Investment Advisers Act of 1940

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Contents

Overview

The Investment Advisers Act of 1940, codified at (USC 15|80b-1) through (USC 15|80b-21), is a United States federal law that was created to regulate the actions of investment advisers (also spelled "advisors") as defined by the law.

The law provides in part:

§ 80b–1. Findings
Upon the basis of facts disclosed by the record and report of the Securities and Exchange Commission made pursuant to section 79z–4 of this title, and facts otherwise disclosed and ascertained, it is found that investment advisers are of national concern, in that, among other things—
(1) their advice, counsel, publications, writings, analyses, and reports are furnished and distributed, and their contracts, subscription agreements, and other arrangements with clients are negotiated and performed, by the use of the mails and means and instrumentalities of interstate commerce;
(2) their advice, counsel, publications, writings, analyses, and reports customarily relate to the purchase and sale of securities traded on national securities exchanges and in interstate over-the-counter markets, securities issued by companies engaged in business in interstate commerce, and securities issued by national banks and member banks of the Federal Reserve System; and
(3) the foregoing transactions occur in such volume as substantially to affect interstate commerce, national securities exchanges, and other securities markets, the national banking system and the national economy.

(USC 15|80b-1)

Dodd-Frank Act Impact on Investment Advisers and Private Investment Funds

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") was signed into law by the president. Title IV of the Dodd-Frank Act, "Regulation of Advisers to Hedge Funds and Others," contains provisions that significantly change the registration requirements and regulation of investment advisers. The following summary highlights some areas in Title IV of the Dodd-Frank Act that will affect our investment management clients. Fortunately, our clients will have time to prepare for most of the changes since many aspects of Title IV of the new law do not take effect for a year.

Repeal of the Private Adviser Exemption

The Dodd-Frank Act repeals the "private adviser" registration exemption provided by Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"). Under prior law, an adviser that (1) has 15 or fewer clients in any 12-month period, (2) is not an investment adviser to a registered investment company or a business development company, and (3) does not "hold itself out" as an investment adviser, is exempt from registration with the Securities Exchange Commission (the "SEC") under the Advisers Act. Most advisers of hedge funds and private equity funds that are not registered currently rely on this exemption. The Dodd-Frank Act eliminates the private adviser exemption and requires advisers to "private funds" with at least $150 million in assets under management ("AUM") to register as investment advisers with the SEC under the Advisers Act unless the adviser qualifies for one of the exemptions discussed below. The legislation broadly defines "private fund" to include any issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940 (the "Investment Company Act"), but for Section 3(c)(1) or 3(c)(7) of that Act.

Exemptions from Registration

The Dodd-Frank Act provides for the following exemptions from investment adviser registration:

$150 Million Exemption and Treatment of "Mid-Sized" Investment Advisers

The Dodd-Frank Act requires the SEC to promulgate a rule that will exempt from registration investment advisers whose sole clients are private funds and who have total AUM in the United States of less than $150 million. Despite this exemption, such advisers will still be subject to SEC reporting, examination, and disclosure rules discussed below.

Previous law generally prohibited an investment adviser from registering with the SEC unless it had at least $25 million in AUM. While this minimum threshold will remain in place, the Dodd-Frank Act specifically prohibits "mid-sized" investment advisers from registration with the SEC unless the investment adviser is solely an adviser to registered investment companies or business development companies. A mid-sized investment adviser is an adviser that (1) is required to be registered as an investment adviser with the securities commissioner of the state in which it maintains its principal office and place of business and, if registered, would be subject to examination by that state commissioner, agency, or office; and (2) has AUM of $25 million to $100 million (or a higher amount as may be set by the SEC). If a mid-sized investment adviser would be required to register with 15 or more states, then the adviser may instead elect to register with the SEC.

Advisers to Venture Capital Funds

The Dodd-Frank Act provides for an exemption from registration for investment advisers that act solely as advisers to one or more venture capital funds. Within one year after the enactment of the legislation, the SEC must issue final rules to define the term "venture capital" for purposes of this exemption. Despite the exemption from registration, advisers to venture capital funds must maintain records and provide the SEC with reports as the SEC "determines necessary or appropriate in the public interest or for the protection of investors."

