July 9, 2010
Authors:
Edward G. Eisert
edward.eisert@klgates.com
+1.212.536.3905
Rebecca H. Laird
rebecca.laird@klgates.com
+1.202.778.9038
Cary J. Meer
cary.meer@klgates.com
+1.202.778.9107
Mark D. Perlow
Increased Regulation of U.S. and Non-U.S. Private
Fund Advisers Under the Dodd-Frank Act
K&L Gates published this alert prior to July 21, 2010, the date on which President Obama signed the
Dodd-Frank Wall Street Reform and Consumer Protection Act into law. However, this alert discusses the
final version of the bill that would eventually be signed into law.
The long-awaited financial reform bill, now entitled The Dodd-Frank Wall Street
Reform and Consumer Protection Act (the “Dodd-Frank Bill” or the “Bill”), appears to
be moving toward passage by the Senate and enactment into law later this month.1
This Alert provides an overview of those provisions of the Dodd-Frank Bill that are
likely to most directly affect investment advisers to hedge, private equity and venture
capital funds, wherever such advisers and funds are domiciled.2 Please see the K&L
Gates Newsstand and the K&L Gates Global Financial Market Watch Blog for
additional background and detailed analysis about the legislative history of the DoddFrank Bill.
mark.perlow@klgates.com
+1.415.249.1070
I. Overview
The authors acknowledge the assistance
of associates Megan Munafo and Jarrod
Melson in the preparation of this Alert.
The Dodd-Frank Bill, as currently drafted, would:
K&L Gates includes lawyers practicing out
of 36 offices located in North America,
Europe, Asia and the Middle East, and
represents numerous GLOBAL 500,
FORTUNE 100, and FTSE 100
corporations, in addition to growth and
middle market companies, entrepreneurs,
capital market participants and public
sector entities. For more information,
visit www.klgates.com.
•
dramatically alter the scope of required federal investment adviser registration
under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), by:
o
removing the private adviser exemption in Section 203(b)(3), which many
advisers to “Private Funds”3 have relied upon in remaining unregistered;
o
creating new exemptions from federal registration, including exemptions for:
ƒ
“foreign private advisers”;
ƒ
advisers solely to Private Funds if these advisers have assets under
management in the United States of less than $150 million;
1
The Dodd-Frank Bill initially emerged from a joint House-Senate Conference Committee in the early
hours of Friday, June 25, based upon a heavily negotiated integration of the bill passed by the House on
December 12, 2009 and the bill passed by the Senate on May 20, 2010. The Dodd-Frank Bill was
passed by the House on June 30, 2010, but its consideration by the Senate has been delayed until after
th
the July 4 holiday recess.
2
Most, but not all, of the provisions relating to investment advisers to Private Funds are contained in
Title IV of the Dodd-Frank Bill, entitled the “Private Fund Investment Advisers Registration Act of 2010.”
Many other provisions of the Dodd-Frank Bill indirectly affect investment advisers, including advisers to
Private Funds. Please see the following K&L Gates Alerts on additional topics related to the DoddFrank Bill: Financial Regulatory Reform - The Next Chapter: Unprecedented Rulemaking and
Congressional Activity (July 7, 2010); Consumer Financial Services Industry, Meet Your New Regulator
(July 7, 2010); Investor Protection Provisions of Dodd-Frank (July 1, 2010); New Executive
Compensation and Governance Requirements in Financial Reform Legislation (July 7, 2010).
3
The Dodd-Frank Bill defines a “Private Fund” for purposes of Title IV as one that would be an
investment company but for the exclusions in Section 3(c)(1) and Section 3(c)(7) of the Investment
Company Act of 1940, as amended. Unless otherwise noted, the term “Private Fund” as used in this
Alert should be read to have the same meaning.
Financial Services Reform Alert
o
ƒ
advisers solely to “venture capital
funds” (subject to new recordkeeping
and filing requirements);
ƒ
advisers to small business investment
companies;
ƒ
“family offices”; and
ƒ
advisers
registered
with
the
Commodity
Futures
Trading
Commission (“CFTC”) as commodity
trading advisors (“CTAs”) that advise
Private Funds;
increasing the minimum assets under
management for federal registration from
$25 million to $100 million (subject to
certain conditions), and giving the
Securities and Exchange Commission (the
“SEC”) the authority to further increase this
minimum;
•
impose significant new recordkeeping and filing
requirements upon registered investment
advisers to Private Funds and subject them to
new examination requirements;
•
change the manner in which a natural person’s
net worth is calculated for purposes of
determining whether such person is an
“accredited investor” under Regulation D of the
Securities Act of 1933, as amended (the
“Securities Act”), to exclude the value of the
person’s primary residence;
•
permit the SEC initially to review the natural
person accredited investor standard (other than
the net worth test) and also require the SEC to
review, and possibly adjust, the accredited
investor standard in its entirety no earlier than
four years after the enactment of the Bill and
then every four years thereafter;
•
require the SEC periodically to adjust for
inflation any dollar amount used in determining
if a client or investor is a “qualified client”
under the Advisers Act (from whom a registered
adviser may receive a performance-based fee or
allocation);
•
place severe limitations on the ability of U.S.
and certain non-U.S. financial institutions
regulated by the Federal Reserve to sponsor or
invest in “hedge funds” or “private equity
funds” (“Covered Funds”);4
•
grant the Financial Stability Oversight Council
(the “FSOC”)5 the ability to impose additional
regulation on certain nonbank financial
companies deemed large enough to pose a
systemic risk, which could include certain large
Private Funds or Private Fund complexes and
their advisers; and
•
mandate that the Government Accountability
Office (the “GAO”) and the SEC conduct
several studies and make reports thereon to
Congress.
II. Dramatic Changes to the Scope and
Contours of Investment Adviser
Registration
The Dodd-Frank Bill dramatically reshapes the
universe of advisers required to register under the
Advisers Act, as described below.
The Bill
provides that all of the provisions discussed below
(other than the provisions described in Sections VI
and VII) take effect one year after the passage of the
Bill, although an adviser may register with the SEC
prior to that date in the adviser’s discretion and
4
For these purposes, the Dodd-Frank Bill explicitly defines
“hedge fund” and “private equity fund” to mean: “an issuer that
would be an investment company, as defined in the
Investment Company Act of 1940… but for section 3(c)(1) or
3(c)(7) of that Act, or such similar funds as the appropriate
Federal banking agencies, the [SEC] and the [CFTC] may, by
rule… determine.”
5
The FSOC, created by the Dodd-Frank Bill, is an interagency body charged with identifying and monitoring systemic
risks to the financial markets, including those posed by U.S.
and non-U.S. “nonbank financial companies.” The FSOC is
composed of ten voting members, nine of which are granted a
seat ex officio and one independent member appointed
directly by the President. The ex officio members include,
among others, the Secretary of the Treasury (who serves as
chairperson of the FSOC), the Chairman of the Federal
Reserve, the Comptroller of the Currency, the Director of the
Bureau of Consumer Financial Protection created under the
Dodd-Frank Bill, the Chairperson of the SEC, the Chairperson
of the CFTC, the Chairperson of the Federal Deposit
Insurance Corporation (the “FDIC”) and other high ranking
officials from various governmental and regulatory authorities.
