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The Wall Street Journal on Sept. 19, 2005, published a story after its first interview of new Securities and Exchange Commission Chairman Christopher Cox, summarizing his agenda on a range of issues. Notwithstanding the controversy that surrounded the adoption of the New Hedge Fund Adviser Rule, strongly advocated by predecessor Chairman William Donaldson, the new SEC chairman stated the new rule, Rule 203(b)(3)-2 under the Investment Advisers Act of 1940 (“Advisers Act”), would be implemented “exactly as adopted.” It is therefore imperative investment advisers and other financial service professionals understand this new rule and its implications for them in order to stay out of the crosshairs of the SEC. ADVISERS ACT By way of background, under the Advisers Act, if investment advisers offer advice on the value of securities for a fee to 15 persons, they must register. Hedge Fund Advisers previously were generally exempt from registration because they had less than 15 clients, some or all of which were “private funds.” To qualify as a private fund, the fund had to be excluded from the definition of investment company under ��3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. Section 3(c)(1) excluded from the definition of investment company “(a)ny issuer whose outstanding securities … are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of securities.” Section 3(c)(7) of the Investment Company Act excluded from the definition of investment company “(a)ny issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are qualified purchasers and which is not making and does not at that time propose to make a public offering of such securities.” To qualify as a �3(c)(i) or �3(c)(7) “private fund,” fund purchasers also had to be permitted to redeem their interests within two years of their purchase. Nor could a �3(c)(1) or �3(c)(7) “private fund” have a public fund as an investor, otherwise the fund had to register under the act. It was advisers of these “private funds,” who are now the focus of the new Hedge Fund Advisor Rule, Rule 203(b)(3)-2. ADOPTION OF THE NEW RULE Rule 203(b)(3)-2 was adopted as a final rule in December 2004. The effective date of the new rule was Feb. 10, 2005, and advisers, who must now be registered under the Advisers Act, have to be in compliance by Feb. 1, 2006. Registration has to be effective by the compliance date and the adviser has to have in place all required policies and procedures. There must be a designated compliance officer and advisers also have to be in compliance with Rule 206(4)-2 relating to custody of client funds and securities. Other rules applicable to registered advisers such as limitations on performance fees (Rule 205-3), the books and records requirements (Rule 206(4)-2), rules governing advertising (Rule 206-(4)-1) and cash solicitations (Rule 206(4)-3), are now applicable to hedge fund advisers who were not previously subject to these rules. The Advisers Act rules were previously not applicable principally because of the “private advisers exemption,” which exempts an adviser from registration if the adviser (1) has had fewer than 15 clients during the preceding 12 months, (2) does not hold itself out generally to the public as an investment adviser and (3) is not an adviser to any registered investment company. It was this “private advisers exemption” in the context of current developments in the capital markets that led to the installation of a new “radar screen” and a far more expanded framework of regulation for investment advisers, which is fully explained in the SEC’s adopting release. (Release No. IA-2333.) The release also explains how the new rule will operate to protect investors, which will now be summarized. Further and more complete study of the new rule by the financial service professional and the attorney that gives advice and counsel can be accomplished by reviewing the release on the SEC Web site. The SEC in its adopting release noted the remarkable growth of hedge funds in the markets in the last few years. At the time of the release it was estimated that hedge funds had approximately $870 billion of assets in 7,000 funds with a projection that in another year the assets would exceed $1 trillion. It was noted that hedge fund assets were growing faster than mutual fund assets and that hedge funds represented between 10 and 20 percent of the equity trading volume in the United States. Hedge fund fraud, the release stated, had also increased dramatically. Late trading and inappropriate market timing of mutual funds involved the critical participation of hedge funds and their advisers. Mutual funds waived restrictions on market timing in exchange for “sticky assets,” i.e., the placement of other assets in other funds managed by the mutual fund adviser. In addition to the growth of hedge fund assets and increase in fraud cases involving hedge funds and their advisers, investments in hedge funds were no longer limited to the very wealthy, but were open to smaller investors, pensioners and a broader class of market participants. The development of “funds of hedge funds” has also created greater access to smaller investors to hedge funds as well as additional perceived regulatory risk. Although the anti-fraud provisions of the Advisers Act as well as other federal securities laws apply to hedge fund advisers that are ostensibly within the “private advisers exemption,” the commission still perceived a need to expand the scope of regulatory oversight by the new rule. It stated in its adopting release:
We do not have an effective program that would provide us with the ability to deter or detect fraud by unregistered hedge fund advisers. We currently rely almost entirely on enforcement actions brought after fraud has occurred and investor assets are gone. We lack basic information about hedge fund advisers and the hedge fund industry, and must rely on third-party data that often conflict and may be unreliable. Requiring hedge fund advisers to register under the Advisers Act will give us the ability to oversee hedge fund advisers without imposing burdens on the legitimate investment activities of hedge funds. … [C]ommenters have not persuaded us that requiring hedge fund advisers to register under the Act, requiring them to develop a compliance infrastructure, or subjecting them to our examination authority will impose undue burdens … or interfere significantly with their operations. … Registration under the Advisers Act enables us to conduct examinations of the hedge fund adviser. Our examinations permit us to identify compliance problems at an early stage, identify practices that may be harmful to investors, and provide a deterrent to unlawful conduct. They are a key part of our investor protection program, and a key reason we are adopting rule 203(b)(3)-2. … … The prospect of a Commission examination … increases the risk of getting caught, and thus will deter wrongdoers. This risk should alter hedge fund advisers’ behavior by forcing them to account for the consequences of a compliance examination … Hedge fund advisers each day make decisions based on risk analysis of alternative investments, and should be particularly sensitive to the consequences of getting caught if their conduct is unlawful. The consequences may involve paying fines, disgorgement and other penalties, including industry suspensions or bars, as well as loss of reputation. This sensitivity … suggests that the benefits of … [SEC] oversight may be substantial.

