Regulation of Private Funds and Their Advisers Under the
Dodd-Frank Wall Street Reform and Consumer Protection
Act
August 3, 2010
I. INTRODUCTION
On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform andConsumer Protection Act (the “Act”), a broad overhaul of the nation’s financial regulatory
system. The Act’s passage represents the culmination of a 13-month effort that began with therelease of the Obama administration’s “white paper” on financial regulatory reform, followedby the negotiation of separate bills in the U.S. House of Representatives and Senate and finallythe reconciliation and passage of the Act. This memorandum focuses on the provisions of the
Act that alter the registration, reporting and recordkeeping obligations applicable to private
funds and their advisers. Previously, private equity and hedge fund advisers generally were
not required to register with the Securities and Exchange Commission (“SEC”) or comply withrelated reporting, recordkeeping and other burdens in reliance on the “private investment
adviser” exemption under the Investment Advisers Act of 1940 (the “Advisers Act”). Under theAct, however, private equity and hedge fund advisers will be required to register with the SEC
if their advisee funds and other client accounts have $150 million in assets or more undermanagement. Advisers solely to “venture capital funds,” regardless of their size, are notrequired to register, although they will be subject to certain reporting requirements. The
registration, reporting and recordkeeping obligations become effective one year after the Act isenacted. 1
While the Act establishes a framework for heightened regulation of the private funds industry,
the provisions of the Act are in many respects incomplete (and in some cases intentionally so),and Congress has authorized the SEC and other federal regulators to fill in these gaps andcomplete this process through further analytical review, rulemaking and interpretation. Thisadministrative process will dictate important aspects of the reform and the exact ways in which
the new legislation will affect private funds and their advisers. As a result, it will likely be quite1

For an overview of the entire Act, including areas not covered by this memorandum, please refer
to our recently published memorandum entitled “U.S. Congress Nears Completion of Landmark
Financial Services Reform Legislation”, a copy of which is available atwww.simpsonthacher.com/content/Publications/pub1013.pdf. For more specific informationon the component of the Act known as the “Volcker Rule”, which generally bans banking
organizations from sponsoring or investing in private equity funds and hedge funds andengaging in proprietary trading, please see our memorandum, “The Volcker Rule Provisions in
the Dodd-Frank Reform and Consumer Protection Act”, which is available atwww.simpsonthacher.com/content/publications/pub1014.pdf.

Memorandum – August 3, 2010

some time until such reforms are broadly implemented and the direct and indirect impact of the
Act on the private funds industry is fully understood.
II. PRIVATE FUND ADVISER REGISTRATION AND REPORTING REQUIREMENTS
A. Registration of Investment Advisers to Private Funds
Under pre-Act regulations, many private fund advisers—including advisers to what arecolloquially referred to as hedge funds, private equity funds and venture capital funds—were
exempted from registration with the SEC, regardless of the amount of their assets undermanagement, in reliance on the “private investment adviser” exemption in the Advisers Act. 2
The Act significantly changes this framework.
Most notably, the Act has eliminated the private investment adviser exemption contained in
Section 203(b)(3) of the Advisers Act and thereby generally requires (subject to the exceptions
noted below) the registration of all advisers to “private funds.” The Act defines a “privatefund” as an issuer that would be an “investment company” under Section 3 of the Investment
Company Act of 1940 (the “Investment Company Act”) but for the exemptions provided in
Sections 3(c)(1) or 3(c)(7) of the Investment Company Act. 3 As a result, investment advisers tomost private funds, subject to certain exceptions, will now be required to register with the SEC.
An adviser will not be required to register with the SEC if it acts solely as an adviser to private
funds and has assets under management in the United States of less than $150 million. 4 In
2

Section 203(b)(3) of the Advisers Act provides an exemption for an investment adviser that (i) has
had fewer than fifteen clients during the preceding twelve months (each fund vehicle is generally
treated as a separate client for this purposes), (ii) does not hold itself out generally to the public
as an investment adviser and (iii) does not act as an investment adviser to any registeredinvestment company or business development company.

3

Section 3(c)(1) of the Investment Company Act generally exempts an issuer that has 100 or fewer
holders of its securities (other than short-term paper) and that does not engage or propose toengage in a public offering of securities. Section 3(c)(7) of the Investment Company Act generally
exempts an issuer all the security holders of which are “qualified purchasers” and that does notengage or propose to engage in a public offering of securities. An important interpretive issue tobe clarified by the SEC is the application of the definition of “private funds” to foreign
investment funds. Based on conversations with the SEC staff and Commissioners, we believe
there is reason to expect that the SEC will only treat as “private funds” those foreign investment
funds that have U.S. advisers or that offer or sell their securities to U.S. residents, so that foreign
investment funds that neither have U.S. advisers nor offer or sell their securities to U.S. persons(even though U.S. persons may acquire such securities in secondary market transactions notarranged by the adviser) will not be treated as private funds.

