United States: Advisers Act Registration and Reporting Under Dodd-Frank: Supplemental Guidance for Non-U.S. Private Fund Advisers

Article by Barbara Stettner , Chris Salter , Dean Collins and Peter M. Vaglio

This client alert provides additional guidance to non-U.S. advisers¹ seeking to rely on one or more exemptions from registration under the U.S. Investment Advisers Act of 1940, as amended (the "Advisers Act"). This alert expands upon our client alert published on November 22, 2010 which is available here. The U.S. Securities and Exchange Commission (the "SEC") recently proposed rules (the "Release")² interpreting, among other things, exemptions from registration for (i) foreign private advisers (the "Foreign Private Adviser Exemption"), (ii) advisers to private funds with less than $150 million in assets under management in the U.S. (the "Private Fund Adviser Exemption"), and (iii) advisers solely to venture capital funds (the "Venture Capital Fund Exemption")³ which were introduced by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act"). The SEC is seeking comments to the Release, and therefore the exemptions provided therein are subject to change. All comments to the Release must be submitted no later than January 24, 2011.

While non-U.S. advisers are able to rely on the Foreign Private Adviser Exemption or the Private Fund Adviser Exemption to avoid full registration under the Advisers Act, each of these exemptions imposes collateral obligations which are discussed below.

Exempt Non-U.S. Advisers - The Foreign Private Adviser Exemption

If a non-U.S adviser qualifies as a "foreign private adviser," it will be exempt not only from registration under the Advisers Act, but from the broad public disclosure and reporting obligations proposed by the SEC implementing release (the "Implementing Release")⁴ and certain record-keeping and SEC examination requirements imposed by the Dodd-Frank Act (the "Reporting and Examination Requirements"). Such advisers would nonetheless be subject to the general anti-fraud rules under Section 206 of the Advisers Act, the SEC's recently adopted "pay-to-play" rule.⁵

The Foreign Private Adviser Exemption is a narrow exemption; it is only available to a non-U.S. adviser which (i) has no place of business⁶ in the U.S., (ii) has, in total, fewer than 15 "clients" in the U.S. and "investors" in the U.S. in private funds advised by the investment adviser, (iii) does not exceed $25 million of aggregate assets under management ("AUM") attributable to such U.S. clients and investors (AUM calculation discussed below), and (iv) does not hold itself out generally to the public in the U.S. as an investment adviser. The SEC has the authority under the Dodd-Frank Act to increase the $25 million of AUM but did not choose to do so in the Release.

A non-U.S. adviser relying on the Foreign Private Adviser Exemption must not only count each U.S. "client," but also each U.S. "investor" in any "private fund"⁷ advised by the non-U.S. adviser. Each of these terms are defined under the Release and should be well understood by any non-U.S. adviser attempting to rely on the Foreign Private Adviser Exemption.

• U.S. Client - the determination of who is a client in the U.S. keeps the safe harbor rule for counting U.S. clients that was promulgated under the repealed private adviser exemption under section 203(b) of the Advisers Act, with some modifications including requiring non-U.S. advisers to count advised persons or entities from which they receive no compensation as a client. Therefore, corporations, general partnerships, limited partnerships, limited liability companies, trusts, or other legal organizations to which the adviser provides advice based on the organization's legal objectives are still counted as a single "client." Two or more legal organizations that have identical shareholders, partners, limited partners, members, or beneficiaries also will be treated as a single client.
• U.S. Investor - An "investor" under this exemption is defined as any person who is a beneficial owner of a private fund under Section 3(c)(1) of the ICA, or a qualified purchaser under Section 3(c)(7) of the ICA. The look-through provisions of Sections 3(c)(1) and 3(c)(7) would require a foreign private adviser to monitor the U.S. beneficial ownership of any third-party fund investor.⁸ While such information is generally obtained through the subscription process, such can analysis can be complex and fact-specific. Other "investors" include "knowledgeable employees" of the fund who have invested in the fund, any beneficial owners of the fund's short-term paper, as well as any holder of an instrument, such as a total return swap, that effectively transfers the risk of investing in the private fund from the record owner of the private fund's securities.  

The use of a nominee account that aggregates investors into a single nominal investor, or an intermediate account through which investors may access a private fund, would be looked through for counting purposes. However, a foreign private adviser would be able to treat as a single investor any person who is an investor in two or more private funds advised by the non-U.S. adviser. Moreover, an adviser would not have to count a private fund as a client if an investor in that private fund has already been counted as an investor.

Accordingly, a non-U.S. adviser with no place of business in the U.S. should first determine whether they fall within the Foreign Private Adviser Exemption, because it serves as a complete exemption from registration as well as from the Reporting and Examination Requirements. As noted however, the Foreign Private Adviser Exemption is narrow and would only apply to non-U.S. advisers engaged in limited fundraising from U.S. investors. For example, if a non-U.S. adviser has a client organized outside the U.S. (e.g., a private investment fund that is a Cayman Islands exempted limited partnership), but that U.S. Person⁹ has contributed more than $25 million to the Cayman fund, it would not be able to rely on this exemption.  

