General. On June 22, 2011, the Securities and Exchange Commission (the "SEC") adopted Final Rules (the "Final Rules")1 implementing amendments to the Investment Advisers Act of 1940 (the "Advisers Act")2effected by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"). The following highlights selected provisions of the Final Rules most relevant to our private fund clients.
March 30, 2012 Compliance Date for Registration. Effective July 21, 2011, the Dodd-Frank Act eliminated the exemption under the Advisers Act that generally exempts investment advisers with fewer than 15 clients from registration with the SEC.3 Many of our private fund clients relied on that exemption. The Final Rules extended until March 30, 2012 the date by which advisers formerly relying on the "fewer than 15 client" exemption are required to register as investment advisers with the SEC, absent the ability to rely on another exemption.4
Venture Capital Fund Adviser Exemption. The Dodd-Frank Act provides an exemption from SEC registration for advisers that advise only venture capital funds, as defined by the SEC ("VC Funds").5 In response to numerous comments received by the SEC, the definition of VC Fund in the Final Rules,6 although narrow, is not as restrictive as the definition originally proposed, principally because of two changes:
- 20% Basket. The Final Rules include a 20% basket for non-qualifying investments held by a VC Fund, as discussed below ("20% Basket").
- No Requirement for Management Involvement. The Final Rules do not include any requirement that the VC Fund's adviser be involved in the management of its portfolio companies.
Definition of VC Fund: For an adviser's client to fall within the definition of a VC Fund, it must meet all of the following requirements or be grandfathered.
Private Fund. A VC Fund must be a "private fund" – i.e., an entity that would be an investment company under the Investment Company Act of 1940 (the "Investment Company Act"), but for the exceptions provided under sections 3(c)(1) or 3(c)(7) of that act.
Holds Itself Out as a VC Fund. A VC Fund must represent to investors that it pursues a venture capital strategy.
Qualifying Investments in Qualifying Portfolio Companies; Short-term Investments. A VC Fund may hold "qualifying investments" in "qualifying portfolio companies" ("QPCs") and short-term investments. It may also own non-qualifying assets, subject to the 20% Basket limitation. "Qualifying investments" are generally equity securities issued by a QPC that have been acquired by the VC Fund directly from the QPC or in exchange for other qualifying investments. A QPC is generally a company that (1) is not an SEC-reporting company or publicly traded, (2) does not borrow and distribute the proceeds of the borrowing to the VC Fund in connection with its investment in the QPC, and (3) is not itself a fund (i.e., it must be an operating company). Permitted short-term investments include cash, cash equivalents, US Treasuries with remaining maturities of 60 days or less, and money market funds.
- 20% Basket. The 20% Basket permits a VC Fund to acquire assets that are non-qualifying assets or short-term investments, provided that, after acquisition of the asset, no more than 20% of the VC Fund's aggregate capital commitments are invested in non-qualifying assets (other than short-term investments). This basket has to be calculated each time such an asset is acquired. Although a VC Fund may use either historical cost or fair value to determine compliance with the 20% Basket limitation, it must apply the same method consistently throughout the VC Fund's term. Examples of non-qualifying investments subject to the 20% Basket limitation include other funds (e.g., venture, venture debt or funds of funds) and debt securities of portfolio companies.
Limitation on Fund Leverage and Guarantees. A VC Fund may not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of its aggregate capital commitments. Any such borrowing, indebtedness, guarantee or leverage must be for a non-renewable term of no more than 120 calendar days, but the 120-day limit does not apply to guarantees of a QPC up to the value of the VC Fund's investment in the QPC.
No Redemption Rights. A VC Fund must not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances.
Grandfathering Provision: The definition of VC Fund also contains a grandfathering provision for any private fund that meets all of the following criteria:
Held Itself Out as a VC Fund. A grandfathered VC Fund must have represented to investors at the time of offering its securities that it pursues a venture capital strategy.
Sold Securities before December 31, 2010. It must have sold securities to investors unrelated to its advisers before December 31, 2010.
No Securities Sales after July 21, 2011. It cannot sell any securities after July 21, 2011.
Exempt VC Fund Advisers Subject to Reporting Requirements: Although advisers that solely advise VC Funds are exempt from SEC registration, they are nonetheless required to file reports with the SEC on Form ADV Part 1A and to update these reports periodically. See "Reporting Obligations of Advisers Relying on VC Fund Adviser Exemption or Private Fund Adviser Exemption" below.
Private Fund Adviser Exemption.7The Dodd-Frank Act directed the SEC to exempt from registration any adviser solely to private funds that has less than $150 million in assets under management in the United States.8The Final Rules implementing this private fund adviser exemption9 are the same as the proposed rules in most respects. Like the proposed rules, they distinguish between advisers with their "principal office and place of business" in the United States ("US Advisers") and those with their principal office and place of business outside the United States ("Non-US Advisers"). For this purpose, "principal office and place of business" means the executive office of the adviser from which its officers, partners or managers direct, control and coordinate its activities.
