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Implications of Dodd-Frank Wall Street Reform and Consumer Protection Act for Private Equity Community

Corporate Services Update John P. Vail

On July 15, 2010, the United States Senate passed the House-approved Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act"), which was signed by President Obama on July 21, 2010. The Dodd-Frank Act represents a sweeping restructuring of United States financial regulation in response to the financial system's near-collapse in late 2008. It consists of 16 distinct sections addressing all areas of financial regulation. Significant elements of the Dodd-Frank Act include:

  • Creation of a new independent watchdog agency intended to serve the interests of consumers of financial products and services.

  • New regulations designed to reduce the risk that taxpayers will be required to bail out large financial institutions.
  • Creation of an overall financial council that will have oversight of the financial system and is intended to identify and address systemic risks posed by large, complex companies and products.
  • Increased regulation with respect to over-the-counter derivatives, asset-backed securities, hedge funds and mortgage brokers.
  • A requirement that public company shareholders have a non-binding vote on executive compensation and authorization for the U.S. Securities and Exchange Commission (the "SEC") to adopt rules granting shareholder access to public company proxy statements for shareholder director nominees.
  • New regulations for transparency and accountability of credit rating agencies.
  • Strengthened ability of regulators to pursue financial fraud, conflicts of interest and manipulation of the financial system.

This update is one in a series of updates that will be prepared by the Quarles & Brady LLP Financial Regulatory Reform Task Force to address portions of the Dodd-Frank Act that are of particular interest to our clients. The following is an overview of the implications of the Dodd-Frank Act on private investment funds, private fund managers and private capital-raising.  


Title IV of the Dodd-Frank Act, which is separately referred to as the Private Fund Investment Advisers Act of 2010 (the "Private Fund Act"), amends the Investment Advisers Act of 1940 (the "Advisers Act") to require registration of hedge fund advisers and certain other private fund advisers. It also requires the SEC to establish reporting and record retention obligations for many managers of private funds. The Private Fund Act introduces new exemptions from registration for advisers to "venture capital funds" and for "family offices" in accordance with the SEC's historical practice. It also requires the SEC to develop an exemption solely for advisers to private funds which have assets under management of
$150 million or less.

Impacting private capital-raising will be the Dodd-Frank Act's adjustment of the net worth requirement in the "accredited investor" definition currently found in Regulation D promulgated under the Securities Act of 1933 ("Regulation D"). The SEC is directed to further review the definition of an "accredited investor" in Regulation D for possible updating at periodic intervals. In addition, the Dodd-Frank Act contains a provision which requires the SEC to adopt rules that disqualify certain felons and other "bad actors" from engaging in offerings and sales of securities under Rule 506 of Regulation D.

Finally, the Dodd-Frank Act adopts a version of the so-called Volcker Rule to prohibit a banking entity from acquiring or retaining any equity, partnership or other ownership interest in, or sponsoring any, hedge fund or private equity fund, subject to certain exceptions.

Registration Requirements Under the Advisers Act

The Advisers Act provides that it is unlawful for an investment adviser to make use of any instrumentality of interstate commerce in connection with his, her or its business as an investment adviser, unless he, she or it is registered as an investment adviser under the Advisers Act. The definition of an "investment adviser" under the Advisers Act is broad as it includes:

"any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities…"[1]

To avoid having to register with the SEC as an investment adviser, a general partner and/or investment manager must generally fall outside of the scope of the definition of an investment adviser or qualify for one of the exemptions in
Section 203 of the Advisers Act.

Elimination of Certain Exemptions

15 or Fewer Clients Exemption

The Private Fund Act eliminates certain exemptions from registration under the Advisers Act that have historically been used by advisers to private funds to avoid registration with the SEC. Perhaps most significantly, the Private Fund Act eliminates the private adviser exemption in Section 203(b)(3) of the Advisers Act which included an exemption from registration for any adviser who had fewer than 15 clients during the previous 12 months. This change will likely require many advisers to hedge funds and/or private equity funds to register under the Advisers Act, unless they qualify for some other exemption. In the past, the SEC treated a fund as a single client as opposed to each investor of a fund being counted as a client.

