In December 2004, by a contentious 3-2 vote, the SEC adopted Rule 203(b)(3)-2 (the “Hedge Fund Rule”) under the Investment Advisers Act of 1940. The Hedge Fund Rule requires investment advisers to count as clients the investors in a “private fund” (as defined in the United States Investment Advisers Act of 1940, as amended, the “Advisers Act”). Hedge fund advisers previously relied on the “private adviser exemption” from registration provided in Section 203(b)(2) of the Advisers Act, which provides that an adviser which has had fewer than 15 clients during the course of the preceding 12 months and that neither holds itself out generally to the public as an investment adviser nor acts as an investment adviser to any registered investment company is not required to register with the SEC. Prior to adopting the Hedge Fund Rule, the SEC had interpreted the definition of “client” to refer to the fund alone, rather than to an entity’s investors. Under the Hedge Fund Rule, many hedge fund advisers were required to register under the Advisers Act by February 2006.
On June 23, 2006, the US Court of Appeals for the D.C. Circuit issued an opinion in the Goldstein decision vacating and remanding the Hedge Fund Rule. The court found that the SEC’s change in its interpretation of the word “client” was “arbitrary” and “falls outside the bounds of reasonableness.” The court stated that “the [SEC]’s interpretation of the word ‘client’ comes close to violating the plain language of the statute. At best, it is counterintuitive to characterise the investors in a hedge fund as the ‘clients’ of the adviser.” The court further opined that the SEC had not adequately explained the justification for treating hedge fund investors as clients and altering its past interpretation of Section 203(b)(3). The court also noted that an adviser would inevitably face conflicts of interest if it owed a fiduciary duty both to investors and to the entity through which such investors invest in the hedge fund.
Will the SEC Appeal? What is the Current Law?
For a short period, there was speculation that the SEC might choose to appeal the court’s opinion, but given the court’s decisive 3-0 vote in vacating and remanding the Hedge Fund Rule, this was at best a remote possibility. On June 20, SEC member Paul S. Atkins addressed a conference sponsored by the American Society of Corporate Secretaries, during which he said that the SEC would not pursue rehearing at the D.C. Circuit Court of Appeals or review by the US Supreme Court. This means that the entire package of rules adopted in December 2004 is likely to be rescinded by the SEC. Hedge funds will now count – as they did prior to the adoption of the Hedge Fund Rule – each fund as a single client of their adviser. An investment adviser with fewer than 15 funds during the preceding 12 months will be eligible to rely on the “private adviser” exemption from registration with the SEC as an investment adviser, which is set out in Section 203(b)(3) of the Advisers Act. Rule 203(b)(3)-1 under the Advisers Act states that the following are counted as a single client for purposes of the private adviser exemption.
- A natural person, and
- Any minor child of the natural person;
- Any relative, spouse, or relative of the spouse of the natural person who has the same principal residence;
- All accounts or trusts of which the natural person and/or the persons referred to above are the only primary beneficiaries; and
- A corporation, general partnership, limited partnership, limited liability company, or other legal organisation (such as an investment unit trust) to which an adviser provides
- investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which are referred to hereinafter as an “owner”); and
- Two or more legal organisations referred to above that have identical owners.
Matters of Note
Two things are important to note: first, an investor in a fund will be considered a separate client if it receives advice separate from advisory services provided to that fund. This potentially could re-classify certain “side pockets” in hedge funds as constituting a separate client of the advisor. Second, a non-US-based investment adviser counts US citizens for purposes of this exemption, and need not count non-US persons investing in an offshore fund at all. The rules set out above were the old rules for counting for purposes of meeting the exemption, and they are again, now the current rules – absent a change in the legislation.
Where to From Here for Asian-based Registered Advisers?
Not wanting to miss an opportunity to ride the coattails of free publicity, a number of members of Congress have already announced their intention to introduce legislation that would give the SEC authority to regulate hedge fund managers. Since it is not clear whether and when legislation would be passed by both houses of Congress, much less what the shape of the legislation would be, we suggest that currently registered investment advisers consider the following:
- Neither the short- nor long-range effects of this decision are clear. Currently registered hedge fund advisers should not deregister at this time. Instead, registered advisers should wait a period of several months, pending further clarification of registration requirements.
- Advisers that have implemented a compliance program should retain these programs as a matter of best business practice, independent of legal developments in the Adviser Act regulatory regime, and independent of any decision to de-register.
- Certain advisers who registered under the so-called “Adviser Lite” compliance regime of the Hedge Fund Rule, because their principal office and place of business is outside the United States, should be aware that the Adviser Lite concept has fallen away. Once registered with the SEC, all registrants are now expected to comply with all the substantive provisions of the Adviser Act, though it is unclear how aggressive the SEC will be in enforcing the Advisers Act in respect of advisers who registered in reliance of a lighter regulatory burden. Advisers who did become registered under the Adviser Lite regime are cautioned not to trumpet or advertise their status as a SEC registered adviser unless they are fully in support of all compliance obligations under the Advisers Act. It is also prudent for such registered advisers to await further developments and clarification from the SEC regarding the status of such advisers before seeking deregistration.
Effie Vasilopoulos is a Partner and Scott Peterman is a Consultant based in the Hong Kong office of Sidley Austin.
Sidley Austin LLP, a Delaware limited liability partnership, operates in affiliation with other partnerships, including Sidley Austin LLP, an Illinois limited liability partnership, Sidley Austin, an English general partnership (through which the London office operates) and Sidley Austin, a New York general partnership (through which the Hong Kong office operates). The affiliated partnerships are referred to herein collectively as Sidley Austin, Sidley or the firm.
This has been prepared by Sidley Austin for informational purposes only and does not constitute legal advice. This information is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Readers should not act upon this without seeking professional counsel.