The Legacy of the Hedge Fund Adviser Registration Rule

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1 The Legacy of the Hedge Fund Adviser Registration Rule By Michael P. Malloy, Joshua B. Deringer and Jillian L. Bosmann This article first appeared in the Summer 2006 issue of The Investment Adviser s Counsel. Reprinted with permission. Joshua D. Deringer Drinker Biddle & Reath LLP Philadelphia (215) (215) fax Joshua.Deringer@dbr.com Michael P. Malloy Drinker Biddle & Reath LLP Philadelphia (215) (215) fax Michael.Malloy@dbr.com Jillian L. Bosmann Drinker Biddle & Reath LLP Philadelphia (215) (215) fax Jillian.Bosmann@dbr.com Philadelphia Berwyn Chicago Florham Park Los Angeles New York Princeton San Francisco Washington Wilmington

2 At this time last year, many hedge fund managers were either preparing to register as investment advisers with the Securities and Exchange Commission (the Commission ) or restructuring their business to avoid the registration requirement that came about as a result of the Commission s amendments to Rule 203(b)(3)-1 (the Rule ) of the Investment Advisers Act of 1940 ( Advisers Act ). However, those amendments were struck down by the U.S. Court of Appeals less than six months after hedge fund managers were required to comply with them. Many hedge fund managers are left to wonder what will happen next. History of the Amendments Prior to the amendments of the Rule, many hedge fund managers did not register with the Commission. They were able to operate without registering because of an exemption under Section 203(b)(3) of the Advisers Act. This section provided that a person does not need to register as an investment adviser if it has had no more than fourteen clients during the preceding year and does not hold itself out to the public as an investment adviser. Since the Commission viewed the private funds themselves as the client rather than the investors in the fund, a manager who had fewer than fifteen funds was not required to register. This approach was codified in Rule 203(b)(3)-1 under the Advisers Act. On October 24, 2004, the Commission voted to amend Rule 203(b)(3)-1, requiring managers to look through the hedge funds they manage for the purpose of determining whether they had more than fourteen clients. Specifically, the amended Rule provided that advisers must count the shareholders, limited partners, members, other securityholders or beneficiaries of a private fund as clients. Hedge fund managers were required to comply with the amendments by February 1, 2006, and many registered with the Commission. The Goldstein Decision However, Philip Goldstein, a hedge fund manager, decided to challenge the Commission s authority to adopt the amendments to the Rule. On June 23, 2006, less than six months after the compliance date of the amendments, the U.S. Court of Appeals for the District of Columbia heard the Goldstein case and vacated the amendments in a unanimous decision. The Court of Appeals found that the amendments to the Rule were inconsistent with prior interpretation and that the Commission had not sufficiently supported its new interpretation by showing a change in circumstance since the prior rule was adopted. When the Court vacated the amendments to the Rule, the status of many provisions included in the adopting release became uncertain. The Commission s Response The American Bar Association ( ABA ) reacted to the ruling by quickly writing a letter (the ABA Letter ) requesting that the staff of the Commission ( Staff ) address some interpretive concerns that arose as a result of the Goldstein decision. Specifically, the decision arguably struck down not only the registration requirement but also provisions intended to assist newly registered hedge fund advisers in complying with the Advisers Act. The ABA Letter 1