The Dodd-Frank Bill provides that the FSOC shall have
certain non-voting members serving in an advisory capacity,
including a state banking supervisor, a state insurance
commissioner and a state securities commissioner.
July 9, 2010
2
Financial Services Reform Alert
subject to the rules of the SEC. The SEC will likely
provide some guidance on how advisers can register
(or de-register) in advance of the effective date in
order to provide for as smooth a transition as
possible.
A. Rescission of the Private Adviser
Exemption. The Dodd-Frank Bill rescinds
Section 203(b)(3) of the Advisers Act, commonly
referred to as the “Private Adviser Exemption” on
which many advisers to Private Funds have relied.
The Private Adviser Exemption has provided an
exemption from Advisers Act registration for an
adviser that would have otherwise been required to
register if (1) during any rolling 12-month period it
had fewer than 15 clients, (2) it did not serve as
adviser to a registered investment company under
the Investment Company Act of 1940, as amended
(the “Company Act”), or a company that had elected
to be registered as a business development company
under the Company Act (a “BDC”), and (3) it did
not hold itself out to the public as an investment
adviser. Generally, subject to certain exceptions, an
adviser to a private investment fund could treat each
fund it advised as a single client, allowing an adviser
to manage up to 14 funds without registration.6
has no place of business in the United
States;
•
has, in total, fewer than 15 clients and
investors in the United States in Private
Funds advised by the investment adviser;7
•
has aggregate assets under management
attributable to clients in the United States
and investors in the United States in Private
Funds advised by the investment adviser of
less than $25 million, or such higher
amount as the SEC may, by rule, deem
appropriate; and
•
neither:
o
holds itself out generally to the
public in the United States as an
investment adviser; nor
o
acts as (i) an investment adviser to
any investment company registered
under the Company Act; or (ii) a
BDC.
Although the Dodd-Frank Bill definition of
Foreign Private Adviser is based upon the
Private Adviser Exemption, it differs from that
exemption in its computation of clients and
investors in two key respects that are likely to
raise interpretive issues.
Most of the advisers that have relied upon the
Private Adviser Exemption will be required to
register either with the SEC or state regulators
because of the limited scope of the new exemptions
from registration provided in the Bill.
First, the Dodd-Frank Bill does not provide a
timeframe for calculating the number of clients
for purposes of the 15-client limit, as did the
Private Adviser Exemption. Accordingly, it is
not clear under the Dodd-Frank Bill whether
non-U.S. domiciled advisers will be able to rely
upon the Foreign Private Adviser exemption if
they have 15 or fewer current U.S. clients or if
the exemption becomes unavailable once an
adviser has had more than 15 current and
former U.S. clients. This omission will create
uncertainty for non-U.S. advisers until it is
resolved through interpretative relief or
enforcement action.
B. New Exemptions from Registration.
1. Foreign Private Adviser Exemption.
a. Overview of the Exemption. The Dodd-Frank
Bill provides an exemption from the registration
requirements of the Advisers Act to any
“Foreign Private Adviser,” defined to mean any
adviser who:
6
Rule 203(b)(3)-1 generally provides that an investment
adviser could deem “the following to be a single client for
purposes of [the Private Adviser Exemption]… (2)(i) a
corporation, general partnership, limited partnership, limited
liability company, trust… or other legal organization… to which
[the adviser provides] investment advice based on its
investment objectives rather than the individual investment
objectives of its shareholders, partners, members or
beneficiaries[.]”
•
7
This language is intended to make clear that advisers would
be required to aggregate the number and assets of U.S.based clients and investors in Private Funds they manage for
purposes of counting the number of their clients and of the
assets under management test.
July 9, 2010
3
Financial Services Reform Alert
.
b. Issues Regarding the Exemption. The
Bill’s definition of Foreign Private Adviser
includes a requirement that the adviser have no
more than $25 million in assets under
management attributable to the adviser’s clients
or investors in the United States (a concept
which it does not define). This requirement may
prove to be too crude a measure of whether the
activities of a foreign adviser may have a
substantial likelihood of having a material
impact on U.S. persons or markets.10 For
example, a foreign adviser with one large and
sophisticated client investing more than $25
million solely in non-U.S. securities would be
regulated by the SEC, whereas a foreign adviser
with 14 unsophisticated individual clients (with
an aggregate of less than $25 million in assets
under management from those clients) investing
in U.S. securities would not be regulated.
Second, the Dodd-Frank Bill makes it clear that,
in calculating the number of its clients, a
Foreign Private Adviser must “look through”
the Private Funds it advises to count the number
of investors in the United States in such funds.8
This new methodology of counting the number
of clients of a non-U.S. adviser is inconsistent
with the methodology applied under the
Advisers Act subsequent to the Goldstein
decision9 as reflected in Rule 203(b)(3)-1 and
Rule 222-2 of the Advisers Act.
Under
Rule 203(b)(3)-1, as noted above, a Private
Fund generally counts as one client. Under
Rule 222-2, this definition of client remains
relevant for purposes of determining whether,
under Section 222 of the Advisers Act, a state
may require an investment adviser with no place
of business in such state to register as an
investment adviser with that state, since the state
may only do so if the adviser has, within the
preceding 12-month period, at least six clients
who are residents of that state.
In addition, the Bill defines a “Private Fund” to
be a fund that relies upon either Section 3(c)(1)
or Section 3(c)(7) of the Company Act without
regard to whether the fund is formed in a nonU.S. jurisdiction or the percentage of its
securities held by U.S. persons.11 Of course, as
a general matter, a non-U.S. fund with a single
U.S. investor may have to rely on one of these
two sections to avoid Company Act
registration. Accordingly, under the Bill, the
definition of a Private Fund includes funds
organized outside of the United States and
managed by non-U.S. advisers without regard
to the percentage ownership of such funds by
U.S. persons, their investment programs, or
whether the non-U.S. advisers or funds are
subject to a robust regulatory scheme
administered by a competent non-U.S.
regulator. For example, a fund organized in the
Cayman Islands, managed by an adviser that
has its only place of business in the U.K. and
If a non-U.S. adviser with a principal office and
place of business outside of the United States
does not meet the exemption for a Foreign
Private Adviser, it should still be able to register
federally regardless of the newly increased $100
million minimum asset under management
requirement for federal registration (discussed
below). As set forth in Section 410 of the
Dodd-Frank Bill, the minimum assets under
management requirement is drafted to apply
only to an adviser that otherwise would be
subject to registration with the securities
commission (or like agency) of the state in
which it maintains its principal office and place
of business.
8
However, Section 406 of the Bill explicitly prohibits the SEC
from defining the term “client” for purposes of 206(1) and (2) of
the Advisers Act, two of the Advisers Act’s antifraud
provisions, “to include an investor in a private fund managed
by an investment adviser, if such private fund has entered into
an advisory contract with such adviser.” It is unclear whether a
limited partnership agreement or limited liability company
agreement that contains the provisions normally found in an
advisory contract would constitute an “advisory contract”
between the general partner or managing member of such
fund and its investors for this purpose.
