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News May 1, 2006 Issue

Texas Messes With IAR Notice Filings and Out-of-State Hedge Fund Advisers

The good folks at the Texas State Securities Board recently received a batch of IARD statistics from the NASD. They took a look at the number of SEC-registered advisers that had ticked the "Texas" box in Item 2.B. of Form ADV. And then they looked at the number of SEC-registered advisers that had registered or notice filed at least one investment adviser representative (IAR) in Texas.

They realized the two numbers didnít match up. Apparently, a significant number of SEC-registered advisers that had notice filed their firms in Texas had not taken the additional step of either registering or notice filing at least one IAR in Texas.

Itís not surprising that so many advisers that notice file in Texas didnít realize they had to additionally register or notice file at least one IAR there, too. "Texas is the only state in the nation that takes that position," said Investment Adviser Association general counsel Karen Barr.

A bit of background: Since the earliest days of the National Securities Markets Improvement Act (NSMIA), Texas has required all SEC-registered advisers with one or more Texas natural person clients to "notice file," despite the fact that most states have required notice filing only if they have a place of business in the state or had six or more clients who are residents of the state during the past twelve months. In addition, Texas additionally requires SEC-registered advisers that notice file in the state to either register or notice file at least one individual as an IAR in Texas ó even if none of the firmís IARs actually have a place of business in the state. As noted, the Lone Star state stands alone in this requirement.

In any event, about two weeks ago Texas sent a one-page statement to all of the SEC-registered advisers for which it did not have a IAR registration or notice filing on record. "It has come to our attention that . . . your [f]irm does not have any [IARs] registered or notice filed in Texas at this time," it warned.

But hereís the kicker: to notice file an IAR, the state asserted that an adviser must submit a Form U-4 for the individual. However, NSMIA made clear that a state can require an SEC-registered adviser to notice file only copies of documents that are filed with the SEC.

And U-4s arenít filed with the SEC.

IM Insight has heard that the Texas State Securities Board has been made aware of this issue. So, before you go through the hassle of filling out that U-4, you might want to contact your favorite lawyer (or your favorite Texas securities regulator) and inquire if you really have to do so.

But wait, thereís more.

If your firm is an SEC-registered hedge fund manager, and views your employees as safely out of reach of any state IAR registration requirements (because your firm has no natural person clients), think again.

Texas appears to be taking the position that out-of-state hedge fund advisers must look through their funds to see whether any of the underlying investors are Texas natural person residents. If so, Texasís view is that the firmís advisory personnel must register as IARs in Texas ó even if they never step foot in the Lone Star state.

Again, this may be subject to change. Hereís why: As you may know, the SECís IAR definition generally picks up any supervised person of an adviser who has more than five clients who are natural persons, and more than ten percent of whose clients are natural persons (other than natural persons who are qualified clients eligible to pay performance fees). For purposes of determining whether a hedge fund should be counted as one client, the IAR definition has long referred to the SECís Rule 203(b)(3)-1. That rule, in turn, states that an adviser can count a limited partnership, LLC, or other entity as one client if the adviser provides investment advice to the entity as a whole, rather than tailoring the advice to the individual investment objectives of its underlying investors.

Of course, Rule 203(b)(3)-1 was amended by the SECís hedge fund rulemaking, which added the look-through provision for "private funds" without a two-year lock-up. When the hedge fund rule was out for comment, the New York Bar Association expressed concern the look-through in the hedge fund rule could inadvertently affect IAR registration. The NY Bar worried that "many employees" of SEC-registered hedge fund advisers could become subject to state registration and related testing requirements because they might have more than five investors in their funds who are natural persons (other than qualified clients). "This unintended consequence," said the group, "could be remedied" by clarifying that the private fund definition was not applicable to the "who is the client" analysis under the IAR definition.

When it adopted the final hedge fund rule, the SEC did just that. It amended its IAR definition to make clear that the traditional Rule 203(b)(3)-1 test applies regardless of whether the fund in question is a "private fund" or not. In other words, for purposes of counting natural person clients, hedge funds could be counted as one client "without giving regard to the look through requirements" in the new hedge fund rule.

Apparently, this didnít sit well with Texas. The SECís final hedge fund release came out on December 2, 2004. Three months later, Texas proposed a new rule of its own, stating that for purposes of adviser and IAR registration, it would look through hedge funds. As adopted last summer, Texas rule 109.6 states that for purposes of determining who is an IAR required to register in Texas, the state will look through any hedge fund to see if any of the fundís underlying investors are natural persons resident in Texas. "Natural persons," explained the Texas State Securities Board, "simply are not institutions, regardless of their net worth or annual income. Likewise, a private investment entity, such as a hedge fund, composed partially or entirely of natural persons, does not equate to an institutional investor."

To put this all in context: Say youíre a SEC-registered adviser with one office in Stamford, Connecticut. All of your employees are based in Stamford. Youíve got two hedge funds, one domiciled in Delaware, the other in the Cayman Islands. You have no individual clients. Of the dozens of investors in your firmís hedge funds, a handful are high-net worth investors from Texas (oil money, no doubt). Under Texas's position, your firmís advisory personnel could find themselves subject to IAR registration in Texas. (Assuming, of course, that Texas knows who your fundís investors are and where they are located.)

The good news is that legally speaking, Texas's look-through rule cannot apply to SEC-registered advisers. For an SEC-registered adviser to be required to register an individual as an IAR, the individual must first meet the federal definition of "investment adviser representative," contained in Rule 203A-3(a). If it doesnít meet that definition, you donít go on to consider whether the individual would meet any applicable state IAR definition. So, for all intents and purposes, Texasís look-through provision, as applied to the question of whether an SEC-registered adviser must register its individuals as IARs in Texas, is moot. (Whether the hedge fund look-through applies to notice filing, however, is another matter. Since NSMIA was intended to be revenue-neutral, Texas arguably could possibly impose such a requirement.).

Going back to our Stamford, Connecticut adviser: To determine whether any of its employees are required to register as IARs in a state, the firm would look first at the SEC IAR definition and conclude that since each of its two hedge funds are managed on the basis of the fundís investment objectives, not those of any individual investor, its employees have, in effect, only two clients (namely, the two hedge funds). And since none of those two clients are natural persons, the employees cannot have five natural person clients.

Apparently, Texas isnít the only state taking this look-through approach to hedge funds. And IM Insight has learned that the issue will be a hot topic at the upcoming annual conference between SEC and state securities regulators, scheduled for May 9.

So stay tuned.

(Texas Securities Commissioner Denise Crawford could not be reached for comment before this article went to press. However, her comments will appear in next week's IM Insight.)