SEC Adopts New Rules and Amendments Under Dodd-Frank Act
Investment Management Update
Date: July 13, 2011
On June 22, 2011, the Securities and Exchange Commission (SEC) adopted new rules and rule amendments under the Investment Advisers Act of 1940 ("Advisers Act") to implement provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act ("Dodd-Frank Act").1 The rules address provisions of Title IV of the Dodd-Frank Act that, among other things, increase the statutory threshold for investment adviser registration with the SEC, require registration by certain advisers to hedge funds and other private funds, and mandate reporting by certain investment advisers that are exempt from registration. Among other things, the rules focus on:
- Eligibility for registration with the SEC, including the mechanics for transitioning to state registration for those advisers that no longer qualify for SEC registration and new rules for pension consultants and multistate advisers. (see SEC and State Registration below)
- Reporting requirements for venture capital funds and other exempt advisers. (see Exempt Reporting Advisers)
- Amendments to Form ADV designed to provide the SEC and clients with additional information about an adviser's operations. (see Amendments to Form ADV Relating to Advisory Operations)
- Amendments to the recently adopted Pay-to-Play rule. (see Amendments to Pay-to-Play Rule)
The rules take effect July 21, 2011.
SEC and State Registration
Transition to State Registration
New Rule 203A-5 provides for an orderly transition to state registration for mid-sized advisers no longer eligible to register with the SEC.
Existing registrants. Each adviser registered with the SEC on January 1, 2012 must file a Form ADV amendment no later than March 30, 2012 that reports the current market value of its assets under management, calculated within 90 days of the filing.3 This filing will be used to determine whether the adviser is eligible for SEC registration.
Mid-sized advisers no longer eligible for SEC registration must withdraw their registrations by filing Form ADV-W no later than June 28, 2012. Accordingly, advisers have 90 days after the March 30, 2012 filing deadline to make such withdrawal if no longer eligible for SEC registration.
After June 28, 2012, the SEC expects to cancel the registration of advisers no longer eligible to register with the SEC that fail to file an amendment or withdraw their registration.
New applicants. Mid-sized advisers applying for registration with the SEC may register with either the SEC or the appropriate state securities authority until July 21, 2011. Thereafter, all such advisers must register with the state securities authorities.
Advisers that have assets under management of $100 million or more will continue to register with the SEC (unless an exemption from registration with the SEC otherwise is available).
Determining Assets Under Management
In most cases, the amount of assets an adviser has under management will determine whether the adviser must register with the SEC or with states. Section 203A(a)(2) of the Advisers Act defines "assets under management" as the "securities portfolios" for which an adviser provides "continuous and regular supervisory or management services." Until now advisers have been permitted to exclude certain assets, such as proprietary assets, assets an adviser manages without receiving compensation and assets of foreign clients, when calculating assets under management.
Under revised instructions, advisers must include in their regulatory assets under management securities portfolios for which they provide continuous and regular supervisory or management services, regardless of whether these assets are family or proprietary assets, assets managed without receiving compensation or assets of foreign clients. Advisers must also calculate regulatory assets under management on a gross basis without deducting outstanding indebtedness or other accrued but unpaid liabilities.
The SEC is also revising the Form ADV instructions to provide guidance regarding how an adviser that advises private funds determines the amount of assets it has under management. An adviser must:
- Include the value of any private fund over which it exercises continuous and regular supervisory or management services, regardless of the nature of the assets of the fund.
- Include the amount of any uncalled capital commitments made to a private fund managed by the adviser.
- Use the market value of private fund assets, or the fair market value if the market value is not available.
Switching Between State and SEC Registration
Rule 203A-1 is designed to prevent an adviser from having to switch frequently between state and SEC registration as a result of changes in the value of assets under management or the departure of one or more clients. The SEC is amending the rule to eliminate the current buffer for advisers that have assets under management between $25 million and $30 million and replacing it with a similar buffer for mid-sized advisers. The amended rule raises the threshold above which a mid-sized investment adviser must register with the SEC to $110 million and provides that an adviser is not required to withdraw its registration until it has less than $90 million of assets under management.
