Implications For Non-U.S. Investment Advisers Of Dodd-Frank Act Provisions And Proposed SEC Rules On Registration Of Private Fund Investment Advisers

The Private Fund Investment Advisers Registration Act (the “Private Fund Legislation”) adopted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amended various provisions of the U.S. Investment Advisers Act of 1940 (the “Advisers Act”) to impose Securities and Exchange Commission (“SEC”) registration obligations on investment advisers to hedge funds, private equity funds and other private pools of capital. The Private Fund Legislation also directed the SEC to promulgate rules in support of the new statutory provisions. On November 19, 2010, the SEC proposed new rules and rule amendments¹ under the Advisers Act (the “Proposed Rules”) to give effect to the Private Fund Legislation (see related report in this issue).

The most significant aspect of the Private Fund Legislation is the elimination of the so-called “15-client rule” (also referred to as the “private adviser exemption”) on which many advisers to private equity funds, hedge funds and other private pools of capital relied to operate without SEC registration. The 15-client rule allowed an investment adviser with fewer than 15 clients in the United States during the preceding 12-month period to operate without registering with the SEC, provided it did not hold itself out as an investment adviser to the U.S. public. At the same time, when counting clients for purposes of the private adviser exemption, an investment adviser to private pools of capital was able to treat the fund it advised as one client, rather than counting each investor in the fund as a separate client.

Historically, while non-U.S. investment advisers to private funds did not need to focus on registration issues, non-U.S. investment advisers advising individual U.S. clients did need to consider potential registration issues, counting, for this purpose, their individual clients resident in the United States. As a result of the Private Fund Legislation, non-U.S. investment advisers to individuals as well as investment managers to a range of funds will now be subject to the same limited exemptions.

We address in this Focus article the potential impact of the regulatory changes on non-U.S. investment advisers that have advisory clients in the United States or act as managers to hedge funds, private equity funds or other private pools of capital that have raised funds in the United States. These changes, including the repeal of the private adviser exemption, will become effective July 21, 2011. The Proposed Rules are subject to a 45-day public comment period, and are to become effective on July 21, 2011.

Foreign Private Adviser Exemption

The Private Fund Legislation provides a new exemption from registration for “foreign private advisers” (the “Foreign Private Adviser Exemption”). Under this narrow exemption, an adviser is not required to register with the SEC if it:

• has no place of business in the United States;

• has a total of fewer than 15 clients in the United States and investors in the United States in private funds² advised by the adviser;

• has aggregate assets under management attributable to clients and investors in the United States in private funds advised by such adviser of less than $25 million³; and

• neither holds itself out generally to the public in the United States as an investment adviser nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940 (the “Investment Company Act”) or any business development company.

The Proposed Rules clarify certain terms used in the Foreign Private Adviser Exemption.

Place of Business

The Proposed Rules define a “place of business” of an investment adviser as 1) any office where the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and 2) any other location that is held out to the general public as a place where the investment adviser provides any such activities.

How to Count ‘Clients’

The Proposed Rules include “safe harbors” for counting clients similar to those currently in effect under the private adviser exemption,⁴ though modified to eliminate the ability to exclude clients from which they receive no compensation. The Proposed Rules make clear that only clients in the United States should be counted. To avoid potential double-counting, an adviser need not count 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.

How to Count ‘Investors’

For purposes of counting “investors,” one would look to the counting methods required by Section 3(c)(1) and Section 3(c)(7) of the Investment Company Act. As such, an investor would be any person that would be included in the determination of 1) the number of beneficial owners of a private fund’s outstanding securities under Section 3(c)(1), or 2) whether a private fund’s outstanding securities are owned exclusively by qualified purchasers under Section 3(c)(7).

