SEC Issues Guidance on Hedge Fund Adviser Rule

Transcription

1 February 2006 / Issue 2 A legal upate from Dechert s Financial Services Group SEC Issues Guiance on Hege Fun Aviser Rule On December 8, 2005, the Staff of the Division of Investment Management (the Division ) of the U.S. Securities an Exchange Commission (the SEC ) release interpretive guiance (the Letter ) 1 on the hege fun aviser registration rule (the Rule ) in response to a request by the American Bar Association Subcommittee on Private Investment Entities (the Subcommittee ) 2 for assistance in interpreting certain provisions of the Rule. 3 In December 2005, Dechert s Financial Services Group issue a legal upate highlighting two critical an time-sensitive issues aresse in the Letter. 4 This upate is a more comprehensive iscussion of the Division s positions an is intene primarily for hege fun avisers that wish to remain exempt from registration, are in the process of registering, are alreay See American Bar Association Subcommittee on Private Investment Entities (pub. avail. Dec. 8, 2005) available at on/aba htm. The Subcommittee s request letter is available at on/aba incoming.pf (the Subcommittee Request Letter ). Section 203(b)(3) of, an Rules 203(b)(3)-1 an 203(b)(3)-2 uner, the Investment Avisers Act of 1940, as amene (the Avisers Act or the Act ). See also Release No. IA-2333 (Dec. 2, 2004) ( Release No. IA-2333 ). Dechert OnPoint: SEC Staff Issues Guiance on New Hege Fun Aviser Registration Rule (Dec. 9, 2005) at pf (iscussing the Division s clarification of the two-year lockup exception as well as the Division s willingness to act quickly on Forms ADV file by January 9, 2006). registere, or maintain their principal place of business outsie the Unite States (i.e., offshore avisers). Issues Affecting Avisers Seeking to Remain Exempt from Registration Reemptions an Transfers Hege fun managers may avoi registration by imposing a two-year lockup (the Two-Year Lockup ) on all capital contributions to a fun on or after February 1, Avisers expresse frustration with the uncertain meaning of the phrase: permits its owners to reeem any portion of their ownership interests within two years of the purchase of such interests. In response to the Subcommittee Request Letter, the Division provie some clarification as to the exact term for which investors must be require to hol interests prior to reemption in orer to allow an aviser to rely on the Two- Year Lockup exception to the efinition of private fun. Accoring to the Division, if an owner is permitte to reeem its interests in the fun prior to the secon anniversary of the ate of investment, then the fun permits its owners to reeem any portion of their ownership interests 5 The Division note that [t]he Aopting Release [for the Rule] makes it clear... that avisers are require to apply the two-year reemption test only to investments mae on or after February 1, A reemption provision or sie agreement relating to investments mae prior to February 1, 2006 which allows for more frequent liquiity will not, itself, require treatment of the fun as a private fun uner the Rule.

2 within two years of the purchase of such interest within the meaning of Rule 203(b)(3)-1()(1)(ii) uner the Avisers Act, an therefore, the aviser cannot rely on the Two-Year Lockup exception. Put another way, in orer for the aviser to rely on the Two-Year Lockup exception, investors must maintain their investment in the fun for two full years (e.g., an investment mae on February 1, 2006 coul not be reeeme before February 1, 2008). Hege fun managers seeking to rely on the Two-Year Lockup exception from the efinition of private fun shoul promptly review their offering ocuments to ensure that reemptions may only be effecte after the expiration of two full years from the ate of investment. The Subcommittee also sought clarification as to the circumstances uner which a transfer between classes of a multi-class fun woul be consiere to be a reemption for purposes of the Two-Year Lockup. In response, the Division inicate that a transfer from one class of a fun to another class of the same fun woul not be consiere a reemption for purposes of the Rule if the two classes share the same unerlying portfolio of investment securities an provie investors with the same reemption rights. However, transfers between classes of a fun which have substantially similar investment objectives (but not ientical portfolios) 6 or ifferent reemption rights 7 may constitute a reemption for purposes of the Rule. Ultimately, whether or not a transfer constitutes a reemption is a question of facts an circumstances. Hege fun managers that avise multi-class funs an seek to rely on the Two-Year Lockup shoul promptly review their offering ocuments to confirm that transfers between classes of shares are permitte only where both classes have the same unerlying portfolio an reemption rights. Aitionally, the Division permits no istinction between U.S. investors an non-u.s. investors with respect to the Two-Year Lockup. If an investor, regarless of resiency, is permitte to reeem its interest within two years of 6 The Division inicate, in this regar, that if either class has investments that are not share in the same proportion by the other, then the two classes woul not be viewe as sharing the same unerlying portfolio. 