Tag: 15 Clients Rule

The Family Office Exemption under the Investment Advisers Act

The Dodd-Frank Wall Street Reform and Consumer Protection Act wiped out the exemption enjoyed by most private funds. I’m still waiting to see how the SEC will define a “venture capital fund manager.” In the meantime, the SEC has published its proposed rule defining a “family office” and its exemption from registration under the Investment Advisers Act.

Historically, family offices have not been required to register with the SEC under the Advisers Act because of the same exemption used by private funds. The Dodd-Frank Act removed that “small adviser” exemption under section 203(b)(3) to enable the SEC to regulate hedge fund and other private fund advisers, but includes a new provision requiring the SEC to define family offices in order to exempt them from regulation under the Advisers Act.

“Family offices” are established by wealthy families to manage their wealth and provide other services to family members. That leaves the fabulously wealthy time to go yachting and leaves others to manage their securities portfolios, plan for taxes, worry about accounting services, and to directing charitable giving. The issue is the the family office management of securities.

In the past, the SEC has issued dozens of exemptive orders for family offices who requested them, removing them from the registration and supervision of the SEC. The proposed rule 202(a)(11)(G)-1 would largely codify the exemptive orders. Most of the conditions of the proposed rule are designed to restrict the structure and operation of a family office relying on the exemption to activities unlikely to involve commercial advisory activities, while still allowing family office activities involving charities, tax planning, and pooled investing.

(b) Family office. A family office is a company (including its directors, partners, trustees, and employees acting within the scope of their position or employment) that:

(1) Has no clients other than family clients; provided that if a person that is not a family client becomes a client of the family office as a result of the death of a family member or key employee or other involuntary transfer from a family member or key employee, that person shall be deemed to be a family client for purposes of this section 275.202(a)(11)(G)-1 for four months following the transfer of assets resulting from the involuntary event;

(2) Is wholly owned and controlled (directly or indirectly) by family members; and

(3) Does not hold itself out to the public as an investment adviser.

The key is how the SEC defines a family member:

(d) (3) Family member means:

(i) the founders, their lineal descendants (including by adoption and stepchildren), and such lineal descendants’ spouses or spousal equivalents;

(ii) the parents of the founders; and

(iii) the siblings of the founders and such siblings’ spouses or spousal equivalents and their lineal descendants (including by adoption and stepchildren) and such lineal descendants’ spouses or spousal equivalents.

I guess that some family offices will be cutting off some distant relations to get under this definition. For “less-beloved” family members, the family office management can use SEC regulation as an excuse to kick them out.  Of course, they can still seek and exemptive order from the SEC if they don’t fit under this definition.

The comments should involve a whole new area for the SEC: family law.

As I expected, this exemption is of no value to private funds look for a safe harbor from SEC registration.

Sources:

Dodd’s Solo View on Private Investment Funds

Senator Dodd

Senator Dodd did not forget about private investment funds. Tucked into page 366 of his 1366 page Restoring American Financial Stability Act of 2010 is the Private Fund Investment Advisers Registration Act.

This is largely the same language in the Private Fund Investment Advisers Registration Act of 2009 contained in Dodd’s draft Restoring American Financial Stability Act of 2009. He circulated that draft back in November to start negotiations with Republicans.

Venture Capital Fund Advisers

There is an exemption from registration for the “provision of investment advice relating to a venture capital fund.” The bill gives the SEC the responsibility for defining a “venture capital fund.”

Private Equity Fund Advisers

Unlike the bill passed by the House, Dodd proposes an exemption from registration or reporting requirements with respect to advice given to private equity funds. The SEC is tasked with defining the term “private equity fund.”  Unlike venture capital funds, private equity funds will be subject to SEC record-keeping requirements to the extent the SEC determines it is “necessary and appropriate in the public interest and for the protection of investors.”

State versus Federal Registration of Investment Advisers

Section 410 of the bill raises the federal registration level to $100 million from $25 million. So investment advisers and funds of less than $100 million will be subject to state regulators instead of federal regulators. David Tittsworth, executive director of the Investment Adviser Association, said the change would shift about 4,200 of the 11,000 money managers now registered at the SEC to state regulation.

Accredited Investors

The Dodd bill would change the threshold for “accredited investor.” Currently, the threshold is $200,000 income for a natural person (or $300,000 for a couple) or $1,000,000 in assets. The SEC would have the power to increase those levels  as “appropriate and in the public interest, in light of price inflation since those figures were determined.”

The Comptroller General is also directed to study the financial thresholds for investor eligibility in private funds.

