Should Hedge Fund Advisers Deregister?

        In their euphoria over the D.C. Circuit’s recent ruling invalidating the SEC’s adviser registration rule, hedge fund advisers may be tempted to rush to deregister.   My analysis of applicable state law, however, demonstrates that this may be a mistake.  Advisers may be merely trading one set of regulations for another.  Therefore, any decision to deregister should be made carefully and with full consideration of the consequences.

         The Investment Advisers Supervision Coordination Act divided registration and oversight responsibilities for investment advisers between state and federal securities regulators.  It is well known that states have the primary responsibility for supervising investment advisors managing less than $25 million in client assets.   However, advisors may be unaware that, regardless of their assets under management, they may be subject to state regulation if they are not registered with the SEC.

The Colorado Securities Act (“CSA”) contains a very broad definition of “investment adviser” similar to that contained in the Investment Advisers Act of 1940 (“Advisers Act”):  “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.” Colo. Rev. Stat.  §11-51-201 (9.5) (a) (I).    The CSA, however, exempts “federal covered advisers” from the definition of an investment adviser. The CSA further defines a federal covered adviser as “a person who is registered or required to be registered” under the Advisers Act. See Colo. Rev. Stat. § 11-51-201 (5.5)(a) and (b)I.  Moreover, the CSA prohibits “a person with a place of business” in Colorado from “ transact[ing] business in [Colorado] as an investment adviser or investment adviser representative unless such person is licensed as such or exempt from licensing.” 

Taken as a whole, these provisions mean that any advisers with offices in Colorado that are “transacting business” here, meaning performing investment advisory activities, [1] must be registered with the State unless they are already registered with the SEC. [2]   The CSA exempts from registration any investment adviser with no place of business in Colorado that has no more than five clients in Colorado.[3] See Colo. Rev. Stat. § 11-51-402(5)(a)(II) and (III).  Accordingly, the CSA complies with de minimis exemptive provisions of the Advisers Act, which make state investment adviser statutes inapplicable to advisers that do not have a place of business in the state and, during the preceding twelve-month period, had fewer than six clients who are residents of that state.  See Advisers Act § 222(d).[4] 

Based on the foregoing, a hedge fund adviser that withdraws from SEC registration would lose  its status as a “federal covered adviser,” causing it to fall within the CSA’s definition of an “investment adviser.” Such an adviser would need to register in Colorado if it were “transacting business” as such within Colorado by, among other things, advising others as to the advisability of purchasing, or investing in, securities.  This analysis would apply even if the adviser had no Colorado clients.   Therefore, whether SEC deregistration would require registration in Colorado would depend on whether its office(s) in the state qualified as a “place of business.”  Although the CSA contains no relevant definition, [5] Advisers Act Rule 222-1(a) states that, for purpose of analyzing the above-described de minimis exemption,  a “place of business” of an investment adviser is “an office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients, and any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.”  Under this definition, any office in Colorado would qualify as a “place of business,” if personnel in the office were to regularly provide investment advisory services.

The potential consequences of registration with the state, the devil they do not know, might lead hedge fund advisers to conclude they are better off with the devil they know, the SEC.  First and foremost, registration with the state would be entail substantive regulatory review.  An official with the Colorado Division of Securities told me that he would likely review Parts I and II of a previously registered adviser’s Form ADV, subscription agreements and offering materials, at a minimum.  Since hedge funds tend to be protective of their privacy, they may not welcome this regulatory intrusion.

