On December 2, 2004 the US Securities and Exchange Commission issued, after a considerable delay, its formal written release (the “Adopting ...

On December 2, 2004 the US Securities and Exchange Commission issued, after a considerable delay, its formal written release (the “Adopting Release”) adopting new rules relating to the registration of hedge fund managers under the Investment Advisers Act of 1940 (the “Advisers Act”). This article highlights the aspects of the new rules and the Adopting Release that we believe are of particular interest to offshore (from the United States) hedge fund managers and investment advisers.

Basics of the Revised Registration Regime
The Advisers Act requires an offshore investment adviser (a term that includes both discretionary and non-discretionary advisers and the managers of investment funds) to register with the SEC if the adviser either has had at least 15 US clients during the past year or “holds itself out publicly” as an investment adviser in the United States. Until now, an SEC rule (Rule 203(3)(b)-1 under the Advisers Act (now amended by the new rules) promulgated in 1985) has provided that an adviser/manager may count a private fund as only one client (provided that it is managed in accordance with its own investment objectives rather than the individual objectives of its investors) and that private US offerings of interests in a fund do not come within the definition of “holding out”.

The central change effected by the new hedge fund rules is that an offshore hedge fund adviser or manager (or an offshore sub-adviser to a hedge fund manager) will now be required to “look through” its managed (or advised) fund in “counting to 15” and, as of February 1, 2006, will be required to register as an investment adviser with the SEC if it reaches that threshold. (Note, however, that, as is explained below under Who is a US person for purposes of the new rules?, certain of the principles stated in the Adopting Release with respect to the definition of a US client may have immediate effect.)

The manner in which the look-through principles will operate will differ depending on whether the fund advised by an offshore adviser is onshore or offshore from the United States.

In the case of an onshore hedge fund (or funds of funds), an offshore manager (or sub-adviser) will be required to count all of that fund’s investors, regardless of whether they would otherwise be US persons for Advisers Act purposes, in reaching the 15-client determination.

In the case of an offshore hedge fund, an offshore manager or adviser will be required to look through only to the fund’s US investors (as defined further below). In addition, an offshore adviser to an offshore hedge fund will be required to look through its managed fund to the US investors in any fund investor that is an offshore fund of funds.

Offshore managers and sub-advisers will also be required to look through hedge fund investors that are (1) US onshore private funds of funds or (2) US public investment funds registered under the Investment Company Act of 1940 (which for practical purposes must be organized in the United States). In that case, however, it is not currently clear whether an offshore adviser will be required to count all the investors in the investing fund of funds or, rather, only the investing fund’s US investors. Because an investment company registered under the Investment Company Act is very unlikely to have fewer than 15 US investors, for practical purposes this would only be an issue in the case of a US investor that is a private fund of funds.

It can be cogently argued that, since an offshore direct investor in an offshore fund is not counted as a US client, it would not make sense to count that same investor merely because he invested through an intermediary organized in the United States. However, this argument conflicts with the principle that all investors in a US-organized fund are to be counted. We anticipate that this will be among a number of questions that the SEC staff will clarify before the look-through rule takes effect.

How are Hedge Funds and Funds of Funds That Must be Looked Through Defined?
For purposes of the new rules a hedge fund (or “private” fund, to use the technical term in the new rules) is an investment vehicle that primarily invests in securities, that derives its exemption from registration under the US Investment Company Act from the so-called “private investment company” exemptions set forth in that Act (these exemptions are set forth in sections 3(c)(1) and 3(c)(7) of the Investment Company Act and related rules) and that permits its investors to redeem their fund interests within two years of making an investment. A private fund of funds that must be looked through by the manager of an underlying hedge fund is defined using the same criteria.

No Need to Look Through Publicly Offered and Regulated Offshore Funds
Offshore advisers will not be required to look through an offshore fund that is regulated as a public investment fund in a jurisdiction in which the fund’s shares (or units of beneficial interest) are publicly offered. This exception, which was requested of the SEC by the European Commission, is designed to exempt UCITS-style funds that are analogous to publicly offered mutual funds in the United States. It is not intended to except funds that are regulated as investment companies in a jurisdiction in which they are not publicly offered (for example, the Cayman Islands, the British Virgin Islands or the Jersey Islands) or publicly offered hedge funds. However, it will not be necessary, in order to comply with this exception, that a fund be publicly offered in all jurisdictions in which its shares or units may be sold. Instead, it will be sufficient if an offshore fund is both regulated as a public investment company and qualifies to make public offerings of its shares (or units of beneficial ownership) in any one country in which its interests may be sold.

