HEDGE FUNDS
MUST I REGISTER?

NEWS ALERT, from The Wall Street Journal, June 23, 2006:
A controversial Securities and Exchange Commission rule tightening oversight of hedge-fund advisers is "arbitrary" and can't stand, according to a ruling Friday by the U.S. Court of Appeals for the D.C. Circuit. The rule, which took effect in February, requires most hedge fund advisers to register with the SEC and undergo routine inspections. For more information, please see: http://online.wsj.com/article/SB115107334310688794.html?mod=djemalert

TOUGHER SEC REGISTRATION RULES BECAME EFFECTIVE FEBRUARY 1, 2006

Many hedge fund advisers meet the (now tougher) definition of “investment adviser” under the Investment Advisers Act of 1940. Under the Advisers Act, investment advisers must register with the SEC and comply with the provisions of that Act and with SEC rules. Registered investment advisers must keep current a Form ADV, filed with the SEC, and provide a disclosure statement to clients that includes the information disclosed on Part II of Form ADV.

At the end of 2004, the SEC told the almost trillion dollar hedge fund industry that many more of its managers have to register as investment advisers. The new rule and amendments under the Investment Advisers Act of 1940, requires that advisers to certain private investment pools (“hedge funds”) register with the SEC. Under the new "look through" rules, investment advisers count as "clients" each investor in a fund for which they provide investment advice. Advisers of hedge funds having fifteen (15) or more investors and $25 million or more in assets under management must register as investment advisers with the SEC.

Note, if you don't qualify for SEC registration and have a securities hedge fund, you may be subject to state registration rules; which vary greatly by state (consult with our attorneys on this matter). If you trade futures, commodities and/or forex, you are not subject to SEC or state jurisdiction; rather you must consider CFTC and NFA rules.

Click here http://www.sec.gov/rules/final/ia-2333.htm to read about the SEC registration rule changes.

Adviser Alert: Some of the States are contemplating law changes as a result of the SEC changes. Now, or in the near future, you may have to register at the state level, when at one time you were exempt from state registration. You now may have to have a compliance plan as well. Click here for more information on compliance plans and the services we offer.

Compliance Alert: Advisers that were required to register under the new rule and rule amendments must have done so by February 1, 2006. If you missed the deadline, contact us for immediate help in getting compliant.

Ready for help or have a question? Please call our attorneys or e-mail us at legal@greencompany.com.

The SEC: Cop on the Beat

The SEC regulates investment advisers – persons and firms who advise others about securities – under the Investment Advisers Act of 1940. The Act contains a few basic requirements, such as registration with the SEC, maintenance of certain business records, and delivery to clients of a disclosure statement (“brochure”). Most significant is a provision of the Act that prohibits advisers from defrauding their clients, a provision that the Supreme Court has construed as imposing on advisers a fiduciary obligation to their clients.

This fiduciary duty requires advisers to manage their clients’ portfolios in the best interest of clients, but not in any prescribed manner. A number of obligations to clients flow from this fiduciary duty, including the duty to disclose fully any material conflicts the adviser has with its clients, to seek best execution for client transactions, and to have a reasonable basis for client recommendations.

Who Is Eligible to Register with the SEC?

Not all advisers must register with the SEC. The Act exempts an adviser from registration if it: has had fewer than fifteen (15) clients during the preceding twelve (12) months; does not hold itself out generally to the public as an investment adviser; AND is not an adviser to any registered investment company.

Advisers taking advantage of this “private adviser exemption” must nonetheless comply with the Act’s antifraud provisions, but they do not file registration forms with the SEC identifying who they are, do not have to maintain business records in accordance with SEC rules, do not have to adopt or implement compliance programs or codes of ethics, and are not subject to SEC oversight. The SEC lacks authority to conduct examinations of advisers exempt from the Act’s registration requirements.

The private adviser exemption reflects Congress’s view that there is no federal interest in regulating advisers who have only a small number of clients and whose activities are unlikely to affect national securities markets.

