SEC Approves Final Dodd-Frank Rules on Oversight of Investment Advisers and Family Offices Definition | Practical Law

SEC Approves Final Dodd-Frank Rules on Oversight of Investment Advisers and Family Offices Definition | Practical Law

An update on the SEC approving final rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions under Title IV of the Dodd-Frank Act relating to new SEC registration and reporting requirements for certain investment advisers to private funds, new exemptions to the registration requirement and related definitions.

SEC Approves Final Dodd-Frank Rules on Oversight of Investment Advisers and Family Offices Definition

by PLC Corporate & Securities
Published on 23 Jun 2011 • USA (National/Federal)
An update on the SEC approving final rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions under Title IV of the Dodd-Frank Act relating to new SEC registration and reporting requirements for certain investment advisers to private funds, new exemptions to the registration requirement and related definitions.
On June 22, 2011, the SEC in an open meeting approved various final rules and rule amendments under the Investment Advisers Act of 1940 (Advisers Act) to implement certain provisions of Title IV of the Dodd-Frank Act, which amended the Advisers Act to:
  • Require investment advisers to certain private funds to register with the SEC by eliminating the private adviser exemption.
  • Create new private adviser registration exemptions under the Advisers Act.
  • Reallocate to the states primary responsibility for regulatory oversight of "mid-sized advisers."
To facilitate the transition to these provisions, the final rules extend the original July 21, 2011 private adviser registration and reporting deadline under the Dodd-Frank Act to March 30, 2012.
The final rules approved by the SEC include new rules and existing rule amendments to give effect to these provisions originally proposed in fall 2010 and were subject to public comment (see Legal Updates, SEC Proposes Family Offices Definition and SEC Proposes Rules to Improve Oversight of Investment Advisers). For a summary of the key provisions of the Dodd-Frank Act relating to investment advisers to private funds, see Practice Note, Summary of the Dodd-Frank Act: Private Equity and Hedge Funds.
The first set of final rules and rule amendments (Implementing Rules) implement provisions of Title IV of the Dodd-Frank Act to, among other things:
  • Increase the statutory thresholds under the Advisers Act for registration by investment advisers with the SEC.
  • Require advisers to hedge funds, private equity funds and other private funds to register with the SEC and comply with certain periodic reporting obligations.
  • Require limited SEC reporting by certain private advisers exempt from SEC registration (for more information on these exempt reporting advisers, see Exemption Rules).
The Implementing Rules also include amendments to the SEC's pay to play rule and address several other changes to the Advisers Act made by the Dodd-Frank Act.
The second set of final rules (Exemption Rules) implement new exemptions from the registration requirements of the Advisers Act for advisers to certain privately offered investment funds, including:
  • Advisers to venture capital funds.
  • Advisers with less than $150 million in private fund assets under management in the US.
  • Certain foreign private advisers.
The third set of final rules (Family Office Rules) implements the new exemption from the registration requirements of the Advisers Act under the Dodd-Frank Act for advisers to family offices.

Implementing Rules

Section 410 of the Dodd-Frank Act, effective July 21, 2011, creates a new group of mid-sized advisers under the Advisers Act and shifts primary responsibility for their regulatory oversight to the state securities authorities. Under this section, an adviser is prohibited from registering with the SEC if it is registered and subject to state examination as an investment adviser in the state in which it maintains its principal office and place of business and it has assets under management between $25 million and $100 million (a mid-sized adviser) (under existing Section 203A of the Advisers Act, smaller advisers with less than $25 million in assets under management generally are already prohibited from registering with the SEC, but are subject to applicable state regulation).
As a consequence of Section 410, the SEC anticipates that 3,200 SEC-registered advisers will be required to withdraw their registrations and register with one or more state securities authorities. The SEC is working closely with the state securities authorities to assure an orderly transition of mid-sized advisers from SEC registration to state regulation. The Implementing Rules provide the SEC with the means to:
  • Conduct an orderly transition and identify advisers that must transition to state regulation.
  • Clarify the application of certain new statutory provisions.
  • Modify certain of the exemptions from the prohibition on SEC registration that the SEC previously adopted under Section 203A of the Advisers Act.

