SEC Proposes New Rules to Eliminate Burdens Arising Under Investment Advisers Supervision Coordination Act

January 13, 1998

The Securities and Exchange Commission (the "SEC") recently proposed the adoption of new rules designed to eliminate burdens arising under the Investment Advisers Supervision Coordination Act (the "Coordination Act") and the rules implementing the Coordination Act, which became effective on July 8, 1997. Among other things, the proposed rules would:

allow an investment adviser otherwise prohibited from registering with the SEC under the Investment Advisers Act of 1940 (the "Advisers Act") to register with the SEC, and thereby avoid registration with state authorities, if the adviser is required to register as an investment adviser in thirty (30) or more states,
expand the existing exemption from state registration requirements applicable to certain "investment adviser representatives,"
clarify when an adviser's annual determination of its assets under management must be made.

EXEMPTION FOR INVESTMENT ADVISERS OPERATING IN MULTIPLE STATES

Section 203A of the Advisers Act currently limits registration with the SEC, in most cases, to investment advisers with at least $25 million of assets under management and preempts state law with respect to these investment advisers. The $25 million threshold was initially designed to eliminate duplicative federal/state regulation by assigning exclusive regulatory responsibility to the SEC for larger investment advisers (whose activities are more likely to affect national markets) and relieving the SEC of responsibility for smaller advisers who would be regulated exclusively by the states. The SEC was given authority under Section 203A-2 of the Advisers Act, however, to exempt smaller investment advisers, by rule or order, from the prohibition on SEC registration if the prohibition would be unfair or a burden on interstate commerce.

Last year, the SEC exercised that authority by adopting Rule 203A-2 to permit SEC registration of, among others, smaller investment advisers affiliated with SEC-registered advisers and newly formed advisers with reasonable expectations that they would soon have $25 million of assets under management. The SEC also granted exemptive relief on an ad hoc basis to investment advisers that do not have $25 million of assets under management but have a national or multi-state practice and conduct advisory activities that require them to register as investment advisers in 30 or more states.

The SEC has proposed amending Rule 203A-2 to codify the individual ad hoc exemptive orders so as to provide relief for all investment advisers required to be registered in numerous states. Under the proposed exemption, an investment adviser required to be registered with thirty (30) or more state securities authorities would be permitted to register with the SEC instead. An adviser applying for registration based on the proposed exemption would be required to submit a representation that it has reviewed its obligations under state law and has concluded that it is required to register in at least thirty states. An adviser would not be permitted to include states in which it is subject to regulation if it is not required to register there, even if it has registered there on a voluntary basis.

Once registered with the SEC, an investment advisor would continue to be eligible for the exemption as long as it is annually able to provide a representation that it has determined that, but for the exemption, it would be obligated to register in at least twenty-five (25) states (five fewer states than is required to register with the SEC initially).

Similar to the exemption for newly formed advisers with reasonable expectations of soon having $25 million of assets under management, the proposed amendments to Rule 203A-2 would permit a newly formed investment adviser not yet registered in any state to register with the SEC if it reasonably expected that it would be required to register in thirty or more states within 120 days. After the 120 day period, the investment adviser would be required to file an amendment to Form ADV revising Schedule I and attach a representation that, but for the proposed multi-state exemption, the investment adviser would be required to register in at least twenty-five states.

