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.


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 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.


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.