Introduction

On October 26, 2004, the US Securities and Exchange Commission (the "SEC") adopted new rule 203(b)(3)-2 and conforming and transitional amendments to other rules (collectively, the "Rules") under the Investment Advisers Act of 1940 (the "Act") that will require most hedge fund advisers to register with the SEC. The SEC also amended the form required to effect registration, Form ADV. Most unregistered US and non-US advisers of hedge funds currently rely on the "private adviser" exemption from registration under the Act for an investment adviser that has had fewer than 15 clients during the preceding 12 months. Before the new Rules, an adviser was permitted to count each of its hedge funds as a single client for purposes of the private adviser exemption. The new Rules will require an adviser to look through its "private funds" to count each US investor as a client for purposes of the private adviser exemption.

The new Rules apply to both an investment adviser whose principal office and place of business is located inside the United States (a "US adviser") and an investment adviser whose principal office and place of business is located outside the United States (an "offshore adviser"). In order to register with the SEC, a US adviser must have a minimum of $25 million in assets under management. This minimum asset requirement does not apply to an offshore adviser. As was the case under the old rules, registration of an offshore adviser will depend on it having a minimum number of US clients. Under the new Rules an offshore adviser is only required to count investors in its private funds who are residents of the United States as clients for purposes of the private adviser exemption. These new Rules represent a sea-change in the regulatory environment for offshore advisers. Before the Rules were enacted, many offshore advisers had considered the application of the Act to their activities so remote that they never sought to comprehend the pronouncements and no-action letters shaping SEC practice regarding offshore advisers.

In addition, the new Rules permit a registered offshore adviser to treat its private funds that are organised under the laws of a country other than the United States ("offshore private funds") as clients (instead of the investors therein) for all purposes of the Act save for provisions that deal with registration, books and records, SEC inspections and certain of the Act's anti-fraud provisions. The SEC has stated that this measure was necessary to avoid unintended extraterritorial application of the Act to dealings between registered offshore advisers and non-US investors in their offshore hedge funds, since it would often not be possible to restrict the burden of compliance with the Act to be only with respect to US investors. As we will discuss below, however, it is not clear what the SEC's intentions are regarding enforcement actions or expanding regulatory obligations, or that these limitations will protect offshore investors from unintended extraterritorial application of the Act.

The SEC has also said that the new Rules are not intended to represent a change from its current practice of substantially limiting the extraterritorial application of the Act. This rings hollow, however, and is at odds with the substance of the rule changes requiring broad registration. By seeking to subject thousands of offshore advisers to registration under the Act, the SEC cannot claim that it intends its extraterritorial effects will be limited. There would seem to be little reason to cause all of these advisers to register unless the SEC intended to have a meaningful oversight or supervisory role. The SEC will either examine offshore advisers, seeking to enforce their compliance with certain provisions of the Act, or the new Rules will be rendered meaningless with respect to offshore advisers. Thus, the SEC continues to send mixed messages to the hedge fund management community worldwide. The resulting uncertainty regarding the SEC's intentions with respect to enforcement actions and its apparent intent to increase its regulatory reach will have negative effects, including reducing overseas investment opportunities for sophisticated US investors. In addition, until the new Rules were proposed, many offshore advisers were able to ignore compliance obligations under the Act. Since offshore funds managed by offshore advisers were not "clients" under the Act, offshore advisers considered the application of the Act to their activities so remote that they never sought, and were not required, to comprehend the large number of SEC pronouncements and no-action letters shaping SEC practice regarding offshore advisers. These SEC pronouncements relate to a wide variety of fact patterns and do not represent integrated and principled guidance for offshore advisers.

This article summarises the registration requirements of the new Rules and the compliance obligations of offshore advisers required to register under the Act. Under the new Rules, hedge fund advisers may have to register with the SEC as soon as February 1, 2006.

