In the aftermath of the 2007-2008 global financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)1 was passed into law and hailed as the most comprehensive financial reform in generations.2 The changes have affected almost every element of the financial services world. Dodd-Frank’s Title IV, the "Private Fund Investment Adviser Registration Act of 2010" (Title IV), is the source of regulatory change for investment advisers. Title IV reallocates regulatory responsibilities between the federal government and the states, and brings a significant additional number of investment advisers into the regulatory ambit. The new regulations also impose significantly expanded disclosure requirements on investment advisers. This article will focus on the new regulatory division between federal and state regulators and on the expanded reach of registration requirements.
The Investment Advisers Act of 1940 (the Advisers Act) defines an investment adviser as a person who engages in the business of advising others, for compensation, regarding the value of securities and whether or not to invest, purchase or sell securities.3 Investment advisers conducting business in the United States are, in the absence of an exemption, required to register with the Securities and Exchange Commission unless the investment adviser’s assets under management (AUM)4 are below the jurisdictional threshold for federal regulation.
The Jurisdictional Divide
Prior to Dodd-Frank, investment advisers were not required to register with the SEC unless they managed $25 million or more AUM on behalf of their clients and did not qualify for an exemption from registration. Advisers managing lesser amounts were relegated to state regulation. Dodd-Frank, however, created a new class of "mid-sized advisers," defined as those that manage between $25 million and $100 million AUM on behalf of their clients.5 With some exceptions,6 mid-sized advisers are now subject to state regulations, either for registration or for exempted status.7 It is important to note that mid-sized investment advisers based in New York state continue to be subject to federal regulation, because New York does not conduct examinations of its registered investment advisers.8 Therefore, in New York the relevant threshold for federal regulation remains $25 million.
Repeal of Private Adviser Exemption
Registered investment advisers are subject to a panoply of regulations that regulate advertisements, solicitation of clients, custody of client assets and other ordinary course activities of investment advisers.9 Perhaps most significantly, registration subjects the adviser to inspections by the SEC. Prior to Dodd-Frank, §203(b)(3) of the Advisers Act had provided an exemption from registration for what were commonly referred to as "private advisers." Section 203(b) exempted advisers who had fewer than 15 clients in the previous 12-month period and who did not hold themselves out to the public as investment advisers. Generally, hedge fund and private equity fund managers were able to rely on this exemption in order to avoid registration with the SEC because each fund, rather than the investors in the fund, was deemed to be the "client" to be counted for purposes of the private adviser exemption. These advisers availed themselves of the exemption even though the AUM of their funds could be enormous and the advice given to fund clients could impact hundreds of fund investors. Title IV repealed the private adviser exemption, leaving private advisers required either to register or to find a new exemption.
Dodd-Frank enacted various new exemptions that focus on specific types of investment advisory activities. These include new exemptions and exclusions for (i) advisers who solely manage venture capital funds, (ii) advisers who solely manage private funds with less than $150 million in AUM, (iii) foreign private advisers, and (iv) family offices.
Title IV exempts advisers that solely manage venture capital funds. A "venture capital fund" is a private fund that represents to investors and/or potential investors that it pursues a venture capital strategy,10 holds no less than 80 percent of its capital commitments in assets (other than short-term holdings) that are qualifying investments,11 doesn’t borrow or incur leverage (other than limited short-term borrowings, with some exclusions) in excess of 15 percent of the fund’s aggregate capital contributions and uncalled committed capital (with minor exceptions), and doesn’t offer investors redemption rights in ordinary circumstances.12
Title IV also provides an exemption for "private fund advisers" with less than $150 million in AUM in the United States and who do not have any clients other than private funds.13 Here, AUM means "the regulatory assets under management as determined under Item 5.F of Form ADV."14 A qualifying investment adviser may advise an unlimited number of qualifying private funds, so long as the aggregate AUM for all of the private funds is less than $150 million.15 Under this exemption, an investment adviser with its principal office and place of business outside of the United States is exempt from registration if it "has no client that is a United States person except for one or more qualifying private funds" and all the "assets managed by the investment adviser at a place of business in the United States are solely attributable to private fund assets, the total value of which is less than $150 million."16 However, the converse is not true: a U.S.-based adviser with private funds in the United States and different clients abroad would not be able to rely on this exemption.