Under the Proposed Rules, advisers would have to “look through” nominee and similar arrangements to the underlying holders of private fund-issued securities to determine whether they have fewer than 15 clients in the United States and private fund investors in the United States. In a master-feeder structure, for example, the investors in the feeder funds — and not the feeder funds themselves — would count as investors in the master fund. Moreover, any holder of an instrument that effectively transfers the risk of investing in the private fund (e.g., a total return swap) from the record owner of the private fund’s securities would need to count as an investor, even though such person is not the record owner of the securities.

Knowledgeable employees with respect to the private fund (and certain persons related to them) and beneficial owners of short-term paper issued by the private fund would count as investors, even though these persons do not count as beneficial owners for purposes of Section 3(c)(1) and knowledgeable employees are not required to be qualified purchasers under Section 3(c)(7).

In the United States

The Proposed Rules define “in the United States” by incorporating certain defined terms used in Regulation S under the Securities Act of 1933. In general, 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. A person that is “in the United States” may be treated as not being “in the United States” if such person was not “in the United States” at the time it became a client or, in the case of an investor in a private fund, at the time the investor acquired its interest in the fund.

Assets under Management

The Proposed Rules include a new uniform method for calculating an investment adviser’s assets under management. Pursuant to the Proposed Rules, “assets under management” would be defined by reference to the requirements of revised Form ADV (renamed as the “Uniform Application for Investment Adviser Registration and Report by Exempt Reporting Advisers”). Under the Proposed Rules, all investment advisers would be required to include in their calculations of assets under management securities portfolios for which they provide continuous and regular supervisory or management services, regardless of whether these assets are proprietary assets, assets managed without receiving compensation or assets of non-U.S. clients, all of which an investment adviser currently may exclude. In addition, an investment adviser may not subtract outstanding indebtedness and other accrued but unpaid liabilities, which remain in a client’s account and are managed by the investment adviser.

‘Conditional’ Exemptions for Non-U.S. Advisers

The Private Fund Legislation also created a new category of investment advisers — “exempt reporting advisers” — that do not need to register with the SEC. Exempt reporting advisers, however, must comply with recordkeeping and reporting requirements and are subject to SEC examination. Exempt reporting advisers may qualify as such in one of two ways: either by 1) advising only private funds and having aggregate assets under management in the United States of less than $150 million or 2) advising only venture capital funds.

Private Fund Adviser Exemption

The Private Fund Legislation directs the SEC to exempt from registration an investment adviser that advises solely private funds and has less than $150 million in assets under management⁵ in the United States. Availability of the exemption depends on whether an adviser has its principal office in the United States or outside the United States. As clarified in the Proposed Rules, the SEC would look to an adviser’s principal office and place of business as the location where the adviser controls, or has ultimate responsibility for, the management of private fund assets, and therefore as the place where all the adviser’s assets are managed, although day-to-day management of certain assets may also take place at another location.

The Private Fund Adviser Exemption would be available to an adviser with a principal office and place of business outside the United States so long as all the adviser’s clients who are U.S. persons (as defined in Regulation S) are private funds even if the adviser has non-U.S. clients who are not private funds. The adviser would need to count towards the $150 million asset limit only private fund assets it manages from a place of business in the United States. In other words, the type and number of non-U.S. clients would not be taken into account.

Venture Capital Exemption

The Private Fund Legislation amended the Advisers Act to exempt investment advisers that solely manage “venture capital funds” from registration under the Advisers Act. The SEC proposed to define “venture capital fund” in the Proposed Rules. A non-U.S. investment adviser may rely on the venture capital exemption if all of its clients, U.S. and non-U.S., are venture capital funds.

Reporting Requirements

Congress gave the SEC broad authority to require exempt reporting advisers to provide reports “as the [SEC] determines necessary or appropriate in the public interest or for the protection of investors.”

Under the Proposed Rules, exempt reporting advisers would be required to file, and periodically update, Form ADV in the SEC’s investment adviser electronic filing system (the Investment Adviser Registration Depository), which would be publicly available on the SEC’s website. Rather than responding to all of the items of Form ADV, exempt reporting advisers would respond to a limited subset of items, including 1) the identity of the adviser’s direct and indirect owners and control persons; 2) details about the private funds the investment adviser manages and other business activities that the investment adviser and its affiliates are engaged in that present conflicts of interest that may suggest significant risk to clients; and 3) the disciplinary history of the investment adviser and its employees that may reflect on the adviser’s integrity.