Executive Summary

The new Rules require investment advisers to count each owner of a private fund towards the threshold of 14 clients for purposes of determining the availability of the private adviser exemption of the Act. An offshore adviser with the requisite number of clients or investors in a private fund will be subject to various compliance obligations, including:

• registration on Form ADV,
  
• the anti-fraud provisions of the Act, including with respect to dealings between the adviser and non-US clients, and
  
• maintaining in English certain books and records.

In addition, registered advisers will be subject to SEC examination.

Definition of a Private Fund

In modifying the private adviser exemption to registration from the Act, the SEC intended that most hedge fund managers register with the SEC under the Act. To accomplish this, the SEC defined the term "private funds" around certain characteristics it believes are typical in most hedge funds. Under the Rules adopted, a private fund is one that:

• would be an investment company under the Investment Company Act of 1940 (the "Investment Company Act") but for the exemptions in Sections 3(c)(1) and 3(c)(7) of the Act;
  
• permits investors to redeem their ownership interests within two years of purchase; and
  
• is offered based on the investment advisory skills, ability or expertise of the investment adviser.

Investment Company Act Exemptions

The SEC crafted the definition of a private fund to include only those pooled vehicles that would be required to register under the Investment Company Act but for the exemptions provided by Sections 3(c)(1) and 3(c)(7) of that act. Offshore private funds, like all investment entities, must find an exemption from the Investment Company Act with respect to its US investors or be registered under that act. If the offshore private fund's exemption from Investment Company Act registration is based on Section 3(c)(1) or Section 3(c)(7), as described below, with respect to US persons, then it is a "private fund" as defined in the new Rules¹. In general, only US persons are counted for purposes of determining whether an offshore private fund satisfies the Section 3(c)(1) or Section 3(c)(7) exemption. Section 3(c)(1) provides an exemption for investment companies whose securities are not beneficially owned by more than 100 persons and does not offer its securities to the public, and Section 3(c)(7) exempts from Investment Company Act registration those issuers whose securities are owned by qualified purchasers² and the issuer does not propose to make a public offering of its securities. In each case, an offshore private fund's non-US person investors are not counted for purposes of relying on the Section 3(c)(1) or Section 3(c)(7) exemptions from the Investment Company Act's registration requirements.

Redemption Requirements

In its new Rules, the SEC drafted the definition of private fund to exclude pooled investment vehicles such as private equity funds or venture capital funds that generally require long-term commitments of capital. The two year redemption test is intended to make this important distinction. The test will not apply to any purchases or capital contributions made before February 1, 2006. The two-year test will apply on a separate basis for each interest purchased or amount of capital contributed to a fund, something that will likely require many funds to develop a "first-in, first-out" system for determining the age of purchases and contributions. The new Rules also expressly provide for two circumstances where a pooled investment vehicle will not be deemed a private fund: first, if it permits owners to redeem their ownership interests within two years of such interest's purchase in the case of "extraordinary events" and, second, where the redeemed interests were acquired through distributed capital gains or income. Furthermore, an investment fund will not be considered to have redeemed the ownership interests of its investors where it makes distributions to all owners, or a class of owners, in accordance with the fund's governing documents.

Advisory Skill, Ability or Expertise

A fund is not a private fund under the rule unless the interests in it are offered based on the ability, expertise and skill of the investment adviser. SEC anti-abuse rules will prevent advisers from circumventing this rule by delegating advisory functions to sub-advisers or other tiered adviser structures.

Publicly Offered Offshore Funds

The new Rules are not intended to require advisers of publicly offered offshore mutual funds or closed-end funds to register under the Act. Therefore, notwithstanding what generally constitutes a private fund under the new Rules, an investment adviser would not be required to look through a fund to count each investor as a client for purposes of determining if it is exempt from registration where (i) the fund has a principal office and place of business outside the United States; (ii) makes a public offering of its securities in a country other than the United States; and (iii) is regulated as a public investment company under the laws of a country other than the United States.