4

For this purpose, the Act does not define the term “assets under management” or specify how
and when “assets under management” will be tested. For example, whether advisers to private
equity funds should test on the basis of aggregate capital commitments, aggregate capital
contributions, fair value of their advisee funds’ investments or some other metric. However, forother purposes of the Advisers Act, including Form ADV and Section 203A, “assets undermanagement” are calculated based on the current fair value of the securities portfolios for which
the adviser provides continuous and regular supervisory or management services.

Page 2www.simpsonthacher.com

Memorandum – August 3, 2010

addition, advisers solely to “venture capital funds,” regardless of their size, are not required toregister. The term “venture capital funds” is not defined in the Act, but the Act directs the SEC
to issue rules, within one year of the effectiveness of the Act, to provide for a definition. 5
Investment advisers solely to venture capital funds (as well as investment advisers solely toother private funds with assets under management below the $150 million threshold) are
exempt from the Act’s registration requirements, but will still be subject to certain reporting andrecordkeeping requirements. In each case, the SEC will at some point in the future specify thereports to be maintained and provided to the SEC based on what it deems “necessary andappropriate in the public interest or for the protection of investors.” Therefore, the practicaleffect of falling within these exemptions remains uncertain since the SEC may impose
recordkeeping and reporting requirements on such exempted advisers that are similar to those
imposed on registered advisers.
The Act also contains a provision that provides a potential exemption from registration (andmore limited reporting obligations) for advisers to “mid-sized private funds.” The term “midsized private funds” is not defined, and it is unclear when the SEC will issue rules providing fora definition and what, if any, exemption or more limited reporting obligations will be provided
for such advisers. 6 In determining which investment advisers will benefit from the potential
exemption, the SEC is required by the Act to take into account the size, governance andinvestment strategy of the advised funds to determine whether they pose systemic risk.
In addition, the Act creates a new limited exemption from registration for “foreign private
advisers.” This foreign private adviser exemption will be available to any adviser that meets allof the following criteria: (i) has no place of business in the United States, (ii) has fewer than 15
clients and investors in the United States in private funds advised by the adviser, (iii) has
aggregate assets under management attributable to clients in the United States and investors in
the United States in private funds advised by the adviser of less than $25 million (such amount
may be increased by the SEC) and (iv) neither holds itself out generally to the public in the
United States as an investment adviser nor acts as an investment adviser to any registeredinvestment company or business development company. Since the exemption is so narrowly
crafted, it will significantly expand the extra-territorial application of the Advisers Act forforeign investment advisers which manage capital on behalf of U.S. investors, which may, inturn, result in restricted access by U.S. investors to the services of non-U.S. advisers.
Notably, under the “foreign private adviser” exemption, an adviser must count the number ofinvestors in the United States in its private funds (as well as its managed account “clients” in5

Based on our conversations with SEC staff and Commissioners, we expect that this exemption
will be narrowly drafted and will focus on advisers to funds that primarily provide privately
negotiated financings to start-up enterprises.

6

Although the term “mid-sized private fund” is not defined, the Act does refer to “mid-sizedinvestment advisers” (in the context of the interplay between state and federal adviser
registration described below) as an adviser with assets under management in excess of $25
million but less than $100 million.

