On November 19, 2010, the Securities and Exchange Commission (the “SEC”) proposed rules under the Investment Advisers Act of 1940 (the “Advisers Act”) to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and exemptions from the registration requirements of the Advisers Act for advisers to certain privately offered investment funds.¹ In addition, the SEC proposed amendments to Part 1A of Form ADV, expanding the disclosure requirements applicable to advisers to private funds and reflecting an ADV filing obligation (which is limited to certain items on Form ADV Part 1A) for advisers relying on the private fund adviser exemption or venture capital adviser exemption.

The proposed rules and form amendments would:

• implement the exemption from registration for advisers solely to private funds with less than $150 million in assets under management (this exemption is available to both U.S. and non-U.S. advisers);
• clarify certain terms used in the foreign private adviser exemption, including the definitions of the terms “investors”, “in the United States”, “place of business” and “assets under management” and clarify the methodology for counting clients;
• define “venture capital fund” for purposes of the venture capital adviser exemption;
• amend Form ADV Part 1A to reflect several significant changes, including changes requiring additional information about private funds managed by an adviser and changes to the method of calculating an adviser’s “regulatory assets under management”;
• impose a Form ADV Part 1A filing obligation on advisers relying on the private fund adviser exemption or venture capital adviser exemption (“exempt reporting advisers”) that would require completion of a limited subset of items on Form ADV Part 1A;
• clarify the transition process for “mid-sized advisers” from SEC registration to state registration; and
  provide a “grandfathering provision” for advisers that are currently exempt from SEC registration with respect to certain performance related records.

I. Exemptions from SEC Registration

(A) Private Fund Adviser Exemption

Dodd-Frank directed the SEC to exempt from registration any investment adviser that: (i) advises only “private funds”²; and (ii) has assets under management in the U.S. of less than $150 million.

U.S. Private Fund Advisers

The SEC has proposed rules to implement this exemption, which provide that an adviser with its principal office and place of business in the U.S. (a “U.S. adviser”) is exempt from registration if the adviser: (i) acts solely as an investment adviser to one or more “qualifying private funds”³; and (ii) manages private fund assets⁴ of less than $150 million (including family/proprietary assets even if no fees are charged). This would preclude an adviser who manages any managed accounts from relying on this exemption. All private fund assets managed by a U.S. adviser would be considered to be “assets under management in the U.S.” even if the adviser has other offices outside of the U.S.

Non-U.S. Private Fund Advisers

If an adviser has its principal office and place of business outside of the U.S. (a “non-U.S. adviser”), the SEC has proposed that the adviser could avail itself of the private fund adviser exemption if: (i) the adviser has no client that is a U.S. Person (as defined in Regulation S under the Securities Act of 1933 (“Regulation S”)) except for one or more “qualifying private funds”; and (ii) all assets managed by the adviser from a place of business in the U.S. are solely attributable to private fund assets, the total value of which is less than $150 million.⁵

It is important to note that a non-U.S. adviser would only need to count private fund assets it manages from a place of business in the U.S. toward the $150 million asset threshold. Therefore, a non-U.S. adviser without a place of business in the U.S. would not need to register with the SEC (regardless of the amount of assets in qualifying private funds), unless the adviser has U.S. clients other than qualifying private funds.

General

In order to determine the continued availability of the private fund adviser exemption, a private fund adviser would be required to determine the value of its private fund assets quarterly based on the fair value of the assets at the end of each quarter. A private fund adviser who manages private fund assets equal to or in excess of $150 million as of the end of a particular calendar quarter would be required to register with the SEC as of the end of the succeeding calendar quarter.

(B) Foreign Private Adviser Exemption

Dodd-Frank amended the Advisers Act to include a new exemption from registration for a foreign private adviser, which is defined in a new Section 202(a)(30) as any adviser that: (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients in the U.S. and investors in the U.S. in private funds advised by it; (iii) has less than $25 million in aggregate in assets under management attributable to such clients and investors; and (iv) does not hold itself out generally to the public in the U.S. as an investment adviser. The SEC has proposed rules clarifying the meaning of certain terms included in this definition.

