jersey Telephone 973.597.2500 65 Livingston Avenue www.lowenstein.com 07068-1791 Fax 973.597.2400

G New Rule 203(b)(3)-2 ability or expertise of the investment adviser. Thus, most hedge funds (but not most private equity or Counting Investors of Private Funds venture capital funds) would be considered Under new Rule 203(b)(3)-2, investment “private funds” for purposes of the new rule and advisers to “private funds” can no longer count thus, the investment adviser would have to count such funds as single clients. New Rule 203(b)(3)-2 each investor as a client for purposes of the private will require investment advisers to “look through” adviser exemption. the “private funds” they advise, by counting each Funds that have lock-ups that apply for two years owner of a private fund as a client for purposes of or longer (with an exemption permitted for determining the availability of the private adviser “extraordinary circumstances”) would not be exemption of Section 203(b)(3) of the Advisers considered “private funds,” will not be subject to Act. As a result, an adviser to a “private fund” may new Rule 203(b)(3)-2, and could continue to rely no longer rely on the private adviser exemption if on the prior rule to count the fund as a single the adviser, during the course of the preceding 12 client. The two year limit on redemption or months, advised a private fund that had more than withdrawal applies to new investors (and additional 14 investors. In addition, any individual clients investments made by existing investors) beginning advised directly by the adviser would be counted on the compliance effective date of together with the investors in any private fund February 1, 2006. advised by such adviser when determining such adviser’s total number of clients. Non - U.S. Investment Advisers Definition of Private Investment Fund New Rule 203(b)(3)-2 contains special New Rule 203(b)(3)-2 defines a “private fund” provisions for advisers located outside the United by reference to three characteristics shared by a States designed to limit the extraterritorial substantial majority of hedge funds. First, the application of the Advisers Act to offshore advisers private fund would be limited to a company that to offshore funds that have U.S. investors. would be subject to regulation under the Investment Company Act of 1940 (“Investment Effects of New Rule 203(b)(3)-2 Company Act”) but for the exception provided in either section 3(c)(1) or section 3(c)(7) of such Amount of Assets Under Management Act. Second, a company is a private fund only if it The new rule does not alter the minimum assets permits investors to redeem their interests in the under management that an investment adviser fund within two years of purchasing them (which must have in order to be eligible to register with the would encompass most hedge funds, since most SEC. Thus, hedge fund advisers with assets under allow for withdrawal or redemption of an management of less than $25 million will generally investment prior to two years after making such not be eligible for SEC registration, unless they also investment). Third, interests in a private fund are advise a company registered under the Investment based on the ongoing investment advisory skills, Company Act, or qualify for registration under one

G of the SEC’s exemptive rules. Advisers with “qualified clients” (as defined in Rule 205-3 of the between $25 and $30 million of assets under Advisers Act). The rule as adopted, however, management will be eligible, but not required to permits the acceptance of performance fees from register with the SEC. Advisers with more than investors that were invested in a fund prior to the $30 million of assets under management must adoption of the rule, even if such investors are not register with the SEC, unless an exemption is qualified clients. available. Suggested Action Steps State Registration Requirements Unregistered fund managers that are affected by The adoption of Rule 203(b)(3)-2 does not new Rule 206(b)(3)-2 must register with the directly alter state investment adviser registration Commission, and comply with the various new requirements. Thus, unregistered hedge fund regulatory requirements that will be applicable to advisers, particularly advisers with assets under them. This involves preparing and filing management of less than $25 million, must be Form ADV, which is available aware of applicable state registration requirements. on the SEC’s Internet Website at It is possible that the states will seek to adopt rules www.sec.gov/ divisions/ investment/ iard/ iastuff.shtl. similar to Rule 203(b)(3)-2, which might require In addition, unregistered fund managers will need hedge fund advisers not registered with the SEC to to have in place all of the compliance programs and register in those states. procedures applicable to registered fund managers by the time they register. Such compliance includes Effects of Registration having designated a Chief Compliance Officer, the person with primary responsibility for administering Regulatory Compliance the firm’s compliance policies and procedures, and Registration under the Advisers Act will not having in place comprehensive compliance policies prohibit hedge fund advisers from implementing and procedures tailored to the business of the any particular investment strategies, nor will it adviser. The effort involved and cost of compliance require or prohibit specific investments. However, will vary depending on the complexity of the advisers required to register will be subject to all adviser’s business. regulations applicable to registered investment Although the compliance effective date is not advisers (rather than only the anti-fraud provisions, until February 1, 2006, the registration and which apply to all investment advisers, whether or compliance process will likely involve a substantial not registered with the SEC). Applicable oversight effort and take several months. The requirements will include SEC inspection and reporting, books of the Advisers Act are complex. Affected fund and records requirements, compliance policy managers should consult counsel experienced with requirements, advertising restrictions, custody these matters. We work closely with our clients to rules, disclosure requirements, the proxy voting put in place a comprehensive system to comply rule, the code of ethics rule and limitations on with the requirements of the Advisers Act, while accepting performance fees from clients other than