SECURITIES AND EXCHANGE COMMISSION

17 CFR Parts 275 and 279

[Release No. IA-2333; File No. S7-30-04]

RIN 3235-AJ25

Registration Under the Advisers Act of Certain Hedge Fund Advisers

AGENCY: Securities and Exchange Commission (the “Commission” or “SEC”).

ACTION: Final rule.

SUMMARY: The Commission is adopting a new rule and rule amendments under the Investment Advisers Act of 1940. The new rule and amendments require advisers to certain private investment pools (“hedge funds”) to register with the Commission under the Advisers Act. The rule and rule amendments are designed to provide the protections afforded by the Advisers Act to investors in hedge funds, and to enhance the Commission’s ability to protect our nation’s securities markets.

DATES: Effective Dates: February 10, 2005, except for the amendments to §275.206(4)-2 [rule 206(4)-2] and §279.1 [Form ADV], which will become effective January 10, 2005.

Compliance Dates: Advisers that will be required to register under the new rule and rule amendments must do so by February 1, 2006. Advisers must respond to the amended items of Form ADV in their next ADV filing after March 8, 2005. Section III of this Release contains more information on the effective and compliance dates.

FOR FURTHER INFORMATION CONTACT: Vivien Liu, Senior Counsel, Jamey Basham, Branch Chief, or Jennifer L. Sawin, Assistant Director, at 202-942-0719 or IArules@sec.gov, Office of Investment Adviser Regulation, Division of Investment Management, Securities and Exchange Commission, 450 Fifth Street, NW, Washington, DC 20549-0506.

SUPPLEMENTARY INFORMATION: The Commission is adopting new rule 203(b)(3)-2 [17 CFR 275.203(b)(3)-2], amendments to rules 203(b)(3)-1 [17 CFR 275.203(b)(3)-1], 203A-3 [17 CFR 275.203A-3], 204-2 [17 CFR 275.204-2], 205-3 [17 CFR 275.205-3], 206(4)-2 [17 CFR 275.206(4)-2], and 222-2 [17 CFR 275.222-2], and Form ADV [17 CFR 279.1] under the Investment Advisers Act of 1940 [15 U.S.C. 80b] (the “Advisers Act” or “Act”).

TABLE OF CONTENTS

1. BACKGROUND
    
1. Growth of Hedge Funds
    
2. Growth in Hedge Fund Fraud
    
3. Broader Exposure to Hedge Funds
    
2. DISCUSSION
    
1. Need for Commission Action
    
2. Matters Considered by the Commission
    
3. Our Legal Authority Under the Advisers Act
    
4. Rule 203(b)(3)-2
    
5. Definition of “Private Fund”
    
6. Other Amendments to Rule 203(b)(3)-1
    
7. Amendments to Rule 204-2
    
8. Amendments to Rule 205-3
    
9. Amendments to Rule 206(4)-2
    
10. Amendments to Rule 222-2 and Rule 203A-3
     
11. Amendments to Form ADV
     
3. EFFECTIVE AND COMPLIANCE DATES
    
4. COST-BENEFIT ANALYSIS
    
5. EFFECTS ON COMMISSION EXAMINATION RESOURCES
    
6. PAPERWORK REDUCTION ACT
    
7. EFFECTS ON COMPETITION, EFFICIENCY AND CAPITAL FORMATION
    
8. REGULATORY FLEXIBILITY ACT
    
9. STATUTORY AUTHORITY
    
   TEXT OF RULE, RULE AMENDMENTS AND FORM AMENDMENTS

I. BACKGROUND

The Commission regulates investment advisers – persons and firms who advise others about securities – under the Investment Advisers Act of 1940. The Act contains a few basic requirements, such as registration with the Commission, maintenance of certain business records, and delivery to clients of a disclosure statement (“brochure”). Most significant is a provision of the Act that prohibits advisers from defrauding their clients, a provision that the Supreme Court has construed as imposing on advisers a fiduciary obligation to their clients.¹ This fiduciary duty requires advisers to manage their clients’ portfolios in the best interest of clients, but not in any prescribed manner. A number of obligations to clients flow from this fiduciary duty, including the duty to fully disclose any material conflicts the adviser has with its clients,² to seek best execution for client transactions,³ and to have a reasonable basis for client recommendations.⁴ The Advisers Act does not impose a detailed regulatory regime.

Not all advisers must register with the Commission. The Act exempts an adviser from registration if it (i) has had fewer than fifteen clients during the preceding twelve months, (ii) does not hold itself out generally to the public as an investment adviser, and (iii) is not an adviser to any registered investment company.⁵ Advisers taking advantage of this “private adviser exemption” must nonetheless comply with the Act’s antifraud provisions,⁶ but do not file registration forms with us identifying who they are, do not have to maintain business records in accordance with our rules, do not have to adopt or implement compliance programs or codes of ethics, and are not subject to Commission oversight. We lack authority to conduct examinations of advisers exempt from the Act’s registration requirements.⁷

The private adviser exemption was not intended to exempt advisers to wealthy or sophisticated clients.⁸ It appears to reflect Congress’ view that there is no federal interest in regulating advisers that have only a small number of clients and whose activities are unlikely to affect national securities markets.⁹ Today, however, a growing number of investment advisers take advantage of the private adviser exemption to operate large investment advisory firms without being registered with the Commission. Instead of managing client money directly, these advisers pool client assets by creating limited partnerships, business trusts or corporations in which clients invest. In 1985, we adopted a rule that permitted advisers to count each partnership, trust or corporation as a single client, which today permits advisers to avoid registration even though they manage large amounts of client assets and, indirectly, have a large number of clients.¹⁰

One significant group of these advisers provides investment advice through a type of pooled investment vehicle commonly known as a “hedge fund.” There is no statutory or regulatory definition of hedge fund, although many have several characteristics in common. Hedge funds are organized by professional investment managers who frequently have a significant stake in the funds they manage and receive a management fee that includes a substantial share of the performance of the fund.¹¹ Advisers organize and operate hedge funds in a manner that avoids regulation as investment companies under the Investment Company Act of 1940, and hedge funds do not make public offerings of their securities.¹²

Hedge funds were originally designed to invest in equity securities and use leverage and short selling to “hedge” the portfolio’s exposure to movements of the equity markets.¹³ Today, however, advisers to hedge funds utilize a wide variety of investment strategies and techniques designed to maximize the returns for investors in the hedge funds they sponsor.¹⁴ Many are very active traders of securities.¹⁵

In 2002, we requested that our staff investigate the activities of hedge funds and hedge fund advisers. First, we were aware that the number and size of hedge funds were rapidly growing and that this growth could have broad consequences for the securities markets for which we are responsible. Second, we were bringing a growing number of enforcement cases in which hedge fund advisers defrauded hedge fund investors, who typically were able to recover few of their assets. Third, we were concerned that the activities of hedge funds today might affect a broader group of persons than the relatively few wealthy individuals and families who had historically invested in hedge funds.¹⁶ We directed the staff to develop information for us on a number of related topics, and advise us whether we should exercise greater regulatory authority over the hedge fund industry.

In connection with the staff investigation, we held a Hedge Fund Roundtable on May 14 and 15, 2003, and invited a broad spectrum of hedge fund industry participants to participate. Information developed at the Roundtable, and a large number of additional submissions that we subsequently received from interested persons, contributed greatly to the staff’s investigation and our understanding of hedge funds and hedge fund advisers as we developed our proposals.¹⁷

In September 2003, the staff published a report entitled Implications of the Growth of Hedge Funds.¹⁸ The 2003 Staff Hedge Fund Report describes the operation of hedge funds and raises a number of important public policy concerns. The report focused on investor protection concerns raised by the growth of hedge funds. The 2003 Staff Hedge Fund Report confirmed and further developed several of our concerns regarding hedge funds and hedge fund advisers.

A. Growth of Hedge Funds

It is difficult to estimate precisely the size of the hedge fund industry because neither we nor any other governmental agency collects data specifically about hedge funds. It is estimated that there are now approximately $870 billion of assets¹⁹ in approximately 7000 funds.²⁰ What is remarkable is the growth of the hedge funds. In the last five years alone, hedge fund assets have grown 260 percent, and in the last year, hedge fund assets have grown over 30 percent.²¹ Some predict the amount of hedge fund assets will exceed $1 trillion by the end of the year.²² Hedge fund assets are growing faster than mutual fund assets and already equal just over one fifth of the assets of mutual funds that invest in equity securities.²³

As a result, hedge fund advisers have become significant participants in the securities markets, both as managers of assets and traders of securities. One report estimates that hedge funds represent approximately ten to twenty percent of equity trading volume in the United States.²⁴ One article portrayed a single hedge fund adviser as responsible for an average of five percent of the daily trading volume of the New York Stock Exchange.²⁵ Another reported that hedge funds dominate the market for convertible bonds.²⁶

B. Growth in Hedge Fund Fraud

The growth in hedge funds has been accompanied by a substantial and troubling growth in the number of our hedge fund fraud enforcement cases.²⁷ In the last five years, the Commission has brought 51 cases in which we have asserted that hedge fund advisers have defrauded hedge fund investors or used the fund to defraud others in amounts our staff estimates to exceed $1.1 billion.²⁸

Although most of our hedge fund fraud cases have involved hedge fund advisers that defrauded their investors, we now too frequently see instances in which hedge funds have been used to defraud other market participants. Most disturbing is that hedge fund advisers have been key participants in the recent scandals involving late trading and inappropriate market timing of mutual fund shares.²⁹ Many of our enforcement cases involved hedge fund advisers that sought to exploit mutual fund investors for their funds’ and their own gain. Some hedge fund advisers entered into arrangements with mutual fund advisers under which the mutual fund advisers waived restrictions on market timing in return for receipt of the hedge fund advisers’ “sticky assets,” i.e., placement of other assets in other funds managed by the mutual fund adviser. Other hedge fund advisers sought ways to avoid detection by mutual fund personnel by conspiring with intermediaries to conceal the identity of their hedge funds. While our investigation is ongoing, the frequency with which hedge funds and their advisers appear in these cases and continue to turn up in the investigations is alarming. Our staff counts almost 400 hedge funds (and at least 87 hedge fund advisers) involved in these cases and others under investigation.³⁰

C. Broader Exposure to Hedge Funds

The third development of significant concern is the growing exposure of smaller investors, pensioners, and other market participants, directly or indirectly, to hedge funds. Hedge fund investors are no longer limited to the very wealthy. We note three developments that we have observed that contribute to this concern.