3 identified issues that affected the newly registered advisers who either wanted to remain registered or who desired to withdraw their registration. In response, the Staff wrote a no-action letter addressing the issues raised by the ABA Letter, as well as some additional issues. Essentially, the Staff s letter reinstated much of the transitional relief that had been provided in the adopting release for hedge fund advisers who registered with the Commission as a result of the amendments to the Rule. It also restored certain provisions unrelated to the registration requirement that had been included in the adopting release. Relief for the Registered For offshore advisers to offshore funds that remain registered, the no-action letter provides relief. Specifically, the Commission had noted in adopting the amendments to the Rule that an adviser having its principal place of business outside the United States ( offshore adviser ) who was advising a fund organized under the laws of a country other than the United States ( offshore fund ) would not be subject to the substantive provisions of the Advisers Act. Instead, the offshore adviser was allowed to treat the offshore fund as its client, and not the individual investors, except for the purpose of determining the number of clients and for antifraud provisions. The no-action letter confirmed that the Staff would continue to maintain its view as expressed in the adopting release. Additionally, under Section 205(a)(1) of the Advisers Act, an adviser may not receive performance-based compensation from clients unless they are qualified clients under Rule The amendments provided that newly registered advisers could continue to receive performance-based compensation from existing clients. Without this exception, newly registered advisers may have been required to terminate existing contracts. However, the no-action letter provided that the Staff would not recommend enforcement action against an adviser who complied with the provisions of the amendments, even though they had been vacated. The ABA Letter also addressed Rule 206(4)-2 under the Advisers Act, which requires that registered advisers who have custody of client funds or securities follow certain procedures. One of those requirements is the furnishing of quarterly account statements. There is an exception, however, for funds who provide annual financial statements, audited in accordance with generally accepted accounting principles, within 120 days after the end of the fund s fiscal year. The amendments to the Rule had extended this time period to 180 days for a fund of funds. This extension was created because of the practical difficulty for a fund of funds to obtain audited financials from the funds in which they are invested in time to complete their own fund audits. The Staff s no-action letter verified that the Staff would not recommend enforcement action for an adviser of a fund of funds who relied on the annual audit exception if audited financial statements were distributed within 180 days after the end of the fund s fiscal year. Furthermore, the adopting release had provided that hedge fund advisers who registered as a result of the amendments would be able to use performance information in advertising materials for periods prior to their registration even if they had not retained sufficient records to 2

4 meet the requirements of another rule, Rule 204-2(a)(16). This was provided so that the newly registered advisers would not be disadvantaged by being unable to use performance information in their advertising. The no-action letter stated that the Staff would not recommend enforcement action for an adviser that registered as a result of the amendments if they utilized such information in their advertising materials without maintaining or preserving books and records as required under Rule 204-2(a)(16). Another issue was not addressed in the ABA Letter, but was noted in the Staff s noaction letter response. When the amendments were adopted, the Commission amended Rule to provide that the records of a private fund are records of the adviser if the adviser or any related person acts as the private fund s general partner, managing member, or in a comparable capacity. This is important because records of the adviser are subject to examination by the Staff. The no-action letter noted that a registered investment adviser must still make records available for examination, and that it may not avoid this requirement by holding records by or through another person. Relief for the De-Registered The ABA Letter and the Staff s no-action letter also addressed some concerns of investment advisers who registered under the vacated amendments to the Rule, and would now prefer to withdraw their registration. Prior to the amendments, hedge fund managers who did not register relied on the exemption of section 203(b)(3) of the Advisers Act. This section requires that the investment adviser have fewer than fifteen clients. It also requires that the adviser not hold itself out to the public as an investment adviser. After registering with the Commission, an adviser may have held itself out to the general public as an investment adviser. The ABA Letter asked whether such an adviser could withdraw registration and rely again on the exemption provided they withdrew their registration within a certain time period. The Staff confirmed that they would not recommend enforcement if the adviser withdraws its registration by February 1, 2007 and ceases to hold itself out as an investment adviser. Additionally, the Staff provided that an investment adviser who had taken on more than fifteen clients (even under the single fund as client rule) during the time it was registered could still rely on the exemption if it reduced its client load to under fifteen clients by the date of withdrawal. This is because the adviser may determine the number of clients it had, and thus the availability of the exemption, by reference to the time period beginning at the date of withdrawal even if that period is less than twelve months. The ABA Letter also dealt with an issue relating to Form ADV-W, the form an adviser must file to withdraw its registration under the Advisers Act. On the form, if an adviser responds affirmatively to any of Items 3, 4, and 6 (which involve custody, money owed to clients, or judgments and liens, respectively) the adviser also has to provide a balance sheet on Schedule W2. Most hedge fund advisers have custody of client assets, but are not required to file a balance sheet with their annual update as a result of Advisers Act Release No (September 25, 2003). Therefore, the ABA Letter argued that it would not be fair to require a balance sheet from advisers as a condition of withdrawal from registration. In response, the Staff stated that it would not recommend enforcement if a withdrawing adviser who registered as a result of the 3