Adding New Rule 203A-5

The Implementing Rules add new Rule 203A-5, which requires each investment adviser (regardless of the size of its assets under management) registered with the SEC on January 1, 2012 to file an amendment to its Form ADV no later than March 30, 2012. This filing will provide the SEC and the state regulatory authorities with information necessary to identify those mid-sized advisers required to transition to state registration. An adviser no longer eligible for SEC registration must then withdraw its SEC registration by filing Form ADV-W no later than June 28, 2012. The SEC expects to cancel the registration of advisers that fail to file an amendment or withdraw under Rule 203A-5. Mid-sized advisers registered with the SEC as of July 21, 2011 must remain registered until January 1, 2012, when it would then transition to state regulation under Rule 203A-5. After July 21, 2011, mid-sized advisers are prohibited from newly registering with the SEC and must register with state securities authorities. Larger advisers (with assets under management of $100 million or more) will continue to register with the SEC after July 21, 2011.

Amending Form ADV

The Implementing Rules amend Form ADV to reflect the new statutory threshold for registration with the SEC and other requirements of the Dodd-Frank Act and to revise the Form ADV instructions to implement a uniform method to calculate assets under management. The amended Form ADV will help the SEC determine which advisers must register with the SEC, which advisers must register with the state regulatory authorities and which advisers are exempt from SEC registration. Form ADV is also amended to include several changes unrelated to Dodd-Frank intended to improve the SEC's ability to assess compliance risk.
The amended Form ADV will require each mid-sized adviser registering with the SEC (rather than the applicable state regulatory authorities) to affirm annually that it is either not required to be registered as an adviser with the state securities authority in which it has its principal office and place of business or it is not subject to examination as an adviser by that state securities authority (either of which would require under the Dodd-Frank Act a mid-sized adviser to register with the SEC rather than its state securities authority, unless another exemption is available). In the Implementing Rules, the SEC noted that all state securities authorities except Minnesota, New York and Wyoming have advised the SEC that advisers registered with them are subject to examination. Mid-sized advisers in these three states will presumably be required to register with the SEC rather than the applicable state securities authority.

Amending Rule 203A-1

The Implementing Rules amend Rule 203A-1 to prevent advisers from having to switch frequently between state and SEC registration owing to changes in the value of its assets under management or the departure of one or more clients. Under the amended rule, this is achieved by:
  • Providing a buffer for mid-sized advisers with assets under management close to $100 million, raising the threshold above which an adviser must switch to SEC registration from state registration to $110 million of assets under management and lowering the threshold below which an adviser must switch to state registration from SEC registration to $90 million of assets under management.
  • Requiring eligibility for SEC registration to be measured only on an annual basis as part of an adviser's annual updating amendment to its Form ADV filing.

Amending Certain Exemptions Previously Adopted under Section 203A of the Advisers Act

The Implementing Rules amend certain of the exemptions from the prohibition on registration that the SEC previously adopted under Section 203A of the Advisers Act. Existing Section 203A(c) of the Advisers Act permits the SEC to exempt small and mid-sized advisers from the prohibition on SEC registration. Under this authority the SEC has previously adopted six exemptions in Rule 203A-2 from the prohibition on SEC registration (for example, permitting nationally recognized statistical rating organizations (NRSROs), pension consultants and multi-state investment advisers to register with the SEC). The amendment to these exemptions includes amending:
  • Rule 203A-2(a) to eliminate the exemption for NRSROs.
  • The Rule 203A-2(b) exemption available to pension consultants to increase the minimum value of plan assets required to rely on the exemption from $50 million to $200 million.
  • Rule 203A-2(d) to permit all investment advisers required to register as an investment adviser with 15 or more states to register with the SEC. These advisers can still choose to maintain their multi-state registrations and not switch to SEC registration.

Eliminating the Rule 203A-4 Safe Harbor

The Implementing Rules eliminate the Rule 203A-4 safe harbor from SEC registration for an investment adviser registered with the state securities authority of the state in which it has its principal office and place of business, based on a reasonable belief that it is prohibited from registering with the SEC because it has insufficient assets under management.

Adding New Rule 204-4

The Implementing Rules add new Rule 204-4, which would require advisers relying on the exemption to SEC registration for private advisers to venture capital funds and private advisers with limited assets under management (Exempt Reporting Advisers) to file reports with the SEC on Form ADV (for more information on the Exemption Rules implementing the new exemptions for these Exempt Reporting Advisers, see Exemption Rules). However, under the new rule, they would only be required to respond to a limited subset of items on Part 1A of Form ADV that provide some basic information about an Exempt Reporting Adviser and its private funds, its business and other activities and its employees to allow the SEC to identify these advisers and whether their activities warrant further SEC attention to protect clients, investors and other market participants. These reporting requirements are subject to reconsideration and potential adjustment by the SEC following receipt of the first year's filing of such information. Form ADV would also be amended to facilitate filings by Exempt Reporting Advisers. Exempt Reporting Advisers must file their initial report with the SEC within 60 days of relying on the applicable exemption from registration, and all reports will be made publicly available. As with SEC registered advisers, Exempt Reporting Advisers are generally required to update their Form ADV filings on annually. Exempt Reporting Advisors would also be subject by law to examinations, but SEC Chairwoman Mary Schapiro indicated in her opening remarks to the open meeting that the SEC does not intend to conduct routine examinations of Exempt Reporting Advisors.

