Investment Management
October 2004
SEC Adopts New Rule and Rule Amendments Requiring
Hedge Fund Advisers to Register Under the Investment
Advisers Act of 1940, as amended
At an open meeting on Tuesday, October 26, 2004,
the Securities and Exchange Commission adopted (by
a 3 to 2 vote) a new rule and rule amendments
requiring hedge fund advisers to register with the
SEC as investment advisers under the Investment
Advisers Act of 1940, as amended (“Advisers Act”),
if 15 or more people invest in the hedge funds
managed by the adviser, and those hedge funds have
at least $25 million in assets. The SEC adopted the
new rule and rule amendments substantially as
proposed. The new rule and rule amendments will
become effective in February 2006, providing
advisers with over a year during which to adjust to
the requirements of the new rule.
The full text of the adopting release will be posted on
the SEC web site shortly. The summary of the
provisions provided in this Alert is based on oral
statements made by the SEC staff and the SEC
Commissioners at the open meeting.
The new rule requires advisers to “private funds” to
“look through” the fund and treat each investor in a
fund as a client of the adviser (rather than treating a
fund as a single client) when determining whether the
adviser is eligible for the Advisers Act exemption
from registration for an adviser with 14 or fewer
clients. The SEC staff stated that hedge fund
investors will not be treated as clients of the adviser
for other purposes. In addition, for purposes of
counting to 15 clients, the adviser will not be
required to count insiders of the adviser who invest
in the adviser’s funds. The SEC staff also stated that
amounts invested by those insiders will not be
counted toward the $25 million threshold requiring
registration.
Just as in the proposed rule, the new rule allows
advisers to private funds to avoid registration under
the Advisers Act if those funds do not permit an
investor to redeem for two years. This ought to
exempt most advisers to private equity and venture
capital funds, as well as advisers to hedge funds that
impose a two-year “lock up period” during which
new investors may not redeem their shares.
In adopting the new rule, several Commissioners,
along with the SEC staff, stressed that the new rule
would permit the SEC to:
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Collect information about hedge funds and
hedge fund advisers that has previously been
available only from a variety of sources; these
sources often have provided conflicting
information;
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Conduct examinations of hedge fund advisers
to identify compliance problems early and deter
questionable practices;
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Require all hedge fund advisers to comply with
recently adopted rules requiring advisers to
develop comprehensive compliance programs
and designate a chief compliance officer; and
n
Prevent felons or individuals with other serious
disciplinary records from managing hedge
funds.
The SEC staff stated that the new rule will contain
special provisions for advisers located outside the
United States. An offshore adviser would be
required to count as clients only clients resident in
the United States, and would not be required to
count as clients natural persons not resident in the
Kirkpatrick & Lockhart LLP
United States, corporations organized outside of the
United States, and trusts with trustees located
outside the United States. In addition, in response to
concerns of commentators that a non-U.S. person
could move into the United States, the SEC staff
stated that an investor’s non-U.S. person status
would be determined solely at the time of investment
in the fund.
The SEC staff stressed that the adoption of the new
rule and rule amendments: (1) would not require
investors to exit from funds in which they were
invested prior to the effective date of the new rule
even if such investors do not meet certain criteria,
such as qualifying as a “qualified client” so as to be
able to pay a performance fee under the Advisers
Act; and (2) that certain recordkeeping requirements
would be relaxed. However, antifraud provisions
would still apply.
The SEC staff stated—although the dissenting
Commissioners disagreed—that it does not expect
the costs associated with complying with the new
rule to be excessive. The SEC staff stated that few
advisers will be required to create a dedicated
compliance position and that most advisers will either
already have an individual dedicated to compliance if
the adviser is large enough or, if the adviser has a
small internal staff, will be able to obtain the services
required from a third party such as a prime broker.
There is some doubt, however, as to whether prime
brokers will provide chief compliance officers to all of
their hedge fund clients, and if so, whether they will
charge those managers for providing the service.
Two SEC Commissioners opposed the new rule and
rule amendments for the same reasons they
previously opposed the new rule and rule
amendments when proposed. Their opposition was
based in part on (1) the lack of a clearly articulated
problem that would be addressed by requiring hedge
fund advisers to register, (2) the unintended
consequences of the proposed new rule and rule
amendments, and (3) the diversion of significant
resources from other, more traditional, areas under
SEC jurisdiction.
