On July 14, 2004, the Securities and Exchange Commission ("Commission") voted 3-2 to propose new rule 203(b)(3)-2 under the Investment Advisers Act of 1940, as amended ("Advisers Act") to require hedge fund advisers to register with the Commission. The Commission also voted to propose certain conforming and transitional amendments to rules 203(b)(3)-1, 204-2, 205-3, 206(4), and Form ADV. The proposal will be open to public comment for 60 days and must be voted on again by the Commission before it can be adopted.
Background
Under the Advisers Act, an investment adviser generally must register with the Commission if it has assets under management of at least $25 million. The Advisers Act and the rules adopted thereunder, however, create several exemptions from the registration requirements, including an exemption for investment advisers with fewer than 15 clients that do not manage registered funds. The Advisers Act rules generally interpret corporate entities, limited partnerships ("LP"), and limited liability companies ("LLC") as a single "client" for purposes of the exemption. Thus, hedge fund advisers traditionally have met this exemption and avoided the Commission's registration requirements by setting up "hedge funds" or investment pools in the form of an LP or LLC that are individually exempt from registration under the Investment Company Act of 1940, as amended ("1940 Act").
As Paul Roye, Director of the Division of Investment Management at the Commission, pointed out during today's meeting, the current rules have enabled hedge fund advisers to manage up to 14 hedge funds, each containing numerous clients, effectively allowing advisers to manage the assets of nearly 7,000 clients with-out registering with the Commission. Moreover, if an investment adviser manages a fund of funds, or an unregistered fund in which the "investors" are also funds, the number of clients may be far greater.
During today's contentious meeting in which each of the Commissioners presented a varying range of opinions before eventually voting to approve the rule proposal in a rare 3-2 split vote, Chairman William Donaldson suggested that the time has come to consider eliminating the registration exemption relied upon by hedge fund advisers. The Commissioners opposing the proposal opined that registration of hedge fund advisers is premature without a better understanding of the type of data that would help the Commission regulate the industry, that registration would place a burden on the Commission's limited resources, and that registration was "regulatory overreaction." The Commissioners in favor of the proposal noted that registration would provide the Commission with better access to information about the hedge fund industry, would help deter fraud among the growing number of hedge fund advisers, and would help protect the growing number of retail investors that invest in registered funds of hedge funds.
New Rule
Proposed new Advisers Act Rule 203(b)(3)-2 clarifies the method of counting "clients" for purposes of the exemption. Investment advisers to "private funds" will be required to count each of the investors in the fund as an investor toward the client limit. The definition of "private fund" in the new rule incorporates the following elements characteristic to all hedge funds: (a) the fund avoids regulation under the 1940 Act by relying on Section 3(c)(1) or 3(c)(7) of the 1940 Act; (b) the fund permits its owners to redeem some portion of their ownership interest within two years of purchase (although the definition notes that not permitting redemptions in extraordinary cases only would not make the fund into a private fund); and (c) the fund is offered and marketed based on the investment adviser's skills, ability, or expertise. Finally, under the pro-posed rule, an adviser managing a fund of funds will be required to count as a single client each investor in the underlying funds.
To prevent the inappropriate application of the proposed rule to foreign advisers, the rule contains certain safeguards. First, the rule would not apply to offshore public investment companies simply because more than 14 of their investors move to the United States. Second, when a foreign adviser to an offshore private fund with U.S. investors is required to register with the Commission, the new rule limits the application of most provisions of the Advisers Act to the fund that necessitated registration.
The proposed rule does not change the minimum assets under management that an investment adviser must have to be eligible to register with the Commission. Currently, only advisers that manage $25 million or more of assets are eligible to register with the Commission. Under the proposed rule, hedge fund advisers with less than $25 million would not be required to register.
Proposed Conforming and Transitional Amendments
In addition to the proposed rule, the Commission voted to propose several conforming and transitional amendments to Advisers Act Rules 203(b)(3)-1, 204-2, 205-3, 206(4), and Form ADV to accommodate hedge fund advisers as they transition to registration. The first of these rule amendments would change the record keeping rule to allow hedge fund advisers to continue marketing their performance history for their pre-reg-istration period even if they do not have all of the required records for that period. The second amendment would allow existing investors to stay in their hedge funds and continue paying performance fees even if they are not "qualified clients," as is currently required. The third amendment makes it simpler for funds of funds to comply with SEC adviser custody rules by extending the period by which an adviser must distribute a fund's audited financial statements to investors from 120 days to 180 days.
Finally, the Commission recommended some minor changes to the investment adviser registration form, Form ADV, in order to more easily identify hedge fund advisers.