An exempt reporting adviser would be required to file its initial report with the SEC on Form ADV no later than August 20, 2011, 30 days after the effective date of the Private Fund Legislation. The Proposed Rules would require an exempt reporting adviser to file updates to its Form ADV within 90 days of the end of the adviser’s fiscal year (or more frequently, if specifically required by the instructions to Form ADV).

SEC Examination and Oversight

Under the Proposed Rules, exempt reporting advisers are subject to Section 204 of the Advisers Act, as a result of which they will be subject to examination by the SEC, as well as subject to the reporting and recordkeeping provisions of the Advisers Act.

Additional Exemptions

The Private Fund Legislation contemplates other exemptions available to non-U.S. investment advisers, including an exemption for investment advisers that are registered with the Commodity Futures Trading Commission as a commodity trading adviser, provided such adviser does not predominantly provide advice with respect to securities. Also, any adviser that solely advises small business investment companies will also be exempt from the registration requirements of the Advisers Act.

Family Offices

On October 12, 2010, the SEC proposed a new rule to give effect to the exclusion under the Private Fund Legislation of “family offices” from the definition of investment adviser (and therefore from the registration requirement of the Advisers Act). Under the SEC proposal, a “family office” would be an entity that:

• provides investment advice only to family members, as defined by the rule; certain key employees; charities and trusts established by family members; and entities wholly owned and controlled by family members;

• is wholly owned and controlled by family members; and

• does not hold itself out to the public as an investment adviser.

The exclusion would not cover family offices servicing multiple families.

SEC Registration

Non-U.S. investment advisers that are unable to take advantage of any of the available exemptions from registration but are nonetheless subject to registration (for example, because they advise individual clients resident in the United States whose number and/or assets under management exceed the exemption thresholds) will need to comply with the full panoply of registration requirements.

In general, investment advisers registered with the SEC are required to 1) prepare, and file with the SEC, certain reports; 2) provide clients and prospective clients with a written disclosure statement; 3) have a code of ethics and enforce certain insider trading procedures; and 4) maintain certain books and records, among others. Registered investment advisers are subject to SEC oversight and may be examined by the SEC staff.

An investment adviser registers with the SEC by filing a Form ADV, which includes two parts. In general:

• Part I requires an adviser to provide general identifying and financial information about the adviser and its business, including whether it maintains custody of client assets and information regarding the disciplinary history of the adviser and its employees.

• Part II — the “brochure” — requires disclosure in a plain English narrative form about the adviser’s qualifications, investment strategies and business practices. This disclosure is designed to provide clients of an adviser with greater information about the individuals who will provide them with investment advice and to allow clients to compare fees charged by different advisers for similar products and fees charged by an adviser for different products. The brochure requires disclosure with respect to, among other things, types of services provided by the adviser and the nature of the clients; valuation policies, especially with respect to any illiquid securities whose value is taken into consideration in the calculation of a management or performance fee; soft dollar arrangements; and allocation of securities (advisers advising more than one fund or account should have well-defined procedures for allocating securities purchases among such funds).

The Proposed Rules amend Form ADV to require, among other things, all registered investment advisers to provide more detailed information about 1) their advisory business (including data about the types of clients they have, their employees, and their advisory activities); 2) their business practices that may present significant conflicts of interest (such as the use of affiliated brokers, soft dollar arrangements and compensation for client referrals); and 3) their non-advisory activities and their financial industry affiliations.

