New Rules Requiring SEC Registration of Large Hedge Fund Advisers

Introduction

On December 2, 2004, the U.S. Securities and Exchange Commission (“SEC” or “Commission) adopted a new rule and rule amendments under the Investment Advisers Act of 1940 (“Advisers Act”)[1] that made it much more difficult for advisers of hedge funds to avoid registration with the SEC.  Advisers had until February 1, 2006 to comply with the new rules.  Between January 1, 2005 and the close of business on February 1, 2006, the SEC declared effective 934 investment adviser registrations from hedge fund managers. [2] 

What’s a “Hedge Fund?”

            A significant group of advisers provides investment advice to pooled investment vehicles commonly known as “hedge funds.”  This commonly used term has no statutory definition, but they are described by the SEC as “funds organized by professional investment managers who frequently have a significant stake in the funds they manage and receive a management fee that includes a substantial share of the performance of the fund.” [1] Hedge funds are usually structured as partnerships, where the general partner is the portfolio manager who makes the investment decisions, and the limited partners are the investors.[2]  Hedge funds often seek to avoid regulation as investment companies under the Investment Company Act of 1940 (“Investment Company Act”). [3]  Typically, they do this by avoiding public offerings of their securities in compliance with statutory exemptions.

The very term “hedge fund” is something of a misnomer, since hedging refers to the practice of attempting to reduce risks associated with adverse price movements of an asset. [4]   In fact, hedge funds often employ risky leveraging investment strategies, including short selling.[5]  HedgeCo.Net, which tracks the hedge fund industry, estimates that there are over 8,000 hedge funds worldwide with $1 trillion in assets under management. [6]  In 2005, the Colorado Division of Securities estimated that between 60 and 80 state-licensed investment advisers in Colorado operated hedge funds or similar pooled investment vehicles.[7]

Hedge funds have increased in popularity.  Traditionally, hedge fund managers sold securities only to wealthy and sophisticated individuals and institutions.  However, the SEC has observed that investors, pensioners, and other market participants have growing exposure to hedge funds. [8]  Too often, fraud has accompanied such growth.  Between 1999 and 2004, The SEC brought 51 cases in which it alleged that hedge fund advisers defrauded hedge fund investors or used the fund to defraud others, in amounts estimated to exceed $1.1 billion.[9]

In 2005 and 2006, securities regulators and investors continued to file hedge fund fraud cases.  Notably, the SEC alleged that managers of the Bayou Funds defrauded investors and misappropriated millions of dollars of assets. [10]  Locally, the Colorado Division of Securities sued officers of Colorado Springs-based XL Capital Partners, Inc. and related entities, charging them with securities fraud, selling unregistered securities and acting as unregistered securities brokers. [11] Moreover, in February 2006, a group of current and former Denver Broncos, including Terrell Davis and Rod Smith, recently filed a lawsuit in Georgia against an Atlanta hedge fund, accusing its principals of theft, forgery and fraud. [12]

Registration of Hedge Fund Advisers

Large “Investment Advisers” Must Register With the SEC

          The definition of an “investment adviser” is extremely broad.  It applies to:   

any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. [13] 

The statutory definition excludes certain categories of entities and individuals.[14]

The Act further requires advisers that have at least $25 million in assets under management and use United States jurisdictional means to register with the Commission, unless they fall within certain exemptions. [15]  Smaller advisers are required to register with the states.  In Colorado, they must register with the Division of Securities.

The “Private Adviser” Exemption from Registration

The most widely applicable exemption from registration is the “private adviser” exemption, which applies to advisers that: (1) have no more than fourteen clients; (2) do not hold themselves out generally to the public as investment advisers; and (3) do not act as investment advisers to any registered investment company or any business development company.[16]  Historically, meeting these conditions was relatively easy.  Advisers were allowed to count each fund as a “client” for purpose of meeting the fourteen-client limit.  Further, few advisers desired to hold themselves out as such,  through advertising or similar means.  Moreover, the hedge funds themselves typically were not registered.  Therefore, hedge fund advisers had little difficulty avoiding registration as long as they provided services to no more than fourteen funds.

