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Dodd-Frank

Registration with the SEC as an Investment Adviser — A Guide for Private Equity and Hedge Funds

by   |   April 5, 2011

The Dodd-Frank Act provides an exemption for registration as an investment adviser for private equity groups and hedge funds that have assets under management of less than $150 million.  Investment advisers to funds which exceed that threshold will be required to register with the SEC as an investment adviser.

 

Registration with the SEC is initially accomplished by filing Form ADV with the SEC.  Form ADV is filed on the IARD system that is managed by FINRA.  To file the form, hedge funds and private equity groups will need to open an IARD user account by completing an IARD Entitlement Packet.  The SEC will review the Form ADV for completeness and take other steps.  The SEC must approve the registration or begin proceedings to deny the registration in 45 days. 

Filing the Form ADV is just one step.   Extensive preparation must be made before filing the Form ADV to comply with the Investment Advisers Act of 1940.   

Compliance Manual.  SEC Rule 206(4)-7 requires investment advisers to adopt policies and procedures to comply with the Investment Advisers Act.   When the SEC adopted the rules, it set forth a laundry list of matters it expected would be covered.  The enumerated items suggested by the SEC include:

  • Portfolio management processes, including allocation of investment opportunities among clients and consistency of portfolios with clients’ investment objectives, disclosures by the adviser, and applicable regulatory restrictions;
  • Trading practices, including procedures by which the adviser satisfies its best execution obligation, uses client brokerage to obtain research and other services (“soft dollar arrangements”), and allocates aggregated trades among clients;
  • Proprietary trading of the adviser and personal trading activities of supervised persons;
  • The accuracy of disclosures made to investors, clients, and regulators, including account statements and advertisements;
  • Safeguarding of client assets from conversion or inappropriate use by advisory personnel;
  • The accurate creation of required records and their maintenance in a manner that secures them from unauthorized alteration or use and protects them from untimely destruction;
  • Marketing advisory services, including the use of solicitors;
  • Processes to value client holdings and assess fees based on those valuations;
  • Safeguards for the privacy protection of client records and information; and
  • Business continuity plans. 

Many of the above areas may not be applicable to private equity groups and hedge funds.  The compliance manual should be narrowly tailored to impose those obligations which are reasonably necessary.

 

The SEC requires that policies and procedures be reviewed annually for adequacy.  The review should consider any compliance matters that arose during the previous year, any changes in the business activities of the adviser or its affiliates, and any changes in the Investment Advisers Act or applicable regulations that might suggest a need to revise the policies or procedures.  Although the rule requires only annual reviews, advisers should consider the need for interim reviews in response to significant compliance events, changes in business arrangements, and regulatory developments. 

Chief Compliance Officer.  Rule 206(4)-7 also requires an investment adviser to designate an “individual” as Chief Compliance Officer to be responsible for administering the policies and procedures developed by the investment adviser.  There is no requirement that the Chief Compliance Officer be an employee and outsourcing is a common practice.

 

Code of Ethics. Investment advisers must establish, maintain and enforce a written code of ethics that, at a minimum, includes:

  • A standard (or standards) of business conduct that is required of supervised persons, which standard must reflect the fiduciary obligations of the investment adviser and those of its supervised persons;
  • Provisions requiring supervised persons to comply with applicable Federal securities laws;
  • Provisions that require all “access persons” to report, and the investment adviser to review, their personal securities transactions and holdings periodically;
  • Provisions requiring supervised persons to report any violations of the code of ethics promptly to the chief compliance officer or, provided the chief compliance officer also receives reports of all violations, to other persons designated in the code of ethics; and
  • Provisions requiring the investment adviser to provide each of its supervised persons with a copy of the code of ethics and any amendments, and requiring the supervised persons to provide the investment adviser with a written acknowledgment of their receipt of the code and any amendments 

An “access person” is any supervised person:

  • Who has access to nonpublic information regarding any clients’ purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or
  • Who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic.
  • If providing investment advice is the primary business, all of the investment advisers directors, officers and partners are presumed to be access persons.

 

Insider Trading.  The code of ethics also needs to be reasonably designed to prevent insider trading.  Some private equity groups may believe this to be inapplicable because they do not trade in the public markets.  However, consideration should be given to the possibility of engaging in an M&A transaction with a public company. 