Title IV also provides an exemption for foreign private advisers that (i) have no place of business in the United States, (ii) have less than 15 clients in the United States, (iii) have less than $25 million in aggregate AUM that can be attributed to clients in the United States, and (iv) do not hold themselves out generally to the public in the United States as investment advisers.17 The determination of 15 clients in the United States takes into account investors in the United States that invest in funds managed by the foreign private advisers.18 The usefulness of this exemption to non-U.S. institutional advisers is limited because of the low $25 million AUM threshold.
Finally, Title IV excludes "family offices" from the definition of investment adviser, effectively creating an exemption for this type of advisory operation that confines its investment advice to clients within a single family.19 Family clients include, among others, current and former family members, charities that are funded solely by family clients, estates of current and former family members or key employees, trusts existing for the sole current benefit of family clients, trusts funded solely by family clients, and companies wholly owned exclusively by and operated for the sole benefit of family clients (with certain exceptions).20 In addition, the family office exclusion requires that family clients wholly own the family office and family members and/or family entities control the family office. Finally, the exclusion is only relevant if the family office refrains from holding itself out to the public as an investment adviser.21
Some investment advisers who do not qualify for one of the foregoing exemptions or exclusions have found different ways to avoid or mitigate the impact of registration. In the last two years, the SEC has effectively granted through a series of No-Action Letters an exemption for captive investment advisers who only advise affiliates.22 The theory behind this effective exemption is that captive investment advisers are not investment advisers within the meaning of the Advisers Act because they don’t "advise others."23 In addition, sponsors of private funds with traditional limited partnership or limited liability company structures, in which the general partner or the managing member would be considered the "investment adviser," have created single third-party investment advisers to manage all of their private funds by contract, thus eliminating the need for registration of multiple general partners and managing members.24
Under current estimates, the shift in regulatory thresholds has led to the deregistration, at the federal level, of at least 2,300 mid-sized investment advisers.25 The elimination of the private adviser exemption has resulted in new federal registrations by over 1,500 investment advisers.26 It remains to be seen whether these tectonic shifts will enhance the overall effectiveness of investment adviser regulation.
Patrick D. Sweeney is a partner and Matthew H. Kunkes is an associate at Herrick, Feinstein.
1. Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No. 111-203, 124 Stat. 1376 (2010).
2. See Baird Webel, Cong. Research Serv., R41350, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Issues and Summary (2010).
3. The definition of investment adviser also includes any person who is in the business of advising "either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities." 15 U.S.C. §80b-2(a)(11) (2012). However, the definition does not apply to, among others, certain lawyers, accountants, engineers, teachers, brokers, dealers, or to banks or bank holding companies which are not investment companies, with the exception that the term "investment adviser" includes any bank or bank holding company to the extent that it serves or acts as an investment adviser to a registered investment company. See Id.
4. "Assets under management" means the securities portfolios with respect to which an investment adviser provides continuous and regular supervisory or management services. See 15 U.S.C. §80b-3a(a)(3) (2012).
5. The jurisdictional thresholds have "buffers" to provide advisers with flexibility in connection with moderate fluctuations in AUM. Advisers managing between $100 million and $110 million in AUM are permitted to register with the SEC, but not required. Similarly, SEC-registered advisers whose AUM drops to between $90 million and $100 million would not be required to withdraw from SEC registration and submit to state regulation.
6. Certain categories of investment advisers are permitted or required to register with the SEC without regard to the jurisdictional threshold, including, among others, advisers to investment companies registered under the Investment Company Act of 1940 (the Investment Company Act) and advisers that would otherwise have to register with 15 or more states. See 15 U.S.C. §80b-3a(a)(2)(A) (2012). In addition, investment advisers in states without an investment adviser statute or without a regulatory examination program for investment advisers are subject to the existing $25 million AUM threshold.
7. New York provides an exemption from registration for a person that has "sold, during the preceding twelve month period, investment advisory services to fewer than six persons residing in [New York], exclusive of financial institutions and institutional buyers." N.Y. Gen. Bus. Law §359-eee(a)(5) (2012).
8. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Adviser Act Release No. IA-3221 (June 22, 2011) at n.152.
9. The Advisers Act also contains anti-fraud provisions to which both registered and unregistered investment advisers are subject.
