On October 12, 2010, the SEC issued a no-action letter providing relief under Rule 206(4)(2 of the Investment Advisers Act of 1940, as amended (the "Custody Rule").

Rule 204(4)-2(b)(4)(ii) contained in the Custody Rule provided certain relief for registered investment advisers to collective investment vehicles ("Funds"), provided that such Funds are subject to an annual audit conducted by an independent public accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (the "PCAOB").

At this time only auditors to public companies are subject to regular PCAOB inspection. Many auditing firms utilized by Funds are not inspected by the PCAOB. Accordingly, registered investment advisers who continue to have such firms audit Funds under their management will not be in compliance with the Custody Rule. To come into compliance, advisers would have to replace a fund's current auditor with one subject to regular PCAOB inspection. The SEC's no-action letter acknowledges that this change could be disruptive to the operation of Funds and advisers and result in additional expense to Fund investors.

To provide relief, the SEC stated that it would not recommend enforcement action where a registered investment adviser engages an auditor who is not subject to PCAOB inspection, if the following conditions were met:

1. the auditor must have been engaged to audit the financial statements of the Fund for the most recently completed fiscal year;

2. the auditor was registered with the PCAOB and engaged to audit the financial statements of a broker-dealer both as of July 10, 2010 and as of the date of the Fund financial statements used to satisfy the requirements of the Custody Rule; and

3. the adviser provides written notification to each Fund investor prior to the distribution of the Fund's annual financial statements that the Fund's auditor is not subject to the PCAOB inspection.

While this relief is significant, it appears to be of relatively short duration. It only applies to financial statements issued prior to the earlier of the promulgation of PCAOB rules governing the inspection of auditors of broker-dealers or July 11, 2011. Accordingly, if the PCAOB does not enact such rules by July 2011, we may be revisiting this issue again.


On July 21, 2010 President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act" or the "Act") into law. The Act provides for major changes to the financial services industry, including a number of new requirements that will impact investment advisers of private investment funds and separately managed accounts. The Act changes the ground rules of investor adviser registration. It will require certain advisers who were previously exempt from federal registration to register with the SEC and will require other investment advisers, previously registered with the SEC, to become subject to state regulation. In addition, the Act changes the "accredited investor" standard for natural persons, which is anticipated to impact private placements conducted by certain private funds and other business entities (public and private) pursuant to Regulation D under the Securities Act of 1933, as amended. The Act also provides for changes to be made to the "qualified client" standard under the Advisers Act, which will limit the ability of registered investment advisers to charge performance compensation. This alert focuses on these specific provisions of the Act and certain others that could affect private investment funds and their advisers. Except as described herein, the provisions of the Act covered by this alert will generally become effective one year from enactment.

Elimination of Private Adviser Exemption

The Act eliminates the "private adviser exemption" under Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), thereby requiring investment advisers who meet the jurisdictional thresholds discussed below to register as an investment adviser under the Advisers Act, unless such adviser can satisfy one of the following exceptions:

•Advisers whose clients are solely "private funds" and who have less than $150 million in assets (in the aggregate) under management ("AUM") in the U.S.

•Foreign private advisers (i.e., an adviser (i) with no place of business in the U.S.; (ii) with aggregate AUM of less than $25 million attributable to U.S. clients and investors in private funds advised by the adviser; (iii) with fewer, in total, than 15 U.S. clients or investors in private funds advised by the adviser; and (iv) that does not hold itself out to the public in the U.S. as an investment adviser, nor act as an investment adviser to any registered investment company or business development company).

•Advisers solely to small business investment companies ("SBICs") licensed under Small Business Investment Act of 1958.

•Advisers solely to "venture capital funds" as such term is to be defined by the SEC.

•Advisers to "family offices", as such term is to be defined by the SEC through rulemaking in accordance with previous exemptive orders and taking into account the broad range of organizational, management, and employment arrangements employed by family offices.

•CFTC registered commodity trading advisors (i.e., advisers that are registered as commodity trading advisors with the Commodity Future Trading Commission and that advise private funds are provided a conditional exemption from SEC registration if their advice is not predominantly related to securities). Such an adviser would become subject to dual registration if its investment activities changed to providing predominantly securities-related advice.