The SEC is retaining the requirement that eligibility for registration be determined annually as part of an adviser's annual updating amendment, allowing an adviser to avoid the need to change registration status based on fluctuations that occur during the course of the year.
The SEC is amending Form ADV to require each mid-sized adviser filing with the SEC to affirm, upon application and annually thereafter, that it is either not required to register as an adviser with the state securities authority in the state where it maintains its principal office and place of business or not subject to examination as an adviser by that state.4
These changes implement the amendments to Section 203A of the Advisers Act to prohibit SEC registration of mid-sized advisers, but only if the adviser is required to register as an investment adviser with the securities commissioner (or any agency or office performing like functions) of the state in which it maintains its principal office and place of business, and, if registered, the adviser will be "subject to examination" as an investment adviser by such commissioner, agency or office.
A mid-sized adviser is not required to register with the state securities authority and must register with the SEC if the adviser is exempt from registration under the law of the state in which is has its principal office and place of business or is excluded from the definition of investment adviser in that state.
Based on information the SEC obtained from calls to state securities authorities, it identified states that do not subject state-registered advisers to examination. Accordingly, an adviser with its principal office and place of business in Minnesota, New York or Wyoming with assets under management between $25 million and $100 million must also register with the SEC.
Exemption to SEC Registration Prohibition
The SEC has permitted six types of investment advisers to register with the SEC under Rule 203A-2.5 It is modifying three of the exemptions:
- NRSROs - The SEC is eliminating the exemption applicable to nationally recognized statistical rating organizations found in Rule 203A-2(a).
- Pension consultants - The SEC is amending Rule 203A-2(b), the exemption available to pension consultants, to increase the minimum value of plan assets from $50 million to $200 million.6
- Multistate advisers - The SEC is amending Rule 203A-2(d) to permit investment advisers of any size who are required to register in 15 or more states to register with the SEC.
Elimination of the Safe Harbor in Rule 203A-4
The SEC is eliminating Rule 203A-4, which has provided a safe harbor from SEC registration to any investment adviser that is registered with the state in which it has its principal office and place of business based on a reasonable belief that it has insufficient assets under management to qualify for registration with the SEC.
Amendments to Form ADV
Item 2 requires each investment adviser applying for registration to indicate its basis for registration with the SEC and to report annually whether it is eligible to remain registered. The SEC is adopting revisions to Item 2.A. of Part 1A of Form ADV to reflect the new threshold for registration and revisions to related rules.
Item 2 requires each investment adviser registered with the SEC (and each applicant for registration) to identify whether it is eligible to register with the SEC because it:
- Is a large adviser that has $100 million or more of regulatory assets under management (or $90 million or more if an adviser is filing its most recent annual updating amendment and is already registered with the SEC).
- Is a mid-sized adviser that does not meet the criteria for state registration and is not subject to examination.
- Has its principal office and place of business in Wyoming (which does not regulate advisers) or outside the United States.
- Meets the requirements for one or more of the revised exemptive rules under Section 203A of the Advisers Act.
- Is an adviser (or subadviser) to a registered investment company.
- Is an adviser to a business development company and has at least $25 million of regulatory assets under management.
- Received an order permitting the adviser to register with the SEC.
Each adviser must check at least one of these items or indicate that it is no longer eligible to remain registered with the SEC. The IARD will prevent an applicant from registering with the SEC, and an adviser from remaining registered, unless it represents on Form ADV that it meets at least one of the specific eligibility criteria set forth in the Advisers Act or the rules thereunder.
