PRIVATE FUND ADVISER REGULATION

The Dodd-Frank Wall Street Reform and Consumer Protection Act eliminates the “private adviser exemption” from the Advisers Act for advisers with fewer than 15 clients* and, with some exceptions, requires advisers to private funds with $100 million or more in assets under management to register with the SEC as investment advisers. Investment advisers that are below the threshold will be subject to state registration. Registered advisers will be subject to reporting and record-keeping requirements and periodic examination by the SEC staff. Information provided by registered advisers can be shared by the SEC with the Financial Stability Oversight Council (discussed below) for assessment of systemic risk.

The Act provides exemptions for advisers who solely advise “venture capital funds” and for advisers who solely advise private funds that have assets under management in the United States of less than $150 million. Exempted advisers will still be subject to record keeping and reporting requirements to be determined by the SEC. Certain advisers to family offices, foreign private advisers and advisers to small business investment companies will also be exempt from registration.

The Act raises the assets under management threshold for federal regulation of investment advisers from $25 million to $100 million. Any investment adviser that qualifies to register with its home state and has assets under management of between $25 million and $100 million (and that otherwise would be required to register with the SEC) must register with, and be subject to examination by, such state. If the investment adviser’s home state does not perform examinations, the adviser is required to register with the SEC.

ACCREDITED INVESTOR AND QUALIFIED CLIENT STANDARDS. The Act modifies the net worth standard in the definition of “accredited investor” to provide that the value of a person’s primary residence is excluded from the calculation of the $1 million net worth requirement. The SEC is directed to periodically review and modify the definition of “accredited investor,” as appropriate, and the GAO is required to submit a report to Congress on the appropriate criteria for accredited investor status and eligibility to invest in private funds. In addition, within one year after the date of enactment (and periodically thereafter), the SEC is required to adjust for inflation the net worth and/or asset-based qualifications applicable to a “qualified client” under the Advisers Act.

* The Advisor's Act Rule 203(b)(3) provides for an exemption from registration to an investment advisor who during the course of the preceding 12 months has fewer than 15 clients and who neither holds himself out generally to the public as an investment advisor nor acts as an investment advisor to any investment company registered under the Investment Company Act or to a company that has elected to be a business development company under the Investment Company Act.