•The Act amends the Advisers Act to change the threshold for exclusive SEC jurisdiction over investment advisers from $25 million AUM to $100 million. Additionally, the Act creates a "mid-sized investment adviser" category for advisers with AUM between $25 million and $100 million that are required to register with the state(s) in which they maintain a principal office. With limited exceptions, mid-sized investment advisers that are subject to state registration requirements will not be permitted to register under the Advisers Act.

For larger advisers, the elimination of the private adviser exemption from investment adviser registration will bring more managers of private funds within the ambit of SEC regulation, even with the increase in the AUM jurisdictional threshold. For smaller advisers, the elimination of the "private adviser exemption" coupled with the increase in the jurisdictional threshold are expected to cause the number of investment advisers subject to state supervision to increase significantly. Those advisers required to deregister with the SEC as a result of the increase in the jurisdictional threshold (and who cannot otherwise avail themselves of the optional registration as a "mid-sized investment adviser") will have to ascertain the registration and compliance requirements of the states in which they maintain their principal office(s) or otherwise do business (particularly those states that have exemptions for advisers meeting the now eliminated federal "private adviser exemption", which would presumably remove an important state-level exemption as a result). Read literally, private fund advisers with AUM between $100 million and $150 million and that have one or more managed accounts would be required to register with the SEC, given that such adviser could no longer avail itself of the exemption for advisers solely to private funds with less than $150 million AUM. Similarly, an adviser to a venture capital fund that is also an adviser to a private fund and/or separately managed account with the requisite AUM would be required to register as an investment adviser under the Advisers Act.

These amendments to (and the new rules to be promulgated under) the Advisers Act will become effective on July 21, 2011.

Books and Records

Advisers to private funds that are now required to register under the Act will, as a result, be required to maintain records and file reports with the SEC for each private fund such adviser manages. The form, content and disclosures required in the reports to be filed and the type of records and periods for which such records are to be maintained shall be determined through rulemaking. Such records and reports shall include the following information for each private fund: AUM, use of leverage (including off balance sheet), counterparty credit risk, trading practices, trading and investment positions, side-letters, valuation policies and practices, types of assets held, and any other information that the SEC, in consultation with the Financial Stability Oversight Council (the "Council"), determines necessary and appropriate for the protection of investors or for the assessment of systemic risk. In addition the records and reports of any private fund managed by a registered investment adviser will be deemed to be the books and records of such adviser. The records will be subject to periodic and special examinations by the SEC, as determined through rulemaking.

The Act provides that confidential treatment will be given to such reports, subject to limited exceptions including sharing with the Council for the purposes of systemic risk regulation, with other U.S. Federal departments, agencies or self-regulatory organizations, or pursuant to Federal court order, among others. However, the Act provides that the SEC, the Council and any other department, agency or self-regulatory organization receiving such information, reports, documents, or records are exempt from the public information requirements under the Freedom of Information Act and any information ascertained by the SEC regarding a fund’s proprietary information (such as investment and trading strategies or analytical or research methodologies) are subject to the same limitations on public disclosure as any facts ascertained during an examination.

Changes to "Accredited Investor" and "Qualified Client" Financial Thresholds
Effective midnight on July 21, 2010, the net worth standard for natural persons ($1 million in net assets) contained in Rule 501 of Regulation D excludes the value of such person’s primary residence. Previously, the value of a natural person’s primary residence (net of mortgages) was included in the net worth calculation. Absent further guidance from the SEC, presumably the new definition will only apply to new money invested in a private fund or other continuing offering, whether by a new investor or an existing investor, and there should be no need to recertify existing investors unless such investor makes an additional capital contribution. Based on this rationale, on the private equity side, if an investor has already made a capital commitment to the fund, the draw-down of capital by the fund from such investor should not require a recertification of the investor in accordance with the new definition. Over the next four years, the SEC is directed to review the other aspects of the "accredited investor" definition as they relate to natural persons (i.e., the annual income tests) to determine whether other adjustments should be made. At the end of the initial four year period, and no less than every four years thereafter, the SEC will review and may adjust the entire accredited investor definition (including net worth thresholds) relating to natural persons for the protection of investors and to reflect the economy, generally. This is expected to limit the pool of investors that would otherwise qualify as "accredited investors" for smaller private investment funds relying on Section 3(c)(1) of the Investment Company Act of 1940, as amended (the "Investment Company Act"), as well as private and public companies that conduct private placements under Regulation D to raise capital.

