Introduction
It has been noted in prior articles in this blog that the old Private Advisers (14 or fewer clients) exemption to SEC registration is dead. This is not quite true in the case of foreign private advisers who will be, if they meet the requirements, exempt from registration with the SEC as investment advisers.
Under the law and the SEC proposed rules, the basic requirements for the foreign private adviser exemption will be:
- No place of business in the US;
- Less than $25 Million in assets under management (“AUM”) for US clients or investors; and
- 14 or fewer US clients or investors
It is the last requirement that brings the old Private Advisers exemption back into play – albeit solely in the context of foreign advisers.
Counting Clients
Many of the old rules for counting the number of clients continue. However, in the case of a private fund client (essentially a pooled investment vehicle) to get the count each investor in the fund will typically have to be counted as a client. So, for example, if a foreign adviser with offices in London has $15 Million AUM from a US private fund which has 15 underlying US investors then the foreign adviser has to register with the SEC as an investment adviser.
This new methodology for counting clients explained in detail in SEC Release IA-3111 (November 19, 2010) will require many currently exempt foreign advisers to register with the SEC.
Counting Investors
The new law has required the SEC to come up with a definition of “investor” for purposes of the Investment Advisers Act. The proposed rule defines an investor as any person who would be (i) included in determining the number of beneficial owners of the outstanding securities of an Investment Company Act Section 3(c)(1) private fund (100 or fewer participants), or (ii) required to be a qualified purchaser (generally an individual with $5 Million (or entity with $25 Million) or more in portfolio securities) in order for a private fund to qualify for the Section 3(c)(7) Investment Company Act exemption.
The SEC specifically states in the Proposing Release that advisers are required to "look through" nominee and similar arrangements to the underlying holders of private fund interests to determine whether they have fewer than 15 clients and private fund investors in the US. The SEC acknowledges that determining the number of private fund investors will require individual determinations based on the facts and circumstances of each case. However, the SEC does provide the following specific examples:
- An adviser to a master fund in a master-feeder arrangement would have to treat as investors the holders of the securities of any feeder fund formed or operated for the purpose of investing in the master fund.
- An adviser would be required to "look through" any entity created for the purpose of making an investment and count each of its beneficial owners as investors.
- An adviser would need to count as an investor any holder of an instrument, such as a total return swap, that effectively transfers the risk of investing in the private fund away from the record owner of the private fund's securities.
- An adviser would need to count as an investor, a holder of both equity and debt securities.
- An adviser would need to count as an investor knowledgeable employees and holders of short term paper, even though such treatment would not be required under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.
In the United States
A foreign investment adviser or fund manager must determine whether its clients and private fund investors are "in the United States." For this purpose, the proposed rule generally requires the status of client or private fund investor to be determined using the definition of "US Person" in Regulation S.
Regulation S defines a US Person as:
- Any natural person resident in the US;
- Any partnership or corporation organized or incorporated under the laws of the US;
- Any estate of which any executor or administrator is a US person;
- Any trust of which any trustee is a US person;
- Any agency or branch of a foreign entity located in the US;
- Any non-discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary for the benefit or account of a US person;
- Any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organized, incorporated, or (if an individual) resident in the US; and
- Any partnership or corporation if:
- Organized or incorporated under the laws of any foreign jurisdiction; and
- Formed by a US person principally for the purpose of investing in securities
In addition, the proposed rule treats any discretionary account owned by a US Person and managed by a non-US affiliate of the adviser as a US Person.
In order to avoid requiring an investment adviser or fund manager to monitor the ongoing location of clients and investors, the Proposed Rule allows the determination to be made once, when the individual or entity becomes a client or acquires the interest in the private fund.
Costs
The SEC has estimated $6,940 in costs to a foreign adviser to determine if it is eligible for the exemption. This estimate is based on consultation with outside counsel (at a cost of $400 per hour) of 10 hours and an internal review of discretionary accounts owned by U.S. persons performed by a senior compliance officer (at a cost of $294 per hour) of 10 hours. Interesting.
Criticism
The argument has been made that the foreign private adviser exemption keeps the gate open to foreign hedge funds being able to pose systemic risks to the US financial system without being detected. A recent article by Michael Overmyer in the Columbia Law Review (December, 2010) suggests that foreign hedge fund advisers with a threshold level of exposure to US equity and debt securities should be required to register with the SEC regardless of whether the investors in the funds are US persons or not. The article does not quantitatively define (albeit it notes the quantitative standards of the SEC's proposed Large Trader Reporting System as being somewhat of a start) what the threshold level is but does state that:
"An appropriate threshold should be based ...on... reflection of a foreign hedge fund’s potential to contribute to systemic risk in the U.S. economy. Relevant factors therefore include a fund’s holdings of U.S. assets, debts owed to U.S. creditors, and obligations to other U.S. counterparties."
In short, the narrow focus on only protecting US investors from the wiles of foreign investment advisers, while leaving the US economy vulnerable to the potentially destabilizing effects of unregulated foreign private investment in the US, may have, at least in part, missed the boat.
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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.
Nothing is this blog is intended to or may be relied upon as specific legal advice. Securities and related laws are complex and competent counsel should be consulted