Section 410 of the Dodd-Frank Act amended Section 203A of the Advisers Act to create a new category of "mid-sized advisers" and shift primary responsibility for their regulatory oversight to the states. A mid-sized adviser is prohibited from SEC registration if it is required to register as an investment adviser in the state in which it maintains its principal office and place of business and has assets under management between $25 million and $100 million.2
The SEC estimates that approximately 3,200 SEC-registered advisers will need to withdraw their SEC registrations and register with one or more state securities authorities as a result of this new requirement. The SEC is adopting rules and rule amendments, discussed below, that provide a means of identifying advisers that must transition to state regulation, clarify the application of the new statutory provisions and modify certain exemptions from prohibitions on SEC registration.
Exempt Reporting Advisers
Rule 204-4 requires Exempt Reporting Advisers to file reports with the SEC on Form ADV using the same process used by registered investment advisers.7
Information in Reports
The SEC is amending Form ADV to facilitate filings by Exempt Reporting Advisers by:
- Re-titling the form to reflect its dual purpose as both the "Uniform Application for Investment Adviser Registration," and the "Report by Exempt Reporting Advisers."
- Amending the cover page to require Exempt Reporting Advisers to indicate the type of report they are filing.
- Amending Item 2 of Part 1A, which requires advisers to indicate their eligibility for SEC registration, to add a new subsection B that requires an Exempt Reporting Adviser to identify the exemption(s) it is relying on to report to, rather than register with, the SEC.
An Exempt Reporting Adviser must complete the following items in Form ADV:
- Item 1 (Identifying Information)
- Item 2.B. (SEC Reporting by Exempt Reporting Advisers)
- Item 3 (Form of Organization)
- Item 6 (Other Business Activities)
- Item 7 (Financial Industry Affiliations and Private Fund Reporting)
- Item 10 (Control Persons)
- Item 11 (Disclosure Information)
- Schedules A, B, C and D
Exempt Reporting Advisers are not required to complete and file with the SEC other Items in Part 1A or prepare and deliver a client brochure. Rule 204-4 also requires an Exempt Reporting Adviser to file a final report on Form ADV when it ceases to be an Exempt Reporting Adviser, when it no longer qualifies as an Exempt Reporting Adviser or when it applies for registration with the SEC.8
The SEC is amending Rule 204-1 under the Advisers Act to require Exempt Reporting Advisers to file updating amendments to reports filed on Form ADV. Rule 204-1(a) requires an Exempt Reporting Adviser to amend its reports on Form ADV:
- At least annually within 90 days of the end of the adviser's fiscal year.
- More frequently, if required by the instructions to Form ADV.
Similarly, the SEC is amending General Instruction 4 to Form ADV to require an Exempt Reporting Adviser to update Items 1 (Identification Information), 3 (Form of Organization) and 11 (Disciplinary Information) promptly if they become inaccurate, and to update Item 10 (Control Persons) if it becomes materially inaccurate. These are the same updating requirements that are applicable to registered advisers, but with respect to fewer items.
The Advisers Act creates two new exemptions from registration for advisers to certain types of "private funds" and repeals the private adviser exemption upon which many hedge funds and other private funds relied in order to avoid registration.
The new registration exemptions cover any adviser that acts solely as an adviser to one or more venture capital funds (new Section 203(l)) and any adviser that acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million (new Section 203(m)) (collectively, "Exempt Reporting Advisers").
The SEC requires advisers under these exemptions to maintain certain records and submit such reports as the SEC determines necessary or appropriate in the public interest.
Amendments to Form ADV Relating to Advisory Operations
Item 1: Reporting $1 Billion in Assets
Section 956 of the Dodd-Frank Act requires the SEC to adopt rules or guidelines addressing certain excessive incentive-based compensation arrangements, including those of investment advisers with $1 billion or more in assets. To identify those advisers subject to Section 956, the SEC is amending Item 1 to require each adviser to indicate whether it had $1 billion or more in assets as of the last day of the adviser's most recent fiscal year. For purposes of this reporting requirement, the amount of assets will be the adviser's total assets determined in the same manner used to calculate the amount of total assets on the adviser's balance sheet for its most recent fiscal year end. Both registered and Exempt Reporting Advisers must complete this item.