Foreign Private Advisers

The legislation provides a limited exemption for "foreign private advisers." A foreign private adviser under the Dodd-Frank Act revision is an investment adviser that (1) does not have a place of business in the U.S., (2) does not have more than $25 million of aggregate AUM attributable to U.S. clients and to U.S. investors in private funds, (3) has fewer than 15 clients in the U.S., and (4) does not hold itself out generally to the public in the U.S. as an investment adviser, nor acts as an investment adviser to any registered investment company or business development company.

Family Offices

Under the Dodd-Frank Act "family offices" are excluded from the definition of investment adviser. The SEC is required to promulgate a definition of "family office." The SEC's definition, which has no timetable for issuance, must (1) be consistent with previous exemptive policy of the SEC for family offices, (2) recognize the range of organizational, management and employment structures and arrangements employed by family offices, and (3) contain a grandfathering provision that permits family offices to provide investment advice to third parties with regard to engagements entered into prior to January 1, 2010.

Advisers to SBICs

The Dodd-Frank Act provides an exemption from registration for any investment adviser that solely advises "small business investment companies" ("SBICs"), licensed under the Small Business Investment Act of 1958. The exemption also applies to advisers to entities that are currently in the process of qualification as a SBIC with the Small Business Administration. Such exemption does not apply to an adviser that has elected to be regulated or is regulated as a "business development company" pursuant to Section 54 of the Investment Company Act.

Accredited Investor and Qualified Client Standards

Under the Dodd-Frank Act, the $1 million net worth standard for accredited investors under Regulation D of the Securities Act of 1933, as amended, excludes the value of the primary residence of the person. Unlike most of the provisions of the Dodd-Frank Act, which are effective one year after enactment, this provision goes into effect immediately. It will be subject to review and adjustment by notice and comment rulemaking every four years.

Similarly, Section 418 of the Dodd-Frank Act requires the SEC to amend Section 205(e) of the Advisers Act (the qualified client standard) in order to adjust for inflation. Such adjustment by the SEC must occur within one year of enactment and every five years thereafter. Each adjustment must be in multiples of $100,000.

Required Reports, Examinations, and Disclosures

The Dodd-Frank Act requires the SEC to establish reporting requirements for advisers to private funds within one year of the legislation's enactment. Further, the Act subjects such records to examination by the SEC. The records and reports required to be maintained by investment advisers and subject to inspection and examination by the SEC include:

  • the amount of assets under management and the use of leverage, including off-balance sheet leverage;
  • counterparty credit risk exposure;
  • trading and investment positions;
  • valuation policies and practices of the fund;
  • types of assets held;
  • side arrangements or side letters;
  • trading practices; and
  • such other information determined necessary and appropriate by the SEC in consultation with the Financial Stability Oversight Council (the "Council").

This provision of the Dodd-Frank Act requires that the SEC establish a schedule and conduct periodic inspections of such records maintained by investment advisers. The SEC may conduct additional, special examinations of such records at any time as the SEC may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

Confidentiality

All records and reports disclosed by investment advisers to the SEC under Title IV of the Dodd-Frank Act will be treated as confidential. The SEC must, however, make available to the Council all reports, documents, records, and information filed with or provided to the SEC by an investment adviser as the Council may consider necessary for the purpose of assessing "systemic risk" posed by a private fund. The Council is exempt from the ambit of the Freedom of Information Act with respect to any information made available to the Council under this provision of Title IV of the Dodd-Frank Act. This provision does not permit the SEC or the Council to withhold information from Congress based upon a confidentiality agreement nor does it prevent the SEC from complying with a request for information from any other federal department, agency, or self-regulatory organization requesting the information for purposes within the scope of such agency's jurisdiction. The SEC and the Council also may not refuse to comply with an order of a U.S. court in an action brought by the United States government or by the SEC.

