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News December 6, 2004 Issue

The Hedge Fund Release is Out!

Itís a monster, with 160 pages and close to 500 painstakingly-detailed footnotes. While the 30-page dissent filed by Commissioners Cynthia Glassman and Paul Atkins makes for an interesting read, the upshot is that roughly 1,000 hedge fund managers will have to register with the SEC as investment advisers by February 1, 2006.

Of note: the release officially states, for the first time in writing, that SEC has delayed the compliance date for the new Advisers Act personal trading rule until February 1, 2005 (see footnote 274).

The final rules contain several changes that will affect currently-registered advisers that manage hedge funds:

Form ADV. Advisers should look for minor changes to Item 7.B. of Form ADV and Section 7.B. of Schedule D when preparing their next annual updating amendment. The changes will appear on IARD on March 8, 2005.

Custody. The custody rule has been modified to give hedge funds 120 days after the end of their fiscal year to distribute their audited financials. Fund of funds have 180 days. The SEC defined fund of funds as a fund that invests 10 percent or more of its total assets in one or more unrelated funds (not advised by a related person of the first fund, its general partner, or its adviser). Related funds should have "ample opportunity" to coordinate their audits, explained the SEC. So, under the new definition, a fund that invests 95 percent in direct investments, and 5 percent in other funds, would not be a fund of funds and would have to distribute its audited financials within 120 days.

Other places where advisers count clients. When counting clients for purposes of the investment adviser representative definition in Rule 203A-3 and the national de minimis exemption (Section 222(d)), advisers can count clients the old-fashioned way (treating each hedge fund as one client, rather than looking through and counting individual investors).

While the final rule text largely tracks that of the proposal, there are several changes that will affect new registrants. Among them:

Proprietary accounts not counted. For purposes of counting investors in the hedge fund, an adviser does not need to count "proprietary" investors, such as the advisory firm itself, the firmís executives, directors, etc., and non-clerical employees who regularly participate in the firmís investment activities with at least one yearís experience.

Exceptions to the lockup. The SEC slightly modified the two-year lockup provision, to permit exceptions to the lockup in extraordinary events, regardless of whether the events were "foreseeable" (a test applied in the proposed rule). Investors can redeem interests in the hedge fund acquired through the reinvestment of distributed capital gains or income (not just through reinvestment of dividends, as had been proposed) without violating the lockup provision. And, in the release, the SEC clarified that advisers must apply the two-year lockup test to investments made on or after February 1, 2006, regardless of whether the investments are made by new or existing investors. Advisers, however, do not need to apply the lockup test to investments made prior to that date.

Performance fees. The final amendments to Rule 205-3 permit non-qualified clients in 3(c)(1) funds that carry performance fees to keep their investments and even add to them, despite the fact that it would otherwise be prohibited once the manager registers as an adviser. Similarly, Rule 205-3 has been amended to permit newly-registered hedge fund advisers to continue any non-fund advisory contracts that contain a performance fee with non-qualified clients.

Foreign advisers. Foreign advisers, which need only count U.S. resident clients towards the 15-client de minimis, need only consider the residency of an hedge fund investor at the time the investor makes their investment in the fund.