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US Regulatory Reform: Impact of the Dodd-Frank Act on Non-US Fund Advisers


30 June 2010

On June 25th delegates from the House of Representatives and the Senate concluded the yearlong quest to reform the regulation of the US financial services sector.  

They have agreed the text of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank Bill).


The Dodd-Frank Bill represents the most significant regulatory reform of the US financial services sector since the Great Depression nearly 80 years ago. Although clearly US fund advisers will be affected, most if not all non-US fund managers will also be significantly affected by US regulatory reform - a point raised in previous Allen & Overy articles - including the following three key elements:

  • an increased likelihood of registration under the US Investment Advisers Act of 1940, as amended (Advisers Act) and supervision by the US Securities and Exchange Commission (SEC),
  • fundamental changes to swaps and other derivatives activities between non-US fund managers and certain US counterparties, and
  • the so-called 'Volcker Rule' restrictions on certain banks and bank holding companies (BHCs), and their affiliates, from sponsoring and investing in certain hedge and private equity funds.

Registration and Reporting Requirements

The Dodd-Frank Bill would dramatically expand the numbers of fund managers and/or fund general partners required to register under the Advisers Act, primarily through the repeal of the so-called 'private adviser exemption'. The private adviser exemption provides that an investment adviser otherwise subject to registration under the Advisers Act need not register if it has fewer than 15 clients in the previous 12 months, does not hold itself out to the public as an investment adviser and does not have any registered investment companies or registered business development companies as advisory clients. Investment advisers whose principal offices and places of business are outside the United States need only count their US clients towards this 15 client limit. For the purposes of this exemption, a collective investment vehicle such as a hedge fund counts as a single client – and a non-US fund entity counts as a non-US client regardless if the fund had US investors – provided the fund receives advice based on its investment objectives rather than the individual objectives of any underlying US investors. Consequently, many non-US fund managers advising non-US fund vehicles have historically been able to rely on the private adviser exemption.

No more. The Dodd-Frank Bill removes the private adviser exemption in its entirety and replaces it with a more limited 'foreign private adviser exemption' for fund managers with no place of business in the United States that have fewer than 15 clients or investors in private funds in the United States and that have less than $25 million (or such higher number as the SEC determines) in assets under management attributable to US clients or US investors in private funds. (A 'private fund' for these purposes is an entity that would be subject to registration under the US Investment Company Act of 1940, as amended ('40 Act) but for Section 3(c)(1) or Section 3(c)(7) thereof.) A non-US fund manager relying on this exemption must not serve as an investment manager of an investment company registered under the '40 Act or generally 'hold itself out' to the US public as an investment adviser.

Due to the size of their investment management activities in the US, many non-US fund managers will not be eligible to rely on the foreign private adviser exemption because US investors in private funds will be counted towards the permissible limit of 15 advisees. (Although the statutory wording is not clear on this point, a US investor that has invested in several different private funds advised by the same non-US fund manager should ordinarily count only as one US investor for purposes of the counting convention.) The Dodd-Frank Bill also includes a new exemption from registration for fund managers that exclusively advise private funds and that have aggregate assets under management in respect of all such private funds in the United States of less than $150 million; however, despite uncertainty in the text, this new exemption appears available only for US fund managers.

Finally, the Dodd-Frank Bill provides an exemption from registration under the Advisers Act for advisers to family offices as well as US and non-US managers that exclusively advise 'venture capital funds'. The term 'venture capital fund' is left undefined and the SEC is instructed to issue a rule to define this term. Any fund manager relying on this exemption is nevertheless subject to certain recordkeeping and reporting requirements. Unfortunately, a similar exemption for advisers to private equity funds that appeared in earlier versions of the reform bills was not retained.

The Dodd-Frank Bill also adds a new Section 204(b) to the Advisers Act authorising the SEC to collect from a registered investment adviser, including a registered non-US fund manager, such information in respect of its private fund advisory clients as is necessary and appropriate in the public interest and for assessing the systemic risk posed by the private fund. The non-exclusive list of information to be required by the SEC would include description of the following: the amount of assets under management and the use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading positions, valuation policies and practices, types of assets held, side letters and trading practices.