Item 1 also is being amended to require an adviser to provide contact information for its chief compliance officer and to disclose whether it or any of its control persons is a public reporting company under the Securities Exchange Act. Finally, Item 1 is being amended to give advisers the option of picking "limited partnership" as a form of organization.
Item 5: Advisory Business Information
Item 5 of Part 1A requires an adviser to provide basic information regarding its business, the types of services it provides and the types of clients it services. To help the SEC better understand the operations of advisers and identify candidates for risk-targeted examinations, it is requiring that registered advisers:
- Disclose the number of employees registered as investment adviser representatives or licensed insurance agents.
- Provide a single numerical approximation in response to the questions about employees.
- Disclose, in addition to the number and types of clients (e.g. high net worth individuals, investment companies, etc.), whether the adviser's clients include business development companies, insurance companies or other investment advisers.
- Disclose its approximate number of clients in excess of 100, report the approximate percentage of clients that are not U.S. persons, disclose the types of clients it advises and report the approximate percentage of assets under management attributable to each client in broad ranges.
- Disclose the types of advisory services it provides.
- Provide the SEC file number for a registered investment company and business development companies if they provide portfolio management for an investment company.10
- Provide information identifying advisers that disclose to their clients that they provide specialized advice.
These changes apply only to SEC-registered advisers.
Items 6 and 7: Other Business Activities and Financial Industry Affiliations
Items 6 and 7 of Part 1A require advisers to report those financial services in which the adviser or a related person is actively engaged. Both registered and Exempt Reporting Advisers must complete this item. The SEC is adopting the following changes to these items so that it can better assess the conflicts of interest and risks that may be created by those relationships and identify affiliated financial service businesses:
- Expanding the lists in both Items 6 and 7 to include business as a trust company, registered municipal adviser, registered security-based swap dealer and major security-based swap participant.
- Adding to the list in Item 6 accountants (or accounting firms) and lawyers (or law firms) that have a separate business.
- Clarifying in the instruction to Item 7 that advisers are to include related persons that are foreign affiliates.
- Adding new Section 6.A. to Schedule D that requires an adviser that is engaged in another business under a different name to list the other business name and the other line of business in which it engages using that name.
- Modifying Item 6.B. to require advisers primarily engaged in another business under a different name to also provide that name in Section 6.B. of Schedule D.
- Amending Section 7.A. of Schedule D to require that advisers provide identifying information for any type of related persons (with limitations as to which related persons must be included).
- Requiring the adviser to report whether a related person financial institution acts as a qualified custodian for client assets under the adviser custody rule.
Item 7.B.: Private Fund Reporting
The SEC is adopting amendments to Item 7.B. of Schedule D to expand the information advisers provide about the private funds they advise. Both registered and Exempt Reporting Advisers are required to complete this item. The amendments will require advisers to:
- Complete Section 7.B. of Schedule D for each private fund that the adviser (and not a related person) advises.
- Report on pooled investment vehicles regardless of how organized.
- Disclose the following information about the private funds they manage:
- The name of the private fund.11
- The state or country where the private fund is organized.
- The name of the general partner, directors, trustees or persons occupying similar positions.
- Information about the organization of the fund, including whether it is a master-feeder fund or fund of funds.
- Information about the regulatory status of the fund or whether it is subject to jurisdiction of a foreign regulatory authority, and regulatory exemptions relied upon by the fund and adviser.
- The gross asset value of the fund.
- The investment strategy employed by the fund and whether it invests in securities of registered investment companies.
- The minimum investment requirements.
- The extent to which clients of the adviser are solicited to invest, and have invested, in the fund.
- Information concerning five types of service providers that generally perform important roles as "gatekeepers" for private funds - auditors, prime brokers, custodians, administrators and marketers.
Only one adviser must report the full scope of information for each private fund even when there are other advisers to the same fund. In addition, an adviser with a principal office and place of business outside the United States is permitted to omit a Schedule D for a private fund that is not organized in the United States and that is not offered to, or beneficially owned by, "United States persons." The term "United States persons" will be defined in the ADV Glossary and be substantially similar to the definition used in Regulation S.
