ANALYSIS: U.S. SEC Significantly Expands Regulation Of Non-U.S. Investment Advisers Through New Final Rules Under Dodd-Frank Act
By Jeff Berman, Steven Gatti, Clifford Cone, and David Adams, of Clifford Chance.
On June 22, 2011, almost five months after the close of the formal public comment period, the U.S. Securities and Exchange Commission (the “SEC”) adopted final rules relating to provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) that modify the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”). These provisions expand the Advisers Act’s coverage to include many formerly exempt investment advisers to private equity and hedge funds (see WSLR, July 2011, page 4).
From the standpoint of non-U.S. investment advisers, the final rules are identical to the proposed rules in nearly all material respects. Two SEC releases, Rules Implementing Amendments to the Investment Advisers Act of 1940, Release No. IA-3221 (the “Implementing Adopting Release”) and Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Release No. IA-3222 (the “Exemptions Adopting Release”), contain the published text of the final rules.
As predicted, the SEC officially postponed the compliance date for the expanded registration requirements. An investment adviser that becomes subject to registration under the Advisers Act due to the elimination of the “private adviser” exemption will not need to register with the SEC (or report information if an “exempt reporting adviser”) until March 30, 2012. Investment advisers required to register with the SEC should plan to file their completed Form ADV (Parts 1 and 2) no later than February 14, 2012 to ensure compliance by the deadline.
This Special Report reviews the aspects of the Exemptions Adopting Release most relevant to investment advisers who are organized and have their principal place of business outside the United States (referred to here as “non-U.S. investment advisers”). In order of preference, these are 1) the complete exemption for “foreign private advisers” (the “Foreign Private Adviser Exemption”) and 2) the conditional exemption for investment advisers who act solely as advisers to private funds and who have less than $150 million of assets under management in the United States (the “Private Fund Adviser Exemption”).
In addition, this Special Report summarizes the reporting, recordkeeping and examination requirements applicable to “exempt reporting advisers” (or “ERAs”), that is, investment advisers relying on the Private Fund Adviser Exemption (but not advisers relying on the Foreign Private Adviser Exemption).
The Implementing Adopting Release requires both registered investment advisers and ERAs to report information about the private funds they advise, including, in respect of each fund: its basic organizational, operational and investment characteristics, the gross value of its assets, the nature of its investors and the identity of its service providers. This information would, in most circumstances, be made available to the public without regard to its proprietary or competitively sensitive nature. Perhaps most significantly, the Implementing Adopting Release makes clear that, although the SEC generally will not conduct routine examinations of ERAs, it will still have the authority to conduct on-site examinations of ERAs if the SEC believes an examination is necessary.
Review of the Final Rules
The exemptions most relevant to non-U.S. investment advisers are the Foreign Private Adviser Exemption, a complete exemption that imposes no ongoing compliance obligations, and the Private Fund Adviser Exemption, a conditional exemption that requires investment advisers to submit to the ERA compliance regime. As defined in the Dodd-Frank Act, a “private fund” is a fund that would be regulated as an “investment company” but for Section 3(c)(1) (excluding funds with not more than 100 owners) or Section 3(c)(7) (excluding funds owned by qualified purchasers only) of the U.S. Investment Company Act of 1940, as amended (the “Investment Company Act”). The final rules make clear that any fund qualifying for exclusion under Section 3(c)(1) or Section 3(c)(7) may be treated as a private fund even if it also qualifies for exclusion from the definition of “investment company” pursuant to another provision of the Investment Company Act, such as Section 3(c)(5)(C) (excluding funds primarily engaged in acquiring interests in real estate). In the case of an investment adviser who advises a private fund, the fund is generally deemed to be the adviser’s “client” for purposes of the Advisers Act and the applicable exemptions (and is referred to here as a “client private fund”); the fund’s investors are not clients in the absence of an independent advisory relationship.
For a short illustration of non-U.S. investment adviser eligibility requirements for the Foreign Private Adviser Exemption and the Private Fund Adviser Exemption under the SEC’s final rules, see the flow chart that appears at the end of this Special Report.
Foreign Private Adviser Exemption
The Dodd-Frank Act provides a complete exemption from registration under the Advisers Act for any investment adviser who 1) has no place of business in the United States, 2) has, in total, fewer than 15 clients in the United States and investors in the United States in client private funds, 3) has aggregate assets under management attributable to clients in the United States and investors in the United States in client private funds of less than $25 million (or any higher amount specified by the SEC), and 4) does not hold itself out generally to the public in the United States as an investment adviser. The Exemptions Adopting Release finalizes Rule 202(a)(30)-1, which includes counting rules for clients and investors and definitions of certain terms used in the Foreign Private Adviser Exemption.