GAO and SEC Studies

The Dodd-Frank Act requires the Government Accountability Office (the "GAO") to conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds and submit a report to Congress within one year after the date of enactment. Within three years of enactment, the GAO must conduct and submit to Congress the findings of a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds. Within two years of enactment, the SEC's Division of Risk, Strategy and Financial Innovation must conduct and submit to Congress the findings of a study on the state of short selling on national securities exchanges and in the over-the-counter markets.

Conclusion

Title IV of the Dodd-Frank Act alters the regulatory landscape applicable to our investment adviser and investment fund clients. This legislation requires a thorough review of nearly every aspect of compliance with the various securities laws applicable to investment advisers of private funds. Day Pitney attorneys are readily available to provide guidance in this area and to ensure that our clients smoothly transition into compliance with the new requirements of the Dodd-Frank Act. Please feel free to contact any of the members of our Private Equity and Investment Funds group to discuss aspects of the how the Dodd-Frank Act may apply to you.

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SEC Proposed Rules amending Investment Advisor Act


On November 19, 2010, the US Securities and Exchange Commission (“SEC”) proposed rules (the “Release”)[1] interpreting certain exemptions from the registration requirements of the Investment Advisers Act of 1940, as amended (the “Advisers Act”) for advisers to privately offered investment funds. The registration exemptions - covering venture capital funds, advisers to private funds with a limited amount of assets under management in the US, and certain foreign advisers - were originally signed into law by President Obama on July 21, 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Dodd-Frank Act”).[2]

The Release provides much awaited interpretive guidance to US and non-US investment advisers seeking to rely on the following exemptions:

  • Venture Capital Exemption: The Dodd-Frank Act provides that an investment adviser that solely advises venture capital funds is exempt from registration under the Advisers Act and directs the SEC to define the term venture capital fund (the “Venture Capital Exemption”). The Release proposes a new rule providing a definition of the term “venture capital fund” and seeks commentary on how the Venture Capital Exemption will apply to non-US investment advisers. An O’Melveny & Myers Client Alert addressing the Venture Capital Exemption will be forthcoming this week.
  • US$150 Million Assets under Management Exemption: The Dodd-Frank Act provides an exemption from registration to any investment adviser that solely advises private funds[3] if the adviser had assets under management in the US of less than US$150 million (the “De Minimis Exemption”). The Release proposes a new rule which includes provisions for determining the amount of an adviser’s private fund assets for purposes of the De Minimis Exemption and when those assets are deemed managed in the US for both US and non-US advisers.
  • Foreign Private Adviser Exemption: The Dodd-Frank Act provides an exemption from registration for “foreign private advisers” that (i) have no place of business in the US, (ii) do not generally hold themselves out to the public in the US, (iii) have fewer than 15 clients and investors in the US, and (iv) have less than US$25 million of aggregate assets under management attributable to clients and investors in the US in private funds (the “Foreign Private Adviser Exemption”). The Release proposes a new rule clarifying the application of the Foreign Private Adviser Exemption and defining a number of key terms.

SEC approves new ADV Part 2

The Securities and Exchange Commission today voted unanimously to adopt changes to the principal disclosure document that SEC-registered investment advisers must provide to their clients and prospective clients.

Form ADV, Part 2 — commonly referred to as the “brochure” — explains to the investor an investment adviser’s qualifications, investment strategies, and business practices.

The brochure in its current format requires advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format that frequently does not correspond well to an adviser’s business. In some cases, the required disclosure may not describe the adviser’s business or conflicts in a way that is truly accessible to the investor.

“These changes are designed to provide clients with greater information about the individuals who will provide them with investment advice,” said SEC Chairman Mary L. Schapiro. “These amendments will help transform the brochure into a plain English narrative that is well-suited to serve investors’ needs and describes the adviser’s conflicts, compensation, business activities, and disciplinary history.”

The amendments adopted by the SEC will:

Improve the format and update the requirements of the brochure.

Expand the content to better include details most relevant to the clients of investment advisers.