Other Implementing Rules Requirements

The Implementing Rules would also require advisers (registered advisers and Exempt Reporting Advisers) to private funds to provide additional information about certain areas of their operations to assist the SEC in overseeing investment advisers, allocate examination resources and create risk profiles. These areas include:
  • Basic information about each private fund they advise, including information about the gross asset value of the fund, its organizational, operational and investment characteristics, and limited general information regarding investors in the fund.
  • Identification of and certain other information for five categories of service providers (such as auditors, prime brokers, custodians, administrators and marketers) that perform critical roles as gatekeepers for private funds.
  • Additional information to better understand an adviser's and its related parties' business, such as the types of services it provides, the clients it provides those services to, its employees, its business practices, its non-advisory activities and its financial industry affiliations.
In the Implementing Rules, the SEC also amends its pay to play rule (Rule 206(4)-5), which generally prohibits registered and certain unregistered advisers from engaging directly or indirectly in pay to play practices identified in Rule 206(4)-5. The amendments include:
  • Extending Rule 206(4)-5 to Exempt Reporting Advisers and foreign private advisers (for more information on these type of advisers as it pertains to the new final rules under Dodd-Frank, see Exemption Rules).
  • Permitting an adviser to pay any registered municipal advisor to solicit government entities on its behalf.
  • Extending the deadline by which advisers must comply with the ban on third-party solicitation from September 13, 2011 to June 13, 2012.

Exemption Rules

The Exemption Rules, effective July 21, 2011, adopted by the SEC facilitate the implementation of three new private adviser SEC registration exemptions under the Advisers Act. These specific exemptions, which were created under the Dodd-Frank Act to replace the broader private adviser exemption, are for:
  • Advisers solely to venture capital funds (new Rule 203(l)) (Venture Capital Exemption).
  • Advisers solely to private funds with less than $150 million in assets under management in the US (new Rule 203(m)) (Private Fund Adviser Exemption).
  • Certain foreign advisers without a place of business in the US (amended Section 203(b)(3) of the Advisers Act) (Foreign Private Adviser Exemption).
These exemptions are not mandatory and a qualifying adviser can still choose to register or remain registered with the SEC (and may still be subject to applicable state registration requirements), subject to the prohibitions on SEC registration for mid-sized advisers described above (see Implementing Rules). In addition, as noted above, advisers qualifying for either the Venture Capital Exemption or the Private Fund Adviser Exemption and not required to register with the SEC are considered Exempt Reporting Advisers and are still subject under the Dodd-Frank Act to limited reporting requirements with the SEC on Form ADV (see Implementing Rules).