The SEC would also be required to promulgate rules regarding the maintenance of records in respect of private funds that would be made available for examination on a regular basis and when required by the SEC. Any information obtained under the reports and disclosures could be shared and made available to the Financial Stability Oversight Council, but would be kept on a confidential basis. Special protections on disclosure to third parties or the public would also be applied to any proprietary information provided by an investment adviser.

What happens next? The provisions of the Dodd-Frank Bill with respect to Advisers Act reform take effect one year from enactment. Therefore, by July 2011, non-US fund managers that are newly subject to registration under the Advisers Act must have filed their Uniform Application for Investment Adviser Registration, also known as 'Form ADV', and implemented policies and procedures in accordance with the Advisers Act rules. The SEC staff has historically taken the view that the substantive provisions of the Advisers Act do not apply to the non-US clients of registered investment advisers whose principal office and place of business is outside the United States. Non-US fund managers that have registered under the Advisers Act may therefore face a less daunting compliance burden if the SEC staff continues this approach after passage of the Dodd-Frank Bill. Allen & Overy will shortly publish a useful guide to SEC registration under the Advisers Act and ongoing compliance requirements for non-US fund managers.

Swaps and Derivatives Activities

Title VII of the Dodd-Frank Bill, the Wall Street Transparency and Accountability Act of 2010, fundamentally alters the regulation of the over-the-counter (OTC) derivatives market in the United States. A comprehensive discussion of the provisions of Title VII is beyond the scope of this eAlert, however certain reforms will undoubtedly affect how non-US fund managers engage in derivatives activities in the United States or with US counterparties. Many 'swaps' and 'security-based swaps' (each as defined in Title VII) will no longer remain OTC and will instead be subject to clearing, trading and reporting requirements for the first time; however, swaps and security-based swaps entered into prior to the effectiveness of the clearing requirement are not required to be cleared, provided they are reported to a properly-regulated swap (or security-based swap) repository. Although Title VII provides an additional exemption from the clearing requirement for those swaps or security-based swaps if at least one counterparty is not a 'financial entity', the term 'financial entity' includes private funds and therefore any swap or security-based swap entered into between a private fund and a swap (or security-based swap) dealer or a major swap (or security-based swap) participant would not be eligible for this exemption from clearing.

Non-US fund managers should also be aware that swaps or security-based swaps entered into with US counterparties will be subject to certain additional reporting requirements. All swaps entered into with US counterparties, whether cleared or not, will be subject to real-time reporting requirements, although swaps that are neither subject to the clearing requirement nor accepted for clearing will be reported in real-time without disclosing the business transactions or market positions of any person, including a private fund and/or its investment adviser. In addition, swaps that perform a 'significant price discovery function', as determined by the Commodity Futures Trading Commission (CFTC), as well as certain security-based swaps may be subject to certain position limits and large trader reporting requirements.

Finally, although non-US fund managers acting on behalf of a US fund client are unlikely to find themselves in the position of having to register as a 'swap dealer' or a 'security-based swap dealer', some non-US fund managers may find that their activities on behalf of a US fund client in respect of swaps and/or security-based swaps cause that client to fall within the definition of major swap (or security-based swap) participant. This term includes any person who is not a swap (or security-based swap) dealer and who meets any one of the three following criteria: (i) it maintains a 'substantial position' (to be subsequently defined) in swaps (or security-based swaps) in one or more categories established by the CFTC or SEC, as applicable, excluding positions put on for hedging commercial risk; (ii) its outstanding positions in such swaps (or security-based swaps) create counterparty exposure risk that could affect the stability of the United States banking system or financial markets; or (iii) it maintains a 'substantial position' as per (i) above and is highly leveraged relative to the amount of capital it holds and is not subject to capital requirements by a US banking regulator.

Registration with the CFTC as a major swap participant and/or with the SEC as a major security-based swap participant would impose certain potentially significant compliance obligations including, certain capital and margin requirements, documentation and recordkeeping requirements as well as certain conduct of business rules issued by the CFTC, SEC, or both, in respect of the registrant's swap and/or security-based swap activities in the United States.