The Proposed Rules would require an investment adviser registered with the SEC on July 21, 2011 to file an amendment to its Form ADV no later than August 20, 2011, 30 days after the effective date of the Private Fund Legislation, and to report the market value of its assets under management determined within 30 days of the filing. Updating amendments are required to be made annually to Form ADV and must be filed with the SEC within 90 days after the adviser’s fiscal year-end. An adviser also has a continuing obligation to update its Form ADV promptly during the course of the year to reflect any material changes to the information provided in the form.

Principal Substantive Requirements

Once registered, if the non-U.S. investment adviser has U.S. clients, the adviser must comply with all of the substantive provisions of the Advisers Act with respect to its U.S. clients. With respect to non-U.S. clients, the substantive provisions of the Advisers Act generally do not apply, although the adviser must comply with certain of the recordkeeping requirements of the Advisers Act with respect to all clients, as well as SEC inspection requirements (see “Bifurcated Regulatory Oversight” discussed below). Non-U.S. investment advisers must also provide the SEC with access to non-U.S. personnel with respect to all of their activities, including making such personnel available for testimony before, or questioning by, the SEC or its staff.

In addition, non-U.S. investment advisers may not hold themselves out to non-U.S. clients as being registered under the Advisers Act, and written communications with non-U.S. clients must either delete any reference to the Advisers Act or make clear that the non-U.S. investment adviser will comply with the Advisers Act only with respect to U.S. clients.

Books and Records

A non-U.S. investment adviser registered with the SEC must keep true, accurate and current books and records reflecting its financial affairs and describing any transactions for, and communications with, its U.S. clients. Specifically, this would include:

• corporate records (by-laws, charters and board minutes);

• accounting records (ledgers, journals and bank statements);

• client records (including contracts and powers of attorney);

• transaction records (order tickets and trade reports); and

• communication records (e.g., marketing materials, client inquiries, client complaints, research reports).

The adviser must maintain its records for at least two years (and longer for certain records) in an appropriate office of the adviser, and thereafter in an easily accessible place for an additional three years.

The Advisers Act sets forth rules regarding the location in the United States at which books and records are maintained and requires notice to the SEC of the address of such location. Alternatively, the adviser may agree with the SEC, in the form of a written undertaking meeting the requirements of the applicable rule, to provide the necessary books and records upon SEC demand.

Inspections

SEC inspection typically occurs within a year after initial registration. The inspection cycle of an adviser will vary depending upon the firm’s size and the risks that the SEC believes the firm presents. It is not uncommon for the SEC to perform an inspection on at least a bi-annual basis.

Books and records are usually the subject of careful review during SEC inspections and, in the case of a non-U.S. investment adviser registered with the SEC, would include records related to the adviser’s non-U.S. clients. While it is clear that registered non-U.S. investment advisers are required to provide the SEC with access to non-U.S. personnel with respect to all of their activities, including making such personnel available for testimony before, or questioning by, the SEC or its staff, there is no express guidance regarding the inspection process as it relates to registered non-U.S. investment advisers. For actions arising under the U.S. securities laws relating to advisory activities for U.S. clients, a non-U.S. adviser’s personnel are required to submit to the jurisdiction of U.S. courts and to appoint a U.S. agent for service of process.

The SEC conducts on-site inspections of registered investment advisers located outside the United States (of which as of July 2010 there were over 250 firms). Many inspections of dually regulated entities may be conducted jointly with the local regulator or may involve coordination between the SEC and the local regulator.

Limitations on Performance-Based Fees

Subject to certain exceptions, investment advisory contracts may not provide for compensation based on a share of capital appreciation (i.e., “carried interest” or “incentive fee”). A performance fee may, however, be charged to:

• private funds, if all investors are “qualified purchasers”;

• sophisticated clients meeting certain criteria (most notably, either a net worth of $1.5 million or a minimum of $750,000 of assets under management by the adviser);

• clients that are non-U.S. residents; or

• registered investment companies, if the fee is a “fulcrum” fee that meets certain conditions.