Due to the relatively broad exemption available to non-U.S. advisers under the private fund adviser exemption, it is unlikely that a non-U.S. adviser would need to rely on the foreign private adviser exemption, unless the adviser also had U.S. clients that were not qualifying private funds (e.g., U.S. managed accounts).⁶

Counting Clients and Defining Investors

The SEC proposes to preserve the general methods of counting a non-U.S. adviser’s clients by including certain safe harbor provisions from current rule 203(b)(3)-1. For example, a natural person and his/her minor children or a natural person and his/her spouse who shares his/her principal residence would continue to be counted as a single client. If an adviser counts an investor in a private fund under the investor “look through”, then the adviser does not also need to count the private fund as a client. The SEC has proposed to require an adviser to count those clients from which it receives no compensation.

The SEC addresses the look-through to investors in private funds by proposing that an “investor” be defined as any person who would be included in the determination of the number of beneficial owners of the outstanding securities of a “3(c)(1) fund” or, with respect to a “3(c)(7) fund”, any person who would qualify as a “qualified purchaser”. The SEC seeks to avoid double-counting by proposing that an adviser treat as a single investor any person who is an investor in two or more funds advised by the investment adviser. However, “knowledgeable employees” would be counted as investors in a private fund and, with respect to a master/feeder structure, an adviser would have to count as investors the investors in the feeder fund(s) which have been formed to invest in the master fund rather than the feeder funds themselves.

In the United States

The phrase “in the United States” is used a number of times in the context of the “foreign private adviser” exemption, and the SEC has sought to clarify its meaning for all of the purposes for which it is used by providing one definition and by conforming the relevant time for making the determination. The terms “U.S. Person” and “United States” would be defined as such terms are defined in Regulation S. In addition, the SEC specifies that a person that is “in the United States” may be treated as not being in the “United States” if the person was not “in the United States” at the time of becoming a client or, in the case of an investor in a private fund, at the time the investor acquired the securities issued by the fund.

Place of Business

Under the proposals, the phrase “place of business” would be defined as “any office where the investment adviser regularly provides advisory services, solicits, meets with, or otherwise communicates with clients, and any location held out to the public as a place where the adviser conducts any such activity”.

Assets under Management

The SEC proposed that the value of the investment adviser’s “assets under management” be determined in accordance with the newly proposed “regulatory assets under management” calculation (which is described below in more detail).

(C) Venture Capital Adviser Exemption

Dodd-Frank directed the SEC to provide for an exemption from registration for an investment adviser that advises solely venture capital funds (as that term would be defined by the SEC).

The SEC’s proposed rules would define a venture capital fund as a private fund that: (i) invests in equity securities of “qualifying portfolio companies”⁷ and at least 80% of each company’s securities owned by the fund were acquired directly from the qualifying portfolio company; (ii) directly, or through its investment advisers, offers or provides significant managerial assistance to, or controls, the qualifying portfolio company; (iii) does not borrow or otherwise incur leverage (other than short term borrowing); (iv) does not offer its investors redemption rights except in extraordinary circumstances; (v) represents itself as a venture capital fund to investors; and (vi) is not registered under the Investment Company Act and has not elected to be treated as a business development company.

The SEC also proposed a “grandfathering provision” in the definition of a venture capital fund for any private fund that: (i) represented to investors and potential investors at the time the fund offered its securities that it is a venture capital fund; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including accepting any additional capital commitments from, any person after July 21, 2011.

II. Proposals Implementing Amendments to the Advisers Act

(A) Amendments to Form ADV Part 1A

The SEC proposed a number of amendments to Form ADV Part 1A, including most significantly, amendments requiring additional information about private funds advised by the adviser and amendments revising the method for calculating assets under management.

