The impact of the new financial reform legislation

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President Obama has signed into law the Private Fund Investment Advisers Registration Act of 2010 as part of the broader Dodd-Frank Wall Street Reform and Consumer Protection Act, which enacts sweeping changes to the US financial regulatory system intended to address both the causes of the recent financial crisis and other perceived gaps in US financial regulation.

The Act establishes a new investment adviser registration regime for managers of hedge funds and private equity funds and certain foreign advisers. It also alters the allocation of federal and state oversight responsibilities and changes certain investor eligibility criteria under the federal securities laws.
Below, we cover how the legislation impacts you:

  • Elimination of the private adviser exemption
  • New recordkeeping and reporting requirements
  • Allocation of federal and state responsibilities
  • Volcker rule

Elimination of the private adviser exemption
The Act eliminates the “private adviser” exemption under the Investment Advisers Act of 1940 (the “Advisers Act”), which is the exemption that most hedge fund and private equity fund managers rely on to avoid registration with the SEC. Now, all hedge fund and private equity fund managers who manage private funds aggregating $150 million or more in assets will be subject to SEC investment adviser registration, unless another exemption is available. Important exemptions and qualifications include:

Managing funds with less than $150 million in total assets but only if the manager manages only private funds and does not manage any separate accounts or other type of investment vehicle;
Managing only “venture capital funds” (to be defined by the SEC); and
Acting as a “foreign private adviser” or “family office”.

The Act authorises the SEC to require venture capital fund managers and managers of funds with less than $150 million in total assets to maintain such records and file such reports that the SEC deems necessary for the protection of investors.

Foreign private advisers

A foreign private adviser is exempt if it (a) has no place of business in the US; (b) has fewer than 15 clients and fund investors in the US; (c) has less than $25 million (or such higher amount as the SEC may deem appropriate) in aggregate assets under management attributable to US clients and fund investors; and (d) neither holds itself out generally in the US as an investment adviser nor acts as an investment adviser to any registered investment company or business development company.

Many non-US managers are not registered with the SEC in reliance on the private adviser exemption but manage funds with more than $25 million of assets from US investors. The Act’s new registration requirements will impact these managers; however, it is possible that the SEC may increase the $25 million threshold to a higher amount (eg, $150 million in the case of foreign fund managers and/or $100 million in the case of foreign separate account managers) to apply a uniform and consistent registration threshold to both US and non-US managers. The SEC may also, as it has done in the past, adopt a lighter regulatory scheme for non-US-based managers to avoid imposing duplicative and potentially onerous regulatory requirements on managers whose home country supervisory authorities may subject them to regulatory oversight.

Family offices

Although the Act gives the SEC authority to define the term “family office”, the Act requires the SEC to adopt rules that are consistent with previous SEC exemptive orders and that take into account the “range of organisational, management and employment structures and arrangements employed by family offices”.

New recordkeeping and reporting requirements
For hedge and private equity fund advisers subject to SEC registration, the Act authorises the SEC to impose substantial new recordkeeping and reporting requirements. The Act treats all records and reports of a private fund that a registered investment adviser manages as the records and reports of the adviser itself and thus subject to examination by the SEC. The Act also requires fund advisers to maintain records and provide the SEC with reports concerning assets under management and the use of leverage, counterparty credit risk exposure, trading and investment positions, valuation policies and practices, types of assets held, side letters with certain fund investors, trading practices and other information necessary for an assessment of systemic risk.

Allocation of federal and state responsibilities
For managers with any separately managed account clients, the Act substantially modifies the applicable SEC registration thresholds. The new registration thresholds are:

A manager with less than $25 million in assets under management is not eligible for SEC registration unless acting as an adviser to a registered investment company (which was the case prior to passage of the Act).

A manager with between $25 million and $100 million in assets under management (a “mid-size investment adviser”) is not eligible for SEC registration if it is required to register with the state in which the manager maintains its principal office, and if registered, would be subject to examination by the applicable state authority.

