Category: Investment Advisers Act

SEC Made It Harder to Earn Performance Fees

As a general rule, investment adviser cannot charge performance fees. Section 205(a)(1) of the Investment Advisers Act of 1940 generally prohibits an investment adviser from entering into, extending, renewing, or performing any investment advisory contract that provides for compensation to the adviser based on a share of capital gains on, or capital appreciation of, the funds of a client. That means no performance fees.

Unless the SEC makes an exception, which it has done so for people that don’t need the protections of that prohibition. Historically, that has meant the person has a “big pile of cash”. The big pile of cash standard had been if the client has at least $750,000 under the management of an investment adviser or the adviser reasonably believes the client has a net worth of more than $1,500,000.

Back in May the SEC has proposed raising those limits to $1 million under management or a minimum net worth of $2 million. The SEC was required to adjust the standard under Section 418 of Dodd-Frank. The adjustment was keyed to inflation. The SEC decided to exclude the value of person’s home, just as they did with the accredited investor standard, in calculating net worth.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund if it is relying on the 3(c)(1) exemption under the Investment Company Act. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  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.

The new standard will go into effect on September 19, 2011.

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Yes, the SEC Wants Real Estate Fund Managers to Register

After six months baking in the oven, the new Form ADV is ready. (To be more precise, the new Part 1 is ready. Part 2 has been sitting on the table for almost a year.) Form ADV still calls for real estate fund managers to register as investment advisers

Earlier I had pointed out how a real estate fund manager could be considered an investment adviser and have to register with the SEC under the Investment Advisers Act. In the Proposed Changes to Form ADV the SEC included “real estate fund”. They also changed the way you calculate assets under management, taking in the value of the fund assets, not just securities held by the fund.

While waiting for Form ADV to finish baking, I wondered if there might be some clarification or changes to pull real estate funds out of the registration requirement. It didn’t happen.

As you can see from the image above, “real estate fund” is still one of the choices when it comes to designating the type of fund. That gives it equal status with hedge fund, venture capital fund, and private equity fund. The definition of real estate fund is unchanged in the instructions for Part 1A of Form ADV:

“Real estate fund” means any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.

Maybe there is room under the definition of “private fund”? In the Glossary it’s defined as “An issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940 but for section 3(c)(1) or 3(c)(7) of that Act.” That does leave open the position that the fund could be exempt under section 3(c)(5). That’s a murkier exemption than the one provided by 3(c)(1) or 3(c)(7).

The other confusion over how to value the assets under management is gone. The old version of Form ADV had a 50% test for assets under management. If less than 50% of the value was not securities, then you didn’t have a securities portfolio and the value was zero.

The new way of calculating assets under management for a private fund from the Instructions for Part 1A:

For purposes of this definition, treat all of the assets of a private fund as a securities portfolio, regardless of the nature of such assets. For accounts of private funds, moreover, include in the securities portfolio any uncalled commitment pursuant to which a person is obligated to acquire an interest in, or make a capital contribution to, the private fund.

It still gets back to being a “private fund” and relying on a 3(c)(1) or 3(c)(7), instead of a 3(c)(5) definition. One thing to realize is that the definition of “private fund” actually comes from Section 402 of Dodd-Frank, not from the wishes of the SEC. The intent of the SEC is clear, even if there may be some wiggle room.

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Real Estate Fund Managers and the CFTC

Many real estate fund managers, used to the lack of regulatory oversight, are wrestling with the implications of Dodd-Frank. One of the biggest sources of hand-wringing is whether to register as an investment adviser given the removal of the 15 clients exemption from the Investment Advisers Act. Another agency is potentially making regulatory changes leading to a registration requirement.

The Commodity Futures Trading Commission has proposed removing some exemptions from the requirement to register as Commodity Pool Operator or a Commodity Trading Advisor. I have never paid much attention to these requirement. That is because interest rate swaps and foreign exchange hedges generally fell outside the definition of a commodity.