Information Regarding Private Funds

Under the proposed amendments, both registered investment advisers and exempt reporting advisers (as described below) would be required to provide detailed information about the “private funds” (as defined above) that they advise. Currently, Form ADV Part 1A, Item 7 requires an adviser to complete Section 7.B of Schedule D for any “investment-related limited partnership” that the adviser or a related person advises. Item 7 would be modified to require an adviser to complete Section 7.B for any “private fund” that the adviser (but not a related person) advises.

Both registered investment advisers and exempt reporting advisers would be required to provide information regarding the basic organizational, operational and investment characteristics of each private fund, including the amount of its gross and net assets, the nature of its investors, the name of its general partner or directors, required minimum investment amounts, and identification of certain of its service providers (i.e., prime broker, custodian, administrator, auditor and marketer (if any)).

Assets under Management

The SEC has also proposed to change: (i) the terminology used in Form ADV Part 1A to refer to an investment adviser’s “regulatory assets under management”; and (ii) the method of calculation of those assets under management. When calculating an adviser’s regulatory assets under management, an adviser would be required to include securities portfolios for which the adviser provides continuous and regular supervisory or management services, even if the assets are family/proprietary assets, are managed without receipt of compensation or are assets of foreign clients. For purposes of calculating its “regulatory assets under management”, advisers cannot subtract outstanding indebtedness and other accrued but unpaid liabilities that remain in a client’s account.

An adviser to a private fund would be required to include in its regulatory assets under management: (i) the value of any private fund (based on fair value) over which it exercises continuous and regular supervisory or management services regardless of the nature of the assets of the fund; and (ii) the amount of any uncalled capital commitments made to the fund.

Information Regarding Adviser’s Assets for Purposes of Potential Regulation of Incentive-based Compensation Arrangements

The SEC proposed to require each adviser to indicate whether it had $1 billion or more of total assets as of the last day of its most recent fiscal year. The SEC is collecting this information to identify advisers that may be subject to further regulation regarding incentive based compensation arrangements. The $1 billion threshold would be based on the adviser’s assets (as reflected on its balance sheet) rather than the amount of assets that the adviser has under management.

(B) Limited Form ADV Reporting Imposed on Private Fund Advisers and Venture Capital Advisers as Exempt Reporting Advisers

As discussed above, Dodd-Frank directed the SEC to exempt from registration advisers to: (i) private funds and (ii) venture capital funds; however, Dodd-Frank granted the SEC the authority to require those advisers to maintain records and submit reports as the SEC determines necessary or appropriate in the public interest.

Under this authority, the SEC proposed a rule requiring those private fund advisers⁸ and venture capital advisers that are exempt from SEC registration be defined as “exempt reporting advisers”, which would require them to complete a limited subset of items on Form ADV Part 1A using the same publicly available website used to access the Form ADV of an investment adviser registered with the SEC.

An exempt reporting adviser would have to complete seven items on Form ADV Part 1A, including identifying information about the adviser, form of organization, other business activities, financial industry affiliations, information about private funds it advises, control persons of the adviser and disciplinary information.

The SEC also noted that exempt reporting advisers will be subject to SEC examination; however, the scope of any examination remains unclear.

(C) Transition between State and SEC Registration

Each investment adviser that is registered with the SEC on July 21, 2011 would be required to amend its Form ADV to report the market value of its assets under management in order to establish its eligibility to remain registered with the SEC. An adviser would have 30 days to file this amendment and then an additional 60 days to withdraw its SEC registration, if the adviser is no longer eligible to remain registered with the SEC.

Mid-Sized Advisers

Dodd-Frank created a new category of “mid-sized advisers” that will be regulated by state securities authorities. A “mid-sized adviser” is prohibited from registering with the SEC if the adviser: (i) is “required to be registered” as an investment adviser in the state in which it maintains its principal office and place of business; (ii) if registered, the adviser would be “subject to examination”; and (iii) has assets under management between $25 million and $100 million.⁹ If an investment adviser has over $100 million in assets under management and is unable to rely on another exemption from registration, the adviser must register with the SEC.

