Dodd-Frank Becomes Law

Key issues for private fund managers

PAUL ROTH, JOSH DAMBACHER, MARC ELOVITZ, JASON KAPLAN, CRAIG STEIN, JOSEPH VITALE & KRISTIN BOGGIANO, SCHULTE, ROTH & ZABEL

The Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act or the Act) includes a number of provisions that affect private fund managers.This article identifies and analyses those regarding (i) adviser registration and other key provisions affecting investment advisers; (ii) the Volcker Rule; and (iii) derivatives.

Adviser registration
The Dodd-Frank Act takes a straightforward approach to expanding the registration requirement under the Investment Advisers Act of 1940 (the Advisers Act) by eliminating the “private adviser exemption” in Section 203(b)(3). Many investment advisers that are currently exempt will now be required to register as investment advisers with the Securities and Exchange Commission. Managers that do not have an exemption from registration will be required to register prior to Title IV of the Act becoming effective, which is set to occur one year after the date of enactment of the Act (which occurred on 21st July 2010). The Act provides specific exemptions for managers and also requires the SEC to prescribe regulations with respect to investment advisers not explicitly covered by the amendments to the Advisers Act.

Advisers with less than $100 million AUM: Advisers with less than $25 million in AUM that are regulated as an investment adviser by a state are prohibited from registering with the SEC. Advisers with $25 million or more in AUM but less than $100 million in AUM are prohibited from registering with the SEC if the adviser is required to register with a state and would be subject to examination by virtue of such registration,1 although such advisers may register with the SEC if they would otherwise be required to register with 15 or more states.2

Advisers with $100+ million AUM: Advisers with AUM of $100 million or more are required to register as investment advisers with the SEC, unless they are exempt pursuant to one of the exemptions contained in the Advisers Act.

Advisers to Private Funds with less than $150 million AUM: The SEC is required to provide an exemption from registration under the Advisers Act for an adviser that acts solely as an adviser to private funds3 with AUM in the US of less than $150 million. Advisers exempted under this provision will be subject to recordkeeping and reporting requirements that the SEC determines necessary and appropriate.

Venture Capital Funds: Investment advisers that manage only venture capital funds are exempt from SEC registration. They are, however, required to maintain records and provide reports to the SEC, the content of which is to be determined by the SEC. The SEC is required to determine the definition of “venture capital fund” within one year of the enactment of the Act. Unlike prior versions of the legislation, the Act does not provide an exemption from registration for advisers to private equity funds.

Family Offices: The Act not only exempts “family offices” from registration, but it also excludes them entirely from the definition of “investment adviser” under the Advisers Act. The term “family office” will be defined by SEC rulemaking consistent with previous exemptions recognising the variety of arrangements used by family offices. A grandfathering provision is to be included in the exemption for any person who was not registered or required to be registered under the Advisers Act on 1st January 2010.

Foreign Advisers: Many advisers based outside the United States will be required to register with the SEC. A new “foreign private adviser exemption” will apply only where the manager: (i) has no place of business in the US; (ii) has fewer than 15 US clients and investors in private funds; (iii) has less than $25 million AUM (or such higher amount determined by the SEC) attributable to US clients and investors in private funds; and (iv) does not (1) hold itself out generally to the US public as an investment adviser or (2) act as an adviser to a registered investment company or business development company. The Act does not specifically provide for the “registration lite” regime that currently applies to many non-US advisers. However, the SEC is given significant discretion in categorising investment advisers for purposes of the requirements of the information requirements of the Advisers Act, and it remains to be seen whether it will maintain a “registration lite” reporting regime for many non-US advisers.

CFTC Registered Advisers: Managers registered as Commodity Trading Advisers with the Commodities Futures Trading Commission (CFTC) will be exempt from SEC registration unless their business becomes predominantly securities-related. This continues the manner in which dual registration was dealt with before.

Small Business Investment Companies: Advisers to small business investment companies licensed under the Small Business Investment Act of 1958 are exempt from SEC registration.

