Last month Futures interviewed Commodity Futures Trading Commission (CFTC) Chairman Gary Gensler shortly after the passage of the Dodd-Frank Act. Gensler spoke of the CFTC’s role in writing rules for the law and cooperating with other regulators to implement it. Since then, the agency already has completed some of its work -- rules for retail foreign exchange trading -- though most of the rules won’t be complete until next summer, a year after Dodd-Frank became law.
We wanted to look closer at how the law can affect different areas of the futures industry and chose experts to examine what the law will mean to these key sectors.
How financial reform will affect managed money
By David Matteson
Inasmuch as the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Act”) represents a wholesale revision to the regulation of financial services in the United States, it follows that the managed money sector of financial services also will be greatly affected. The scope of the changes will be significantly influenced by the rules to be adopted by the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC). Because most of those rules have not been proposed, much less adopted, we are left to speculate as to what 2011 and beyond will mean for alternative investment products. Here are the implications for private funds and their advisors:
Removal of de minimus
The Act removes the most common exemption from the investment adviser registration requirement for advisers to private funds under the Investment Advisers Act of 1940, as amended (“Advisers Act”). The de minimus exemption applies to an adviser with fewer than 15 clients in any 12-month period that does not hold itself out generally to the public as an investment adviser. This exemption is commonly relied on by private fund managers advising fewer than 15 funds because each fund is generally treated as a single client of the manager without regard to the number of underlying investors in the fund under Rule 203(b)(3)-1 of the Advisers Act. A private fund is defined in Section 402 as any pooled investment vehicle that would be an investment company under the Investment Company Act of 1940, as amended (the “1940 Act”) but for sections 3(c)(1) or 3(c)(7) thereof.
Implications: Every alternative manager that manages some type of securities that had relied on the de minimus exemption from registration with the SEC as an investment adviser will have to find another exemption or register.
New exemptions for advisers with less than $150 million
Section 408 creates a new exemption from registration for advisers to private funds with total assets under management in the United States of less than $150 million. These advisers are subject to such recordkeeping and reporting rules that the SEC determines.
Such advisers may have to register under one or more state laws. Section 408 provides that the SEC must consider the systemic risk posed by mid-sized private funds when prescribing registration and examination procedures for advisers to those funds. The Act does not define “mid-sized private funds” but, presumably, they are smaller private funds whose advisers are not eligible for the $150 million exemption.
Section 410 of the Act maintains the minimum amount of assets under management for registration with the SEC at $25 million. However, it provides that investment advisers with between $25 million and $100 million in assets under management may not register with the SEC, unless the adviser otherwise would be required to register with 15 or more states. The SEC may increase the $100 million threshold by rule.
Implications: The threshold for hedge fund managers to register with the SEC has changed from “counting the clients” to “counting the AUM.” The good news is that hedge fund managers with less than $150 million under management will be exempt from SEC registration. Earlier versions of the legislation had placed that threshold as low as $30 million or $50 million. The bad news is that advisors that are exempt from federal registration likely will have to register in one or more states where the adviser and clients are located. This may involve multiple state registration processes and rules that are not uniform.
New exemptions for family offices and venture capital
The Act changes the definition of investment adviser to exclude family offices (Section 409) and add exclusions from registration for advisers to venture capital funds (Section 407). The Act directs the SEC to define “venture capital fund” within one year of enactment. Venture capital fund advisers relying on the exemption are subject to such recordkeeping and reporting rules as the SEC determines are necessary or appropriate in the public interest and for the protection of investors. There are no recordkeeping or reporting obligations for family offices.
Implications: Private equity funds did not get the “pass” that family offices and venture capital advisers received. The definition of family office to be adopted by the SEC will be critical in determining the breadth of this exemption. Many family offices render services to non-family clients and operate in a quasi-commercial capacity and may not be able to qualify as a family office.
Recordkeeping and reporting requirements
In addition to the existing regulatory and reporting obligations of registered investment advisers, Section 406 requires registered investment advisers of private funds to provide the SEC and a newly created Financial Stability Oversight Counsel (FSOC) with additional information about each private fund they manage. The Act also directs the SEC to conduct periodic inspections of all records of private funds managed by registered investment advisers. These records will generally be treated as confidential and not subject to public disclosure. The records must include a description of: 1) assets under management and use of leverage; 2) counterparty credit risk exposure; 3) trading and investment positions; 4) valuation methodologies; 5) types of assets held; 6) side agreements or side letters; 7) trading practices; and 8) such other information as the SEC, in consultation with the FSOC, deems necessary and appropriate in the public’s interest and for the protection of investors or for the assessment of systemic risk.
Implications: Most of the discussion in the popular press during the Dodd-Frank deliberations related to the new registration requirements. In fact, the process of getting registered as an investment adviser with the SEC is simple and straightforward. The difficult and more costly aspects of registration are the compliance programs that are required and the ongoing reporting obligations.
David Matteson is a partner with Drinker Biddle & Reath LLP and heads their managed futures practice.