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News September 11, 2006 Issue

Hedge Fund Managers Go Back to School on SEC Registration Decision

For those of you who have seen the Disney/Pixar film "Finding Nemo," think of that last scene where the aquarium fish have finally escaped captivity and are floating in the ocean, free at last. But thereís a catch: Each fish is encapsulated in an individual plastic bag.

"Now what?" asks one of the fish.

Thatís pretty much the situation that newly-registered hedge fund managers find themselves in. The Goldstein decision has come and gone, the court has issued its mandate, and the SECís hedge fund rule no longer exists. SEC Chairman Christopher Cox has announced that he will not pursue the rule. While there has been talk in Congress about hedge fund manager registration, the betting money is that nothing will happen (at least until the next Long Term Capital Management, as one lawyer quipped).

In any event, newly-registered hedge fund managers are free at last to deregister. But until they do, they remain encapsulated by their existing SEC registrations.

So, like the fish, many managers are floating along, asking themselves, "Now what?"

Willkie Farr partner Barry Barbash indicated that some of his clients are just now turning to the business decision of whether to deregister. The Goldstein decision "was beach reading," he said. "Now, itís fall," and people are beginning to think seriously about deregistering. "Itís slow going right now," he said.

"Most of our clients are sitting and waiting," said David Moody, a partner at Purrington Moody Weil. "They are seeing what happens." Many hedge fund managers seem to be "waiting for people to calm down" before deciding whether to deregister. "Theyíve all figured out a way to manage with [registration]," he said. And, he noted, "thereís a cost of undoing it." Firms that registered already have their CCOs and compliance programs in place. "Youíve spent the money. The only risk is SEC audit risk. Thatís the only thing that remains to be seen." And, he noted, registered firms get to say that they are SEC-registered. "Thereís some advantage to that," he noted.

"I think that most people are going to end up staying registered unless they see a huge trend of people deregistering," said Fried Frank partner Terrance OíMalley. "I think part of that is going to be driven by investor relations and the ability to raise additional capital." In his view, there is a "slight bias" among institutional investors to use registered firms. "I donít think itís a hard and fast rule among institutions," he added. But "all things being equal, they would rather see a registered manager."

One reason that some firms may choose to remain registered is that they do not want to have to go back and tell their existing investors why they are now deregistering. However, said OíMalley, a firm could certainly explain that it had registered because of the SEC rule, that it had done so reluctantly, and that now that the rule has been lifted, it is deregistering because the amount of time needed to comply with SEC requirements and undergo SEC audits could possibly distract from "our ability to do what we do best, which is manage your money." Such explanations, OíMalley noted, may "go over better" with certain types of investors. For example, if a manager has many "long and loyal" investors in its hedge funds, they may not mind. With some institutional investors, such as a fund of funds, "it might be more difficult."

OíMalley noted a few other reasons why managers may choose to remain registered:

  • To avoid becoming subject to more onerous state registration requirements, if applicable.
  • Because, if deregistered, they would be uncomfortably close to the 14-client limit in Section 203(b)(3).
  • SEC registration is required for QPAM status under ERISA.
  • They want to market their advisory skills and offer private account management (not permissible under Section 203(b)(3)ís "no holding out" requirement).

While SEC audit risk is perceived as the largest drawback to remaining SEC registered, OíMalley noted that there will undoubtedly be additional technical compliance issues in the future. "Plus," he said, "you donít know what future rules the SEC will come up with."

The good news is that the SEC staffís recent ABA no-action letter has eased the transition and provided plenty of time for firms to weigh the pros and cons of deregistering. "I think everyoneís got some time to sort out what they are going to do going forward," said Dechert partner David Vaughan.

Hedge fund managers that plan to deregister will need to retrieve Rule 203(b)(3)-1 from the dustbin of history, clean it off, and put it back on their shelf of Rules to Care About. "If you are going to deregister, you had better be sure that you qualify for the exemption," warned Vaughan. "I think at least in the short term, it is something that the SEC will be focusing on, just because itís been such an issue."

And now, the SEC has a list. "Everyone that registered and is now deregistering is now on their radar screen," said Vaughan. He pointed out that when Chairman Cox announced that the SEC would not pursue hedge fund manager registration, Cox made clear that the SEC is "not giving up completely" and that "they are going to exercise the authority they have over hedge funds." In Vaughanís view, Coxís remarks may signal that the SEC staff plans to carefully focus on determining whether hedge fund managers that deregister "actually qualify for the exemption."