7 Thus, a transfer from Class A shares that have a two-year lockup to Class B shares that have a one-year lockup woul cause the fun to be eeme to be a private fun. purchase, the aviser cannot rely on the Two-Year Lockup exception to the efinition of private fun. However, uner limite circumstances for purposes of the Two-Year Lockup, the Division has inicate that it woul interpret a captive master-feeer structure as operating as an integrate structure, such that the aviser nee look only to whether the investors in the feeer funs are permitte to reeem any portion of their interests in the feeer funs within two years of their purchases for purposes of the efinition of private fun in Rule 203(b)(3)-1() uner the Avisers Act. Thus, the aviser to a fun so organize may look to the reemption provisions applicable to investors in the feeer funs rather than those applicable to the feeer funs investment in the master fun for purposes of the Two-Year Lockup. Consequently, capital may be freely reeeme by the feeer funs from the master fun. Extraorinary Events; Reinvestment of Gains Rule 203(b)(3)-1()(2) uner the Avisers Act allows avisers to rely on the Two-Year Lockup exception where more frequent reemptions are permitte only with respect to (1) extraorinary events an (2) interests acquire through reinvestment of istribute capital gains or income. In orer to help hege fun managers interpret this provision, the Subcommittee sought further specific guiance from the Division as to the sort of events that may be consiere to be extraorinary. Uner the Letter, the issolution or liquiation of an entity owner, i.e., an investor that is a partnership, limite liability company, corporation or other type of entity, may be consiere an extraorinary event where the entity ceases to operate an the aviser has a reasonable basis to believe that the entity owner s issolution or liquiation is bona fie an not esigne to avoi the relevant two-year reemption perio. Furthermore, the Division inicate that the bankruptcy of an owner, whether an iniviual or an entity, woul also be an extraorinary event. In such situations, an aviser may permit an investor that issolves, liquiates or is in bankruptcy to reeem its interests within the two-year reemption perio without causing the aviser to lose the ability to rely on the Two-Year Lockup. Release IA-2333 inicate that extraorinary events may also inclue changes of circumstance within the aviser such as the eath, isability, incapacitation or cease involvement of key avisory personnel. The Subcommittee asserte that significant withrawals by the aviser or its key personnel shoul similarly be consi- February 2006 / Issue 2 2

3 ere to be extraorinary events within the contemplation of the Rule. The Division isagree with the Subcommittee s assertion, noting that, unlike the eath or incapacity of key personnel of the aviser, a significant withrawal of an investment by an aviser or its principals is not an extraorinary event because such a withrawal is generally within the aviser s iscretion. Consequently, a sie letter that gives investors special reemption rights in the event of a significant withrawal by the aviser or its personnel woul not be compatible with reliance on the Two-Year Lockup. The Division s position on this issue aversely affects avisers that may enter into sie letters permitting investors to withraw early in the event of a significant withrawal by the aviser or its key personnel. Fortunately, investments mae prior to February 1, 2006 are not consiere when etermining an aviser s ability to rely on the Two-Year Lockup; however, sie letter arrangements entere into prior to that ate may nee to be moifie with respect to subsequent investments in orer to maintain reliance on the Two-Year Lockup. Similarly, sie letters that permit early withrawals as a result of poor investment performance woul also preclue an aviser from relying upon the Two-Year Lockup, an accoringly, such sie letter woul nee to be moifie. Furthermore, the Division confirme that following expiration of the initial two-year lockup perio, an investor may reeem not only its original investment, but also any gains or income an subsequent appreciation on those gains or income, without triggering the efinition of private fun. Reemptions by the Aviser s Personnel