Who is a US Person for Purposes of The New Rules?
Historically, the SEC staff has stated in no-action letter interpretations that it would generally look to the definition of a “US person” in Regulation S under the Securities Act of 1933 to determine who is a US client for purposes of the Advisers Act. However, in the Adopting Release the SEC stated that the transactional focus of the Securities Act differs from the ongoing relationship focus of the Advisers Act and that, as a result, there may be circumstances in which the use of the Regulation S definition is not appropriate in an Advisers Act context. In keeping with the distinction between the two Acts, the new rules and the Adopting Release announce several changes in who will be considered a US client for purposes of the Advisers Act. Two of those changes may be of immediate importance to offshore advisers.

In the first, and favorable, change from the hedge fund rules as originally proposed, the SEC decided that a non-US person who invests in an offshore fund and then moves to the United States will not be counted as a US client for purposes of the look-through principles – or, putting it differently, that the US status of an offshore fund investor will be determined by his or her residency at the time of the investment (new rule 203(b)(3)-1(b)(7)). This principle will prove helpful in keeping an offshore adviser that does not permit its funds to be offered in the United States from having to register since it would hardly be feasible for an adviser to force redemption on investors who move to the United States. It should be noted, however, that the Adopting Release makes it clear that this principle does not apply to a direct advisory relationship; rather, in such a case a person who moves to the United States will thereafter be considered a US client. In addition, an existing offshore fund investor who moves to the United States will be considered a US client if he makes a further investment in the same fund while a US resident. Separately, in view of the fact that secondary market transfers of interests in private funds are generally not permitted without the fund’s acquiescence, a US person who buys outstanding shares or units in an offshore fund from an existing investor will be counted as a US client.

Moving to less favorable developments, in an Adopting Release footnote the SEC states (for the first time) that, at least until it has more time to consider the subject, it “would not object” if an offshore adviser considers an offshore corporation or other business entity to be a US client for purposes of the Advisers Act if that entity has its principal office and place of business in the United States. The SEC’s “would not object” locution is an example of the kind of language typically used by the SEC staff in granting no-action letters. An offshore adviser’s failure to comply with this position will not necessarily lead to enforcement action, even if the failure comes to the SEC's attention; but compliance will be necessary in order to have assurance that no issue will be raised.

This is significant because, under Regulation S, an offshore corporation organized for purposes of investment by US “accredited investors” (as defined in Regulation D under the Securities Act) who are not individuals, estates or trusts is not a US person, regardless of where its principal office and place of business is located. Indeed, for Regulation S purposes even an offshore corporation organized by US individuals is not a US person if it was not organized principally for the purpose of investing in securities that are not registered under the Securities Act. Thus, under the principles stated in the Adopting Release footnote, offshore managers/advisers may have direct entity advisees, or advise private funds that have entity investors, that the advisers would not previously have considered to be US clients but would be so considered now. This development is not only relevant in counting to 15 under the look-through principles, but may also be relevant to determining Advisers Act registration obligations immediately.

Second, the same footnote states that the SEC will not object if a US client of an offshore discretionary investment adviser is counted as a US client either by a fund or a further sub-adviser to that discretionary adviser – even if the fund or the sub-adviser has dealt only with the offshore discretionary adviser in accepting an investment or an advisory mandate for the benefit of that US client. Correlatively, a foreign advisee of a US investment adviser will not be treated as a US person, regardless of whether the advisory relationship is discretionary or nondiscretionary.

This was previously a grey area and, again, differs from Regulation S, under which a US client's account that is under the discretionary management of an offshore adviser is not deemed to be a US person. A US client of a nondiscretionary adviser was already treated as a US person under Regulation S.