First, some hedge funds today are expanding their marketing activities to attract investors who may not previously have participated in these types of risky investments.³¹ Many hedge funds maintain very high minimum requirements, and many of the hedge fund participants at our Roundtable expressed no interest in attracting “retail investors.” Our staff observed, however, that some hedge funds’ minimum investment requirements have decreased over time.³² In developed markets outside the United States, hedge funds have sought to market themselves to smaller investors, and we can expect similar market pressures to develop in the United States as more hedge funds enter our markets.³³

Second, the development of “funds of hedge funds” has made hedge funds more broadly available to investors.³⁴ Today there are 52 registered funds of hedge funds that offer or plan to offer their shares publicly.³⁵ Most funds of hedge funds are today offered only to institutional investors, but there are no statutory limitations on the public offering of these funds. Funds of hedge funds today represent approximately twenty percent of hedge fund capital, ³⁶ and are the fastest growing source of capital for hedge funds today.³⁷

Finally, and perhaps most significantly, in the last few years, a growing number of public and private pension funds,³⁸ as well as universities, endowments, foundations, and other charitable organizations, have begun to invest in hedge funds or have increased their allocations to hedge funds.³⁹ More of these institutions have also recently begun to consider these alternative investments.⁴⁰ Institutional investments may increase in the next four years to $300 billion.⁴¹ Investors that have not been traditional hedge fund investors, including pension plans that have millions of beneficiaries, are thus today purchasing hedge funds. As a result of the participation by these entities in hedge funds, the assets of these entities are exposed to the risks of hedge fund investing. Losses resulting from hedge fund investing and hedge fund frauds may affect the entities’ ability to satisfy their obligations to their beneficiaries or pursue other intended purposes.

In response to these developments, and after extensive consultation with participants in the hedge fund industry in connection with our staff’s investigation, we proposed in July of 2004 a new rule that would require hedge fund advisers to count each investor in a hedge fund, rather than only the hedge fund itself, as a client for purposes of the private adviser exemption.⁴² As a result, most hedge fund advisers would have to register with the Commission and would be subject to SEC oversight. The rule and rule amendments were designed to provide the protections afforded by the Advisers Act to investors in hedge funds, and to enhance the Commission’s ability to protect our nation’s securities markets.⁴³

We received letters from 161 commenters, including investors, hedge fund advisers, other investment advisers, trade associations, and law firms.⁴⁴ Forty-two commenters did not express a view on whether we should or should not require hedge fund advisers to register, but asked us to consider particular issues or concerns if we adopted the rule.⁴⁵ Thirty-six commenters supported the rule proposal and our efforts to improve our oversight of hedge fund advisers.⁴⁶ Several investors and other commenters hailed the proposal as an important step towards protecting investors and the overall securities markets.⁴⁷ They pointed out that while registering hedge fund advisers would not eliminate fraud, it would allow the Commission to address potential opportunities for fraud. These commenters also noted that registration may help the hedge fund industry to the extent it discourages persons intent on committing fraud from entering the industry and damaging the reputation of the legitimate managers.⁴⁸ They also cautioned that the Commission should not wait until the next crisis before taking measures of protection against potential fraud.⁴⁹ Some hedge fund advisers and other advisers already registered with the SEC also welcomed the proposal. They used their own experiences to illustrate that registration would not overburden a firm’s operation, and that benefits of being a registered adviser more than compensated for the costs.⁵⁰

Eighty-three commenters, including many unregistered hedge fund advisers, their attorneys, and trade associations, however, argued strongly against the proposal. They expressed concerns about the costs of compliance under the new rule,⁵¹ and raised questions about our effectiveness in preventing hedge fund fraud,⁵² and the potential intrusiveness of our oversight of hedge fund managers.⁵³ Some hedge fund investors were concerned that their advisers might pass the costs of registration to them and increase management fees.⁵⁴

II. DISCUSSION

We have carefully considered all of the comments we received.⁵⁵ For the reasons discussed below and in the Proposing Release, we are adopting rule 203(b)(3)-2 and related amendments to rule 203(b)(3)-1 and Form ADV, which would require most hedge fund advisers to register with us under the Act.⁵⁶

A. Need for Commission Action

The Commission is the federal agency with principal responsibility for the enforcement and administration of the federal securities laws and the supervision of the securities markets. The federal securities laws seek to protect investors by providing for the transparency of markets, by prohibiting fraud, and by imposing fiduciary obligations.⁵⁷ They encourage the formation and efficient allocation of capital and the participation of investors in the capital markets.⁵⁸ Our obligations under these laws as well as our commitment to protect investors require us to respond to important market developments, and the authority provided us by those laws permits us to adopt rules and interpret the statutes in order to preserve fair and honest markets.⁵⁹

We believe that, in light of the growth of hedge funds, the broadening exposure of investors to hedge fund risk, and the growing number of instances of malfeasance by hedge fund advisers, our current regulatory program for hedge fund advisers is inadequate. We do not have an effective program that would provide us with the ability to deter or detect fraud by unregistered hedge fund advisers. We currently rely almost entirely on enforcement actions brought after fraud has occurred and investor assets are gone. We lack basic information about hedge fund advisers and the hedge fund industry, and must rely on third-party data that often conflict and may be unreliable.⁶⁰

Requiring hedge fund advisers to register under the Advisers Act will give us the ability to oversee hedge fund advisers without imposing burdens on the legitimate investment activities of hedge funds. We understand the important role that hedge funds play in our financial markets, and we appreciate that the lack of regulatory constraints on hedge funds has been a factor in the growth and success of hedge funds. But commenters have not persuaded us that requiring hedge fund advisers to register under the Act, requiring them to develop a compliance infrastructure, or subjecting them to our examination authority will impose undue burdens on them or interfere significantly with their operations.⁶¹ Indeed, the large number of hedge fund advisers currently registered under the Act—many of whom voluntarily register—provides a powerful refutation of the assertions made by commenters who opposed the rule on these grounds.⁶² We presume these hedge fund advisers would take steps to avoid registration under the Act if the consequences of registration were as dire as some commenters have asserted.⁶³ Comments we received from hedge fund advisers that are registered under the Act provide persuasive testimonials that confirm our conclusion.⁶⁴

The Act does not require an adviser to follow or avoid any particular investment strategies, nor does it require or prohibit specific investments. Its most significant provision, which requires full disclosure of conflicts of interest and prohibits fraud against clients, applies regardless of whether the adviser is registered under the Act, and will be furthered by the registration requirement.⁶⁵ No commenter identified any provision of the Act that would provide an impediment to an adviser’s successful operation of a hedge fund.⁶⁶ Arguments by some that registration would somehow inhibit hedge fund advisers’ willingness to engage in complex or innovative strategies because they would be second-guessed by our examination staff are baseless. They are refuted by the experience of registered hedge fund advisers.⁶⁷ One commenter familiar with the obligations of registered advisers noted that registration would not require hedge fund advisers to reveal their trading strategies or disclose their portfolio holdings, and would not interfere with their ability to leverage their portfolios, and that our proposal would not restrict the ability of hedge funds to provide liquidity to the markets.⁶⁸

We are not aware of any evidence that suggests that registration under the Advisers Act has impeded investment advisers’ performance, and commenters did not suggest that registration would have such an effect. Moreover, a recent study, while not conclusive, found that there were no significant differences between performance of hedge funds managed by registered advisers and those managed by unregistered advisers.⁶⁹ Five of the ten largest (and presumably most successful) hedge fund advisers are today registered with us under the Advisers Act.⁷⁰

The bare assertions of adverse consequences of registration under the Advisers Act offered by many commenters opposed to our proposed rule, and the anecdotal evidence offered by others, simply do not stand up to scrutiny. There has been no suggestion that hedge funds managed by registered advisers play a diminished role in the financial markets compared to hedge funds managed by unregistered advisers. The empirical evidence we have seen, and the information collected informally by our staff,⁷¹ suggests that registration under the Advisers Act has no adverse effect on the legitimate market activities of hedge funds.