US Advisers: For a US Adviser to qualify for this exemption, it must meet the following requirements:
Solely Advises QPFs. A US Adviser can act solely as an investment adviser to "qualifying private funds" ("QPF"), which include funds excepted from the definition of investment company under any provision of section 3 of the Investment Company Act, not just sections 3(c)(1) or 3(c)(7).10
Manages less than $150MM. It can only manage QPF assets of less than $150 million, including assets managed inside or outside of the United States. See "Calculating QPF Assets" below.
Non-US Advisers: A Non-US Adviser is exempt from registration under this exemption if it meets the following requirements:
Assets Managed at US Place of Business are QPF Assets and Total less than $150MM. All assets managed by the Non-US Adviser at a "place of business" in the United States are solely attributable to QPF assets, and the total value of such assets is less than $150 million. For this purpose, "place of business" generally means an office where the adviser regularly provides advisory services, solicits, meets with, or otherwise communicates with clients.
Accordingly, if a Non-US Adviser has no place of business in the United States, and all of its clients that are US persons are also QPFs, the Non-US Adviser would qualify for the exemption, regardless of the amount of its assets under management.
Calculating Private Fund Assets: The value of QPF assets is calculated by reference to Form ADV13 and is generally equal to the fair market value of the assets of the QPFs, plus the amount of uncalled capital commitments. In a change from the quarterly calculation originally proposed, advisers are required to determine the value of QPF assets that they manage on an annual basis.
Transition Rule: An adviser has 90 days to file for registration with the SEC after reporting on its annual Form ADV amendment an increase in the value of its QPF assets that renders it ineligible to continue to rely on the private fund adviser exemption.
Exempt Private Fund Advisers Subject to Reporting Requirements: Private fund advisers exempt from SEC registration are nonetheless "exempt reporting advisers" and are required to file reports with the SEC on Form ADV Part 1A and to update these reports periodically. See "Reporting Obligations of Advisers Relying on VC Fund Adviser Exemption or Private Fund Adviser Exemption" below.
Foreign Private Adviser Exemption.14Under the foreign private adviser exemption in the Dodd-Frank Act,15 an investment adviser qualifies as a foreign private adviser and is exempt from SEC registration (and reporting and SEC examination) only if it satisfies the following criteria:
No US Place of Business. The adviser has no place of business in the United States.
Fewer than 15 US Clients and Fund Investors. It has fewer than 15 clients in the United States and investors in the United States in private funds it manages.
Less than $25MM in AUM Attributable to US Clients and Fund Investors. It has less than $25 million in assets under management attributable to clients in the United States and investors in the United States in private funds it manages.
No Holding Out as Adviser. It does not hold itself out generally to the public in the United States as an investment adviser. Participation in a private placement does not run afoul of this provision.
Not an Adviser to a Registered Fund or BDC. It does not act as an adviser to any registered investment company or business development company.
The Final Rules define a number of terms in connection with this exemption.16 These definitions are generally the same as originally proposed and reflect the SEC's view of the narrow scope of this exemption.
No US Place of Business: For this exemption, "place of business" generally means an office where the adviser regularly provides advisory services, solicits, meets with, or otherwise communicates with clients.
Fewer than 15 US Clients and Fund Investors: In counting the number of clients in the United States and investors in the United States in private funds the adviser manages, only clients and investors that are US persons, as defined in Regulation S under the 1933 Act, at the time of becoming a client or investor in a private fund are counted. In counting the number of an adviser's clients in the United States, the Final Rules generally preserve the client counting rules that were applicable under the "fewer than 15 client" exemption eliminated by the Dodd-Frank Act. However, if an adviser provides investment advisory services to any clients (including employees and family members) without compensation, those clients will now have to be counted. In counting the number of investors in the United States in private funds an adviser manages, an adviser would include any person (1) who would be included in determining the number of beneficial owners of the funds under section 3(c)(1) of the Investment Company Act or whether the outstanding securities of the funds are owned exclusively by "qualified purchasers" under section 3(c)(7) of the Investment Company Act, and (2) beneficial owners of the fund's short-term paper. This approach is similar to the proposed rules, except that the proposed rules would have included "knowledgeable employees" under Investment Company Act rules, and such employees are not counted under the Final Rules. The Final Rules also include provisions to avoid double-counting.
Less than $25MM in AUM Attributable to US Clients and Fund Investors: For purposes of determining whether an adviser has less than $25 million attributable to US clients or fund investors, the value of assets under management is determined by reference to Form ADV.