Interestingly, while the aviser an its principals an other knowlegeable employees ( insiers ) who invest in a fun manage by (or are otherwise clients of) the aviser are not counte towars the fifteen client threshol to trigger registration, the Division has inicate that such insiers must be equally subject to the Two-Year Lockup as an outsie investor woul be. The Division reasone that owner, for purposes of Rule 203(b)(3)-1()(1)(ii) uner the Avisers Act, inclues anyone who owns an interest in a poole investment vehicle, incluing such insiers. The Division believes that because subjecting insiers to the Two-Year Lockup prevents insiers from enjoying preferential liquiity terms not available to other investors, its interpretation is consistent with the SEC s objectives in aopting the Rule (i.e., investor protection). Avisers relying on the Two-Year Lockup exception shoul aopt policies an controls to monitor reemptions by their employees. Deferre Fees Fun managers (both registere an unregistere) to offshore funs sometimes efer fees, incluing incentive fees. The Subcommittee expresse concern that the Two-Year Lockup might be interprete to prevent withrawal by the aviser of eferre fees earne particularly if the aviser is consiere to be an owner of the fun an requeste the Division s agreement that such withrawals will not be inconsistent with the Two-Year Lockup. While isagreeing with the Subcommittee s general argument that the aviser is not an owner, the Division agree that avisers may withraw eferre incentive fees an allocations earne without surrenering the ability to rely on the Two-Year Lockup. The Division views eferre performance incentive fees an accrue allocations of performance compensation to be compensation for services provie by the aviser an the general partner rather than contributions of capital, which woul be subject to a Two-Year Lockup. Consequently, an aviser or its affiliate general partner (or managing member) may withraw eferre fees or incentive allocations that were reallocate to its capital account at any time an still meet the requirements for the Two-Year Lockup exception. Transfers Aitionally, the Division has inicate that the original purchase ate may be attribute to an interest transferre in a seconary market transaction provie that there has been no arrangement between the fun or the aviser an either investor to circumvent the Two-Year Lockup. Family Funs Family funs are treate the same as any other fun for purposes of the Rule. All owners of a family fun that meets the efinition of private fun provie by Rule 203(b)(3)-1(b)(1) uner the Avisers Act, incluing family members, must be counte as provie uner Rule 203(b)(3)-2(a) when etermining whether the aviser is require to register uner the Avisers Act. February 2006 / Issue 2 3

4 However, uner Rule 203(b)(3)-1(a)(1), a natural person may be aggregate with: His or her minor chilren Other family members sharing the same resience All trusts 8 or other accounts of which that person an his minor chilren or family members sharing the same resience are the only primary beneficiaries In such circumstances, the aggregate persons count as a single client. The Registration Process Completing Part I of Form ADV The Subcommittee requeste guiance as to how an aviser to funs operate in a master-feeer structure shoul complete Form ADV, Part I, Scheule D, Section 7.B. In response, the Division note that, if both the master fun an the feeer funs are investment-relate limite partnerships or limite liability companies having the aviser or a relate person as their general partner or managing member, or are otherwise private funs avise by the aviser, then the aviser is to ientify both the feeer funs an the master fun, an provie the current amount of total assets in each. Avisers may wish to inicate, in the fiel naming the feeer fun(s), that such funs are investe solely in a specific master fun. Compliance Issues For Registere Avisers to Hege Funs Custoy Avisers to private funs may choose to comply with certain provisions of the Custoy Rule, 9 by proviing investors with a copy of the fun s auite financial statements within 120 ays of the fun s fiscal year en (180 ays for funs of funs) (the Annual Auit Exception ) in lieu of the more burensome alternative of istributing account statements to investors on a quarterly basis. However, such auite financials must be fully compliant with generally accepte accounting principles ( GAAP ). It is common practice for avisers, particularly avisers to start-up funs, to amortize the start-up costs of a fun over a five year perio so that initial investors o not isproportionately bear the buren of such organizational costs. Such an approach is not fully compliant with GAAP an may result in the fun s auitor issuing a qualifie auit opinion if the auitor