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Staff Issues Guidance on Vacated Hedge Fund Adviser Rules

The SEC's Division of Investment Management has responded to a request by the American Bar Association's Subcommittee on Private Investment Entities for interpretive guidance on matters that have arisen since the U.S. Court of Appeals for the District of Columbia vacated the SEC's regulatory framework for hedge fund advisers (SEC No-Action Letters Ind. & Summaries (WSB) #0814200601 (August 10, 2006)). The ABA explained that, by responding to its request, the staff could immediately provide guidance to the advisory community and alleviate the current uncertain regulatory environment rather than wait for future rule proposals and adoptions.

The court's decision in Goldstein v. SEC appeared to vacate the entire rulemaking initiative for hedge fund advisers, and not just the provisions related to treating hedge fund investors as clients for the purposes of determining the availability of an exemption from the Investment Advisers Act. The SEC's rulemaking initiative included numerous rules, interpretations and transitional provisions that were also affected. 

In response to the ABA's inquiry, the staff confirmed that the substantive provisions of the Investment Advisers Act do not apply to offshore advisers who remain registered with the SEC with respect to their dealings with offshore funds and other offshore clients. Offshore advisers must comply with the Act and other rules with respect to any U.S. clients they may have.

The SEC's rules created a limited transition exception from the requirement that registered investment advisers maintain certain records that demonstrate the calculation of their performance information that is used in advertising and other materials. The staff advised that it will not recommend enforcement action if an investment adviser that registered as a result of the SEC's hedge fund adviser rules does not maintain the books and records required by rule 204-2(a)(16) as long as the adviser meets the terms and conditions of vacated rule 204-2(e)(3)(ii).

The SEC provided a grandfather provision when it adopted the hedge fund adviser rules to allow for existing advisory agreements on performance-based compensation for advisers that had to register as a result of the rules. The staff will not recommend enforcement action against a registered hedge fund adviser that receives performance-based compensation to the extent that the adviser would have been exempt from the prohibition on receiving such compensation under vacated rule 205-3(c)(2) or (3).

The SEC's rules extended the deadline for the delivery of audited financial statements to investors from 120 days to 180 days after a fund of funds' fiscal year-end for advisers that have custody of client funds or securities. The staff will not recommend enforcement action against an adviser to a fund of funds that relies on the annual audit exception if the audited financial statements are distributed to investors within 180 days of the fund of funds' fiscal year-end.

The staff also advised that it will not recommend enforcement action if a hedge fund adviser that registered as a result of the SEC's rules withdraws its registration in reliance on the exemption provided by section 203(b)(3), regardless of whether the adviser held itself out to the public while it was registered and had more than 14 clients, counting each private fund as a single client, while it was registered. In order to rely on this position, the adviser must withdraw its registration no later than February 1, 2007. During the 12 months following withdrawal from registration, the adviser may, for the purpose of assessing its eligibility for the exemption, determine the number of clients it has had by reference to the period of time beginning on the date of withdrawal. That period may be less than 12 months.

A hedge fund adviser that registered as a result of the SEC's rules that withdraws from registration in reliance on the section 203(b)(3) exemption by February 1, 2007 will not have to provide the information required in a balance sheet on Form ADV-W, Schedule W2, as a result of responding "yes" to Item 3. An adviser that responds "yes" to Item 3 that wishes to rely on the staff relief should complete the Schedule W2, but enter "0" for all of the entries.

The staff also responded to two additional matters that were not raised in the ABA's letter. The Form ADV that appears on the IARD will continue to reflect the form changes brought about by the vacated rules. The SEC has directed the contractor to change the IARD programming, but until the changes are implemented, the staff directed SEC-registered advisers to seek guidance on its Web site for completing the current Form ADV.

The SEC amended rule 204-2 to provide that the records of a private fund are records of the adviser which are subject to examination by the staff if the adviser or any related person acts as the private fund's general partner, managing member or in a comparable capacity. The staff advised that a registered investment adviser must make records available for examination in accordance with section 204 of the Act. The adviser may not avoid this requirement by holding records through another person, including a related person or a private fund, according to the staff.