Notwithstanding the above exclusion, a mid-size investment adviser must register with the SEC if it (i) advises a registered investment company or business development company, or (ii) is not required to be registered and examined by state authorities.

A mid-size investment adviser has the option to voluntarily register with the SEC if it would otherwise be required to register with 15 or more states.

Any manager exempt from SEC registration should review state law to determine if it is subject to any state investment adviser registration requirement. The change in the federal registration threshold raises issues about the capacity and resources of the states to regulate and examine what is expected to be a significantly increased number of state-registered investment advisers.

Also, the applicability of the new registration regime to private equity fund managers will likely present new challenges to both federal and state regulators who may not be as familiar with the private equity business model.

Volcker rule
Proprietary trading

The Volcker Rule prohibits banks from (i) engaging in proprietary trading activities, and (ii) investing in hedge funds and private equity funds, and acting as sponsor to those funds (eg serving as general partner, managing member or otherwise controlling the management of a fund). Activities that are excluded from the proprietary trading ban include US government and agency securities trading, underwriting and market-making, risk-mitigating hedging, agency transactions on behalf of customers and certain activities engaged in by regulated insurance companies and certain non-US institutions.

As a result of these provisions, many bank proprietary trading desks may spin off or otherwise depart to start their own hedge funds or join other fund groups, which could create opportunities for existing fund managers that are able to scale up and absorb the additional personnel. The reduction in bank trading activity will likely remove some liquidity (and competition) from the marketplace.

Hedge and private equity fund prohibition

The Volcker rule also contains important exceptions to the ban on investing in or sponsoring hedge and private equity funds, provided that these permitted investments do not involve a “material conflict of interest” or cause a bank to have “material exposure…to high risk assets or high risk trading strategies”.

A major exception to the ban permits banks to organise and offer hedge and private equity funds if (i) the fund is organised and offered in connection with the bank’s provision of “bona fide trust, fiduciary or investment advisor services” to customers of the bank with respect to those services, and (ii) the bank’s ownership in the fund is limited to a “de minimus investment”.

This means that a bank can provide seed capital or other de minimus funding provided that (i) it actively seeks outside investors to dilute its interest and otherwise reduces its interest to no more than 3 per cent of the fund’s total ownership interests within one year of the fund’s establishment, and (ii) the interest is “immaterial” and in any event does not exceed 3 per cent of the bank’s Tier 1 (core) capital.

As a result of the new prohibitions, many banks may have to divest a substantial portion of their ownership stakes in hedge and private equity funds in the future.

Nonbank financial companies

The Volcker Rule also subjects certain large nonbank financial companies supervised by the Fed to certain capital requirements and quantitative limits on their proprietary trading and fund investing/sponsoring activities.

Implementation period for compliance

The Volcker rule is not self-implementing. The final regulations implementing the Volcker rule will take effect within two years of enactment; thereafter, banks have two more years to divest their non-complying assets/activities, subject to the Fed’s authority to grant extensions for up to three one-year periods and a one-time, five-year extension with respect to the divestiture of interests in certain illiquid funds.

For managers who previously relied on the private adviser exemption, the Act allows a one-year transition period for compliance with the new registration requirements. Smaller managers (ie, fund-only managers with less than $150 million in assets and other managers with less than $100 million in assets) should consider if they will now be subject to state registration. Larger managers will have to cope with the increased transparency associated with SEC registration and systemic risk reporting.

Hedge fund managers with an institutional compliance infrastructure should be better prepared to deal with SEC regulation, but the degree and scope of the new regulatory burden will be determined largely by how the SEC implements its new rulemaking authority regarding the Act’s new examination, recordkeeping and reporting provisions. The Act may have more onerous consequences for private equity fund managers and foreign advisers not generally familiar with SEC regulation, though the scope of the related regulatory burden will also depend on the SEC’s new rulemaking and examination initiatives for those entities.

Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.