However, Section 712(d)(1) of the Dodd-Frank Act empowers the CFTC and SEC to define swaps and could re-classifies “swaps” as “commodities”. That brings these formerly unregulated contracts under the regulatory regimes of the CFTC and the SEC. Under the comprehensive framework for regulating swaps and security-based swaps established in Title VII of Dodd-Frank, the CFTC is given regulatory authority over swaps and the SEC is given regulatory authority over security-based swaps. They can fight over mixed swaps.

The concern I have is that a real estate fund is likely to have “swaps” in place to reduce interest rate risk. If they are operating overseas, they may have hedges in place to reduce foreign exchange risk. Since those are likely to fall under the new definition of swap, and there is no end-user exemption, the real estate fund and its manager could now also fall under the regulatory regime of  the CFTC.

CFTC Rule 4.13(a)(3) currently exempts a fund from registration as a Commodity Pool Operator if:

  • the fund’s interests are exempt from registration under the Securities Act of 1933 (’33 Act);
  • the investors in the fund are only Qualified Eligible Persons, accredited investors or knowledgeable employees;
  • the pool’s aggregate initial margin and premiums attributable to futures and options on futures do not exceed 5 percent of the liquidation value of the pool’s portfolio;
  • the fund is not marketed at a vehicle for trading in commodity futures or commodity options markets.

Rule 4.13(a)(4) currently exempts you from registration as a Commodity Pool Operator if the interests in the fund are exempt from registration under the ‘33 Act and the operator reasonably believes all participants are Qualified Eligible Persons or accredited investors.

The CFTC  is proposing to eliminate these exemptions because it is concerned that they are big loopholes from exemption. I think an unintended consequence could be dragging real estate funds and real estate operators into the regulatory framework.

I have to admit that I’ve just started reading the swap rules and the CFTC framework so I don’t understand how it all fits together. Frankly, the provision in Dodd-Frank and the proposed rules are a mess and full of inconsistencies, making this situation even harder to figure out and likely creating some unintended consequences.

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What do Wyoming, New York, and Minnesota Have in Common?



They don’t examine investment advisers.

Wyoming has long been on this list because it does not have a law regulating investment advisers. In Item 2 of Form ADV there was a box to check if your principal office and place of business was Wyoming. That kept you in SEC registration.

The importance of whether a state does exams affects mid-sized advisors. Dodd-Frank allows mid-sized advisors to stay with SEC registration instead of state registration if their home state doesn’t do exams.

At last week’s SEC Open Meeting on the new investment adviser act rules, Bob Plaze, associate director of the SEC’s Division of Investment Management, revealed that New York did not respond in writing to the SEC’s question about investment adviser examinations. The SEC took the position that a non-response was a statement that the state doesn’t examine investment advisers.

Minnesota responded that they don’t conduct exams.

This means mid-sized advisers in Wyoming, New York, and Minnesota won’t have to switch to state supervision if they have between $25 million and $100 million in assets under management.



Finally, Some SEC Action on the July 21 Deadline for Fund Managers

If you’re a private fund manager you have been worried about the looming July 21 deadline for registration. Given the 45 day review period, the filing deadline was June 6. That came and went without the SEC having the rules in place for registration. Sure, the SEC commissioners and staff have been saying the plan to extend the deadline. But, still no extension.

Looking ahead to June 22, it looks like the SEC will finally take up the formal action. The Open Meeting for June 22 is all about the Investment Advisers Act.

Agenda:

Item 1: The Commission will consider whether to adopt new rules and rule amendments under the Investment Advisers Act of 1940 to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act. These rules and rule amendments are designed to give effect to provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for registration of investment advisers with the Commission, require advisers to hedge funds and other private funds to register with the Commission, and address reporting by certain investment advisers that are exempt from registration.