Non-US Investment Advisers

As stated earlier, an investment adviser whose principal office and place of business is located outside the United States is only required to count as clients those investors in its private funds who are residents of the United States. If the offshore adviser has had more than 14 US investors or advisory clients during the preceding 12 months, the offshore adviser must register with the SEC³ . The Rules, however, contain a transitional provision and do not require an offshore adviser to look further back than February 1, 2006, when counting US clients or investors. This transitional provision gives offshore advisers an opportunity, prior to February 1, 2006, to evaluate their investor base and determine whether it is willing to subject itself to SEC registration. For example, an adviser may determine to redeem US investors from the funds it manages in order to avoid registration. After January 31, 2006, the adviser may have to determine not to admit further US investors, or at least be selective in which US investors it admits (for example, admitting a large institutional or fund of hedge funds investor, but not taking up a "slot" for a lesser investor), in order to avoid registration.

Importantly, master-feeder structures require the adviser to look through the master fund as well as the feeder fund in order to count US investors as clients.

The Rules allow an adviser to a private fund to determine whether an investor is a US client or non-US client at the time of the investment of the client in the private fund. Guidance from the SEC in the release accompanying the issuance of the final rule suggests that (1) in the case of individuals, the adviser looks to the residency of the individual; (2) in the case of a business entity, the adviser looks to the location of the principal office and place of business of the entity; (3) in the case of an account managed by other investment advisers, the adviser should look through the account to the location or residency of the beneficiary of the managed account; and (4) in the case of a personal trust or estate, the adviser should look to Regulation S promulgated under the Securities Act of 1933, as amended, for guidance in determining the status of the trust or estate. Regulation S indicates that a trust of which any trustee is a US person is considered a US person and an estate of which any executor or administrator is a US person is also considered a US person. Certain types of estates and trusts, however, are deemed not to be US persons.

Compliance Obligations

An offshore adviser with the requisite number of clients or investors in a private fund will be subject to various compliance obligations including registration on Form ADV, the anti-fraud provisions of the Act, examinations by the SEC, and will be required to keep certain books and records in English.

Unfortunately for offshore advisers with US investors or clients, the SEC's guidance regarding the scope of an offshore adviser's compliance obligations is unclear. The SEC has sent mixed messages in its statements, in the release proposing the new Rule and in the release accompanying the final version of the new Rules, asserting that most provisions of the Act will not apply to offshore advisers yet still asserting extraterritorial authority over them, subjecting them to US anti-fraud rules even for relationships not involving US investors or clients and exposing them to SEC examination. The SEC's ability to conduct examinations of offshore advisers, applying US anti-fraud rules to them, and requiring all records to be maintained in English fundamentally means that the offshore adviser's activities can be scrutinised almost as thoroughly as an adviser domiciled in the United States. It is important to note under the Act, accounts and funds managed by a registered offshore adviser can still be examined by the SEC, even if such fund does not contain US investors. The SEC expressly retains the authority to insure that the funds and accounts containing US investors are being treated fairly, similarly, or otherwise not being prejudiced by the adviser in favour of the accounts and funds that do not contain US investors. An offshore adviser, therefore, will bear particular scrutiny for activities involving a potential conflict of interest, such as conducting agency cross transactions and principal trades.

Registration

An offshore adviser required to register with the SEC under the new Rules will have to file a registration statement on Form ADV with the SEC identifying itself as an adviser to a private fund and include basic disclosures. The registered adviser will also be responsible for keeping its Form ADV "current"⁴. In Form ADV, offshore advisers will be required to provide basic information to the SEC, including:

• the identity of the private funds they manage and the amount of assets in these funds;
  
• information about past disciplinary events of the investment managers;
  
• information concerning their investment strategies;
  
• the identity of their key employees;
  
• the identity of all directors and investment managers who provide advice to US clients;
  
• information about other businesses they conduct; and
• the identity of those who control or own them.