Require brochure “supplements” to be delivered to new and prospective clients to give resume-like information about the individuals at an investment advisory firm who will provide services to the clients.

Ensure investors have easy access to the brochures as investment advisers are required to file them electronically for posting on the SEC’s website. Many state-registered investment advisers also currently file Form ADV with their regulators. The Commission authorized the staff to delay publication of the revised Form ADV, Part 2 for five business days in order to work with the states to accommodate technical, state-specific changes to the items and instructions of the form. This process would enable publication of Form ADV, Part 2 as a uniform SEC-state form.

The amended rules and forms will be effective 60 days after publication in the Federal Register. Most investment advisers will begin distributing and publicly posting new brochures in the first quarter of 2011.

  • FACT SHEET

Overview

When individuals consider whether to hire a particular investment adviser, they often have basic questions about the professional who may be advising them. That is why, for 21 years, investment advisers registered with the SEC have been required to provide new and prospective clients with a brochure explaining the adviser’s qualifications, investment strategies, and business practices.

Under existing rules, advisers can satisfy this requirement either by providing clients with the portion of the registration form — known as Part 2 of Form ADV — that contains this information, or by creating a separate document that includes the information required by that form.

Currently, Part 2 requires advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format. Unfortunately, that format frequently does not correspond well to an adviser’s business. And, in some cases, the required disclosure may not describe the adviser’s business or conflicts in a user-friendly manner.

Today, the Commission is considering adopting amendments to Part 2 of Form ADV and related rules that will substantially improve the quality of the disclosure advisers provide to their clients.

Under the new rules, advisers will have to provide new and prospective clients with narrative brochures that are organized in a consistent, uniform manner and that include plain English disclosures of the adviser’s business practices, fees, conflicts of interest, and disciplinary information. Advisory firms also must provide “brochure supplements” to clients containing information about the employees who will provide the advisory services to that client.

The Amendments

Improved Format and Updating Requirements. Advisers are required to prepare a narrative, plain English, brochure, presented in a consistent, uniform manner that will make it easier for clients to compare different advisers’ disclosures. The clear and concise narrative descriptions provided in the brochure will improve the ability of clients and prospective clients to evaluate advisers and to understand conflicts of interest that the firms and their personnel face, the effects of those conflicts on the firms’ services, and the steps the adviser takes to address the conflicts.

Advisers must deliver the brochure to a client before or at the time the adviser enters into an advisory contract with the client. In addition, advisers must provide each client an annual summary of material changes to the brochure and either deliver a complete updated brochure or offer to provide the client with the updated brochure.

Expanded Content. The new brochure addresses those topics the Commission believes are most relevant to clients, including:

Advisory business — An investment adviser must describe its advisory business, including the types of advisory services offered, state whether it holds itself out as specializing in a particular type of advisory service, and disclose the amount of client assets that it manages.

Fees and compensation — An investment adviser must describe how it is compensated for its advisory services, provide a fee schedule, and disclose whether fees are negotiable. The investment adviser must also describe the types of other fees or expenses, such as brokerage fees, custody fees, and fund expenses that clients may pay in connection with the services provided.

Performance-based fees and side-by-side management — An investment adviser that accepts performance-based fees, or that supervises an individual who accepts such fees, is required to disclose this fact. If the investment adviser also manages accounts that are not charged a performance fee, the adviser must explain the conflicts of interest that arise from the simultaneous management of these accounts and must describe how it addresses those conflicts.

Methods of analysis, investment strategies, and risk of loss — An investment adviser must describe its methods of analysis and investment strategies and explain that investing in securities involves risk of loss which clients should be prepared to bear. Investment advisers who use a particular method of analysis or strategy or who recommend a particular type of security are required to explain the material risks involved and discuss the risks in detail if those risks are unusual.

Disciplinary information — An investment adviser is required to disclose in its brochure material facts about any legal or disciplinary event that is material to a client’s evaluation of the advisory business or to the integrity of its management personnel. An investment adviser must deliver promptly to clients updated information when there is new disclosure of a disciplinary event or a material change to an existing disciplinary event.

