K&LNG
DECEMBER 2005
Alert
Hedge Funds
The SEC Plays Santa and Scrooge: The SEC’s
Response to the ABA Letter on Hedge Fund Issues
While Santa and his elves put the finishing touches
on their yearly efforts, the SEC and its fledgling
hedge fund regulatory program also have been hard
at work—although perhaps not quite as merrily. Last
Thursday, December 8, 2005, the Division of
Investment Management issued its long-awaited
response (“SEC Response Letter”) to a series of
interpretive questions posed by an ABA
subcommittee on Rule 203(b)(3)-1 under the
Investment Advisers Act of 1940 (“Advisers Act”),
the rule requiring many hedge fund managers to
register with the SEC as investment advisers. Then,
on Friday, December 9, 2005, the Court of Appeals
for the D.C. Circuit heard oral arguments on whether
the SEC even had the authority to adopt this rule.1
And this week may see a significant number of hedge
fund managers filing their Forms ADV to begin the
process to register as investment advisers. Managers
who file their Forms ADV by this Thursday,
December 15, 2005 generally should expect to be
registered by the February 1, 2006 deadline (although
the SEC staff also notes in the SEC Response Letter
that it would seek to accommodate any adviser that
files its Form ADV by January 9, 2006).
Some of the interpretive guidance in the SEC
Response Letter is as welcome as a new toy from Old
Saint Nick, and some of it is like a lump of coal. The
letter itself is 20 pages long and covers a large number
of issues. But here, in the spirit of the season, are
some of the highlights, both naughty and nice:
REDEMPTION AND LOCK UP PROVISIONS
In general, a hedge fund manager with at least
15 clients, and at least $25 million under
management, must register with the SEC as an
investment adviser. Under Rule 203(b)(3)-1(d), a
hedge fund manager may treat a hedge fund as a
single client, rather than being required to “lookthrough” the fund and count each investor in the fund
as a client, if no fund investor may, except in
extraordinary circumstances, redeem any portion of
her ownership interests in the hedge fund within two
years of the purchase of the interests. Many of the
questions posed by the ABA related to this “two-year
lock up” provision.
From Santa:
■
The two-year lock up applies only to
contributions of capital, and not, for example,
to deferred incentive fees and accrued
incentive allocations payable to a fund’s
general partner (the staff views these as
payment for services).
■
Gains and income allocated to an owner’s
capital account are assigned the date of the
owner’s original investment giving rise to that
gain or income, and after two years from the
date of the related investment, the owner can
withdraw her investment, and/or any related
gains or income.
■
If an owner acquires an interest in a fund in the
secondary market from another owner, the
original purchase date may be attributed to the
1 Goldstein
v. SEC, No. 04-1434. It is highly unlikely that the court will issue a decision prior to the time that hedge fund managers will need to file their
Forms ADV to ensure that they are registered by the February 1, 2006 deadline. Indeed, as discussed in the text, many managers may be filing their Forms
ADV this week.
Kirkpatrick & Lockhart Nicholson Graham LLP |
DECEMBER 2005
transferred interest, provided that there is no
arrangement between the fund and either
owner to circumvent the two-year restriction.
■
The bona fide dissolution or liquidation of a
fund investor is an extraordinary event, and an
adviser that has a reasonable basis, after
reasonable inquiry, for believing that such a
dissolution or liquidation has occurred may
permit that investor (or its estate) to redeem its
investment, notwithstanding the two-year lock
up. The bankruptcy of an investor also is an
extraordinary event.
But Scrooge Says:
■
REGISTRATION OF SUBADVISERS
From Santa:
Offshore subadvisers to hedge funds are not subject
to the look-through and registration requirements of
Rule 203(b)(3)-1 if:
■
the subadviser is hired (and subject to being
discharged) by the private fund’s registered
adviser;
■
the subadviser is otherwise not required to
register with the SEC;
■
the subadviser does not control, is not
controlled by, and is not under common control
with the fund’s primary adviser;
From Scrooge:
■
The lock up must be for a full two years—
January 1, 2007 to December 31, 2008 is one
day too short. Some funds may decide to revise
the timing of their purchase and redemptions
procedures to accommodate this rule (e.g., by
permitting a redemption on the first business
day following two years from an investment).
