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News August 14, 2006 Issue

IM Staff Eases Post-Goldstein Hedge Fund Manager Transition Woes

By broadly vacating the SECís entire hedge fund rulemaking, the U.S. Court of Appealís June 23 Goldstein v. SEC opinion tossed quite a few babies out with the "who-is-the-client" bathwater.

Last week, the staff of the Division of Investment Management undid some of the courtís damage.

In an August 10 no-action letter, the staff reinstated many of the transitional and interpretive provisions originally contained in the SECís hedge fund rulemaking. The staffís letter, however, did not affect the fundamental ruling in the case (the notion that for purposes of the 15 client de minimis exemption, advisers should count their hedge funds, not the fundsí underlying investors, as "clients"). The staffís letter came in response to a July 31 request by the American Bar Associationís subcommittee on private investment entities, which was penned by Schulte Roth partner Paul Roth.

Much of the staffís relief was geared towards hedge fund managers that had registered because of the SECís hedge fund rule and now plan to remain registered. The staff said that it would not recommend enforcement action against advisers that rely on the performance fee and recordkeeping grandfathering provisions in the rulemaking as if they were still in effect.

The staff also took a no-action position effectively re-extending the Unibanco relief in the release to offshore hedge fund advisers. Under that relief, "the substantive provisions of the [Advisers Act] do not apply to offshore advisers with respect to such advisersí dealings with offshore funds and other offshore clients to the extent described in [the Unibanco letter and its progeny]." The staff cautioned, however, that an offshore adviser that remains registered must fully comply with U.S. law vis a vis any U.S. clients and prospective U.S. clients.

In addition, the staff effectively re-extended the period for fund of funds managers that rely on the annual audit exception under the custody rule. Such advisers will continue to have 180 days to provide their audited financial statements to investors in their funds.

The letter also contained relief for advisers that choose to deregister. In particular, the staff dealt with the issue of hedge fund managers that had begun to "hold themselves out" as advisers while registered with the Commission.

The staff took a fairly straight-forward approach to putting that particular genie back in the bottle: At the time a hedge fund manager deregisters in reliance on Rule 203(b)(3)-1, it must in fact operate in a way that makes it eligible for that exemption. However, instead of looking back at its number of clients over the past twelve months, as the exemption specifies, the staff effectively stated that it would only look back to the time of deregistration. And while itís okay if the manager held itself out as an adviser while registered, once it deregisters there can be no more holding out. At 12 months after deregistration, the lookback (for purposes of counting clients) would revert to the ruleís 12 month lookback. To obtain the benefits of this relief, an adviser that registered due to the hedge fund rule must withdraw its registration no later than February 1, 2007. [Editor's note: this paragraph was amended slightly on September 24, 2007 for clarity.]

The staff also said that hedge fund advisers that withdraw their registration do not need to provide a balance sheet in connection with filing Form ADV-W. Advisers that answer "yes" to Item 3 on Form ADV-W because they have custody must go on to complete a Schedule W2, but can answer "0" to all of the questions on that schedule.

The letter also addresses a technical Form ADV issue, which for the time being is applicable to all registered advisers: Because of "system and programming constraints," Form ADV, for now, will continue to ask questions about "private funds." Eventually, the form will be changed. Until then, look for staff guidance on how to answer Form ADV on the SECís IARD website: www.sec.gov/divisions/investment/iard.shtml.

More staff guidance is in the works. Mayer Brown partner Michael Butowsky confirmed that he has submitted a no-action letter request to the Division of Investment Management seeking written guidance on the treatment of persons who are paid to locate investors for hedge funds. In June, OCIE staff stated in a regional CCOutreach meeting that examiners would no longer cite SEC-registered advisers for violations of Rule 206(4)-3 if such persons were not treated as solicitors under the SECís cash solicitation rule.

Butowsky stated that his understanding was that the letter was "currently under consideration" by the Division staff.