On November 10, 2009, Senate Banking Committee Chairman Christopher Dodd (D-CT) introduced to the Senate a draft of the Restoring American Financial Stability Act of 2009 (the "RAFSA"). Included within the RAFSA is the Private Fund Investment Advisers Registration Act of 2009 (the "PFIARA"), which is the fifth bill introduced this year aimed at regulating private investment funds, including hedge funds and private equity funds.1
Federal Registration Requirement
Currently, many advisers to private investment funds rely upon the private adviser exemption to avoid registering as an investment adviser with the Securities and Exchange Commission ("SEC") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"). In general, the private adviser exemption provides that an adviser with less than 15 clients that does not hold itself out to the public is exempt from registration under the Advisers Act. The PFIARA would eliminate the private adviser exemption by removing Section 203(b)(3) of the Advisers Act in its entirety. Consequently, investment advisers with a requisite amount of assets under management who serve as advisers to domestic or offshore private investment funds, institutional clients, managed accounts, or high net worth individuals, among other types of clients, would be required to register with the SEC regardless of the number of clients to whom the adviser provides advisory services, unless an exemption applies. Such investment advisers would therefore be required to comply with all applicable provisions of the Advisers Act.
Furthermore, under the PFIARA, broker-dealers that provide investment advice that is solely incidental to the conduct of their business as a broker-dealer would no longer be excluded from the definition of "investment adviser" in Section 202(a)(11) and would be required to register with the SEC if they provide advisory services. Currently, many broker-dealers are not required to register with the SEC and are not subject to other provisions of the Advisers Act based on an exclusion from the definition of "investment adviser" for registered broker-dealers who (i) give investment advice that is "solely incidental to their brokerage business, and (ii) receive no "special compensation" for this investment advice. As a registered investment adviser, broker-dealers would be subject to the Advisers Act's rules regarding principal transactions and cross trades, although the PFIARA provides that the SEC may exempt certain persons or transactions from such restrictions so long as such exemption is in the public interest and for the protection of investors, and the investment adviser provides investors with adequate protection against conflicts of interest or principal transactions that are not in the best interest of the investors.
As currently drafted, the PFIARA would require all investment advisers to be registered as of the date the bill is signed into law, unless an exception applies. It is possible that the PFIARA could be amended to provide a grace period to enable such investment advisers to register. Alternatively, the SEC may issue a temporary exemption under Section 206A of the Advisers Act to provide a registration grace period.2
Exemptions From Federal Registration Requirement
- Advisers To Venture Capital Funds: The PFIARA would exempt advisers to "venture capital funds" from the requirement to register, but has tasked the SEC with defining the term "venture capital fund" and crafting the exemption.
- Advisers To Private Equity Funds: The PFIARA would exempt advisers to "private equity funds" from the requirement to register, but has tasked the SEC with defining the term "private equity fund" and crafting the exemption. The PFIARA would however, require the SEC to issue final rules within six months requiring investment advisers to private equity funds to maintain such records and provide to the SEC such annual or other reports as the SEC determines necessary and appropriate in the public interest and for the protection of investors.
- Foreign Private Advisers: The PFIARA would exempt "foreign private advisers", defined as investment advisers that have (i) no place of business in the U.S., (ii) do not generally hold themselves out to the public in the U.S., (iii) have fewer than 15 clients in the U.S., and (iv) have less than $25 million in assets under management that are attributable to U.S. clients, from registration under the Advisers Act.
- Advisers With Assets Under Management Of Less Than $100,000,000: Investment advisers with less than $100,000,000 of assets under management would not be subject to registration as an investment adviser with the SEC under the PFIARA. Such investment advisers may be required to register with one or more state securities regulators.
- Family Office Of The Investment Adviser: The PFIARA would exempt from the definition of "investment adviser" in Section 202(a)(11) any "family office," which would be defined by SEC rule.
Custody
The PFIARA directs the SEC to prescribe rules requiring registered investment advisers to use an independent custodian to hold client assets, where necessary and appropriate in the public interest and for the protection of investors.
Recordkeeping, Reporting And Examinations
The PFIARA would require investment advisers to "private funds" to file certain information including, for each private fund, the assets under management, the use of leverage, counterparty credit risk exposure, types of assets held, valuation methodologies of the fund, side arrangements or side letters, and trading and investment positions, among other things. The PFIARA defines a "private fund" as a fund that (A) "is organized or created under the laws of the United States or of a state" or "has 10 percent or more of its outstanding securities owned by U.S. Persons", and (B) would be deemed an "investment company" under the Investment Company Act of 1940 (the "1940 Act"), but for the exceptions in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.
The PFIARA would also provide the SEC with broad authority to require investment advisers to maintain records and to submit reports to the SEC to enable the SEC or another federal department or agency to supervise systemic risk. The SEC would be required to consult with the Agency for Financial Stability (the "Agency") when determining what records an investment adviser to a private fund is required to maintain and the reports they are required to file.
The PFIARA would provide the SEC with broad authority to examine the records of advisers to private funds and the records of such funds. The SEC could also request that advisers make available to the SEC copies or extracts of such records.
The SEC would be required to share with the Agency or any other federal agency having systemic risk responsibilities copies of all reports, documents, records and information filed with the SEC. The SEC would keep such information confidential and, subject to certain limited exceptions, could not be compelled to disclose it. Finally, the PFIARA would authorize the SEC to require advisers to private funds to provide such information as the SEC deems necessary or appropriate in the public interest to investors, prospective investors, counterparties and creditors.
Potential Changes To The Definition Of "Client"
Under the current interpretation of the Advisers Act, the term "client" includes only persons or entities that have a direct advisory relationship with the adviser. In the case of a private investment fund, the fund itself would be considered to be the client of the adviser, but the underlying investors in the fund would not be clients.
The PFIARA provides the SEC with statutory authority to define the term client. If the PFIARA is adopted in its current form, the SEC could potentially define "client" to include the underlying investors in a private investment fund, which would have a significant impact on a registered adviser with respect to its fiduciary duties to clients, the cash solicitation rule (Rule 206(4)-3), and the custody rule (Rule 206(4)-2). While it is too early to predict whether the SEC would take this approach if the PFIARA were to be adopted in its current form, a similar bill that was approved by the House Financial Services Committee on October 27 prohibits the SEC from including the underlying investors of a private investment fund in the definition of client so long as such fund has entered into an advisory agreement with the adviser.
Footnotes
1. The four prior bills introduced earlier this year were (1) the Hedge Fund Adviser Registration Act of 2009, (2) the Hedge Fund Transparency Act, (3) the Private Fund Transparency Act of 2009 (Click to read "Private Fund Transparency Act of 2009 is introduced in Congress", a July 2009 O'Melveny Client Alert), and (4) the Private Fund Investment Advisers Registration Act of 2009 (Click to read "Private Fund Investment Advisers Registration Act of 2009", an October 2009 O'Melveny Client Alert), which was introduced to the House Financial Services Committee by Representative Paul Kanjorski (D-PA) on October 1, 2009.
2. A similar bill proposed by Representative Paul Kanjorski was amended to provide investment advisers with a one-year transition period.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
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