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Banking and Finance

Podcast and Podcast Transcript: Impact on Private Fund Advisors of the Dodd-Frank Wall Street Reform and Consumer Protection Act

MODERATOR: This is the LexisNexis Corporate and Securities Law Community Podcast presentations and interviews with leading attorneys and industry professionals. On this edition Richard Phillips and Mike Eisenberg on the Dodd-Frank Act.

RICHARD: Good morning. Our program this morning is focused on the regulation of private fund advisers under the services reform legislation, the Dodd-Frank Act. We will focus on the impact of the legislation on private fund advisers. My name is Richard Phillips, I'm a partner of K&L Gates in San Francisco. With me this morning is Mike Eisenberg who is a former acting director of the SEC's Division of Investment Regulation and a member of the faculty of both Columbia University law school and Willamette University law school.

I'll start with an overview of the legislation as it affects private fund advisers, and Mike will go into much more detail on the impact of the legislation on private fund advisers. The legislation, the Dodd-Frank bill, will dramatically alter the scope of required federal investment adviser registration on the Advisers Act of 1940. It would affect not only private fund advisers but also other advisers that might be required to register under the act as presently drafted. First, the act would remove the private adviser exception for less than 15 clients, which has been in the act since 1940, and many private advisers have relied on this exemption to remain unregistered. It would, however, create a host of new exemptions from registration, including limited exemptions for private advisers who are organized outside the United States, foreign private advisers. Advisers solely to private funds with assets of less than $150 million. Advisers solely to venture capital funds, (but there are certain new record-keeping and filing requirements as required by the SEC, which would be applicable to them), advisers to SBIC's (so-called family offices), an entirely new concept under the act and commodity trading advisers. It would also increase the minimum assets under management for federal registration from $25 million to $100 million, provided that the advisers with $100 million of assets or under are subject to registration and examination by the states. Interestingly, it would impose new record keeping and filing requirements on registered advisers to private funds and, of course, subject them to new SEC examination requirements, which is probably the most important part of the Investment Advisers Act of 1940. The record keeping and filing requirements have provisions that subject them to confidentiality and exempt them from public disclosure under the Freedom of Information Act. The confidentiality requirements do not apply if the operations of the advisers create systemic risk in the view of the regulators, and, of course, they don't apply to requests of disclosures to congress and disclosure in connection of any kind of enforcement or legal proceeding.

The legislation will have an impact far beyond private funds and advisers to private funds because it changes and provides the mechanism for further changes in the class of persons who can be qualified for so-called private offering under the Securities Act and the Investment Company Act and Reg. D. thereunder. First and significant for investors who live in California and other jurisdictions where housing prices are relatively high, in calculating a natural person's net worth for purposes of the accredited investor standard, one must now exclude the value of the person's primary residence. So, for example, under the present accredited investor standard, there's $1 million minimum net worth necessary to qualify as a hedge fund or other private fund adviser. That [one]million dollars must now be calculated by excluding the value of the residence. Secondly, the SEC is permitted, not required but permitted initially, to review the natural person accredited investor standard other than the net worth test and adjust it. Increase it if they think it's justified. And after four years, they can do it for the entire set of qualifications including the net worth qualifications. Secondly, for qualified clients, clients which under the Investment Advisers Act can be charged a performance fee, the SEC is required, not just permitted, to adjust the standards no later than four years after enactment of the bill and every four years thereafter. Significantly, there is no change and no ability of the SEC to change the qualified purchasers standard of Section 3(c)(7) under the Adviser's Act, which permits so-called private offering to an unlimited amount of investors. That standard, which requires generally a minimum of $5 million of investments, is unchanged, and there's no authority vested in the SEC to make any change in the future.

Significantly also, the act places limitations under the so-called Volcker Rule on the ability of US and certain non-US financial institutions that are regulated by the Federal Reserve board to sponsor or invest in hedge funds or private equity funds, and there's also authority in a new Financial Stability Oversight Council consisting of the heads of the financial industry regulators to also set additional limitations if the firms are large enough to pose a systemic risk. These limitations under the so-called Volcker Rule are very significant for banking institutions. They basically say that a banking entity can only sponsor or offer hedge funds and private equity funds to their bonafide fiduciary trust and investment adviser clients. They can't guarantee results and have to disclose that the bank does not bare the risk of an investment. The funds cannot have a similar name to the banking entity, and there can be no ownership by bank director or employees except those directly involved in managing the private fund, which is, as I said, is limited to clients of the bank in a fiduciary trust or investment advisory capacity. Significantly also, bank can only have de minimus investment interest in a hedge fund or private equity fund. They can, for their own sponsored funds, have seed investments for up to 100% of the seed investment amount for one year, and after one year, they cannot have more than a 3% interest in the sponsored hedge funds. They can't lend money to the hedge funds and to the other restrictions on transactions with the sponsored hedge funds.

There are a number of studies also authorized or required by the act. There's a study by the GAO that's authorized and required for accredited investor qualifications, which could significantly affect the eligibility of persons to invest in private funds. There is significantly also a GAO-mandated study of the feasibility of organizing a self-regulatory organization for private funds. And then there's a third study that talks about the compliance cost of SEC custody rules. And one of the provisions in the legislation which we haven't mentioned, which I call the Madoff rule, would permit the SEC to write rules dealing with custody and public accountants for private funds. It could be a very important provision. These are the highlights of the legislation. It's enormously complicated, even if limited to private funds. To get into some of the complications in the application and registration provisions, I turn the program over to Mike Eisenberg.

MIKE: Thank you Dick. The most important thing, of course, is that the significant change and the impact of this legislation. Just to start, we capitulate just a little bit of what Dick said, just to lay out that it removes the private adviser exemption under Section 203(b)(3), which used to be relied upon, and it creates instead a whole bunch of new exemptions. So the new exemptions replace Section 203(b)(3) now. So unless you qualify for an exemption, you're going to register, which means a lot of people are going to have to register that did not have to register before. Among those who do have to register or would have to register if they're under a certain amount, $100 million in assets, then there is a division of authority and the Commission, the SEC would cede jurisdiction to the states, assuming that the states who have the legislative authority in their own states to register these companies.

RICHARD: Mike, is it right in believing that if an investment adviser has one client that, with assets over $100 million, is required to register as an investment adviser on the Adviser's Act.

MIKE: That's right. That's an example of the significant overhaul, which is fairly pervasive. The question then becomes, okay, what are these exemptions? And Dick listed them and, listing them briefly, an introduction, there are exemptions for foreign private advisers; advisers solely to private funds, if they have assets under management in the US of less than $150 million; advisers to venture capital funds; advisers to business investment companies, and family offices business. Also advisers to registered CFTC, CPA's.

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Richard Phillips is a senior partner at K&L Gates. He concentrates his practice in securities regulation particularly investment management, broker dealer and SCC enforcement.

Mike Eisenberg is the former acting director SEC Division of Investment Management and SEC deputy general counsel. Since 2006, he has been a visiting professor at Willamette University College of Law, teaching courses on securities regulation and is a senior research scholar and lecturer in law at Columbia University School of Law.

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