consiers the amortization of start-up costs material in relation to the total amount of assets uner management. The Subcommittee requeste that avisers be permitte to rely on the Annual Auit Exception notwithstaning the amortization of start-up costs. However, the Division refuse to soften the Custoy Rule s strict requirement that a fun s financial statements be fully GAAP compliant in orer for an aviser to rely on the Annual Auit Exception. As such, if an aviser s amortization is eeme material an therefore the auitor issues a qualifie auit opinion, the aviser woul not be able to rely on the Annual Auit Exception. Of course, cost allocation methos which are consistent with GAAP woul be permissible. Books an Recors In general, a registere investment aviser is require to maintain its books an recors in an appropriate office of the investment aviser. 10 It is common practice for avisers of non-u.s. omicile funs to appoint an aministrator. The Division confirme that avisers may engage an aministrator to maintain an preserve, on the aviser s behalf, the books an recors require to be kept pursuant to Rule uner the Avisers Act provie that the following two conitions are satisfie: The aministrator acts as a service provier to the aviser in maintaining, preparing, organizing an/or upating the aviser s recors for the aviser s ongoing use in its business, an oes not merely provie longterm storage of the recors 8 It is not necessary that a family member serve as trustee. 9 See Rule 206(4)-2 uner the Avisers Act. See also Release No. IA-2176 (Sept. 25, 2003). 10 Rule 204-2(e)(1) uner the Avisers Act. Generally, avisers maintain such books an recors at their principal place of business. February 2006 / Issue 2 4

5 Upon request of the SEC s staff, the recors are prouce promptly for the staff at the appropriate office of the aviser or an office of the aministrator By permitting avisers to maintain their books an recors with the aministrator, avisers are relieve from the buren of maintaining a uplicate set of books an recors on site. Moreover, the Division recognize that the aministrator may act as a service provier for the aviser for these purposes even if the aministration agreement is actually with the fun or its general partner. Books an Recors of Non-U.S. Domicile Funs that Have an Inepenent Boar of Directors The Division also confirme that, if neither the aviser nor any of its relate persons acts as the private fun s general partner, managing member, or in a similar capacity, Rule 204-2(1) uner the Avisers Act oes not cause the books an recors of the private fun to be the recors of the aviser. Although the Subcommittee s question inicate that a majority of the fun s irectors woul be unaffiliate with the aviser, the Division i not conition its response on the presence of an inepenent boar. In practice, this position affects avisers to non-u.s. omicile funs that are forme as corporations. If a fun is forme as a corporation, the aviser is neither a general partner nor a managing member of the fun. Rather, the aviser acting as investment manager is eeme to be a service provier to the fun. Rebalancing Fun Portfolios Section 206(3) of the Avisers Act significantly restricts the ability of an aviser to engage in principal transactions an agency cross transactions, an generally requires that an aviser obtain client consent to such transactions prior to completion, following written isclosure by the aviser. 11 Avisers to multiple funs hav- 11 Section 206(3) of the Avisers Act makes it unlawful for any investment aviser, irectly or inirectly acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without isclosing to such client in writing before the completion of such transaction the capacity in which he is acting an obtaining the consent of the client to such transaction. Rule 206(3)-2 allows for prior blanket consent to agency cross transactions uner certain circumstances. ing the same strategy may fin that their funs portfolios become unbalance as a result of contributions an reemptions an, consequently, may wish to trae securities between such funs for the purpose of rebalancing. 12 Uner certain circumstances, funs manage by an aviser might be consiere to be proprietary accounts of the aviser perhaps as a result of investment by the aviser an its personnel in the fun an transactions between such funs (or the fun an another account) woul be subject to the Act s restrictions on principal transactions. 13 The Division i not provie an unequivocal response as to whether rebalancing transactions among an aviser s unregistere funs woul be viewe as principal transactions subject to the notice an consent requirements of Section 206(3) of the Avisers Act nor i the Division provie a specific percentage of ownership by an aviser an its personnel in an unregistere fun that woul cause the fun to be viewe as a proprietary account of the aviser for purposes of Section 206(3). Instea, the Division note that the application of Section 206(3) to such rebalancing transactions woul epen upon the relevant facts an circumstances. 