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GT Alert

SEC Adopts Rule to Require Registration of Hedge Fund Advisers

October 2004
By Steven M. Felsenstein, Greenberg Traurig, Philadelphia Office

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Just three months after proposing a rule requiring registration of hedge fund advisers, and just one month after the close of the comment period, the U.S. Securities and Exchange Commission has adopted proposed rules to regulate advisers to the hedge fund industry. The proposal was adopted by the same split vote of three to two by which the proposal was issued in a July 20, 2004 release. To allow previously exempt advisers time to meet the extensive regulatory burdens imposed by the new rules, the Commission provided for a long phase-in period, with the rule taking effect in February 2006.

Steven Felsenstein
"Just three months after proposing a rule requiring registration of hedge fund advisers, and just one month after the close of the comment period, the U.S. Securities and Exchange Commission has adopted proposed rules to regulate advisers to the hedge fund industry."

The Commission meeting included two surprises. It was disclosed that just the other day the President’s inter-agency financial coordination group opposed adoption of the rule at this time. It also was disclosed that, almost at the last minute, the U.S. Commodities Futures Trading Commission, a sister financial agency, had requested the rule provide an exemption to mitigate unintended duplicative regulatory impacts of the rule on certain Commodity Trading Advisers registered with the CFTC. In a strange twist for an agency that advocates full disclosure, word of the CFTC request apparently was not provided to the two dissenting Commissioners until yesterday. The pleas of fellow regulators were to no avail however, though the approving Commissioners and the staff appeared to hint at efforts during the phase-in period to address concerns such as those raised by the other agencies.

For the most part the comments of the Commissioners, and of course their votes, echoed their positions at the meeting at which the Commission proposed the rule for public comment. Chairman Donaldson, a Republican who pushed the adoption of the rule, voted with two Democratic Commissioners Goldschmid and Campos to approve the rule while Commissioners Glassman and Atkins, the other two Republicans, voted against approval. The proponents argued that increased regulation of the hedge fund business will protect investors, cut back on industry abuse, keep ‘bad guys’ out of the business, and deter misconduct. The opponents argued that the studies have not confirmed that the problems being attacked are actually present to a significant extent, and they claim that the cost of complying with the increased regulation will outweigh the benefits to investors. The opponents also criticized what they seemed to feel was an unseemly haste to adopt the rule before answers to questions were found.

The rule impacts the criteria for exemption from registration as an investment adviser. Under Section 203(b)(3) of the Investment Advisers Act of 1940 (the “Advisers Act”), an adviser that has had fewer than fifteen clients during the preceding twelve months (and meets other tests) is not required to register. The result of the exemption is that such an adviser does not have to comply with all of the regulatory burdens of the Advisers Act. When a person acts as an adviser to an entity or pool of assets, existing Rule 203(b)(3)-1 defined the entity to be a single client. New Rule 203(b)(3)-2 overrides the older rule by providing that if an entity is a “private fund” as defined in the new rule, then each owner (such as limited partners, members, etc.) must be treated as a client.

A “private fund” under the new rule is one that relies on Sections 3(c)(1) or 3(c)(7) of the Investment Company Act to be exempt from registration as an investment company. An adviser to such an entity is required to look through the entity to count noses unless the entity does not permit owners to redeem their interests for at least two years of the purchase of such interests. (See the discussion below of “lock-up” issues.) Commissioner Atkins, in a note of humor at an otherwise intense meeting, noted we will soon have “735 Plans” (two years and a few days for safety) to add to such choices as “529 Plans” (named after the tax section). The discussion also included consideration of some fine-tuning of the proposal to address other issues, such as how foreign investors are counted (they are not), whether relocation of a foreign investor to the U.S. changes that investor’s status (it should not), and how the rule impacts advisers to foreign funds with enough U.S. investors (it will).

Once the new registration provision kicks in, each newly registered adviser will have to meet all of the usual provisions of the Advisers Act governing registered advisers. This will include such matters as books and records requirements, extensive compliance procedures, and the appointment of a chief compliance officer. The new provisions do include transitional waivers. For example, new registrants will not be required to have supporting books and records information for periods prior to registration, and performance data for earlier periods will be subject to less rigorous provisions.

Unclear at this point is how the performance reporting provisions will be handled. Under present procedures, unregistered advisers are limited in their ability to “hold themselves out” to the public. Once registered, such advisers may wish to advertise. While the rule allows the newly registered advisers to use performance data without certain reporting books and records otherwise required to be held, such performance may not be “AIMR-GPPS Compliant.” Another complication is that both 3(c)(1) and 3(c)(7) funds are not allowed to make a public offering, and it is not clear how public dissemination of a fund’s performance information would be viewed.

One of the most significant changes under the rule is that once registered, an adviser can collect performance-based compensation only from a “qualified client,” a term defined under the Advisers Act to include only substantial investors.1 Thus, one of the key impacts of the rule will be that accredited investors that are not qualified clients will either lose the option of investing in hedge funds that want to pay performance compensation to an adviser, or will have to invest in a fund that adopts lock-in provisions limiting the investor’s access to investments and lock up their money for at least two years. This provision is clearly anti-consumer. Knowledgeable investors who are not qualified clients will lose options that might otherwise be of interest, or they will be forced to invest in funds that lock up their money. As noted at the Commission’s meeting, this means that investors are going to be deprived of the ability to “vote with their feet” if an adviser is not performing as expected. The Commission’s action, while it will be happily adopted by hedge fund advisers pleased to lock in investors, does not serve the interests of investors.

The rule also recognizes the impact of the lock-up concept when investors face sudden changes requiring access to their assets, but the relief provided by the rule is very narrowly focused, and does not take into account whether an investor’s goal has changed in a manner that does not garner relief under the new rules, since the rules are limited to “extraordinary and unforeseeable events.”

The rule does have a “grandfather” provision that allows investors who are not qualified clients, and who invested in a hedge fund prior to the new rule, to remain in the fund and continue to pay compensation as originally agreed, including performance-based compensation. It will be interesting to see whether this provision will be used as a selling tool by funds now, with investors being told to “get it while you can” because next year you will be barred.

As noted above, the proposed effective date is set for 2006. Whether the rules will take effect at that time is still up in the air to some extent, as there have been indications that legal challenges may be brought on the basis that the new rules are beyond the power of the SEC. Recognizing this concern, the Chairman requested that the General Counsel to the Commission discuss the issue, and he expressed the view that adoption of the proposal is proper, and defensible.


1 The standard is more stringent than mere “accredited investors.” It uses such criteria as $750,000 under the management of the adviser, a net worth of more than $1.5 million, or status as a “qualified purchaser.”


© 2004 Greenberg Traurig

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