9
Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).
10
This is the standard that the SEC and the courts traditionally
have used in determining the extraterritorial effect of the U.S.
securities laws.
11
In other instances, the SEC has used the definition of “U.S.
person” set forth in Rule 902 of Regulation S under the
Securities Act when a definition of “U.S. person” is required.
See, e.g., Rule 500 of Regulation AC under the Securities
Exchange Act of 1934, as amended.
July 9, 2010
4
Financial Services Reform Alert
that invests all of its assets in securities that are
not traded on U.S. markets is a Private Fund if
any of the shares or interests in the fund are
owned by U.S. persons. Under these
circumstances, the U.K.-based adviser would be
required to register, unless it qualifies as a
Foreign Private Adviser or under another
exemption. Complicated issues may arise as to
the extent to which the requirements of the
Advisers Act would apply to the non-U.S.
operations, clients or accounts managed or
serviced by such adviser and its non-U.S.
regulated affiliates.12 These issues may lead
many non-U.S. Private Fund advisers to avoid
U.S. investors.13
there is a significant possibility that the SEC
will create a very narrow definition of “venture
capital fund,” erring on the side of
overinclusiveness
in
requiring
adviser
registration. Such a narrow definition could
undermine the Congressional purpose in
exempting venture capital fund advisers.
When the SEC attempted to compel hedge fund
advisers to register in 2004, it distinguished
between private funds that did, and did not, lock
up their investors’ capital for two years or more
as a means of distinguishing between “hedge
funds” and other types of Private Funds; it is
conceivable that in implementing the Bill, the
SEC would use similar criteria, perhaps with a
longer lock-up period required to avoid
registration. This could lead to changes in the
structure of the Private Fund industry as
advisers seek to avoid registration by extending
the lock-up period of their funds, as was the
case after the 2004 registration requirement was
adopted.
2. Advisers Solely to Venture Capital Funds.
a. Overview of the Exemption. Section 407 of
the Dodd-Frank Bill provides an exemption
from registration for advisers that solely advise
one or more “venture capital funds,” a term the
Dodd-Frank Bill requires the SEC to define
within one year after the enactment of the Bill.
Although such advisers are exempt from
registration, the Dodd-Frank Bill mandates the
SEC “to require such advisers to maintain such
records and provide to the [SEC] such annual or
other reports as the [SEC] determines necessary
or appropriate in the public interest or for the
protection of investors.” There is no similar
exemption for advisers solely to private equity
funds, as had been included in an earlier version
of the financial reform bill.
b. Issues Regarding the Exemption. There is
no commonly accepted definition of “venture
capital fund.” Because of the blurring of the
lines between the private equity and venture
capital industries, it may be difficult for the SEC
to define “venture capital fund” in a manner that
is not open to abuse by private fund advisers
seeking to avoid registration. Accordingly,
3. “Mid-Sized”
Private
Fund
Advisers.
Section 408 of the Dodd-Frank Bill requires the
SEC to provide an exemption from registration
“to any investment adviser [who]… acts solely
as an adviser to Private Funds and has assets
under management in the United States of less
than $150,000,000.” Although they will be
exempted from registration, the SEC must
require this class of exempted advisers to
maintain “such records and provide to the
[SEC] such annual or other reports as the [SEC]
determines necessary or appropriate in the
public interest or for the protection of
investors.”14
The scope of the exemption that will be
provided under these provisions is unclear
because, among other matters, in prescribing
regulations to carry out the foregoing
requirements, the Bill requires the SEC to “take
into account the size, governance, and
investment strategy of such funds to determine
whether they pose systemic risk, and shall
provide for registration and examination
12
See, e.g., Uniao de Banco de Brasileiros S.A., SEC NoAction Letter (pub. avail. July 28, 1992); ABN AMRO Bank,
N.V., SEC No-Action Letter (pub. avail. July 1, 1997).
13
For a more detailed discussion of these issues, please see
the discussion of the definition of a “hedge fund” in K&L Gates’
March Alert entitled: “New Dodd Bill Would Dramatically Step
Up Regulation of Private Fund Advisers.”
14
Dodd-Frank Bill § 408.
July 9, 2010
5
Financial Services Reform Alert
procedures with respect to the investment
advisers of such funds which reflect the level of
systemic risk posed by such funds.”15 These
advisers and funds could, therefore, still be
subject to regulation and oversight similar in
nature or rigor as that applicable to registered
advisers and their Private Funds. The utility of
this exemption also is limited because it is
unavailable
to
advisers
who
provide
management services to Private Funds as well as
other types of clients, such as separate account
clients.
registered investment advisers that identify
investment opportunities to the family office
and invest in those opportunities on
substantially the same terms, subject to
specified conditions. Unlike exempt advisers to
venture capital funds, however, exempted
family offices are not required by the Bill to
maintain such records and provide to the SEC
such reports as the SEC determines to be
necessary or appropriate in the public interest or
for the protection of investors.
The scope and contours this exemption will
take as a result of SEC rulemaking are unclear.
Previously, many advisers to a single family
attempted to stay within the Private Adviser
Exemption. The SEC has, however, historically
granted exemptive orders to certain family
offices that exceeded the 15-client limitation of
the Private Adviser Exemption on a case-bycase basis.16 Given that the Private Adviser
Exemption will be rescinded on the first
anniversary of the Bill’s passage and that there
is no timeframe specified for the adoption of a
rule defining “family office,” these advisers
may face increased uncertainty.
4. Advisers to “Small Business Investment
Companies.” The Dodd-Frank Bill provides an
exemption from the requirement to register
under the Advisers Act for advisers (other than
entities regulated as BDCs) who solely advise
small business investment companies that are
licensed by the Small Business Administration
(the “SBA”) under the Small Business
Investment Act of 1958, have received from the
SBA notice to proceed to qualify for a license,
or are pending applicants that are affiliated with
one or more licensed small business investment
companies.
5. Family Offices. The Dodd-Frank Bill provides a
new exemption from the definition of
“investment adviser” under the Advisers Act for
a “family office.” The Dodd-Frank Bill requires
the SEC to define the term “family office,” but,
in contrast to the requirement for defining
“venture capital fund,” the Bill does not specify
a date by which the SEC must provide a
definition. The Bill also requires the SEC to
implement the family office exemption in a
manner consistent with regulatory relief granted
in the past, to recognize “the range of
organizational, management, and employment
structures and arrangements employed by family
offices.” The SEC also may not exclude from
the exemption certain persons who were not
registered or required to be registered on
January 1, 2010 in providing investment advice
to, among others, any “company owned
exclusively and controlled by members of the
family of the family office” and certain
15
Id.
