Category: Investment Advisers Act

Do You need State Licensing if You’re an SEC Registered Investment Adviser?

With Dodd-Frank‘s elimination of the 15 client exemption, thousands (my guess) of private fund managers will need to register with the Securities and Exchange Commission as investment advisers to their funds. For alternative investment funds, like real estate, you’ll need to look at whether you are giving advice regarding securities.

If you have less than $100 million you will be in the state registration system and may need to have individuals licensed with the state. If you have over $100 million, you be registering with SEC. The deadline is July 21, 2011.

That leaves the question of whether you need a state license for the firm or individuals in the firm, like the Series 65.

One benefit of SEC registration is that the Investment Advisers Act preempts some state licensing for private fund management companies. Section 203(A)(b) prohibits the states from licensing an investment adviser registered with the SEC (or exempt from definition of Section 202(a)(11)).

The exception is that a state may require licensing for an “investment adviser representative” who has a place of business in that state. For a private fund manager, you need to determine if any of the management company employees fit into the definition in Rule 203A-3.

“(a)(1) “Investment adviser representative” of an investment adviser means a supervised person of the investment adviser:

i. Who has more than five clients who are natural persons (other than excepted persons described in paragraph (a)(3)(i) of this section); and

ii. More than ten percent of whose clients are natural persons (other than excepted persons described in paragraph (a)(3)(i) of this section).”

For a private fund manager, the key part of the definition is whether they have any clients who are natural persons. The manager’s funds are the clients and those funds are not natural persons. Employees of the fund manager should fall outside the definition of “investment adviser representative” and therefore not need a license.

Sources:

Is a Fund Manager an Investment Adviser?

Yes, for private investment funds, the general partner is generally considered an investment adviser under the Investment Adviser Act.

Let’s start with the definition of an investment adviser from the Investment 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, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities…” [202(a)(11)]

You can parse three elements out of that definition:

  1. Compensation
  2. Advice concerning securities
  3. In the business

Compensation

The first one is the easiest. I don’t think you’re going to find a fund manager who is not getting paid. It may be a combination of management fees or carried interest, but it’s still compensation. You could look at some academic arguments about who would fall in and out of the definition, but those arguments are irrelevant to fund managers.

Advice concerning securities

If you are giving recommendations to buy or sell, then you are giving advice. In addition, if you are telling people when to switch between different investments or how to select investment advisers then you are giving advice. The fund manager is making the decision about what to buy, sell and finance so the fund manager is giving advice. [I’m writing about the “securities” side in another post.]

In the business

Lastly, you need to be “in the business” of giving advice. That’s going to rule out your shoeshine boy, but clearly fund managers are in the business of giving advice. Again, there are some academic questions that could make this prong of discussion interesting. But for a fund manager, it’s very straightforward.

Abrahamson

It’s not just me making this interpretation. The Second Circuit answered this question in 1978. [See: Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) , overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)] “These provisions reflect the fact that many investment advisers ‘advise’ their customers by exercising control over what purchases and sales are made with their clients’ funds.”

Exclusions

There are six exclusions in the definition of the “Investment Adviser” [202(a)(11)]but they are inapplicable to most fund managers:

  1. banks
  2. lawyers, accountants, teachers and engineers
  3. Certain broker/dealers
  4. publishers of bona fide newspapers and magazines in general circulation
  5. government securities advisers
  6. Nationally recognized statistical rating organization

Registration

That means fund managers are typically going to be considered to investment advisers. That also means that they may have to register with the SEC, unless there is an exemption from registration. Up until the Dodd-Frank Act, there was the 15 client exemption. That’s gone.

Changes to the Qualified Client Standard

In addition to the changing standard for an accredited investor, the standard for a “qualified client” under the Investment Advisers Act is also changing. Section 418 of the requires the SEC to increase the standard.

SEC. 418. QUALIFIED CLIENT STANDARD.
Section 205(e) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–5(e)) is amended by adding at the end the following: ‘‘With respect to any factor used in any rule or regulation by the Commission in making a determination under this subsection, if the Commission uses a dollar amount test in connection with such factor, such as a net asset threshold, the Commission shall, by order, not later than 1 year after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, and every 5 years thereafter, adjust for the effects of inflation on such test. Any such adjustment that is not a multiple of $100,000 shall be rounded to the nearest multiple of $100,000.’’.