Regulation D Offerings

Separately in the bill, Senator Dodd is proposing to tinker with exemption from registration under Rule 506. Section 926 of his bill, gives the SEC the power to designate certain Rule 506 offerings to not be “covered securities.”  That would get the states more involved in the review and regulation of private offerings, including private fund offerings.

Now What?

This bill still has a long way to go in the Senate. Most reports indicate that private funds are not one of the hotly contested issues in the bill. Assuming the Senate passes the bill, they will need to negotiate the differences between the House and Senate. Assuming it passes, it looks like a big chunk of work would be dropped onto the SEC to define the fund types.

Sources:

Trust and Financial Regulation

colombo

Ronald J. Colombo of Hofstra University School of Law wrote a great paper on The Role of Trust in Financial Regulation.

Trust is an important part of our financial markets. Scandals, massive incompetence, massive irresponsibility, massive fraud, have shaken trust in the financial markets. Commentators, policy makers, and industry leaders have all recognized the need for trust’s restoration.

Consistent with financial scandals in the past, the public officials are looking for increased regulation to restore trust in the markets. The last round of financial scandals in the Enron-WorldCom era brought us Sarbanes-Oxley.

Professor Colombo thinks the advocates for increased regulation have it half right.

“A critical set of questions should be considered. Can regulation serve to bolster and repair relationships dependent upon trust? And in the absence of trust, can regulation serve as an effective substitute to trust? In short, are there limits to the ability of regulation to resuscitate an economy that has suffocated due to lack of trust?

Conversely, can regulation work to “crowd out” trust, effectively transforming relationships that once were close and trustworthy to arm’s length and legalistic? Could regulation serve to displace relationships of trust with transactions subject merely to the “morals of the marketplace”?”

The Role of Trust in Financial Regulation applies trust scholarship to examine the current U.S. financial regulatory regime and some of the proposed reforms. I focused on a few sections.

Private Offering Regulation

In addressing the difference in treatment between the regulation of public offerings and private offerings, Mr. Colombo thinks the difference can be justified on grounds relating to the issue of trust.

A private offering is more like a personal contract between the issuer and the investor, free of public advertising. Also, a private offering is more likely to have a pre-existing relationship. “Interpersonal relationships and communications are conducive to such trust, and such relationships and communications are often found among the parties to a private offering.”

He concludes that the current regulation of private offering strikes the correct balance from a trust-favoring perspective.

Regulation of Investment Advisers

I found it interesting that Mr. Colombo spends some time focused on the 15 client rule exemption from registration. He finds that much of the investment adviser regulation has developed a heavy band of regulation that “can crowd out trust in a relationship, converting expectations and behavior based upon honor and integrity to those based on the letter of the law.”

Investment advisers with a small number of clients can have “closer, more personal and more lasting relationships with their small number of clients than those advisers with a much larger client base.” The small adviser exemption from regulation when you have fewer than 15 clients facilitates the trust aspect.

The Private Fund Investment Advisers Registration Act, just approved by the House Financial Services Committee, eliminates this exemption.

Hedge Funds

From a trust perspective, Mr. Colombo thinks the lack of hedge fund regulation seems sensible. As with the world of investment advisers, the hedge fund industry is marked by repeat players. Frequent and historical interactions among the parties can “lay the foundation for affective and generalized trust to develop.” After all, the original legislative intent of the U.S. securities laws was to protect the layperson, unfamiliar with the financial markets, with sophisticated investors fending for themselves. Give the high financial thresholds for investment in private funds, the investors are either sophisticated or have easy access to sophisticated investment advice.

Regulatory Reforms

Mr. Colombo does not seem to like the removal of the small adviser exemption from investment adviser regulation. For larger advisers, the increased disclosure and reporting requirements may be a good things.

As for hedge funds he thinks that hedge funds currently operating successfully on the basis of trust, with little regulation, have little to benefit their investors by registering with the SEC  and submitting themselves to the regulatory oversight. However, for funds that have not been able to develop that trust, voluntarily registering and submitting themselves to the regulatory oversight could help develop that trust. (I’m skeptical that investors think SEC registration carries any value in the world of private funds.)

The paper concludes that the existing financial regulatory regimes do a pretty good job with our understanding of trust. Greater regulation is imposed upon those sectors of the financial services industry where such regulation is trust enhancing, and lesser regulation is imposed upon those sectors where such regulation is trust defeating.

“In those areas where high quality trust relationships exists (or have the greatest potential to exist), we have, relatively speaking, the lowest levels of regulation: private offerings, investment advisers, and hedge funds. In those areas where only lower quality trust relationships are likely to exist (that is, relationships of cognitive and specific trust), we witness the highest levels of regulation: public offerings, secondary market trading, and banking.”