5 amendments failed to provide the information on Schedule W2. However, such an adviser would still need to fill out the form by placing a 0 for all entries. Not raised by the ABA Letter, but addressed by the Staff in their no-action letter response, was the need for revisions to Form ADV. When the Commission adopted the amendments, several changes were made to Form ADV requiring registered advisers and applicants for registration to provide certain information on the private funds that they advise. The Goldstein decision appeared to eliminate these changes but, due to programming constraints, Form ADV continued to reflect the changes from the vacated amendments. The no-action letter announced that the Commission s website, at would post guidance on how to complete Form ADV until the changes were reversed. Under the guidelines as currently posted, an investment adviser can choose to respond to Item 7.B. and Section 7.B. of Schedule D of Part 1A as written or to respond as if the questions did not reference private funds. Looking Down the Road On July 25, 2006, about one month after the Goldstein decision came down, Chairman Cox testified at a U.S. Senate Committee hearing on hedge funds. He used the time to reconfirm the Commission s authority over hedge funds and their advisers under the antifraud provisions of the Advisers Act and other sections of the federal securities laws. Rather than simply defer to Congress or otherwise withdraw attempting to regulate hedge fund advisers, Chairman Cox announced that he expected the Commission to continue in its general efforts. At the hearing, the Chairman announced plans for a new antifraud rule based on the Commission s authority under section 206(4) of the Advisers Act. Similar to the amendments to the Rule, this possible rule proposal would have the effect of looking through a hedge fund to its investors to enable the Commission to protect individual investors from fraud. Many of the antifraud provisions of the Advisers Act prohibit the adviser from taking certain actions with regard to a client, and the Goldstein decision said that the investors were not clients of the adviser. However, section 206(4) contains a broad prohibition against fraudulent practices, leaving the Commission with room to craft a rule to eliminate conduct, even by unregistered hedge fund managers, that might injure individual investors of a fund. Chairman Cox also noted plans to address the retailization of hedge funds. According to the Chairman, the current definition of accredited investor found in Regulation D of the Securities Act of 1933 ( Securities Act ), is out of date and wholly inadequate to protect unsophisticated investors. In avoiding registration under the Securities Act, managers rely on Regulation D, which limits offerings to accredited investors. Under the current definition, an accredited investor includes an individual that has net worth, or joint net worth with a spouse, of $1 million or more, or income in each of the two most recent years of $200,000 individually or $300,000 jointly. In his address to the Senate committee, Chairman Cox explained that inflation and rising housing costs have reduced the significance of such levels as indicators of the degree of investor sophistication. 4

6 In the long term, Chairman Cox indicated in his testimony that improved hedge fund regulation may require further legislation. However, he also indicated that such legislation should neither interfere with the operations of the hedge fund nor require extensive portfolio disclosure. Michael P. Malloy is a partner and chair of the Investment Management Group at Drinker Biddle & Reath LLP and Joshua B. Deringer (Joshua.Deringer@dbr.com) is a senior associate in the Group. Jillian L. Bosmann (Jillian.Bosmann@dbr.com), an associate in the Investment Management Group, assisted in the preparation of this article. Drinker Biddle & Reath LLP is a full service law firm of approximately 450 lawyers headquartered in Philadelphia, PA, USA with offices in New York, NY; Washington, DC; Los Angeles and San Francisco, CA; Chicago, IL; Princeton and Florham Park, NJ; Berwyn, PA and Wilmington, DE. The Investment Management Group advises a broad array of investment management clients on financial services, products, registration issues and related matters, including products such as registered investment companies, common trust funds, collective investment funds and alternative products, including registered funds of hedge funds, hedge funds and private equity funds. One Logan Square 18th and Cherry Streets Philadelphia, PA Drinker Biddle & Reath LLP, a Pennsylvania limited liability partnership. All rights reserved. This discussion is not intended to constitute legal advice regarding any client s legal problems or specific questions and should not be relied upon as such. 5