The three SEC Commissioners who voted in favor of
the new rule and rule amendments, along with the
SEC staff, stated that concerns of the dissenting
Commissioners and several commentators that the
SEC lacks sufficient resources to implement the new
rule were unfounded. The SEC staff stated that a
task force consisting of SEC staff members will
develop a risk-based inspection model to allow the
SEC staff to allocate optimally its inspection
resources. The risk-based inspection model
developed by the SEC staff will be completed in
conjunction with the effective date of the new rule
and rule amendments (i.e., February 1, 2006).
CARY J. MEER
202.778.9107
cmeer@kl.com
ROBERT H. ROSENBLUM
202.778.9464
rrosenblum@kl.com
DAVID J. MICHEHL
202.778.9274
dmichehl@kl.com
Kirkpatrick & Lockhart LLP
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Kirkpatrick & Lockhart LLP maintains one of the leading investment management practices in the United States,
with more than 70 lawyers devoting all or a substantial portion of their practice to this area and its related
specialties.
We represent mutual funds, closed-end funds, hedge funds, offshore funds, insurance companies, broker-dealers,
investment advisers, retirement plans, banks and trust companies and other financial institutions. We also
regularly represent mutual fund distributors, independent directors of investment companies and service providers
to the investment management industry. In addition, we frequently serve as outside counsel to industry
associations on a variety of projects, including legislative and policy matters.
We work with clients in connection with the full range of investment company industry products and activities,
including all types of open-end and closed-end investment companies, funds of hedge funds, variable insurance
products, private and offshore investment funds and unit investment trusts. Our practice involves all aspects of
the investment company business.
We invite you to contact one of the members of the practice, listed below, for additional assistance. You may also
visit our website at www.kl.com for more information, or send general inquiries via email to
investmentmanagement@kl.com.
BOSTON
Michael S. Caccese
Philip J. Fina
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William P. Wade
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NEW YORK
Jeffrey M. Cole
Ricardo Hollingsworth
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Keith W. Miller
Scott D. Newman
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SAN FRANCISCO
Eilleen M. Clavere
Jonathan D. Joseph
David Mishel
Timothy B. Parker
Mark D. Perlow
Richard M. Phillips
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WASHINGTON
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
thickey@kl.com
nhodge@kl.com
gzornada@kl.com
Clifford J. Alexander
Diane E. Ambler
Mark C. Amorosi
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Jennifer R. Gonzalez
Robert C. Hacker
Kathy Kresch Ingber
Michael J. King
Rebecca H. Laird
Cary J. Meer
R. Charles Miller
Dean E. Miller
R. Darrell Mounts
C. Dirk Peterson
David Pickle
Alan C. Porter
Theodore L. Press
202.778.9068
202.778.9886
202.778.9351
202.778.9289
202.778.9046
202.778.9042
202.778.9286
202.778.9016
202.778.9015
202.778.9214
202.778.9038
202.778.9107
202.778.9372
202.778.9371
202.778.9298
202.778.9324
202.778.9887
202.778.9186
202.778.9025
calexander@kl.com
dambler@kl.com
mamorosi@kl.com
cbardsley@kl.com
abrown@kl.com
adelibert@kl.com
jgonzalez@kl.com
rhacker@kl.com
kingber@kl.com
mking@kl.com
rlaird@kl.com
cmeer@kl.com
cmiller@kl.com
dmiller@kl.com
dmounts@kl.com
dpeterson@kl.com
dpickle@kl.com
aporter@kl.com
tpress@kl.com
Robert H. Rosenblum
William A. Schmidt
Lori L. Schneider
Lynn A. Schweinfurth
Donald W. Smith
Martin D. Teckler
Robert A. Wittie
Robert J. Zutz
202.778.9464
202.778.9373
202.778.9305
202.778.9876
202.778.9079
202.778.9890
202.778.9066
202.778.9059
rrosenblum@kl.com
william.schmidt@kl.com
lschneider@kl.com
lschweinfurth@kl.com
dsmith@kl.com
mteckler@kl.com
rwittie@kl.com
rzutz@kl.com
Francine J. Rosenberger 202.778.9187 francine.rosenberger@kl.com
The attorneys resident in all offices, unless otherwise indicated,
are not certified by the Texas Board of Legal Specialization.
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This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2004 KIRKPATRICK & LOCKHART LLP. ALL RIGHTS RESERVED.