Venture Capital Exemption

The SEC approved new Rule 203(l)-1 defining "venture capital fund" for purposes of the Venture Capital Exemption available to advisers solely to private venture capital funds. Under this new definition, which is intended to distinguish venture capital funds from hedge funds and private equity funds, a venture capital fund is a private fund that:
  • Represents itself to investors as pursuing a venture capital strategy to its investors.
  • Holds no more than 20% (measured immediately following any investment) of the fund's total capital commitments in non-qualifying investments (Non-Qualifying Basket). Under the new definition, "qualifying investments" generally consist of:
    • equity securities (as defined in the Exchange Act to include common stock, preferred stock, warrants and other securities convertible into common stock as well as limited partnership interests) of qualifying portfolio companies (including equity securities acquired directly from the qualifying portfolio company, issued in a reorganization in exchange for directly acquired equity securities of the qualifying portfolio company or issued by another company in exchange for directly acquired equity securities of a qualifying portfolio company in a merger or other acquisition of the qualifying portfolio company); and
    • short-term holdings such as cash and cash equivalents of US Treasuries with a remaining maturity of 60 days or less and shares of registered money market funds. The value of all short term holdings are excluded from determining the percentage of fund non-qualifying and qualifying investments.
  • Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15% of the private fund's aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days.
  • Does not offer redemption or other similar liquidity rights to its investors except in extraordinary circumstances.
  • Is not registered under the Investment Company Act and has not elected to be treated as a business development corporation.
A "qualifying portfolio company" is a company that:
  • Is not publicly traded (at the time of the initial investment).
  • Does not both incur leverage in connection with the investment by the private fund and distribute to the fund the proceeds of such borrowing in exchange for the fund's investment. This element of the final Venture Capital Exemption is less restrictive than the proposed rule and allows venture capital funds more flexibility to make qualifying investments through leverage buyouts.
  • Is not a fund itself (for example, it is an operating company).
Importantly, the final adopted Venture Capital Exemption creates the Non-Qualifying Basket of 20% of capital commitments for investments by the fund that do not otherwise conform to the requirements of the new rule. This Non-Qualifying Basket was not part of the original proposed rules issued by the SEC, was in response to public comments received by the SEC and was generally created as an alternative to adopting a long list of additional specific investment exceptions (such as interests in other venture capital funds, non-convertible debt securities or publicly traded securities). It seeks to address the concerns of commenters regarding occasional deviations from typical venture capital investing activity or inadvertent violations of the definition criteria and the needed flexibility to address evolving or future business practices in the venture capital industry.
In addition, the final rule excluded from the definition of venture capital fund the requirement in the proposed rule that the fund provide a significant degree of managerial assistance to, or control, its qualifying portfolio companies. The SEC was persuaded by commenters that defining managerial assistance under the rule would introduce additional complexity and may not distinguish venture capital funds from other types of funds.
The Venture Capital Exemption also grandfathers any existing fund that has held itself out as a venture capital fund, so long as such fund's first closing was before December 31, 2010 and no new capital commitments are made to the fund after July 21, 2011. The Venture Capital Exemption can be used by non-US advisers as well as US advisers so long as all the private funds managed by the adviser are venture capital funds and otherwise meet the criteria of the exemption (or the grandfathering provision).

Private Fund Adviser Exemption

The SEC approved new Rule 203(m)-1 to implement the Private Fund Adviser Exemption. The availability of the exemption from registration for advisers to solely to qualifying private funds (defined generally by reference to the Advisers Act definition of private fund) with less than $150 million in assets under management in the US in the aggregate (regardless of the number of private funds it advises) would vary depending on whether an adviser is a US adviser or a non-US adviser:
  • A US adviser would have to meet the conditions of the exemption for all of its private fund assets under management.
  • A non-US adviser would have to meet the conditions for its assets under management in the US without consideration of the size of its investments managed from abroad so long as all of its clients that are US persons are qualifying private funds. This allows a foreign adviser to enter the US market and take advantage of the Private Fund Adviser Exemption without regard to the type or number of its non-US clients or the amount of assets it manages outside of the US.

Foreign Private Adviser Exemption

The Dodd-Frank Act amended Section 203(b)(3) of the Advisers Act to provide an exemption from registration for "foreign private advisers" that do not have a place of business in the US (or hold themselves out as an investment adviser in the US) and have:
  • Fewer than 15 US clients and US investors in private funds it advises. Investors is defined as any person who would be included in determining the number of beneficial owners of 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.
  • Less than $25 million in aggregate assets under management from those US clients and US private fund investors.
The SEC approved new Rule 202(a)(30)-1 to define certain terms included in the statutory definition of a foreign private adviser as defined in Section 202(a)(30) of the Advisers Act to clarify the application of the Foreign Private Adviser Exemption. The definitions address the terms:
  • Investor.
  • In the US.
  • Place of business.
  • Assets under management.

Definition of Family Office

The SEC also approved new rule 202(a)(11)(G)-1 under the Advisers Act to define "family office" as required by the Dodd-Frank Act. Because the Dodd-Frank Act excludes family offices from the definition of investment adviser under the Advisers Act, it therefore exempts them from the SEC registration requirements under the Advisers Act. The Family Office Rules define a family office with reference to three general conditions, including a firm that:
  • Provides investment advice only to "family clients." In general, family clients includes
    • current and former family members (as defined by the rule);
    • certain key employees of the family office;
    • charities funded exclusively by family clients;
    • estates and trusts created for family members or key employees; and
    • entities wholly owned and controlled by family members.
  • Is wholly owned by family clients and controlled by family members or family entities.
  • Does not hold itself out to the public as an investment adviser.
The Family Office Rules provide a transition period from the July 21, 2011 effective date to March 30, 2012. This allows family offices time to evaluate whether they meet the new family office exclusion and, if not, to either restructure to meet the exclusion or prepare to register with the SEC by the March 30, 2012 deadline.
For more information on key provisions of the Dodd-Frank Act relating to investment advisers and to US and non-US hedge and private-equity funds, see Practice Notes, Summary of the Dodd-Frank Act: Private Equity and Hedge Funds and Road Map to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.