Modification of Intrastate Adviser Exemption

In addition, the Private Fund Act narrows the scope of the intrastate adviser exemption which has traditionally exempted from registration investment advisers who do not provide advice, or issue analyses or reports, regarding securities listed or admitted to unlisted trading privileges on a national securities exchange and whose clients are all residents of the state in which the adviser maintains his, her or its principal office. However, the Private Fund Act modifies this exemption by making it unavailable for advisers to "private funds." A "private fund" is defined as any fund that would be considered an "investment company" under the Investment Company Act of 1940 (the "1940 Act") but for the exemptions available in Section 3(c)(1) or 3(c)(7) of the 1940 Act. These exemptions generally apply to issuers of securities that have fewer than 100 owners or whose owners are all qualified purchasers (as defined in the 1940 Act). This modification to the intrastate exemption will have the effect of requiring advisers to funds that are not registered investment companies and who would otherwise have been exempt from registration as an investment adviser because of their solely intrastate business to now register with the SEC.

New Exemptions for Advisers to Venture Capital Funds, Private Funds, SBICs and Foreign Advisers; Exclusion for Family Offices

Venture Capital Adviser Exemption

The Private Fund Act includes a new exemption from registration for any investment adviser that acts as an adviser solely to one or more venture capital funds. Significantly, the Private Fund Act does not define what constitutes a "venture capital fund," but rather mandates that the SEC issue final rules within one year of the passage of the Private Fund Act that define the term "venture capital fund." The rules to be issued by the SEC with respect to advisers to venture capital funds must include provisions requiring the maintenance of certain records and the provision of certain reports by advisers to venture capital funds who are relying upon this exemption from registration.

Exclusion for Family Offices

The SEC has excluded "family offices" from the definition of an investment adviser through a series of no-action letters since the Advisers Act was passed in 1940. The Private Fund Act now specifically excludes "family offices" from the definition of an investment adviser. However, it requires that the SEC adopt rules to define the term "family office." The rules must provide an exclusion for family offices that is consistent with the previous policies and orders issued by the SEC and must take into account the range of organizational and employment structures used by family offices. In addition, the rules must include a grandfathering provision that would exclude anyone who was not registered or required to be registered on January 1, 2010, solely because it provides investment advice to (and was so engaged before
January 1, 2010):

  • Natural persons who are officers, directors or employees of the family office who have invested with the family office before January 1, 2010, and are "accredited Investors" under Regulation D.

  • Any company owned exclusively and controlled by members of the family of the family office or as the SEC may prescribe by rule.
  • Any SEC-registered investment adviser that provides advice and identifies investment opportunities to the family office, invests in these opportunities on the same terms as the family office, and whose assets as to which the family office directly or indirectly provides investment advice represent no more than 5 percent of the value of the total assets as to which the family office provides investment advice.

Significantly, any family office that would not fall within the SEC's definition but for the grandfathering provision would still be an investment adviser for purposes of the anti-fraud provisions of the Advisers Act.

Exemption for Private Fund Advisers with Managed Assets of $150 Million or Less

The Private Fund Act also calls for the SEC to provide an exemption from registration to any investment adviser to private funds if the adviser acts as an adviser solely to private funds and has assets under management in the United States of less than $150,000,000. The exemption is available for advisers that would otherwise be subject to registration with the SEC (see discussion below on the new threshold for federal registration). Notwithstanding this exemption, the SEC will require such advisers to maintain specified records and provide the SEC with such annual or other reports as the SEC determines are necessary or appropriate in the public interest or for the protection of investors.

Foreign Private Adviser Exemption

An exemption to registration is included for "foreign private advisers". A "foreign private adviser" is defined as any investment adviser who has:

  • No place of business in the United States;

  • In total, fewer than 15 clients (with an investment fund and its investors each counting as one client in the
    United States); and

  • Total assets under management attributable to clients (including private funds and their investors) in the
    United States of less than $25 million, or such higher amount as the SEC may deem appropriate;

and does not:

  • Hold itself out to the public in the United States as an investment adviser;

  • Act as an investment adviser to a registered investment company; or
  • Act as a company that has elected to be a business development company pursuant to the 1940 Act and has not withdrawn its election.

SBIC Exemption

The Private Fund Act includes a new exemption for any investment adviser, other than a business development company, that solely advises: (a) small business investment companies ("SBICs") that are licensees under the Small Business Investment Act of 1958 ("SBIA"); (b) entities that have received from the Small Business Administration notice to proceed to qualify for a license as an SBIC under the SBIA, which notice or license has not been revoked; or (c) applicants affiliated with one or more licensed SBICs and that have applied for another license under the SBIA, which application remains pending.