Additional Disclosure Requirements

An investment adviser must provide clients with resume-like disclosure about “associated persons” that formulate investment advice for a client and about persons that have discretionary authority over a client’s assets (so long as such persons have direct client contact). In addition, the adviser must describe how the advice provided by supervised persons is monitored, including contact information for the supervisor of each supervised person. This information need not be filed with the SEC.

Advertising

The Advisers Act generally prohibits investment advisers from distributing any advertisement that, among other things, contains untrue statements of a material fact or that is otherwise false or misleading. There are also specific provisions that prohibit:

• any type of testimonial⁶ concerning the adviser or any advice, report or service rendered by the adviser; and

• claims with respect to “black box” investment strategies without disclosure of all of the limitations associated with such a strategy.

The SEC staff has taken a number of positions concerning the presentation of performance information, including:

• Net vs. Gross: Performance presentations should generally be based upon net figures rather than gross. In other words, advisory fees, brokerage commissions and other client-related expenses should be deducted from performance returns. “Gross” information may be used if net performance is also shown with equal prominence or in one-on-one private presentations with sophisticated investors (if certain guidelines are followed).

• Deduction of Model Fees: The SEC has expressed the view that the Advisers Act does not prohibit an adviser from advertising performance that reflects the deduction of a model fee when doing so would result in performance figures that are no higher than those that would have resulted if actual fees had been deducted.

• Prior performance: An adviser’s ability to present performance experienced at another manager/employer is generally limited to circumstances in which the adviser was “primarily responsible” for the results achieved at such other manager or employer.

• Back-up: An adviser must have records that substantiate any performance shown.

Use of Non-Public Information

An investment adviser must establish, maintain and enforce certain written policies and procedures that are reasonably designed to prevent and detect the misuse of material non-public information by the adviser or any person associated with it. The adviser must provide its clients with a notice of its privacy policies and practices and must not disclose non-public personal information about a client to non-affiliated third parties unless certain conditions are met. The adequacy of these procedures has been a focus of SEC enforcement actions even in circumstances where there was no allegation that material non-public information was misused.

Advisory Contracts

Each advisory contract must contain a clause stating that the contract may not be assigned by the investment adviser without the client’s consent. Also, the contract may not contain any clause that allows the adviser to waive compliance with any provision of, or rule under, the Advisers Act.

Custody

An investment adviser that has custody of clients’ assets will be subject to the requirements of the Advisers Act, including that of maintaining the assets with a “qualified custodian” (e.g., banks, broker-dealers, foreign financial institutions).

Compliance Policies and Procedures

An investment adviser must adopt and implement written policies and procedures reasonably designed to prevent and detect violations of the Advisers Act by the adviser or any of its “associated persons.”⁷ Compliance policies and procedures should address, among other things, maintenance of books and records, disclosure of information, anti-fraud safeguards and conflicts of interest. An adviser must review its policies and procedures annually to determine the adequacy and the effectiveness of their implementation. It must also designate a chief compliance officer to administer the policies and procedures.

Code of Ethics

An investment adviser must have and enforce a written code of ethics that sets forth the standard of business conduct that the adviser requires from all associated persons. The standard must reflect the adviser’s fiduciary obligations and those of its associated persons.

Personal Securities Trading

An investment adviser’s “access persons”⁸ must be subject to reporting requirements in respect of any personal securities trading. The adviser’s access persons must report personal securities transactions to the adviser’s chief compliance officer.

The SEC has recommended elements of personal securities trading policies, including the following:

• pre-clearance before access persons can effect personal securities transaction;

• maintenance of “watch” lists of issuers that the adviser is analyzing or recommending for client transactions and prohibitions on personal trading of securities of such issuers;

• maintenance of “restricted lists” of issuers about which the adviser has inside information and prohibitions on any trading in securities of such issuers;

• “blackout periods” during which access persons may not transact in such securities;

• reminders that investment opportunities must be offered first to clients before the adviser or its employees may act on them; and

• prohibitions or restrictions on “short-swing” trading and market timing.

