December 10, 2004 Hedge Fund Alert A periodic update on trends and developments affecting the industry SEC Publishes Adopting Release for Final Hedge Fund Adviser Registration Requirements The SEC has issued the formal release (the Release ) adopting a new rule and rule amendments (the Amendments ) under the Investment Advisers Act of 1940, as amended (the Advisers Act ) designed to require hedge fund advisers to register under the Advisers Act. The Amendments narrow the exemption from SEC registration available to certain advisers with fewer than 15 clients under Section 203(b)(3) of the Advisers Act (the Private Adviser Exemption ) by requiring an adviser to look through private funds to the underlying owners for purposes of counting clients. The Amendments and the Release also: (a) address the manner in which various aspects of the Advisers Act and its related rules will apply to advisers newly registered as a result of the Amendments, (b) relax the audit requirement under the Advisers Act custody rule for all advisers to funds of funds, permitting the distribution of audited financial statements of funds to investors within 180 days after fiscal year-end (rather than 120), and (c) modify the Form ADV disclosures to include private funds. This Alert outlines the Amendments and highlights certain issues that may require special consideration or action. The Amendments have provoked significant discussion, and a lengthy dissent by two of the five SEC Commissioners, and questions have been raised regarding the SEC s authority to effect the Amendments. However, the Amendments currently have a February 1, 2006 compliance date and certain recordkeeping requirements have practical effect as early as February 10, 2005 (as discussed in more detail below). The registration process (once the forms are completed and filed) can take up to 45 days (which means that the filings should be made by December 16, 2005), and selecting a chief compliance officer, crafting a compliance manual and building infrastructure can take significantly longer. In addition, advisers who are registered with the SEC should note that the amendments to Form ADV become effective March 8, 2005. Definition of Private Fund The Amendments apply to any adviser to a private fund, which is defined as a fund having each of the following characteristics: it is not registered under the Investment Company Act of 1940, as amended (the 1940 Act ), in reliance on 1940 Act Section 3(c)(1) (a 3(c)(1) fund ) or Section 3(c)(7) (a 3(c)(7) fund );
it permits investors to redeem their interests within two years of purchase (not including certain extraordinary redemptions) (the two year redemption test ); and it is offered on the basis of the investment skills and expertise of the adviser. The SEC stated in the Release that the two year redemption test is designed to exclude private equity funds, venture capital funds and certain structured finance vehicles from being defined as private funds. In addition, as a result of the Amendments focus on 3(c)(1) and 3(c)(7) funds, certain funds, such as a real estate securities fund relying on Section 3(c)(5)(C) for an exclusion from registration under the 1940 Act, will not be private funds. Offshore funds whose investors are exclusively non-u.s. persons and that do not rely on Sections 3(c)(1) or 3(c)(7) of the 1940 Act will not be private funds (even if they have a U.S. adviser). The two year redemption test applies to each interest purchased and to each contribution of capital. The Release observes that advisers may use a first-in, first-out method to determine whether the test is met, which would require an adviser to track redemptions based on the date of each fund investment or capital contribution rather than the date a person first becomes an investor or makes a capital commitment. Although the issue is not addressed in the Release, investors that purchase interests in a private fund on January 1st would presumably need to wait until the second January 1st (rather than December 31st) following the date of purchase in order to meet the two year redemption test. Under the Amendments, a redemption that an adviser determines is extraordinary after reasonable inquiry will not cause a fund to fail the two year redemption test. (The SEC did not adopt its original proposal which would have required an adviser to determine that a redemption was both extraordinary and unforeseeable at the time the private fund interest was issued.) The Release identifies certain types of circumstances under which a fund s governing documents may offer redemption rights without failing the two year redemption test: the investment becomes impractical or illegal; an owner dies or becomes totally disabled; key personnel at the adviser die, become incapacitated, or cease to be involved in the management of the fund for an extended period of time; the fund undertakes a merger or reorganization; redemption is necessary to avoid a materially adverse tax or regulatory outcome; or redemption is necessary to keep the fund s assets from being considered plan assets under ERISA. It is unclear how the SEC would treat these redemption rights if they were offered to investors at the discretion of the investment adviser or general partner of the fund. The Release does not address provisions frequently found in fund governing documents that authorize a fund s general partner to redeem an investor s interest under specified Goodwin Procter LLP Page 2