We note in this connection that the SEC generally considers an offshore bank trustee for US resident beneficiaries (or settlors, in the case of a revocable trust) to come within the definition of an investment adviser, which may imply that, under the Adopting Release footnote principles, an offshore adviser to such a trust will need to count the trust’s US beneficiaries (or a revocable-trust settlor) as US clients. As with the change in interpretation with regard to entities managed from the United States, this treatment of US clients of advisers to, or funds receiving investments from, offshore discretionary managers could have an immediate impact on offshore advisers’ registration obligations, as well as on their need to register under the new hedge fund rules.

The footnote in question also states that the principles used to determine whether individuals, trusts or estates are US clients for Advisers Act purposes remain as they were. That is, in the case of an individual, residency governs; in the case of a trust or estate, offshore advisers will be able to look to the definition of US person in Regulation S. Under Regulation S an estate is a US person if any of its executors or administrators is a US person, except that an estate that is governed by foreign law is not a US person if a US professional fiduciary acts as an executor or administrator and a foreign executor or administrator has sole or shared investment authority with respect to the estate’s assets. A trust is a US person if any of its trustees is a US person, except that, if a US professional fiduciary acts as trustee and no beneficiary of the trust (or settlor if the trust is revocable) is a US person, the trust is not a US person if a foreign trustee has sole or shared investment discretion with respect to the trust’s assets.

Under Regulation S a trust with only offshore trustees is clearly not a US person, even if the trust has US beneficiaries or is a revocable trust with a US settlor. The application of Regulation S principles to such a trust would appear to fly in the face of the principle described in the text of this memorandum that a trustee may be deemed to provide investment advice to the trust’s beneficiaries (or settlor, in the case of a revocable trust), from which it would appear to follow that US beneficiaries or revocable-trust settlors would be deemed to be US clients of any sub-advisers that the trustee hires to manage the trust’s investments or, as a result of the look-through principles, any adviser to a private fund in which the trust invests. This issue will probably require clarification by the SEC or its staff.

Some “master-feeder” fund structures utilize a limited partnership or limited liability company organized in the United States as the feeder fund to be used for investment by US taxable investors in an offshore master fund. In a typical master-feeder structure an offshore master fund holds all the invested assets, but the investors may invest through a feeder fund whose only asset consists of an interest in the master fund. The master fund itself is taxed on a flow-through basis as a partnership in the United States (even though it may be (and frequently is) organized in the form of an offshore private corporation), and US taxable investors invest either directly in the master fund or in a feeder fund that is also taxed as a partnership and may be organized either in the United States or offshore (thereby avoiding adverse tax consequences that may affect a taxable investor in either a US or an offshore entity that is taxed as a corporation). Foreign and US nontaxable investors, on the other hand, invest through an offshore corporation that is taxed as a corporation in the United States, thereby avoiding, in the case of the US investors, adverse tax consequences that may be imposed on a nontaxable entity that invests on a flow-through basis in a leveraged vehicle (as is typical in the case of a hedge fund).

The use of such a structure raises the question of whether the US feeder fund, whose only asset consists of an interest in an offshore master fund, should be considered a US or an offshore fund. Because such a structure could just as easily utilize an offshore feeder fund or permit direct investment in the offshore master fund as the investment option offered to taxable US investors, we believe there is a strong policy argument that such a US feeder fund should not be treated as a US fund. Because the investors in such a feeder fund are generally US residents (except for US citizens residing abroad who are taxed in the United States), the significance of this issue does not primarily lie in the application of the look-through principles; rather, its significance lies in whether such a US feeder fund will be treated as a US person in determining the kind of regulatory regime that will apply to an offshore adviser that is required to register (discussed in the next section below). This is another issue that will require clarification by the SEC staff before the new rules take effect; in the meantime, we strongly suggest that an offshore adviser setting up a new master-feeder structure establish an offshore feeder for investment by US taxable investors.