Mid-Sized Private Fund Registration

The Private Fund Act also contains an unclear provision that grants the SEC the authority to issue regulations with respect to investment advisers to "mid-sized private funds" that take into account the size, governance and investment strategy of such funds to determine whether such funds pose systemic risk. The regulations are also to provide for registration and examination procedures applicable to advisers to such funds to reflect the level of systemic risk posed by such funds. The Private Fund Act does not define a "mid-sized private fund." Possibly advisers to private funds that have assets under management in excess of $150 million, but less than some higher threshold, will have a simpler or reduced registration process. It is an open question as to how the SEC will approach these so-called "mid-sized private funds."

New Threshold for Federal Registration - $100 Million

The Advisers Act and the current rules issued by the SEC thereunder provide that an investment adviser is subject to regulation by the securities commissioner in each state where the adviser has a place of business or where during the prior 12-month period the adviser had more than five clients. An investment adviser must register in any such state if the state requires registration of advisers (unless a state exemption is available). If an investment adviser has over
$25 million of assets under management, the investment adviser may choose to register with the SEC instead of the states (or must register under limited circumstances). Registration with the SEC is mandatory once an investment adviser has $30 million or more of assets under management (unless an appropriate exemption is available). The Private Fund Act amends the Advisers Act to prohibit an investment adviser from registering with the SEC if he, she or it:

  • Is required to be registered with the state commissioner in the state where it maintains his, her or its principal office and, if registered, would be subject to examination by such commissioner; and

  • Has assets under management between $25 million and $100 million (or such higher amount as may be specified by the SEC).

An adviser with assets under management between $25 million and $100 million may, however, choose to register with the SEC if the adviser would otherwise be required to register with 15 or more states.

New Recordkeeping and Reporting Regime

In addition to modifying the exemptions from registration available under the Advisers Act, the Private Fund Act also sets forth heightened reporting obligations for registered investment advisers to private funds. Specifically, it requires the SEC to implement rules and regulations that require advisers to private funds to maintain (for such periods of time as are specified by the SEC) and file various records and reports with the SEC regarding each private fund advised by the adviser. The scope of the SEC's authority in this regard is quite broad. The SEC may require a registered investment adviser to provide such information as the SEC deems "necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council." The Private Fund Act mandates that the records and reports for each private fund advised by the investment adviser include the following information:

  • The amount of assets under management and use of leverage, including off-balance-sheet leverage;

  • Counterparty credit risk exposure;
  • Trading and investment positions;
  • Valuation policies and practices of the fund;
  • Types of assets held;
  • Side arrangements or side letters, whereby investors in a fund obtain more favorable rights or entitlements than other investors;
  • Trading practices; and
  • Such other information as the SEC in consultation with the Financial Stability Oversight Council (the "Council") determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

The SEC also has the authority to conduct periodic and special examinations of any records maintained by a registered investment adviser with respect to a private fund. The Private Fund Act further provides that the SEC must provide the Council with any information filed with or provided to the SEC by a registered investment adviser that the Council deems is necessary to assess the systemic risk posed by a particular private fund. The SEC and the Commodity Futures Trading Commission (the "CFTC") will, after consultation with the Council, issue rules that establish the form and content of the new reports required to be filed with the SEC and the CFTC no later than 12 months after the enactment of the Private Fund Act.

The Private Fund Act also provides that the SEC and the Council must keep any such records or reports confidential, provided that the SEC may not withhold information from Congress, upon an agreement of confidentiality, and must comply with requests for any such information by other federal departments or agencies, or any self-regulatory organization for purposes within the scope of its jurisdiction. However, any recipients of the information must also maintain the confidentiality of the information provided by the SEC. In addition, the Private Fund Act indicates that private fund records and reports are not subject to the Freedom of Information Act and that "proprietary information" of investment advisers received by the SEC is subject to the same limitations on public disclosure as any facts ascertained during an examination by the SEC as provided in Section 210(b) of the Advisers Act. "Proprietary information" includes the adviser's sensitive non-public information regarding investment or trading strategy, analytical or research methodologies, trading data, computer hardware or software containing intellectual property and any other information deemed to be proprietary by the SEC.

Finally, the Advisers Act previously provided that an investment adviser was not required to disclose the identity, investments or affairs of any client of the adviser, except as may be necessary or appropriate in connection with a particular proceeding or enforcement action. The Private Fund Act allows the SEC to require this information for the purposes of assessing potential systemic risk.

The amendments to the Advisers Act contained in the Private Fund Act (except those related to the definition of an "accredited investor" described below) will become effective one year after the Private Fund Act becomes law. However, an investment adviser may elect to register with the SEC prior to such date.

Capital-Raising: Changes to Regulation D

The Dodd-Frank Act requires that the SEC take certain actions to revise Regulation D that will impose new requirements on who can rely on Regulation D to issue securities and affect the definition of an "accredited investor."