Unlike some of the arguments over whether the accredited investor standard should be adjusted based on inflation, this standard is explicitly tied to inflation.

The definition of a qualified client is set out in Rule 205-3.

Currently, the investor has to have at least $750,000 under management with the adviser/fund.  That standard was adopted in July 1998. Using the CPI-U of 163.2 in  July 1998 and 217.965 in June 2010, the minimum investment amount should increase to $1,000,000.

The net worth amount of $1.5 million was also adopted in July 1998. Using the same ratio, I would expect the minimum net worth to rise to $2 million.

As for private  funds, Rule 205-3 requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.

If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

Sources:

That fancy SEC logo appeared briefly on the SEC’s website on Monday. (Thanks for pointing this out Bruce.) It was odd enough that I thought it should be re-used.

Fund Manager Fraud for Exceeding Leverage Limits

It turns out that failing to adhere to your investment guidelines can not only get you sued by your investor, it can get you sent to jail.

Mark D. Lay ran a hedge fund whose sole investor was the Ohio Bureau of Worker’s Compensation. The fund agreement had a non-binding 150% leverage guideline. Lay apparently relied on the non-binding nature of it and had 2/3 of the trades in excess of 150 leverage and over 20% of those trades involved leverage over 1000%. Lay ended up losing $214 million of the $225 million invested by the Bureau.

Apparently Lay not only greatly exceeded the leverage guidelines, he also lied about his excess.

Lay was convicted investment advisory fraud, conspiracy to commit mail and wire fraud, and two counts of mail fraud. Those convictions earned him a 12-year sentence at the Federal Correctional Institution in Fort Dix, N.J. and an order to repay nearly $213 million from the loss and forfeit $590,526 of the $1.7 million in fees the bureau paid.

Lay lawyers tried get him out of the investment advisory fraud by claiming that the Bureau was not a client. They argued that the Bureau was merely an investor in the fund and that Lay advised the fund. It was this handling of deeming an investor in the fund as the “client” that caught my attention.

Lay’s legal team used the Goldstein v. SEC case to argue that the SEC is precluded form treating fund investors as clients. The Sixth Circuit Court of Appeals did agree with that argument. The found that the SEC could not treat all investors in a fund as clients, but they could treat some as clients under the Investment Advisers Act.

In this case, the Bureau was already a client under a different investment management agreement. So a client relationship was already established. Also, the Bureau was the only investor in the fund. This is an atypical fund relationship.

The case points out that investors in a fund may still be clients of the fund manager under the Investment Advisers Act.

Sources:

Performance Fees for Private Investments Funds under the Investment Adviser Act

regulatory umbrella

As  more private investment funds will be pulled under the regulatory umbrella of the Investment Advisers Act,they will need to focus on the limitation on performance fees.

Section 205(a)(1) of the Advisers Act generally prohibits any investment adviser, unless exempt from registration pursuant to Section 203(b) of the Advisers Act, from entering into, extending, renewing, or performing under any investment advisory contract if the contract includes a performance fee. With the financial reform bill likely to pass any day, the 203(b) exemption will evaporate for many private investment funds.

Section 205(e) grants the SEC the power to create an exemption from the limitation “on the basis of such factors as financial sophistication, net worth, knowledge of and experience in financial matters, amount of assets under management, relationship with a registered investment adviser,” and other factors. The SEC created an exemption in Rule 205-3 for “qualified clients.”

A “qualified client”

1. has at least $750,000 under the management with the investment adviser

2. has a net worth of more than $1.5 million at the of the investment

3. is a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 [15 U.S.C. 80a-2(a)(51)(A)]

4. is an executive officer, director, trustee, general partner, or person serving in a similar capacity, of the investment adviser

or

5. is an employee of the investment adviser who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser.

The rule requires a look -through from the fund to the investors in the fund. If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should all be qualified purchasers or knowledgeable employees and you won’t need to look much further.

If the fund is using the 3(c)(1) exemption, then it will need to take a closer look at its investors to make sure that each is a qualified client.

Sources:

The image is a black Tour de France umbrella available at the official store of Le Tour de France. (Yes, I’m a huge fan of the Tour de France.)

A Closer Look at the new SEC Rule 206(4)-5 on Pay to Play

Over the weekend, the Securities and Exchange Commission released the full text of Rule 206(4)-5 in Release No. IA-3043. I made few notes during the broadcast of the open meeting, but there were lots of unanswered questions.