This information will be publicly available.
Item 8: Participation in Client Transactions
Item 8 of Part 1.A. requires an adviser to report information about transactions with clients. The SEC is adopting the following changes to Item 8 that are designed to help it identify additional conflicts of interest advisers may face.
- If an adviser has discretionary authority to determine the brokers or dealers for client transactions and if it recommends brokers or dealers to clients, it must disclose whether those brokers or dealers are related persons of the adviser.
- An adviser that indicates that it receives "soft dollar benefits" must report whether all those benefits qualify for the safe harbor under Section 28(e) of the Exchange Act for eligible research or brokerage services.
- An adviser will be required to indicate whether it or its related person receivesdirect or indirect compensation for client referrals. This requirement complements the existing requirement that an adviser disclose whether it compensates any person for client referrals.
Item 9: Custody
The SEC is amending Item 9 to require advisers to indicate the total number of persons that act as qualified custodians for client assets. Recent amendments to Item 9 require advisers to disclose whether they or a related person act as a qualified custodian, but do not require disclosure of information about other qualified custodians.
The SEC is also adopting a number of amendments to Form ADV. It is requiring that investment advisers provide additional information on Form ADV about their operations in order to permit the SEC to provide more effective oversight. The additional operational information will focus on:
- Information regarding private funds managed by the adviser.
- Data about the adviser's advisory business and business practices that may present significant conflicts of interest.
- Information about advisers' non-advisory activities and their financial industry affiliations.
The SEC is also revising Part 1 of Form ADV to allow it to better assess compliance risks and identify advisers that are subject to the Dodd-Frank Act's requirements concerning certain incentive-based compensation arrangements.9
Amendments to Pay-to-Play Rule
- Amending the scope of Rule 206(4)-5 so that it applies to Exempt Reporting Advisers and foreign private advisers. Rule 206(4)-5 currently applies to advisers that are registered with the SEC or exempt from registration in reliance on Rule 203(b)(3). Because the Dodd-Frank Act repeals the "private adviser exemption" in Section 203(b)(3) of the Advisers Act, some Exempt Reporting Advisers previously covered by the rule will, absent the amendment, no longer be subject to it.
- Amending Rule 206(4)-5(a)(9)(i) to include municipal advisers registered under Section 15B of the Securities Exchange Act and subject to pay-to-play rules adopted by the Municipal Securities Rulemaking Board as "regulated persons" that advisers may use to solicit a governmental entity for investment advisory services.
- Extending to June 13, 2012 the date by which advisers must comply with the ban on third-party solicitation.
The SEC decided not to adopt the proposal to amend the definition of a "covered associate" of an investment adviser to provide that a legal entity that is a general partner or managing member of an investment adviser can meet the definition.
2However, unlike a small adviser, a mid-sized adviser must register with the SEC if the adviser is not required to be registered as an investment adviser with the securities commissioner (or any agency or office performing like functions) of the state in which it maintains its principal office and place of business; or, if registered with the state, it would not be subject to examination as an investment adviser by that securities commissioner. Additionally, a mid-sized adviser may register with the SEC if it is required to register in 15 or more states.
6The SEC is increasing the threshold to $200 million in light of Congress' determination to increase to $100 million the amount of assets under management that requires all advisers to register with the SEC, and to maintain the current ratio of plan assets to the statutory threshold for registration.
7Each Form ADV will be considered filed with the SEC upon acceptance by the IARD, and advisers filing the form would be required to pay a filing fee. The SEC anticipates the filing fee to be the same as that for a registered investment adviser.
8Amended Form ADV provides guidance to Exempt Reporting Advisers transitioning to becoming registered with the SEC. An Exempt Reporting Adviser wishing to register with the SEC can file a single amendment to its Form ADV that serves as both a final "report" as an Exempt Reporting Adviser and an application for registration under the Advisers Act.