The Act also amends Section 205(e) of the Advisers Act to require the SEC to adjust for inflation any factor that uses a dollar amount test (i.e., the net asset threshold and AUM test) to determine "qualified client" status under Rule 205-3 of the Advisers Act), no later than one year after enactment and every five years thereafter. Generally, performance-based compensation may not be charged to U.S. clients by registered investment advisers, unless each client or investor (in a private fund) is a "qualified client" (which definition includes "qualified purchasers" investing in so-called 3(c)(7) funds). This is expected to primarily impact smaller 3(c)(1) funds managed by registered advisers, which may have to choose between facing a more limited pool of potential investors that can satisfy the qualified client threshold or not being able to charge "prohibited" performance fees. It may also affect advisers to separately managed accounts

Disqualification of Private Placements by Certain "Bad Actors"

The Act directs the SEC to issue disqualification rules within one year of enactment which would disqualify offers and sales of securities made under Rule 506 of Regulation D by certain "bad actors" that are (i) subject to final "bar" orders from state-securities commissions, banking, savings and credit union authorities, insurance commissions, and appropriate Federal banking agencies or final orders for deceptive, fraudulent or manipulative conduct within 10 years of the date of filing of the offer or sale or (ii) convicted of any felony or misdemeanor in connection with the purchase or sale of securities or the making of false filings with the SEC.

Private Fund Self-Regulatory Organization

In addition, the General Accountability Office must study and report on the feasibility of forming a self-regulatory organization to oversee private funds and submit such report to the respective Senate and House committees within one year after enactment of the Act.

Fiduciary Duty for Broker-Dealers

The Act directs the SEC to continue to study the relative standards of care that apply to broker-dealers and investment advisers (and persons associated with both), including whether there are any regulatory or legal gaps related to "retail customers." A report on such study is due within six months of enactment of the Act. In addition, the Act amends Section 15 of the Securities Exchange Act of 1934, as amended, to give the SEC explicit rulemaking authority to impose a fiduciary duty on broker-dealers when providing personalized investment advice about securities to a retail customer.

The Volcker Rule

The Act prohibits any "banking entity" from sponsoring or investing in hedge funds or private equity funds, except: (i) in connection with the provision of bona fide trust, fiduciary, or investment advisory services by the banking entity, (ii) where the private fund is organized and offered only to persons that are customers of such services, (iii) where the banking entity makes de minimis investments in such private funds that do not exceed 3% of the total ownership interest of the fund (subject to certain seed investments where banking entity actively seeks unaffiliated investors and reduces its 3% ownership stake within one year of establishing such private fund) and the banking entity’s interest in such funds do not exceed 3% of the banking entity’s Tier 1 capital, (iv) where the banking entity does not share the same name or a variant thereof with the private fund, (v) where the banking entity does not guarantee, assume or otherwise insure the obligations of the private fund, and (vi) where no employee or director of the banking entity receives equity in the private fund (except those directly engaged in providing permitted services to the funds), among other things. To a limited degree, banking entities may provide prime brokerage services to private funds they are permitted to sponsor or invest in. "Nonbank financial companies" may sponsor or invest in hedge or private equity funds, subject to additional capital requirements and quantitative limits to be established by rulemaking. Another exception to the "Volcker rule" permits banking entities to make investments in SBIC funds or other investments designed to promote the "public welfare." In addition, there is an exemption for the sponsoring or acquisition of ownership interests in private funds outside the U.S., where the banking entity is not controlled by a U.S. banking entity and the interest is not offered or sold within the U.S. The "Volcker rule" will become effective only at the earlier of 12 months after the adoption of final regulations and two years after enactment of the Act, and banking entities covered by the rule will have an additional two year period to comply with the rule.