The commission went on to note that SEC registration would enable the staff to screen individuals associated with the adviser, and to deny registration if they had been convicted of a felony or had a disciplinary record subjecting them to disqualification. Further registration will require that hedge fund advisers that have not already adopted, developed and implemented a compliance infrastructure will be now required to do so. The commission also explained the basic policy of the rule as follows:

In adopting Rule 203(b)(3)-2, an important consideration has been … dissatisfaction with the operation of the existing safe harbor because it permits advisers, without registering under the Act, to manage large amounts of securities indirectly through hedge funds that may have collectively, hundreds of investors … [T]he safe harbor has become inconsistent with the underlying purpose of the registration exemption in Section 203(b)(3) which was designated to exempt advisers whose business activities are so limited as not to warrant federal attention. … Our actions … withdraw … [the] safe harbor and require advisers to private funds — which … include most hedge funds to count the number of investors as ‘clients’ for purposes of the private adviser exemption.

The key to the way the new rule works is that the adviser can no longer rely on the private adviser exemption if the adviser, during the course of the preceding 12 months, has advised private funds that had more than fourteen investors. Individual clients must be counted to determine the total number of clients for purposes of �203(b)(3) of the Investment Company Act, and if the total number of clients including those who invested in the private fund exceeds 14, the adviser is not eligible for the private adviser exemption. In short form, the new rule is designated to amend the method of counting the number of investors that hedge fund advisers use for purposes of relying on the private adviser exemption and does not alter the duties or obligations owed by an adviser to its clients. Each shareholder, limited partner, member or beneficiary of a private fund must be counted. Advisers, however, do not have to count the advisory firm and can exclude certain knowledgeable advisory firm personnel who are “qualified clients,” i.e., “insiders.” An adviser to a private fund may also exclude the value of these insiders’ interest in calculating the firm’s assets under management for purposes of determining the $25 million registration threshold for federal as opposed to state registration. The same counting requirements exist for domestic and offshore advisers. However, only U.S. residents are counted. If an investor is a non-U.S. client at the time of the investment, even though he or she relocates to the United States, that client may continue to be counted as a non-U.S. client. In respect to the definition of “private funds,” companies that have their principal office and place of business outside the United States, make a public offering outside of the United States, and are regulated as a public investment company under the laws of a country other than the United States are not considered to be “private funds” requiring a “look through” count of each of the individual investors. An offshore adviser to an offshore fund may treat the fund and not the investors as its client. The substantive provisions of the Advisers Act generally would not apply to the offshore advisers dealing with offshore funds. PRIVATE FUNDS ONLY It should be noted and emphasized that the new rule applies only if a “private fund” is involved. Advisers are not required to “look through” most clients that are business organizations, including insurance companies, broker-dealers and banks. Companies that are excepted from the definition of investment company under ��3(c)(1) or 3(c)(7) are the “private funds” that are the rule’s focus, i.e., “types of pooled investment vehicles investing in securities, including hedge funds.” A company will also only be a private fund if it permits investors to redeem their interests in the fund within two years of purchasing the funds and this requirement applies to each interest purchased or amount of capital contributed. Additionally, a private fund will only exist if the interest offered is based on the investment advisory skills, ability or expertise of the advisor or his firm. As a result of the rule, new regulatory and compliance approaches have to be considered. The new registration provision will increase examinations by the Office of Compliance Inspections and Examinations that previously unregistered hedge fund advisers were not subject to and for which they now need to be fully prepared. OTHER CONSIDERATIONS Other additional considerations are as follows: Advisers are entitled to market their performance from periods prior to their registration even if they did not keep the documentation that the rules would otherwise require. Their existing records, however, must be retained. To determine whether the hedge fund advisor is meeting his fiduciary obligations a registered hedge fund adviser will be required to make and keep records of private funds for which the adviser or related person is acting as a general partner, managing member or serving in a similar capacity. In respect to performance fees registered advisers can only charge “qualified clients.” Prior performance fee agreements with existing clients, however, for the previously unregistered advisers will be able to be continued. The time to complete audits under the custody rule (Rule 206(4)-2) will also be extended from 120 to 180 days. These and other considerations have to be carefully reviewed with counsel. CONCLUSION Supreme Court Justice Louis Brandeis once stated, “sunlight is the best disinfectant.” The new rule creates a new “radar screen” for the SEC to look at hedge fund advisers that were not previously subject to regulatory oversight. These financial service professionals are now in the sunlight. In view of this new transparency the best approach will be one of heightened compliance both with the new rule and other rules under the Advisers Act. Norman B. Arnoff practices law in New York City and is a regular columnist on professional liability issues for the New York Law Journal. Stephen B. Wexler is a member of the Long Island, N.Y., law firm Wexler & Burkhart where he heads the litigation practice group, focusing on securities broker/dealers and the defense of accountant malpractice cases.

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