Page 3www.simpsonthacher.com

Memorandum – August 3, 2010

the U.S.). Including U.S investors in private funds in this counting metric is a reversal of themethodology set forth in the Goldstein v SEC decision in 2006. 7 The term “investors” is notdefined for purposes of this exemption and it is not clear whether an investor participating in
multiple funds sponsored by the same adviser would be counted separately in determining theaggregate number of U.S. investors. As a related matter, the Act prohibits the SEC fromdefining the term “client” to require “look-through” treatment for purposes of applying thegeneral anti-fraud prohibitions in Sections 206(1) and (2) of the Advisers Act to investors in a
private fund advised by an adviser if the private fund has entered into an advisory contract
with the adviser. It does not, however, limit the applicability of Rule 206(4)-8, which the SEC
passed following the Goldstein ruling, to prohibit advisers to pooled investment vehicles frommaking materially misleading statements or omissions to investors or prospective investors inthose vehicles.
The Act also exempts from registration with the SEC any adviser (i) registered with theCommodity Futures Trading Commission as a commodity trading advisor and advising private
funds, so long as the business of the adviser is not predominantly providing securities-related
advice and (ii) to a small business investment company, which is licensed under the Small
Business Investment Act of 1958. Further, the Act provides that any “family office” does not fallwithin the definition of “investment adviser” as such term is defined in the Advisers Act. The
Act delegates to the SEC the authority to define “family office” as part of its rulemaking
process, which definition must be consistent with previous SEC exemptive orders andinterpretations.
Additionally, the Act modifies the interplay between state and federal adviser registration by
expanding the prohibition on federal registration to include any adviser (i) with assets undermanagement in excess of $25 million but less than $100 million (either such amount may be
increased by the SEC), (ii) that is required to register with the individual states in which theadviser maintains its principal office and principal place of business and (iii) that, if registered,would be subject to examination by such state regulatory authorities. 8 (It should be noted in
7

In Goldstein v SEC, the U.S. Court of Appeals for the D.C. Circuit struck down the SEC’s hedge
fund adviser registration rule on the basis that the SEC exceeded its authority by defining theterm “client” to require advisers to “look-through” their advisee funds for client-counting undersuch rule.

8

Currently, Section 203A of the Advisers Act provides that an adviser with less than $25 million ofassets under management (such amount may be increased by the SEC) is prohibited from federal
registration and such adviser would therefore be required to register with each applicable statethat maintains an investment adviser statute, unless an exemption under such state statuteapplies and subject to the national de minimis standard provided in Section 222 of the Advisers
Act (providing that an adviser may not be required to register in any state in which it (i) does nothave a place of business and (ii) during the previous 12 months had fewer than 6 clients who areresident of such state). In addition, Rule 203A-1 of the Advisers Act provides that an adviser
with at least $30 million of assets under management must register with the SEC (unless an
exemption from registration is available), and which would therefore allow such adviser towithdraw its registration from any state regulatory authorities, although it would seem that thisregistration requirement would now be subject to the prohibition on federal registration by

Page 4www.simpsonthacher.com

Memorandum – August 3, 2010

this regard that New York State, where many fund managers are located, does not appear tohave an investment adviser examination program.) If, however, this expanded prohibition
would require an adviser to register with 15 or more states, then the adviser may register with
the SEC (in lieu of registration with each applicable state regulatory authority). 9 In making
these changes, the Act seeks to shift the regulatory responsibility for smaller investment
advisers to the state securities agencies in order to reduce the burden on the SEC that is
expected to result from the elimination of the “private investment adviser” exemption.
However, it remains to be seen whether this effort will be effective given that a number of states
have no or limited registration and/or examination requirements.
B. Reporting and Recordkeeping Requirements
Advisers of private funds that are required to register with the SEC will be subject to newreporting and recordkeeping requirements. (Advisers to private funds will also become subject
to the existing reporting and recordkeeping provisions of the Advisers Act.) The Act authorizes
the SEC to require registered investment advisers to maintain records (for such periods as the
SEC prescribes) and file such reports with the SEC as deemed necessary or appropriate in the
public interest or for purposes of “systemic risk” assessments made by the newly establishedFinancial Stability Oversight Council (the “Council”). 10 All such records will also be subject toperiodic and special examination by the SEC.
The records required to be maintained (and made available for SEC inspection and subject to
SEC filing requirements to be prescribed) in respect of each private fund advised by aninvestment adviser will include information on (i) the amount of assets under management, (ii)use of leverage, including off balance sheet leverage, (iii) counterparty credit risk exposure, (iv)
trading and investment positions, (v) valuations policies and practices, (vi) types of assets held,(vii) side arrangements or side letters whereby certain investors in a fund obtain more favorable
rights or entitlements than other investors and (viii) trading practices of the fund. Such private
funds will also be required to maintain (and make available to the SEC) “such otherinformation” as the SEC, in consultation with the Council, determines is “necessary or
appropriate in the public interest and for the protection of investors or for the assessment ofsystemic risk.” The Act provides that the “other information” requirements may include theestablishment of different reporting requirements for different classes of fund advisers, basedon the type or size of private fund being advised. The broad “other information” category
provides the SEC significant latitude in determining what information may be required and thespecific content and form of the reports to be filed with the SEC are not detailed in the Act. As aadvisers with less than $100 million of assets under management and which are subject to stateregistration and examination requirements, as described above.
9

The Act also provides that an adviser to a registered investment company or businessdevelopment company must register with the SEC, irrespective of its assets under management.