Rule 206(4)-5 is only 12 pages long, but Release IA-3043 also includes another 190 pages of commentary and discussion.

Summary (from the SEC):

The Securities and Exchange Commission is adopting a new rule under the Investment Advisers Act of 1940 that prohibits an investment adviser from providing advisory services for compensation to a government client for two years after the adviser or certain of its executives or employees make a contribution to certain elected officials or candidates. The new rule also prohibits an adviser from providing or agreeing to provide, directly or indirectly, payment to any third party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third parties are registered broker-dealers or registered investment advisers, in each case themselves subject to pay to play restrictions. Additionally, the new rule prevents an adviser from soliciting from others, or coordinating, contributions to certain elected officials or candidates or payments to political parties where the adviser is providing or seeking government business. The Commission also is adopting rule amendments that require a registered adviser to maintain certain records of the political contributions made by the adviser or certain of its executives or employees. The new rule and rule amendments address “pay to play” practices by investment advisers.

Limitations on Political Contributions

It is unlawful for an investment adviser to provide “investment advisory services for compensation to a government entity within two years after a contribution to an official of the government entity is made by the investment adviser or any covered associate of the investment adviser.”

The rule defines an official as candidate for an elective office that can

  1. directly or indirectly influence the hiring of an investment adviser, or
  2. has the authority to appoint a person who can directly or indirectly influence the hiring of an investment adviser.

Unfortunately, investment advisers are left on their own to figure out if any political position is one that falls into the prohibited bucket.

De Minimis Exception

There are two de minimis exceptions. For an official they are entitled to vote for, a covered associate can contribute up to $350 per election. That exception is lowered to $150 if they are not entitled to vote for the official.

A primary election is separate election from the general election. [Release page 63]

Those are increases from the proposed rule.

Who is a Covered Associate?

  1. Any general partner, managing member or executive officer, or other individual with a similar status or function;
  2. Any employee who solicits a government entity for the investment adviser and any person who supervises, directly or indirectly, such employee; and
  3. Any political action committee controlled by the investment adviser or by any person described in 1 or 2.

Placement Agent Ban

The rule retreated from the complete ban on placement agents that was in the draft rule. The SEC seems willing to put a ban in place. For now, the rule allows you to use a placement agent provided that they are either an SEC registered investment adviser or a SEC registered broker dealer. The extra limit on the broker dealer is that they have be subject to a an equivalent restriction on political contributions. Something that  is not yet place. Apparently, FINRA is working on pay-to-play regulations for broker-dealers.

Does Rule 206(4)-5 Apply to Private Funds?

Rule 206 (4)-5 will apply to registered investment advisers and unregistered investment advisers who are relying on the small adviser exception to registration. (Of course, that exception is scheduled to be eliminated shortly as part of the financial reform legislation.)

Also, the rule deems the adviser to a “covered investment pool” to be providing investment advisory services directly to the investor in the pool.

Therefore, private equity fund managers and their employees will be subject to this rule. Even venture capital fund managers who managed to keep a registration exemption in the financial reform bill will need comply with this new rule.

The financial reform bill is bumping the SEC registration up to $100 million from $25 million. That means a bunch of advisers and small funds will fall out from having to comply with this rule since it does not apply to state-registered advisers.

Record-Keeping

The new rule also imposes new record-keeping requirements. A private fund will need to keep track of

  1. its covered associates
  2. all government entities that are investors
  3. all contributions made to an “official of a government entity”
  4. all contributions made to a political party
  5. all contributions made to a political action committee

You don’t need to keep records if you have no government clients.

What’s a Contribution?

“[A]ny gift, subscription, loan, advance, or deposit of money or anything of value made for:

(i) The purpose of influencing any election for federal, state or local office;
(ii) Payment of debt incurred in connection with any such election; or
(iii) Transition or inaugural expenses of the successful candidate for state or local office.”

Cash donations are clearly contributions. The release says that volunteer activity is not a contribution.[Release Page 23]

Effective Date

The rule has not made its way into the federal register, but will be effective 60 days after publication.

The limitations on political contributions and the record-keeping requirments have a compliance deadline of six months after the effective date. That means you need to get ready by the end of this calendar year, with the actual deadline likely to be in early March.

