Dodd-Frank Changes to Investment Adviser Regulation

October 18, 2010

Background.  The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) was signed into law by President Obama on July 21, 2010, and became effective one day later.  The Dodd-Frank Act will, among other things, significantly increase the regulation of investment advisers, in particular managers of hedge funds, private equity funds, venture capital funds, and other private funds.  The Dodd-Frank Act will subject more money managers to the registration requirements of the Investment Advisers Act of 1940 (the “Advisers Act”) and subject certain other money managers to state regulation.  For example, many money managers that have previously relied on the “private adviser exemption” from registration under Section 203(b)(3) of the Advisers Act will now be required to register as investment advisers with the U.S. Securities and Exchange Commission (the “SEC”) or the states in which they do business by July 21, 2011.  In addition, the Dodd-Frank Act gives to the SEC the power to subject private fund investment advisers to additional regulatory and reporting requirements.  This Alert does not deal with all of the financial services regulatory changes resulting from the Dodd-Frank Act, but instead seeks to highlight those changes that will be of particular interest to our investment advisory clients.

Registration Requirements and Thresholds.  The Dodd-Frank Act removes two important exemptions from the investment adviser registration requirements.  These exemptions have traditionally been relied upon by investment advisers to hedge funds and other private investment companies to avoid both state and SEC registration.  The effect of these changes will be to require investment advisers to hedge funds and other private investment companies to register with the SEC (if eligible under the new asset thresholds described below) or each of the states in which they do advisory business.

First, it eliminates the so called “de minimis” exemption from Section 203(b)(3) of the Advisers Act, which applies to an adviser with fewer than 15 clients in any 12-month period that does not hold itself out generally to the public as an investment adviser and does not advise registered investment companies.  This exemption is commonly relied on by private fund managers advising fewer than 15 funds because each fund is treated as a single client of the manager without regard to the number of underlying investors in the fund.

Second, it eliminates the “intra-state” exemption from Section 203(b)(1) of the Advisers Act for advisers to private funds so that such advisers are not eligible to use the current exemption for investment advisers whose clients are all residents of the adviser’s home state.

Although the Dodd-Frank Act will require more investment advisers to become registered, the Act also has amended the Advisers Act requirements for SEC registration.  The biggest change made by the new law is a requirement that an investment adviser with between $25 million and $100 million in assets under management that would be required to be registered with the state in which they have their primary place of business (and would be subject to examination by such state), may not register with the SEC, unless the investment adviser otherwise would be required to register with 15 or more states.  Currently, investment advisers with more than $25 million in assets under management may register with the SEC instead of with a state.

Therefore, as of July 21, 2011, investment advisers to private funds with assets under management of less than $100 million must register with one or more states.  (The SEC may, by rule, increase this $100 million threshold.)  In addition, even without SEC registration, an investment adviser solely to private funds (such as hedge funds) and with assets under management of less than $150 million, may still be required to maintain certain records and file certain reports with the SEC even though not required to register with the SEC as an investment adviser.

Exclusions from Registration.  The Dodd-Frank Act creates exclusions from registration under the Advisers Act for certain other types of entities that may otherwise be considered money managers.  They are:  (i) commodity trading advisers (“CTAs”) registered with the Commodity Futures Trading Commission and that provide advice to a private fund; (ii) foreign private advisers; (iii) venture capital fund managers; (iv) advisers to small business investment companies that are licensees under the Small Business Investment Act, have received notices to proceed to qualify as small business investment companies or certain other affiliated persons; and (v) family offices.  The “commodity trading adviser” exemption applies to CTAs that advise private funds so long as the advice provided is not predominantly securities-related advice.  The “foreign private adviser” exclusion applies to money managers who:  (i) have no place of business in the U. S.; (ii) have fewer than 15 clients in the U. S. (either directly or through a private fund managed by the investment adviser); (iii) have assets under management attributable to clients in the U. S. of less than $25 million (or such higher amount as the SEC may prescribe); and (iv) do not generally hold themselves out in the U. S. as an investment adviser and are not an investment adviser to a registered investment company or business development company.  This exclusion can be used for off-shore hedge fund managers.  Advisers to venture capital funds are excluded from SEC registration.  At the present time, the term “venture capital fund” is not a defined term.  The Dodd-Frank Act instructs the SEC to define the term “venture capital fund” by July of 2011.  The Dodd-Frank Act changes the definition of investment adviser to exclude family offices.  On October 12, 2010, the SEC released a rule proposal defining the term “family office.”  Please note, however, that the proposed rule does not include multi-family offices within the definition of family office, and if adopted as proposed, such multi-family offices would be required to register with the SEC or states.