Reporting Obligations of Advisers Relying on VC Fund Adviser Exemption or Private Fund Adviser Exemption. Under the Final Rules, advisers that are exempt from SEC registration under either the VC Fund adviser exemption or the private fund adviser exemption are referred to as "exempt reporting advisers," and are required to file reports electronically with the SEC on Form ADV Part 1A, and to update these reports periodically.17 The Implementing Release indicates that exempt reporting advisers must file their initial reports on Form ADV between January 1, and March 30, 2012.18 The information that exempt reporting advisers must provide was extensive under the proposed rules and remains extensive. An exempt reporting adviser is required to disclose (a) basic identification details, such as its name, address, contact information and form of organization, as well as the identity of its owners, (b) the basis for its exemption from SEC registration, (c) certain details regarding business activities of the adviser and its affiliates, including financial industry affiliations and private funds, and (d) information regarding the disciplinary history of the adviser and its employees. These reports will be publicly available on the SEC website.
Recordkeeping Obligations of Advisers Relying on VC Fund Adviser Exemption and Private Fund Adviser Exemption; Examinations. The SEC indicated that recordkeeping requirements for exempt reporting advisers will be addressed at a future date.19 It also noted that it did not expect SEC staff to conduct regular compliance examinations of these advisers, but examinations would be conducted for cause.20
Rules Implementing Prohibition on SEC Registration by Mid-Sized Advisers. The Dodd-Frank Act generally prohibits an investment adviser with less than $100 million in assets under management from registering with the SEC unless (1) the adviser is not required to be registered in the state in which it maintains its principal office and place of business, (2) if registered in its home state, the adviser would not be subject to examination in its home state, or (3) the adviser would be required to register in 15 or more states as a result of not registering with the SEC.21 The following is a discussion of select issues addressed in the Final Rules in connection with this prohibition:
Buffer for Advisers with AUM near $100MM: To provide advisers with flexibility, the SEC added a 20% buffer to the $100 million in assets under management test that prohibits SEC registration.22 The Final Rules increase the trigger that prohibits an adviser from registering with the SEC to $110 million in assets under management and decrease the trigger that requires an SEC-registered adviser to withdraw from SEC registration to $90 million.
Required Amendment to Form ADV: Each adviser registered with the SEC on January 1, 2012 must file an amendment to its Form ADV no later than March 30, 2012 and report the market value of its assets under management within 90 days of the filing. This will indicate which advisers are prohibited from SEC registration. An adviser no longer eligible to register with the SEC would have to register in any required states by June 28, 2012 and withdraw its SEC registration by filing Form ADV-W.23
Subject to State Examination: An adviser with less than $90 million in assets under management is not subject to the prohibition on SEC registration if its home state does not examine advisers. SEC staff guidance indicates that this provision only excepts from the prohibition on SEC registration advisers whose home states are New York or Wyoming.24
State Registration: Exempt advisers should bear in mind that SEC registration insulates them from state registration requirements.25 Advisers that are entitled to an exemption from SEC registration should consider the potential applicability of state registration requirements if they do not register with the SEC. For many advisers, state registration will not be required because of the provision in the Advisers Act that preempts state registration requirements for advisers who do not have a place of business in a state and during the preceding 12 months had fewer than six clients who are residents of the state.26 For other advisers, more detailed analysis may be required.
Amendment to SEC Pay-to-Play Rule: The Pay-to-Play Rule under the Advisers Act27 is designed to prevent registered and certain unregistered advisers from engaging directly or indirectly in "pay-to-play" activity (i.e., contributions by an investment adviser or its employees to public officials or other payments in order to influence the selection of investment advisers). It includes a prohibition on payments to solicitors of government business for advisers, unless the solicitor is an adviser subject to the Pay-to-Play Rule, a broker-dealer subject to similar pay-to-play rules or an employee of the adviser. The Final Rules make it clear that the Pay-to-Play Rule applies to exempt reporting advisers, as well as foreign private advisers. The Final Rules also create a new category of permitted solicitors – municipal advisors registered under section 15B of the Securities Exchange Act of 1934 and subject to similar pay-to-pay rules.
Advisers Not Currently Registered with the SEC: Each adviser not currently registered with the SEC needs to determine as soon as practicable if an exemption from registration is available under the Final Rules. Only advisers eligible for the narrow foreign private adviser exemption will not need to take further action. Any adviser who may rely on the VC Fund adviser or the private fund adviser exemption is an exempt reporting adviser and must file Form ADV Part 1A with the SEC between January 1, and March 30, 2012, bearing in mind that reporting on this Form will require considerable lead time. Any adviser who is no longer exempt must file its Form ADV Part 1A and Part 2A with the SEC by February 14, 2012 in order to be registered with the SEC by March 30, 2012, and it will also need to adopt and implement compliance policies and procedures which will require additional lead time.