The Series LLC allows the potential investor the benefit of selecting among an offering of multiple investment products and/or strategies offered by one hedge fund. Conversely, hedge funds will have the opportunity to offer multiple investment products and strategies under a single brand and thereby appeal to a wider variety of investors. The most commonly used United States jurisdiction for the series LLC is Delaware. (In the Cayman Islands, this entity is referred to as a segregated portfolio company.) A Delaware Series Limited Liability Company provides liability protection across multiple series interests (sometimes referred to as “cells”) which are insulated from cross liability arising from another series. Under the Delaware Code, the debts, liabilities, obligations and expenses incurred, contracted for or otherwise existing with respect to a particular series are enforceable against the assets of such series only, and not against the assets of the company generally or any other series thereof. Classes or groups of member interests can be established having the rights set forth in the series Limited Liability Company Operating Agreement. That Agreement can designate series of members, series of managers, or series of LLC interests, each of which have separate rights and duties with respect to specific LLC property or obligations. Separate Series can own specific assets and have different managers and members. Separate Series can have different business operations. A fund manager could operate a Series LLC that would allow for multiple strategies to operate under a single identity. Thus, a Series LLC is able to offer: a commodity pool series; a securities series; a real-estate series; a distressed debt series; and the like. Each series is protected. Each series interest may have different investment managers, different fee structures, different investment limitations, and the like. Thus, the Series LLC permits separate liability insulated series within a single LLC entity. The Operating Agreement establishes the rights and obligations of the managers and members. It may designate a series of members and managers; each series interest may have separate managers and members. In operating a Series LLC it is necessary that separate records be maintained for each series and separate and distinct financial accounting be conducted for each series. If assets from separate series interests are commingled or records consolidated, this action may negate the protection against cross liability and thereby expose investors in one series to the losses sustained by investors in another series. Each series should also maintain separate bank accounts, enter into contracts, notes, or other agreements in the name of the series, and fully document any transactions involving this series. Any filings on behalf of the Series LLC for a specific series should identify the specific series. Of concern, is the fact that liability insulation and separation of assets have not yet been ruled upon by the courts. Whether or not other states or jurisdictions would recognize the legal separate of assets or insulation of liability within the Series LLC is yet to be determined. As of January 2008, the Internal Revenue Service has held that distinct series of Series LLC will generally be taxed as separate entities for federal income tax purposes although many states have not provided guidance regarding state tax issues. Similarly, the Cayman Islands law provides for segregated portfolio companies. The segregated portfolio company separate portfolios of assets and liabilities which are separate from the general assets and liability of the company and from assets and liabilities within the segregated portfolios. The portfolios of assets are traded independently and are protected from the general liabilities of the company and those of the other segregated portfolios. The segregated portfolio company is a single legal entity. The segregated portfolio within the company is not a legal entity separate from the company. Each segregated portfolio is separately designated and must be designated as a “segregated portfolio” contract with the segregated portfolio which is executed by the company on behalf of the segregated portfolio. Directors failing to do so properly become personally liable for the liabilities of the company and the segregated portfolio. A company may pay a dividend with respect to any segregated portfolio shares whether or not a dividend is declared on any other class or series of segregated portfolio shares or any other shares. A segregated portfolio company has assets which are either general assets of the company or segregated portfolio assets. The segregated portfolio assets are the assets of the specific segregated portfolio and are the only assets available to meet the liabilities of the specific portfolio. The general assets are all other assets other than segregated portfolio assets. Directors of each segregated portfolio company must establish and maintain procedures to keep segregated portfolio assets separate from other segregated portfolio assets and general assets of the company. As with the Delaware Series LLC, there is very little jurisprudence or case law available for interpretation of segregated portfolio companies.

 

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SUMMARY

Delaware Limited Partnerships provide much greater flexibility in eliminating fiduciary duties than do limited partnerships in other states. Delaware Limited Partnerships may modify and eliminate fiduciary duties of a general partner with no test of manifest unreasonableness. Limited partnerships in other states can only modify fiduciary duties (not eliminate), and those modifications are subject to the test of “manifest unreasonableness.” However, all Delaware Partnerships continue to be subject to the contractual covenant of good faith and fair dealing, which may not be eliminated but the obligation can be spelled out. Furthermore, modifications (eliminations) of fiduciary duties must be clearly spelled out in the contract, or default fiduciary duties will apply.

DELAWARE LP’s

By default, the only fiduciary duties that a Delaware General Partner owes to the partnership and the other partners are (1) the duty of care and (2) the duty of loyalty. These fiduciary duties may be limited or eliminated in the partnership agreement. However, every Delaware General Partner is also bound by an implied contractual covenant of good faith and fair dealing , which is not considered to be a fiduciary duty. A partnership agreement may not eliminate this covenant, nor may it limit liability for a bad faith breach of this covenant. The standard of performance for “good faith” may be spelled out in the agreement, but the covenant always remains and cannot be eliminated. For example, where a general partner retains “sole and absolute discretion” to deny consent to substitution of a limited partner, that discretion must nonetheless be exercised in good faith. The obligation of good faith is always affected by the terms of the agreement, because it is essentially a measure the consistency to which the general partner adheres to its contractual obligations. However, unlike the Revised Uniform Partnership Act (“RUPA”), which many states use, the modification of the good faith and fair dealing standard under Delaware Law is not subject to the test of manifest unreasonableness. Thus, substantial flexibility is built into the Delaware partnership acts that allows the partners to eliminate fiduciary duties and to restrict the obligation of good faith and fair dealing.

