Investment Management
JULY 2004
SEC Votes to Propose New Rule and Rule Amendments
Requiring Hedge Fund Advisers to Register Under the
Investment Advisers Act
At its July 14, 2004 open meeting, the Securities and
Exchange Commission (the “SEC”) proposed (by a 3
to 2 vote) a new rule and rule amendments that would
require hedge fund advisers to register with the SEC
as investment advisers under the Investment
Advisers Act of 1940, as amended (“Advisers Act”).
In particular, the SEC will publish a release proposing
new Rule 203(b)(3)-2 and certain conforming and
transitional amendments to Rules 203(b)(3)-1, 204-2,
205-3, 206(4)-2 and Form ADV under the Advisers
Act.
The proposed new rule would require an adviser to a
“private fund” to register with the SEC by requiring
the adviser to “look through” the fund and to count
the number of investors in the fund (rather than the
fund) when determining whether the adviser is
eligible for the Advisers Act’s exemption from
registration for an adviser with 14 or fewer clients.
The SEC proposes to define a “private fund” for
these purposes as a fund that:
n
would be an investment company but for the
exceptions in Sections 3(c)(1) or 3(c)(7) of the
Investment Company Act of 1940, as amended;
n
permits owners to redeem their ownership
interests within two years of purchase; and
n
is offered based on the investment advisory
skills, ability or expertise of the investment
adviser.
The proposed new rule would not require advisers to
private equity or venture capital funds to register
under the Advisers Act.
The proposed new rule contains special provisions
for advisers located outside the United States that
are designed to limit the extraterritorial application of
the Advisers Act to offshore advisers to offshore
funds that have U.S. investors.
In each case, hedge fund advisers still must have at
least $25 million of assets under management in order
to register with the SEC.
The proposed amendments to existing rules under
the Advisers Act would: (1) permit hedge fund
advisers to continue charging performance fees to
investors that may not qualify as a “qualified client”
under Rule 205-3 if the adviser becomes SEC
registered; (2) permit advisers to advertise fund
performance history even if the adviser may not be
able to satisfy fully the recordkeeping requirements
with respect to performance history; and (3) extend
from 120 days to 180 days the time period within
which fund of hedge funds need to provide audited
financial statements to fund investors in compliance
with the Advisers Act’s custody rule. The SEC also
will propose amendments to Form ADV to more
clearly identify hedge fund advisers that are
registering due to their hedge fund activities.
The SEC staff did not expressly address to what
extent hedge fund advisers that register with the SEC
would be subject to other provisions of the Advisers
Act, such as the requirements with respect to
principal trades and agency cross-trades. However,
based on SEC staff comments at the open meeting, it
appears that advisers will be subject to some of these
other Advisers Act provisions, including, for
example, designating a chief compliance officer and
implementing written policies and procedures.
The SEC staff estimates that hedge fund advisers
manage approximately $850 billion of assets under
management and that this number could grow to
$1trillion in the near future. The SEC staff is
Kirkpatrick & Lockhart LLP
concerned regarding the lack of information with
respect to this growing industry, recent enforcement
cases involving hedge funds and their managers, and
the growing exposure of smaller investors to the risk
of hedge funds. The SEC believes that the
registration of hedge fund advisers under the new
rule would permit the SEC to:
n
Collect and provide to the public basic
information about hedge funds and hedge fund
advisers, including the number of hedge funds
operating in the United States, the amount of
assets, and the identity of their advisers.
n
Examine hedge fund advisers to identify
compliance problems early and deter
questionable practices. The SEC believes that,
if fraud occurs, examinations offer a chance to
discover it early and limit the harm to investors.
n
Require all hedge fund advisers to adopt basic
compliance controls to prevent violation of the
federal securities laws.
n
Improve disclosures made to prospective and
current hedge fund investors.
n
Prevent felons or individuals with other serious
disciplinary records from managing hedge
funds.
The SEC and its staff clarified that the proposed new
and amended rules are not intended to: (1) require
hedge funds to register as investment companies; (2)
extend SEC jurisdiction where it does not already
exist; (3) establish a new regulatory scheme; or (4) in
any way impede the legitimate operations of hedge
funds and the vital role they can, and in many cases
do, play in our financial markets.
As noted above, two SEC Commissioners opposed
the proposal. Their opposition is based in part on
(1) lack of a clearly articulated problem that would be
addressed by requiring hedge fund advisers to
register, (2) unintended consequences of the
proposed new rule and rule amendments, and
(3) diversion of significant resources from other,
more traditional, areas under SEC jurisdiction.
Comments on the proposed provisions should be
submitted to the SEC by September 15, 2004.
The full text of the detailed release concerning the
proposed provisions will be posted on the SEC web
site shortly. The summary of the proposed
provisions provided above is based on written and
oral statements made by the SEC staff and the SEC
Commissioners at the July 14, 2004 open meeting.
ROBERT H. ROSENBLUM
202.778.9464
rrosenblum@kl.com
CARY J. MEER
202.778.9107
cmeer@kl.com
RONALD A. HOLINSKY
202.778.9425
rholinsky@kl.com
Kirkpatrick & Lockhart LLP
2
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, insurance companies, broker-dealers, investment advisers, retirement
plans, banks and trust companies, hedge funds, offshore funds 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
Mark P. Goshko
Thomas Hickey III
Nicholas S. Hodge
George Zornada
617.261.3133
617.261.3156
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617.261.3231
LOS ANGELES
William P. Wade
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NEW YORK
Ricardo Hollingsworth
Philip L. Kirstein
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Keith W. Miller
212.536.4859
212.536.4831
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kmiller@kl.com
SAN FRANCISCO
Eilleen M. Clavere
Jonathan D. Joseph
David Mishel
Timothy B. Parker
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1012
415.249.1015
415.249.1042
415.249.1070
415.249.1010
eclavere@kl.com
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dmishel@kl.com
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mperlow@kl.com
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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
Francine J. Rosenberger 202.778.9187 francine.rosenberger@kl.com
Robert H. Rosenblum
William A. Schmidt
Lori L. Schneider
Lynn A. Schweinfurth
Donald W. Smith
Martin D. Teckler
Robert A. Wittie
Leslie C. Zimberg
Robert J. Zutz
202.778.9464
202.778.9373
202.778.9305
202.778.9876
202.778.9079
202.778.9890
202.778.9066
202.778.9215
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
lzimberg@kl.com
rzutz@kl.com
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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.