Anti-Fraud

The SEC has taken the position that the Act should not generally govern dealings between an offshore adviser and its offshore clients, even when the offshore adviser is registered under the Act. This "hands-off" position is based on a "conduct and effects" approach the SEC has applied in determining whether it has jurisdiction over persons outside the United States. Under this approach most of the Act's provisions are not applied to the dealings of an offshore adviser with its offshore clients, unless those dealings give rise to the requisite degree of "effects" for US markets or clients. The SEC staff has always reserved the right to apply the Act to dealings between an offshore adviser and its offshore clients because these dealings have the potential to have a significant effect on the offshore adviser's US clients or on US markets. The SEC staff has concluded that the SEC must retain the ability to monitor and enforce an offshore adviser's obligation to its US clients and to insure the integrity of the US markets.

Applying the conduct and effects approach to testing its extraterritorial reach, the SEC has concluded that it has the authority to examine the trade allocation policies of an offshore adviser, the pricing mechanisms it uses and how the offshore adviser treats conflicts of interest between itself and its clients as well as between its clients. The SEC has consistently concluded that it has the right and the obligation to subject offshore advisers to this level of scrutiny, but this is inconsistent with the SEC's statement that it will seek to limit the extraterritorial effect of universal registration. In fact, one of the SEC's goals in requiring universal registration is to facilitate its enforcement activities.

Examinations

As discussed above, registered offshore advisers will be subject to examination by the SEC. A registered offshore adviser will be required to provide to the SEC staff any and all records, in English, required by the SEC rules as well as all records required under foreign law, whether or not they relate to US investors. It is unclear whether the SEC will require that other records maintained by an offshore adviser be translated into English. It seems logical that the SEC would require such translations, otherwise its claimed right to pursue enforcement actions based on the conducts and effects test would be substantially meaningless.

Books & Records to be Maintained by Offshore Advisers to Private Funds

If required to register under the Act, the offshore adviser may treat the fund as its client for most purposes under the Act. The offshore adviser will, however, have to maintain certain books and records. Specifically, the adviser must retain order memoranda and originals of all written communication received and copies of written communication sent that pertain to the recommendations or advice, receipt or delivery of securities, or an order or placing of an order to purchase or sell any securities of the US investors in its private fund or advisory clients. The offshore adviser must also maintain the following for its US investors: a list of all accounts in which the investment adviser is vested with discretionary authority; powers of attorney granting the discretionary authority; copies of the written agreements between the investment adviser and the client; copies of the statements it sends to the client or investor; written acknowledgement of receipt obtained from clients; and the records to support performance advertisements. Furthermore, because these offshore advisers are not required to comply with all of the provisions of the Act, the offshore advisers must not hold themselves out to potential or existing offshore clients as being registered under the Act.

The books and records required to be maintained by advisers registered under the Act must be retained for a period of not less than five years. These records must be maintained in the adviser's principal place of business for a period of two years and then should be retained in an accessible area for the remaining three years. Additionally, the investment adviser must provide these records promptly when asked by the SEC examiners. The adviser is allowed to keep records in electronic format. If stored in electronic format, these records must be arranged for ease of accessibility by the SEC examiners. Duplicate copies of the electronic records must be stored in a safe location. Data that are stored in an electronic manner must be protected and the adviser should limit access to such records. Also, the adviser must ensure the true, legible and complete reproduction of the records if they are stored in electronic format.

Rule 204-2(a) provides in detail the books and records an investment adviser must maintain in order to fulfill its registration requirements. A detailed and somewhat inconsistent body of law and guidance accompanying rule releases provides assistance on which records an offshore adviser advising an offshore private fund with no US clients (other than for "counting" purposes) must keep. Under such guidance, the offshore adviser must keep the following:

• a journal or journals, including cash receipts and disbursements, records and any other records of original entry forming the bases of entries into any ledger;
  
• general and auxiliary ledgers reflecting asset, liability, reserve, capital, income and expense accounts;
  
• cheque books, bank statements, cancelled cheques and cash reconciliations of the investment adviser;
  
• all bills or statements (or copies thereof), paid or unpaid, relating to the business of the investment adviser as such; and
  
• all trial balances, financial statements and internal audit working papers relating to the business of such investment adviser.