The limitation on the use of third parties to solicit government business has a compliance deadline one year after the effective date. That will likely be sometime during the summer of 2011.

Chief Compliance Officers and Private Investment Funds

If you are running a private investment fund, do you need a chief compliance officer?

If you are not registered with the SEC, it’s a gray area. If you are registered with SEC, then “yes.”

Rule 206(4)-7 requires a registered investment adviser to “[d]esignate an individual (who is a supervised person) responsible for administering the policies and procedures that you adopt under paragraph (a) of this section.”

Since the financial reform bill is going to remove the small adviser exemption from registration, hundreds (thousands?) of private fund managers will need to register with the SEC once the bill is finalized and signed by the president.

Do you need to hire a new person to serve as CCO? The rule does not require advisers to hire an additional executive to serve as compliance officer. [See Footnote 74 of SEC Release No. IA-2204] You merely have to designate someone to serve in the role.

What are the requirements for a CCO for private equity fund?

  • Must be competent and knowledgeable regarding the Advisers Act.
  • Must be empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm.
  • Must have sufficient seniority and authority within the organization to compel others to adhere to the compliance policies and procedures.

Having the knowledge about the act is going have many firms look toward their general counsel to act as CCO.

A dual role of general counsel and CCO may put the individual into conflict with their obligations to maintain attorney-client privilege.

Sources:

Image is Yes from Administration by Ranken Jordan

Code of Ethics for an Investment Adviser

With the upcoming requirement that advisers to many private investment funds must register with the SEC, I figured it was time to look at some of the requirements that registration will impose.

Section 204A of the Investment Advisers Act requires registered investment advisers to

“establish, maintain, and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser’s business, to prevent the misuse … of material, nonpublic information by such investment adviser or any person associated with such investment adviser.”

It also requires the SEC to adopt “adopt rules or regulations to require specific policies or procedures reasonably designed to prevent misuse.” That leads to the issuance of  Rule 204A-1 under the Investment Advisers Act of 1940

Rule 204A-1 has three key elements: Adoption, Reporting, IPOs.

The adoption element lays out what needs to be in the advisers code of ethics:

  1. A standard of business conduct that you require which reflect the fiduciary obligations;
  2. Provisions requiring your supervised persons to comply with applicable federal securities laws;
  3. Provisions that require all of your access persons to report, and you to review, their personal securities transactions and holdings periodically;
  4. Provisions requiring supervised persons to report any violations of your code of ethics promptly; and
  5. Provisions requiring you to provide each of your supervised persons with a copy of your code of ethics and any amendments, and requiring your supervised persons to provide you with a written acknowledgment of their receipt of the code and any amendments.

Number five requires the standard delivery of the code and signature that they received the code. The prompt reporting is also standard for a code of conduct, as is the compliance with laws.

The fiduciary obligations may be a surprise for the advisers to private investment funds. Fund managers typically structure the funds as limited partnerships. The enabling statute impose a fiduciary duty on the general partner of a limited partnership, which for a private fund will be the investment adviser affiliate. Delaware limited partnership law allows a general partner to reduce its fiduciary obligations, but still must retain the implied contractual covenant of good faith and fair dealing. (see 17 Del Code §17-1101)

On the other hand, Section 206 of the Investment Advisers Act imposes fiduciary duties on investment advisers, regardless of whether or not they are registered with the SEC. This is a different body of law defining the obligations of an investment adviser as opposed to the general partner of a limited partnership.

The fiduciary obligation in 206 make its a violation to

  • employ any device, scheme, or artifice to defraud any client or prospective client;
  • engage in any transaction, practice, or course of business which operates as a fraud or deceit upon any client or prospective client;
  • engage in any act, practice, or course of business which is fraudulent, deceptive, or manipulative;

Those are your conventional anti-fraud provisions. There is one more violation and it gets the most attention:

“Acting as principal for his own account, knowingly to sell any security to or purchase any security from a client, or acting as broker for a person other than such client, knowingly to effect any sale or purchase of any security for the account of such client, without disclosing to such client in writing before the completion of such transaction the capacity in which he is acting and obtaining the consent of the client to such transaction.”

The key here is that is a violation to if you don’t disclose the conflict prior to completion of the transaction.