Revision of "Accredited Investor" Definition

The Private Fund Act mandates that the SEC adjust the net worth threshold for an accredited investor to require that an individual have, either individually or jointly with his or her spouse, net worth of more than $1,000,000, excluding the value of such individual's primary residence. In the past, an individual was allowed to include the value of his or her primary residence in determining whether he or she has met the net worth threshold.

This provision becomes effective upon the Private Fund Act becoming law and will remain in effect for a period of four years. This means that the revised net worth standard is immediately effective for new investors and possibly current investors making additional purchases. Hopefully, the SEC will provide further guidance on this issue.

During the four-year period, the SEC may review and adjust the accredited investor definition applicable to natural persons (other than the net worth threshold) as it deems appropriate for the protection of investors, in the public interest and in light of the economy. Moreover, upon the expiration of the initial four-year period and every four years thereafter, the SEC must review the accredited investor standards applicable to natural persons and may make such additional adjustments as it deems appropriate.

"Bad Actors" Disqualification

The Dodd-Frank Act also contains provisions disqualifying "bad actors" from engaging in offerings and/or sales of securities under Rule 506 of Regulation D. Specifically, it requires the SEC to issue rules no later than one year after the Dodd-Frank Act's passage that disqualify any offering or sale of securities made by a person that is subject to a final order of a state securities commission, a state authority that supervises or examines banks, savings associations or credit unions, a state insurance commission, a Federal banking agency or the National Credit Union Administration that:

  • Bars the person from (i) association with any entity regulated by such authority, (ii) engaging in the business of securities, insurance or banking, or (iii) engaging in savings association or credit union activities;

  • Constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative or deceptive conduct within the ten-year period ending on the date of the filing of the offer or sale; or
  • Has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security, or involving the making of any false filing with the SEC.

The Volcker Rule

Also impacting the formation and fundraising of private funds will be the Dodd-Frank Act's inclusion of a modified version of the so-called "Volcker Rule." It is an amendment to the Bank Holding Company Act of 1956 (the "BHC Act") and prohibits any "banking entity" from engaging in proprietary trading, or sponsoring or investing in a hedge fund or private equity fund, subject to certain exceptions.

Important Definitions

"Proprietary trading" by a banking entity or systemically important non-bank financial company means engaging as principal for the trading account of the entity in any transaction to purchase or sell, or otherwise acquire or dispose of, any security, any derivative, any contract of sale of a commodity for future delivery, any option on any such security, derivative or contract, or any other security or financial instrument that the appropriate regulators may determine.

A "banking entity" is any insured depository institution, any company that controls an insured depository institution, or that is treated as a bank holding company for purposes of Section 8 of the International Banking Act of 1978 (generally, a foreign bank that has a branch, agency or commercial lending subsidiary in the United States), and any affiliate or subsidiary of any such entity. Excluded from the definition of an "insured depository institution" is any institution that functions solely in a trust or fiduciary capacity, if (a) all or substantially all of the deposits are in trust funds and are received in a bona fide fiduciary capacity, (b) no deposits which are insured by the FDIC are offered or marketed by or through an affiliate of such institution, (c) the institution does not accept demand deposits or deposits that the depositor may withdraw by check or similar means for payment to third parties or others or make commercial loans, and (d) the institution does not obtain payment or payment-related services from any Federal Reserve Bank or exercise discount or borrowing privileges pursuant to the Federal Reserve Act.

"Hedge fund" and "private equity fund" mean an issuer that would be an investment company but for Section 3(c)(1)
or 3(c)(7) of the 1940 Act or similar funds determined by the appropriate regulatory authorities.

To "sponsor" a fund means (A) to serve as a general partner, managing member or trustee of a fund, (B) in any manner to control (or to have employees, officers, directors or agents who constitute) a majority of the directors, trustees or management of a fund, or (C) to share with a fund, for corporate, marketing, promotional or other purposes, the same name or a variant of the same name.