Brochure.  Registered investment advisers are required to provide their advisory clients and prospective clients with a written disclosure document.  Advisers comply with this requirement by providing advisory clients and prospective clients with Part 2 of their Form ADV.   Each year, a registered investment adviser must deliver Part 2 or summary of material changes to each client, without charge.  The adviser is required to maintain a copy of each disclosure document and each amendment or revision to it that was given or sent to clients or prospective clients, along with a record reflecting the dates on which such disclosure was given or offered to be given to any client or prospective client who subsequently became a client.

 

Performance Based Fees.  The Investment Advisers Act places limitations on charging performance based fees unless the clients are “qualified clients.”  A “qualified client” is:

  • A natural person who or a company that immediately after entering into the contract has at least $750,000 under the management of the investment adviser;
  • A natural person who or a company that the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
    • Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $1,500,000 at the time the contract is entered into; or
    • Is a qualified purchaser under the Investment Company Act of 1940 at the time the contract is entered into; or
  • Certain officers, directors and employees of the investment adviser. 

The requirements regarding performance based fees may be a significant impediment to private equity groups and hedge funds that have previously sold securities to investors based only on an accredited investor representation since the accredited investor standard under the Securities Act reflects a lower threshold.

 

Advertising.  To protect investors, the SEC prohibits certain types of advertising practices by advisers. An “advertisement” includes any communication addressed to more than one person that offers any investment advisory service with regard to securities. An advertisement could include both a written publication (such as a website, newsletter or marketing brochure) as well as oral communications (such as an announcement made on radio or television). 

The SEC staff has said that, if an adviser advertises its past investment performance record, it should disclose all material facts necessary to avoid any unwarranted inference.  For example, SEC staff has indicated that it may view performance data to be misleading if it:

  • does not disclose prominently that the results portrayed relate only to a select group of the adviser’s clients, the basis on which the selection was made, and the effect of this practice on the results portrayed, if material;
  •  does not disclose the effect of material market or economic conditions on the results portrayed (e.g., an advertisement stating that the accounts of the adviser’s clients appreciated in value 25% without disclosing that the market generally appreciated 40% during the same period);
  • does not reflect the deduction of advisory fees, brokerage or other commissions, and any other expenses that accounts would have or actually paid;
  • does not disclose whether and to what extent the results portrayed reflect the reinvestment of dividends and other earnings;
  • suggests or makes claims about the potential for profit without also disclosing the possibility of loss;
  • compares model or actual results to an index without disclosing all material facts relevant to the comparison (e.g., an advertisement that compares model results to an index without disclosing that the volatility of the index is materially different from that of the model portfolio); and
  • does not disclose any material conditions, objectives, or investment strategies used to obtain the results portrayed (e.g., the model portfolio contains equity stocks that are managed with a view towards capital appreciation).

 

Record Keeping  Registered advisers must make and keep true, accurate and current certain books and records relating to their investment advisory business. Some of the more important books and records are:

  • Advisory business financial and accounting records, including: cash receipts and disbursements journals; income and expense account ledgers; checkbooks; bank account statements; advisory business bills; and financial statements.
  • Records that pertain to providing investment advice and transactions in client accounts with respect to such advice, including: orders to trade in client accounts (referred to as “order memoranda”); trade confirmation statements received from broker-dealers; documentation of proxy vote decisions; written requests for withdrawals or documentation of deposits received from clients; and written correspondence sent to or received from clients or potential clients discussing the advisers recommendations or suggestions.
  • Records that document the advisers authority to conduct business in client accounts, including: a list of accounts in which it has discretionary authority; documentation granting discretionary authority; and written agreements with clients, such as advisory contracts.
  • Advertising and performance records, including: newsletters; articles; and computational worksheets demonstrating performance returns.
  • Records related to the code of ethics, including those addressing personal securities transaction reporting by access persons.
  • Records regarding the maintenance and delivery of written disclosure documents and disclosure documents provided by certain solicitors who seek clients on the advisers behalf.
  • Policies and procedures adopted and implemented under the compliance manual, including any documentation prepared in the course of the annual review.

 

Privacy Policy.  An investment adviser must adopt a privacy policy that complies with Regulation S-P.

 

Other.  Other specific SEC rules to be considered include:

  • Rules regarding payments to finders for referring new clients to investment advisers.
  • Rules regarding custody of assets.
  • “Pay-to-play” rules that are implicated when political contributions are made or persons are paid to solicit government entities.

 

State Registration.  While registering with the SEC generally preempts state investment adviser registration, states can still impose notice filings and charge a fee if you have investment advisers in that state.

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