• Hedge Fund Advisers: What to Do in the Wake of Goldstein
  • August 22, 2006 | Authors: Gregory J. Nowak; Jennifer A. Howell
  • Law Firm: Pepper Hamilton LLP - Philadelphia Office
  • On August 7, 2006, Christopher Cox, the Chairman of Securities and Exchange Commission (SEC), announced that the SEC would not appeal the U.S. Court of Appeals decision in Phillip Goldstein, et. al. v. the Securities and Exchange Commission, which unanimously struck down the hedge fund adviser registration rules under the Investment Advisers Act of 1940 (Advisers Act). Chairman Cox noted that because the appellate court’s unanimous decision was based on multiple grounds, the SEC believed that an appeal would be futile and would distract from the SEC’s main goal of investor protection. Instead, he stated that the SEC would focus on rulemaking and staff guidance to address the legal consequences of the rules’ invalidation.

    The SEC followed up with a no-action letter to the American Bar Association’s Subcommittee on Private Investment Entities on August 10, 2006, discussing certain ramifications of the Goldstein decision. The following are highlights from that letter.

    Continued Availability of the “Small Adviser” Exemption of Section 203(b)(3)

    The SEC stated that an adviser who had registered due to the SEC’s now invalid “look through” counting rules could withdraw from registration with no penalty until February 1, 2007, as long as at the time of withdrawal, the adviser meets the exemption in Section 203(b)(3) of the Advisers Act. The exemption provides that an adviser need not register with the SEC as long as it does not hold itself out generally to the public and had 14 or fewer clients (with a fund counting as one client).

    The SEC also noted that the adviser would be permitted to withdraw without regard to whether the adviser held itself out generally to the public while registered or had more than 14 clients while registered.

    The SEC clarified that for the first 12 months following withdrawal, an adviser may – for purposes of assessing Section 203(b)(3) eligibility – determine the number of clients it had by reference to the period since withdrawal, which may be less than 12 months.

    Pepper Comment: The ability to avoid federal adviser registration is dependent on having fewer than 15 clients (counting each private fund as one client) and managing less than $30 million in assets (registration for advisers with assets under management between $25 million and $30 million is elective; registration for advisers with $30 million or more in assets under management is mandatory if the number of the adviser’s clients exceeds 14). Certain exceptions apply for family members and uncompensated accounts, etc.

    Also, an adviser may not “hold itself out” to the public as an adviser – which means the adviser may not advertise its services to the public if it is not registered (and even then, advertising must meet specific criteria). Participation as the general partner or manager in the private placement of interests in a hedge fund, however, generally does not constitute “holding oneself out.” See Rule 203(b)(3)-1(c) under the Advisers Act.

    Avoiding federal registration does not absolve an adviser from registering with various state authorities where it does business. Please review compliance with all state adviser blue sky rules before withdrawing from federal registration.

    If the adviser is a QPAM under ERISA, it must remain a federal registered adviser to retain QPAM status.

    Form ADV-W Balance Sheet Requirement

    Filing a Form ADV-W to withdraw from registration with the SEC requires an adviser to complete a balance sheet on Schedule W2 in certain situations. Until February 1, 2007, hedge fund advisers withdrawing from registration as a result of the Goldstein decision are not required to complete an actual balance sheet, but must fill in “0” for all entries on Schedule W2.

    Form ADV

    Form ADV currently requires an adviser to identify and provide information regarding private funds that it manages. As the Goldstein decision seems to invalidate these requirements, the SEC will post on its Web site (http://www.sec.gov/divisions/investment/iard.shtml) additional guidance regarding how SEC-registered advisers should complete Form ADV until the online system is upgraded to reflect these changes.

    Access to Records

    A registered investment adviser must continue to make hedge fund records available for examination when requested by the staff.

    Pepper Comment: Federal and state registered advisers still must keep up-to-date offering materials available for inspection. Compliance with the Securities Act of 1933 and avoidance of liability under Rule 10b-5 under the Securities Exchange Act of 1934, as well as ordinary prudence, requires an adviser not to sell or be party to the sale of interests in a fund it manages using stale disclosure documents.

    Offshore Advisers to Offshore Funds

    The SEC confirmed that the substantive provisions of the Advisers Act do not apply to dealings of offshore advisers with offshore clients, including offshore funds. Registered offshore advisers must comply with the Advisers Act with respect to U.S. clients and prospective U.S. clients.

    Custody Rule

    The SEC clarified that registered fund-of-funds advisers could continue to rely on the safe harbor in Rule 206(4)-2, as long as the adviser provides audit financial statements to the hedge fund’s investors at least 180 days after the end of the fund’s fiscal year.

    Pepper Comment: Since the funds underlying a fund-of-funds have 120 days to issue their financial statements to the fund-of-funds, the fund-of-funds needs the extra 60 days to complete their financial statements.

    Records Supporting Performance Information

    As the Transition Rule with respect to books and records was technically vacated by the Goldstein decision, the SEC noted that registered advisers could continue to rely on the rule’s safe harbor. The Transition Rule provides that if the adviser was exempt from registration prior to February 10, 2005, the books and records rule regarding maintenance of performance records only applies after the sooner of February 10, 2005, or after the adviser registered with the SEC.