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News July 19, 2004 Issue

Hedge Fund Manager Registration: The Details

The SEC last week proposed to require hedge fund managers to register with the SEC as investment advisers. If registered, hedge fund managers would be subject to the same regulatory scheme (with just a few exceptions) as any other SEC-registered investment adviser and would be subject to SEC inspections.

As expected, the proposal passed 3-2, with Commissioners Cynthia Glassman and Paul Atkins dissenting. At press time, the SECís release wasnít expected to be out for a least a few more days, as Glassman and Atkins asked that their views be added to the release. Comments will be due by September 15.

New Advisers Act Rule 203(b)(3)-2 would require advisers to "private funds" to look through each private fund and count each investor as a client (rather than the fund itself) for purposes of the 14 or fewer client de miminis exemption in Section 203(b)(3). The rule would define "private fund" as one that:

  • relies on Section 3(c)(1) or 3(c)(7) under the 1940 Act for an exemption from investment company registration;
  • permits its owners to redeem some portion of their ownership interests within two years of purchase (permitting redemptions in extraordinary cases only, such as for tax or regulatory reasons, would not make a fund into a private fund); and
  • is offered based on the investment advisory skills, ability, or expertise of the adviser.

SEC assistant director Jennifer Sawin explained that the staff believes that these characteristics are shared by virtually all hedge funds and distinguish them from other private pooled investment vehicles such as venture capital funds and private equity pools. She noted that the rule would not attempt to define hedge funds by reference to their investment strategies, trading frequency, or fee structure.

The SECís "private fund" definition is similar, but not identical, to the Department of Treasuryís proposed definition of "unregistered investment company" in the 2002 hedge fund rules. Among other things, Treasuryís definition only picks up funds with $1 million or more in total assets.

Speaking of assets: the SECís proposal would not change the $25 million assets under management threshold to be eligible for SEC registration as an investment adviser. Hedge fund advisers with less than $25 million AUM would not register with the SEC and could be subject to state registration.

In the fund of funds context, "an adviser to an underlying hedge fund would have to look through registered and unregistered funds of funds when counting its clients," said Sawin.

Sawin said that the rule would not apply to advisers to offshore public investment companies just because more than 14 of their investors move to the United States. Moreover, when offshore advisers to offshore private funds do have U.S. investors and have to register, the new rule would limit the application of the Advisers Act to those funds, she said.

It looks like hedge funds that hold out on registration will have an easier time than their brethren that came in voluntarily. The SEC proposed to amend the Advisers Act books and records rule to allow newly-registered hedge fund advisers to continue marketing their performance history from their pre-registration period, even if they did not have all the required performance back-up records from that period. Similarly, the performance fee rule would be amended to allow newly-registered hedge fund advisers to continue charging a performance fee to existing investors that do not meet the tests for "qualified client" status.

The SEC also proposed to make "minor changes" to Form ADV.