More than 8,500 advisory firms that collectively manage over $23 trillion dollars of assets are today registered under the Advisers Act. We have seen no credible evidence that the Act has in any way impeded their ability to employ successful investment strategies, or to effectively compete with other financial institutions that manage securities portfolios here or abroad.

Some commenters also expressed concerns about what the Commission might in the future do that could adversely affect the operation of hedge funds.⁷² Such inchoate fears, however, do not provide reason for our not going forward with this important rulemaking. Our record of 64 years of administering the Advisers Act provides no basis for such fears.⁷³ Our regulatory efforts to date that relate specifically to hedge fund advisers have been to modify our rules to accommodate these advisers.⁷⁴ Indeed, our proposals, and the rules we are adopting today, include additional regulatory relief to accommodate the needs of funds of hedge funds.⁷⁵

B. Matters Considered by the Commission

In the Proposing Release, we identified a series of considerations that led us to propose rule 203(b)(3)-2. These considerations have now led us to adopt the rule. These considerations explain what we intended to achieve by the proposed rule, why we believed some alternative approaches would not be effective, and why we believed our proposed rule reflected the proper administration of the Advisers Act. Many of the commenters discussed these considerations extensively. Those supporting the proposal tended to agree with the considerations we set out; those opposing the proposal challenged them. Below, we discuss each of the considerations set out in the Proposing Release, as well as others raised by commenters. For each, we address our considerations, the principal arguments commenters made against our adoption of the rule, and why we found those arguments to be unpersuasive.⁷⁶

1. Census Information

Registration under the Advisers Act provides the Commission with the ability to collect important information that we now lack about this growing segment of the U.S. financial system.⁷⁷ Registered advisers must file Form ADV with us, the data from which will provide us with information we need to better understand the operation of hedge fund advisers, to plan examinations, to better develop regulatory policy, and to provide data and information to members of Congress and other government agencies. This includes information about the number of hedge funds managed by advisers, the amount of assets in hedge funds, the number of employees and types of other clients these advisers have, other business activities they conduct, and the identity of persons that control or are affiliated with the firm.⁷⁸

Currently, neither we nor any other government agency has any reliable data on even the number of hedge funds or the amount of their assets. We must rely on third-party surveys and reports, which often conflict and may be unreliable.⁷⁹ Many commenters acknowledged this as a concern, and several agreed that the Commission needs reliable, current and in-depth information about hedge fund advisers.⁸⁰ Some commenters, however, urged that, instead of registering advisers and obtaining information on Form ADV, we rely on a coordinated collection of filings and transaction reports currently made by hedge funds, their advisers, or broker-dealers with various government agencies or self-regulatory organizations.⁸¹ We have considered this alternative, but believe that it would lead our staff to engage in a time-consuming forensic exercise to extract a composite of largely transactional information that would ultimately result in an incomplete picture of each hedge fund adviser and an incomplete picture of the hedge fund industry.⁸² We still would not know, for example, how many hedge funds, or hedge fund advisers, operate in the United States or their aggregate assets. As we explained in the Proposing Release, we need information that is reliable, current, and complete, and we need it in a format reasonably susceptible of analysis by our staff.

2. Deterrence of Fraud

Registration under the Advisers Act enables us to conduct examinations of the hedge fund adviser.⁸³ Our examinations permit us to identify compliance problems at an early stage,⁸⁴ identify practices that may be harmful to investors, and provide a deterrent to unlawful conduct.⁸⁵ They are a key part of our investor protection program, and a key reason we are adopting rule 203(b)(3)-2.⁸⁶

We are not suggesting that registration under the Advisers Act will result in our eliminating, or even identifying, every fraud. The prospect of a Commission examination, however, increases the risk of getting caught, and thus will deter wrongdoers.⁸⁷ This risk should alter hedge fund advisers’ behavior by forcing them to account for the consequences of a compliance examination that, like a tax audit, may not occur with great frequency.⁸⁸ Hedge fund advisers each day make decisions based on risk analysis of alternative investments, and should be particularly sensitive to the consequences of getting caught if their conduct is unlawful. The consequences may involve paying fines, disgorgement and other penalties, including industry suspensions or bars, as well as loss of reputation. This sensitivity, which may be reflected in the strength of the opposition among some hedge fund advisers to this rulemaking, suggests that the benefits of our oversight may be substantial.

Commenters opposing the rule challenged our concerns regarding fraud on two grounds. Some asserted that there was an inadequate record of fraud by hedge fund advisers to support requiring hedge fund advisers to register. They asserted that the 46 cases we cited in the Proposing Release represented only two percent of our enforcement cases over the applicable five-year period.⁸⁹ We note, however, that these cases, which have now grown to 51, represented over ten percent of our cases against investment advisers during the same period.

Some commenters cited to us a sentence from the 2003 Staff Hedge Fund Report that indicated that there was no evidence that hedge fund advisers engaged disproportionately in fraudulent activity.⁹⁰ The 2003 Staff Hedge Fund Report was issued before the discoveries of hedge fund involvement in late trading and inappropriate market timing of mutual fund shares.⁹¹ In addition, implicit in these commenters’ arguments is that the Commission should wait to act until hedge fund frauds do comprise a disproportionate amount of fraudulent activity. We reject such arguments. In the face of trends that we now observe, including the potential impact of hedge fund fraud on a growing and broadening number of direct and indirect investors in hedge funds, we believe that waiting would be irresponsible.

Second, some commenters asserted that the Commission would be unsuccessful at detecting fraud by hedge fund advisers, pointing to frauds that have occurred involving mutual funds.⁹² Such an assertion amounts to a generalized attack on the Commission’s ability to deter and detect fraud in general, and on the premise of statutes that provide us with authority to examine investment advisers.⁹³ This assertion is unsupported by any empirical data, and is as illogical as an assertion that because police officers are unable to prevent or detect all crime, they should be removed from their beats. Our examination staff uncovered, during routine or sweep exams, five of the eight cases we brought against registered hedge fund advisers,⁹⁴ and two of the cases involving unregistered advisers originated out of examinations of related persons that were registered with us.⁹⁵

Finally, some commenters suggested that hedge fund advisers are different from other advisers and that our examiners would be unable to fully understand their trading strategies and investments.⁹⁶ This argument does not acknowledge that we are today responsible for the oversight of significant number of registered hedge fund advisers (not all of which are engaged in complex trading strategies), as well as many other advisers (some of which are engaged in complex trading strategies). In our experience, there is nothing unique about hedge fund advisers or the types of frauds they have committed that suggests that our examination program would not or could not play the same effective role. The fraud actions we have brought against unregistered hedge fund advisers have been similar to the types of fraud actions we have brought against other types of advisers, including misappropriation of assets,⁹⁷ portfolio pumping,⁹⁸ misrepresentation of portfolio performance,⁹⁹ falsification of experience, credentials and past returns,¹⁰⁰ misleading disclosure regarding claimed trading strategies¹⁰¹ and improper valuation of assets.¹⁰²

3. Keeping Unfit Persons from Using Hedge Funds to Perpetrate Frauds

Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or had a disciplinary record subjecting them to disqualification.¹⁰³ We intend to use this authority to help keep fraudsters, scam artists and others out of the hedge fund industry.¹⁰⁴

Several of the frauds we have seen appear to have been perpetrated by unscrupulous persons using the hedge fund as a vehicle to defraud investors. These persons appear to never have intended to establish a legitimate hedge fund, but used the allure of a hedge fund to attract their “marks.”¹⁰⁵ We have been concerned that these individuals may have been attracted to hedge funds because they could operate without regulatory scrutiny of their past activities.¹⁰⁶ Our lack of oversight may have contributed to the belief that their frauds would not be exposed. Our ability to screen individuals and, in some cases, to block their entrance into the advisory profession should serve to discourage unscrupulous persons from using hedge funds as vehicles for fraud.¹⁰⁷

4. Adoption of Compliance Controls

Registration under the Advisers Act will require hedge fund advisers to adopt policies and procedures designed to prevent violation of the Advisers Act, and to designate a chief compliance officer.¹⁰⁸ Hedge fund advisers that have not already done so must develop and implement a compliance infrastructure. We adopted this requirement last year for all advisers registered with us in recognition that advisers have the primary obligation to ensure compliance with the securities laws, and to foster more effective compliance practices.¹⁰⁹ Our examination staff resources are limited, and we cannot be at the office of every adviser at all times. Compliance officers serve as the front line watch for violations of securities laws, and provide protection against conflicts of interests.