circumstances and provides no guidance regarding other circumstances under which a redemption could be considered extraordinary. The redemption of fund interests acquired through reinvestment of capital gain or income distributions is not subject to the two year redemption test. In addition, distributions by the fund s general partner or investment adviser to the fund s owners or a class of owners in accordance with the fund s governing documents are disregarded for purposes of the two year redemption test. An investor s transfer of a fund interest to a new limited partner in a secondary market transaction is not a redemption for purposes of the two year redemption test. Finally, the Release states that a fund that uses side letters to give some, but not all, investors the opportunity to redeem fund interests within two years, would fail the two year redemption test. With respect to the third element of the private fund definition (that the fund be offered on the basis of its adviser s investment skills and expertise), the Release notes that once a fund is offered based on the skills/expertise of any adviser, the fund is deemed to be offered on the basis of the skills/experience of all its advisers, including advisers who may not be mentioned in offering documents, e.g., subadvisers in a manager of managers structure. The Release separately states that an adviser may not circumvent this aspect of the Amendments by delegating advisory functions to sub-advisers or by using a manager of managers structure. The Amendments include an exception to the definition of private fund for a fund that has its principal office and place of business outside the United States and makes a public offering of its securities in a non-u.s. country under whose laws the fund is regulated as a public investment company. The SEC will not currently offer guidance on situations where a jurisdiction s listing criteria are distinct from its criteria for public offerings. The Release states that the Amendments are not designed to alter the manner in which advisers count clients for other purposes under the Advisers Act. In this regard, the Amendments clarify that for purposes of Advisers Act Rule 203A-3 (definition of investment adviser representative) and Rule 222-2 ( de minimis standard for state adviser registration) advisers and their supervised persons may count clients as provided in Rule 203(b)(3)-1 without regard for the look through provisions of Rule 203(b)(3)-2. Look Through Provisions Under new Advisers Act Rule 203(b)(3)-2 and amendments to Advisers Act Rule 203(b)(3)-1, an adviser must generally look through each private fund that it advises to count each underlying investor as a client for purposes of the Private Adviser Exemption. The Release indicates that an adviser must look through any registered or unregistered fund of funds that holds an interest in that private fund or, where the private fund is a master fund in a master feeder structure, through any private fund feeders. An adviser may exclude from its client count: itself, regardless of the form its private fund ownership takes; insiders who are qualified clients, i.e., the adviser may charge them a performance fee under Advisers Act Rule 205-3; or Goodwin Procter LLP Page 3
any private fund whose investors the adviser is required to count for purposes of the Private Adviser Exemption. Rule 203(b)(3)-2 provides that an adviser to a private fund in which a registered investment company is directly or indirectly an owner must count the registered investment company s owners as clients for purposes of the Private Adviser Exemption. Although the Amendments do not permit an adviser to rely on Rule 203(b)(3)-1 to treat a private fund as a single client for purposes of the Private Adviser Exemption, they do not prevent an adviser looking through a private fund from relying on other portions of that Rule when counting the private fund s underlying owners, e.g., an adviser may still treat relatives living in the same household as a single client. Implications of Registration Although advisers, whether registered or unregistered, are currently subject to certain provisions of the Advisers Act (e.g., the anti-fraud provisions of Section 206 and the duty to supervise under Section 203(e)(6), registration would impose a number of additional obligations on currently unregistered private fund advisers. Among the more significant obligations, an adviser would need to adopt compliance policies and procedures and designate a chief compliance officer. Following registration, private fund advisers would also be subject to Advisers Act requirements regarding examination by the SEC, recordkeeping, personal securities transaction reporting, custody, voting of proxies, use of performance data and other advertising activities, as well as