The Volcker Rule

Section 619 of the Dodd-Frank Bill sets out the 'Volcker Rule' – previously discussed in Allen & Overy eAlerts herehere and here – which is named after former Chairman of the Board of Governors of the Federal Reserve system (Federal Reserve), and current economic adviser to President Obama, Paul Volcker. The terms of the Volcker Rule apply to 'banking entities', which are defined to include US banks, BHCs organised under the laws of the United States or of a State, and non-US banks treated as BHCs under the US International Banking Act of 1978 through opening a branch or agency in the United States, and their affiliates and subsidiaries. The Volcker Rule restricts any such banking entity from engaging in 'proprietary trading' and from sponsoring or investing in hedge or private equity funds.

Please note that the restrictions on sponsorship of hedge and private equity funds set out below would not apply to a non-US bank that is treated as a BHC as described above, provided that any such hedge or private equity fund's activities are conducted entirely outside the United States and no interests in such funds are offered or sold to US investors. (However, such activities remain subject to the Volcker Rule's general prohibition on activities that would result in a 'material conflict of interest' between the banking entity and its clients/customers, a material exposure by the banking entity to high-risk assets or high-risk trading strategies, would result in a threat to the safety and soundness of the banking entity or to the financial stability of the United States.)

The Volcker Rule conditionally restricts, inter alia, banking entities from 'sponsoring' hedge and private equity funds, which includes any of the following: (i) serving as a general partner, managing member, or trustee of a fund; (ii) selecting or controlling (or having employees, officers, or directors, or agents who constitute) a majority of the directors, trustees, or management of a fund; or (iii) sharing with a fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name. As part of a last-minute compromise in the House-Senate negotiations, the earlier outright prohibition has been pruned back so that a banking entity may 'sponsor' a hedge or private equity fund if the following conditions (Sponsorship Conditions) are met:

  • The banking entity must provide 'bona fide trust, fund, or investment advisory services';
  • The 'fund is organized and offered only in connection with the provision of bona fide trust, fund, or investment advisory services and only to persons that are customers of such services of the banking entity';
  • The banking entity can invest seed money in the fund of any amount, provided that no later than one year after the date of the establishment of the fund the total ownership interests of the banking entity in the fund are three percent or below and the aggregate limit of all such fund investments by the banking entity does not exceed three percent of the Tier I capital of the banking entity;
  • The banking entity complies with rules that govern conflicts of interest and limit services that can be provided to the fund as detailed below;
  • 'The banking entity does not, directly or indirectly, guarantee, assume, or otherwise insure the obligations or performance of the ... fund';
  • The banking entity cannot share the same name, or a variation thereof, with the fund;
  • Directors and employees of the banking entity can take equity interests/receive carry only where they are directly engaged in providing investment advisory or other services to the fund; and
  • Proper disclosure is made to investors.

As mentioned above, one of the Sponsorship Conditions hinges on compliance with rules that restrict conflicts of interest and services to be provided specifically, a banking entity serving as investment manager, investment adviser or sponsor of a hedge or private equity fund must subject any transactions between itself (or its affiliates) and the fund to the rules regarding 'covered transactions' in Sections 23A and 23B of the US Federal Reserve Act, as amended (FRA). Section 23A of the FRA would significantly restrict a banking entity from lending to, buying assets from, or providing guarantees to or on behalf of, a hedge or private equity fund that it advisers or sponsors, whereas Section 23B would generally require that all permissible services and activities between a banking entity and the hedge or private equity fund that it advises or sponsors be on market terms.

Prime brokerage transactions with a sponsored hedge or private equity fund are not subject to the provisions of Section 23A of the FRA, provided that the Sponsorship Conditions set out above are complied with and are annually certified in writing by the banking entity's CEO and that the Federal Reserve has determined that the transactions are consistent with the safe and sound operation and condition of the banking entity. All qualifying prime brokerage transactions nevertheless remain subject to the market terms requirements of Section 23B of the FRA.

Should the Dodd-Frank Bill be enacted as currently drafted, it is certain that the extraterritorial reach of the US financial services legislation will be extended to cover non-US fund managers, but the extent of that reach will remain uncertain until the rules implementing the Dodd-Frank Bill have been written.


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