New US Registration Requirements for Hedge Fund Advisers
Hedge funds have historically been considered the domain of a small number of sophisticated investors. Until recently, in the United States it was believed that hedge fund investment did not significantly affect the national securities markets. In the past, the United States Securities and Exchange Commission (SEC) did not regulate hedge funds differently from other types of investment funds, and it was extremely simple for a fund to avoid registration with the SEC. In recent years, however, investment in hedge funds has grown to encompass a broad investor base that runs the gamut from pension funds to unsophisticated retail investors and is currently worth an estimated $1 trillion. There has also been a significant increase in SEC enforcement actions targeting hedge funds under various anti-fraud provisions of the securities laws.
In the light of these factors, the SEC has made hedge funds the focus of extensive study in recent years, and the SEC has now decided that hedge funds merit closer regulatory attention.
In December 2004, this process culminated in the release of final rules amending the Investment Advisers Act of 1940, as amended (the “Act”), which will require a broader cross-section of hedge fund advisers to register under the Act. These new rules are designed to expand the protections of the Act, which requires investment advisers to register with the SEC, maintain business records, establish compliance programs and appoint a chief compliance officer, as well as restricting advertising and performance fee arrangements with respect to registered advisers, to cover investors in hedge funds.
Investment advisers required to register for the first time under these rule changes must do so by 1 February 2006. Advisers already registered with the SEC must respond to the amended reporting requirements laid down by the new rules in their first regular filing after 8 March 2005.
Interestingly, although the SEC has made clear that its intention with these new rules is to regulate “hedge funds”, the new rules do not provide a definition of the term. The SEC has hinted that it loosely understands the term to mean any privately organised, professionally managed, pooled investment vehicle engaged in a wide variety of investment activities. Indeed, the term “hedge fund” has never been statutorily defined by the SEC, a point that illustrates the SEC’s historic absence from hedge fund regulation.
Instead, the new rules define the term “private fund” by reference to three characteristics shared by virtually all hedge funds and that differentiate hedge funds from other pooled investment vehicles such as private equity funds or venture capital funds. The new rules define a private fund according to the following criteria:
Under the previous rules, the most common means of avoiding registration was to qualify as a private adviser. Section 203(b)(3) of the Act (the “private adviser exemption”) has provided an exemption from registration for advisers who (i) serve 14 or fewer clients (non-US advisers only count clients who are US residents), (ii) do not advise registered investment companies and (iii) do not hold themselves out generally to the public as investment advisers. A broad definition of the term “client” for the purposes of this exemption meant that any partnership, corporation or hedge fund could be counted as a single client, regardless of the number of individuals it represented. These rules allowed hedge fund advisers to serve a virtually unlimited number of individual clients free of SEC oversight.
Advisers to hedge funds, however, now face a more restrictive application of the private adviser exemption. The new rule 203(b)(3)-2 requires an investment adviser to look through each private fund that it advises and count each shareholder, limited partner, member or beneficiary toward its 14-client threshold. Advisers may no longer count these corporations and partnerships as a single client, but must look through the legal entity and count each owner. Similarly, a hedge fund adviser whose clients include funds of funds must look through the top tier private fund and count all investors as clients for purposes of the private adviser exception. The SEC estimates that this will increase by eight to 15 per cent of the number of advisers subject to registration.
These new rules contain no general exemption for non-US advisers. Regardless of where its clients themselves are located, even an adviser whose principal office and place of business is outside the United States (an “offshore adviser”) must still look through any hedge fund that meets the three private fund conditions and count individual investors against the private adviser exemption. Furthermore, although there is a de minimis exemption for US advisers with less than $30m in assets under management, there is no such exemption for non-US advisers. The SEC has, however, carved out limited yet significant exceptions to the “look-through” rules with offshore advisers in mind that should reduce the extraterritorial impact of the new legislation.
Offshore advisers would still only count US clients towards the 14-client limit. Any offshore adviser of private funds must look through the funds and count only those individual clients who are US residents. Non-US clients of offshore advisers do not count toward the 14-client limit. In determining offshore status, advisers must look to an individual’s residence or to a business entity’s principal office or place of business at the time of the investment. It is not necessary to monitor an investor’s location, as the SEC has indicated that the adviser may continue to count the investor as a non-US client even if the investor subsequently relocates to the United States.
The SEC has stated that it does not wish to require the registration of an adviser to a non-US public fund merely because more than 14 investors in the fund are US residents. Consequently, the SEC has decided that an entity will not be considered a private fund, and therefore not subject to the look-through rules, if it (i) has its principal place of business outside the United States, (ii) makes a public offering of its securities in a country other than the United States and (iii) is regulated as a public investment company under the laws of its home country. Hence, a non-US public fund meeting these criteria can be counted as a single client. Offshore advisers should find this exception helpful in avoiding registration.
In addition to this exception from registration, offshore advisers who are required to register will not be subject to the full regulatory regime of the Act. Consistent with past practice, the SEC has expressed its intention not to apply the Act’s more burdensome substantive requirements (such as the Act’s compliance rule, custody of client funds rule and proxy voting rule) to offshore advisers. Offshore advisers will also not be obliged to deliver the written disclosure brochure from Part II of Form ADV to non-US clients. Offshore advisers’ obligations are limited to record keeping, periodic examination by the SEC, and the anti-fraud rules that apply regardless of registration status.
The SEC continues to emphasise that these new rules are not the first step on a slippery slope towards burdensome regulation for hedge funds and their advisers, but they are, by any measure, a first step of some kind. More hedge fund advisers, including some offshore advisers, will come under SEC regulation as a result of these amendments, but since the rules regulate advisers, rather than the funds themselves, there is no additional disclosure of portfolio assets, clients or trading strategies. The rules are not intended to alter or impede the operations, flexibility or creativity of hedge fund managers with respect to their investment strategy, which has proven so successful to the growth of the hedge fund industry in the first instance.