There are two ways in which a partnership agreement may unambiguously modify (or eliminate) fiduciary duties. The agreement can plainly state that it is modifying the general partner’s fiduciary duties (e.g. “The general partner may compete with the partnership.”). The other way is to cover the topic so specifically that there is no room for traditional fiduciary duties. Id. Any restriction on fiduciary duties of a general partner must be stated clearly.

LP’s IN STATES OTHER THAN DELAWARE

In most states, the law applicable to limited partnerships is based on the Revised Uniform Limited Partnership Act (“RULPA”). RULPA does not identify fiduciary duties, nor does it specify whether they can be restricted or waived. The fiduciary duties of a general partner under RULPA are determined by reference to whichever Partnership Act the state has adopted: either the Uniform Partnership Act (“UPA”) or the Revised Uniform Partnership Act (“RUPA”).

UPA does not explicitly identify fiduciary duties, or address whether they can be waived. However, case law under the UPA indicates that a general partner is bound by the following fiduciary duties: (1) duty of loyalty, (2) care, (3) disclosure, and (4) good faith and fair dealing. Courts have upheld the ability of partners to specify by contract the degree to which their fiduciary duties may be limited, the scope of fiduciary duties, the standards for determining the scope of fiduciary duties, and the mechanisms for blessing actions that, if consent is lacking, might breach a fiduciary duty.

Under RUPA, a general partner by default owes the fiduciary duties of (1) loyalty and (2) care, and is bound by the contractual covenant of good faith and fair dealing. Section 103 of the Act specifies that the fiduciary duties and covenants may be spelled out or reduced in certain specific ways, but the reduction is always subject to the “manifestly unreasonable” test. Specifically, the partnership agreement may not reduce unreasonably the duty of care, which, like Delaware, is statutorily defined under the default rules to include only grossly negligent or reckless conduct, intentional misconduct, or knowing violation of law. In addition, partners are free to provide an agreement that identifies specific types of activities that do not violate the duty of loyalty, but only if not “manifestly unreasonable.” The partnership agreement may specify a mechanism by which the partners, after full disclosure, may consent to a specific act or transaction that otherwise would violate the fiduciary duty of loyalty. The non-fiduciary duty of good faith and fair dealing also may be defined within the agreement, but it may not be manifestly unreasonable. RUPA thus leaves to the courts the task of defining the manifestly unreasonable test and the outer limits of good faith and fair dealing.

CONCLUSION

The default provisions are for the most part similar between Delaware and other states. The advantage that Delaware provides is that fiduciary duties can actually be eliminated, and there is no “manifestly reasonable test” applied to the agreement. On the other hand, fiduciary duties can be limited by agreement in other states as well (as we already do in our limited partnership agreements), but they cannot be entirely eliminated, and the limitations are subject to the “manifest reasonableness” test. Similarly, provisions spelling out the obligation of “good faith” are subject to the “manifest reasonableness test” in states other than Delaware. Thus, Delaware allows greater flexibility and is more favorable towards a partnership agreement waiving fiduciary duties. The fact that language eliminating or reducing fiduciary duties must be clear and explicit is significant. While it may help to limit liability, it may also discourage investors. In addition because the covenant of good faith (a somewhat nebulous concept) can never be eliminated in Delaware, egregious acts by a general partner acting with ill will (though falling short of fraud) may still be considered bad faith acts.

 

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You must now be registered with the State of Georgia in order to conduct business. Effective July 1, 2009, the new Georgia Uniform Securities Act provides for the national de minimis standard which only exempts an investment adviser from registration if the investment adviser:

• does not maintain a place of business in the state; and
• had fewer than six resident clients during the preceding 12 months.

Are you one of the many Investment Advisers in Georgia still relying on the de minimis exemption found in the previous Georgia Securities Act (of 73') , which only required registration if the Investment Adviser, located in or out of Georgia, had six or more Georgia resident clients. If yes, contact Turn Key Hedge Funds, Inc today to get the registration process started.

 

The proposed Private Fund Investment Advisers Registration Act of 2009 (the "Registration Act") will have a significant impact on hedge funds. The proposed Registration Act is likely to amend several provisions of the Investment Advisers Act of 1940, as amended.