Inapplicability of Volcker Rule to "Permitted Activities"

The Volcker Rule will not apply to so-called "permitted activities." The SEC, CFTC and the federal banking regulators have the authority to identify permitted activities. However, the Dodd-Frank Act indicates that certain activities are excluded from the Volcker Rule's prohibitions. One of these exclusions is for the sponsoring of, and investment in, a hedge fund or private equity fund so long as certain requirements are met:

  • The fund is organized and offered only in connection with the provision of bona fide trust, fiduciary or investment advisory services and only to persons that are customers of such services of the banking entity;

  • The banking entity does not acquire or retain an equity interest, partnership interest or other ownership interest in the fund except for a de minimis investment;
  • The banking entity and its affiliates comply with the Federal Reserve Act's restrictions on transactions with
    such fund;

  • The banking entity does not, directly or indirectly guarantee, assume or otherwise insure the obligations or performance of the fund, or any fund in which such fund invests;
  • The banking entity does not share with the fund, for corporate, marketing, promotional or other purposes, the same name or a variant of the same name;
  • No director or employee of the banking entity takes or retains an equity interest, partnership interest or other ownership interest in the fund, except for any director or employee who is "directly engaged in providing investment advisory or other services" to the fund; and
  • The banking entity discloses to prospective and actual investors in the fund, in writing, that any losses in such fund are borne solely by investors therein and not by the banking entity, and otherwise complies with any additional rules that the regulators may issue that are designed to ensure that losses are borne in that manner.

Seed Capital; De Minimis Investment Level

A banking entity may make and retain an investment in a hedge fund or private equity fund that the banking entity organizes and offers for the purposes of (i) establishing the fund and providing the fund with sufficient initial equity for investment to permit the fund to attract unaffiliated investors (so-called seed capital), or (ii) making a de minimis investment (defined below). However, a banking entity that initially makes an investment that exceeds the de minimis level must actively seek unaffiliated investors to reduce or dilute the investment of the banking entity to the
de minimis level.

To qualify as a de minimis investment, investments by a banking entity in a hedge fund or private equity fund must:

  • Not later than one year after the date of establishment of the fund, be reduced through redemption, sale or dilution to an amount that is not more than three percent of the total ownership interests of the fund; and

  • Be immaterial to the banking entity (as defined by future SEC rule), but in no case may the aggregate of all of the interests in all such funds exceed three percent of the Tier I capital of the banking entity.

If a banking entity is not the sponsor of a fund, it appears that the banking entity must generally divest itself of its investments in hedge funds and private equity funds within the permitted periods for divestiture. Banking regulators or other federal agencies are likely to issue rules or other interpretive guidance on this issue in the future.

Transition Provisions for Volcker Rule

Within six months of enactment, the Council must study and then issue recommendations with respect to the implementation of the Volcker Rule. Thereafter, federal banking, securities and commodities regulators will issue regulations that will further implement the Volcker Rule. The agencies are required to act within nine months of the completion of the six-month study. In any event, the Volcker Rule's amendment to the BHC Act will take effect on the earlier of (i) 12 months after the final regulations are issued, or (ii) two years from enactment.

Banking entities and systemically important non-bank financial companies must conform their activities and investments to the Volcker Rule within two years after its effective date. The Federal Reserve Board is permitted to grant an organization up to three one-year extensions of the transition period, if "consistent with the purposes of this section" and "not detrimental to the public interest." A further extension may be possible for up to a maximum of five years, upon application by a banking entity to the Federal Reserve Board, to fulfill a contractual obligation that was in effect on
May 1, 2010, to take or retain any equity, partnership or other ownership interest in, or otherwise provide funding to, an "illiquid fund." An "illiquid fund" is a hedge fund or private equity fund that, as of May 1, 2010, was principally invested in, or was invested and contractually committed to principally invest in, illiquid assets such as portfolio companies, real estate investments and venture capital investments.

Quarles & Brady Comments

The various provisions of the Dodd-Frank Act that affect private fund advisers and private capital-raising anticipate rulemaking by the SEC, CFTC and, in some cases, the federal banking regulators. These rules will be extremely important towards the creation of more clarity as to various aspects of the Dodd-Frank Act. However, it is very clear that hedge fund advisers and, possibly to a lesser extent, private equity fund managers will be facing possible SEC registration and new compliance obligations in connection with their operations. In light of recent pressures on the SEC to engage in a more heightened level of oversight over the financial markets, it is unlikely that the SEC will be timid in its rulemaking. Quarles & Brady will be vigilant with respect to the SEC's future actions and issue additional client alerts as appropriate.

For more details on the Private Fund Act or the Dodd-Frank Act, or if you have any questions, please contact John P. Vail at (312) 715-5042 / [email protected], Anneke Diem (312) 715-5088 / [email protected] or your Quarles & Brady LLP attorney.

[1] Note, however, that the definition contains a list of activities and/or organizations that fall outside of the definition of an investment adviser such as banks or bank holding companies that act as an investment adviser to a registered investment company, and lawyers, engineers or teachers where the performance of such services is incidental to the individual's profession.
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