10. A venture capital strategy is not clearly defined by the SEC. However, the SEC has indicated that it "distinguishes venture capital funds from hedge funds and private equity funds by focusing on the lack of leverage of venture capital funds and the non-public, start-up nature of the companies in which they invest." Mary Schapiro, Chairman, SEC, Opening Statement at SEC Open Meeting: Dodd-Frank Act Amendments to the Investment Advisers Act (June 22, 2011).
11. According to the SEC, "qualifying investments" generally consist of equity securities of "qualifying portfolio companies." See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Adviser Act Release No. IA-3222 (June 22, 2011) (hereinafter Exemptions for Advisers) at 131. A "qualifying portfolio company" is a company that "is not a reporting company and does not have a control relationship with a reporting company," "does not borrow or issue debt obligations in connection with the investment by the private fund and then distribute proceeds of the borrowing or issuance to the private fund in exchange for the private fund investment" and is "not itself a fund (i.e. an operating company)." Id. at 132, citing 17 C.F.R. §275.203(l)-(1)(c)(4) (2012).
12. Although exempt from registration, investment advisers to venture capital funds are required to report certain information regarding their private funds on Form ADV as exempt reporting advisers.
13. According to the SEC, the term "private fund" means "an issuer that would be an investment company, as defined in section 3 of the [Investment Company Act], but for section 3(c)(1) or 3(c)(7) of [the Investment Company Act]." See Exemptions for Advisers, supra note 11 at n.8. Private funds "include hedge funds, private equity funds and other types of pooled investment vehicles that are excluded from the definition of "investment company" under the [Investment Company Act] by reason of Section 3(c)(1) or 3(c)(7) of [the Investment Company Act]." See Id. at 3-4.
14. 17 C.F.R. §275.203(m)-1(d)(1) (2012). Regulatory AUM is a new concept introduced by the SEC in connection with the amendment of disclosure requirements on Form ADV. The adviser is required to include in its calculation of regulatory AUM the securities portfolios to which it provides continuous and regular supervisory and management services. Regulatory AUM, which is used for reporting and exemptive purposes, lessens the degree of flexibility exercised by investment advisers in determining their AUM. Investment advisers are required to include within their regulatory AUM assets of foreign clients, assets for which no compensation is paid, and unfunded capital commitments in client funds.
15. See Exemptions for Advisers, at 76.
16. 17 C.F.R. §275.203(m)-1(b)(1)-(2) (2012). Private fund advisers with less than $150 million in AUM also have the obligations of exempt reporting advisers on Form ADV.
17. See Exemptions for Advisers. The exemption is not available to an investment adviser that "acts as (I) an investment adviser to any investment company registered under the Investment Company Act [ ]; or (II) a company that has elected to be a business development company [ ], and has not withdrawn its election." Id. at n.417, citing 15 U.S.C. §80b-2(a)(30)(D)(ii) (2012).
18. According to the SEC, an investor in a private fund is "any person who would be included in determining the number of beneficial owners of the outstanding securities of a private fund under section 3(c)(1) of the Investment Company Act [ ], or whether the outstanding securities of a private fund are owned exclusively by qualified purchasers under section 3(c)(7) of [the Investment Company] Act." Id. at 107.
19. Family offices were the subject of numerous No-Action Letters prior to the enactment of Dodd-Frank, in which various family office structures were approved. The SEC will permit family offices that previously received and relied upon such No-Action Letters to continue to rely on them, but new family office structures will be limited to those defined in Title IV’s exclusion from the definition of investment adviser. Notably, the new exclusion for family offices only permits single family offices, as opposed to multiple family offices.
20. See Family Offices, Investment Adviser Act Release No. IA-3220 (June 22, 2011).
21. See id.
22. See Zenkyoren Asset Management of America, SEC Staff No-Action Letter (June 30, 2011).
23. See Id.
24. The SEC had previously advised that a single special purpose vehicle (SPV) formed to act as the general partner or managing member of a private fund did not need to register separately, and a 2012 No-Action Letter clarified that this position was not limited to a registered investment adviser with only one SPV. See American Bar Association Subcommittee on Hedge Funds, SEC Staff No-Action Letter (Jan. 18, 2012).
25. See Press Release, SEC, More Than 1,500 Private Fund Advisers Registered With the SEC Since Passage of Financial Reform Law (Oct. 19, 2012).
26. See id.