limitations on when a registered adviser may charge its clients performance based fees. (With respect to the Advisers Act s recordkeeping requirements, the Amendments specify that a registered adviser s books and records also include the books and records of any private fund which it advises and for which it or any of its related persons (as defined in Form ADV) acts as the private fund s general partner, managing member, or in a comparable capacity.) The Amendments modify certain of the foregoing requirements, as discussed in more detail below. The Amendments do not alter (i) state and federal investment adviser registration requirements, e.g., the requirement that an adviser must generally have $25 million in securities portfolios under management to qualify for SEC registration, or (ii) registration obligations that an adviser may have with other regulators such as the CFTC. Grandfather Provisions The Amendments permit an adviser that relied on the Private Adviser Exemption prior to the effectiveness of the Amendments (a Former Private Adviser ) to market performance from periods prior to its registration, even if the adviser has not retained the supporting documentation required under Advisers Act Rule 204-2 for pre-february 10, 2005 performance. The adviser is nevertheless required to retain whatever documentation it already has supporting its pre-february 10, 2005 performance and must retain records that comply with Advisers Act Rule 204-2 for performance periods beginning February 10, 2005 or later. The Amendments also grandfather certain existing performance fee arrangements (arrangements based on a share of a fund s capital gains or appreciation) that would be prohibited under Section 205 of the Advisers Act and Advisers Act Rule 205-3 once an adviser registers. A Former Private Adviser is exempt from the requirement under Rule 205-3 that it look through a 3(c)(1) fund to determine whether an underlying investor is a Goodwin Procter LLP Page 4
qualified client for purposes of permitting performance fee arrangements, provided that the investor s interest in the fund dates from before February 10, 2005. The Amendments also allow a Former Private Adviser to continue performance arrangements with its non-3(c)(1) fund clients provided the advisory contract reflecting those arrangements was entered into prior to February 10, 2005. Offshore Advisers Determining Availability of Private Adviser Exemption The Amendments treat an adviser whose principal office and place of business is outside the U.S. (an offshore adviser ) somewhat differently when determining whether that adviser is eligible for the Private Adviser Exemption. Like a U.S. based adviser, an offshore adviser must look through each private fund it advises, whether or not the fund is also located offshore, for purposes of counting its clients. Unlike a U.S. adviser, an offshore adviser need only count each investor that is a U.S. resident as a client. In this context, the determination as to whether a client is a U.S. or non-u.s. resident is made at the time of investment. If an investor is a non-u.s. client at the time of investment, the adviser may continue to count the investor as a non-u.s. client even if the investor subsequently relocates to the United States. If, however, a non-u.s. investor transfers the investor s interest to a U.S. investor, the adviser should count the transferee as a U.S. client. The Release notes that commenters suggested that U.S. resident be defined in the same manner as U.S. person under Regulation S under the Securities Act of 1933. The SEC declined to do so, noting that Regulation S is designed for use in transactions, not ongoing advisory relationships. The SEC did, however, indicate that it would not currently object if advisers determine whether an investor is a U.S. resident based on the following: in the case of individuals, their residence; in the case of corporations and other business entities, their principal office and place of business; in the case of personal trusts and estates, the rules set out in Regulation S; and in the case of discretionary or non-discretionary accounts managed by another investment adviser, the location of the person for whose benefit the account is held. Offshore Advisers to Offshore Private Funds Although Rule 203(b)(3)-2(b) requires an offshore adviser to look through both offshore and U.S. private funds for purposes of determining the availability of the Private Adviser Exemption, Rule 203(b)(3)-2(c) provides that an offshore adviser required to register under the Advisers Act may treat an offshore private fund (one that is organized or incorporated under the laws of a non-u.s. country) as its client for all purposes under the Advisers Act, other than Section 203 (registration and enforcement powers), Section 204 (books and records) and Sections 206(1) and 206(2) (anti-fraud). An offshore adviser relying on this aspect of Rule 203(b)(3)-2 would be required (unless eligible for an exemption) to register under the Advisers Act and to keep certain books and records regarding the offshore private fund mandated by various Advisers Act rules (as modified by past no-action letter guidance regarding the recordkeeping obligations of registered offshore advisers), and would be subject to examinations by the SEC staff (including with respect to any records the adviser keeps pursuant to foreign law). Other Goodwin Procter LLP Page 5
