Before the Dodd-Frank Act, fund managers could avoid registering with the SEC by limiting the number of funds they advised to less than fifteen. Now this exemption has been replaced with a general requirement that advisers meeting certain AUM thresholds must register with the SEC—unless they fall into one of several limited exemptions. Many advisers are now hoping to fall within an exemption, believing that "exempt" status conveys substantial benefits in terms of a reduced regulatory burden.
You might have heard this all before, but what you may not know is that becoming an exempt reporting adviser does not constitute a complete free pass: there are concealed dangers that can trap unwary advisers.
First, the good news. An exempt reporting adviser will not make all the filings required of a registered adviser, which reduces the regulatory burden. Likewise, there will be no mandate to change current practices on custody, advertising or performance fees, or to establish a compliance program and appoint a chief compliance office. Exempt reporting advisers may be subject to less regulatory oversight in other areas as well. Certain federal regulations, such as those addressing privacy requirements of investors and employees, do not apply to an unregistered adviser and the SEC has indicated that it will not regularly examine exempt advisers.
This news may come as a relief, but don’t be lulled into a false sense of complacency as a result; exempt advisers will still have plenty to do and to think about. The regulators require even exempt reporting advisers to do much of the work associated with registration. Being required to file portions of Form ADV means that they will still make significant fund level disclosures and their operations will be subject to much greater public scrutiny.
An exempt reporting adviser, for example, must describe potential conflicts of interest and disclose for each private fund a fair amount of sensitive information. The adviser must provide details about the fund's auditors, prime brokers, custodians, administrators, and marketers. The SEC has not provided specific details about the record-keeping requirements it will expect from exempt reporting advisers, stating that it will address these in the future.
With the regulators, no news is not always good news. In the absence of contrary guidance, exempt advisers may wish to think seriously about maintaining books and records in a manner consistent with registration requirements. While this will assist in complying with reporting requirements that are adopted, an even more important consideration involves the possible need to register in the future.
And it is with the possibility of future registration that the limited nature of the exempt reporting adviser status becomes most apparent. Many exempt reporting advisers will register in the future because of growth in assets under management or changes to their business model, changes they want to make in order to expand their business opportunities. An adviser who wants to avoid inadvertently triggering registration requirements will need a mechanism to monitor regulatory changes. If the need to register comes as a surprise, an unprepared adviser will be hard pressed to update its processes on the spot.
Unfortunately, some of these updates take significant time. For example, losing an exemption may mean that a previously exempt adviser immediately faces limits on the ability to charge performance based fees, depending on the credentials of the investors in the funds that the firm manages. Exempt reporting advisers should know the status of their fund investors in this respect ahead of time. They might decide that, as a matter of good corporate governance, the prudent course of action is to shadow custody, advertising, reporting and other requirements that would apply if, or when, the need to register arises.
Don't forget that unregistered does not mean unregulated. Many areas targeted for enforcement apply regardless of registration status, like insider trading, which remains a hot topic for regulators and journalists alike. All advisers must also be aware of, and comply with, legal requirements relating to fund investors (including pension funds, governmental entities and foreign investors) and laws applicable to their particular investment strategy, including relevant state laws. This is a huge wilderness of regulation not covered in the Investment Advisers Act that advisers are required to address. Unfortunately there has been a tendency to criminalize missteps in these situations, even inadvertent ones.
Against this backdrop, exempt reporting advisers (and indeed all advisers) can utilize a strong compliance program as a means of protecting firm value. At a time when all advisers are expected to process and comply with a significant amount of regulation, the US Federal Sentencing Guidelines and the U.S. Attorneys' Manual provide significant benefits to a firm that establishes a good, appropriately structured compliance program. Thus a comprehensive governance program is one of the keys to the success of an adviser, especially those new to the regulatory landscape.