New recordkeeping and reporting duties
Significant expansions of recordkeeping and reporting obligations are mandated and authorised by the Act. The SEC must require registered investment advisers to maintain certain records (which may be examined by the SEC) and file reports with the SEC, in such form as the SEC deems necessary and appropriate.4 In addition to the existing Advisers Act requirements, registered investment advisers will be required, for each private fund they advise, to maintain records describing:

• Amount of assets under management;
• Use of leverage, including off-balance sheet leverage;
• Counterparty credit risk exposure;
• Trading and investment positions;
• Valuation policies and practices;
• Types of assets held;
• Side letter arrangements;
• Trading practices; and
• Other information the SEC determines necessary.

New confidentiality protections are provided by the Act to go along with these new reporting obligations (although the confidentiality protections have quickly come under attack and may be challenged).

New Short Sale Reporting Requirements
The Act creates a new short sale reporting obligation. Section 13(f) of the Securities Exchange Act of 1934 is amended to require the SEC to write rules for the “public disclosure of the name of the issuer and the title, class, CUSIP number, aggregate amount of the number of short sales of each security, and any additional information determined by the Commission.” The disclosure of short sales is to be on at least a monthly basis. The Act does not provide further specification as to who will be required to make such disclosures and what information will be made publicly available.

Regulation D Private Offering Process.
The Act includes changes to the definition of accredited investor and a requirement to implement a “bad actor” disqualification provision for Rule 506 of Regulation D, the private placement safe harbor promulgated under Section 4(2) of the Securities Act of 1933. The Act requires that the SEC, within one year, issue rules disqualifying “bad actors” from offering and selling securities under Rule 506, which are required to be substantially similar to those under Section 262 of the Securities Act (which currently provides for disqualification in a wide range of circumstances but is only applicable to offerings under $5 million pursuant to Rule 505 of Regulation D). The accredited investor net worth standard has been modified so that a natural person is no longer permitted to include the value of his or her primary residence in determining whether such person meets the $1 million net worth test.5
New SEC Compliance Examiners. The Act requires the SEC’s Division of Trading and Markets and the Division of Investment Management each to have staff to perform compliance inspections and examinations of entities subject to the jurisdiction of the respective divisions and to report to the directors of those divisions. No specifics are provided in the Act with respect to how such examination staff will interface with the SEC’s Office of Compliance Inspections and Examinations, which is separate from the divisions and does not report to them.

Deadline for Completing SEC Investigation and Examination.
On the enforcement side, the SEC will be required to file an action or notify the Director of the Division of Enforcement of its intent not to file an action within 180 days of submission of a Wells notification indicating that the enforcement staff intends to pursue charges. For examinations, the SEC will be required to notify a manager that the exam has been concluded (along with the findings thereof) within 180 days of completion of the on-site visit. However, these timeframes may be extended for any investigation or examination if the Director of the applicable division of the SEC determines that the investigation or examination meets the criteria to do so.

Strengthening Enforcement by the SEC.
The Act grants US courts extraterritorial jurisdiction over actions brought by the US or the SEC that allege a violation of antifraud provisions of federal securities laws where the violation involves conduct within the US that constitutes significant steps in furtherance of the violation, even if the transaction occurs abroad and only involves foreign investors, or involves conduct outside the US but has a foreseeable substantial effect within the US The Act also fills in several gaps in the securities laws’ enforcement provisions, including giving the SEC uniform authority to impose monetary penalties in cease-and-desist proceedings, permitting the SEC to impose collateral bars under the Securities Exchange Act and the Advisers Act and specifically covering non-exchange traded securities under market manipulation prohibitions.

