Will Wait for SEC Final Registration Regulations to Propose New Rules
California currently has an exemption from the registration requirements for certain fund managers with more than $25M of AUM (Rule 260.204.9). Back in March California requested input from the investment management community on how they might change the registration requirements when the SEC finalizes its IA registration rules as a result of the Dodd-Frank act. At that time it was expected that the SEC would finalize its IA registration rules in time for managers to register before the July 21, 2011 registration deadline. However, the SEC subsequently indicated that it would likely extend the registration deadline until the first quarter of 2012. From this story by IA Watch, it looks like the Division of Investment Management is moving closer to officially moving the registration deadline to next year.
Because of the uncertaintly of rulemaking at the federal level, the states are left in limbo as to how to proceed with respect to fund managers who may or may not fit under certain exemptions after the federal laws
become effective (even if new federal rules are not yet effective). California is addressing this exact scenario in a letter it addressed the investment management community on May 13, 2011. The letter states:
“some uncertainty may exist about the need to become registered after July 21, 2011, for California IAs who are currently unregistered, in reliace on the existing exemption set forth in Rule 260.204.9.”
The letter goes on to state:
“The Department will soon issue emergency regulations to address this potential uncertainty. These emergency regulations will amend Rule 260.204.9, but have the effect of preserving the status quo. Therefore, California IAs who currently rely on the exemption from registration for private advisers, will be able to continue to rely on that exemption until such time as the Deparment adopts final rules related to private fund advisers.”
This is good news for current managers located in California and relying on the exemption from registration in California. We believe that other states (such as Connecticut which has a similar exemption) will soon follow California and release emergency regulations to deal with issues related to the failure of the SEC to finalize the IA registration regulations. Until the SEC does issue final regulations, it would seem that states would (or probably should) stop proposing changes to state regulations (see previous post on Massachusetts proposed changes).
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Cole-Frieman & Mallon LLP is a law firm focused on the investment management industry. The firm provides investment adviser registration services to hedge funds and other investment managers. Bart Mallon can be reached directly at 415-868-5345.
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Higher Threshold for Performance Fee Proposed
Under current SEC Rule 205-3, an SEC registered investment adviser can charge a performance fee (also called a performance allocation, incentive fee or incentive allocation) only to those investors who either has:
- a $1.5M net worth or
- at least $750,000 in assets with the manager
Many states have the same rules for state registered advisers or they explicitly make reference to the SEC regulation.
As a result of the Dodd-Frank act, the SEC is now proposing to increase the threshold for managers to be able to charge these performance fees. The proposal declares that clients or investors of an SEC registered investment adviser can be charged a performance fee only if the client has:
- a $2M net worth (excluding a primary residence) or
- at least $1M in assets with the manager
What this means for SEC Registered Managers
While there will likely be a grandfathering provision for current fund managers with current investors who are “qualified clients”, when the new regulations go into effect, SEC registered managers (and potentially state registered managers) will likely need to make sure new investors meet the new threshold in order to charge these investors a performance fee. Additionally, managers will need to update their offering documents to reflect the new definition (reprinted in full as proposed below).
The new regulation is likely to affect smaller funds disproportionally. Many times smaller funds have investors who may just meet the qualified client threshold. [Note: for some managers, they may allow non-qualified clients into the fund, but then just charge them a higher management fee in lieu of a performance allocation.]
Managers are urged to send comments to the SEC. The comment period is open until July 11, 2011.
The SEC notice can be found here.
The full proposed rule can be found here: Performance Fee Rule Proposal.
Current comments on the proposal can be found here.
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Proposed Changes to Rule 205-3
Section 275.205-3 is amended by:
a. Revising paragraph (c);
b. Revising paragraphs (d)(1)(i) and (ii); and
c. Adding paragraph (e).
The revisions and addition read as follows.
§ 275.205-3 Exemption from the compensation prohibition of section 205(a)(1) for investment advisers.
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(c) Transition rules.