Comment letters opposing registration of hedge fund advisers did not challenge the benefits of compliance programs; rather, they complained of the costs of developing a compliance infrastructure, and of submitting to our compliance examinations.¹¹⁰ They asserted that these costs would make them less competitive, and would impose barriers to entry preventing new hedge fund advisers from starting their own hedge funds.¹¹¹ We acknowledge that development and maintenance of compliance controls involves costs,¹¹² but these are costs that today all advisers registered with us must bear, including advisers that are much smaller and have substantially fewer resources than many hedge fund advisers.¹¹³

Our 2003 Staff Hedge Fund Report noted that, while many unregistered hedge fund managers had strong compliance controls, others had very informal procedures that appeared to be inadequate for the amount of assets under their management.¹¹⁴ These lack of controls concern not only us, but also hedge fund investors. A recent survey of institutional investors reported that the adequacy of operational controls at hedge fund advisory firms was one of most frequently mentioned concerns.¹¹⁵ While these investors can request to see a hedge fund manager’s compliance policies and procedures, we are in a position to determine whether the hedge fund adviser’s operations seem to be in accordance with those policies and procedures.

Application of our recent rule requiring more formalized compliance policies administered by an employee designated as a chief compliance officer will serve to better protect hedge fund investors.¹¹⁶ We also believe it will well serve hedge fund advisers that, for business reasons alone, should have a compliance infrastructure commensurate with the nature of their operations and the risks involved.¹¹⁷ These costs appear small relative to the scale of the industry.¹¹⁸ The typical hedge fund fee structure, which involves both a management fee of two percent or more and a performance fee of twenty percent or more provides hedge fund advisers with a substantial cash flow.¹¹⁹ Today there are many investment advisers registered with us that manage a comparable amount of assets, charge substantially lower fees, and bear these same compliance costs. One recent study estimated that “in 1999, with $450 billion in assets under management, hedge funds’ fee revenues were higher than those of the whole U.S. equity mutual fund industry.”¹²⁰

There are today “[e]xtremely low barriers to entry and tremendous monetary and non-monetary incentives for hedge fund [advisers],”¹²¹ and thus the cost of compliance with these rules should not present significant additional barriers to entry for new hedge fund advisers. Indeed some have suggested that our regulatory initiative may “play a positive role of increasing confidence in hedge fund use by further demystifying them.”¹²²

5. Limitation on Retailization

Registration under the Advisers Act will have the salutary effect of resulting in all direct investors in most hedge funds meeting minimum standards of rule 205-3 under the Advisers Act, because hedge fund advisers typically charge performance fees.¹²³ Rule 205-3 requires that each investor, in a private investment company that pays a performance fee, generally have a net worth of at least $1.5 million or have at least $750,000 of assets under management with the adviser.¹²⁴ Many hedge fund advisers will rely on rule 205-3 to continue charging a performance fee to the funds they manage.

Most commenters did not address this effect of registration under the Act, except with respect to expressing their support for the transitional rule we also proposed, and which we discuss later in this Release.¹²⁵ Some argued that we should, instead, raise the “accredited investor” standards applicable to private offerings pursuant to Regulation D, which may have a similar effect on limiting direct investments in hedge funds.¹²⁶ Raising the accredited investor standards would not address the broader concerns, discussed above, of the indirect exposure to hedge funds by an increasingly large number of persons who are beneficiaries of pensions plans or invest through other intermediaries that are likely to meet any higher standards.

6. CFTC Regulation

Several commenters suggested that the Commission exempt from registration hedge fund advisers that are registered with the CFTC as commodity pool operators in order to avoid duplicative registration.¹²⁷ In 2000 Congress addressed this concern by adding section 203(b)(6) to the Advisers Act, which exempts any CFTC-registered commodity trading advisor from investment adviser registration if its business does not consist primarily of acting as an investment adviser.¹²⁸ A hedge fund adviser that qualifies for this statutory exemption is not required to register with us.

We disagree that our oversight of hedge fund advisers that are also commodity pool operators would be duplicative. Most hedge fund portfolios consist primarily of securities, and the CFTC’s oversight necessarily focuses more on the area of futures trading, which is the activity of most concern to the CFTC.¹²⁹ It would be inconsistent with principles of functional regulation and contrary to the design and purpose of the 2000 amendments to the Advisers Act for the Commission not to oversee hedge fund advisers whose primary business is acting as an investment adviser.¹³⁰

7. Moral Hazard Implications

Some commenters urged us not to adopt the rule because Commission oversight of hedge fund advisers might tend to cause hedge fund investors to rely on that oversight instead of performing appropriate due diligence before making an investment in a hedge fund.¹³¹ Such an argument, if accepted, would support withdrawal of the Commission’s oversight of all advisers, particularly of those advisers whose clients are less sophisticated and who might be less likely to appreciate the limitations of regulatory oversight.¹³² Congress addressed such arguments in 1940 when it passed the Advisers Act by including a provision in the Act that makes it unlawful for any investment adviser to “represent or imply in any manner whatsoever that [the adviser] has been sponsored, recommended, or approved, or that his abilities or qualifications have in any respect been passed upon by the United States or any agency or officer thereof.”¹³³

8. Proper Administration of the Advisers Act

In adopting rule 203(b)(3)-2, an important consideration for us has been our dissatisfaction with the operation of the existing safe harbor because it permits advisers, without registering under the Act, to manage large amounts of securities indirectly through hedge funds that may have, collectively, hundreds of investors.¹³⁴ We believe that the safe harbor has become inconsistent with the underlying purpose of the registration exemption in Section 203(b)(3), which was designed to exempt advisers whose business activities are too limited to warrant federal attention. Commenters have not persuaded us otherwise. Our actions today withdraw that safe harbor and require advisers to “private funds”—which will include most hedge funds—to “look through” the funds to count the number of investors as “clients” for purposes of the private adviser exemption.

Many commenters who opposed the rule urged us to maintain the safe harbor because it operated to exempt advisers to hedge funds in which only wealthy and sophisticated investors participated.¹³⁵ This argument implicitly concedes that the Commission should look to the investors in the hedge fund (rather than the hedge fund itself) to determine whether the adviser should be required to register, but concludes that we should continue to exempt the adviser from registration because the ultimate advisory clients are wealthy or sophisticated.

Section 203(b)(3) was not intended to exempt advisers to wealthy or sophisticated clients. First, they were the primary clients of many advisers in 1940 when the provision was included in the Act.¹³⁶ Second, it would make no sense for Congress to have imposed a limit on the number of wealthy or sophisticated clients an adviser could have before it had to register under the Act. Surely, the fifteenth wealthy or sophisticated client would not trigger the need for registration. Other provisions in the federal securities laws designed to exempt transactions or relationships with wealthy or sophisticated investors contain no such limitations.¹³⁷

The intent of Congress in enacting section 203(b)(3) appears to have been to create a limited exemption for advisers whose activities were not national in scope¹³⁸ and who provided advice to only a small number of clients, many of whom are likely to be friends and family members.¹³⁹ These advisers are unlikely to significantly affect investors and the securities markets generally.¹⁴⁰ While provisions of the Securities Act (and its rules) provide exemptions from registration under that Act for securities transactions with persons, including institutions, that have such knowledge and experience that they are considered capable of fending for themselves and thus do not need the protections of the applicable registration provisions,¹⁴¹ the Advisers Act does not. When a client—even one who is highly sophisticated in financial matters—seeks the services of an investment adviser, he acknowledges he needs the assistance of an expert. The client may be unfamiliar with investing or the type of strategy employed by the adviser, or may simply not have the time to manage his financial affairs. The Advisers Act is intended to protect all types of investors who have entrusted their assets to a professional investment adviser.

Several commenters opposing the rule pointed to legislation enacted in 1996 that created a new exclusion from the definition of “investment company” under the Investment Company Act for pools of securities offered exclusively to “qualified purchasers” as evidence that Congress intended that hedge fund advisers be left unregulated by the Advisers Act as well as the Investment Company Act.¹⁴² These commenters offered no support for this proposition.

The 1996 National Securities Markets Improvement Act (NSMIA) exempted these qualified purchaser funds from only the Investment Company Act.¹⁴³ Its legislative history explains only that Congress believed the protections afforded by the Investment Company Act were unnecessary for financially sophisticated investors.¹⁴⁴ Moreover, the current safe harbor, which can result in hedge fund advisers with hundreds of millions of dollars of assets being registered with one or more state regulators, is inconsistent with the policy and purposes of NSMIA, which allocated oversight responsibility for larger advisers to the Commission.¹⁴⁵

The legislative record of NSMIA, in fact, suggests that Congress may have expected the Commission to regulate the activities of advisers to hedge funds eligible for the new Investment Company Act exclusion. NSMIA amended section 205 of the Advisers Act to exempt qualified purchaser funds from restrictions on performance fees. Section 205 of the Act does not apply to advisers “exempt from registration pursuant to Section 203(b),” and thus affects only funds advised by investment advisers registered with the Commission. Thus, Congress understood that at least some of these qualified purchaser pools would be advised by registered advisers, and chose to exempt these advisers only from the restrictions on performance fees.

9. Alternatives Submitted

Several commenters submitted alternative approaches for our consideration. These alternatives included provisions aimed at addressing several of the considerations that led us to propose rule 203(b)(3)-2, such as the need for information about hedge fund advisers and the broadening exposure of investors to hedge funds. We have considered these alternatives. However, as discussed below, the alternatives each involve partial responses to our concerns, and all would deny us the ability to examine the activities of hedge fund advisers, and would not, in our judgment, accomplish the goals of this rulemaking.