Item 2: The Commission will consider whether to adopt rules that would implement new exemptions from the registration requirements of the Investment Advisers Act of 1940 for advisers to venture capital funds and advisers with less than $150 million in private fund assets under management in the United States. These exemptions were enacted as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The new rules also would clarify the meaning of certain terms included in a new exemption for foreign private advisers.

Item 3: The Commission will consider whether to adopt a rule defining “family offices” that will be excluded from the definition of an investment adviser under the Investment Advisers Act of 1940.

Hopefully, they won’t change their mind about extending the deadline.

Have You Set Up Your IARD Account?

With the impending deadline for filing Form ADV to register as an investment adviser, you need to jump through some hoops before you can do the filing. First step is visiting the Investment Adviser Registration Depository. Form ADV needs to be filed electronically and this is the electronic mailbox.

But first you need an account. To get an account you need an IARD Super Account Administrator. To get an IARD Super Account Administrator, you need to fill out the SEC Registrant Entitlement Packet (.pdf). It’s a simple form, but you need to mail it back to get your account. (There is an overnight delivery address.)

Once IARD gets the form they are supposed to send you emails with your username and password. Then you need create a financial account. To fund the account you need to use bank wire or check and that has a two day delay in funding.

I’m not trying to give you a tutorial. I’m just pointing that it will take at least a few days for you to get the mechanics set up to file.

There are only eight business days left until the June 6 filing deadline for fund managers. (Unless the SEC acts to extend the deadline.) Seems like its time to get the mechanics moving.

Time for the SEC to Extend a Deadline

Dodd-Frank set a July 21 deadline for changes to the Investment Advisers Act in Title IV:  The Private Fund Investment Advisers Registration Act. This included the  expiration of the private adviser exemption from registration under the Investment Advisers Act, the addition of an new exemption for “venture capital fund advisers” and the increase in the threshold for registration with the SEC to $100 million.

The SEC proposed a new Form ADV in November to deal with these changes. But the final form has not been published.

The SEC proposed a definition of “venture capital fund adviser” in November. The final definition has not been published.

With the increase in the registration threshold to $100 million, about 4,000 investment advisers will be moved to the state authorities for supervision. Many states are still in the middle of revising their statutes and regulations to deal with the changes.

Since the SEC has a 45 day review period on the Form ADV, the filing deadline in June 6. That’s just two weeks away. Throw in Memorial Day weekend in the middle of that to lose a few more days.

In April, the SEC hinted that they would extend the July 21 deadline.  The IARD registration system would not be ready for the new Form ADV until the end of 2011. It sounded like the SEC is not ready.

I think it’s unrealistic for the SEC to release the new regulations and forms in the next two weeks and expect their regulated constituents to be able to pull the pieces together. Actually, it’s probably unrealistic to expect that the SEC will be ready in the next two weeks. They keep talking about have the regulations in place by July 21. That’s 45 days too late. Looking at this week’s SEC meeting, the subject is not on the agenda.

This week, I’m sitting down to start registering on the old Form ADV. The boxes don’t fit very well and some of the dollar amounts are wrong. It may be a waste of time, but we are out of time.

To entertain myself in the face of this deadline, I present the deadline post-it video

Will Private Equity be Exempted from Registration?

In earlier versions of Dodd-Frank, when it was being formulated in the House committee, there was an exemption for private equity fund managers from registration under the Investment Advisers Act. It also had an exemption for venture capital fund managers. Only the venture capital exemption managed to survive.

Of the many attempts to cut back on Dodd-Frank, at least one bill is slowly moving forward. The Small Business Capital Access and Job Preservation Act, H.R. 1082, would exempt advisers to private equity funds from SEC registration under the Investment Advisers Act.

The bill is straightforward:

Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

It still leaves you with issue of how to define “private equity fund or funds.” The SEC would have 6 months to define the term. Even if the SEC extends the deadline for registration and even if this bill gets passed quickly, that would leave a very narrow window for a private equity fund manager to determine if they need to register.

