By Anne-Marie Godfrey, Amy Natterson Kro
On July 21, 2010, President Barack Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the “Reform Act”) into law, bringing about sweeping changes to the regulation of the U.S. financial system, many of which will directly impact investment advisers and fund managers who have their office and principal place of business outside the U.S. (“Non-U.S. Managers”). The full impact of these changes will emerge over the next several years as U.S. agencies undertake the extensive rulemaking mandated in the Reform Act.
Elimination of “ Private Adviser” Exemption
The Reform Act amends the U.S. Investment Advisers Act of 1940 (the “Advisers Act”), and eliminates, effective July 2011, the “private adviser” exemption commonly relied on by Non-U.S. Managers that do not wish to register with the U.S. Securities and Exchange Commission (the “SEC”). The “private adviser” exemption was available to a Non-U.S. Manager if‚ inter alia it advised fewer than 15 “clients” resident in the U.S. during the preceding 12 months and neither held itself out to the public in the U.S. as an investment adviser nor acted as an investment adviser to any investment company registered under the U.S. Investment Company Act of 1940‚ as amended (the “1940 Act”), or any entity electing to be treated as a business development company under the 1940 Act (each registered fund and business development company under the 1940 Act, a “1940 Act Fund”). For purposes of the 15 client limit, each fund advised by the Non-U.S. Manager counted as a single client and the U.S. investors in such fund were not counted as separate clients.
The Reform Act provides for a narrower “foreign private adviser” exemption that exempts a Non-U.S. Manager from registration under the Advisers Act provided that it (a) has no place of business in the U.S; (b) has, in aggregate, less than US$25 million (or such higher amount as the SEC may determine) in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds that it manages; (c) has fewer than 15 clients and investors in the U.S. in private funds which it advises; and (d) neither holds itself out generally to the public in the U.S. as an investment adviser nor acts as an investment adviser to any 1940 Act Fund.
Many Non-U.S. Managers that previously relied on the “private adviser” exemption are unlikely to qualify for the “foreign private adviser” exemption, given the low US$25 million threshold. Furthermore, under the new “foreign private adviser” exemption, the ultimate U.S. investors in the funds advised by a Non-U.S. Manager will be counted towards the 15 person limit. The SEC may consider raising the US$25 million threshold, although there is no assurance that it will do so.
Non-U.S. Managers should consider if they qualify for other Reform Act exemptions from Advisers Act registration, such as new exemptions available to advisers solely to (a) private funds if such advisers have assets under management in the U.S. of less than US$150 million or (b) “Venture Capital Funds”. The SEC must define“Venture Capital Funds” by July 2011, and, until it does, the scope of the Venture Capital Fund exemption will be unclear. Non-U.S. Managers currently relying on the “private adviser”exemption, and who do no qualify for an alternative exemption, are required to register by July 2011.
The Reform Act imposes new disclosure and recordkeeping requirements, including on some investment advisers that are not required to register with the SEC. A Non-U.S. Manager that registers with the SEC must observe, at least with respect to its U.S. clients, the applicable SEC regulatory requirements, including implementing compliance policies and procedures, maintaining certain books and records, making publicly available filings with the SEC, accepting periodic SEC examinations, and adopting and enforcing detailed codes of ethics and personal trading rules for their personnel.
The Volcker Rule
The Reform Act amends the U.S. Bank Holding Company Act of 1956 to generally prohibit a “banking entity” from, (a) acquiring or retaining ownership interests in hedge funds and private equity funds and (b) engaging in proprietary trading (the“Volcker Rule”). The Volcker Rule potentially reaches many Non-U.S. Managers as the definition of “banking entity” includes any affiliate or subsidiary of a U.S. insured depository institution and also of any company that controls an insured depository institution (a “bank holding company”) — which includes those non-U.S. holding companies that own or control U.S. banks — or that is treated as a bank holding company for purposes of the International Banking Act of 1978. The Reform Act does not prohibit a banking entity from acquiring, retaining and sponsoring hedge and private equity funds “solely” outside the U.S. provided that (a) such funds are not offered to U.S. persons, and (b) the banking entity is not directly or indirectly controlled by a banking entity organized under the laws of the U.S. or one or more U.S. states.
As a result of the above, banking entities regulated by the Federal Reserve System (the “FED”) may be required to redeem certain of their holdings in hedge and private equity funds in the future. Non-U.S. Managers to such funds should examine their organizational documents and fund-related contracts (e.g. investor “side letters”) to determine how the redemption, sale and/or transfer of affected fund interests may be effected.
The Reform Act does not prohibit proprietary trading by non-U.S. banking entities that are not controlled, directly or indirectly, by a banking entity that is organized under the laws of the U.S. or one or more of the States, if the non-U.S. banking entity’s activities are conducted exclusively outside the U.S. with non-U.S. persons. If a Non-U.S. Manager or its advised funds are directly or indirectly controlled by a U.S. banking entity, such as a bank holding company or another banking entity, including a U.S. subsidiary or affiliate of a U.S. banking entity, then the Non-U.S. Manager and its advised funds may need to consider whether the Volcker Rule could impact current trading activities. As readers may have noted, many U.S. banking entities are moving to divest their interests in hedge and private equity funds, in part to allow those funds to continue to function unfettered by the Volcker Rule as well as in anticipation of the prohibition on holding interests in such funds.