Some commenters suggested we except hedge fund advisers from the adviser registration requirement if all investors in their hedge funds meet “qualified purchaser” standards under section 3(c)(7) of the Investment Company Act.¹⁴⁶ Others suggested that in lieu of requiring hedge fund adviser registration, we should increase the current “accredited investor” standards for private securities offerings under Regulation D.¹⁴⁷ These alternatives would address one aspect of our concern about the prospect of direct ownership of hedge funds by investors who may not previously have participated in these types of risky investments, but would not permit us to protect the interests of those whose exposure is through intermediaries such as funds of funds and pension funds.¹⁴⁸ Moreover, as discussed earlier, the Advisers Act does not exempt an adviser from registration merely because its clients may be wealthy or sophisticated.¹⁴⁹

Other commenters offered alternatives based on amending our Form D to require hedge funds to provide certain information about their advisers.¹⁵⁰ Some suggested that hedge fund advisers whose funds submitted this information be excepted from adviser registration requirements,¹⁵¹ while others suggested it be an alternative to registration.¹⁵² Some commenters further suggested that these information requirements be combined with limited application of specific rules that apply only to registered advisers, such as the custody rule or the compliance rule.¹⁵³ None of these alternatives, however, would provide us with examination authority.¹⁵⁴

Finally, some commenters suggested that, instead of registering hedge fund advisers, we gather information about them from a variety of regulatory filings currently made by hedge funds, their advisers, and broker-dealers.¹⁵⁵ We have considered this alternative, but the reports and information currently available would provide at best a partial, inadequate view of the activities of hedge fund advisers. While some of the reports emphasized by these commenters might provide us with basic identifying information about hedge funds advisers that are registered as broker-dealers or commodity pool operators, many are not registered in either capacity. These commenters also focus on several existing transactional reporting requirements, arguing they contain a wealth of information about hedge funds. However, as discussed above, making use of this information would require substantial effort on the part of our staff to extract a composite of information about any particular hedge fund, yielding limited information about its assets instead of any useful information about whether its adviser is fulfilling its fiduciary duties. As we stated in the Proposing Release, we need information that is reliable, current, and complete, and we need it in a format reasonably susceptible to analysis by our staff.

C. Our Legal Authority Under the Advisers Act

A few commenters challenged our legal authority to adopt rule 203(b)(3)-2, asserting that the approach of the rule, which requires an adviser to “look through” a hedge fund to determine whether it is eligible for the private adviser exemption, is contrary to the Act. For the reasons discussed below, we believe we have broad authority to adopt the rule. We start our discussion with the statutory language.

Section 203(b)(3) of the Act provides an exemption from registration for certain investment advisers. To qualify for the exemption, Congress provided two specific tests, each of which an adviser must satisfy. First, the adviser must not advise fifteen or more clients and, second, the adviser must not hold itself out to the public as an investment adviser. In enacting this provision, Congress exempted from the registration requirements a category of advisers whose activities were not sufficiently large or national in scope, e.g., advisers to family or friends, to implicate the policy objectives identified in section 201 of the Act.¹⁵⁶

Congress did not appear to have addressed or considered whether an adviser must count an investor in a pooled investment vehicle as a client for purposes of section 203(b)(3). Nevertheless, it has long been recognized that determining whether the exemption applies could not be limited to a formalistic assessment of whether the adviser provided investment advice to a single legal entity, but instead requires consideration of the surrounding circumstances of the advisory arrangement, which, in appropriate cases, might call for “looking through” the advised entity.¹⁵⁷

For purposes of counting clients, “looking through” the advised entity in appropriate circumstances is fully consistent with the broad remedial purposes of the Advisers Act and the exemptive provisions of section 203(b)(3).¹⁵⁸ The Act’s objectives would be substantially undermined if an adviser with more than fifteen clients could evade its registration obligation through the simple expedient of having those clients invest in a limited partnership or similar fund vehicle – which the adviser would thereafter count as a single client. This concern is amplified where the adviser solicits investments directly in the fund vehicle based on the adviser's investment management skills, and offers investors the ability to redeem their assets on a short-term basis, as they would be permitted to do if they opened an account directly with the adviser.

The legislative and regulatory history of the Advisers Act since its enactment in 1940 is consistent with the understanding that the statute in appropriate cases may require “looking through” the entity for purposes of counting clients. Congressional action involving section 203(b)(3), the Commission’s rulemaking under the provision, and staff no-action letters¹⁵⁹ evidence the longstanding recognition that the exemption does not require a rigid approach to counting clients without consideration of the surrounding circumstances.

First, the amendment to section 203(b)(3) in 1980 confirmed that the exemption could be read to require an adviser to “look through” a legal entity and count its investors. In 1980, Congress amended the section to provide that, in the case of a business development company, “no shareholder, partner, or beneficial owner . . . shall be deemed to be a client of such investment adviser unless such person is a client of such investment adviser separate and apart from his status as a shareholder, partner or beneficial owner.” The language of this provision would have been superfluous absent a recognition that, in some cases, a shareholder, partner, or beneficial owner, could be counted for purposes of the exemption. Further, the legislative history indicates that Congress deliberately left open the question of how to count clients for entities other than business development companies.¹⁶⁰

Second, the Commission’s creation of the existing safe harbor in current rule 203(b)(3)-1 would have been entirely unnecessary if there had not been a substantial concern, at that time, that an adviser to a hedge fund might, in some cases, either be required to “look through” the fund for counting purposes or to view itself as having violated the “holding out” limitation set out in the statutory exemption.

When adopting the safe harbor in 1985, we determined to resolve the uncertainty regarding when advisers to hedge funds must register by expressly exempting them from registration.¹⁶¹ At that time, when advisers to hedge funds played a far less significant role in the national markets than they do today, we did not consider it inconsistent with the legislative objectives embedded in the statutory exemption to exempt those advisers from registration. However, as we stated when we proposed the safe harbor, “a different approach could be followed in counting clients.”¹⁶² In light of the developments regarding hedge funds and their advisers, we are now taking a different approach.

As discussed above, in the intervening two decades and particularly in recent years, much has changed in our capital markets. The growth of hedge funds, their market activity and their trading volume has been dramatic, and as a result they now have a substantial effect on national securities markets and on the national economy. This growth, together with the increase in fraud involving hedge fund advisers, fully justifies a reexamination of whether it is consistent with the Act to continue to provide an across-the-board registration exemption for all advisers to hedge funds. The amendments adopted by the Commission today recognize those changed circumstances and constitute an appropriate use of the Commission’s rulemaking authority under the Act.

The Commission has broad rulemaking authority under section 211(a) of the Act, which states that the Commission may adopt rules "necessary or appropriate to the exercise of the functions and powers conferred upon the Commission elsewhere in this title . . ." and "may classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters."¹⁶³ Section 206(4) of the Act provides us with authority to adopt rules “that define, and prescribe means reasonably designed to prevent such acts, practices, and courses of business as are fraudulent, deceptive or manipulative.”¹⁶⁴ Once these advisers are registered, the Commission will be able to carry out its regulatory function with respect to them, such as conducting inspections and examinations,¹⁶⁵ and implementing other provisions, discussed elsewhere in this Release, to further investor protection.

The amendments we adopt today implement our rulemaking authority in a manner specifically targeted to those advisers whose activities involving “private funds” most directly suggest the need for registration. As discussed in more detail below,¹⁶⁶ first, a private fund will be one that is excepted from the definition of investment company under section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. By definition, these funds engage in significant securities related activities in a context where they deal privately with each of their investors (since under sections 3(c)(1) and 3(c)(7) they may not engage in a public offering).¹⁶⁷ Second, the term “private funds” is limited to investment pools with redemption features that offer investors a short-term right to withdraw their assets from management, based on their individual liquidity needs and other preferences, in a manner similar to clients that directly open an account with an adviser. This condition will ensure that the definition does not inadvertently include private equity funds, venture capital funds, or other funds that require long-term commitment of capital. Third, the term is limited to those funds that are marketed based on the skills, ability, and expertise of the adviser to the fund, thereby confirming the direct link between the adviser’s management services and the investors. These investors thus not only expect to receive, but are solicited explicitly on the basis of, the investment management ability of the adviser. Under the definition of private fund, an adviser will only need to look through for purposes of counting clients where some affirmative steps have been taken to make fifteen or more potential clients aware of the ability to obtain the adviser’s services through the fund vehicle.¹⁶⁸ Based on this definition of private fund, we believe registration of these advisers will advance the objectives of the Advisers Act.

