• Senate Passes the Restoring American Financial Stability Act
  • September 1, 2010 | Author: Jonathan E. Silverblatt
  • Law Firm: Phillips Nizer LLP - New York Office
  • On May 20, 2010, the U.S. Senate passed the Restoring American Financial Stability Act of 2010 (the “Senate Bill”), which follows the adoption of the Wall Street Reform and Consumer Protection Act of 2009 by the U.S. House of Representatives on December 11, 2009 (the “House Bill”).  Both the Senate Bill and the House Bill contain a number of new regulations which would impact managers of private investment funds.  Significantly, both the Senate Bill and the House Bill would require most advisers to hedge funds (with exceptions) to register as investment advisers with the SEC under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The Senate Bill would also change the “accredited investor standard”, and the House Bill would change the “qualified client” standard.

    The Senate Bill and the House Bill are now being reconciled by a joint House-Senate Conference Committee chaired by Barney Frank with the aim to present a final bill to the President before the July 4th weekend.  The new requirements under either bill would generally be effective one year from enactment.

    Proposed Registration of Private Fund Managers

    • Both the Senate Bill and the House Bill contain provisions which would eliminate much of the current "private adviser exemption" under Section 203(b)(3) of the Advisers Act and thereby require advisers to “private funds”[1]  to register as investment advisers under the Advisers Act unless exempted thereunder.  This would impact advisers to virtually all hedge funds, private equity funds and venture capital funds marketed in the U.S.

    • Both bills contain exemptions to the registration requirements of the Advisers Act for (i) certain foreign private advisers with no place of business in the U.S. and minimum assets under management (“AUM”) attributable to a limited number of U.S. clients or investors, (ii) advisers solely to SBICs licensed or about to be licensed under the Small Business Investment Act of 1958, and (iii) advisers to “venture capital funds.”[2] The Senate Bill also includes exemptions for advisers to “private equity funds” and “family offices” (to be defined, together with “venture capital fund” by the SEC through rulemaking following enactment).  Conversely, the House Bill does not expressly exclude advisers to private equity funds, but contains an exemption for advisers solely to “private funds” that have less than $150.0 million AUM. Read literally, advisers to “private equity funds” (other than “foreign private advisers”) with AUM in excess of $150.0 million would be required to register with the SEC under the House Bill.  How the SEC crafts the definitions of “venture capital fund” and “private equity fund” will further impact an adviser’s ability to satisfy a particular exemption.

    • Both bills would generally require advisers to hedge funds and other “private funds” registered under the Advisers Act to maintain records and file reports with the SEC for each private fund managed regarding AUM, use of leverage, counterparty credit risk, trading practices, trading and investment positions, and any other information that the SEC determines necessary and appropriate for the protection of investors and for the assessment of systemic risk.  Additionally, the Senate Bill would include side-letters, valuation practices, and types of assets held to the categories of information to be reported. Both bills provide for the confidential treatment of such reports, subject to certain exceptions including in connection with proposed systemic risk regulation, among others.  These reports will be subject to periodic and special examinations by the SEC.

    • The Senate Bill would amend the Advisers Act to change the threshold for SEC jurisdiction over investment advisers (including advisers to private funds) from $25.0 million AUM to $100.0 million AUM. The House Bill keeps the current $25.0 million AUM threshold in place, but adds a “mid-sized investment adviser” category for investment advisers with between $25.0 million and $100.0 million AUM.  “Mid-sized investment advisers” would subject to state registration, unless no state(s) in which they are located would require regulation and examination of such adviser or where it is required to register in five or more states, in which case such advisers would be required to register (or maintain their registration) with the SEC.  The increase in the change of the jurisdictional threshold together with the elimination of the “private adviser exemption” is expected to cause the number of investment advisers subject to state supervision to increase significantly.  Investment advisers currently with less than $100 million in AUM (including those which are currently registered with the SEC) should prepare for the possibility that they will be required to register with one or more states.

    Proposed Changes to Investor Financial Thresholds

    The Senate Bill also requires the SEC to increase the thresholds for determination of "accredited investor status" for purposes of Regulation D (“Regulation D”) under the Securities Act of 1933, as amended (the “Securities Act”).  Commencing effective upon the enactment of the bill and for a period of four years thereafter, the net worth standard for natural persons (currently $1.0 million in net assets) will exclude the value of such person’s primary residence.  During this initial period, the SEC is directed to review the other aspects of the “accredited investor” definition as it relates to natural persons to determine whether other adjustments should be made.[3]  At the end of the initial four year period, and no less than every four years thereafter, the SEC will review and adjust the entire accredited investor definition (including net worth thresholds) relating to natural persons for the protection of investors and to reflect the economy, generally.  This could effectively remove a large portion of investors that would otherwise qualify as “accredited investors” and limit the pool of capital available for smaller private investment funds relying on Section 3(c)(1) of the Investment Company Act of 1940, as amended. 

    The House Bill would amend Section 205(e) of the Advisers Act to require the SEC to adjust for inflation any factor (i.e., the net asset threshold used by the SEC for purposes of determining “qualified client” status under Rule 205-3 of the Advisers Act), no later than one year after enactment and every five years thereafter.  Generally, performance-based fees may not be charged to U.S. clients by registered investment advisers, unless each client or investor (in a private fund) is a “qualified client” or meets a higher financial threshold, such as is the case with 3(c)(7) funds.  This amendment would primarily impact fundraising for smaller 3(c)(1) funds with registered advisers, to the extent such funds have a more limited pool of potential investors that can no longer satisfy the qualified client threshold or, alternatively, such advisers will not be able to charge “prohibited” performance fees.

    Disqualification of Private Placements by Certain “Bad Actors”

    The Senate Bill also directs the SEC to issue disqualification rules which would disqualify offers and sales of securities in reliance on Regulation D by certain “bad actors” that are (i) subject to final “bar” orders from state-securities commissions, banking authorities, insurance commissions, and appropriate Federal banking agencies or final orders for deceptive,
    fraudulent or manipulative conduct within 10 years of the date of filing of the offer or sale or (ii) convicted of any felony or misdemeanor in connection with the purchase or sale of securities or false filings with the SEC.

    Private Fund Self-Regulatory Organization

    In addition, the GAO must study and report on the feasibility of forming a self-regulatory organization to oversee private funds and submit such report to the respective Senate and House committees within one year after enactment.

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    NOTES:

    1  Both bills generally define “private fund” to cover all entities that would be deemed to be investment companies under the Investment Company Act of 1940, as amended, but for Sections 3(c)(1) and 3(c)(7) thereof.

    2  Although the House Bill exempts advisers to “venture capital funds” it provides for certain recordkeeping and reporting requirements for such advisers.  The Senate Bill does not impose such requirements.

    3  The Senate Bill also requires a GAO study of the appropriate financial thresholds or other criteria needed to qualify for accredited investor status and be eligible to invest in private funds within the first three years after enactment.

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    We are available to provide counsel and guidance concerning similar Securities Law issues, as well as others not discussed in this Alert.  Please contact any of the attorneys named below.

    Jonathan E. Silverblatt
    212.841.0761
    [email protected]

    Christopher J. Kula
    212.841.0733
    [email protected]

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