Further, although I have not performed a comprehensive comparison of state versus federal regulation, in at least one respect, state registration is potentially more burdensome in that “investment adviser representatives” with a place of business in Colorado are required to be registered .  An investment adviser representative is defined according to federal law as an investment adviser’s “supervised person,” e.g., any "partner, officer, director . . . or employee,”[6] who has more than five clients who are “natural persons” (excluding qualified clients) [7] and more than 10% of whose clients are natural persons.”  See Advisers Act Rule 203A-3(a)(1).  The Rule excludes from the definition of an “investment adviser representative” supervised persons who do not “on a regular basis solicit, meet with, or otherwise communicate with clients of the investment adviser,” or “provide[] only impersonal investment advice.”  See Rule 203A-3(a) (3).  Again, the term “place of business” is defined broadly for purposes of this definition.  Since state registration could well be an arduous process resulting in new regulatory requirements, hedge fund advisers should pause and consult with an attorney before rushing for the SEC deregistration exit.

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[1] The CSA further indicates that “transacting business” in Colorado for purpose of state licensing of investment advisers includes:

engaging in any of the activities enumerated in section 11-51-201 (9.5) (a) or holding oneself out as an investment adviser, financial planner, or similar type of adviser or consultant if such activities are engaged in, or the holding out occurs, within the state regardless of whether a person to whom services are provided or to whom such holding out is made is physically present within the state. 

Colo. Rev. Stat. § 11-51-102(8).

[2] The other part of the CSA’s “federal covered adviser” definition exempts from state registration advisers that are “required to be registered,” but are not in fact registered, with the SEC.  Needless to say, it would be imprudent to admit violating federal law as a means to avoid state registration requirements.

[3]  The CSA indicates that institutional investors, insurance companies and certain other specified entities should not be counted towards the five-client limit.

[4] Advisers Act Rule 222-2 provides that an adviser may rely on Rule 203(b)(3)-1 when counting clients for purposes of the de minimis standard.  Rule 203(b)(3)-1(b)(1) states that you must count a shareholder of a legal organization, including a limited liability corporation, only “if you provide investment advisory services to the owner separate and apart from the investment advisory services you provide to the legal organization.”  Accordingly, for purposes of the de minimis standards, clients were to be calculated without giving effect to the look-through requirements of Rule 203(b)(3)-2, even prior to the D.C. Circuit’s invalidation of the latter rule.

[5] Colo. Rev. Stat. § 11-51-201(12.5) defines “place of business” for an “investment adviser representative,” according to Advisers Act Rule 203A-3.  This definition of “place of business” would be relevant to determining whether MCA personnel in Colorado would be required to be individually licensed, but is not relevant to whether MCA itself would be required to be registered with the State, if MCA were to withdraw from SEC registration.

[6] Advisers Act § 202(a)(25).   

[7]  Qualified clients are defined as natural persons who are wealthy in that they have at least $750,000 under management, has a net worth of at least $1.5 million, or are qualified purchasers as defined by Section 2(a)(51)(A) of the Investment Company Act of 1940.  See Rule 205-3(d)(1).

Comments

[Jack Doueck, Stillwater Asset Backed Strategies]

At Stillwater we feel strongly that all hedge fund managers with more than $25 million under management or more than 14 clients should register with the SEC. We have been registered with the SEC and have been through a very thorough but appropriate audit last summer. The SEC Auditors checked all our books and records. They reviewed our checks and balances, trying to discover any conflicts of interest, any inconsistencies between what we promise our clients and what we actualy deliver. They checked the books and records of our funds and our management company. When I saw the level of detail that they paid attention to, I was very excited about the possibility that EVERY hedge fund that we invest in would be subject to these periodic audits without a lot of notice. That is a good check for the industry in general. Our Stillwater Asset Backed Lending business invests money with other asset backed hedge funds which are complex and difficult to do the due diligence work on. If every one of these funds were audited by the SEC, we would feel much safer and more certain that these managers would be operating in accordance not only with GAAP, but with
the rules of the SEC, that they are delivering what they are promising and that there is less of a chance of foul play.
That being said, the best way to regulate the Hedge Fund Industry is for SEC to require that every manager publish or make public their assets (in general, without specifics) via independent administrators and brokers on a monthly basis. That would further deter greedy and reckless managers from fraud. Our decision to register with the SEC was a good one and we hope managers follow our lead.