SEC Adopts New Rules to Reduce Multi-State Investment Adviser Registration Obligations
August 7, 1998
The Securities and Exchange Commission (the “SEC”) recently adopted previously proposed 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 adopted rules:
* 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.”
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(c) 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.
The SEC initially exercised this 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 has now amended Rule 203A-2 to permit SEC registration of 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 thirty (30) or more states. Under the amended rule, an investment adviser required to be registered with thirty (30) or more state securities authorities would instead be permitted to register with the SEC.
An adviser applying for registration based on this 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 (30) states. An adviser is not 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 adviser 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 amendments to Rule 203A-2 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 (30) 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 multi-state exemption, the investment adviser would be required to register in at least twenty-five (25) 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 persons [1] , 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.
The SEC has amended 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 valueless) to continue to have accommodation clients without being subjected to state qualification requirements. The SEC will retain the ten percent allowance but will 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 current rule, certain “high net worth” individuals are considered to be “excepted persons” for purposes of the definition of investment adviser representative and thus are not counted towards the ten percent allowance. The criteria for determining which clients are excepted persons are based on the criteria in Rule 205-3 under the Advisers Act, which permits advisers to enter into performance fee contracts with certain clients. In the past, natural persons who had at least $500,000 under management with the investment adviser representative’s firm, or who the firm reasonably believed had (together with their spouses) a net worth in excess of $1 million (“high net worth” clients) were excluded from the number of clients counted against the ten percent allowance. The SEC has recently revised the “high net worth” criteria to reflect the effects of inflation since the rule was adopted in 1985 and to include qualified purchasers and certain knowledgeable employees of the investment adviser.
Effective August 20, 1998, the following clients will not be counted towards the ten percent allowance: (1) clients who immediately after entering into the investment advisory contract have at least $750,000 under management with the investment adviser; (2) clients whom the investment adviser reasonably believes, immediately prior to entering into the investment advisory contract, either have a net worth of more than $1,500,000 at the time the contract is entered into or are qualified purchasers as defined in section 2(a)(51)(A) of the Investment Company Act at the time the contract is entered into; and (3) executive officers, directors, trustees, general partners, or persons serving in a similar capacity, of the investment adviser, as well as certain other employees of the adviser who participate in investment activities and have performed such functions for at least 12 months. For additional information concerning “high net worth” criteria, refer to our Hedge Fund & Investment Managers Advisory dated July 22, 1998 entitled “SEC Amends Rules Allowing Investment Advisers to Charge Performance Fees.”
[1] 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 on this topic, you may contact Howard A. Neuman or Carol Spawn Desmond.