6. Registered CTAs.
The Advisers Act has
provided and continues to provide an exemption
from registration for an adviser that is
registered with the CFTC as a CTA whose
business “does not consist primarily” of acting
as an investment adviser, as defined in the
Advisers Act, and that does not primarily act as
an investment adviser or act as an investment
adviser to investment companies registered
under the Company Act or BDCs. The DoddFrank Bill adds a new exemption for an adviser
that is registered with the CFTC as a CTA and
advises a Private Fund, provided that, if after
the enactment of the Dodd-Frank Bill, the
“business of the advisor should become
16
The first of these orders was In the Matter of Donner
Estates, Inc., Investment Advisers Act Release No. 21 (Nov.
3, 1941). Over the years, the SEC has granted exemptive
relief on a case-by-case basis in other circumstances where
an adviser provides services to a single family and a limited
number of closely related persons (such as the portfolio
managers of the family office adviser) and where the family
office is intended to serve the family’s interests, is controlled
by family members and does not itself pursue profit.
July 9, 2010
6
Financial Services Reform Alert
predominantly the provision of securities-related
advice, then such adviser shall register with the
[SEC].”
to deregister if it no longer qualifies for federal
registration; it is not clear whether the SEC will
provide some form of “grandfathering” relief.
C. Raising the Federal Registration Minimum
Assets Under Management. Section 410 of the
Dodd-Frank Bill prohibits an adviser from
registering with the SEC if: (i) it is required to be
registered as an investment adviser with the
securities regulator of the state in which it maintains
its principal office and place of business and, if
registered, it would be subject to examination; and
(ii) it has assets under management between
$25 million and $100 million (as such amounts may
be increased by the SEC by rule), unless: (x) it is an
adviser to an investment company registered under
the Company Act or a company that has elected to
be a BDC pursuant to the Company Act and has not
withdrawn its election; or (y) it would be required to
register with 15 or more states.
III. Imposition of Significant New
Recordkeeping
and
Filing
Requirements and Potential Additional
Custody Requirements
Previously, an investment adviser with $25 million
under management, but less than $30 million, had
the option of registering federally. An adviser with
$30 million or more under management was
required to register federally, absent an exemption.
As a result of the change effected by the Dodd-Frank
Bill, state agencies and examiners will take over the
regulation of a large portion of smaller advisers,
including advisers to small Private Funds. Some,
including SEC Commissioners, have expressed
concern over the states’ ability to assume the
increased financial and inspection burden resulting
from this higher registration threshold.17
Another issue presented by the Bill is whether an
adviser that is now registered based on satisfying the
existing $25 million asset threshold will be required
17
In an April 19, 2010 interview with Melanie Waddell on the
website www.investmentadvisor.com, Chairwoman Schapiro
stated that the increase to $100 million “results in about 40%
of investment advisors who are currently subject to SEC
registration being state regulated—about 4,000 plus advisors”
and expressed concern about “whether the states have
resources, particularly at this time, to take on an additional
4,000 registrants[.]” See Melanie Waddell, As Goldman Fraud
Case Raises SEC Self-Funding Issue and Reform Bill Looms,
Schapiro Talks to IA on Reform, www.investmentadvisor.com
(April 19, 2010)(available here.)See also Commissioner Elisse
B. Walter, Remarks at the 2010 Investment Adviser
Compliance Forum (February 25, 2010) (available at
http://www.sec.gov/news/speech/2010/spch022510ebw.htm).
A. Private Fund Records and Reports.
1. Types of Records and Information. Section 404
of the Dodd-Frank Bill provides the SEC with
the authority to require advisers to Private
Funds to maintain records, file reports and,
upon request or examination, produce records
regarding those Private Funds. Under the
Dodd-Frank Bill, a registered adviser to Private
Funds must maintain records regarding its
Private Funds (which will be treated as the
adviser’s own records and be made available
for inspection by the SEC) that include a
description of:
•
amount of assets under management and
use of leverage, including off-balance-sheet
leverage,
•
counterparty credit risk exposure,
•
trading and investment positions,
•
valuation policies and practices,
•
types of assets held,
•
side arrangements or side letters whereby
certain investors obtain more favorable
rights than other investors,
•
trading practices, and
•
such other information as the SEC (in
consultation with the FSOC) determines is
necessary and appropriate in the public
interest and for the protection of investors
or for the assessment of systemic risk.
The Dodd-Frank Bill requires the SEC to issue
rules requiring each adviser to a Private Fund to
file reports containing such information as the
SEC deems necessary and appropriate. The
SEC is given the ability to establish different
reporting requirements for different “classes” of
Private Fund advisers based on the type or size
July 9, 2010
7
Financial Services Reform Alert
of Private Fund(s) advised. As noted above,
advisers solely to venture capital funds are
exempted from registration but will be required
to “maintain such records and provide to the
[SEC] such records… as the [SEC] determines
necessary or appropriate.”18
Taken as a whole, the provisions of the Bill
mandating more rigorous regulation and
recordkeeping will create greater challenges for
smaller managers, which may lack the resources
to comply with these requirements, and thus
may accelerate the trend toward concentration in
the hedge fund industry.
2. Maintenance Period. The Dodd-Frank Bill
grants the SEC the ability to determine by rule
the period for which these records must be
maintained.
Thus, information regarding
Private Funds could be subject to the normal
record retention requirements of the Advisers
Act, or it could be subject to a different holding
period or set of holding period requirements.
Different holding periods could create
complications for advisers managing Private
Fund and other types of accounts.
B. Confidentiality of Private Fund Records and
Reports.
1. Information Sharing. As noted above, the SEC
must make available to the FSOC any “reports,
documents, records, and information filed with
or provided to the SEC by an investment
adviser” regarding a Private Fund as the FSOC
considers necessary for assessing systemic risk.
It is important to note that the Dodd-Frank Bill
amends the client confidentiality protections set
forth in Section 210(c) of the Advisers Act.
Section 210(c) provides that nothing in the
Advisers Act shall allow the SEC to require an
adviser to disclose the identity, investments or
affairs of any client “except insofar as such
disclosure may be necessary or appropriate in a
particular proceeding or investigation having as
its object the enforcement of a provision or
provisions of [the Advisers Act].” The DoddFrank Bill adds to the end of this provision the
18
See Dodd-Frank Bill § 407.
additional factor: “or for the purposes of
assessing potential systemic risk.”
2. Broad Exemption from the Freedom of
Information Act (“FOIA”). Section 404 of the
Dodd-Frank Bill provides that the SEC, the
FSOC “and any other department, agency, or
self-regulatory organization that receives
information, reports, documents, records, or
information from the [SEC] under this
subsection [e.g., information regarding Private
Funds, as set forth in Section III.A. above] shall
be exempt from the provisions of Section 552
of title 5 [FOIA].”
3. Proprietary Information. The Dodd-Frank Bill
provides that any “proprietary information”
ascertained by the SEC as a result of reports
required to be filed by Private Fund advisers
shall be treated in the same manner as facts
ascertained during an examination pursuant to
Section 210(b) of the Advisers Act.
“Proprietary information” is defined to mean
“sensitive, non-public information regarding:
(i) the investment or trading strategies of the
investment adviser; (ii) analytical or research
methodologies; (iii) trading data; (iv) computer
hardware or software containing intellectual
property; and (v) any additional information the
[SEC] determines to be proprietary.”