Aiding and Abetting.
The Act amends the standard applicable when the SEC pursues aiding and abetting claims. Previously, the SEC had to prove that a party “knowingly” provided substantial assistance to someone who committed a fraud. The Act provides that the standard is now “knowingly” or “recklessly” providing such assistance. In addition, the Act extends the SEC’s aiding and abetting cause of action—and the recklessness standard—to violations of the Advisers Act, the Investment Company Act of 1940 and the Securities Exchange Act.
Incentive-Based Compensation. The SEC—along with other federal regulators—is required to issue regulations or guidelines by 21st March 2011, requiring investment advisers to disclose their incentive-based compensation arrangements. The SEC also must issue rules prohibiting incentive-based compensation that encourages “inappropriate risks.” Investment advisers with assets (not AUM) of less than $1 billion will be exempt from such requirements.

Study regarding SRO for Private Funds and Other Required Studies
The Comptroller General is required to conduct a study on the feasibility of forming a self-regulatory organisation to oversee private funds and report on the results of such study prior to 21st July 2011. The Act mandates a number of other studies to be completed and reported on in the time frames set by Congress, including, among others, studies regarding (i) the effectiveness of current standards of care for broker-dealers and investment advisers in connection with providing advice to retail consumers; (ii) the definition of accredited investor; (iii) the effects of position limits imposed on excessive speculation, and on the movement of transactions from US-based exchanges to trading venues outside of the US; (iv) the feasibility of requiring the derivatives industry to adopt standardised, computer-readable algorithmic descriptions which may be used to describe complex and standardised financial derivatives; (v) swap regulation in the US, Asia and Europe, and clearinghouse and clearing agency regulation in the US, Asia and Europe, in order to identify areas of regulation that are similar and those that should be harmonised; (vi) the impact of short selling on the markets and the feasibility, benefits and costs of requiring daily short-selling reporting in real time; (vii) the need for enhanced examination and enforcement resources for investment advisers; (viii) costs associated with compliance with the Custody Rule; and (ix) ways to improve investor access to information on investment advisers and broker-dealers. Congress, the SEC and other regulatory agencies are likely to engage in additional rulemaking based on the findings of the various studies required to be conducted by the Act.

The Volcker rule
General Prohibition on Fund Activity.
The Volcker Rule, among other things, prohibits all US depository institutions and their affiliates (as well as foreign banks operating in the US and their affiliates) (each a “Banking Entity”) from acquiring or retaining any equity, partnership or other ownership interest in, or sponsoring, any hedge fund or private equity fund (each defined as any entity exempt from registration as an investment company pursuant to Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, or any similar fund as determined by the federal banking regulators, the SEC or the CFTC), subject to certain exceptions (including a seemingly broad exception with regard to sponsoring such funds) and a transition period. However, a Banking Entity will be permitted to “organise and offer” a private equity or hedge fund (including serving as its general partner, managing member or trustee, or selecting or controlling a majority of the fund’s directors, trustees or management), subject to certain requirements and limitations, including significant restrictions on transactions with the fund.

Permissible Investments.
Notwithstanding the general investment prohibition, a Banking Entity will be permitted to make certain de minimis and seeding investments (potentially subject to additional capital requirements).

However, on its face, the Volcker Rule limits these exceptions to funds that the Bank Entity “organises and offers.” Thus, it appears that all investments in third-party funds will be prohibited.

De Minimis Exception: A Banking Entity will be permitted to make or retain an investment in a private equity or hedge fund that it organises and offers, provided: (i) the aggregate interest of the Banking Entity and its affiliates does not exceed 3% of that particular fund’s total ownership interests and (ii) the aggregate interest of the Banking Entity and its affiliates in all private equity and hedge funds does not exceed 3% of the Banking Entity’s tier 1 capital.

Seeding Activities: A Banking Entity will be permitted to make any investment (i.e., up to 100%) in a private equity or hedge fund that it organises and offers, for the purpose of establishing the fund and providing it with sufficient capital to attract unaffiliated investors. However, the Banking Entity must actively seek unaffiliated investors to reduce or dilute its interest and such interest must comply with the aforementioned de minimis exception within a year of the fund’s launch (with the possibility of obtaining an extension of up to two additional years).