requirements, including the Advisers Act s compliance rule, custody rule, and proxy voting rule, would not apply to the offshore adviser. In addition, an offshore adviser without U.S. clients would not be required to adopt a code of ethics pursuant to Advisers Act Rule 204A-1 but would need to retain the personal securities transaction reports required under the Rule. An offshore adviser would not be required to deliver a written disclosure brochure to its offshore clients (or to investors in an offshore private fund it advises) although it would have a fiduciary duty to provide those clients with full and fair disclosure of any conflicts of interest. The offshore adviser s contracts with its offshore clients, including any offshore private fund, would not need to include certain contractual provisions that would otherwise be required by Section 205 of the Advisers Act. In addition, with respect to its offshore clients, the offshore adviser would not be subject to the restrictions on principal transactions set forth in Section 206(3) of the Advisers Act or to Advisers Act rules governing adviser advertising or cash solicitations. An offshore adviser would need to comply with the Advisers Act with respect to any U.S. clients (other than those treated as clients solely for counting purposes). Form ADV The Amendments revise Form ADV to include private funds in the existing disclosure requirements applicable to investment-related limited partnerships and limited liability companies. Custody Rule Audit Requirements In a rule change unrelated to the Private Adviser Exemption, the Amendments allow an adviser that chooses to distribute audited fund financial statements to fund investors in order to comply with the requirements of the Advisers Act custody rule to make the required distribution within 180 days of the fund s fiscal year end for a fund of funds rather than 120 days as otherwise required. The extended deadline applies only if the fund of funds invests at least ten percent of its assets in other, unrelated, pooled investment vehicles. Effective and Compliance Dates The effective date of the Amendments with respect to the Custody Rule and Form ADV is January 10, 2005. The effective date of new Rule 203(b)(3)-2 and of the Amendments relating to Rule 203(b)(3)-1, Rule 203A-3 (investment advisory representative), Rule 204-2 (recordkeeping), Rule 205-3 (performance fees) and Rule 222-2 ( de minimis standard for state adviser registration) is February 10, 2005. Advisers may begin complying with the Amendments as of their respective effective dates. Advisers must comply with the Amendments by February 1, 2006. By February 1, 2006, each adviser required to register as a result of the Amendments must have its registration effective (a process which under normal circumstances can take up to 45 days after the filing of Form ADV with the SEC). Once its Advisers Act registration is effective, an adviser must comply with the Advisers Act and its rules, which includes: (a) having in place compliance policies and procedures (and a chief compliance officer), an insider trading policy, proxy voting policies and procedures, a code of ethics including personal securities transaction reporting and (b) observing requirements relating to performance fees, books and records, advertising and cash solicitations. Advisers must apply the two year redemption test discussed above to any Goodwin Procter LLP Page 6
investments made on or after February 1, 2006, whether those investments are made by new or existing investors, but need not apply this test to investments made prior to the compliance date. The IARD filing system used to electronically file Part 1 of Form ADV will incorporate the Amendments affecting Form ADV on March 8, 2005. A registered adviser amending its Form ADV after the Amendments have been incorporated must respond to the Form as amended and in any event must amend its Form ADV to respond to the revised item by February 1, 2006. This schedule is designed to allow most registered advisers to respond to the revised Form ADV item in conjunction with their regular annual updating amendment, rather than requiring them to file an additional amendment. If you would like additional information about the issues raised in this Alert, please contact: Elizabeth Shea Fries efries@goodwinprocter.com 617.570.1559 Peter T. Fariel pfariel@goodwinprocter.com 617.570.1524 Jackson B.R. Galloway jgalloway@goodwinprocter.com 617.570.1050 Full access to all publications prepared by Goodwin Procter is available at: http://www.goodwinprocter.com/publications.asp This publication, which may be considered advertising under the ethical rules of certain jurisdictions, is provided with the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin Procter LLP or its attorneys. 2004 Goodwin Procter LLP. All rights reserved. Goodwin Procter LLP Page 7