Some commenters argued that the Commission lacks authority because the new rule and rule amendments contradict the “unambiguous” intent of Congress expressed in section 203(b)(3).¹⁶⁹ However, as discussed above, the intent of Congress appears to have been to create a limited exemption for advisers whose activities were not national in scope and who provided advice to family members or friends. Further, since hedge funds did not exist until 1949,¹⁷⁰ it is unclear whether Congress would have viewed a hedge fund or the hedge fund's investors as the client.¹⁷¹ Moreover, the term “client” is not defined in the Act, nor does the word have one clear meaning.¹⁷² To the extent section 203 is unclear, the Commission has authority to interpret an exemption and to adopt a rule that is reasonably related to the statutory purpose.¹⁷³ As we have explained above, rule 203(b)(3)-2 is such a rule.¹⁷⁴

Although Congress in 1940 may not have anticipated the client counting questions that arose from the development of hedge funds and other pooled investment vehicles, by 1960 it clearly anticipated that, in certain cases, enforcement of the Act may require the Commission or courts to “look through” legal artifices to address the substance of a transaction or relationship.¹⁷⁵ Section 208(d), added in 1960, made it unlawful for any person “to indirectly, through or by any other person to do any act or thing which it would be unlawful for such person to do directly under the provisions of this [Act], or any rule or regulation thereunder.”¹⁷⁶

Today, an adviser with, for example, 15 clients and $100 million in assets under management can take those client assets, move them into a hedge fund it advises and, because the adviser now has but one client, withdraw its Advisers Act registration.¹⁷⁷ If those clients’ assets had been managed similarly or identically (and today in many cases they are),¹⁷⁸ nothing will have changed, except that the clients will have lost the protection of our oversight. Advisers to hedge funds market their services based on the skills, ability and expertise of the persons who will make the fund’s investment decisions. Thus, the clients will still rely exclusively on the efforts and skill of the investment adviser, and any new investors will be attracted to the hedge fund as a means to obtain the asset management services of the adviser. The clients will periodically receive reports from the adviser about the hedge fund, and their decisions whether or not to withdraw their assets from the fund will necessarily rely heavily on those reports.¹⁷⁹

A hedge fund adviser may not treat all of its hedge fund investors the same. Some investors may have greater access to risk and portfolio information,¹⁸⁰ different lock-up periods may be provided,¹⁸¹ and some investors may be able to negotiate lower fees.¹⁸² “Side pockets,” in which assets are segregated, may operate to provide different investors with different investment experiences.¹⁸³ Thus, today each account of a hedge fund investor may bear many of the characteristics of separate investment accounts, which, of course, must be counted as separate clients for purposes of section 203(b)(3). Our rule closes this loophole.

D. Rule 203(b)(3)-2

Rule 203(b)(3)-2 requires investment advisers to count each owner of a “private fund” towards the threshold of 14 clients for purposes of determining the availability of the private adviser exemption of section 203(b)(3) of the Act.¹⁸⁴ As a result, an adviser to a “private fund,” which is defined in rule 203(b)(3)-1 and discussed below, can no longer rely on the private adviser exemption if the adviser, during the course of the preceding twelve months, has advised private funds that had more than fourteen investors.¹⁸⁵ Furthermore, an adviser that advises individual clients directly must count those clients together with the investors in any private fund it advises in determining its total number of clients for purposes of section 203(b)(3).¹⁸⁶ If the total number of individual clients and investors in private funds exceeds fourteen, the adviser is not eligible for the private adviser exemption and must register with us, assuming it meets our minimum requirements for assets under management.

The new rule is designed to amend the method of counting that hedge fund advisers use for purposes of applying the private adviser exemption. It is not intended to alter the duties or obligations owed by an investment adviser to its clients.¹⁸⁷

1. Minimum Assets Under Management

Rule 203(b)(3)-2 does not alter the minimum amount of assets under management that an investment adviser generally must have in order to register with the Commission. A hedge fund adviser whose principal office and place of business is in the United States cannot (subject to certain exceptions) register with the Commission unless it manages at least $25 million.¹⁸⁸ A hedge fund adviser whose principal office and place of business is outside the United States (an “offshore adviser”) must register with the Commission if it has more than fourteen clients who are resident in the United States regardless of the amount of assets the adviser has under management. We are not applying the $25 million threshold to offshore advisers, as urged by some commenters,¹⁸⁹ because that threshold is premised on regulation of the unregistered adviser by one or more states in which the adviser has its principal office and place of business.¹⁹⁰

In determining the amount of assets it has under management, a hedge fund adviser whose principal office and place of business is in the United States must include the total value of securities portfolios in its assets under management. That is, it may not reduce the value of those assets by amounts borrowed to acquire them. An adviser may exclude proprietary assets invested in the fund, and need not include the value of assets attributable to non-U.S. investors.¹⁹¹

2. Counting “Owners”

Rule 203(b)(3)-2 requires investment advisers to count each owner of a private fund towards the threshold of fourteen clients, that is, each shareholder, limited partner, member, or beneficiary of the private fund.¹⁹² In response to suggestions by several commenters we have revised the rule. First, we have added a provision clarifying that an adviser does not have to count itself as a client regardless of the form its ownership in the pool takes.¹⁹³ Second, we permit a hedge fund adviser to exclude certain knowledgeable advisory personnel who are “qualified clients” (i.e., who are “insiders”) that may be charged a performance fee.¹⁹⁴ An adviser to a private fund may also exclude the value of these insiders’ interests in the private fund when calculating the firm’s assets under management for purposes of the $25 million registration threshold.¹⁹⁵

3. Funds of Hedge Funds

Under rule 203(b)(3)-2, a hedge fund adviser whose investors include a fund of funds that is itself a “private fund” must apply the general provisions of the new rule, which compel looking through that “top tier” private fund and counting its investors as clients for purposes of the private adviser exemption.¹⁹⁶ If the fund of funds is a registered investment company, rule 203(b)(3)-2(b) requires the adviser to an underlying private fund to look through the investment company and to count its investors as clients for purposes of the exemption. Without the look-through requirement, an adviser could provide its services through fourteen or fewer top tier funds and continue to indirectly manage the assets of hundreds or, in the case of registered funds of hedge funds, thousands of investors, without registering or being subject to the Commission’s oversight.¹⁹⁷

4. Offshore Advisers

Some commenters suggested that advisers located offshore¹⁹⁸ be exempted from regulation under the Advisers Act if they are subject to regulation in their home jurisdiction.¹⁹⁹ The Commission has not chosen to take such an approach.  The Commission's primary concern when developing regulatory policy that has implications for foreign participants in our markets is to ensure that U.S. investors are protected and that there is a level playing field for all market participants. In this regard, a single set of rules provides greater transparency to investors, who can be confident that they will receive the same level of protection with respect to their investments regardless of the country of origin of their investment adviser.  Similarly, a single set of rules assures a level playing field for both U.S. and foreign participants in our markets.  Our approach to offshore advisers to offshore funds with U.S. investors, discussed below, represents an accommodation and not a fundamental change of policy in this regard.

Acceptance of home jurisdictional regulatory protections or "mutual recognition" may be a compelling alternative for participants in a common regulatory and statutory framework, such as the European Union. However, the absence of such a framework would require us to determine regulatory equivalence of hundreds of potential home jurisdictions.  Such an effort would tax our resources.  Moreover, regulatory systems that may be equivalent today may diverge in a matter of a few years, thus the evaluation would have to occur on an ongoing basis.²⁰⁰

a. Counting Clients of Offshore Advisers

The final rules impose the same counting requirements on offshore advisers to hedge funds as offshore advisers providing advice directly to U.S. clients. Thus, for purposes of eligibility for the private adviser exemption, an offshore hedge fund adviser must look through each private fund it advises, whether or not those funds are also located offshore, and count each investor that is a U.S. resident as a client.²⁰¹ An offshore adviser to any hedge fund that, in the course of the preceding twelve months, has more than fourteen investors (or other advisory clients) that are U.S. residents generally must register under the Advisers Act.²⁰²

At the suggestion of commenters, we are adopting a provision that allows an adviser to a private fund to determine whether an investor is a U.S. client or a non-U.S. client at the time of the investment in the private fund.²⁰³ If an investor is a non-U.S. client at the time of that investment, the adviser may continue to count the investor as a non-U.S. client even if the investor subsequently relocates to the United States.

Several commenters suggested that offshore advisers be required to look through their private funds only if more than 25 percent of the fund was held by U.S. investors.²⁰⁴ We believe that this suggestion would result in most offshore advisers that serve U.S. investors being exempt from registration, and we are not adopting it.²⁰⁵

b. Advisers to Offshore Publicly Offered Funds

The final rule includes an exception to the definition of “private fund” for a company that has its principal office and place of business outside the United States, makes a public offering of its securities in a country outside the United States, and is regulated as a public investment company under the laws of the country other than the United States.²⁰⁶ Absent this provision, advisers to offshore publicly offered mutual funds or closed-end funds might be required to register with us simply because more than fourteen of their investors are now residents in the United States.²⁰⁷ The exception applies to any type of publicly offered fund, whether in corporate, trust, contractual or other form,²⁰⁸ so long as the fund is authorized for sale in the same jurisdiction in which it is regulated as a public investment company.²⁰⁹

c. Advisers to Offshore Privately Offered Funds

Rule 203(b)(3)-2 limits the extraterritorial application of the Advisers Act that would otherwise occur as a result of the new rule, by providing that an offshore adviser to an offshore private fund may treat the fund (and not the investors) as its client for most purposes under the Act.²¹⁰ Because we do not apply most of the substantive provisions of the Act to the non-U.S. clients of an offshore adviser,²¹¹ and because the offshore fund would be a non-U.S. client,²¹² the substantive provisions of the Act generally would not apply to the offshore adviser’s dealings with the offshore fund.²¹³

Commenters supported this aspect of the rule, but also requested that we clarify how we would apply the Advisers Act to offshore advisers relying on it.²¹⁴ The offshore adviser will be required (unless eligible for an exemption) to register under the Act²¹⁵ and to keep certain books and records as required by our rules,²¹⁶ and will remain subject to examinations by our staff.²¹⁷ Other requirements, including the Act’s compliance rule,²¹⁸ custody rule,²¹⁹ and proxy voting rule,²²⁰ would not apply to the registered offshore adviser, assuming it has no U.S. clients other than for counting purposes under the private adviser exemption.²²¹ The registered offshore adviser without U.S. clients (other than for counting purposes) will not be required to adopt a code of ethics but must retain its access persons’ personal securities reports that would otherwise be required under such a code.²²²

E. Definition of “Private Fund”

Because our concern is focused on hedge fund advisers and their oversight, we did not propose to require advisers to “look through” every business or other legal organization they advised for purposes of determining the availability of the “private adviser” exemption. Our proposal included a definition of “private fund” in order to identify those legal organizations that advisers would be required to look through.²²³ We proposed to define a “private fund” by reference to three characteristics shared by virtually all hedge funds, and that differentiate hedge funds from other pooled investment vehicles such as private equity funds²²⁴ or venture capital funds.²²⁵ In our amendments to rule 203(b)(3)-1, we are adopting the definition substantially as proposed, and we discuss each of the characteristics of a private fund below.