10

The Act establishes a ten-member Financial Stability Oversight Council, chaired by the Treasury
Secretary, to identify and manage systemic risk in the financial system and improve interagency
cooperation.

Page 5www.simpsonthacher.com

Memorandum – August 3, 2010

result, the exact impact and burden of private fund advisers’ SEC reporting obligations will not
be known until such obligations are fleshed out through SEC rulemaking.
To the extent that any “proprietary information” of a private fund is contained in reports
required to be filed with the SEC, the Act provides for protections from public disclosure under
the Freedom of Information Act. The term “proprietary information” is defined to includesensitive, non-public information regarding the investment or trading strategies of theinvestment adviser; analytical or research methodologies; trading data; computer hardware orsoftware containing intellectual property; and any additional information that the SEC
determines to be proprietary. The Act requires the SEC to report to Congress annually about
how it used data it collected to monitor markets and protect investors and the markets.
The Act provides that the new registration requirements under the Act for advisers of private
funds do not eliminate any registration obligations of such advisers, if any, under the
Commodity Exchange Act. Additionally, the SEC and the CFTC are required, in consultation
with the Council, no later than one year after enactment, to jointly establish rules governing theform and content of reports to be filed with the SEC and with the CFTC by investment advisers
registered both under the Advisers Act and the Commodity Exchange Act.
C. Implementation/Timing
Title IV of Act, which contains the private fund adviser registration, reporting andrecordkeeping provisions, takes effect one year after the date of enactment (i.e. July 2011).
During this period, the SEC is expected to adopt the rules and regulations relating toregistration and reporting, which will dictate the true impact of these reforms on the private
funds industry. During this one year phase-in period, advisers may voluntarily register with
the SEC. As part of this rulemaking process, the SEC is expected to provide guidance regarding
the transition from the existing to the new registration regime (for example, whether aninvestment adviser with $75 million of assets under management that has previously registeredwith the SEC will be required to de-register and instead register with the relevant state
regulatory authorities).
III. ACCREDITED INVESTOR ELIGIBILITY
Since 1982, issuers have been able to rely on the safe harbor of Regulation D under the Securities
Act of 1933 to issue securities in private placements without registering those securities with theSEC. Under Rule 506 of Regulation D, an issuer may sell an unlimited amount of unregisteredsecurities to investors that are “accredited investors.” 11 The purpose of this qualification is tolimit such an offering to those investors with sufficient financial sophistication and ability to
11

Under the rules, an individual qualifies as an accredited investor if that individual meets either of
two tests: (i) the individual’s net worth, or joint net worth when combined with his or her spouse,(including the value of his or her primary residence) exceeds $1 million at the time the securities arepurchased (the “net worth test”); or (ii) the individual had income exceeding $200,000, or joint
income with his or her spouse exceeding $300,000, in each of the two most recent years, and that
individual or couple expects to meet those income thresholds in the current year (the “incometest”).

Page 6www.simpsonthacher.com

Memorandum – August 3, 2010

evaluate the risks and rewards of making the investment. Recently, the SEC has expressed
concern that the existing accredited investor standards for individuals are outdated, as they
have not been adjusted over the past 28 years to account for inflation or the increase in property
values. To address this concern, the Act requires the SEC to modify the accredited investor
standard such that, effective immediately upon enactment, and for four years thereafter, the net
worth test will be $1 million, excluding the value 12 of the investor’s primary residence. Although
the dollar threshold for the net worth test is not being increased, by excluding the value of aninvestor’s primary residence, the Act has effectively tightened the eligibility standards. The Act
authorizes the SEC to review and modify the accredited investor definition applicable toindividuals “as appropriate for the protection of investors, in the public interest, and in light ofthe economy”. Moreover, the Act requires the SEC to conduct such a review every four years.
Therefore, although the Act does not directly modify the income test or increase the dollar
threshold for the net worth test to adjust for almost three decades of inflation, it is likely that the
SEC will do so as part of its subsequent review process. 13
IV. QUALIFIED CLIENT STANDARD
Currently, any client of an investment adviser (whether or not registered), including an investor
in a private fund, that is charged an incentive fee or carried interest must be a “qualifiedclient” 14. To be a qualified client, an investor must either (i) have $750,000 in assets invested
with the adviser, (ii) have a net worth in excess of $1.5 million, (iii) be a “qualified purchaser”
for purposes of the Investment Company Act or (iv) be one of certain high-level employees of
the investment adviser. As with the accredited investor standard, critics have voiced concernthat the dollar thresholds for the qualified client standard, which was last updated in 1997, are
not adjusted for inflation and therefore, certain financially unsophisticated investors may now
be considered qualified clients.
In response, the Act requires the SEC, within one year of enactment and every 5 years
thereafter, to adjust for inflation the dollar amounts used in the qualified client standard (withany adjustments to be made in $100,000 increments). Although this potential change would notaffect “3(c)(7) funds” 15 given that all “qualified purchasers” are automatically “qualifiedclients”, such a change may impact fundraising for “3(c)(1) funds”15 as the minimum eligibility
requirements for investing in such a fund will now be more restrictive.
12