Regulations to be Promulgated under the Act

Much of the provisions of Act covered in this alert will be fleshed-out by regulations to be adopted by the SEC and the CFTC, in consultation with the Council. Such rulemaking initiatives are expected to play a significant role in shaping the practical application of the Act.


1 The "private adviser exemption" from registration under the Advisers Act previously applied to advisers with fewer than 15 clients during the preceding 12 month period and who did not hold themselves out to the public as an investment adviser.

2 The Act defines "private fund" to cover all entities that would be deemed to be investment companies under the Investment Company Act, but for the application of Sections 3(c)(1) and 3(c)(7) of the Investment Company Act. This does not capture real estate funds and commercial lending funds, which are exempt under 3(c)(5) of the Investment Company Act.

3 The Act provides for certain recordkeeping and annual or other reporting requirements for such exempted advisers (as determined by the SEC).

4 Or such higher amounts as the SEC may determine through rulemaking.

5 Although the Act exempts advisers to "venture capital funds", it provides for certain recordkeeping and annual or other reporting requirements for such advisers (as determined by the SEC).

6 In referring to the $25 million AUM threshold, Section 203A(a)(1) of the Advisers Act provides for such higher amounts as the SEC by rule deemed appropriate. Prior to the Act, Rule 203A-1 promulgated by the SEC pursuant to Section 203A(a)(1) provided that advisers with $25 million or more AUM were permitted to register with the SEC, while advisers with $30 million or more AUM were required to register with the SEC.

7 Both the $25 million and $100 million AUM thresholds may be adjusted to reflect such higher amounts as the SEC may determine through rulemaking.

8 Note that the Act did not change Section 203A(a)(1) of the Advisers Act, which provides that advisers with AUM less than $25 million will generally remain subject exclusively to state regulation.

9 Mid-sized investment advisers who would be required to register with 15 or more states may register with the SEC.

10 The Senate Committee on Banking, Housing, and Urban Affairs estimated that the number of advisers subject to state investment adviser regulation will increase by 28%. See "Summary: Restoring American Financial Stability", Senate Committee on Banking, Housing, and Urban Affairs, Chairman Chris Dodd (D-CT), available at

SEC Amends IA custody rule

On December 30, 2009, the SEC adopted its long awaited amendments to Rule 206(4)-2 under the Investment Advisers Act of 1940, as amended (the "Custody Rule"),1 which become effective on March 12, 2010. As previously, an adviser with custody of client assets must maintain those assets with a qualified custodian and inform the client in writing of the name and address of such custodian. The Custody Rule has been amended, inter alia, to require SEC-registered investment advisers to undergo an annual surprise examination by an independent public accountant registered with the Public Accounting Oversight Board (the "PCAOB") to verify assets under such investment adviser's custody. The annual surprise examination requirement does not apply to (i) advisers who have custody of client assets solely because they are authorized to deduct fees from client accounts; (ii) advisers to pooled investment vehicles who deliver audited financial statements to pool participants; and (iii) advisers who have custody because they maintain client assets with a related person that is "operationally independent" of such adviser.

Annual Surprise Examination

As noted above, all SEC-registered investment advisers with custody of client assets must undergo an annual surprise examination of such assets by an independent accountant registered with the PCAOB. The Custody Rule makes it clear that an adviser has custody if it or a "related person"(essentially an affiliate of such adviser) physically possesses client funds or securities or has the authority to obtain possession thereof.

The Custody Rule requires that client account statements be delivered directly to the adviser's clients by the "qualified custodian." Advisers will no longer have the option of complying with the rule by delivering such statements themselves. Advisers must have a reasonable basis, after due inquiry, for believing that the qualified custodian has sent an account statement, at least quarterly, to each client for which it maintains custody. Generally speaking, the account statement shall set forth the assets and transactions in the account as reflected in the custodian's records. In this regard, the SEC has indicated that an adviser will be deemed to have satisfied this requirement where the qualified custodian provides it with a copy of the account statement that was delivered to the client.

