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Investment Advisers to Private Funds Subject to Registration with the SEC Under the Obama Administration's Plan for Financial Regulatory Reform

On June 17, 2009, the Obama Administration proposed a sweeping plan for regulatory reform to modernize and protect the integrity of the United States financial system (the “Plan”). Prompted by the financial crisis and the failure of a number of large financial institutions, the Plan seeks to correct weaknesses in the government’s supervision of financial institutions by providing regulatory agencies with broader access to information.

Because private pools of capital can pose systemic risks and, to a lesser extent, as a better guard against fraud on investors by investment advisers, the Plan includes a proposal that would require all investment advisers to hedge funds, private equity funds, and other pools of capital (collectively, “Funds”) whose assets under management exceed a “modest threshold”[1] to register with the Securities and Exchange Commission (the “SEC”) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Currently, many investment advisers to Funds are not required to register with the SEC regardless of their assets under management in reliance on the “private adviser exemption” set forth in Section 203(b)(3) of the Advisers Act.[2]

Registering with the SEC will have significant impact on private investment advisers. All federally registered advisers are subject to the inspection programs of the SEC, and the SEC has broad authority to inspect such advisers’ books and records. In addition, federally registered advisers are required among other things, to (i) maintain custody of client assets with a qualified custodian (e.g., a bank or a broker-dealer) and provide account statements (either directly, or indirectly through the qualified custodian) to investors on a quarterly basis [3], (ii) restrict advertising practices to comply with Advisers Act rules as well as interpretations promulgated by the SEC Staff, (iii) draft extensive written supervisory policies and procedures reasonably designed to prevent violations of the Advisers Act, (iv) make and maintain books and records pertaining to their advisory business, including accounting records, written advisory agreements, order memorandums, and documents relating to the adviser’s investment performance claims, (v) disclose all material facts about their financial condition and disciplinary history, and (vi) complete and annually update the Form ADV.

In addition to the foregoing, the Plan proposes a more robust supervisory regime for any financial institution whose combination of size, leverage, and interconnectedness to the markets could pose a threat to the financial system. Such institutions, referred to in the Plan as Tier 1 Financial Holding Companies (“Tier 1 FHCs”), would be subject to heightened and consolidated supervision and regulation by the Federal Reserve, which currently supervises all major U.S. commercial and investment banks under the Bank Holding Act. The Plan would require federally registered advisers to disclose to the SEC on a confidential basis the amount of assets under management, leverage, off balance sheet exposures, and other information to determine whether each Fund poses a threat to the stability of the financial system. The SEC would then share the reports with the Federal Reserve, which would determine whether a Fund is a Tier 1 FHC subject to its oversight. In doing so, the Federal Reserve will consider the following factors:

• The impact the Fund’s failure would have on the financial system and the economy;
• The Fund’s combination of size, leverage, and degree of reliance on short term funding;
• The Fund’s criticality as a source of credit for households, business, and state and local governments, and as a source of liquidity for the financial system; and
• The systemic importance of the Fund under stressed economic conditions, including the impact the Fund’s failure would have on other large financial institutions, on payment, clearing and settlement systems, and on the amount of cash in the economy.

The Plans would require the Federal Reserve to impose rigorous liquidity risk requirements on Funds that qualify as Tier 1 FHCs to mitigate the potential negative impact on the financial system of a Fund experiencing financial distress, rapid deleveraging, or a disorderly failure. The Federal Reserve would also be required to implement capital requirements for Tier 1 FHCs which would require them to maintain enough high-quality capital during strong economic periods to sustain them above prudential minimum capital requirements during distressed economic periods. Finally, Tier 1 FHCs would be subject to a prompt corrective action regime that would require the Fund or its supervisor to take corrective action as the firms’ regulatory capital levels decline.

While it is too early to say what aspects of the administration’s Plan will be enacted into law, there has been growing momentum to require advisers to Funds to register. As a result, Advisers to Funds should begin to analyze their supervisory systems and business practices in anticipation of needing to register with the SEC.

[1] The Plan does not provide guidance with respect to the assets under management threshold that would trigger SEC registration. Currently, the Advisers Act generally requires investment advisers with more than $30 million under management to register with the SEC, and it permits investment advisers with $25 million under management to register with the SEC.

[2] Pursuant to Section 203(b)(3) of the Advisers Act, investment advisers are not required to register with the SEC so long as they have fewer than 15 clients within the preceding 12 month period, do not advise registered investment companies (e.g., mutual funds or business development companies), and do not hold themselves out to the public as investment advisers.

[3] The SEC has recently proposed amendments to Rule 206(4)-2 under the Advisers Act (the “Custody Rule”). A full description of the proposed amendments to the Custody Rule prepared by O’Melveny & Myers LLP is available here.