Impact of Dodd-Frank on Hedge and Private Equity Funds
By Mark Shaffer and Don Snyder
The passage of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Pub. L. 111-203 (2010)), enacted on July 21, 2010 (the “Act”), will affect every financial institution in the country, big and small. Financial institutions and other entities face new regulations in the fields of banking, securities, derivatives, executive compensation and others. While the reach of the Act is clearly very broad, this article will focus on the Act’s impact on hedge funds and private equity funds (“Funds”), which will experience government regulation in ways they have not previously. Except where otherwise specified, the Act’s provisions take effect on July 21, 2011.
The Act’s changes affect several aspects of private fund activity. For example, several types of products commonly used by Funds, such as swaps, derivatives and asset-backed securities, are now subject to greater government oversight, rulemaking and future regulation. However, no change will be a dramatic as the new registration requirements for Funds and their corresponding recordkeeping and reporting obligations.
Prior to the Act, most fund advisors relied upon the “private investment adviser” exemption contained in the Investment Adviser’s Act to avoid registration as an investment advisor. Pursuant to this exemption, an advisor who had fewer than 15 clients during the course of the preceding 12 months (under this exemption, each fund is counted as a single client) and did not hold itself out to the public was exempt from registration. The Act eliminates this exemption and specifically states that “private fund” advisors – those advising a fund that would be an investment company but for the exemptions contained in sections 3(c)(1) or 3(c)(7) of the Investment Company Act – are no longer exempt from registration unless they meet a further exemption under the Act.
The Act then details certain advisors who may remain exempt from registration. These advisors include: foreign private advisors, venture fund investment advisors (to be defined by the SEC), investment advisors to “family offices” (to be defined by the SEC) and investment advisors who “solely” advise private funds with an aggregate amount (per such advisor) of less than $150 million in assets in the United States (these advisors will be required to keep certain records, and will periodically have to provide informational records to the SEC).
The elimination of this exemption will require many previously exempt advisors to register. While it is true that exempt advisors were always required to comply with the Investment Advisers Act’s anti-fraud provisions, registered advisors have to comply with additional compliance obligations, including, among others: appointing a chief compliance officer, establishing a compliance program and complying with certain advertising restrictions. In addition to these new obligations resulting from registration, the Act imposes new recordkeeping and reporting requirements on registered advisers. For example, among other things, registered advisers must report to the SEC: their assets under management; their use of leverage (including off-balance sheet); counterparty credit risk exposure; trading and investment positions; valuation policies; trading practices and types of assets held.
In addition to these potentially onerous new registration, recordkeeping and reporting requirements imposed on Funds by the Act, the Act also changes the definition of an “accredited investor.”
In order to avoid registering its offering and its securities pursuant to the Securities Act and having to comply with the requirements that attach to such registration, most Funds rely upon one of the exemptions from registration found in Regulation D of the Securities Act, the most common being the exemption under Rule 506. Pursuant to this exemption, a company can raise an unlimited amount of money from an unlimited number of investors so long as, among other criteria, each investor is an “accredited investor” as defined in Rule 501. The Act modifies this definition as applied to an individual investor, excluding the value of a primary residence for the purpose of calculating whether an individual has a net worth of $1 million or more. The SEC is also required to revisit the definition of an “accredited investor” every 4 years, reviewing and modifying the standard “as appropriate for the protection of investors, in the public interest, and in light of the economy.” This change may not be a problem for large Funds, whose investors are generally institutional investors, but could be very relevant for employee investments in Funds and for “friends and family” type funds.
So, the bottom line is that previously exempt advisors of private funds need to determine whether they meet any of the new exemptions provided by the Act, or whether they now need to register. And if they do need to register, they need to ensure that that have in place the appropriate policies and procedures to comply with the governance, recordkeeping and reporting obligations that come with such registration.
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Mark Shaffer is counsel with Gabbard & Kamal LLP. Don Snyder is a law clerk with the firm, and is not yet admitted to the Bar.