Section 210(b) of the Advisers Act provides
that neither the SEC, nor any member, officer
or employee of the SEC shall publicly reveal
“any
facts
ascertained
during
any…
examination or investigation[,]” except with the
approval of the SEC, in the course of a public
SEC hearing or in response to a request or
resolution from either House of Congress.
4. Specific Treatment of Filed Reports. For
reports filed with the SEC regarding Private
Funds, the Dodd-Frank Bill provides that
“[n]otwithstanding any other provision of law,
the [SEC] may not be compelled to disclose any
report or information contained therein required
to be filed with the [SEC,]” except that the SEC
may not “withhold information from Congress,
upon an agreement of confidentiality” or
prevent the SEC from complying with “a
request for information from any other Federal
department or agency or any self-regulatory
July 9, 2010
8
Financial Services Reform Alert
organization requesting the report or
information for purposes within the scope of its
jurisdiction” or “an order of a court of the
United States in an action brought by the United
States or the [SEC].” The Dodd-Frank Bill
provides that any other federal agency or any
self-regulatory organization (“SRO”) that
receives reports or information pursuant to a
request described above shall maintain the
confidentiality of such information in a manner
“consistent with the level of confidentiality”
established for the SEC.
5. Annual Report to Congress. The SEC must
report annually to Congress on how it has used
the data regarding Private Funds provided
pursuant to the Dodd-Frank Bill provisions.
Notwithstanding the Bill’s provisions designed
to protect the confidentiality of information
regarding Private Funds, mistakes in handling
information and leaks from government
agencies are always a possibility. In a recent
example, earlier this year the SEC inadvertently
publicly posted on its website an earnings report
provided to it by Citadel Securities, LLC that
was intended for internal SEC review only,
giving competitors access to Citadel’s business
and operations.19 In providing documents to
government agencies, particularly in cases in
which those documents may be shared among a
wide range of agencies, information leaks
(either intentional or inadvertent) are a justified
concern for Private Fund managers.
C. Potential Additional Custody Requirements.
The SEC recently amended Rule 206(4)-2 under the
Advisers Act, the rule governing custody of client
assets by registered advisers.20 The Dodd-Frank Bill
creates a new Section 223 of the Advisers Act that
19
See Miles Weiss, Citadel Securities Filing Gives Glimpse of
Ken Griffin’s Banking Startup, Bloomberg (May 20, 2010),
available at http://www.bloomberg.com/news/2010-05-20/rgcitadel-securities-filing-gives-glimpse-of-ken-griffin-s-bankingstart.html (last visited July 5, 2010).
20
For a discussion of the amendments to the custody
provisions of the Advisers Act, see the following K&L Gates
Alerts: SEC Releases Amended Custody Rule (January 8,
2010) and SEC Offers Guidance on Looming Custody Rule
Amendments (March 10, 2010).
provides an investment adviser “shall take such
steps to safeguard client assets over which such
adviser has custody, including, without limitation,
verification of such assets by an independent public
accountant, as the [SEC] may, by rule, prescribe.”
It is unclear what additional custody rules are
envisioned or contemplated, if any, but given the
weaknesses in the custody requirements revealed by
the Madoff scandal and the SEC’s recent focus on
custody in its examination and rulemaking, new
custody provisions and requirements are possible.
IV. Restrictive Changes to
Accredited Investor Standard
Natural Persons
the
for
A. Exclusion of Value of Primary Residence.
Under existing law, a natural person qualifies as an
accredited investor if he or she (1) has an individual
net worth, or joint net worth with his or her spouse,
including any net equity in a primary residence, that
exceeds $1 million at the time of the purchase of
securities (the “Net Worth Test”), or (2) had an
individual income in excess of $200,000 in each of
the two most recent years or joint income with that
person’s spouse in excess of $300,000 in each of
those years and has a reasonable expectation of
reaching the same income level in the current year
(the “Income Test”). The Dodd-Frank Bill requires
the SEC to exclude the value of a natural person’s
primary residence in determining whether he or she
satisfies the Net Worth Test. This change will have
a particularly significant effect upon less wealthy
individual investors and the Private Funds that are
designed for this class of prospective investors.
B. Initial Adjustment. The Dodd-Frank Bill
permits the SEC to undertake an initial review of
the accredited investor definition as it applies to
natural persons. In this initial review (and for four
years following the enactment of the Dodd-Frank
Bill), the SEC cannot increase the $1 million level
of the Net Worth Test. Based on its initial review,
however, the SEC can, by notice and comment
rulemaking, modify or adjust the definition in other
ways.21 The Dodd-Frank Bill expressly prohibits
21
The SEC issued a set of proposed rules in 2007 (which
were not adopted) that would have revised portions of
Regulation D, including the definition of the term “accredited
July 9, 2010
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Financial Services Reform Alert
the SEC from raising the dollar level of the Net
Worth Test for the first four years following its
enactment, but, notably, does not include any such
prohibition on increases to the amount required to
satisfy the Income Test or the other dollar-based
tests in the definition of “accredited investor.”
C. Subsequent Adjustments. After the initial
review, the Dodd-Frank Bill requires that the SEC
review the accredited investor definition as it applies
to natural persons in its entirety no earlier than four
years after the Bill’s passage, and not less frequently
than every four years thereafter. In one or more of
these subsequent reviews, the SEC may, by notice
and comment rulemaking, propose additional
changes to the definition of accredited investor as it
applies to natural persons, including increasing the
$1 million amount of the Net Worth Test or
increasing the Income Test.
D. Issues Presented.
The exclusion of a
prospective investor’s primary residence in
satisfying the Net Worth Test as well as the SEC’s
initial and subsequent adjustments to the definition
of “accredited investor” (to a lesser extent) will
shrink the pool of natural persons who meet this
standard. Although this would not affect those
natural persons who also qualify as “qualified
purchasers” and may invest in Private Funds that
rely on Section 3(c)(7) of the Company Act, it will
affect natural persons who seek to invest in Private
Funds that rely on Section 3(c)(1) of the Company
Act and the advisers to those funds. Among other
things, it is unclear how these adjustments will affect
the ability of existing investors in a Private Fund
who become ineligible after the exclusion of a
primary residence from the Net Worth Test, or after
the initial or subsequent changes to the accredited
investor definition, from making additional
investments in the same Private Fund. It is unclear
whether the SEC might adopt some form of
grandfathering provision, which might permit such
investors to make additional investments in the
Private Funds in which they had invested prior to
any such change.
investor.” The proposing release may provide guidance on the
changes the SEC could seek to make in its initial review. See
Revisions of Limited Offering Exemptions in Regulation D,
Securities Release No. 33-8828 (August 3, 2007).
