The Dodd-Frank Wall Street Reform and Consumer Protection Act carries sweeping change for private equity funds, hedge funds, and venture capital funds. Some key changes are highlighted below.

Registration and Exemption for Fund Advisers

Until now, private fund advisers have been able to rely on the "private investment adviser" exemption of Section 203(b)(3) of the Investment Advisers Act of 1940, as amended, which exempts from registration investment fund advisers who (1) have had fewer than 15 clients in the past 12 months, (2) do not hold themselves out generally to the public as investment advisers, and (3) do not act as investment advisers to a registered investment company or a business development company. In a major industry change, the Dodd-Frank Act eliminates the exemption for investment advisers with fewer than 15 clients and generally requires all investment advisers to register with the U.S. Securities and Exchange Commission, with the following narrow exemptions:

  • Exemption from Registration for "Private Fund" Advisers. This exemption requires the SEC to exempt by rule any investment adviser that acts solely as an adviser to "private funds" and has less than $150 million in assets under management in the United States

    • A "private fund"1 is an issuer that would be defined as an "investment company" under Section 3 of the Investment Company Act of 1940, as amended, but for the exemptions under Sections 3(c)(1) and 3(c)(7).2
    • Exempt private fund advisers must still maintain records and provide annual or other reports, as determined by the SEC.
    • In prescribing registration and examination requirements for "mid-sized private fund advisers," the SEC will consider size, governance, and investment strategy registration and examination procedures to determine if they pose systemic risk. The term "mid-sized private funds" is not defined by the Dodd-Frank Act.

    • Exemption from Registration for "Venture Capital Fund" Advisers. This exemption applies to an investment adviser that solely advises one or more "venture capital funds," a term that will be required to be defined by the SEC during the next year. Venture capital fund advisers will nonetheless still be required to maintain records and provide annual or other reports, as determined by the SEC.

    • Exemption from Registration for "Foreign Private Advisers." This exemption applies to an investment adviser who:

      • Does not have a place of business in the United States
      • Has fewer than 15 clients and investors in the United States in private funds that it advises
      • Has $25 million or less in aggregate assets under management (or a higher amount, as determined by the SEC) attributable to clients and investors in the United States in private funds that it advises
      • Does not hold itself out generally to the public in the United States as an investment adviser or act as an investment adviser to any registered investment company or business development company

      • Exemption from Registration for "Family Offices." The SEC will be required to provide an exemption for "family offices" that (1) is consistent with the SEC’s previous exemptive policy for family offices; (2) recognizes the range of organizational, management, and employment structures of family offices; and (3) does not exclude any person from the definition of "family office" who was not registered or required to be registered on January 1, 2010, solely because such person provided investment advice before then.

      • No SEC Registration for State-Regulated Advisers. State-regulated advisers with less than $100 million of assets under management shall not register with the SEC unless serving as the investment adviser to a registered investment company or a business development company. However, if the investment adviser would be required to register with 15 or more states, then it may register with the SEC.

      Books and Records Requirements

      Pursuant to the Dodd-Frank Act, private fund advisers are now required to maintain records that are subject to inspection by the SEC and include the following information with respect to private funds advised:

      • The amount of assets under management and the use of leverage, including off-balance-sheet leverage
      • Counterparty credit risk exposure
      • Trading and investment positions
      • Valuation policies and practices of the funds
      • Types of assets held
      • Any side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors
      • Trading practices
      • Such other information as the SEC, in consultation with the Financial Stability Oversight Council, deems necessary

      The SEC will be conducting periodic examinations of all such records and special examinations as deemed necessary. Any proprietary information filed with the SEC will be subject to the same limitations on public disclosure as information in other typical SEC examinations.

      Change in the Definition of an Accredited Investor

      Previously, a person qualified as an "accredited investor" under Rule 501 of the Securities Act of 1933, as amended, if (1) his or her individual net worth, or joint net worth with his or her spouse, exceeded $1 million (which can include the value of the person’s primary residence); or (2) his or her individual income was $200,000 in the last two years, or $300,000 in combination with his or her spouse, and he or she had a reasonable expectation of reaching that income level in the current year. The Dodd-Frank Act changes the net worth standard, so that:

      • For the first four years, beginning immediately after enactment, the net worth standard is $1 million, excluding the value of the person's primary residence.