Exempt Reporting Advisers - The Private Fund Adviser Exemption

If a non-U.S. adviser cannot qualify for the Foreign Private Adviser Exemption it may alternatively be able to rely on the Private Fund Adviser Exemption which exempts from registration under the Advisers Act a non-U.S. adviser (i.e., its principal office and place of business is outside the U.S.) whose advisory activities in the U.S. are limited to solely managing "qualifying" private funds¹⁰ and, if the non-U.S. adviser has a place of business in the U.S., it manages in the aggregate less than $150 million in private fund assets from that place of business in the U.S. Although non-U.S. advisers relying on this exemption would be exempt from full registration with the SEC, they would nonetheless become "exempt reporting advisers" subject not only to the anti-fraud and pay-to-play provisions under the Advisers Act, but also to the Reporting and Examination Requirements discussed below  

• Non-U.S. Private Fund Advisers with a Place of Business in the U.S.
  
  The Private Fund Adviser Exemption only limits non-U.S. advisers in the amount of private fund assets they manage from a place of business in the U.S. (i.e., $150 million). For purposes of this exemption, assets "managed from a place of business in the U.S." are those qualifying private fund assets for which the non-U.S. adviser provides "continuous and regular supervisory or management services" from its place of business in the U.S.¹² Any assets managed from a U.S. place of business for clients other than qualifying private funds would make this exemption unavailable.
  
  Unlike U.S. advisers, who must count all of the assets of all of the U.S. and non-U.S. private funds it manages toward the $150 million threshold, a non-U.S. adviser with a place of business in the U.S. only needs to count the qualifying private fund assets its manages from its place of business in the U.S. toward the same threshold. Moreover, a non-U.S. private fund adviser will not lose its exempt reporting status as a result of its advisory activities conducted outside the U.S., e.g., non-U.S. funds and separate accounts managed from outside the U.S. are not counted toward the $150 million threshold. 

• Non-U.S. Private Fund Advisers with No Place of Business in the U.S.
  
  A non-U.S. private fund adviser is not required to have a U.S. place of business to take advantage of this exemption. A non-U.S. adviser with no place of business in the U.S. may also manage unlimited assets from an unlimited number of U.S. clients and U.S. investors from their non-U.S. place of business so long as all of the adviser's "clients" that are U.S. Persons are qualifying private funds.

The SEC has proposed a transition period which provides a non-U.S. private fund adviser with one calendar quarter to register with the SEC after becoming ineligible to rely on the Private Fund Adviser Exemption due to an increase in the value of its private fund assets. This is a short period of time in which to register with the SEC and develop compliance policies and procedures and therefore the SEC is likely to receive comments requesting a longer transition period. Further, this transition period will not be available to any exempt reporting adviser that has not complied with all applicable reporting obligations under the exemption, necessitating a robust compliance reporting program for advisers relying on this exemption.  

Calculation of Assets Under Management

The SEC has proposed to define "assets under management" for purposes of calculating whether an adviser qualifies for an exemption from registration by reference to Item 5 of Form ADV, the adviser's registration statement under the Advisers Act. As a result, the SEC requires an adviser to observe the following guidelines in calculating assets under management:

• Include the value of any private fund over which it exercises continuous and regular supervisory or management services, regardless of the nature of the assets held by the private fund. As a result, the adviser would be required to count assets held by private funds that are not considered securities under the Advisers Act, such as commodities and real estate;
• Include the assets of proprietary accounts, accounts managed without receiving compensation, or accounts of non-U.S. clients, all of which an adviser currently may exclude;
• Include the amount of any uncalled capital commitments to the private fund;
• Use the fair value of private fund assets (e.g., the cost basis of assets may not be used in calculating assets under management);
• If acting as sub-adviser to a private fund, the adviser may only include assets over which it provides advisory services; and
• Advisers may not subtract outstanding indebtedness and other accrued but unpaid liabilities from assets under management.
  
  

Reporting and Examination Requirements

Exempt reporting advisers that rely on the Private Fund Adviser Exemption or the Venture Capital Exemption will be subject to the Reporting and Examination Requirements. A brief summary of the Reporting and Examination Requirements is set forth below.

• SEC Examination and Recordkeeping Requirements
  
  Exempt reporting advisers are expected to be required to maintain books and records as required by the SEC. Although the SEC did not provide specific books and records requirements in the Implementing Release, it indicated that books and records requirements will be addressed in a future release in the event the SEC deems it necessary or appropriate in the public interest or for the protection of investors.
  