1. Section 3(c)(1) and 3(c)(7)

First, a fund will not be a “private fund” unless it is a company that would be subject to regulation under the Investment Company Act but for the exception, from the definition of “investment company,” provided in either section 3(c)(1) (a “3(c)(1) fund”) or section 3(c)(7) (a “3(c)(7) fund”) of such Act.²²⁶ Thus, advisers are not required to “look through” most clients that are business organizations, including insurance companies, broker-dealers, and banks, but are required to look through many types of pooled investment vehicles investing in securities, including hedge funds.²²⁷

Several commenters suggested that the definition of private fund exclude 3(c)(7) funds because investors in a 3(c)(7) fund must all be qualified purchasers and can be presumed to have a certain level of financial sophistication.²²⁸ We have considered these comments but believe such an exclusion would not be consistent with the purpose and scope of the private adviser exemption. As we discussed above, the Advisers Act does not exempt from registration advisers whose clients are all financially sophisticated, and indeed a client’s decision to engage a professional adviser acknowledges that the client needs an expert’s assistance.²²⁹

2. Redemption Within Two Years

Second, a company will be a private fund only if it permits investors to redeem their interests in the fund within two years of purchasing them.²³⁰ The provision applies to each interest purchased or amount of capital contributed to the fund.²³¹ Hedge funds typically offer their investors liquidity access²³² following an initial “lock-up” period, which is typically for less than two years.²³³ Thus, this provision will include most hedge fund advisers, but will exclude advisers that manage only private equity funds, venture capital funds, and similar funds that require investors to make long-term commitments of capital.²³⁴ These other funds are similar to hedge funds in some respects, but the Commission has not encountered significant enforcement problems with advisers with respect to their management of private equity or venture capital funds. In contrast, the Commission has developed a substantial record of frauds associated with hedge funds. A key element of hedge fund advisers’ fraud in most of our recent enforcement cases has been the advisers’ misrepresentation of their funds’ performance to current investors,²³⁵ which in some cases was used to induce a false sense of security for investors when they might otherwise have exercised their redemption rights.²³⁶ Because hedge funds are where we have seen a recent growth in fraud enforcement actions, we will focus our examination resources on their advisers, rather than on advisers to private equity or venture capital funds, at this time.²³⁷ Most commenters who spoke to the issue supported drawing this distinction between hedge funds, on the one hand, and private equity and venture capital funds, on the other.²³⁸

The rule permits a fund to offer redemption rights under extraordinary circumstances without being considered a private fund under the rule.²³⁹ Private equity and venture capital funds may offer redemption rights under extraordinary circumstances, and these extraordinary redemptions do not change the basic character of the investment pool into a hedge fund. We are omitting the proposed requirement that such circumstances be “unforeseeable.” Commenters suggested that to the extent an investor negotiated for the right to redeem its interest in extraordinary circumstances, the circumstances could be viewed as “foreseeable.”²⁴⁰ The redemption test also does not restrict the general partner or investment adviser from initiating distributions payable to all owners, or a class of owners, in accordance with the fund’s governing documents.²⁴¹ The rule also provides an exception to the two-year redemption test for interests acquired through reinvestment of distributed capital gains or income.²⁴²

3. Advisory Skills, Ability, or Expertise

Third, a company will be a private fund only if interests in it are offered based on the investment advisory skills, ability or expertise of the investment adviser.²⁴³ As we discussed in the Proposing Release, a hedge fund adviser’s history, experience, past performance, strategies, and disciplinary record are likely important to investors, who rely on the adviser for their investment’s success, in deciding whether to invest in a particular hedge fund.²⁴⁴ Accordingly, hedge fund advisers often emphasize the portfolio manager’s record when marketing their fund, and provide prospective investors with information about the adviser and individual manager. This reliance by hedge fund investors implicates the need for the protections that Advisers Act registration offers.²⁴⁵

F. Other Amendments to Rule 203(b)(3)-1

We are amending rule 203(b)(3)-1 to clarify that investment advisers may not count hedge funds as single clients under that safe harbor.²⁴⁶ As discussed earlier, many hedge fund advisers have avoided Advisers Act registration in the past by relying on paragraph (a)(2)(i) of this rule, which we adopted in 1985 in order to permit advisers to count a legal organization, rather than its owners, as a single client.²⁴⁷ Advisers to private funds may, however, continue to rely on the other paragraphs of rule 203(b)(3)-1 when determining the number of their clients for purposes of the private client exemption.²⁴⁸ We have designed new rule 203(b)(3)-2 to be used in conjunction with rule 203(b)(3)-1.²⁴⁹ The adviser to a private fund must, under rule 203(b)(3)-2, look through the fund to its investors, but may rely on the safe harbor of rule 203(b)(3)-1 to determine whether each investor must count as a separate client or whether a “single client” may include more than one investor.²⁵⁰

G. Amendments to Rule 204-2

We are adopting two amendments to the adviser recordkeeping rule. The first of these amendments permits hedge fund advisers that are required to register with us under new rule 203(b)(3)-2 to market their performance from periods prior to their registration with us, even if they have not kept documentation that our rules would otherwise require.²⁵¹ This exception applies not only to the adviser’s private funds (as proposed), but also to other accounts.²⁵² Hedge fund advisers are required to retain whatever records they do have that support the performance they earned prior to their registration with us, but are excused from our recordkeeping rule to the extent that those records are incomplete or otherwise do not meet the requirements of rule 204-2.²⁵³

As proposed, the exemption would have covered only the records supporting the performance of the adviser’s private funds. Commenters pointed out that a hedge fund adviser may also manage other pools, such as private equity funds. The amendment as we are adopting it applies to records supporting any accounts managed by the hedge fund adviser.²⁵⁴

Our second amendment to the recordkeeping rule clarifies that, for purposes of section 204 of the Advisers Act,²⁵⁵ the books and records of a registered hedge fund adviser include records of the private funds for which the adviser acts as investment adviser and the adviser or a related person²⁵⁶ acts as general partner, managing member, or in a similar capacity.²⁵⁷ Our examiners require access to these records to determine whether a hedge fund adviser is meeting its fiduciary obligations to a private fund under the Advisers Act and rules.²⁵⁸

H. Amendments to Rule 205-3

We are adding grandfathering provisions to rule 205-3 under the Advisers Act, the performance fee rule, to avoid disrupting existing arrangements between newly-registered hedge fund advisers and their current pool investors or separate account clients.²⁵⁹ Most hedge fund advisers charge a “performance fee” based on their fund’s capital gains or appreciation. Our rules, however, permit registered investment advisers to charge performance fees only to “qualified clients.”²⁶⁰ Unregistered hedge fund advisers have not necessarily required all of their investors to meet this standard.²⁶¹ We proposed (and commenters supported) an amendment to rule 205-3 grandfathering the existing equity accounts of hedge fund investors, and allowing these investors to add to their accounts.²⁶² Commenters noted, however, that our proposal would disrupt performance fee agreements with other types of investment pools or separate accounts sometimes managed by hedge fund advisers.²⁶³ We have revised the coverage of the amendment to permit existing owners in any 3(c)(1) fund to retain their investment and to add to it,²⁶⁴ and to permit the newly-registered advisers to continue in effect advisory contracts they may have with other clients that are not 3(c)(1) funds.