14 Specific factors that shoul be consiere in etermining whether Section 206(3) applies inclue the extent of the ownership interest of the aviser an/or its personnel in the fun as well as the relationship of the personnel to the aviser. As such, avisers that permit their principals an employees to invest in their unregistere fun an that engage in rebalancing shoul aopt controls an proceures to monitor the aggregate ownership interests of 12 When a hege fun manager engages in rebalancing, the manager sells securities from one or more funs an purchases the securities for one or more of the other funs in a simultaneous transaction so that each fun maintains the same pro rata ownership of each securities position. 13 The Subcommittee ha specifically requeste, among other things, that the Division provie guiance as to the threshol percentage of an unregistere pool that must be owne by the fun s investment aviser an the aviser s personnel before the pool must be viewe as a principal account See Subcommittee Request Letter, supra note The Division invites managers to seek guiance as to the applicability of Section 206(3) to rebalancing. Such avisers shoul provie the Division with specific factual information an shoul explain how the transactions may implicate section 206(3) an whether they raise the concerns unerlying that section (i.e., price manipulation an umping). February 2006 / Issue 2 5

6 the aviser an its principals an employees in the fun so that the aviser may etermine whether Section 206(3) of the Avisers Act shoul apply with respect to the aviser s rebalancing transactions. Perhaps more importantly, the Division remine avisers that rebalancing transactions, whether principal transactions or otherwise, may create a conflict of interest. The Division note that Sections 206(1) an (2) of the Avisers Act impose a fiuciary uty on avisers with respect to their clients an a uty of full an fair isclosure of all material facts. Accoring to the Division, those provisions may require an aviser to isclose information about rebalancing transactions an transactions effecte by the aviser involving an unregistere fun in which the aviser an/or its personnel have an ownership interest, regarless of whether Section 206(3) of the Avisers Act also applies. This statement suggests that avisers that engage in rebalancing transactions among unregistere funs shoul isclose this practice an escribe the methos use to rebalance fun portfolios in Part II an Scheule F of Form ADV even if the ownership percentage of the aviser an/or its personnel woul not be significant enough to cause the transaction to be eeme to be a principal transaction. Aitionally, Rule 206(4)-7 uner the Avisers Act requires registere avisers to maintain compliance policies an proceures reasonably esigne to prevent violation of the Act an rules thereuner by the aviser an its associate persons. Accoringly, avisers engage in rebalancing shoul aopt policies an controls to monitor rebalancing to emonstrate, among other things, that rebalancing is not being one to favor one fun over another fun. SPVs Do Not Have to Register if the Affiliate Aviser Is Alreay Registere Many U.S.-omicile hege funs are structure so that there is a general partner of a limite partnership in aition to a separate investment manager. 15 The investment manager itself woul be registere as an investment aviser. Both the general partner an the investment manager are owne an operate by the same persons an have the same employees. The Division s concurrence that a special purpose vehicle ( SPV ) establishe to act as a general partner or managing member of a private fun that is an affiliate of a registere 15 The reason for the establishment of two entities is to achieve certain tax efficiencies. investment aviser is not require to register as an investment aviser as well, is, therefore, welcome relief to the U.S.-base hege fun community. Although the SPV woul not have to register, its investment avisory activities woul be subject to the Avisers Act an the rules thereuner, an the SPV woul be subject to examination by the SEC staff. Moreover, an SPV establishe to act as a general partner or managing member of a private fun, along with all of its employees an the persons acting on its behalf, woul be consiere persons associate with the registere investment aviser so that the SEC coul enforce the requirements of the Avisers Act against the SPV, those persons, an the registere investment aviser. 