The SEC has responded to change in the landscape. A growing number of investment advisers took advantage of the private adviser exemption to operate large investment advisory firms without being registered with the SEC. Instead of managing client money directly, these advisers pooled client assets by creating limited partnerships, business trusts, or corporations in which clients invest. In 1985, the SEC adopted a rule that permitted advisers to count each partnership, trust or corporation as a single client, which today permits advisers to avoid registration even though they manage large amounts of client assets and, indirectly, have a large number of clients. This is no longer the case.

The New Play in the Book: Rule 203(b)(3)-2

Rule 203(b)(3)-2 requires that investment advisers count each owner of a “private fund” towards the threshold of fourteen (14) clients for purposes of determining the availability of the private adviser exemption of Section 203(b)(3) of the Act. As a result, an adviser to a “private fund,” which is defined in rule 203(b)(3)-1, can no longer rely on the private adviser exemption if the adviser, during the course of the preceding twelve months, has advised private funds that had more than fourteen (14) investors. An adviser that advises individual clients directly must count those clients together with the investors in any private fund it advises in determining its total number of clients for purposes of section 203(b)(3).

If the total number of individual clients and investors in private funds exceeds fourteen (14) the adviser is not eligible for the private adviser exemption and must register with us, assuming it meets our minimum requirements for assets under management.

The new rule amends the method of counting that hedge fund advisers use for purposes of applying the private adviser exemption.

New Kid on the Block: The Chief Compliance Officer

Registration under the Advisers Act will require hedge fund advisers to adopt policies and procedures designed to prevent violation of the Advisers Act, and to designate a chief compliance officer, per Rule 206(4)-7. Hedge fund advisers that have not already done so must develop and implement a compliance infrastructure.

The SEC adopted this requirement in 2003 for all advisers registered with the SEC in recognition that advisers have the primary obligation to ensure compliance with the securities laws, and to foster more effective compliance practices.

See Compliance Programs of Investment Companies and Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 17, 2003) [68 FR 74714 (Dec. 24, 2003)]. http://www.sec.gov/rules/final/ia-2204.htm.

The Compliance officers serve as the front line watch for violations of securities laws, and provide protection against conflicts of interests.

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SEC Registration: Welterweights Need Not Apply

Minimum Assets Under Management

Rule 203(b)(3)-2 does not alter the minimum amount of assets under management that an investment adviser generally must have in order to register with the SEC. A hedge fund adviser whose principal office and place of business is in the United States cannot (subject to certain exceptions) register with the SEC unless it manages at least $25 million.

SEC Registration: International Advisers

A hedge fund adviser whose principal office and place of business is outside the United States (an “offshore adviser”) must register with the SEC if it has more than fourteen (14) clients who are resident in the United States regardless of the amount of assets the adviser has under management. The SEC does not apply the $25 million threshold to offshore advisers, because that threshold is premised on regulation of the unregistered adviser by one or more states in which the adviser has its principal office and place of business.
In determining the amount of assets it has under management, a hedge fund adviser whose principal office and place of business is in the United States must include the total value of securities portfolios in its assets under management. That is, it may not reduce the value of those assets by amounts borrowed to acquire them. An adviser may exclude proprietary assets invested in the fund, and need not include the value of assets attributable to non-U.S. investors.

Counting “Owners”

Rule 203(b)(3)-2 requires investment advisers to count each owner of a private fund towards the threshold of fourteen clients, that is, each shareholder, limited partner, member, or beneficiary of the private fund.

An adviser does not have to count itself as a client regardless of the form its ownership in the pool takes. A hedge fund adviser can exclude certain knowledgeable advisory personnel who are “qualified clients” (i.e., who are “insiders”) that may be charged a performance fee. An adviser to a private fund may also exclude the value of these insiders’ interests in the private fund when calculating the firm’s assets under management for purposes of the $25 million registration threshold.

Counting Clients of Offshore Advisers

The rules impose the same counting requirements on offshore advisers to hedge funds as offshore advisers providing advice directly to U.S. clients. Thus, for purposes of eligibility for the private adviser exemption, an offshore hedge fund adviser must look through each private fund it advises, whether or not those funds are also located offshore, and count each investor that is a U.S. resident as a client. An offshore adviser to any hedge fund that, in the course of the preceding twelve months, has more than fourteen investors (or other advisory clients) that are U.S. residents generally must register under the Advisers Act.