The Custody Rule requires that a notice be sent to each client upon the opening of a custodial account with a qualified custodian which contains a legend stating that the client should compare the custodian-provided account statement with any account statement provided by the client's adviser. For advisers who choose to send such account statements, in addition to those sent by the qualified custodian, the cautionary legend must be included in any subsequent adviser-provided account statements that are delivered to clients after the initial notice during the conduct of the account so as to minimize any confusion. The SEC believes such regular notice will serve to more effectively remind clients to take steps to protect their assets.

An adviser subject to the surprise examination requirement must enter into a written agreement with the accountant that provides for the first examination to take place by December 31, 2010. Such written agreements must also require the accountant to: (i) file a certificate on Form ADV-E within 120 days of the time chosen by the accountant for the surprise examination, stating that the accountant has examined the funds and securities and describing the nature and scope of the examination; (ii) notify the SEC within one business day if it finds any material discrepancies during the examination; and (iii) file a Form ADV-E within four business days of its resignation or dismissal from the engagement or if it is removed from consideration from reappointment, either voluntarily or involuntarily, which shall include a narrative statement setting forth any problems encountered by the accountant which may have contributed to the termination. Accountants will file the Form ADV-E electronically through the Investment Adviser Registration Depository ("IARD").

For advisers becoming subject to the rule after the effective date, such advisers must have a surprise examination within six months after becoming subject to the rule. If the adviser itself (and not a related person) acts a qualified custodian, the first surprise examination must take place within six months after obtaining an internal control report, which is discussed below.


(a) Advisers with Custody Solely Due to Fee Deduction

An adviser who has custody solely because it has authority to deduct fees from client accounts is not required to undergo an annual surprise examination. This is no doubt a response to the criticisms of the proposed rule made during the comment period.

(b) Advisers to Pooled Investment Vehicles Subject to Audit

Advisers to pooled investment vehicles whose financial statements are audited annually in accordance with U.S. GAAP by a PCAOB-registered independent accountant and delivered to pool participants within 120 days after the end of the fiscal year (180 days in the case of a fund of funds) are not subject to the surprise examination requirement.4 This exemption will not apply if all of the pool participants are themselves pooled investment vehicles which are related persons of the adviser. This has been done to prevent an adviser from avoiding compliance with the rule by setting up a tier of funds to receive financial statements. Also, if a pooled investment vehicle uses special purpose vehicles ("SPVs"&Mac255;), the adviser to such pooled investment vehicle must either include the assets of such SPVs in the scope of the audit or treat each SPV as an individual client (requiring it to comply separately with the Custody Rule's audit distribution or account statement/surprise examination requirements).

(c) Advisers with Custody Through "Operationally Independent"&Mac255; Related Persons

An investment adviser who has custody solely because it utilizes a related person as the qualified custodian is not subject to undergoing an annual surprise examination if such related person is "operationally independent"&Mac255;. A related person will not be operationally independent unless (i) client assets are not subject to the claims of the adviser's creditors; (ii) the adviser's personnel do not have access to the client's assets or the power to control the disposition of such assets for the benefit of the adviser or its related persons; (iii) personnel of the adviser and the related person who have access to client assets are not under common supervision; and (iv) the personnel of the adviser do not hold any positions or share space with the related person.

Internal Control Report

Where an adviser or its related person is acting as the qualified custodian (as opposed to using an "independent" qualified custodian), in addition to undergoing a surprise examination,5 such adviser or related person must obtain an annual internal control report with respect to its controls over custody of client assets prepared by an independent PCAOB-registered accountant. This is to address the custodial risks associated with an affiliated custodial relationship. The SEC indicated that the surprise examination requirement alone would not adequately address such risks as the accountant seeking to verify client assets would rely, in part, on custodial reports issued by the adviser or the related person. The internal control report must include the accountant's opinion as to whether the qualified custodian's internal controls are suitably designed and are operating effectively to meet control objectives related to custodial services, including the safeguarding of fund and securities of advisory clients during the year, among other things. If the qualified custodian is the adviser to a pooled investment vehicle or a related person of the adviser, the adviser to the pool would have to obtain, or receive from the related person, an internal control report.