The Reform Act requires rulemaking implementing the Volcker Rule to be effective no more than two years after the effective date of the Reform Act except that the FED or othe regulators can extend effectiveness for up to three one-year periods and on a case-by-case basis, the FED can grant a one time five-year extension for the divestiture of “illiquid funds” held by a banking entity.
Nonbank financial companies that are supervised by the FED are not prohibited from engaging in proprietary trading or from acquiring or retaining ownership interests in hedge and private equity funds. The Volcker Rule does direct regulators, however, to adopt rules imposing additional capital requirements for and additional quantitative limits with regard to such activities.
To the extent that the Volcker Rule could impact the activities of Non-U.S. Managers, the rulemaking process being undertaken by U.S.agencies, in particular the FED, provides an opportunity for Non-U.S. Managers to meet with regulators now and explain how the regulations implementing the Volcker Rule could be drafted to minimize unintended impact on activities outside the U.S.
Primary Residence Now Excluded from “Accredited Investor” Test
Non-U.S. Managers relying on Regulation D under the U.S. Securities Act of 1933 (“Regulation D”) to offer securities to high net worth individuals in the U.S. on a private placement basis without registering the offering with the SEC will be impacted by changes to the “accredited investor” test. An “accredited investor”, as defined in Regulation D, includes among others, individual investors with a net worth, or joint net worth with their spouse, that exceeds US$1 million (“Net Worth Threshold”). The Reform Act, effective upon enactment, prohibits including the value of individuals’ primary residence in determining whether they have sufficient net worth, or joint net worth with their spouse, to meet the Net Worth Threshold. At the same time, the SEC has taken the position that any indebtedness secured by an individual investor’s primary residence (up to its fair market value) may be excluded from the calculation of the Net Worth Threshold.
The Reform Act requires the SEC to maintain the Net Worth Threshold at US$1 million (excluding the value of the investor’s primary residence) until 2014. Starting in 2014, the SEC is authorized to review the definition of “accredited investor” as it applies to natural persons, and to make any necessary changes at least once every four years.
Non-U.S. Managers may need to revise their offering and subscription documents for private funds they manage to address these changes.
Adjusting the “Qualified Client” Test for Inflation
The Advisers Act generally prohibits SEC registered investment advisers
from charging performance fees. However, an exemption is available that generally permits registered investment advisers to charge performance fees to“qualified clients”, which are defined to include natural persons or companies (a) with at least US$750,000 under management with the adviser immediately after entering into such advisory relationship, (b) with a net worth of more than US$1.5 million (including assets held jointly with a spouse), and (c) that are“qualified purchasers” under the 1940 Act. The Reform Act amends the Advisers Act to require the SEC, within one year after the enactment of the Reform Act and every 5 years thereafter, to adjust the US$750,000 and US$1.5 million thresholds for inflation when determining a client’s status as a “qualified client”. Non-U.S. Managers who are registered with the SEC may need to revise their offering and subscription documents for private funds they manage to address these provisions.
The Reform Act replaces the handsoff approach to OTC derivatives previously found in U.S. laws with requirements for regulation of products, markets and market participants. The new laws and implementing regulations will impact products defined generally as “swaps” that include swaps, options forwards and similar products the value of which relate to, among other things, rates, currencies, commodities, indices and other financial or economic interests. “Securities-based swaps”, defined as swaps based on narrow-based indices, single securities or events related to single issuers or narrow groups of issuers also will be impacted.
The Commodity Futures Trading Commission (“CFTC”) will regulate swaps, the SEC will regulate securities-based swaps, and “mixed swaps” with characteristics of both will be regulated according to rules adopted jointly, in consultation with the FED.
The regulatory scheme for swap activities, once rulemaking is completed, will include centralized clearing for swaps and securitiesbased swaps designated by the CFTC and SEC. In addition, swap dealers and major swap dealers will be required to disclose to counterparties material risks, conflicts of interest, incentives and assigned values for swaps and securities-based swaps.
The Reform Act excludes from CFTC jurisdiction swaps and swap activities outside the U.S., unless they have a “direct and significant”connection with activities in or effect on U.S. commerce, and excludes from SEC jurisdiction securitiesbased swap activities outside the U.S. unless the transactions were in contravention of rules prescribed to prevent evasion of the Reform Act. The Reform Act nevertheless likely will affect Non-U.S. Managers that use swaps and securitiesbased swaps. In the U.S., Non-U.S. Managers likely will find that many OTC products will become centrally cleared and will begin to trade like other market-based products. Furthermore, outside the U.S. similar changes are likely in other money-centre jurisdictions, resulting in fundamental global changes in the way that derivatives are purchased and traded.
The Reform Act has the potential to increase significantly the compliance obligations of Non-U.S. Managers. Non-U.S. Managers should consider the potential impact of the Reform Act on their businesses and in particular, should assess if they are required to register with the SEC or take other steps to comply with the requirements of the new regime.
Whilst every effort has been made to ensure the accuracy of this article, it is for general guidance only and should not be treated as a substitute for specific legal advice
By Anne-Marie Godfrey, Amy Natterson Kro