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Hedge Fund Advisers May Be Subject
to Controversial
New SEC Proposed Rule Requiring Registration
By
Keith
G. Baldwin
[August 2004]
On July 20, 2004, the Securities Exchange Commission
(the “Commission”), by a narrow 3-2 vote, proposed
a new controversial rule and rule amendments under the Investment
Advisers Act of 1940 (the “Act”). The new rule would
limit the private adviser exemption from registration currently
available to advisers of private investment pools and could
have a significant effect on the hedge fund industry. If adopted,
it would require investment advisers (including, for most funds,
general partners and managing members) to count each limited
partner or member of a private fund partnership as an investment
advisory client for purposes of determining the availability
of the private fund exemption, thereby effectively eliminating
the exemption from registration for all but the smallest private
investment partnerships. The Commission has requested public
comments on the proposed new rule by Sept. 15, 2004. The two
dissenting Commissioners filed a separate statement expressing
their view on the proposed rule.
Davis Wright Tremaine LLP has a national hedge
fund practice and a large number of hedge fund clients, many
of which are already registered under the Act because of their
own business needs and the peculiar requirements of certain
state laws, including the law of Washington. However, many hedge
fund clients have so far been able to avoid the registration
requirements. The proposed rule would sweep almost all private
investment funds under its coverage.
Regulatory Background
Section 203(b)(3) of the Act exempts from registration
an investment adviser (other than an adviser of a registered
investment company or business development company) if it (i)
has fewer than 15 advisory clients during the preceding twelve
months; (ii) does not hold itself out generally to the public
as an investment adviser; and (iii) is not an adviser to any
registered investment company. In addition, Section 203A of
the Act limits the exemption to advisers with less than $25,000,000
in assets under management. Rule 203(b)(3)-1 under the Act currently
permits investment advisers to treat a limited partnership as
one “client.” Thus, investors in the limited partnership
do not count as clients for purposes of the exemption. The Commission
estimates that approximately 50 to 60 percent of hedge fund
advisers currently rely on Rule 203(b)(3)-1 and Rule 230A exemptions.
The impetus behind the Commission’s proposed
rule includes the growth of hedge funds in the past decade,
the increasing number of hedge fund fraud enforcement cases,
and the “retailization” of hedge funds–that
is, the growing exposure of smaller investors and other market
participants, either directly or indirectly, to hedge funds.
The proposed rule would provide the Commission with an oversight
program that is aimed at deterring or detecting fraud at an
early stage.
The Commission’s Proposal
Proposed new Rule 203(b)(3)-2 would require investment
advisers to count each owner (most often, a limited partner)
of a private fund as a client to determine eligibility for the
private adviser exemption under Section 203(b)(3) of the Act.
Thus, if during the preceding 12 months an adviser advised a
private fund with more than 14 investors, it could no longer
rely on the exemption. Offshore hedge fund advisers would be
required to look through the funds they manage, whether or not
those funds are located offshore, and count investors that are
U.S. residents as clients. However, the rule excepts advisers
of publicly offered mutual funds or closed-end funds regulated
by a foreign jurisdiction. A private fund is defined as a company
that (i) would be subject to regulation under the Act but for
the exception under either Section 3(c)(1) or Section 3(c)(7)
of the Act, (ii) permits owners to redeem their ownership interests
in the company within two years of purchase, and (iii) offers
interests in it based on the on-going investment advisory skills,
ability, or expertise of the investment adviser. Finally, the
safe harbor under Rule 203(b)(3)-1 would be amended to clarify
that investment advisers may not count hedge funds as single
clients. Amendments to Rule 204-2 would relieve record keeping
requirements to substantiate performance claims for new registrants.
The amended rule would permit an adviser to use performance
history relating to the period prior to its registration even
if records supporting such performance may be incomplete or
otherwise do not meet the requirements of Rule 204-2. The new
registrant still must comply with the Commission’s recordkeeping
rule going forward. Under the new rule, the books and records
of a registrant include those of the private funds for which
the adviser acts as general partner, managing member, or in
a similar capacity.
An amendment to Rule 205-3 of the Act would avoid
requiring certain hedge fund investors to divest their current
interests in the funds by permitting advisers to impose performance
fees on investors in that fund who are not “qualified
clients” if those clients have already invested prior
to the adviser’s registration. Generally, a qualified
client is an investor with a net worth of more than $1.5 million
or at least $750,000 of assets under the adviser’s management.
Another proposed amendment would revise Form
ADV, the investment adviser registration form, to require advisers
to private funds to identify themselves as hedge fund advisers
in Part 1A and Schedule D. Finally, amendments to Rule 206(4)-2,
the adviser custody rule, would accommodate advisers to funds
of hedge funds by extending the period for pooled investment
vehicles to distribute their audited financial statements to
investors from 120 days to 180 days.
The Commission has not set a compliance deadline
for the proposed amendments and is requesting comments on the
issue. The proposal suggests giving advisers between six months
to a year to register and revise their compliance systems.
Controversy
The Commission’s proposed amendments
under the Act are clearly controversial, even at the SEC. The
two dissenting Commissioners expressed their view that, with
the amendments, the majority “proposes a solution to an
ill-defined problem without having given proper consideration
to viable alternative solutions in light of the limitations
of [the SEC’s] own capabilities.” They cite a 2003
Staff Hedge Fund Report that found no “retailization”
and no disproportionate increase in fraud accompanying the growth
of the hedge fund industry. In addition to raising investment
costs, which would ultimately be borne by investors, the dissenters
argue that registration would not reduce enforcement actions
because frauds are typically perpetrated by advisers who are
too small to register or who have already registered or evaded
registration requirements. Finally, other opponents are concerned
that the new regulatory scheme may do unnecessary damage to
the liquidity and efficiency of the U.S. capital markets.
Proponents of the amendments, however,
cite the 1998 collapse of Long-Term Capital Management to argue
that the hedge fund industry is a “dark corner”
about which the Commission must gain information and oversight.
Senator Paul Sarbanes says the Commission’s proposal may
be “an ounce of prevention that forestalls many pounds
of cure.”
There is no guarantee that the proposed
rule will be adopted, but we believe the regulatory atmosphere
is ripe for change and heightened regulation, particularly in
view of other Congressional initiatives such as the Sarbanes-Oxley
Act of 2002, which imposed significant new requirements on public
companies. Additional bulletins will be provided by Davis Wright
Tremaine LLP as the SEC’s rule-making procedures, and
the public comments, continue.
For further information, please contact:
This Corporate Finance Advisory
is a publication of the Business Transactions/Corporate Finance
Group of Davis Wright Tremaine LLP. Our purpose in publishing
this Advisory is to inform our clients and friends of developments
in business, corporate finance and securities laws. It is not
intended, nor should it be used, as a substitute for specific
legal advice as legal counsel may only be given in response
to inquiries regarding particular situations.
Copyright ©
2004, Davis Wright Tremaine LLP.
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