Statutory Anti-Fraud Provisions

Registered non-U.S. investment advisers are subject to the anti-fraud provisions of the Advisers Act, which prohibit any fraudulent conduct on the part of a registered adviser and its employees. In respect of its U.S. clients, these provisions govern agency-cross and principal transactions and custody of client assets, among other aspects. With respect to non-U.S. clients, the anti-fraud provisions of the Advisers Act generally do not apply unless the non-U.S. investment adviser’s conduct otherwise has an effect in the United States or on its U.S. clients.

Timing

The SEC must act on the Form ADV within 45 days of filing. Typically, a Form ADV will become effective in less time.

Substantive requirements must be complied with from the date that the registration is effective. Therefore, it is best not to file Form ADV until the adviser is in a position to operate in compliance with the requirements of the Advisers Act. Among other things, this means that the firm should have implemented appropriate compliance policies and procedures and appointed a chief compliance officer.

A typical registration timeline involves the following:

• initial compliance and operational gap analysis (months 1 and 2);

• development and/or enhancement of compliance policies and procedures manual and completion of ADV Part 1A and Part 2 (months 2 and 3);

• identification of additional requisite partners and vendors (e.g., e-mail archiving) (months 2 through 4);

• host employee compliance training session(s) (month 4);

• firm-wide adoption and implementation of compliance manual (month 5);

• file Form ADV with the SEC (month 5); and

• mock SEC inspection and annual review of compliance program (months 6 through 9).

Bifurcating Regulatory Oversight

Over the years, the SEC has addressed in various ways the challenges faced by non-U.S. investment advisers subject to SEC registration.

To the extent that a non-U.S. investment adviser has U.S. and non-U.S. clients, the SEC has taken the position since 1992 that the Advisers Act does not govern the relationship between a registered non-U.S. investment adviser and its clients residing outside the United States. It does, however, govern access to certain books and records and inspection by SEC staff. This position, known as “Adviser Lite” regulation, is now based largely on a “conduct and effects” approach to the extraterritorial application of U.S. rules, and was most recently confirmed in 2004 as part of the SEC’s (then unsuccessful) efforts to regulate advisers to private funds.

Advisers with global operations have often relied on relief granted under no-action letters to insulate non-U.S. operations from U.S. regulatory oversight by forming affiliated entities that register with the SEC. Practitioners have focused on the nature of the relationship between the parent and the registered subsidiary and the functions performed at the subsidiary level. Pre-1992 requirements in respect of “separateness” were relaxed with the announcement of the “conduct and effects” approach and confirmation that separate entities would be considered independently (with a focus on whether the registered entity is staffed with personnel, located in the United States or abroad, that are capable of providing investment advice and whether those rendering investment advice to U.S. clients are subject to SEC jurisdiction). (Note that where a non-U.S. investment adviser has a U.S. subsidiary, that U.S. subsidiary does not benefit from the Adviser Lite principle.)

Although a non-U.S. investment adviser can register directly, rather than operate its U.S. business through a separate registered legal entity, and seek to apply the substantive requirements of the Advisers Act only to U.S. client accounts, the non-U.S. investment adviser will still be subject to SEC regulation, covering in certain respects its non-U.S. clients.

Firms subject to regulation outside the United States that become subject to U.S. registration will also need to consider the implications of complying with two separate regulatory regimes. Also firms that elect, or are required to, register one of their affiliates with the SEC may need to structure their activities to ensure that activities that are permissible for the SEC registered affiliate (generally those in respect of U.S. clients) are not undertaken by employees of any non-registered affiliate in the group.

Mark S. Bergman is Co-Head of the Securities and Capital Markets Group, and Patricia Vaz de Almeida is an Associate, at Paul, Weiss, Rifkind, Wharton & Garrison LLP, London. Philip A. Heimowitz is Counsel in the Investment Management and Securities Group in the law firm’s New York office. The authors may be contacted at mbergman@paulweiss.com, pvazdealmeida@paulweiss.com, and pheimowitz@paulweiss.com.