Hereís a quick refresher on Section 203(b)(3): The section provides an exemption from SEC registration for advisers that during the course of the past twelve months had fewer than fifteen clients and that do not hold themselves out to the public as an investment adviser. Thatís fifteen clients, cumulatively, over a twelve month period: Just because you have 14 clients right now doesnít mean you necessarily qualify. (For example, say you had 13 clients until last June, when you lost three of them. However, in July, you gained four new clients, bringing your current number of clients to 14. For 203(b)(3) purposes, youíve had a total of 17 clients.)

Advisers to registered funds are not eligible to rely on the exemption, so if youíve launched a registered fund, youíll have to shut it down before deregistering.

Rule 203(b)(3)-1 explains how to count clients for purposes of the "fewer than fifteen" limit. For example, the rule provides that separate accounts for a husband, wife, kids, certain other family members living in the same house, and their individual trusts, can be counted as one client. Clients that donít pay any advisory fees donít need to be counted. Funds that have identical owners are counted as one client. Foreign advisers, i.e., those with their principal office and place of business outside the United States, are not required to count non-U.S. clients towards the 14 client limit. (U.S. based firms must count all clients).

As most relevant to hedge fund managers, the rule provides that a fund that is managed on the basis of the fundís investment objectives, rather than the individual investment objectives of its investors, can be counted as one client. The key here is to make sure you have not structured your fund in a way that the SEC staff might deem it being managed on the basis of its limited partnersí investment objectives, rather than the investment objectives of the fund as a whole.

The Division of Investment Management has addressed this issue in two no-action letters: Burr, Egan, Deleage (pub. avail. April 27, 1987) and Latham & Watkins (pub. avail. August 24, 1998). Burr Egan, an adviser to several venture capital funds, had asked the staff whether it could accommodate the different tax situations of its limited partners by dividing its funds into two pools, one issuing partnership interests and the other issuing corporate stock, without each pool being counted as a separate client for 203(b)(3) purposes. The staff declined to confirm that such funds could still be counted as one client, saying that restructuring the funds to accommodate the individual tax situations of the limited partners may result in the adviser providing advice to the limited partners. The substance of the proposed restructuring, said the staff, "is to provide a means by which the limited partners can switch from one limited partnership arrangement to another thereby accommodating the individual investment objectives of the limited partners."

The staff seemed to loosen up a bit in the Latham & Watkins letter, where it agreed that restructuring a fund to allow distributions in either cash or securities would not cause a fund to be counted as more than one client. The staff distinguished the situation from that in Burr Egan, describing it as an accommodation of the tax situations of the limited partners that would not substantially alter the structure and operation of the fund.

In any event, advisers should be alert to this "managed on the basis of the fundís investment objectives" issue. For example, if a side letter specified that a particular limited partner would have his investment holdings tailored in a manner different from the rest of the fund, the SEC staff might presume that a special advisory relationship has been created, and count that limited partner as a separate client.

However, if a side letter simply provides that a particular limited partner will receive information reported on a basis different from the standard quarterly update or that the limited partner has special liquidity rights, it would not seem to require the fund to be looked through. Since side letters are such a hot topic right now, itís probably best to check with your favorite lawyer, just to be sure.

What about sub-accounting for IPOs, to ensure that persons prohibited by the NASDís hot issue rule do not receive an improper allocation? "I donít think anything that is designed to ensure that a legal restriction is carried out is managing the money differently," said Barbash.

Also keep in mind that Rule 203(b)(3)-1 provides that if an adviser provides investment advice to a fundís limited partner separate and apart from the advice provided to the fund, that limited partner has to be counted as a separate client for purposes of the fourteen client limit. Of course, most 3(c)(7) funds neednít worry about this particular provision. "If the fund is a 3(c)(7) fund that has only institutional investors," said OíMalley, "there is no way that you are providing individual investment advice."

However, if your firm offers multiple hedge funds and has a relatively retail base, youíll want to make sure that your customer service team is not providing individual advice, perhaps by helping individual investors pick the fund that is right for them given their risk tolerances, investment horizons, and personal financial goals.

Firms relying on 203(b)(3) also will have to ensure that they are not "holding out." While registered, did your firm add statements to its pitch books that it is willing to accept private clients? Before you deregister, take it out ó thatís classic "holding out."

Also, your pitch books should be focused on your hedge funds, not your advisory firm. Similarly, if your firm created a website advertising its investment management services while registered, youíll either need to take it off the web, or, at a minimum, remove all public references to your firmís advisory services and funds and make it a password-protected site.

Lastly: The decision to lift two-year lockups seems to be a relatively straight-forward business decision, rather than a legal issue: Many managers would prefer to keep them, but investors may begin to agitate for their removal now that the SECís hedge fund rule has been lifted.

Managers that had explained a business rationale to clients when they first imposed a two-year lockup, but now have a business reason for removing it, "are obligated to go back to their clients . . and tell them that that rationale no longer exists," Barbash said.