      • After the four-year period following enactment, the net worth requirement must be greater than $1 million, excluding the value of the person’s primary residence.

      The definition of "accredited investor" will be reviewed and amended, as necessary, every four years, and the SEC will otherwise be permitted to amend the definition of "accredited investor" at its discretion.

      Disqualification of "Bad Actors" from Regulation D Offerings

      Under the Dodd-Frank Act, the SEC is instructed to create rules within one year that substantially match the disqualification provisions in Regulation A promulgated under the Securities Act of 1933 and disqualify any offering or sale of securities by certain "bad actors."

      Regulation A provides that its exemption3 does not apply to an issuer that has committed, or has an officer or director who has committed, one of the following acts:

      • Filed a registration statement that is the subject of any pending proceeding or examination or any refusal order or stop order within five years before the filing of an offering statement

      • Been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of false SEC filings within five years before the filing of an offering statement

      • Is subject to any order, judgment, or decree, entered within five years before the filing of an offering statement, restraining or enjoining such person from engaging in the purchase or sale of any security or involving the making of false SEC filings

      • Is subject to a U.S. Postal Service false representation order within five years before the filing of an offering statement

      • Is suspended or expelled from membership in, or from association with, a national securities exchange

      "Bad actors" disqualified from participating in an offering or sale of securities include any person who has been subject to a final order of a state or federal agency that regulates securities, banks, credit unions, or insurance under which such person is barred from associating with a regulated entity or engaging in a regulated business, or an order based on a violation of law for fraud, manipulation, or deceptive conduct within the past 10 years. Any person convicted of a felony or misdemeanor related to the purchase or sale of securities or false SEC filings is also disqualified from participating in offerings or sales of securities.

      Important Changes Related to Advisory Agreements

      • Section 205 of the Advisers Act prohibits investment advisers from receiving compensation based on a share of capital gains or capital appreciation. Formerly, this provision did not apply to most private fund advisers; however, it will upon effectiveness of the Dodd-Frank Act. Under Rule 205-3 promulgated under the Advisers Act, investment advisers who advise "qualified clients" are exempt from Section 205, and accordingly, private fund advisers will need to be more careful in screening investors in the future if they desire to rely on this exemption.4
      • The Act amends Section 205(a) of the Advisers Act (relating to advisory agreement requirements) to clarify that it does not apply to state-registered advisers.

      Ballard Spahr's Financial Institutions Reform Task Force will continue to monitor these and other portions of the Dodd-Frank Act, and its members are available to assist clients as they prepare to address the new requirements. Please contact Steven B. King, 215.864.8604 or kings@ballardspahr.com.

      Return to the Dodd-Frank Act Brings Sweeping Regulatory Changes alert.


       

      1. The Dodd-Frank Act's definition of "private fund" is virtually identical to the SEC's definition of the term in Rule 203(b)(3)-1(d), promulgated under the Advisers Act.
      2. Section 3(c)(1) of the Investment Company Act exempts issuers with 100 or fewer holders of its securities who do not engage or propose to engage in a public offering of securities. Section 3(c)(7) exempts issuers whose security holders are all "qualified purchasers" and who do not engage or propose to engage in a public offering of securities.
      3. Regulation A authorizes the SEC to exempt from registration small offerings and sales of securities not exceeding $5 million in any 12-month period.
      4. A qualified client is a natural person or company that has at least $750,000 under management by the investment adviser or has a net worth of more than $1.5 million or is a qualified purchaser (as defined in the Investment Company Act of 1940), or who is an executive officer, director, trustee, general partner, or an employee who participates in the investment activities of the adviser. Moreover, the Dodd-Frank Act requires the SEC to adjust the dollar-amount standard of a "qualified client" within the first year of the Dodd-Frank Act, and every five years thereafter, to respond to the effect of inflation on the standard.

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