Foreign Activities.
A foreign Banking Entity that is not directly or indirectly controlled by a US Banking Entity will be permitted to sponsor and/or invest, without being subject to any of the foregoing restrictions, in any offshore private equity or hedge fund that: (i) is not marketed or sold to US residents and (ii) generally conducts no business in the US, other than as incidental to its non-US activities.

Systemically Important Non-banks. Although nonbank firms identified by the Financial Services Oversight Council as systemically important are not generally prohibited from sponsoring or investing in private equity or hedge funds, such nonbanks will need to adhere to certain quantitative limits and other restrictions (to be determined by Federal Reserve Board regulation) and adhere to certain additional capital requirements (also to be determined by regulation).

Anti-Evasion.
An otherwisepermissible activity will be prohibited if an appropriate federal regulator has “reasonable cause” to believe that the activity is being conducted “in a manner that functions as an evasion” of the Volcker Rule.

Proprietary Trading.
In addition to restricting fund activity, the Volcker Rule also prohibits (subject to certain enumerated exceptions) a Banking Entity from engaging as principal, for its own trading account, in any transaction to acquire or dispose of any security, derivative, commodity futures contract, or option on the foregoing (or any other security or financial instrument determined by the federal banking regulators, the SEC and the CFTC).

Compliance Dates.
In general, the Volcker Rule will become effective upon the earlier of: (i) 12 months after the issuance of final implementing regulations (which must occur no later than 15 months after enactment of the Act); or (ii) two years after enactment of the Act. Once the rule is effective, Banking Entities and systemically important nonbanks will still have two additional years to become compliant (with the possibility of up to three one-year extensions). A Banking Entity may request an extension of up to five years to the extent necessary to comply with a contractual obligation in place as of 1st May 2010, to make or retain an investment in an “illiquid fund” (defined as a fund that, de facto and by investment strategy, is principally invested in “illiquid assets” (not defined)). Within six months after enactment of the Act, the Federal Reserve Board must promulgate rules governing the general two-year divestiture period and available extensions thereto.

Derivatives
The Act introduces three primary changes that will significantly alter the derivatives industry. The first is a new regulatory framework that repeals laws that limited the regulation of derivatives and that grants new regulatory authority to the SEC and the CFTC. The second is that many derivative transactions will trade through clearinghouses and exchanges, which may shift the industry toward more standardised products and change the way in which margin is calculated and applied across products and platforms. The third is that some large private fund managers that are considered major swap participants will have to register, which will entail a host of new obligations. The Act requires extensive rulemaking by the SEC and the CFTC, and the implementation of these rules and regulations will provide more concrete guidance. Until the publication of such rules and regulations, many specific provisions of the Act will remain uncertain.

Dual Regulatory Oversight.
Under the Act, the SEC and the CFTC will have dual oversight of derivatives. The Act provides that the SEC will regulate “security-based swaps” and the CFTC will regulate “swaps.” “Mixed swaps” will be subject to joint regulation. “Security based swaps” are derivatives based upon (1) a narrow based security index, (2) a single security or loan, or (3) the occurrence or nonoccurrence of an event relating to a single issuer or issuers of securities in a narrow based index. “Swaps” are derivative products other than security based swaps. “Mixed swaps” have attributes that are both security based swaps and swaps.

Clearinghouses/Exchanges/Margin.
The Act provides that the CFTC or SEC have the right to mandate that swaps clear through a clearinghouse and are executed through an exchange. The CFTC or SEC will designate certain swaps for clearing based upon notional exposures, trading liquidity, adequate pricing data, the effect on the mitigation of systemic risk, the effect on competition, among other factors. Clearinghouses and exchanges are not required to accept swaps for clearing that the regulators designate for clearing (based on, for example, illiquidity or difficulty in pricing). If no clearinghouse accepts a swap designated for clearing by a regulator, the CFTC or the SEC may take whatever action it “determines necessary and in the public interest, which may include . . . adequate margin or capital.” This broad discretion allows the regulators to potentially limit the trading of certain derivatives or the notional of certain derivatives, or to implement restrictions on trading.