(1) Registered investment advisers. If a registered investment adviser entered into a contract and satisfied the conditions of this section that were in effect when the contract was entered into, the adviser will be considered to satisfy the conditions of this section; Provided, however, that if a natural person or company who was not a party to the contract becomes a party (including an equity owner of a private investment company advised by the adviser), the conditions of this section in effect at that time will apply with regar
d to that person or company.
(2) Registered investment advisers that were previously exempt from registration. If an investment adviser was exempt from registration with the Commission pursuant to section 203 of the Act (15 U.S.C. 80b-3), section 205(a)(1) of the Act will not apply to an advisory contract entered into when the adviser was exempt, or to an account of an equity owner of a private investment company advised by the adviser if the account was established when the adviser was exempt; Provided, however, that section 205(a)(1) of the Act will apply with regard to a natural person or company who was not a party to the contract and becomes a party (including an equity owner of a private investment company advised by the adviser) when the adviser is no longer exempt.
(d) Definitions. For the purposes of this section:
(1) The term qualified client means:
(i) A natural person who, or a company that, immediately after entering into the contract has at least $1,000,000 under the management of the investment adviser;
(ii) A natural person who, or a company that, the investment adviser entering into the contract (and any person acting on his behalf) reasonably believes, immediately prior to entering into the contract, either:
(A) Has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,000,000, excluding the value of the primary residence of such natural person, calculated by subtracting from the estimated fair market value of the property the amount of debt secured by the property, up to the estimated fair market value of the property; or
(B) Is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940 (15 U.S.C. 80a-2(a)(51)(A)) at the time the contract is entered into; or
* * * * *
(e) Inflation adjustments. Pursuant to section 205(e) of the Act, the dollar amounts specified in paragraphs (d)(1)(i) and (d)(1)(ii)(A) of this section shall be adjusted by order of the Commission, effective on or about May 1, 2016 and issued approximately every five years thereafter. The adjusted dollar amounts established in such orders shall be computed by:
(1) Dividing the year-end value of the Personal Consumption
Expenditures Chain-Type Price Index (or any successor index thereto), as published by the United States Department of Commerce, for the calendar year preceding the calendar year in which the order is being issued, by the year-end value of such index (or successor) for the calendar year 1997;
(2) For the dollar amount in paragraph (d)(1)(i) of this section, multiplying $750,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000; and
(3) For the dollar amount in paragraph (d)(1)(ii)(A) of this section, multiplying $1,500,000 times the quotient obtained in paragraph (e)(1) of this section and rounding the product to the nearest multiple of $100,000.
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Cole-Frieman & Mallon LLP is a hedge fund law firm focused on the investment management industry. Bart Mallon can be reached directly at 415-868-5345.
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Story of the CME & CBOT Merger
Just a quick note to say I recently picked up the book Zero-Sum Game by Erika S. Olson. Olson is, at the time the story begins, a newly hired managing director of marketing for the Chicago Board of Trade and she chronicled her experiences during the merger of the CBOT and the Chicago Mercantile Exchange in 2007. In addition to detailing her experiences, she provides background information on many of the major players in the negotions and on events that transpired in the nine months following the merger announcement.
For me some of the more interesting parts of the story include:
- Jeff Sprecher’s moves to get the ICE involved in the merger/acquisition discussion [note: some of the marketing tactics remind me of the tactics Marc Benioff used against Siebel, as described in Behind the Cloud]
- The story of the CBOT Class B Shareholders and their CBOE ERPs (would have actually liked to read more about this)
- Story of Caledonia and ownership of memberships at a number of exchanges; their involvement near the proxy vote
- Discussion of John Lothian's commentary throughout merger negotiations
Of course, with any narrative that involves someone from outside the futures industry, there are the funny anecdotes of being introduced to some of Chicago’s more colorful characters – the traders. (For an up close look at some of these personalities, Floored is a great movie…)
Overall I thought it was a good, quick read that shed a bit of light into what was going on during the merger. I thought Olson had a great voice and told the story well, but I was left wanting more detail and background into certain situations.
For more on the book, see the Futures Magazine review.
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Cole-Frieman & Mallon LLP provides
full legal services to the managed futures industry. Bart Mallon can be reached directly at 415-868-5345.