          However, the December 2004 rule amendments changed this standard by establishing “look through” provisions requiring advisers to count each shareholder of a “private fund” towards the fourteen-client limit.[17]   Under the amendments, an adviser to a “private fund” can no longer rely on the private adviser exemption if the adviser has advised private funds that had more than fourteen investors during the course of the preceding twelve months.  According to the Commission, under the new rules, advisers are required to count each investor in a hedge fund, rather than only the hedge fund itself, as a client for purposes of the private adviser exemption. [18] 

The amendments contain a complex, three-part definition of “private fund.”  This definition states that a “private fund:” (1) is a company that would be an investment company under Section 3(a) of the Investment Company Act “but for” the exception provided by that definition by either Section 3(c)(1) or 3(c)(7) therein; (2) that permits its owners to redeem their interests within two years; and (3) such interests are offered based on the advisory skills, ability or expertise of the adviser. [19] The amendments also contain a foreign carve-out from the definition, stating that a company is not a private fund if it has its principal office and place of business outside the United States, makes a public offering of its securities in a country other than the United States, and is regulated as a public investment company under the laws of the country other than the United States.[20] 

Whether the first part of the “private fund” test is met requires analysis of the definition of an “investment company,” which is set forth in Section 3(a) of the Investment Company Act. This term is defined as: (1) any “issuer,” i.e. a company that issues securities; [21] (2) that is or holds itself out as being engaged primarily in the business of investing, reinvesting, or trading in securities. [22]   The term “security” includes familiar instruments such as stocks, bonds and notes, as well as less familiar instruments such as investment contracts. [23]  The definition of an investment company excludes any issuer primarily engaged in business other than that of investing, reinvesting, owning, holding, or trading in securities,[24] including persons primarily engaged in acquiring “mortgages and other liens on and interest in real estate.” [25] 

Assuming the fund in question otherwise qualifies as an investment company and cannot rely on any other statutory exemptions, practitioners must analyze whether the Section 3(c)(1) or (c)(7) exemptions apply.  Section (c)(1) excludes from the definition of an investment company any issuer whose outstanding securities are beneficially owned by not more than 100 persons, and Section (c)(7) similarly excludes any issuer whose securities are owned exclusively by “qualified purchasers,” [26] i.e., relatively wealthy investors. [27]  To qualify under either provision, the fund must avoid making, or proposing to make, a “public offering” of its securities.  Although this term is not defined, it can be assumed that this means, among other things, that the fund has not advertised the offering or otherwise engaged in a general solicitation.[28]

Having determined that the fund at issue satisfies the first part of the “private fund” definition contained in Rule 203(b)(3)-1(d)(1), practitioners must then examine whether it permits its owners to redeem their interests within two years.  In its adopting release, the SEC explained that “[h]edge funds typically offer their investors liquidity access following an initial “lock-up” period, which is typically for less than two years.”[29]  Media reports indicate that at least some hedge fund advisers have imposed a 25-month lockup period to avoid SEC registration. [30]

  The third part of the definition inquires as to whether interests in the fund are offered “based on the advisory skills, ability or expertise of the adviser.”  The SEC explained that this condition will be deemed satisfied if the fund markets the “history, experience, past performance, strategies, and disciplinary record” of the adviser of the fund.[31]  Finally, before reaching a conclusion, practitioners must determine whether the fund qualifies for the foreign investment company definitional “carve-out.”  This may require an analysis of foreign law to determine whether the fund is in fact regulated as a public investment company in a country other than the United States.

Regulatory Requirements

Whether an investment adviser is required to register is important because the Advisers Act, while not imposing a detailed regulatory regime, imposes various requirements on registered advisers.  Among other things, the statute regulates advertising, the use of solicitors, disclosures to clients, management of client accounts, maintenance of internal controls, specialty products, and recordkeeping.  Notably, starting on October 5, 2004, investment advisers were required to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act, review those policies and procedures annually, and designate an individual to serve as chief compliance officer. [32]  The Commission has indicated that an adviser’s policies and procedures should, at a minimum, address portfolio management processes, trading practices, propriety and personal trading, the accuracy of disclosures, safeguarding of client assets, recordkeeping creation and maintenance, marketing advisory services, processes to value client holdings, client privacy safeguards, and business continuity plans.[33]  Although the requirements imposed by the Advisers Act are significant, they fall far short of those applicable to other industry participants.  For instance, advisers, unlike broker-dealers, are not required to file audited financial statements with the Commission. [34]

Conclusion

          By narrowing the “private fund” exemption to the definition of an investment adviser, the SEC has attempted to regulate many hedge fund advisers that were previously exempt from registration.  However, the applicable regulatory scheme is limited in scope.  Given the increasing popularity of hedge funds, and the continuing stream of headlines concerning fraud by hedge funds and their managers, it remains to be seen whether the SEC’s regulation of a larger number of hedge fund advisers will prevent additional abuses or comfort increasingly nervous investors.   

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[1]  See Securities and Exchange Commission, Registration Under the Advisers Act of Certain Hedge Fund Advisers, 17 C.F.R. parts 275 and 279, Release No. IA-2333 (Dec. 1, 2004) (“Adopting Release”), available at http://www.sec.gov/rules/final/ia-2333.htm#P56_6719.