Clearinghouses both domestically and internationally have different waterfalls that apply upon the insolvency of a clearinghouse, and fund managers should carefully evaluate how they will be paid in the unlikely event of the insolvency of a clearinghouse or a clearinghouse member. In addition, if a fund manager is trading both over-the-counter (OTC) derivatives with a counterparty with which it is also clearing, fund managers should carefully evaluate the set-off and default provisions in the documentation related to clearing. For example, unlike in the traditional OTC market where all positions with a defaulting counterparty may be set off, cleared transactions and OTC transactions cannot be set off. In addition, there may be a circumstance where a fund manager will be able to terminate all its OTC derivatives with a defaulting counterparty but will not have the right to terminate its cleared transactions with such defaulting counterparty.

Clearinghouses will have initial and variation margin requirements that will apply to hedge funds through the member firms of the clearinghouses. The Act also requires increased initial and variation margin for OTC derivative transactions, applied directly to the swap dealer and major swap participants (as further discussed below), which will very likely be passed along to hedge funds. The Act does not expressly provide that capital or margin requirements will be applied to existing swaps; however, it does not “grandfather in” existing swaps or exempt them from any new rules and regulations. The retroactive application of margin may be of considerable concern to private fund managers if it requires the unanticipated rebalancing of assets, which could force fund managers to liquidate current positions to satisfy margin calls. In addition, given that some transactions will trade with clearinghouses, some with traditional counterparties and some with potentially new derivative entities that will result from the regulation, it’s possible that the paradigm of traditional portfolio margining will change significantly, and that financing and the cost of utilising derivatives may consequently increase.

Major Swap Participants. Another tool to be used by the regulators to maintain the integrity of the market and to manage systemic risk is the oversight of fund managers that are considered major swap participants or major security-based swap participants. A major swap participant will be subject to a number of requirements. As with other aspects of the Act, the details of what will constitute a major swap participant will be further defined by rules and regulations. Major swap participants will be required to register with the SEC or the CFTC (as applicable) within one year after the enactment of the Act. Fund managers may be considered a major swap participant for some products and not for others. The SEC and the CFTC, as applicable, will outline reporting and recordkeeping requirements, capital requirements, and initial and variation margin requirements for major swap participants. In addition, each major swap participant will have to maintain daily trading records and a complete audit trail for conducting comprehensive and accurate trade reconstructions. Furthermore, the SEC or the CFTC will promulgate documentation standards and major swap participants will be obligated to implement robust and professional risk management systems.

Finally, major swap participants will be subject to business conduct requirements and conflict of interest requirements, among other obligations, and will be obligated to hire a chief compliance officer who will implement standards to ensure compliance with the Act.

Paul N. Roth, Josh Dambacher, Marc E. Elovitz, Jason S. Kaplan, Craig Stein, Joseph P. Vitale and Kristin Boggiano of Schulte Roth & Zabel LLP, the New York, Washington, D.C. and London-based full-service law firm, contributed to this article.

References

1. Note that New York State, where many fund managers are located, does not appear to have an investment adviser examination program.

2. A prior version of the Act indicated that smaller advisers may register with the SEC if they would otherwise be required to register with five or more states. This provision may be subject to a “technical correction” to reduce the number from fifteen to five.

3. The term “private fund” means an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940, but for Sections 3(c)(1) or 3(c)(7) of that Act, which are the exceptions largely relied on by alternative investment funds.

4. The SEC also must require unregistered investment advisers (e.g., an adviser that acts solely as an adviser to private funds with AUM in the US of less than $150 million or that acts solely as an adviser to venture capital funds) to maintain certain records and file reports with the SEC, as the SEC deems necessary or appropriate in the public interest or for the protection of investors.

5. The SEC has confirmed that, pending implementation of the changes to the SEC’s rules required by the Act, the related amount of indebtedness secured by the primary residence (up to its fair market value) may also be excluded for purposes of the $1 million net worth test. Indebtedness secured by an investor’s primary residence in excess of its value should be considered a liability and deducted from the investor’s net worth.