Sprinkled among the 2,300+ pages of the Dodd-Frank Wall Street
Reform and Consumer Protection Act are a number of provisions that
will affect both registered investment advisers and other wealth
managers who may not have registered as investment advisers up
until now.
Impact on Existing Registered Investment Advisers
Effective one year after Dodd-Frank's passage, July 21,
2011, the dollar thresholds for determining whether an adviser is
to register under federal or state law will change. Currently,
advisers with assets under management of under $25 million must
register with a state regulator, those with assets under management
of between $25 million and $30 million may choose either state or
federal regulation, and those with assets under management
exceeding $30 million must register federally with the SEC. Under
Dodd-Frank, generally all advisers with assets under management of
under $100 million must register with state regulators and those
with over $100 million under management must register with the SEC.
Exceptions to this rule are advisers with assets of less than $25
million which do business in 30 or more states, or those with
assets between $25 million and $200 million which do business in 15
or more states – they are permitted but not required to
register with the SEC. So advisers now registered with the SEC but
whose assets under management fall into the $25 million to $100
million category will be required to withdraw their SEC
registration (by filing a Form ADV-W on the IARD system) and then
refiling with one or more states. More guidance on appropriate
procedures can be expected from the SEC and states prior to the
July 21, 2011 deadline.
Registered investment advisers generally may only charge
performance-based fees (i.e. fees based on investment success
rather than the usual percentage-of-managed-assets fees) to
"qualified clients." Qualified clients have been defined
as those with either $750,000 or more of funds under management or
having over $1,500,000 net worth. These thresholds have remained
unchanged for many years; Dodd-Frank now requires the SEC to adjust
them for inflation, starting within one year of the bill's
enactment and every five years thereafter. This will almost
certainly reduce the potential number of clients eligible for
performance fee arrangements.
Registered advisers which sponsor or advise pooled investment funds
(hedge funds and the like, now called "private funds")
will be impacted in a couple of different ways. First, the
potential universe of investors in such funds will shrink since
Dodd-Frank now requires the SEC to re-write its definition of
"accredited investors." Since the advent of the SEC's
Regulation D in the early 1980's, the definition was set as
natural persons with either $200,000 of annual income ($300,000 for
couples) or $1 million of net worth (including one's
residence). Dodd-Frank mandates that personal residences be
excluded from the net worth calculation and that the thresholds be
inflation-indexed. So the number of potential investors in these
funds will inevitably decrease.
Second, Dodd-Frank requires sponsors of private funds to maintain
voluminous records for the funds, available for SEC examination and
to the new Financial Stability Oversight Council, as well as to
investors. The required records include, among others,
documentation of leverage, counterparty risk exposure, trading
practices and "such other information" as the regulators
may deem appropriate. Hedge funds will become more like registered
mutual funds in many respects.
Dodd-Frank requires the SEC to review and analyze the need for
enhanced examination and enforcement resources for its oversight of
investment advisers and report back to Congress in 180 days. Among
the issues required to be considered is whether the SEC should
designate a self-regulatory organization (such as FINRA) to become
involved in investment adviser oversight and examination. If that
happens, then investment advisers, like broker-dealers now, can
expect examinations by both the SEC and FINRA.
Impact on Previously Unregistered Wealth
Advisors
The Investment Advisers Act of 1940 had from its inception an
exemption from the registration requirement for advisers with less
than 15 clients who did not hold themselves out to the public as
investment advisers. Much of the hedge fund industry was built upon
fund sponsors which avoid Adviser Act registration since a hedge
fund with multiple investors of its own counted as only one client
for Adviser Act purposes. The SEC attempted to circumvent this
perceived loophole by a rule in 2005 that required a look-through
of hedge funds to their investors for this purpose, but the rule
was invalidated by the U.S. Court of Appeals which ruled it
exceeded the SEC's statutory authority. Dodd-Frank has now
eliminated the under-15 client exemption altogether, replacing it
with several more narrow exemptions:
- certain foreign advisers with no place of business and less than 15 U.S. clients and less than $25 million of assets under management are exempt.
- advisers exclusively to "venture capital funds" (to be defined by the SEC within one year) are exempt. Not to be confused with advisers to "private equity funds" which will not be exempt; distinguishing them definitionally will be interesting.
- advisers exclusively to "family offices," also to be defined by the SEC.
- advisers exclusively to Small Business Investment Companies (SBICs), presumably because SBICs are closely regulated by the Small Business Administration.
- intrastate advisers, defined as those with clients only in one state and which do not advise as to listed securities. Of course, state regulation will still apply.
- Advisers exclusively to "private funds," i.e. hedge funds, private equity funds, etc. which fall outside the definition of an investment company, and have under $150 million of assets. So there is still room for a small hedge fund without direct SEC regulation.
Dodd-Frank also wades into the issue of financial planner
regulation. Financial planners who do not advise as to particular
investments have heretofore avoided regulation as investment
advisers or otherwise. Dodd-Frank requires the Comptroller General
of the United States to conduct a study to determine whether
financial planners should now be regulated.
Conclusions
Dodd-Frank continues the trend of the last ten years of
ever-increasing regulation of investment advisers, with the
prospect of still higher costs of compliance.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.