The final rule includes “safe harbors” for counting clients broadly similar to those in effect under the “private adviser” exemption (which was repealed by the Dodd-Frank Act as of July 21, 2011). In addition, the final rule avoids potential double-counting by providing that an investment adviser need not count 1) a private fund as a client if any investor in the private fund was counted as an investor for purposes of determining the availability of the Foreign Private Adviser Exemption, or 2) a person as an investor in a private fund if the person was also counted as a client.
The final rule generally defines an “investor” in a private fund as any person or entity that would be included in determining the number of beneficial owners of the private fund under Section 3(c)(1) of the Investment Company Act or whether the private fund is owned exclusively by qualified purchasers under Section 3(c)(7) of the Investment Company Act. In a master-feeder structure, for example, the investors in the feeder funds, and not the feeder funds themselves, would be treated as investors in the master fund. The final rule also avoids potential double-counting by providing that an investment adviser may treat as a single investor any person or entity that has invested in two or more client private funds. However, note that holders of “short-term paper” (as that term is defined in Section 2(a)(38) of the Investment Company Act) are deemed to be investors in a 3(c)(1) fund for purposes of the final rule. The final rule, unlike the proposal, does not treat as investors beneficial owners who are “knowledgeable employees” (as that term is defined in the SEC’s Rule 3c-5 under the Investment Company Act) with respect to a private fund.
‘In the United States’
The final rule defines “in the United States” — a phrase used in the Foreign Private Adviser Exemption no fewer than five times — by incorporating certain defined terms used in Regulation S under the Securities Act of 1933, as amended (the “Securities Act”). Therefore, as a general matter, a place of business is in the United States if it is in the “United States,” as defined in Regulation S, and a client or investor is in the United States if it is a “U.S. person,” as defined in Regulation S. In addition, the final rule clarifies that, if a client or investor was not “in the United States” when it became a client of the investment adviser or acquired its interest in the investment adviser’s client private fund (as applicable), the client or investor may continue to be treated as such even after relocating to the United States.
Place of Business
The final rule defines an investment adviser’s “place of business” as any office where the adviser regularly provides investment advisory services or meets with or otherwise communicates with clients, and any location held out to the public as a place where the adviser conducts such activities. We believe that an office in the United States where an investment adviser engages solely in marketing activities for a client private fund, and meets with or otherwise communicates with investors and prospective investors in the fund, should not be deemed a place of business in the United States for purposes of the final rule. However, in this regard, the Exemptions Adopting Release muddies the waters by advancing an “intrinsic to the provision of investment advisory services” test for identifying a “place of business.” According to the Exemptions Adopting Release, an office where an adviser conducts research in order to produce non-public information relevant to the investments of, or the investment recommendations for, any of an adviser’s clients would be a place of business under the “intrinsic” test. The Exemptions Adopting Release does specify that a “place of business” would not include an office where an adviser does not communicate with clients and solely performs administrative services and back-office activities — but subject to the unhelpfully circular proviso that such services and activities must not be intrinsic to providing investment advisory services.
Non-U.S. investment advisers with U.S. affiliates will not generally be presumed to have a place of business in the United States. However, a non-U.S. investment adviser might be deemed to have a place of business in the United States if its personnel regularly conduct activities at an affiliate’s place of business in the United States.
Assets under Management
The final rule specifies the calculation of “assets under management” for purposes of the Foreign Private Adviser Exemption.
Calculating Assets under Management
Under the final rule, assets under management are determined using the method for calculating “regulatory assets under management” for Part 1A, Item 5 of Form ADV (see “ERA Compliance Regime — Form ADV Requirements” below). The same methodology is used for calculating assets under management for purposes of the Private Fund Adviser Exemption.
Less-Than-$25 Million Ceiling Unchanged
The Dodd-Frank Act set an unrealistically low ceiling on assets under management attributable to clients and investors in the United States, but gave the SEC explicit authority to raise the ceiling to any level deemed appropriate in accordance with the purposes of the Advisers Act. Despite virtually unanimous industry commentary imploring the SEC to accept Congress’s invitation to make the Foreign Private Adviser Exemption genuinely available, the final rule leaves the less-than-$25 million, effectively de minimis ceiling unchanged. Just as troubling as the SEC’s failure to act is its dismissive remark, buried in footnote 503 of the Exemptions Adopting Release, that “we have not considered raising the threshold in connection with this rulemaking, but we will evaluate whether doing so may be appropriate in the future.”
Many (if not most) non-U.S. investment advisers are likely to find the Foreign Private Adviser Exemption too narrow a basis for an exemption from registration under the Advisers Act. However, as discussed under “Threshold Jurisdictional Requirements” below, a strong argument can be made that any assertion by the SEC of extraterritorial authority to regulate “foreign-cubed” investment advisers, i.e., 1) non-U.S. investment advisers 2) who conduct all of their investment advisory business outside the United States and 3) all of whose clients are outside the United States, is simply beyond the intended scope of the Advisers Act and the U.S. federal securities laws…