Advisers Currently Registered with the SEC: Each adviser registered with the SEC needs to determine as soon as practicable whether it is prohibited from continuing its registration under the Final Rules and will need to file an amendment to its Form ADV Part 1A by March 30, 2012. If no longer eligible for SEC registration, it will need to identify states in which registration is required, register in those states by June 28, 2012 and withdraw its SEC registration by filing Form ADV-W. This process will also require considerable advance planning.
If you have any questions about the matters addressed in this alert, or if the WilmerHale Fund Formation Group or Investment Management Group can be of assistance to you in determining whether you are required to register or in the registration or reporting process, please contact your WilmerHale attorney.
1 Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Rel. No. IA-3222 (June 22, 2011) ("Exemption Release") and Rules Implementing Amendments to the Investment Advisers Act of 1940, Rel. No. IA 3221 (June 22, 2011)("Implementing Release"). For a discussion of the proposed rules, see the WilmerHale Client Alerts, SEC Proposes Definition of "Venture Capital Fund" and Other Rules to Implement the Private Fund Adviser Registration Provisions of the Dodd-Frank Act, dated November 24, 2010, and SEC Proposes Rules to Implement Exemptions to Registration Under the Investment Advisers Act and Make Other Changes to Registration and Reporting Requirements, dated December 1, 2010.
2 All Section and Rule references are to sections of the Advisers Act, as amended by the Dodd-Frank Act, and rules thereunder, unless otherwise indicated.
3 Section 203(b)(3) of the Advisers Act (prior to amendment by the Dodd-Frank Act).
4 Rule 203-1(e).
5 Section 203(l).
6 Rule 203(l)-1.
7 The Exemption Release addressed the application of the private fund adviser exemption and the foreign private adviser exemption to affiliated advisers as follows: First, it noted that two or more affiliated advisers that are separately organized but operationally integrated would be treated as a single adviser which could result in a requirement for one or both advisers to register, citing Richard Ellis, Inc. SEC Staff No-Action Letter (Sept. 17, 1981). Then, it affirmed the SEC staff position in the Unibanco no-action letter (Uniao de Bancos de Brasileiros S.A., SEC Staff No-Action Letter (Jul. 28, 1992)) and related letters that essentially permit a non-US adviser affiliated with a US SEC registered adviser to not register with the SEC despite sharing personnel and resources with the US adviser, provided certain conditions are met. The conditions include the following: (1) the non-US adviser and its SEC registered affiliate are separately organized; (2) the SEC registered affiliate is staffed with personnel capable of providing investment advice; (3) all personnel of the non-US adviser involved in US advisory activities are deemed associated persons of the registered affiliate; and (4) the SEC has adequate access to trading and other records of the non-US affiliate and its personnel necessary to enable it to identify conduct that may harm US clients or markets. The SEC then expressed its expectation that the SEC staff will provide guidance regarding the application of the Unibanco letters in the context of the private fund adviser and foreign private adviser exemptions. Exemption Release, at 124 et seq.
8 Section 203(m).
9 Rule 203(m)-1.
10 Whether a single investor fund is a private fund for purposes of the private fund adviser exemption depends on the facts and circumstances. See Exemption Release, at 79.
11 Certain discretionary and other fiduciary accounts are also treated as US persons to avoid potential abuse of the exemption. See Exemption Release, at 100, 117.
12 Since the jurisdiction of organization or incorporation of a partnership or corporation generally determines whether it is a US person under Regulation S, an offshore fund with certain US investors would not be a US person.
13 The Final Rules provide a uniform method of calculating an adviser's "assets under management" for a variety of purposes under the Advisers Act and introduce a new term, "regulatory assets under management," that includes (1) the fair market value of any securities portfolios for which the adviser provides continuous and regular supervisory or management services, regardless of whether the assets are (a) proprietary assets, (b) managed without receiving compensation or (c) assets of foreign clients, and (2) with respect to any private fund managed by the adviser, the fair market value of the assets of the private fund plus the amount of uncalled capital commitments of the private fund. See Implementing Release, at 20 et seq.
14 See note 7 above.
15 Section 203(b)(3).
16 Rule 202(a)(30)-1.
17 Rule 204-4.
18 Implementing Release, at 95.
19 Implementing Release, at 42.
20 Implementing Release, at 48.
21 Section 203A(a)(2).
22 Rule 203A-1.
23 Rule 203A-5. See also Division of Investment Management: Frequently Asked Questions Regarding Mid-Sized Advisers, available at www.sec.gov/divisions/investment/midsizedadviserinfo.htm ("Mid-Sized Adviser FAQ").
24 See Mid-Sized Adviser FAQ.
25 Section 203A(b).
26 Section 222(d).
27 Rule 206(4)-5.