[2] See Hedgeco.net, What is a Hedge Fund,  http://www.hedgeco.net/hedge-funds.htm

[3] See Investment Company Act of 1940, 15 U.S.C. § 890a-1 et seq. (West 1997 and supp. 2005).

[4]  See Investopedia Dictionary, http://investopedia.com/terms/h/hedge.asp (last visited Mar. 3, 2006).

[5]  See Securities and Exchange Commission, “Hedging Your Bets: A Heads Up On Hedge Funds And Funds Of Hedge Funds, available at  http://www.sec.gov/answers/hedge.htm

[6]  See Hedgeco.net, About Hedge Funds, http://www.hedgeco.net/about/aboutus.php (last visited March. 3, 2006).

[7]  See Tom Locke, Hedging Their Bets,  Denver Business Journal (Jan. 15, 2005), available at http://www.bizjournals.com/denver/stories/2005/01/17/focus1.html.

[8]  See Adopting Release, supra note 3.

[9] See id.

[10] See SEC v. Samuel Israel III, No. 05-CV-8376 (S.D.N.Y. Sept. 29, 2005), litigation release available at http://www.sec.gov/litigation/litreleases/lr19406.htm.   

[11] See Fred Joseph v. XL Capital Partners, Inc., No. 04 CV-9931 (Denver Dist. Ct. 2004).   

[12]  See Will Shanley, Athletes Get Wild Pitches, Denver Post, Feb. 21, 2006, available at http://www.denverpost.com/search/ci_3529753.

[13]  See Advisers Act § 202(11).

[14]  For example, the definition excludes banks that advise individuals or entities other than investment companies, individuals whose advisory services are incidental to the practice of their profession, and any broker or dealer whose advisory services are incidental to the conduct of his business and who receives no special advisory compensation, and “the publisher of any bona fide newspaper, news magazine or business or financial publication of general and regular circulation.” Id. 

[15]  See Advisers Act §§ 203(a) and 203A(a)(1).

[16]  See id., at § 203(b)(3).

[17] See Advisers Act Rule 203(b)(3)-2.

[18] See Adopting Release, supra note 3.

[19] See Advisers Act Rule 203(b)(3)-1(d)(1).

[20] See Rule 203(b)(3)-1(d)(3).

[21] The term “issuer” includes both natural persons and companies.  See 15 U.S.C.  80a-2(a)(22).

[22] See id., §80a-3(a).

[23] See id., §80-a2(a)(36).  This is the same definition of “security” contained in § 2(a)(1) of the Securities Act of 1933, see 15 U.S.C. 77b(a)(1), and § 3(a)(10) of the Securities Exchange Act of 1934, see 15 U.S.C. 78c(a)(10).

[24]  See id., §80-a3(b)(1).

[25]  See id., §80-a3(c)(5).

[26]  Funds are allowed to have an unlimited number of non-U.S. investors within the meaning of this provision.  See Adopting Release, note 22, supra note 3.

[27]  See id., §2(a)(51), defining “qualified purchaser” as, among other things, any natural person or “family-owned organization or entity” who owns $5 million or more in net investments. 

[28]  See Regulation D, Rule 502(c).  If satisfied, Regulation D provides a safe harbor for the private offering exemption of Section 4(2) of the Securities Act of 1933, exempting from registration all “transactions by an issuer not involving any public offering.”  See SEC v. Tuchinsky, 1992 U.S. Dist. LEXIS 13650 (S.D. Fla.  1992), p. 13; Louis Loss & Joel Seligman, Securities Regulation, § 3-C-7 (3d ed. 2004). 

[29] See Adopting Release, note 233.

[30]  See “Hedge Fund Managers Bridle Under New Regs,” Boston Business Journal (Feb. 19, 2006), available at http://www.msnbc.msn.com/id/11454510/.

[31] See id.,

[32] See Rule 206(4)-7.

[33]   See Compliance Programs of Investment Companies and Investment Advisers, Rel. No. IA-2204 (December 17, 2003), http://www.sec.gov/rules/final/ia-2204.htm.

[34] Cf. Rule 17a-5 of the Securities Exchange Act of 1934, requiring registered broker-dealers to file a report on Form X-17A-5, known as the FOCUS report, on at least a quarterly basis.  This report includes statements or schedules reflecting the broker-dealer’s financial condition.

Comments

[Anny]

Hi,

Very valuable information here within your Blog. Keep up the great work.

I was wondering if an Investment Company (Funds of Hedge Funds) needs to register as a Investment Adviser.