16 Accoringly, the SPV shoul be treate an operate as if it were, itself, a registere investment aviser. In particular, the SPV shoul be mae subject to the relate aviser s compliance policies an proceures an its personnel subject to the relate aviser s supervision an control. Issues Specific to Offshore Avisers Non-U.S. Base Sub-Avisers Although the Division etermine that U.S. sub-avisers generally woul be subject to the same requirements uner the Rule as any other aviser to a private fun, the Division provie limite relief for non-u.s. subavisers. Unless otherwise subject to registration, a non- U.S. base sub-aviser to a private fun is not require to register as an investment aviser with the SEC provie: The sub-aviser is hire (an subject to being ischarge) by the private fun s aviser that is registere with the SEC ( primary aviser ) The sub-aviser is not otherwise require to register with the SEC The sub-aviser oes not control, is not controlle by, or is not uner common control with the fun s primary aviser The written materials provie to the fun s investors clearly isclose that a portion of the 16 For example, any isciplinary history that the SPV woul have been require to isclose on Form ADV ha it registere as an investment aviser woul be isclose on the affiliate registere investment aviser s Form ADV. February 2006 / Issue 2 6

7 fun s assets may be manage by one or more offshore sub-avisers not registere with the SEC At the time the sub-aviser is hire, an at the time any aitional assets of the fun are allocate to the sub-aviser for management, the sub-aviser oes not manage more than 10% of the fun s total assets Aitionally, the Division note that the primary aviser retains responsibility for ensuring that all of the fun s assets are maintaine in accorance with the requirements of the Custoy Rule. Foreign Affiliates The Division also confirme that, with regar to the registration of affiliate entities, registere avisers (whether U.S. base or offshore ) an their non-u.s. affiliates may rely on the relief provie in previous noaction letters to the extent that their facts an circumstances are substantially similar to those escribe in no-action letters issue to, among others, Unibanco an Royal Bank of Canaa with respect to the use of participating affiliates. 17 Conclusion Although the Letter clarifies a number of issues which ha cause significant confusion in the hege fun aviser community, a number of open issues remain. Unregistere hege fun managers that seek to remain unregistere must be vigilant in preserving their exemption(s). Hege fun managers that are registere shoul carefully consier their compliance obligations an unertake to review their policies an proceures perioically to ensure that their operations are in compliance with the Avisers Act. This upate was authore by Davi A. Vaughan ( ; avi.vaughan@echert.com), George J. Mazin ( ; george.mazin@echert.com), Keith T. Robinson ( ; keith.robinson@echert.com), Michael L. Sherman ( ; michael.sherman@echert.com), Roerick J. Cruz ( ; roerick.cruz@echert.com), an Joshua A. Weinberg ( ; joshua.weinberg@echert.com). 17 See, e.g., Uniao e Banco e Brasileiros S.A. (pub. avail. July 28, 1992) ( Unibanco ) an Royal Bank of Canaa, et al., (pub. avail. June 3, 1998). Aitional practice group contacts For further information, please contact the authors, one of the attorneys liste, or any Dechert LLP attorney with whom you are in regular contact. Visit us at Saner M. Bieber saner.bieber@echert.com Elliott R. Curzon elliott.curzon@echert.com Ruth S. Epstein ruth.epstein@echert.com Stephen H. Bier stephen.bier@echert.com Douglas P. Dick Newport Beach ouglas.ick@echert.com Susan C. Ervin susan.ervin@echert.com Timothy M. Clark timothy.clark@echert.com Jennifer O. Epstein jennifer.epstein@echert.com Joseph R. Fleming Boston joseph.fleming@echert.com February 2006 / Issue 2 7

8 Brenan C. Fox Jack W. Murphy Freerick H. Sherley Charlotte Davi J. Harris John V. O Hanlon Boston john.ohanlon@echert.com Patrick W. D. Turley patrick.turley@echert.com Robert W. Helm robert.helm@echert.com Jeffrey S. Puretz jeffrey.puretz@echert.com Brian S. Vargo Philaelphia brian.vargo@echert.com Jane A. Kanter jane.kanter@echert.com Jon S. Ran jon.ran@echert.com Davi A. Vaughan avi.vaughan@echert.com Stuart J. Kaswell stuart.kaswell@echert.com Keith T. Robinson keith.robinson@echert.com Anthony H. Zacharski Hartfor anthony.zacharski@echert.com George J. Mazin george.mazin@echert.com Alan Rosenblat alan.rosenblat@echert.com U.S. Boston Charlotte Harrisburg Hartfor Newport Beach Palo Alto Philaelphia Princeton San Francisco, D.C. U.K./Europe Brussels Frankfurt Lonon Luxembourg Munich Paris 2006 Dechert LLP. All rights reserve. Materials have been abrige from laws, court ecisions, an aministrative rulings an shoul not be consiere as legal opinions on specific facts or as a substitute for legal counsel. February 2006 / Issue 2 8