The Staff of the SEC has announced interpretive guidance that the amount of any debt that issecured by an individual’s primary residence (i.e., mortgage debt) should be excluded from thetest (along with the gross value of the residence) so long as the gross value of the residence
exceeds the amount of its mortgage debt (and if the residence has negative net equity, the amountof the negative net equity should be included as a liability in calculating the individual’s net
worth).

13

However, the Act restricts the SEC from adjusting the net worth test for the first four years afterenactment.

14

Advisers Act Rule 205-3

15

See Note 3 above.

Page 7www.simpsonthacher.com

Memorandum – August 3, 2010

V. GAO STUDIESIn addition to authorizing, and in some cases requiring, the SEC to review the funds-related
regulations as described above, Congress has delegated related analyses to its own investigativearm, the U.S. Government Accountability Office (“GAO”). Such mandate includes a review by
the GAO of the following items: (i) the feasibility of forming a self-regulatory organization to
oversee private funds, with a report on this subject due to Congress not later than one year
following enactment and (ii) the appropriate criteria for determining the financial thresholds
and other criteria to qualify as an accredited investor and eligibility to invest in a private fundwith a report due to Congress within three years of enactment. 16
VI. CONCLUSION
While the passage of the Act represents a significant development in the regulation of theprivate funds industry, over the next several years, a significant number of studies, rules andregulations required by the Act will be prepared and implemented. As this process unfolds, theimpact of the new legislation on the private funds industry will become more clear. We willcontinue to monitor and report on the progress of these regulatory developments.
This memorandum is for general informational purposes and should not be regarded as legal advice.
Furthermore, the information contained in this memorandum does not represent, and should not be
regarded as, the view of any particular client of Simpson Thacher & Bartlett LLP. Please contact yourrelationship partner if we can be of assistance regarding these important developments. The names andoffice locations of all of our partners, as well as additional memoranda, can be obtained from our website,www.simpsonthacher.com.

The contents of this publication are for informational purposes only. Neither this publication nor the lawyers who authored it are
rendering legal or other professional advice or opinions on specific facts or matters, nor does the distribution of this publication to
any person constitute the establishment of an attorney-client relationship. Simpson Thacher & Bartlett LLP assumes no liability inconnection with the use of this publication.

16

Unlike the SEC study related to the definition of accredited investors discussed in Section III
above, the GAO review would apply more broadly to the eligibility criteria for both individual
and institutional investors.

Page 8www.simpsonthacher.com

Memorandum – August 3, 2010

UNITED STATESASIANew York

Beijing

425 Lexington Avenue

3119 China World Office 1

New York, NY 10017-3954+1-212-455-2000

1 Jianguomenwai Avenue
Beijing 100004
China+86-10-5965-2999

Los Angeles
1999 Avenue of the Stars
Los Angeles, CA 90067+1-310-407-7500

Palo Alto
2550 Hanover Street
Palo Alto, CA 94304+1-650-251-5000

Hong Kong
ICBC Tower
3 Garden Road, Central
Hong Kong+852-2514-7600

Tokyo

1155 F Street, N.W.
Washington, D.C. 20004

Ark Mori Building
12-32, Akasaka 1-Chome
Minato-Ku, Tokyo 107-6037
Japan+1-202-636-5500+81-3-5562-6200

EUROPE

SOUTH AMERICA

LondonSão Paulo

Washington, D.C.

CityPoint
One Ropemaker Street
London EC2Y 9HUEngland+44-(0)20-7275-6500

Av. Presidente Juscelino Kubitschek, 1455
São Paulo, SP 04543-011
Brazil+55-11-3546-1000