AMENDMENTS TO THE DEFINITION OF INVESTMENT ADVISER REPRESENTATIVE

The Advisers Act preempts most state regulatory requirements for SEC registered investment advisers and their supervised persons1, but permits states to continue to license, register or otherwise qualify an "investment adviser representative" who has a place of business in the state. In Rule 203A-3(a), the SEC defined investment adviser representative as a supervised person more than ten percent (10%) of whose clients are natural persons. The "ten percent allowance" in the definition of investment adviser representative was designed to permit supervised persons who provide advisory services principally to institutional clients to continue to accept close friends, relatives and other so-called "accommodation clients" without subjecting themselves to state qualifications requirements. Excluded from the number of clients counted against the ten percent allowance are natural persons who have at least $500,000 under management with the investment adviser representative's firm, or who the firm reasonably believes have (together with their spouses) a net worth in excess of $1 million ("high net worth" clients). The "high net worth" criteria are the same as those contained in Rule 205-3 under the Advisers Act for determining those clients with whom investment advisers may enter into a performance fee arrangement. The SEC is now proposing two alternative amendments to the definition of investment adviser representative to allow supervised persons who provide services to only one or a few institutional or business client accounts (for whom the ten percent allowance is meaningless) to continue to have accommodation clients without being subjected to state qualification requirements.

Under the first alternative, the SEC proposes to retain the ten percent allowance but to allow a supervised person to have the greater of five (5) natural person clients (who need not be accommodation clients) or the number of natural person clients permitted under the ten percent allowance and still avoid characterization as an investment adviser representative.

Under the second alternative, the ten percent allowance would be eliminated and supervised persons could have an unlimited number of natural person clients who are either "high net worth" clients or have a family or business relationship with the supervised person or his business or institutional client and still be excluded from the definition of investment adviser representative. Clients who would be deemed to have the necessary family or business relationship would include persons who are (A) partners, officers, or directors or the investment adviser for whom the supervised person works or of a business or institutional client of that investment adviser, (B) relatives, spouses, or relatives of spouses of such partners, officers or directors, or (C) relatives or spouses, or relatives of spouses of the supervised person (essentially, accommodation clients). The SEC has proposed to permit supervised persons to advise these "high net worth" and accommodation clients because it is presumed that these individuals do not need the protections of state qualification requirements. A supervised person who had any other natural person clients, though, would not be excluded from the definition of investment adviser representative and, accordingly, would not be exempt from state qualification requirements.

In a companion proposal, the SEC has announced that it intends to revise the "high net worth" criteria in Rule 205-3. The criteria for determining which individuals qualify as "high net worth" individuals for purposes of the definition of investment advisor representative would also be revised to reflect the changes being proposed in Rule 205-3. As currently proposed, the threshold high net worth criteria would increase from $500,000 under management to $750,000 under management and from $1 million net worth to $1.5 million net worth.2

ADDITIONAL AMENDMENTS TO SCHEDULE I OF FORM ADV

Instructions to Schedule I provide guidance on how an investment adviser should determine the amount of its assets under management for purposes of Section 203A under the Advisers Act. The SEC is proposing to amend Instruction 7 to Schedule I to clarify that, in determining the total amount of assets under management, investment advisers may include only those securities portfolios for which they provide continuous and regular supervisory or management services as of the date of filing Schedule I. In valuing these securities portfolios, investment advisers may use market values as determined 90 days prior to the filing of Schedule I.

ELIMINATION OF RULE 203A-5 AND THE WITHDRAWAL OF FORM ADV-T

In order to implement the Coordination Act the SEC implemented rule 203A-5 as a transition rule under the Advisers Act. Rule 203A-5 required that every investment advisor file a Form ADV-T with the SEC no later than July 8, 1997 indicating either its withdrawal from registration with the SEC or the continuation of its registration with the SEC by fully completing Form ADV-T. Rule 203A-5 and Form ADV-T have become unnecessary and are therefore being eliminated as the transition under the Coordination Act is now complete.

If you would like further information about investment adviser registration requirements or to discuss other issues relating to hedge funds and their investment managers, contact Howard A. Neuman at (212) 818-9200 or visit the Satterlee Stephens Burke & Burke LLP Website at:

To take action on any of the information contained in this report, you should seek professional advice.

For more information, please contact Howard Neuman in the firm's New York office at (212)818-9200.

Footnotes:

A supervised person is defined as any "partner, officer, director..., or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser." Even the sole principal of an advisory firm is subject to the supervision and control of the advisory firm and is, therefore, a supervised person.
For additional information concerning performance fee arrangements and the proposed amendments to Rule 205-3, see our Hedge Fund & Investment Managers Advisory dated January 12, 1998.