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Massachusetts Proposes Registration Requirement for 3(c)(1) Fund Managers
As we discussed earlier in our post of state regulation of expert networks, the states are beginning to propse rules for investment advisers based on changes to the federal securities laws as a result of the Dodd-Frank Act (see California Request for Comments). The purpose of the rule changes at the state level are to create a uniform system of regulatory oversight of advisers and to avoid a form of regulatory arbitrage. That is, if the state laws remained the same after the federal laws go into effect, many smaller fund managers could remain unregistered.
Massachusetts, which has a current investment adviser registration exemption for certain hedge fund managers, is proposing to essentially eliminate any registration exemption for hedge fund managers, except for those managers to Section 3(c)(7) funds. This means that if the Massachusetts proposed regulations (reprinted below) are adopted as proposed, all Section 3(c)(1) hedge fund managers in Massachussets will need to register as investment advisers in order to continue accepting assets.
Proposed Regulations Overview
There are two main parts of the new proposed rules:
1. Change in the definition of “institutional buyer”. The current MA regulations exempt managers from the registration requirements if they only provide investment advice to “institutional buyers”. The term “institutional buyer” currently includes hedge funds with only accredited investors who contribute at least $50,000 to the fund. The new definition will essentially erase hedge funds from the definition of institutional buyer. There is a grandfathering provision for managers which currently rely on the exemption; however, those managers will not be able to accept any new investors into their funds
and they will not be able to allow existing investors to add additional subscription amounts (unless the manager subsequently registers as an investment adviser).
2. Exemption for Certain Exempt Reporting Advisers. An Exempt Reporting Adviser is a fund manager which is not registered with the SEC becasue the manager has less than $150M of AUM. For managers that are (i) exempt reporting advisers, (ii) located in Massachusetts and (iii) provide investment advice to one or more Section 3(c)(7) funds, an exemption from registration in Massachusetts is available if:
- The firm and the representatives are not subject to certain “disqualification” provisions
- The firm files the Exempt Reporting Adviser form with the commonwealth of Massachusetts (probably electronically through the IARD)
- The firm pays a fee to the Securities Division
What This Means
Essentially fund managers who are located in Massachussets will need to register with the Securities Division (unless the manager provides advice only to Section 3(c)(7) funds). Registration generally will take about two months and the firm and representatives will face certain regulatory requirements such as maintaining a bond and taking certain proficiency exams (generally the Series 65 exam).
For other state managers, this likely means that other states will follow suit and begin to propose new regulations requiring investment adviser registration.
Comment Period
The Division of Securities is accepting comments on the proposed rules prior to promulgating final regulations. Interested persons have until June 24 to file comments with the Division.
Below we have provided the Division’s stated reason for proposing these regulations (which can also be found here) and we have also printed the full proposed changes.
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Change in Exclusion/Exemption Requirements for Hedge Funds and other “Private Funds”
On July 21, 2010, Congress passed the most sweeping financial legislation enacted since the 1930s: the Dodd-Frank Consumer Protection and Regulatory Reform Act. The proposed amendments to the Massachusetts regulations referenced in this section are necessary to promote consistency between state and new federal requirements concerning investment adviser regulation, including regulation of “private funds.”
In part to address the elimination of the exemption for advisers with fewer than fifteen clients, the Securities and Exchange Commission (“SEC”) has proposed to exempt: 1) advisers solely to private funds with less than $150 million in assets under management, and 2) venture capital funds regardless of the amount of assets under management. The SEC has proposed to define a “private fund” as a fund that would be Investment Company under the Investment Company Act of 1940, but for section 3(c)(1) or 3(c)(7) of the Act. This new category of “exempt reporting” advisers must submit reports to the SEC and are subject to other regulatory requirements.
Exempt reporting advisers at the federal level will still be required to either register with the individual states in which they do business, or claim an available exclusion or exemption. The North American Securities Administrators Association (“NASAA”) has proposed a private funds model rule consistent with the new Dodd-Frank requirements.