An adviser to a private fund should determine whether an investor is a U.S. client or a non-U.S. client at the time of the investment in the private fund. If an investor is a non-U.S. client at the time of that investment, the adviser may continue to count the investor as a non-U.S. client even if the investor subsequently relocates to the United States.

Funds of Hedge Funds

Under rule 203(b)(3)-2, a hedge fund adviser whose investors include a fund of funds that is itself a “private fund” must apply the general provisions of the new rule, which compel looking through that “top tier” private fund and counting its investors as clients for purposes of the private adviser exemption. If the fund of funds is a registered investment company, rule 203(b)(3)-2(b) requires that the adviser to an underlying private fund look through the investment company and count its investors as clients for purposes of the exemption.

Division of Authority between the SEC and the States

The regulatory landscape applying to investment advisers changed dramatically in 1996 as a result of the National Securities Markets Improvement Act (NSMIA). Consequently, advisers are subject to regulation at only one level: large advisers by the SEC and small advisers and their associated persons by the states.

The underlying principle is that the SEC should focus on those advisers with a more national business, and state regulators should focus on those advisers with a more local business. All the states, as well as the District of Columbia, Puerto Rico, and Guam, regulate securities through laws typically referred to as Blue Sky Laws. The state securities department responsible for securities administers these laws.

As suggested by the SEC here, "for information about state securities registration requirements, including notice filing requirements for SEC-registered advisers, check with the appropriate state securities authorities and NASAA." These links give you a handy map to locate your state regulator.

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Exemption from State-Level Registration

The NSMIA imposes a ''national de minimis standard,'' which precludes a state from requiring an investment adviser to register if the investment adviser has no place of business located within the state and has had fewer than six (6) clients who are residents of that state during the preceding twelve- month period. See NASAA, Memorandum of Understanding Concerning Investment Advisers and Investment Adviser Representatives (1997), by clicking here.

Alert: Some of the States may be readying to adopt the SEC rule changes. Even if you are not eligible for SEC registration, you may now have to register with the state, when at one time you could rely on an exemption from state registration. You must monitor for legislative changes in any state in which you do business.

State authority over advisory personnel is more far-reaching. States retain the authority to license persons working for an SEC-registered adviser who have a place of business in the state. As a result of the NSMIA, the nature of an adviser's business determines which regulator has authority over that adviser.

States retain limited authority with respect to SEC-registered advisers. In particular, they can require an SEC-registered adviser to make certain filings and pay fees.

Caution: State-registered advisers that are exempt from registration requirements under the de minimis standard in states where they have no place of business still are subject to the anti-fraud prohibitions in those states. However, this does not contemplate an avenue for the states to impose their substantive regulation against SEC-registered advisers. Therefore, for example, a state cannot obligate an SEC-registered adviser to comply with its net capital requirements by saying that its anti-fraud provisions mandate such compliance. A state could, for instance, enforce its anti-fraud provisions against an SEC-registered adviser that is stealing money.

For many advisers, it will be clear whether they must register with the SEC or the states. Others will need to engage in a more complicated examination of their business operations to determine which registration requirements apply.

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Where Do I Register?

Registration has its own set of costs and continuing overhead. However, there are also advantages to registering. The advantages relate to how your business is perceived by certain knowledgeable investors. Those that understand the implications of registration know that your business is set up to ensure that all regulatory protections available to the clients are given to them. They understand that you are being held to a different standard than someone who did not register.

The consequences of not registering when you should are huge!

If you should register as an investment adviser with a state and you do not, you are setting yourself up for a huge problem. The laws are specific, and each state and set of circumstances brings a different answer to the question.

If you should have, but did not, register, and your fund does not do well (resulting in a lawsuit), you could be liable for reimbursement for any funds lost. In addition, you will be in very hot water with your state securities commission - not a good situation.

Registration rules are complex and highly nuanced. It's wise to seek good legal counsel before proceeding with your hedge fund business plan.

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