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News November 1, 2004 Issue

Welcome to Our World: Hedge Fund Managers to Register as Advisers

Chairman William Donaldson has his hedge fund rule ó with four business days before the election to spare!

In a 3-2 vote, the Commission last week adopted new Advisers Act Rule 203(b)(3)-2, which will require an estimated 1,000 or so hedge fund managers to register with the SEC as investment advisers by February 1, 2006 (assuming, of course, that Chairman Donaldson doesnít resign post-election and is replaced with a pro-hedge fund Chairman before 2006 and assuming that the rule withstands an expected legal challenge and assuming that established hedge fund managers donít simply impose two-year lock-ups on post-February 1 investments to avoid registration).

During the open meeting, dissenting Commissioners Cynthia Glassman and Paul Atkins criticized both the substance of the registration requirement as well as the SECís process in adopting the rule.

In particular, both pointed out that they did not have advance notice of an October 7 letter from House Capital Markets Subcommittee Chair Richard Baker (R-OH) to Treasury Secretary John Snow urging the Presidentís Working Group (which Snow heads) to coordinate interagency information sharing on hedge funds before the SEC proceeded on the rule. The letter was copied to Chairman Donaldson and Federal Reserve Chairman Alan Greenspan. Glassman and Atkins said they didnít see the letter until the day before the SECís open meeting.

In her questions, Glassman focused on how, exactly, the SEC coordinated with other agencies. Division of Investment Management director Paul Roye explained that the staff had met with counterparts at various federal regulators to engage in a "dialogue" on the hedge fund issue.

To which Glassman asked: "Did you listen to anything they said, or you just had a Ďdialogueí?"

Roye, to his credit, didnít miss a beat. "We certainly listened to what they had to say, we listened to their concerns," he replied. But, he added, "the bottom line is that we have the responsibility for enforcing the federal securities laws."

Glassman asked Roye whether he thought the CFTC and the Presidentís Working Group would be supportive of the SECís hedge fund rule as it stood before the Commission.

"No," said Roye.

"I didnít think so," replied Glassman.

For its part, the Managed Funds Association is playing nice. After the rule was adopted, the group quickly issued a statement saying that it is "dedicated to working with the SEC" to ensure that the new registration regime wonít unduly impede hedge funds. The group said it was committed to leading its membership in complying with the new requirements.

The release isnít up on the SECís website yet (give it a week or two). Here are some details, discussed during the open meeting:

Donít read too much into this. IM associate director Robert Plaze said that the staff added a sentence to the release "making it absolutely clear that the rulemaking is solely limited to the method of counting clients for purposes of Section 203(b)(3)" and does not alter the duties or obligations owed by hedge fund advisers to clients or investors in any respect.

Who is a "U.S. client"? Offshore advisers only have to count U.S. clients towards the 14-client threshold. Plaze noted that the Advisers Act looks to the "residence" of a U.S person, but acknowledged that hedge fund investors that are corporations, trusts, and managed accounts "donít have residences." Plaze said the staff "clarified that in case of a corporation or business entity, itís the place of organization, [for] trusts, itís the location of the trustee."

What if a non-U.S. client moves? Plaze noted that typically, a non-U.S. person would become a U.S. person following a move to the States. However, he said that commenters "persuasively argued" that the staff should take a different approach for pooled vehicles. Under the rule, as recommended to the Commission, "you would look to the residency or the place of organization of the person at the time he or she invests in the pool."

Small and start-up hedge fund managers. Plaze said that commenters persuaded the staff to make a number of changes to the way the rule would apply to smaller hedge fund managers, such as family advisers. "This is actually one of the most significant changes from the proposal," he said. Certain executives, partners, and key employees of the advisory firm would be excluded from being counted towards the 14 client threshold. In the same vein, proprietary assets of the firm would not be counted towards the $25 million threshold. "The Advisers Act is not about protecting people you are in business with," said Plaze.

Grandfathering provisions and transition rules. Plaze said that the release will contain statements that the SEC staff "stands prepared to deal and assist with technical issues that come up," said Plaze. He also said the release will contain a number of transitional rules:

  • All investors in hedge funds as of the February 2006 compliance date will be grandfathered (as will be any individual clients of a hedge fund adviser), regardless of their status as "qualified clients" eligible to receive performance fees. "Nobody is going to have to leave the hedge fund who perhaps wouldnít be able to be eligible to be in the hedge fund in the future," Plaze promised.
  • The 12-month look-back for counting clients will go back only as far as February 1, 2006. (So, for example, in March 2006, there will effectively be a one-month look back). This, explained Plaze, is to address a situation where a hedge fund had many investors in the past, but come February 2006, only has five. "You wouldnít have retroactive registration obligations on hedge fund advisers that perhaps have gotten smaller [or] rearranged their business arrangements to avoid registration," said Plaze.
  • The two-year lock-up provision applies only to investments offered after February 1, 2006. "We would not make that retroactive," said Plaze. The upshot: a fund can impose a two-year lockup on all new investments coming into the fund post February 1, 2006, and thus avoid registration.
  • The performance backup requirements of the Advisers Act recordkeeping rule are being "relax[ed]" for hedge fund advisers, said Plaze, noting that they will still be subject to the anti-fraud provisions. Hedge fund managers "really werenít on notice that they were required to keep those records," he said.