Dodd-Frank did not define the terms “required to be registered” or “subject to examination”. Therefore, the SEC proposed amendments to Form ADV to provide guidance regarding the meaning of these terms.

One of the requirements for an adviser to qualify as a “mid-sized adviser” is that the adviser is “required to be registered” in the state in which the adviser maintains its principal office and place of business. In order for the SEC to determine whether an adviser is eligible for SEC registration, the SEC has proposed to require a mid-sized adviser to affirm, both in its initial filing and in annual amendments, that it is not required to be registered in the state where it maintains its principal office and place of business. Consequently, an adviser that is exempt from state registration would not be able to qualify as a “mid-sized adviser” and would have to register with the SEC unless the adviser is able to rely upon another exemption from registration.

The SEC has indicated that it does not intend to evaluate each state’s investment adviser examination program to determine whether an adviser is “subject to examination”. The SEC will instead request that each state inform the SEC whether an investment adviser registered in the state would be subject to examination.

The SEC proposes to abolish the current $5 million buffer that permits an investment adviser with between $25 million and $30 million of assets under management to remain state registered, and does not propose to implement a similar buffer with respect to the new $100 million threshold. An adviser (who is not relying on the private fund adviser exemption or the venture capital adviser exemption) that files its annual updating amendment to Form ADV reporting that it is no longer eligible for SEC registration will have 180 days from its fiscal year end to de-register with the SEC.

(D) Performance Information

The SEC proposed to amend Rule 204-2 under the Advisers Act to update the “grandfathering provision” for advisers that are currently exempt from registration under the private adviser exemption but will be required to register under Dodd-Frank. These advisers would not be required to keep certain performance related records to the extent they pertained to the performance of a private fund or account they advised for the period prior to July 21, 2011, provided that the adviser was not registered with the SEC during that time.

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¹ Dodd-Frank eliminated the current private adviser exemption from SEC registration for investment advisers with fewer than 15 clients. Therefore, an investment adviser who has over $25 million in assets under management will be required to register with the SEC, unless the adviser is a “mid-sized adviser” or is able to rely upon one of the exemptions from registration, further described in this memo, or otherwise provided in the Advisers Act.

² “Private Fund” means an issuer that relies upon the exclusion from the definition of investment company provided for in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”).

³ “Qualifying Private Fund” means any private fund that is not registered under Section 8 of the Investment Company Act and has not elected to be treated as a business development company under the Investment Company Act. The proposed rule does not provide guidance regarding whether an entity (e.g., a single member limited liability company) formed for one investor would be considered a “qualifying private fund”.

⁴ “Private fund assets” mean the investment adviser’s assets under management attributable to a qualifying private fund.

⁵ Unlike the foreign private adviser exemption (described below), the private fund adviser exemption does not contain a “look through” provision to underlying investors in the private fund.

⁶ A non-U.S. adviser relying on the foreign private adviser exemption would not be subject to the ADV reporting requirements (described below) imposed upon exempt reporting advisers. A non-U.S. adviser relying on the private fund adviser exemption, however, would be subject to those reporting obligations.

⁷ A “qualifying portfolio company” is a company that (i) is not publicly traded, (ii) does not incur leverage in connection with the investment by the private fund, (iii) uses the capital provided by the fund for operating or business expansion purposes rather than to buy out other investors, and (iv) is not itself a fund.

⁸ As previously noted, a non-U.S. adviser that relies on the private fund adviser exemption would be required to comply with the ADV Part 1A reporting requirements; however, a non-U.S. adviser that relies on the foreign private adviser exemption would not be subject to those reporting requirements.

⁹ An adviser to a registered investment company under the Investment Company Act or to a business development company is required to register with the SEC regardless of assets under management, and an adviser that would have to register in 15 or more states would be permitted to register with the SEC.