He also points out the more important areas of the capital markets are more heavily regulated. After all, we cannot wait to see if trust can be developed if the failure will lead to a systemic breakdown. The turbulence after the Lehman collapse was in part caused by the lack of trust. Nobody was sure if they could trust the stated financial stability of their counterparty.

References:

Colombo, Ronald J., Trust and Financial Regulation (October 1, 2009). Villanova Law Review, Forthcoming; Hofstra Univ. Legal Studies Research Paper No. 09-22. Available at SSRN: http://ssrn.com/abstract=1481327

Some other references from The Role of Trust in Financial Regulation:

Hedge Fund Adviser Registration Act of 2009

capuanoCongressmen Mike Capuano of Massachusetts and Mike Castle of Delaware introduced the Hedge Fund Adviser Registration Act of 2009 (H.R. 711). The Act, if passed, would delete Section 203(b)(3) from the Investment Advisers Act of 1940.

This section of the Investment Advisers Act exempts from registration an investment adviser who has fewer than 15 clients and does not hold themselves out to the public as an investment adviser. The general partner of a private investment fund is generally considered an investment adviser to that fund. Many private investment funds use this exemption if they have less than 15 funds.

Since the bill was just proposed on January 27, 2009 it is too early to speculate as to whether it will be passed.

This act falls into the bucket with the Hedge Fund Transparency Act of 2009 as one of several prospective changes to the private investment fund industry.

Hedge Fund Registration Act

Senator Charles Grassley of Iowa is looking to expand the registration requirements of the Investment Advisers Act. According to Jim Hamilton’s World of Securities Regulation, the Senator Will Reintroduce in 111th Congress Bill Requiring SEC Registration of Hedge Fund Advisers. The Washington Post story has Senator’s Grassley’s statement coming out of the House Oversight and Government Reform Committee hearing: Fund Chiefs Back Oversight.

The SEC issued a rule in 2004 to try to expand the registration requirement under the Investment Advisers Act by defining client to mean each of the limited partners in a private investment fund, not just the fund itself. That rule was overturned by Goldstein v. SEC which found the rule to be broader than what was authorized under the Investment Advisers Act.

See also:

Counting Clients under the Investment Advisers Act

With the demise of The Hedge Fund Rule, you can look to Rule 203(b)(3)-1 to help you figure out how to count clients.  The key part of the rule from a private investment fund perspective is (a)(2)(i):

A corporation, general partnership,limited partnership, limited liability company, trust (other than a trust referred to in paragraph (a)(1)(iv) of this section), or other legal organization (any of which are referred to hereinafter as a “legal organization”) to which you provide investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which are referred to hereinafter as an “owner”)

This rule is the opposite of The Hedge Fund Rule. Here the entity is the client, not the individuals or organizations in the entity.

For a private investment fund, the limited partnership is the client, not the invidiual limited partners.

Counting Clients under the Investment Advisers Act – The Demise of the Hedge Fund Rule

Section 203(b) lays out the exceptions to registration under the Investment Advisers Act. Section 203(b)(3) exempts you if during the previous 12 months (i) you have fewer than 15 clients and (ii) you do not hold yourself out as an investment adviser.

For private investment funds, the general partner is generally considered an investment adviser [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)]

In the private investment world, as long as you had fewer than 15 funds and did not hold yourself out as an investment adviser you did not have to register.  The question is what was a fund/client for the purposes of the Investment Company Act?

With the demise of Long Term Capital, the SEC was interested in regulating hedge funds. In 2004 the SEC passed the Hedge Fund Rule which tried to expand the scope of the Investment Advisers Act by defining “client” under Section 203(b)(3). The rule specified that for “[f]or purposes of section 203(b)(3) of the [Advisers] Act (15 U.S.C. § 80b-3(b)(3)), you must count as clients the shareholders, limited partners, members, or beneficiaries . . . of [the] fund.” § 275.203(b)(3)-2(a). Effectively, the SEC tried to shift the definition from the fund up to the investors in the fund.

This Hedge Fund Rule was overturned by the United States Court of Appeals for the District of Columbia Circuit in the appelate case of Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

“An investor in a private fund may benefit from the adviser’s advice (or he may suffer from it) but he does not receive the advice directly. He invests a portion of his assets in the fund. The fund manager – the adviser – controls the disposition of the pool of capital in the fund. The adviser does not tell the investor how to spend his money; the investor made that decision when he  invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.”