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MAKING SENSE OF DODD-FRANK

The Dodd-Frank Act has broad and deep implications that will touch every corner of financial services and multiple other industries. This site, developed and maintained by attorneys at Stinson Leonard Street, is dedicated to making sense of this complex legislation and helping businesses understand how it will affect them specifically. Our Bloggers »

Dodd-Frank

Dodd-Frank and Investment Advisors

by   |   July 25, 2010

The Dodd-Frank Wall Street Reform and Consumer Protection Act contains several provisions that will have a significant impact on investment advisors and removes some key exemptions from the requirement to register as an investment advisor.

Dodd-Frank also contains a “private fund” definition, which is a keystone for a number of other provisions contained in the Act, including several new exemptions.  A private fund is_defined as an entity that would fall within the definition of an “investment company” under the Investment Company Act but for relaiance on one of two exemptions from that definition.  An “investment company” is broadly defined to include those entities which hold themselves out as being  primarily engaged in investing in securities. The first exemption from the definition of an “investment company” referred to in Dodd-Frank is available when an issuer has less than 100 beneficial owners of its securities.  The second exemption applies when all of the issuers owners are “qualified purchasers,” meaning certain entities that have significant invested amounts.

All of the changes summarized below take effect on July 21, 2011.  However, advisers that will be required to register when these changes become effective need not wait until next year to begin the registration process, but instead are authorized to register with the SECduring this one year transition period.

Registration as an Investment Adviser

Elimination of the private adviser exemption. The private adviser exemption allowed an investment adviser to avoid registration if it had fewer than 15 clients in the preceding 12 months, did not hold itself out to the public as an investment adviser, and did not serve as an investment adviser to any registered investment company or any business development company.  For the purpose of determining the number of clients under the private adviser exemption, the Investment Advisers Act of 1940 allowed the shareholders, partners, or beneficial owners of an entity to be disregarded as separate clients apart from the entity itself, such that a fund with many investors would be regarded as a single client for purposes of the private adviser exemption. The Act eliminates the private adviser exemption and the consolidated method of counting clients altogether, exposing many previously exempt investment advisers to registration and regulation.  The Act does offer several new, narrow exemptions in place of the private adviser exemption.

Narrowing of the intrastate exemption.  The Advisers Act previously provided an exemption from registration for investment advisers that served clients only in the state in which the investment adviser had its principal place of business and that refrained from furnishing advice or analysis relating to securities listed on a national exchange.  The Act significantly narrows this intrastate exemption by excluding investment advisers that advise a private fund.

Exemption for advisers to venture capital funds. Investment advisers that advise only one or more venture capital funds are not subject to the registration requirements of the Advisers Act.  The SEC is directed to promulgate rules within the next year that define the term “venture capital fund” and provide for the maintenance of records and filing of reports by advisers subject to this new exemption.

Exemption for advisers to mid-sized private funds. Under the Act, an investment adviser that serves as an adviser only to private funds and has assets under management in the U.S. of less than $150 million will be exempt from SEC registration as an investment adviser.  The Act does not directly provide this exemption, but instead directs the SEC to promulgate rules to define its scope and other provisions  However, such advisers will still be subject to the reporting requirements set forth below, and state regulation.

Exemption for family offices. Another important new exemption is the Act’s amendment of the definition of “investment adviser” in the Advisers Act to exclude “family offices.”  The Act also directs the SEC to develop, through rules, regulations, or orders, a definition of “family office” that is consistent with the SEC’s previous exemptive orders and other SEC guidance for family offices.

Increased Information Reporting and Regulation

The Advisers Act previously provided that no provision of the act should be construed to allow the SEC to require any investment adviser to “disclose the identity, investments, or affairs of any client of such investment adviser, except insofar as such disclosure may be necessary or appropriate in a particular proceeding or investigation.”  The Act now carves out an exception to this principle, allowing the SEC to require the disclosure of such information “for purposes of assessment of potential systemic risk.”  This new authority of the SEC to require disclosure of highly confidential information is manifested in record keeping and reporting requirements applicable to advisers to private funds.

Disclosure by advisers to private funds. The Act authorizes and directs the SEC to promulgate rules requiring investment advisers to private funds to collect, maintain, allow inspection of, and file periodic reports containing information relating to the private funds so that the Financial Stability Oversight Council can make evaluations relating to systemic risk.  These rules could require investment advisers to maintain and disclose to regulators records relating to highly confidential aspects of the operations of the private funds they advise, including:

  • 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;
  • types of assets held;
  • side arrangements, side letters, and other agreements that provide special treatment for certain investors in a fund;
  • trading practices; and
  • such other information as the SEC and the Council determine is necessary in the public interest in order to protect investors and assess systemic risk.

Disclosure by advisers to mid-sized private funds. Even though the Act provides a new exemption from registration for investment advisers to mid-sized private funds, these advisers will still be subject to rules requiring them to maintain records and file reports with the SEC.  The specific record keeping and reporting requirements will be developed by the SEC. 

Safeguarding client assets. In what is being called the “Madoff rule,” the Act now allows the SEC to require a registered investment adviser to take “steps to safeguard client assets over which such adviser has custody,” such as, for example, hiring an independent public accountant to verify the existence of the assets.

Emphasis on state regulation of advisers to private funds. The Act shifts the responsibility for regulation of investment advisers to the various states with respect to investment advisers to mid-sized private funds, perhaps allowing the SEC to focus on advisers with more assets under management.  The Act prohibits mid-sized investment advisers (defined as those that are required to register in the state of their principal place of business and that have between $25 million and $100 million in assets under management) from utilizing the federal registration regime.  There is an exception from this general prohibition of the use of federal registration for investment advisers that advise an investment company or a business development company, or that would otherwise be required to register in 15 or more states.