V. Indexing the Qualified
Standard to Inflation
Client
A. Initial and Periodic Adjustment.
The
Advisers Act generally prohibits an adviser from
charging a client performance-based compensation,
such as the performance fee or incentive allocation
normally charged by fund advisers to Private Funds
(and their investors).22 Rule 205-3 under the
Advisers Act, however, permits such a fee to be
charged against a client (or the investors in a Private
Fund) if that client (or each investor in a fund) is a
“qualified client” as defined in the Rule.23
Section 418 of the Dodd-Frank Bill requires that, if
the SEC uses a dollar amount test to determine who
is a “qualified client,” as it now does, it shall, not
later than one year after the enactment of the Bill
and every five years thereafter, adjust such amount
for the effects of inflation. The Bill requires any
such adjustment that is not a multiple of $100,000
to be rounded to the nearest multiple of $100,000.
B. Issues Presented. As for adjustments to the
definition of “accredited investor,” discussed above,
it is unclear how the SEC will treat persons who
previously qualified as “qualified clients” but, as a
22
See Section 205(a) of the Advisers Act, which states:
“No investment adviser, unless exempt
from registration pursuant to section
203(b), shall make use of the mails or any
means or instrumentality of interstate
commerce, directly or indirectly, to enter
into, extend, or renew any investment
advisory contract, or in any way to
perform any investment advisory contract
entered into, extended, or renewed on or
after the effective date of this title, if such
contract … (1) provides for compensation
to the investment adviser on the basis of
a share of capital gains upon or capital
appreciation of the funds or any portion of
the funds of the client…”
23
“Qualified client” is defined to mean (1) a natural person
who or a company that immediately after entering into the
contract has at least $750,000 under the management of the
investment adviser, (2) a natural person who or a company
that the investment adviser entering into the contract (and any
person acting on his behalf) reasonably believes, immediately
prior to entering into the contract, either: (i) has a net worth
(together, in the case of a natural person, with assets held
jointly with a spouse) of more than $1.5 million at the time the
contract is entered into; or (ii) is a qualified purchaser as
defined in Section 2(a)(51)(A) of the Company Act at the time
the contract is entered into; or (3) certain key personnel,
officers, directors and employees of the adviser.
July 9, 2010
10
Financial Services Reform Alert
result of the initial or subsequent changes to this
definition required by the Dodd-Frank Bill, no
longer meet the dollar-amount requirements. Under
such circumstances, it is uncertain whether an
adviser to a Private Fund could still charge a
performance fee. In addition, it is not clear whether
the SEC, in its initial adjustment of the dollaramount test, will adjust for the effects of inflation in
the many years since the test was adopted.
VI. Volcker Rule as Applied to Covered
Funds
The provisions of the Dodd-Frank Bill that are
known as the “Volcker Rule” will become a new
Section 13 of the Bank Holding Company Act
(“BHCA”). These provisions generally prohibit any
“banking entity”24 from engaging in proprietary
trading, “sponsoring” or investing in Covered Funds
or “such similar funds” as certain federal agencies
may determine by rule. “Sponsoring” a Covered
Fund is defined to include: (1) serving as a general
partner, managing member or trustee of a Covered
Fund; (2) selecting or controlling in any manner a
majority of the directors, trustees or management of
a Covered Fund; or (3) sharing with the Covered
Fund the same name or variant of a name, which is
used for corporate, marketing, promotional, or other
purposes.
A. Permissible Activities. While the Dodd-Frank
Bill contains a general prohibition on a banking
entity acquiring or retaining any equity, partnership
or other ownership interest in, or sponsoring any
Covered Fund, a banking entity, to the extent
permitted by any other provision of federal or state
law and any restrictions or limitations that the
appropriate federal regulators may determine, may
organize and offer a Covered Fund, and sponsor it,
if all of the following conditions are met:
•
The banking entity provides bona fide trust,
fiduciary, or investment advisory services;
•
The Covered Fund is organized and offered
only in connection with the provision of bona
fide trust, fiduciary or investment advisory
services and only to customers of such services
of the banking entity;
•
The banking entity does not, directly or
indirectly, guarantee, or assume or otherwise
insure the obligations or performance of the
Covered Fund or of any other Covered Fund in
which the Covered Fund invests;
•
The banking entity does not share the same
name, or variation thereof, with the Covered
Fund;
•
No director or employee of the banking entity
takes or retains an equity interest, partnership
interest or other ownership interest in the
Covered Fund, except for any director or
employee who is directly engaged in providing
investment advisory or other services to the
Covered Fund;
•
The banking entity discloses to prospective and
actual investors in the Covered Fund, in writing,
that any losses in such Covered Fund are borne
solely by investors in the Covered Fund and not
by the banking entity, and otherwise complies
24
See Section 619 of the Dodd-Frank Bill, which contains the
Volcker Rule provisions. Banking entities are defined to
include any FDIC-insured institution. FDIC-insured entities
include commercial banks, savings banks, cooperative banks
and thrifts, but also industrial loan companies and credit card
banks. The insured institution definition does not include nondepository trust companies, which are not FDIC-insured, or
those FDIC-insured trust companies that comply with the trust
company exemption under the BHCA. In addition, a “banking
entity” includes any company that controls an insured
institution, as defined, which would include the parent holding
company of an industrial loan company or credit card bank,
i.e., entities that would otherwise be exempt under the BHCA
because they are not bank holding companies for purposes of
the BHCA. Further, any company that “is treated as a bank
holding company for purposes of Section 8 of the International
Banking Act of 1978” is a “banking entity.” This includes any
foreign banking organization with a United States branch,
agency, commercial lending company or depository institution
subsidiary. It would not include a foreign banking company
with only a representative office in the United States. Finally,
a “banking entity” includes any affiliate or subsidiary of any of
the foregoing entities, which means that all subsidiaries and
affiliates of any of the “banking entities” are themselves
“banking entities.”
The Volcker Rule provisions generally apply as well to
systemically important nonbank financial companies, as
designated under the Dodd-Frank Bill. Under the Bill, the
authority of the Federal Reserve with respect to a non-U.S.
nonbank financial company, generally, includes only the U.S.
activities and subsidiaries thereof. For ease of reference, this
discussion refers only to “banking entities,” which should be
read to include a “nonbank financial company supervised by
the [Federal Reserve] Board.”
July 9, 2010
11
Financial Services Reform Alert
with any additional regulatory requirements; and
•
b) De minimis longer term investments,
which after one year are reduced to an
amount that is not more than three
percent of the total ownership, and are
“immaterial” to the banking entity. 25
In no case may the banking entity’s seed and
de minimis investments in Covered Funds
exceed three percent of the banking entity’s
tangible common equity.
The de minimis exception has generally been
reported as permitting investments in Covered Funds
as to which the banking entity has no sponsorship
role, i.e., a pure investment, as well as in Covered
Funds sponsored by the banking entity. However,
under the actual wording of the Bill, it appears that
the de minimis exception is available only for
investments in Covered Funds organized and offered
by the banking entity and sold only to customers
subject to the limitations listed above.
However, no transaction, class of transactions or
activity may be deemed to be a permitted activity if
it would:
25
Result directly or indirectly in an unsafe and
unsound exposure (to be defined by the
appropriate regulatory agencies) by the banking
entity to high risk assets or high-risk trading
strategies;
•
Pose a threat to the safety and soundness of
such banking entity; or
•
Pose a threat to the financial stability of the
United States.