The first contingency seems destined. Most fund manager CCOs that I’ve talked to are not expecting the July 21 deadline to be in place. Everyone is expecting the deadline to be extended into the first quarter of 2012. They’re just wondering what is taking the SEC so long to make it official.

The bigger question is whether this bill be passed quickly and whether it will be passed at all. Certainly there is some legislative support for the exemption. It had been in earlier versions of Dodd-Frank. The risks of private equity are not the same risks as hedge funds. On the other hand, the some Congressional testimony about the bill focused on the leverage buyout sector of private equity. Many associate this high leverage business model with all of private equity.

The bill was forwarded by the Subcommittee on Capital Markets and Government Sponsored Enterprises to the full House Committee on Financial Services. It still has a long way to go and its future is uncertain. Continue moving forward with implementing your compliance program.

For those of you who need a brush-up on the legislative process, Schoolhouse Rocks still tells it best:

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The SEC Is Making it Harder for Investment Advisers to Earn Performance Fees

The Securities and Exchange Commission is proposing to raise the dollar thresholds for someone to be considered a “qualified client.”

The definition of a qualified client is set out in Rule 205-3. This is an exemption to the Section 205(a)(1) general prohibition on performance fees.  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.”

Section 418 of the requires the SEC to adjust the standard for a Qualified Client for the effects of inflation within one year and then every five years.

Back in August I predicted the standard would be raised to a minimum investment of $1 million and the minimum net worth would rise to $2 million. I was proven wrong about my prediction of a rise in the accredited investor standard.

The SEC is proposing that the standard increase to a minimum investment of $1 million and the minimum net worth would rise to $2 million. As to net worth, they are excluding the value of a person’s primary residence.

The SEC is using the same primary residence calculation they used in the “new” accredited investor standard. So, if you owe more on your mortgage than the value of your house, then you need to treat the overage as a negative asset. Once again, owning a house can only be a negative for the SEC standards.

While I used the CPI-I standard as the benchmark for inflation, the SEC chose to use the Personal Consumption Expenditures Chain-Type Price Index (“PCE Index”), published by the Department of Commerce

One of the comments the SEC is seeking in the proposed rule is whether the PCE index is the appropriate measure of inflation.

As for private  funds, Rule 205-3(b) requires a look -through from the fund to the investors in the fund. Each “equity owner … will be considered a client for purposes of the” limitation.  If the fund is relying on the 3(c)(7) exemption from the Investment Company Act then the fund’s investors should be “qualified purchasers”  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.

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Massachusetts Is Looking to Dodd-Frank Investment Advisers and Fund Managers

Just to keep you on your toes if you have less than $150 million under management, states are now filling in the gaps left by Dodd-Frank. If you are under that threshold, you lose the ability to register with SEC and now have to look to at being regulated at the state level.

Massachusetts used to have a very broad exemption if your clients were all “institutional buyers.”

An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $50,000.

For a private fund manager, this was a great exemption since their investors would need to be accredited investors. As long they kept capital commitments at a minimum of $50, 000 they could usually take advantage of this exemption.

The Massachusetts Secretary of State has proposed removing this exemption as well as cleaning up other aspects of investment adviser/fund manager regulation to get ready for Dodd-Frank.

The proposal would also create new Massachusetts registration exemptions for advisers whose only clients are “venture capital funds” or funds excluded from the definition of “investment company” under Section 3(c)(7) of the Investment Company Act. As you might expect, the term “venture capital fund” would be defined by reference to the SEC’s definition of the term. The SEC has proposed a draft definition of venture capital fund, but not yet finalized it.

What is abundantly clear is that the SEC has run out of time it trying to meet the July 21, 2011 deadline in Dodd-Frank. It’s time to raise the white flag and move the deadline. Since the SEC has not yet finalized the rules, regulated parties would have no time to understand the rules and get changes in place by July 21. Given that thousands of advisers are being kicked out of SC registration and over to state registration, the states do not have the rules in place to deal with the regulatory changes.

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