Fora private fund, you will need to take a look at Rule 206(4)-8 because it lays out some additional fraud prohibitions for investment advisers to private investment funds.

If you run a private fund and don’t have written code of  ethics, it’s time to start thinking about putting one in place. Here are some examples of investment adviser code of ethics:

If you don’t have a code of conduct and are looking for a starting point. Those three are worth taking a look at. There are plenty of others out there and findable with an internet search.

Also keep in mind that you will have to revisit your code next year. Rule 206(4)-7 requires an annual review of your code of ethics.

Sources:

  • Section 204A of the Investment Adviser Act
  • Rule 204A-1 – Investment Adviser Code of Ethics
  • Investment Adviser Code of Ethics Rule by Shearman and Sterling
  • Section 206 of the Investment Advisers Act
  • Rule 206(4)-7
  • Rule 206(4)-8

It Will be up to the SEC to Define Venture Capital

With the financial reform bill set to eliminate the 15 client rule exemption for registration under the Investment Advisers Act, the only remaining exemption for fund companies with over $150 million in assets under management will be for venture capital. The Congressional conference decided to not include the Senate’s exemption for private equity.

The bill would leave it up to the Securities and Exchange Commission to define “venture capital.” So what do you think that definition will be?

Wikipedia provides a nice overview, but lacks much in the way of a definition for regulators.

Venture capital is provided as seed funding to early-stage, high-potential, growth companies and more often after the seed funding round as growth funding round in the interest of generating a return through an eventual realization event such as an IPO or trade sale of the company. Venture capital investments are generally made in cash in exchange for shares in the invested company.

Next I turned to a trade group’s definition of venture capital. So I went to the website for the National Venture Capital Association. I had a hard time finding a comprehensive definition. Although I’m sure that they are working on some proposals for the SEC. Here are some tidbits:

Venture capitalists invest mostly in young, private companies that have great potential for innovation and growth.

Venture capitalists are long-term investors who take a very active role in their portfolio companies. When a venture capitalist makes an investment he/she does not expect a return on that investment for 7-10 years, on average.

Venture capital is a subset of the larger private equity asset class. The private equity asset class includes venture capital, buyouts, and mezzanine investment activity. Venture capital focuses on investing in private, young, fast growing companies. Buyout and mezzanine investing focuses on investing in more mature companies. Venture capitalists also invest cash for equity. Other private equity investors tend to use debt as part of their transactions.

Venture capital is more like a different business model for investing than a legally definable industry. Since the SEC is going to come up with a definition, that means that there will be a legal definition.

That also means that the SEC definition will most likely affect the types of investments by venture capital firms, the nature of their capital investment, and the exit strategy from their investments.

Here are some guesses:

  • Prohibition or limitation on holding debt
  • Limitation on holding preferred shares
  • Restricted to holding common shares in operating companies
  • Prohibitions or limitations on holding publicly-traded securities
  • Limitations on holding shares in companies that have debt obligations
  • Restrictions on the type of operating companies they can invest in

They are just guesses. But the industry should be very worried about the eventual definition. The SEC has expressed a desire to regulate all private investment funds so I would expect their eventual definition to be very narrow.

I’m sure that the venture capital industry views the exemption as a victory. But the exemption could end up being a heavy weight around their necks. They may need to change their operating approach and investing style to stay within the boundaries of the definition and the exemption.

In the end, it may just be easier to register and regain the flexibility for a wider variety of investment approaches.

Sources:

You can get the “Trust Me, I’m a Venture Capitalist” hat at Cafe Press.

Regulation of Advisers to Private Funds

One of the differences between the Senate and House financial reform bills is how they treat advisers to private equity funds. The Senate bill has an exemption for private equity and venture capital. The House bill only has an exemption for venture capital. Since I work for a private equity firm, I am very focused on how this gets resolved.

In reconciling the two bills at the conference, they removed the Senate exemption for private equity: Title IV as passed by the Senate conferees. They also agreed to the house provision creating an exemption from SEC registration for private fund advisers with less than $150 million dollars in assets under management. Those advisers will need to register and comply with state registration instead.

That means private equity fund advisers with more than $150 million in assets under management will need to register with the SEC as investment advisers and will be subject to the rules governing investment advisers.

The bill has not been passed yet, but it seems unlikely that they will be going back to further revise this section of the bill. There are much more contentious provisions that legislators still need to deal with.