US regulator, the SEC announced in August that it would not appeal the June court decision invalidating its controversial “hedge fund regist...

US regulator, the SEC announced in August that it would not appeal the June court decision invalidating its controversial “hedge fund registration” rule. John Langan, partner in the funds, investment and tax group at international law firm Withers LLP, explains some of the key issues.

How the Rule Worked
The rule essentially required a hedge fund manager to “look through” the funds it managed for purposes of counting the number of clients to whom they were providing investment advice. The look-through rule effectively precluded most hedge fund managers from relying on the registration exemption generally available to investment advisors that have fewer than 15 “clients” during the past 12 months.

Effect of Repeal
Following repeal, fund managers once again may count each fund as a client, without regard to the number of investors in those funds. As a result, registration will not be required in general, except where the advisor also has separately-managed client accounts or “holds himself generally out to the public as an investment advisor.”

Should I Deregister?
Investment advisors who registered solely to comply with the now-invalidated rule may now deregister.

This option has significant appeal as conventional wisdom suggests that advisors who remain registered are more likely to be audited by a newly-enlarged SEC audit staff.

In addition, deregistration would avoid the burden of complying with the SEC’s reporting, proxy voting and other rules applicable to registered advisors. Prior to deregistering, however, advisors should take into account the following considerations.

The SEC hasn’t given up the fight
It has indicated that it will attempt to institute an anti-fraud rule with analogous look-through provisions. While it remains to be seen whether this can be achieved in a constitutional manner, there is at least some risk that an advisor who deregisters will have to re-register in the near future.

What is “holding yourself out”?
Even after repeal of the rule, the 15-client exception is available only to advisors who are not holding themselves out generally to the public as investment advisors.

The SEC interprets “holding yourself out” very broadly, including not only advertising but also (i) maintaining a listing as an investment advisor in a telephone or building directory; (ii) using letterhead or business cards that refer to investment advisory services; or (iii) letting it be known by word of mouth that you will accept new investment advisory clients.

Deregistration may be worse
In certain cases in the US, an investment advisor may be required to register with one or more individual states. However, federal registration generally pre-empts these state registration requirements, and deregistering at the federal level may trigger one or more state filing obligations. The requirement to comply with multiple state-level regimes may be a fate worse than remaining registered with the SEC.

Investors like registered advisors
Increasingly, pension funds and other institutional investors have expressed a preference for investing with managers who are registered investment advisers. Given the general lack of transparency in the industry, these investors take comfort in the knowledge that their fund managers are subject to governmental oversight and compliance regimes.

The SEC feels your pain
It has issued a “no action” letter that essentially restores certain advisor-friendly provisions of the invalidated rule in an effort to curtail deregistration. Among other technical fixes, if an offshore advisor registered solely because it manages an offshore fund with US investors, the SEC would seek to permit the advisor to comply with the so-called “registration lite” regime and exempt the advisor from the more stringent compliance, reporting and proxy voting rules.

In addition, if an advisor deregisters by 1 February 2007, it will not be penalised for having 15 or more clients or “holding itself out” as an investment advisor during the period of its registration.