Wednesday, June 22, 2011

SEC Adopts Regulations Requiring Registration of Hedge Funds and Private Equity Funds; Defines Venture Capital Fund

The SEC has adopted regulations facilitating the registration of advisers to hedge funds and other private funds as required by the Dodd-Frank Act, which ended the statutory exemption for advisers with fewer than 15 clients. As a result, many of these private fund advisers will now, not only register with the Commission, but be subject to its rules, its regulatory oversight and its examination program. In order to facilitate an orderly transition and enable private fund advisers to come into compliance with the new regime, advisers will not be required to comply with these registration requirements until the first quarter of 2012. To provide these advisers with a window to meet their new obligations, the transition provisions the Commission adopted require these advisers to be registered with the Commission by March 30, 2012.

The new registration regime will provide the SEC and the public with information about the business operations of these advisers, as well as information about their conflicts of interest, disciplinary history and investment strategies. The regulations will also require these advisers to detail the size and strategy of their hedge funds and other private funds, as well as the identities of critical gatekeepers such as auditors and prime brokers that provide services to these funds. According to SEC Chair Mary Schapiro, the registration and reporting requirements are designed to obtain a meaningful collection of data that would aid investors and assist SEC regulatory and examination efforts, without requiring any disclosure that could inadvertently harm the interests of private fund investors.
While imposing new registration responsibilities upon advisers to hedge funds and many other private funds, Dodd-Frank exempted from registration advisers solely to venture capital funds and advisers solely to private funds with less than $150 million in assets in the United States. But Congress mandated that these advisers be subject to certain reporting requirements.

The SEC followed a balancing approach in developing a reporting regime for want Chairman Schapiro called “exempt but reporting advisers.” The Commission seeks information on key census data about the firm, its private funds and any disciplinary information, noted the Chair, but decided not to require the full panoply of information, including the ADV, Part 2 client-oriented narrative disclosure that would be required of a registered investment adviser.
Since this is the SEC’s first time developing a reporting a regime for advisers that are exempt from registration, noted Chairman Schapiro, it is important that the Commission assess the reporting requirements for these advisers once it has experience receiving the information and can fine-tune the information collected at that point. Thus, Chairman Schapiro directed the staff to reconsider the information collected from “exempt but reporting advisers” after assessing the first year’s filings. In her view, this will enable the Commission to make necessary adjustments if it is not receiving sufficient information from these advisers.

Although the law enables the Commission to examine these “exempt but reporting advisers,” observed the Chair, the SEC does not intend to conduct routine examinations of them. The Commission will use its scarce resources to the advisers that are actually registered which, sad the Chair, is where the investing public expects the agency to be focused.
With regard to the $150 million assets under management threshold, the SEC said that, while many advisers will calculate fair value in accordance with GAAP or another international accounting standard, other advisers acting consistently and in good faith may utilize another fair valuation standard. While these other standards may not provide the quality of information in financial reporting, the SEC expects that these calculations will provide sufficient consistency for purposes of regulatory assets under management.

However, the SEC expects, consistent with the good faith requirement, that an adviser calculating fair value in accordance with GAAP or another basis of accounting for financial reporting purposes will also use that same basis for purposes of determining the fair value of its regulatory assets under management. In addition, the fair valuation process need not be the result of a particular mandated procedure and the procedure need not involve the use of a third-party pricing service, appraiser or similar outside expert. An adviser could rely on the procedure for calculating fair value that is specified in a private fund‘s governing documents.

The SEC defined venture capital funds in a way that distinguishes them 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.

The regulation focuses on the provision of capital for the operating and expansion of start-up businesses, rather than buying out prior investors. In crafting the definition of venture capital fund, the goal was to develop an accurate and legitimate definition without including loopholes that could be inappropriately exploited down the road.

The definition flexibly provides a 20 percent basket that would be outside the strict venture capital-oriented investment parameters imposed on the remaining 80 percent of the fund. This 20 percent basket would enable legitimate one-off investments and flexibility while maintaining a fund’s core venture capital nature.

The SEC regulations do not define a venture capital fund as a fund advised by an adviser with a principal office and place of business in the United States. Thus, a non-U.S. adviser, as well as a U.S. adviser, may rely on the venture capital exemption provided that they solely advise venture capital funds that satisfy all of the elements of the rule. A non-U.S. adviser may rely on the venture capital exemption if all of its clients, whether U.S. or non-U.S., are venture capital funds.

Chairman Schapiro added that the Commission will supplement the new regulations with consideration of adoption of new Form PF. As proposed earlier this year, Form PF would provide additional information from private fund advisers that would be reported on a non-public basis pursuant to the Dodd-Frank Act. The information would be used to inform the SEC and the Financial Stability Oversight Council about the systemic risk profile of private fund advisers and the private funds they manage.

The Dodd-Frank Act provided an exemption from registration for foreign private advisers that do not have a place of business in the United States, have less than $25 million in aggregate assets under management from U.S. clients and private fund investors and fewer than 15 clients in the US. The SEC defined certain terms included in the statutory definition of “foreign private adviser” in order to clarify the application of the exemption and reduce the potential burdens for advisers that seek to rely on it.

Under the SEC regulations, a foreign adviser can treat as a single client a corporation or partnership to which the adviser provides investment advice. Moreover, if an adviser reasonably believes that an investor is not in the United States, the adviser may treat the investor as not being in the United States. Also, a person who 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, each time the investor acquires securities issued by the fund. This regulation is designed to reduce the burden on the foreign adviser of having to monitor the location of clients and investors on an ongoing basis

Under the regulations, any office from which an adviser regularly communicates with its clients, whether U.S. or non-U.S., would be a place of business. In addition, an office or other location where an adviser regularly conducts research would be a place of business because research is intrinsic to the provision of investment advisory services. But a place of business would not include an office where an adviser solely performs administrative services and back-office activities if they are not activities intrinsic to providing investment advisory services and do not involve communicating with clients.

The SEC indicated that there is no presumption that a non-U.S. adviser has a place of business in the United States solely because it is affiliated with a U.S. adviser. A non-U.S. adviser might be deemed to have a place of business in the United States, however, if the non-U.S. adviser‘s personnel regularly conduct activities at an affiliate‘s place of business in the United States.