What is The Nature of the Regulatory Regime That Will Apply to Offshore Fund Managers?
Registration under the Advisers Act is initiated by filing “Part 1” of an electronic Form ADV with the SEC. This is followed by a review period in which the SEC staff examines the form, may raise questions concerning it and, if the adviser or designated advisory or controlling persons are subject to specified statutory disqualifications (relating, for example, to violations of foreign securities laws), may deny registration. The registration process requires payment of a modest fee and typically takes between 35 and 75 days. A registrant must also prepare, but is currently not required to file with the SEC, “Part 2” of Form ADV, which sets forth information that an offshore adviser must deliver to its direct US clients (and that a US resident adviser must deliver to all its clients). Once an adviser is registered, both parts of its Form ADV must be updated on a current basis to reflect changes in specified information and on an annual basis with respect to all other information.

A substantial line of SEC staff no-action letters provides that it is not necessary for a US registered offshore adviser to treat its offshore client relationships as governed by the Advisers Act. As a result, except for certain record-keeping requirements, offshore advisers need not comply with the Advisers Act’s requirements in the conduct of those relationships. The Adopting Release for the new rules extends this principle to an offshore private fund that is advised by an offshore adviser, regardless of how many US persons invest in the fund. This means that, if an offshore adviser is required to register under the Advisers Act solely because it is deemed to have 15 US clients as a result of the application of the new look-through principles, the US regulatory regime to which that offshore adviser will be subject will be quite restricted, consisting only of record-keeping requirements and subjection to the Advisers Act’s basic anti-fraud principles. The SEC would, however, acquire examination authority over such an offshore registered adviser, and it must be noted that the required records will include detailed, and periodically updated, records concerning the securities holdings and trading activities of the registered adviser’s personnel.

On the other hand, if a registered offshore adviser has any direct US clients, the Advisers Act’s full set of regulatory requirements will apply (except that the adviser’s relationships with its offshore clients will still not be governed by US law). Those requirements include, among other things, the adoption and enforcement of a compliance program (including the appointment of a chief compliance officer to administer and enforce the program), a code of ethics (in a form largely prescribed by SEC rules), policies and procedures to prevent the misuse of material inside information, and policies and procedures with regard to voting portfolio securities that the adviser controls on behalf of direct US clients. A registered offshore adviser with direct US clients will also be required comply in relation to its US clients with the requirement to deliver to them Part 2 of the adviser’s Form ADV (including an annual update delivery), with the SEC's rules on the custody of client securities (which require custody to held by an independent third party), with a rule relating to performance fees (which generally restricts the payment of such fees by clients that do not have a specified net worth) and with substantive rules relating to advisory contracts and principal transactions between the adviser’s US clients and the adviser itself or its other clients.

When Will The New Rules Take Effect?
Although the new rules formally take effect on February 10, 2005, advisers who must register as a result of the application of the look-through principles will not be required to do so until February 1, 2006. Because of possible delays in the registration process, we would recommend that new registrants file Part 1 of their Form ADV by no later than November 15, 2005, and preferably earlier. If an offshore adviser that is required to register has direct US advisees, it will need to have its required compliance programs and policies and procedures in place, and amend its investment advisory agreements to comply with the applicable requirements of the Adviser’s Act, by the time the registration becomes effective. Correlatively, all offshore advisers that are required to register because of the application of the look-through principles will need to comply with the SEC’s books and records rules upon the effectiveness of their registrations.
If an offshore adviser wishes to avoid the application of the look-through principles by instituting a two-year withdrawal restriction, that restriction (as previously noted in footnote 7 above) must be effective for all investments from and after February 1, 2006 (including new investments by existing investors).

We again emphasize, however, that the interpretive principles announced in the Adopting Release with regard to the identification of US clients for purposes of the Advisers Act apparently are immediately effective. As a result, offshore advisers with corporate (or other entity) clients that have their principal offices and places of business in the United States or who have sub-advisory relationships with offshore discretionary advisers (including trustees) where the underlying client is a US person should conduct an assessment of whether they have 15 or more US clients and consider registering under the Advisers Act immediately.

Probability of Future Interpretive Clarifications
As with any set of new SEC rules and interpretive positions, certain of the matters discussed above, as well as other aspects of the new rules and the Adopting Release that are not currently identified, will doubtless be the subject of further interpretations and clarifications. We intend to participate in that process and expect to be fully informed concerning further developments.