The banking entity does not acquire or retain an
equity interest, partnership interest or other
ownership interest in the Covered Fund, other
than:
a) A seed investment in connection with
establishing a Covered Fund, for a
period of up to one year, which may
be up to 100% of the ownership
interests; and
•
•
Involve or result in a material conflict of interest
(to be defined by the appropriate regulatory
agencies) between the banking entity and its
clients, customers or counterparties;
A banking entity is required to seek unaffiliated investors to
reduce or dilute its seed investment to the three percent de
minimis level or make redemptions to meet this test if not
accomplished by new investments in the initial one year
period.
B. Transactions with Affiliates Restrictions. In
addition, any banking entity that serves, directly or
indirectly, as the investment manager, investment
adviser of a Covered Fund, or organizes and offers a
Covered Fund under the rules described above, and
any affiliate of such banking entity, is prohibited
from entering into a transaction with such Covered
Fund, or any other Covered Fund controlled by such
Covered Fund, that would be a covered transaction
under Section 23A of the Federal Reserve Act. A
“covered transaction” in this context would include:
(1) a loan or extension of credit to the Covered
Fund, (2) a purchase of, or an investment in,
securities issued by the Covered Fund, (3) a
purchase of assets, including assets subject to
repurchase, from the Covered Fund, (4) the
acceptance of securities issued by the Covered Fund
as collateral security for a loan, or (5) the issuance
of a guarantee, acceptance, or letter of credit on
behalf of the Covered Fund.
Under the provisions of the Volcker Rule noted
above, it is permissible for a banking entity to make
an investment in a Covered Fund in the form of a
seed or de minimis investment. This provision is
clearly inconsistent with a prohibition against
entering into a transaction that would be a
prohibited Section 23A covered transaction, which
includes investing in securities issued by an
affiliate. Furthermore, there is no special exemption
for transactions by foreign banking entities such as
those permitting investments in certain offshore
funds discussed below. Still, Congress’s clear
intent was to permit seed and other de minimis
investments, which should supersede the application
of Section 23A. Resolution of these conflicts must
await the federal regulatory agencies’ interpretation
of these provisions.
July 9, 2010
12
Financial Services Reform Alert
In addition, any banking entity that serves, directly
or indirectly, as the investment manager or
investment adviser – but not sponsor – of a Covered
Fund, or that organizes and offers a Covered Fund as
a permissible activity, will be subject to
Section 23B of the Federal Reserve Act.
Section 23B generally requires that all transactions
between a member bank and its affiliates be
conducted on terms that are at least as favorable to
the bank as those prevailing at the time for
comparable
transactions
with
unaffiliated
companies. This could mean, for example, that,
when a banking entity is serving as investment
adviser to a Covered Fund, the Covered Fund would
have to pay the bank affiliated adviser and all other
bank-affiliated service providers no less than market
rates. Banking entities might also be restricted in
the extent to which they can provide waivers of
service fees to Covered Funds.
The Federal Reserve Board may grant an exemption
from the transactions with affiliates rules found in
Section 23A of the Federal Reserve Act to allow a
banking entity to enter into a prime brokerage
transaction with a Covered Fund managed,
sponsored or advised by such banking entity if the
banking entity is in compliance with the permissible
activities provisions, the banking entity enters into
an enforceable undertaking that the transaction will
not be used to avoid losses to any investor in a
Covered Fund, and the Federal Reserve Board has
determined that such transaction is consistent with
the safe and sound operation of the banking entity.
C. Offshore Funds. The Volcker Rule provisions
also contain an exception for the acquisition or
retention of any equity, partnership, or other
ownership interest in, or sponsorship of, a Covered
Fund by a banking entity described in paragraphs (9)
or (13) of Section 4(c) of the BHCA that is solely
outside of the United States, but only if no
ownership interest in such Covered Fund is offered
for sale or sold to a resident of the United States.
Further, the banking entity may not be directly or
indirectly controlled by a U.S. banking entity.
Section 4(c)(9) of the BHCA exempts from the
BHCA’s non-banking prohibitions shares held or
activities conducted by a foreign company, the
greater part of whose business is conducted outside
of the United States. Under Section 4(c)(13) of the
BHCA, shares of, or activities conducted by,
companies that do no business in the United States,
except as incidental to their international or foreign
business, are exempted from the BHCA. This
exemption will not be of use to sponsors of offshore
Covered Funds that have both U.S. and non-U.S.
investors. Moreover, foreign banking entities may
still be restricted in dealing with Covered Funds by
the transactions with affiliates rules discussed
above.
D. Capital. The federal regulatory agencies are
required to adopt rules imposing additional capital
requirements and quantitative limitations on
permissible activities as necessary to protect the
safety and soundness of banking entities. For
purposes of determining compliance with any such
rules, the aggregate amount of outstanding
investment by a banking entity in seed capital and
de minimis investments in a Covered Fund must be
deducted from the assets and the tangible capital of
the banking entity.
E. Exceptions and Anti-Evasion. The federal
regulatory agencies may determine that other
activities are permissible that would “promote and
protect” the safety and soundness of banking
entities and the financial stability of the United
States. The federal regulatory agencies must issue
rules regarding internal controls and recordkeeping
to insure compliance with the Volcker Rule. In
addition, the federal regulatory agencies are
required to order termination of an investment or
activity that functions as an evasion of the rules.
F. Effective Date and Rulemaking and
Transition. Regulations implementing the Volcker
Rule must be promulgated by the appropriate
Federal banking agencies (with regard to insured
depository institutions), the Federal Reserve Board
(with regard to holding companies and affected
nonbank financial companies), the SEC (with
respect to any entity for which the SEC is the
primary regulatory agency) and the CFTC (with
respect to entities for which the CFTC is the
primary federal agency), after coordination among
the agencies and with the intent of adopting
comparable regulations. In addition, the Chair of
the FSOC has responsibility for coordinating the
regulations issued by the agencies. The agencies
are required to act within nine months after the
July 9, 2010
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Financial Services Reform Alert
completion of a six month study by the FSOC on
implementation of the Volcker Rule.
before the FSOC, as well as judicial review, of these
determinations.
In any event, the Volcker Rule provisions will take
effect on the earlier of 12 months after the issuance
of final rules implementing the Bill or two years
after the date of enactment.
The Dodd-Frank Bill contemplates that the Federal
Reserve will regulate systemically significant
companies under stringent prudential standards
based on those recommended by the FSOC or that
the Federal Reserve establishes on its own. The
recommendations of the FSOC with respect to
nonbank financial companies could include:
(1) risk-based or contingent capital requirements;
(2) leverage limits; (3) liquidity requirements;
(4) resolution plan and credit exposure report
requirements; (5) concentration limits; (6) enhanced
public disclosures; (7) short-term debt limits; and
(8) overall risk management requirements.