Code of ethics, participation or interest in client transactions, and personal trading — An investment adviser is required to describe briefly its code of ethics and state that a copy is available upon request. The adviser must also disclose whether it or an affiliate recommends to clients, or buys or sells for client accounts, securities in which the adviser or an affiliate has a material financial interest and, if so, the conflicts of interest associated with that practice. The adviser also must disclose whether it or an affiliate invests (or is allowed to invest) in the same securities that it recommends to clients or in related securities, such as options or other derivatives, and must explain the conflicts involved and how it addresses those conflicts. In addition, an investment adviser that trades in the recommended securities at or around the same time as the client has to explain the specific conflicts inherent in that practice and how it addresses them.

Brokerage practices — An investment adviser is required to describe the factors considered in selecting or recommending broker-dealers for client transactions and determining the reasonableness of brokers’ compensation. Investment advisers also must disclose soft dollar practices (research or other products or services, other than execution, provided by brokers or a third party to the investment adviser in connection with client transactions); client referrals (using client brokerage to compensate brokers for client referrals); directed brokerage (asking or permitting clients to send trades to a specific broker for execution); and trade aggregation (bundling trades to obtain volume discounts on execution costs). Investment advisers must explain how they address the various conflicts of interest associated with these practices.

Supplements. An adviser is required to deliver “brochure supplements” to new and prospective clients providing them with information about the specific individuals who will provide services to the clients. The supplement will contain brief résumé-like disclosure about the educational background, business experience, other business activities, and disciplinary history of the individual, so that the client can assess the person’s background and qualifications. It will also include contact information for the person’s supervisor in case the client has a concern about the person.

Internet Availability. Advisers are required to electronically file brochures, which will be publicly available on the SEC’s website.


A full decade after first proposing to revamp form ADV Part 2, the Securities and Exchange Commission is set to approve revisions to this key disclosure document this week.

Adviser groups for years have been urging the SEC to take action on the redesign of the ADV Part 2. They contend that the new narrative form will be more investor-friendly than the old check-the-box format.

The ADV Part 2 includes information on business practices, conflicts of interest and background of individual advisers and advisory firm personnel who work with clients.

The plan is to disclose ADV Part 2 on the SEC's website rather than simply requiring advisers to give it to new clients. Advisers will have to prepare “plain-English" written narratives for the new form.

The change "will require a significant effort by all investment advisers to revise their current Part 2 forms," David Tittsworth, executive director of the Investment Adviser Association, wrote in an e-mail.

The SEC is scheduled to vote on the new adviser registration form at its open meeting this Wednesday.

In recent weeks, regulators have taken other steps to harmonize the disciplinary disclosures of advisers and brokers. In June, state regulators rolled out an online disclosure system for advisers similar to the BrokerCheck system run by the Financial Industry Regulatory Authority Inc. The system covers all individual advisers, regardless of whether their advisory firms are registered with the SEC or a state.

This month, the SEC approved a Finra rule to increase the amount of disciplinary information disclosed through BrokerCheck.

Together, the changes make similar the amount of data disclosed online about both brokers and advisers.

SEC proposes new rule on family offices

The Securities and Exchange Commission today proposed a new rule, based on requirements under the Dodd-Frank Wall Street Reform and Consumer Protection Act, that would help those managing their own family's financial portfolios determine whether their "family offices" can continue to be excluded from the Investment Advisers Act of 1940.

Family offices are entities established by wealthy families to manage their money and provide tax and estate planning and similar services.

Historically, family offices have not been required to register with the SEC under the Advisers Act because of an exemption provided to investment advisers with fewer than 15 clients. The Dodd-Frank Act removes that exemption 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.

The Commission is proposing to define a family office as any firm that:

  • Provides investment advice only to family members, as defined by the rule; certain key employees; charities and trusts established by family members; and entities wholly owned and controlled by family members.
  • Is wholly owned and controlled by family members.
  • Does not hold itself out to the public as an investment adviser.

Public comments on the proposed rule should be received by the Commission by Nov. 18, 2010.

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