  The SEC may also exercise its authority under the Dodd-Frank Act to conduct examinations of exempt reporting advisers in order to monitor systemic risk.
• SEC Reporting and Disclosure Obligations
  
  Exempt reporting advisers will also become subject to the SEC's new pay-to-play rule and the following filing obligations which will be publicly available on the SEC's website:
  
  
  • File and periodically update reports by completing a sub-set of items on Part I of Form ADV, including:
    
    
    • Basic identifying information;
    • Direct and indirect owners and control persons;
    • Financial industry affiliates;
    • Other business activities in which the adviser and its affiliates engage; and
    • Disciplinary history of the adviser and its employees
      
      
  • Provide extensive fund-level reporting, similar to the information fund investors commonly seek in diligence questionnaires, such as:
    
    
    • Gross asset and net asset value of each private fund;
    • Value of the private fund's level, 1, 2, and 3 assets and liabilities calculated in accordance with U.S. generally accepted accounting principles;¹³
    • Number of beneficial owners, percentage of fund owned per category of investor (e.g., private fund, institutional investor, or individual investor), and percentage of fund owned by non-U.S. Persons;
    • Information about placement agents marketing the fund;
    • Identifying information about auditors, prime brokers, custodians and administrators; and
    • Any sub-advisers to the fund.
      
      

Initial reports are due no later than August 20, 2011.

Footnotes

1. A non-U.S. adviser is an investment adviser with a principal office and place of business (e.g., the location where the advisor controls, or has ultimately responsibility for the management of client assets) outside of the United States.

2. A complete copy of the Release is available here.

3. A "venture capital fund" has been defined narrowly in the Release and is likely of little use to many non-U.S. advisers. While we have focused this Alert on the exemptions more relevant to non-U.S. advisers, the November 29, 2010 O'Melveny & Myers client alert addressing the exemption for advisers to venture capital funds is available here.  

4. A complete copy of the Implementing Release is available here.

5. The SEC pay-to-play rule for investment advisers prohibits an adviser from receiving compensation for two years for providing investment advisory services in connection with investment by a government entity if the adviser, or certain of its officers and employees, make a political contribution to certain public officials or candidates for public office. Although federal law prohibits foreign entities and foreign citizens from making political contributions in any U.S. election, U.S. subsidiaries of foreign advisers and U.S. citizens resident outside of the United States are not subject to that prohibition and may participate in federal, state, and local elections. Accordingly, to the extent that a non-U.S. adviser either employs U.S. citizens or has U.S. subsidiaries, there is some risk that it may make a contribution that will trigger the pay-to-play rule's restrictions. 17 CFR 275.206(4)-5.

6. A "place of business" is defined to mean 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 activities.

7. The Dodd-Frank Act defines a "private fund" as a fund that would be an investment company under the Investment Company Act of 1940, as amended (the "ICA") but for the exceptions in Section 3(c)(1) or Section 3(c)(7) of the ICA.

8. For example, section 3(c)(1)(A) of the ICA requires a private fund issuer relying on Section 3(c)(1) of the ICA to "look-through" a private fund investor and count the beneficial owners in such investor as the beneficial owners of the private fund issuer's securities if the investor holds 10% or more of the outstanding voting securities of the private fund issuer.

9. In determining the meaning of the term "in the United States" for purposes of determining (i) the number of an adviser's clients and investors, (ii) the adviser's place of business, and (iii) whether the adviser holds itself out to the public in the United States, the SEC has proposed to adopt the definition of "U.S. Person" promulgated under Rule 902(k) under Regulation S of the Securities Act of 1933, as amended.

10. A qualifying private fund means any private fund that is not registered under section 8 of the ICA and has not elected to be treated as a business development company pursuant to section 54 of the ICA.

11. 17 CFR 275.203(m)-1, as proposed by the SEC. See Item 5.F of Form ADV.

12. Proposed rule 203(m)1(e)(1) defines "assets under management" as determined under Item 5.F of Form ADV. See fn 204 and accompanying text of Release.

13. The Financial Accounting Standards Board issued Statement of Financial Accounting Standards No. 157: Fair Value Measurements ("FAS 157") in September 2006 to provide guidance about how entities should determine fair value estimations for financial reporting purposes. FAS 157 emphasizes the use of market inputs in estimating the fair value for an asset or liability. The framework established in FAS 157 uses 3-level fair value hierarchy to reflect the level of judgment involved in estimating fair values as follows:

level 1 - observable market inputs reflecting quoted prices for identical assets or liabilities;

level 2 - observable market inputs other than quoted prices for identical assets or liabilities (e.g., quoted prices for similar assets or liabilities, or inputs such as interest rates, yield curves);

level 3 - unobservable market inputs, for example inputs derived through extrapolation that are not able to be corroborated by observable market data. 

O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.

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