The proposed Registration Act would:

    Delete the so called private investment adviser exemption from the Advisers Act Sec. 203(b); which would require most investment advisers to register with the SEC unless they are exempted or otherwise not required to register. As proposed, the Registration Act contains the following exemptions from registration:

1) the SEC may exempt from the registration requirement investment advisers to "private funds" if each of such private funds has assets under management in the United States of less than $150 million. "Private fund" is defined as an investment fund that would be an investment company under the Investment Company Act of 1940, as amended, but for the exception from that definition provided by either Sec. 3(c)(1) or Sec. 3(c)(7) thereunder;

2) the Registration Act would exempt venture capital fund advisers from the registration requirement but leaves to the SEC the tasks of defining "venture capital fund" and crafting the registration exemption for such advisers; and

3) "foreign private fund advisers" who have no place of business in the U.S. and only advise offshore funds with no U.S. investors or privately offered U.S. funds with less than $25 million in assets would be exempted from registration.

    Give the SEC new authority to impose additional reporting requirements on investment advisers and to require reporting that the SEC deems to be in the public interest, necessary for investor protection or for the assessment of systemic risk. The Registration Act provides no assurances that these reports will remain confidential, and the SEC may also be required to disclose the reports to any regulatory body that oversees systemic risk.

    Give the SEC enhanced rule making authority to define terms used in the Advisers Act.

The Registration Act does not require commodity trading advisors to commodity pools to register with the SEC and investment advisers whose assets under management fall below the $30 million threshold established by Advisers Act Rule 203A-1 would not be permitted to register with the SEC.

 

On July 30, 2009, Senator Arlen Specter introduced legislation (S. 1551) in the United States Senate that would expand federal securities fraud liability under section 10(b) of the Securities Exchange Act of 1934 (SEA) and Rule 10b-5 to entities such as law firms, accounting firms and investment banks that provide "substantial assistance" in a fraud on the investing public.

Presently the law limits fraud liability to "primary actors."Central Bank v. First Interstate Bank of Denver, 511 U.S. 164 (1994), Stoneridge Investment Partners, LLC v. Scientific-Atlanta, Inc. et. al, 552 U.S. 148 (2008). In the Central Bank case, the Supreme Court held that the law "prohibits only the making of material misstatement (or omission) or the commission of a manipulative act, and does not reach those who aid and abet a violation." In the Stoneridge case the Supreme court ruled that a SEA section 10(b) and Rule 10b-5 claim against Respondents for "scheme liability" was nothing more than a claim of aiding and abetting, and no private right of action exists for such claims under section 10(b) as the Supreme Court ruled in Central Bank.

 

The "Emergency Economic Stabilization Act of 2008" (the "Act"), has as its primary purpose the stabilization of the credit markets through  authorization of the Treasury Department to purchase up to $700 billion in nonperforming loans from financial institutions.  The Act also includes a provision  eliminating the ability of investment managers of offshore investment funds to continue to defer the taxation of the fee income they derive from the performance of investment management services for Offshore Funds.

After December 31, 2008, investment managers who provide services to Offshore Funds pursuant to investment management agreements will not  be able to  defer the taxation on all or a portion of the fees payable to them by the Offshore Funds.  The Act effectively eliminates the ability of managers to defer their fee income derived from services performed for Offshore Funds by taxing such fee income at such time as there is no "substantial risk of forfeiture." For purposes of the Act, a "substantial risk of forfeiture" occurs only if when manager's rights to such compensation are conditioned upon the performance of substantial future services.

The Act directs the Treasury Department to issue  guidance providing a limited period of time during which a deferred compensation arrangement attributable to services performed before 2009 may be amended to conform the payment date of compensation to the date the compensation is required to be included in income. Presumably, such guidance would include guidance applicable to the Manager of an Offshore Fund with a fiscal year ending on June 30 who has already made a deferral election relating to the fiscal year ending June 30, 2009.