Miscellaneous Changes of Interest.  In addition to the registration changes described above, the Dodd-Frank Act also imposes some other rules and requirements that will be of interest to investment advisers.  For example, the SEC is permitted to impose new recordkeeping rules and reporting obligations on registered investment advisers to private funds beyond those currently required under the Advisers Act.  Such new rules will allow the SEC to gain more information about private funds managed by registered investment advisers.  Other changes of note may impact who is eligible to invest in a private fund.

Record Keeping Changes.  Registered investment advisers to private funds, such as hedge funds, will be required to provide the SEC and a newly created Financial Stability Oversight Counsel with additional information about each private fund they manage.  The Dodd-Frank Act also directs the SEC to conduct periodic inspections of all records of private funds managed by registered investment advisers.  These records must include a description of:  (i) assets under management and any use of leverage (including off-balance sheet leverage); (ii) counterparty credit risk exposure; (iii) trading and investment positions; (iv) valuation policies and procedures; (v) types of assets held; (vi) side agreements or side letters; (vii) trading practices; and (viii) any other information the SEC, in consultation with the Financial Stability Oversight Counsel, deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.  These reporting requirements apply to all registered investment advisers to private funds, not just SEC-registered investment advisers.  Accordingly, an investment adviser registered in one or more states would also have reporting requirements to the SEC concerning the private funds they manage.

Even though investment advisers to venture capital funds are excluded from SEC registration, they are subject to the recordkeeping and reporting rules the SEC determines are necessary or appropriate in the public interest and for the protection of investors.

There are no recordkeeping or reporting obligations for family offices.

Changes to Investor Eligibility.  Eligibility for investors investing in a private fund, such as a hedge fund, changed effective July 21, 2010.

“Accredited Investor” Net Worth Test.  The Dodd-Frank Act changed the “accredited investor” standard as set forth in Rule 501 of Regulation D under the Securities Act of 1933, as amended (the “1933 Act”), to exclude the value of an investor’s primary residence from the determination of whether the individual’s net worth (or joint net worth with that person’s spouse) exceeds $1 million.  Prior to enactment, an individual could include his or her primary residence in determining whether he or she was an accredited investor based on net worth.  Managers of private funds that are currently engaged, or will be engaged, in Regulation D private offerings should screen prospective individual investors to ensure that they meet the revised standard.  A current individual investor in a private fund must meet the revised standard only when making an additional investment in the fund.

The definition of “accredited investor” may be subject to additional changes during the next four years.  The SEC is prohibited from adjusting that $1 million amount prior to the expiration of the four-year period from enactment of the Dodd-Frank Act (i.e., before July 22, 2014).  The Dodd-Frank Act does allow the SEC, during this initial four-year period, to review other components of the accredited investor definition applicable to natural persons and enact rules relating to those other components.  After that initial four-year period, and no less frequently than every four years thereafter, the SEC must undertake a review of the entire accredited investor definition applicable to natural persons and may enact rules adjusting that definition upon completion of each review.

The impact of these changes could be to exclude some investors, previously eligible to invest in a private fund, from the definition of an “accredited investor” under Regulation D of the 1933 Act.  Most private funds rely on Regulation D to privately offer their securities.  For additional guidance on what to do if you have an investor who no longer qualifies as an accredited investor, see our previous Alert “IMMEDIATE CHANGE IN ACCREDITED INVESTOR REQUIREMENTS” dated July 22, 2010.

“Qualified Client” Standard Adjusts Periodically for Inflation.  The Dodd-Frank Act requires the SEC to adjust the “Qualified Client” standard contained in Rule 205-3(d)(1) under the Advisers Act for inflation by July 22, 2011, and every 5 years thereafter.  These changes could impact investment advisers who charge performance fees.

If you have any questions concerning this Alert, or what registration requirements may apply to your investment advisory firm, please do not hesitate to contact an attorney in our Investment Management Group.