A transfer between classes, where the classes
only have substantially similar investment
objectives, or where the classes have different
redemption rights, may constitute a redemption.
■
The two-year lock up applies to anyone who
owns an interest in a fund, including the
adviser, the general partner, and other
“knowledgeable employees.”
■
the written materials provided to fund investors
clearly disclose that a portion of the fund’s
assets may be managed by unregistered
offshore advisers; and
■
The two-year lock up also must apply to
offshore investors in the fund.
■
■
The significant withdrawal of proprietary
investments or ownership interests by an
adviser is not an extraordinary event, and such
a withdrawal would not serve as a basis for
permitting other fund investors to withdraw
their investments prior to the expiration of a
two-year lock up.
at the time the subadviser is hired, and at the time
any additional assets of the fund are allocated to
the subadviser for management, the unregistered
offshore subadviser does not manage more than
10% of the fund’s total assets.
From Scrooge:
■
From Both:
Santa Says:
■
2
An owner of a hedge fund interest has not
redeemed her interests if she transfers the
interest from one class to another class of the
fund, where the two classes share the same
underlying portfolio of securities and provide
owners with the same redemption rights.
Similarly, there is no redemption when an
investor transfers her investment from one
feeder fund to another feeder fund investing in
the same master fund, if the two feeder funds
also offer the same redemption rights. The
two-year holding period for the investment
would run from the date of purchase of the
interest in the original class or feeder fund.
U.S. subadvisers to hedge funds are subject to
the look-through and registration requirements
of Rule 203(b)(3)-1, even if they are not named
in the fund’s offering memo and manage 15%
or less of the fund’s assets.
REGISTRATION OF THE GENERAL PARTNER AND
OFFSHORE AFFILIATES OF THE ADVISER
From Santa:
■
A special purpose vehicle (“SPV”) set up to act
as a fund’s general partner or managing
member is not required to register as an
investment adviser if all of the investment
advisory activities of the SPV (including the
activities of its employees) are subject to the
Advisers Act and the rules thereunder, and the
SPV is subject to examination and enforcement
by the SEC.
Kirkpatrick & Lockhart Nicholson Graham
LLP
|
DECEMBER 2005
■
Similarly, an offshore affiliate of a registered
adviser (such as an offshore affiliate
established to focus on investments in a
particular foreign jurisdiction) is not required
to register as an investment adviser if it meets
certain conditions designed to assure that the
foreign entities are subject to the Advisers Act
and the SEC’s regulatory oversight.
master fund, and to identify the current value
of the total assets in each, if the adviser or a
related person acts as the adviser, general
partner or managing member of both the
master fund and the feeder fund(s).
CUSTODY
From Santa:
■
FAMILY OFFICES AND FAMILY FUNDS
From Santa:
■
An adviser to a family investment fund may
treat a trust whose sole beneficiaries are certain
family members as a single client, even if the
trustee of the trust is not a family member.
From Scrooge:
■
■
The look-through and other provisions of Rule
203(b)(3)-1 are applicable to a fund composed
solely of family members, even if a family
member is the adviser or controls the adviser.
The SEC Response Letter did note, though,
that some family investment funds may not be
offered based on the expertise of the adviser
and suggested that in those cases the rule
would be inapplicable to those funds.
From Scrooge:
■
A registered adviser may not treat a security as
a “privately issued security,” which is not
required to be held by a qualified custodian, if
the security is one [a security] for which
payment or transfer is controlled by or requires
approval from a third party.
■
The adviser to a hedge fund that has annual
audited financial statements that are not
presented in accordance with GAAP, because
the fund has amortized organizational expenses
rather than immediately expensing those costs,
must provide quarterly custody reports to the
investors in the fund (if the financial statements
were prepared in accordance with GAAP, the
quarterly custody reports would not be
required).
An adviser to a family investment fund must
count all owners of the fund, including family
members, as clients. However, certain family
members sharing the same residence (and certain
trusts with such family members as the only
beneficiaries) may be counted as a single client.