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erline;”>12.205(1)(a)(6) – Definition of Institutional Buyer
The proposed amendment to 12.205(1)(a)(6) will phase out existing subsection (b), which defined institutional buyer as including “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.” Following the date of implementation, investment advisers will no longer be able to rely on this exemption for new beneficial owners or additional funds for existing investors. However, advisers can continue to rely upon the exemption for business that existed prior to the implementation date.
12.205(2)(c) Exemption for Exempt Reporting Advisers
The Division proposes to remove the institutional buyer exemption located in 12.205(b), and adopt an exemption in order to ensure proper regulation of investment entities whose regulatory oversight has come within the ambit of state responsibility. In its place, the Division proposes to adopt a regulation consistent with the Dodd-Frank requirements.
The proposed addition to 12.205(2) creates a registration exemption for “exempt reporting advisers.” The proposal would exempt advisers to 3(c)(7) and venture capital funds from Massachusetts registration requirements, subject to certain limitations. These exempt advisers will file the same report and amendment thereto that an exempt reporting adviser is required to file with the SEC.
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Change in Exclusion/Exemption Requirements for Hedge Funds and other “Private Funds”
Changes to the “Institutional Buyer” Exclusion in 950 CMR 12.205(1)(a)(6)
Delete the current language of 950 CMR 12.205(1)(a)(6) and replace with the following:
6. Institutional Buyer shall include any of the following:
a. An organization described in Section 501(c)(3) of the Internal Revenue Code with a securities portfolio of more than $25 million.
b. An investing entity:
i. 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; and
ii. which existed prior to [effective date]; and
iii. which, as of [effective date], ceased to accept beneficial owners or additional funds for existing investors.
c. An investing entity whose only investors are financial institutions and institutional buyers as set forth in M.G.L. c. 110A, § 401(m) and 950 CMR 12.205(1)(a)6.a. and b.
Registration Exemption for Exempt Reporting Advisers
Insert a new subsection (c) into 950 CMR 12.205(2) as follows:
(c) Registration Exemption for Exempt Reporting Advisers.
1. An investment adviser who provides advice solely to one or more 3(c)(7) funds or venture capital funds shall be exempt from the registration requirements of Section 201 of the Act if the investment adviser satisfies the following conditions:
a. Neither the investment adviser nor any of its advisory affiliates are subject to a disqualification as described in Rule 262 of SEC Regulation A, Section of title 17 CFR § 230.262.
b. The adviser files with the Commonwealth each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to SEC Rule 204-4, 17 CFR 275.204-4.
c. The adviser pays the fee specified in 950 CMR 12.205(2)(b)1.b.
2. A Federal Covered Adviser shall not be eligible for this exemption and shall comply with the state notice filing requirements applicable to such advisers pursuant to 950 CMR 12.205(2)(b).
3. An investment adviser representative is exempt from the registration requirements of 950 CMR 12.205(2)(d) if registration would be required solely because of employment or association with an adviser exempt from registration under this subsection (c).
4. The report filings described in paragraph 1.b. above shall be made electronically through the IARD. A report shall be deemed filed when the report required by 950 CMR 12.205(2)(a)(1) and the fee are filed and accepted by the IARD on the state's behalf.
5. This exemption shall not be available to any investment adviser when one or more of the investment adviser's private funds accepts investments from non-natural persons for the purposes of evading registration or the conditions or limitation explicitly stated in this section.
6. Definitions:
a. “Private fund” means an issuer that would be an investment company as defined in section 3 of the Investment Company Act of 1940, 15 U.S.C. 80a-3, but for sections 3(c)(1) or 3(c)(7).
b. “3(c)(7) fund” means a private fund that is excluded from the definition of an investment company under section 3(c)(7) of the Investment Company Act of 1940, 15 U.S.C. 80a-3(c)(7).
c. “Venture capital fund” means a private fund that meets the definition of a venture capital fund in SEC Rule 203(l)-1, 17 C.F.R. § 275.203(l)-1.
Renumber the current subsection (c) of 950 CMR 12.205(2) as subsection (d) Registration of Investment Adviser Representatives.
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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm which provides state and SEC investment advisor registration services for hedge funds. Bart Mallon can be reached directly at 415-868-5345.
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