However, in making such recommendations, the
FSOC is required to take into account, among other
things, differences among nonbank financial
companies and bank holding companies.27 These
enumerated requirements are primarily oriented
toward the regulation of banks and broker-dealers,
and advisers to Private Funds are likely to find it
difficult to operate within such a framework, unless
it is tailored to their particular circumstances.
Within two years after the effective date of the
requirements, banking entities must bring their
investments and activities into compliance with the
statute. The Federal Reserve Board may extend the
two-year period for not more than one year at a time
for a total of three years in the aggregate. With
regard to divestiture of illiquid Covered Funds, the
Federal Reserve Board may extend the transition
period for up to a maximum of five years on a caseby-case basis.
An illiquid Covered Fund is a
Covered Fund that, as of May 1, 2010, was
principally invested in and contractually committed
to principally invest in illiquid assets, such as
portfolio companies, real estate investments and
venture capital investments and that makes all
investments pursuant to and consistent with an
investment strategy to invest in illiquid assets.
VII. Potential for Additional Regulation
at FSOC Recommendation
The FSOC is charged with identifying and
monitoring systemic risks to the financial markets,
including those posed by certain U.S. and non-U.S.
“nonbank financial companies,” a term defined in
Section 102 of the Dodd-Frank Bill broadly enough
to encompass Private Funds and their advisers.
Under Section 113 of the Dodd-Frank Bill, the
FSOC could require, by a two-thirds vote (including
a vote of the Chairperson of the FSOC), that any
nonbank financial company (including a non-U.S.
nonbank financial company) whose material
financial distress could pose a threat to the financial
stability of the United States be placed under the
supervision of the Federal Reserve.26 Section 113
provides for notice and an opportunity for a hearing
VIII. Mandated Studies
The Dodd-Frank Bill requires various government
agencies to conduct a wide range of studies. Listed
below are those studies most relevant to Private
Funds and their advisers, though this list is by no
means exhaustive.
A. GAO Studies. Among a range of other
required studies, the Dodd-Frank Bill directs the
Comptroller General, the head of the GAO, the
investigative agency of Congress, to conduct studies
and submit reports to specified House and Senate
Committees on the following subjects:
1. Accredited Investor Qualifications Study.
Notwithstanding that the SEC is required
periodically to review the definition of
“accredited investor” in the context of a natural
26
Section 170 of the Dodd-Frank Bill would require the Federal
Reserve to promulgate regulations on behalf of, and in
consultation with, the FSOC that set forth the criteria “for
exempting certain types or classes of U.S. nonbank financial
companies or [non-U.S.] nonbank financial companies” from
supervision by the Federal Reserve.
27
In making recommendations concerning the prudential
standards applicable to such non-U.S. nonbank financial
companies, the FSOC would be required to “give due regard
to the principle of national treatment and equality of
competitive opportunity.”
July 9, 2010
14
Financial Services Reform Alert
person, the GAO is required to study the
appropriate criteria for determining the financial
thresholds or other criteria needed to qualify as
an “accredited investor” and the eligibility to
invest in any Private Fund and issue a report
within three years of the enactment of the Bill.
2. Private Fund SRO Study. The GAO is required
to study the feasibility of forming an SRO to
oversee “Private Funds” and to issue a report
within one year of the enactment of the Bill.
Such an SRO (or placing oversight of the
Private Fund industry with an existing SRO,
such as the Financial Industry Regulatory
Authority, Inc. (“FINRA”)) is an idea that has
been raised at various times, most recently
during the 2008-2009 market turmoil, but has
not been embraced by the industry, partly
because of the industry’s resistance to another
layer of regulation and potential regulation by
an SRO oriented toward broker-dealers.
3. Custody Rule Costs Study. The GAO is required
to study the compliance costs associated with
SEC Rules 204-2 and 206(4)-2 under the
Advisers Act regarding custody of funds or
securities of clients by investment advisers and
the additional costs associated with eliminating
the requirement in such rules relating to
“operational independence.”
The GAO is
required to submit a report on the results of such
study to the Committee on Banking, Housing
and Urban Affairs of the Senate and the
Committee on Financial Services of the House
no later than three years after the enactment of
the Bill.
B. SEC Studies. The SEC’s newly formed Division
of Risk, Strategy and Financial Innovation (the
“Division”) is required to conduct two studies
focusing on short selling:
1. Short Selling Study. In the first study, the
Division must examine the state of short selling
on exchanges and in the over-the-counter
market, with particular attention to the impact of
recent rule changes and the incidence of the
failure to deliver shares sold short, i.e., “naked”
short selling (the “Short Selling Study”). The
SEC is required to submit a report on the results
of the Short Selling Study to the Committee on
Banking, Housing and Urban Affairs of the
Senate and the Committee on Financial
Services of the House no later than two years
after the enactment of the Bill.
2. Short Reporting Study. In the second study, the
Division must examine the feasibility, benefits
and costs of (1) requiring public reporting of
real time short sale positions of publicly listed
securities or, alternatively, providing such
reports only to the SEC and FINRA, and
(2) conducting a voluntary pilot program in
which public companies would agree to have
trades of their shares marked as “short,”
“market maker short,” “buy,” “buy-to-cover”
and “long” and reported in real time through the
Consolidated Tape (the “Short Reporting
Study”). The SEC is required to submit a report
on the results of the Short Reporting Study to
the Committee on Banking, Housing and Urban
Affairs of the Senate and the Committee on
Financial Services of the House no later than
one year after the enactment of the Bill.
IX. The Need for Future Rulemaking
and
an
Increased
Focus
on
Enforcement
In implementing the Bill, the SEC will need to
propose and adopt many new rules and regulations
to provide clarity and guidance to the Bill’s
potentially ambiguous language. In the wake of the
Madoff scandal and the financial crises, and given
the current political climate, it may be difficult for
the SEC to take positions or issue rules that the
public would perceive as “easy” on Private Funds
and their advisers. There also is concern that the
SEC’s actions might be motivated in part by a fear
that it might miss the next scandal. Thus, any new
rules aimed at the private fund industry are likely to
be broad and stringent. In addition, the Bill gives
the SEC staff the power to obtain significant
amounts of new information about Private Funds
and their advisers. The SEC has made clear that its
enforcement program will focus on hedge fund
advisers: in prosecuting the Galleon insider trading
case,28 the SEC’s Enforcement Division staff have
28
See SEC v. Galleon Management, 09-CV-8811 (S.D.N.Y.
2009).
July 9, 2010
15
Financial Services Reform Alert
stated that they believe that insider trading is
endemic to the private fund industry, and the
Enforcement Division has organized a new Asset
Management Unit that is concentrating on bringing
cases against fund managers. The SEC’s
examination staff also is likely to direct a substantial
portion of its efforts toward Private Fund advisers
for several years so that it can obtain better
information about and a better understanding of
industry practices. In sum, the Bill carries the
potential of subjecting the hedge fund industry, and
to a lesser extent the entire private fund industry, to
a rapidly evolving and uncertain regulatory regime
that will create an environment in which it is
considerably more difficult for Private Funds and
their advisers to operate.
This client alert is part of a series of alerts focused on
monitoring financial regulatory reform.
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July 9, 2010
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