RELATED ISSUES
The SEC Response Letter also addressed several
other issues related to hedge funds arising under
other parts of the Advisers Act.
RECORD KEEPING
From Santa:
■
PRINCIPAL TRANSACTIONS
From Scrooge:
■
The prohibition in Section 206(3) of the Advisers
Act against principal transactions between a
registered adviser and a client may apply to
rebalancing and other transactions between a
hedge fund with significant investments by the
adviser and its employees, and a separate hedge
fund managed by the adviser.
FORM ADV
From Scrooge:
■
3
An adviser to a master-feeder fund structure
must complete item 7.B of Schedule D of Form
ADV to report both the feeder fund(s) and the
A foreign prime broker is a “qualified
custodian” that can hold a hedge fund’s assets
under the custody rule (Rule 206(4)-2), if the
specific risks of using that foreign prime broker
as a custodian are discussed in the fund’s
offering memorandum and the adviser’s Form
ADV, and the foreign prime broker
appropriately segregates the fund’s assets.
A registered adviser may use a third party
administrator to maintain the adviser’s required
books and records, and still comply with the
requirement that an adviser maintain and
preserve the records for the first two years at
the appropriate office of the investment
adviser, as long as the administrator: (1) acts as
a service provider in maintaining, preparing,
organizing and updating the records of the
adviser, and not act merely to provide longterm storage of the records; and (2) promptly
produces the records for the SEC staff upon its
request at the office of the adviser or
administrator.
Kirkpatrick & Lockhart Nicholson Graham
LLP
|
DECEMBER 2005
■
The records of an offshore private fund formed
as a corporation are not books and records that
must be maintained by the adviser to that fund,
if a majority of the fund’s directors are not
affiliated with the adviser, and neither the
adviser nor any of its related persons acts as
the private fund’s general partner, as its
managing member, or in a similar capacity.
Robert H. Rosenblum
202.778.9464
rrosenblum@klng.com
Thomas A. Hickey, III
617.261.3208
thickey@klng.com
Douglas F. MacLean
617.261.3134
dmaclean@klng.com
For more information you may also visit our website at www.klng.com, or send general inquiries via e-mail to
hedgefunds@klng.com.
BOSTON
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
617.261.3133
617.261.3156
617.261.3163
617.261.3208
Nicholas S. Hodge
George Zornada
617.261.3210 nhodge@klng.com
617.261.3231 gzornada@klng.com
LONDON
Philip J. Morgan
Neil D. Robson
LOS ANGELES
William P. Wade
mcaccese@klng.com
pfina@klng.com
mgoshko@klng.com
thickey@klng.com
+44.20.7360.8123 pmorgan@klng.com
+44.20.7360.8130 nrobson@klng.com
310.552.5071 wwade@klng.com
NEW YORK
Robert J. Borzone, Jr. 212.536.4029
Jeffrey M. Cole
212.536.4823
Ricardo Hollingsworth 212.536.4859
Beth R. Kramer
212.536.4024
Richard D. Marshall
212.536.3941
Keith W. Miller
212.536.4045
Scott D. Newman
212.536.4054
rborzone@klng.com
jcole@klng.com
rhollingsworth@klng.com
bkramer@klng.com
rmarshall@klng.com
kmiller@klng.com
snewman@klng.com
SAN FRANCISCO
Jonathan D. Joseph
David Mishel
Timothy B. Parker
Mark D. Perlow
415.249.1012
415.249.1015
415.249.1042
415.249.1070
Richard M. Phillips
415.249.1010 rphillips@klng.com
WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Deborah A. Linn
Cary J. Meer
R. Charles Miller
Charles R. Mills
Jean E. Minarick
David Pickle
Theodore L. Press
Robert H. Rosenblum
William A. Schmidt
Donald W. Smith
Martin D. Teckler
Robert J. Zutz
202.778.9068
202.778.9886
202.778.9289
202.778.9046
202.778.9874
202.778.9107
202.778.9372
202.778.9096
202.778.9029
202.778.9887
202.778.9025
202.778.9464
202.778.9373
202.778.9079
202.778.9890
202.778.9059
jjoseph@klng.com
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tpress@klng.com
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