The following books and records need to be maintained by offshore advisers when the transactions involve US clients and related securities transactions:

• Memorandum of each order given by the investment adviser for the purchase and sale of any security, of any instruction received by the investment adviser concerning the purchase, sale, receipt or delivery of a particular security, and of any modification or cancellation of any such order or instruction. Such memoranda shall show the terms and conditions of the order, instruction, modification or cancellation; shall identify the person connected with the investment adviser who recommended the transaction to the client and the person who entered or placed such order; and shall show the account for which the order or instruction was entered, the date of entry, and the bank, broker or dealer by or through whom executed where appropriate. Discretionary orders shall be so designated.
  
• Originals of written communications received from clients and all copies of written communications sent by such investment adviser relating to (i) recommendations given or proposed to be made and advice given or proposed to be given, (ii) any receipt, disbursement or delivery of funds or securities, or (iii) the placing or execution of any order to purchase or sell any security.

The following should be kept for US investors even when treating the fund as the client.

• A list or other record of all accounts in which the investment adviser is vested with discretionary power of any client.
  
• All powers of attorney and other evidences of the granting of discretionary authority by any client to the investment adviser.
  
• All written agreements (or copies thereof) entered into by the investment adviser with any client or otherwise relating to the business of such investment adviser as such.
  
• A copy of each notice, circular, advertisement, etc or other communication that the investment adviser circulates or distributes, directly or indirectly, to 10 or more persons, and if such notice recommends the purchase or sale of a security and does not state the reasons for such recommendation, a memorandum of the investment adviser indicating the reasons thereof.
  
• Access persons' personal securities reports.

Conclusion

Thus with the swipe of its regulatory pen, the SEC extended the scope of its authority over investment advisers to well beyond the geographic boundaries of the United States. By requiring all hedge fund advisers to look through their funds and count the owners of those funds in order to determine eligibility for the private advisers exemption, the SEC added hundreds, if not thousands, of offshore investment advisers to its regulatory rolls. Offshore hedge fund advisers that previously relied upon the private advisers exemption to escape regulation under the Investment Advisers Act and that had largely ignored the regulations under the Act and other related SEC pronouncements are now faced with having to evaluate the implications of registering with the SEC on its business. Even though the SEC insists that the offshore adviser required to register for 'counting purposes only' will not have to comply with the full set of regulations, the SEC does require those advisers to maintain a current Form ADV, maintain books and records in English, and submit to periodic examinations by SEC staff, including examination of accounts and funds of offshore advisers that contain no US investors. The new Rules, therefore, are understandably threatening to offshore advisers.

These Rules were not unanimously enacted. Accompanying both the proposed Rules and the final Rules was a strongly worded dissent from two of the SEC Commissioners. Commissioners Atkins and Glassman opposed the new Rules, objecting to the swift enactment period, the lack of coordination with other regulatory bodies, and the justification that a swiftly growing industry requires universal regulation. Moreover, many of the comment letters received by the SEC sought clarification on how the Rules would dovetail with the existing body of no-action letters and previous SEC releases relating to offshore advisers, but no new unifying principals or additional guidance were offered.

The lack of clarity in the Rules and confusion about the ultimate reach should not, however, leave the offshore adviser in despair. The SEC has publicly announced plans to rethink the inspection model, which historically has focused on site visits and information requests, and shift to a risk-based examination model that will focus examiners on the advisers that demonstrate, in the Commission's view, a heightened risk of fraudulent activity. A risk-based examination model should make periodic examinations less burdensome for the advisers that comply with the new Rules. The deadline for final compliance with the Rules is about a year away from the date of this article, and offshore advisers that establish and maintain rigorous compliance programmes will likely find this new regulatory burden to be less onerous after the first full year of enactment.