Other Matters

(a) Form ADV Part 1A and Schedule D have been amended to require more detailed disclosure of advisor custody practices and to update the information. In addition, the identity and certain other information must be disclosed regarding accountants performing audits, surprise examinations and internal control reviews as well as the identity of any related person that acts as qualified custodian for client assets.

(b) "Privately offered securities", as defined by the Custody Rule, may no longer be omitted from the purview of the annual surprise examination.

(c) A companion release 6 provides accountants with guidance addressing the scope of the surprise examination and the internal control report, as well as the relationship between them.

(d) Liquidation audit "„ the amended Custody Rule requires advisers to pooled investment vehicles that follow the rule's annual audit provision must also obtain a final audit of the pool's financial statements upon liquidation of the pool and distribute them to pool investors promptly after the completion of the audit.

(e) The SEC has provided guidance regarding compliance polices and procedures to be considered as controls over the safekeeping of client assets. These include:

- background and credit checks on employees with access to client assets;

-dual authorization for (i) moving assets within a client account; (ii) withdrawing assets from a client account; or (iii) changing account ownership information;

-limiting employee contact with custodians and, where the adviser serves as the qualified custodian, segregating the duties of advisory personnel from custodial personnel;

-establishing the basis for reasonable belief that qualified custodians send account statements to clients on at least a quarterly basis;

-ensuring that the adviser remain "operationally independent"&Mac255; from related persons acting as qualified custodians; and

-testing the adviser's controls over the safekeeping of client assets on a periodic basis, including comparing adviser prepared account statements with those prepared by the custodian, testing the computation of advisory fees deducted from client accounts and monitoring client addresses.

(f) Required records "„ advisers shall be required to maintain (i) a copy of the internal control report from its related person and (ii) the memorandum describing the basis upon which the adviser determined that any related person is operationally independent for a period of five years from the end of the fiscal year in which such items were finalized

Quarterly Reporting Requirement Proposed By NFA For CPOs

On August 25, 2009, pursuant to Section 17(j) of the Commodity Exchange Act, as amended, the National Futures Association (the"NFA") submitted proposed NFA Compliance Rule 2-46 (the "Proposed Rule") to the Commodity Futures Trading Commission (the "CFTC") regarding CPO reporting rules.

The Proposed Rule requires registered CPOs to file with the NFA on a quarterly basis, a report for each pool operated by the CPO, even those pools operated pursuant to the exemption contained in CFTC Regulation 4.7, a report containing the following information:

The identity of the pools administrator, carrying broker, trading manager and custodian.

A statement of the change in pool's net asset value for quarter.

The monthly performance for the three months comprising the quarter being reported on.

A schedule of investments which identifies any investment which exceeds 10% of the pool's net asset value at the end of the quarter being reported on.

In filing the Proposed Rule, the NFA invoked the "ten day" provision of Section 17(j) of the Commodity Exchange Act. Accordingly, the Proposed Rule will be effective when the NFA completes the necessary changes to its reporting system. While the Proposed Rule will apply to Regulation 4.7 exempt pools, it will not apply to pools operated pursuant to the Regulation 4.13 exemptions.

The information regarding the specific third party service providers will have to be filed or inputted at the time the initial quarterly filing is made for the pool. Subsequent quarterly filings for the pool will not have to repeat this information unless there are changes to any such third party service providers.

During the comment period for the Proposed Rule, concern was expressed with respect to the schedule of investments. The NFA concluded that a 10% threshold was the most appropriate for risk assessment purposes. Reacting to concerns that such reporting will be burdensome, the NFA has expressed its intention to make the reporting system as user friendly as possible and not require specific position information to the extent possible.

The inclusion of information for Regulation 4.7 exempt pools also inspired critical comment. However, the NFA was concerned that it does not have enough information regarding such pools (which comprise approximately 75% of the pools now operating) to utilize its risk system's capabilities to identify CPO trends and assign auditing and examination priorities. In this regard, the NFA noted that it has recently taken regulatory action against CPOs for fraudulent activity in the operation of Regulatin 4.7 exempt pools.