I. Amendments to Rule 206(4)-2

We are amending rule 206(4)-2, the adviser custody rule, to allow additional time for completion of audit work on behalf of advisers to funds of hedge funds that choose to distribute audited fund financial statements to investors under the custody rule.²⁶⁵ The amendments extend from 120 to 180 days the time within which an adviser to a fund of funds may distribute the fund’s audited financial statements. Some advisers to funds of funds are not able to comply with the current 120-day deadline because they cannot obtain completion of their fund audits prior to completion of the audits for the underlying funds in which they invest. To be eligible for the extended deadline, a fund of funds must invest at least ten percent of it assets in other, unrelated, pooled investment vehicles.²⁶⁶ Commenters strongly supported the amendment, but persuaded us that our proposal to extend the period for all pooled investment vehicles (instead of just funds of funds) would lead to the underlying funds taking advantage of the extension themselves, leaving funds of funds in no better position to comply than they were previously.²⁶⁷

J. Amendments to Rule 222-2 and Rule 203A-3

This rulemaking is designed to alter the method of counting clients that hedge fund advisers use for purposes of determining their registration obligations with us. It is not our intention to amend advisers’ method of counting clients for other purposes. Two commenters raised concerns about whether private fund investors must be counted as clients for purposes of applying the national “de minimis” standard for state adviser registration.²⁶⁸ One commenter also questioned whether advisers’ supervised persons must count private fund investors as clients for purposes of the definition of “investment adviser representative” in rule 203A-3.²⁶⁹

To respond to commenters’ concerns, we are amending both rules 222-2 and 203A-3 to clarify that advisers and supervised persons may, for purposes of those rules, count clients as provided in rule 203(b)(3)-1 without giving regard to the look through requirements in rule 203(b)(3)-2.²⁷⁰

K. Amendments to Form ADV

We proposed to amend Form ADV to require advisers to “private funds” as defined in the proposed rule to identify themselves as hedge fund advisers, and we are adopting this provision as proposed. One commenter spoke to these changes to say they were essential.²⁷¹

III. EFFECTIVE AND COMPLIANCE DATES

The effective date of the amendments to rule 206(4)-2 and Form ADV is January 10, 2005. The effective date of new rule 203(b)(3)-2 and amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, and 222-2 is February 10, 2005. Hedge fund advisers may elect to begin complying with the new rule and the rule amendments as of their effective date, but have until February 1, 2006 to come into compliance with rule 203(b)(3)-2 and the amendments to rules 203(b)(3)-1, 203A-3, 204-2, 205-3, 206(4)-2, and 222-2.²⁷² We are providing hedge fund advisers with this long transition period so that they have time to work through any technical issues as they prepare for registration. Our staff will be available to work with these new registrants on resolving technical questions.

By the compliance date, February 1, 2006, each adviser required to register under the new rule²⁷³ must have its registration effective, and must have in place all policies and procedures required under our rules.²⁷⁴ Each adviser must also have designated a chief compliance officer.²⁷⁵ Also by February 1, 2006, advisers must ensure that they are in compliance with our rule for custody of client funds and securities.²⁷⁶ We expect that most private funds are already subject to an annual audit and that advisers will elect to have the audit results distributed to investors within the appropriate time period under the custody rule. Some advisers, however, may need to either arrange for their private funds to be audited or for quarterly transaction statements to be distributed to the investors in lieu of audit results.

Once their registrations are effective, the new registrants must, of course, comply with the Advisers Act and all of our rules, including provisions applying to registered advisers such as the limitations on performance fees,²⁷⁷ our books and records requirements,²⁷⁸ and our rules governing advertising²⁷⁹ and cash solicitations.²⁸⁰

Several commenters asked whether the two-year redemption test under the definition of private fund would apply to investments made prior to the effectiveness of the new rules. Advisers must apply the two-year redemption test to any investments made on or after February 1, 2006, whether those investments are made by new or existing investors, but need not apply this test to investments made prior to the compliance date.

The IARD filing system will incorporate the amendments made to Form ADV on March 8, 2005. Registered advisers amending their Form ADV after the form has incorporated the amendments must respond to Item 7.B of Part 1A as amended²⁸¹ and must in any event amend their Form ADV to respond to the revised item by February 1, 2006. By implementing these changes to the IARD system in March of 2005, we will allow most registered advisers to respond to the revised item in conjunction with their regular annual updating amendment, rather than requiring them to file an additional amendment. Implementing this change to the IARD system promptly will also ensure that our staff, as well as members of the investing public, can begin to access information about advisers to private funds.

IV. COST-BENEFIT ANALYSIS

We are sensitive to the costs and benefits that result from our rules. Rule 203(b)(3)-2 requires certain hedge fund advisers to register with us under the Investment Advisers Act of 1940. We are also adopting related rule amendments to facilitate a smooth transition for hedge fund advisers. In the Proposing Release, we identified possible costs and benefits of the rule and rule amendments and requested comment on our analysis. Many commenters supported the new rule,²⁸² although many commenters, chiefly hedge fund advisers and a trade association, expressed reservations at the potential costs of the new rule.²⁸³

A. Benefits

As discussed above in this Release, we expect that hedge fund investors, advisory clients and advisers will benefit from the rule and rule amendments, although these benefits are difficult to quantify.

1. Benefits to hedge fund investors

(a) Deter fraud and curtail losses. Our oversight may prevent or diminish losses that hedge fund investors would otherwise experience as a result of hedge fund advisers’ fraud. Registration allows us to conduct examinations of hedge fund advisers, and our examinations provide a strong deterrent to advisers’ fraud, identify practices that may harm investors, and lead to earlier discovery of fraud that does occur.²⁸⁴ Registration also permits us to screen individuals seeking to advise hedge funds, and to deny entry to those with a history of disciplinary problems.²⁸⁵

In the last five years, the Commission has brought or authorized 51 enforcement cases in which we assert hedge fund advisers have defrauded hedge fund investors or used the hedge fund to defraud others. While three of these frauds were detected in time to prevent investor losses, this was the exception rather than the rule.²⁸⁶ In 40 of these cases, our staff estimates potential investor losses aggregate approximately $1.1 billion.²⁸⁷ Staff cannot at this time estimate the amount of losses in the remaining eight cases.²⁸⁸ We are concerned that individuals have targeted hedge fund investors and chosen hedge funds as a vehicle for fraud because these individuals could operate their funds without regulatory scrutiny of their activities. Only eight of the 51 cases involve investment advisers registered with the Commission, with over $75.7 million in estimated aggregate investor losses.²⁸⁹ The remaining 43 cases involve advisers that were not registered with us, with over $1 billion in estimated aggregate investor losses.²⁹⁰

While our regulatory oversight cannot guarantee hedge fund investors will never be defrauded, we expect our oversight will reduce investor losses.²⁹¹ Some commenters argued that registration of hedge fund advisers would not address the frauds evidenced by these enforcement cases, arguing the majority of the advisers in these fraud cases were too small to meet the $30 million threshold for registration under the Advisers Act or were registered already.²⁹² We disagree with these commenters. Half of the advisers in these 51 cases appear to have managed more than $30 million or otherwise been eligible for registration with us, and it was these larger advisers who caused nearly all the investor losses, representing over $1 billion of the estimated total losses of $1.1 billion. This strongly suggests that the Commission’s registration requirement will affect an appropriate group of hedge fund advisers and serve as an effective response to combat hedge fund fraud.

In addition, these commenters argued that examination programs are unable to detect fraud, and that regulatory authorities must instead rely on “tips” to uncover misconduct. However, in 5 of the 8 cases against registered advisers, it was our examiners who uncovered the fraudulent conduct.²⁹³ These cases show that registered hedge fund advisers contemplating their chances of “getting away” with a breach of their fiduciary duty to their clients would be well advised to fear detection. We believe this has a genuine deterrent effect.²⁹⁴

(b) Provide basic information about hedge fund advisers.

Form ADV information that hedge fund advisers will file in registering will aid hedge fund investors in evaluating potential managers. Filing Form ADV will require hedge fund advisers to disclose information about their business, affiliates and owners, and disciplinary history. As commenters pointed out, many investors currently lack good access to this information about their hedge fund managers.²⁹⁵ Although the information hedge fund advisers will be required to provide on their Form ADV filings and to comply with our rules cannot substitute for an investor’s due diligence, it should aid investors by providing a publicly accessible foundation of basic information.²⁹⁶

(c) Improve compliance controls.

Hedge fund investors should benefit from their advisers’ improved compliance controls. Several commenters confirmed this assessment in their comment letters.²⁹⁷ Once registered, hedge fund advisers will be required to have comprehensive compliance procedures and to designate a chief compliance officer.²⁹⁸ Specific procedures governing proxy voting²⁹⁹ and a code of ethics including requirements for personal securities reporting will also be required.³⁰⁰ In addition, the obligation to commit to a program of compliance controls combined with our examinations foster adherence to a culture of compliance by advisers.³⁰¹ These compliance measures are the first line of defense in protecting investors against an adviser’s misconduct.

2. Benefits to mutual fund investors

Mutual fund investors will benefit from hedge fund adviser registration to the extent that Commission oversight deters hedge funds and their advisers from illegal conduct that exploits mutual funds. Many of the market timers and illegal late traders involved in recent mutual fund scandals have been hedge fund advisers.³⁰² The 51 enforcement cases discussed earlier do not include 18 other actions we have brought to date against persons charged with late trading of mutual fund shares on behalf of hedge fund groups, and against mutual fund advisers or principals for permitting hedge fund advisers to market time mutual funds contrary to the mutual funds’ prospectus disclosure.³⁰³ Hedge fund advisers reaped huge profits for their funds over an extended period while costing our nation’s retail mutual fund investors hundreds of millions of dollars.³⁰⁴

3. Benefits to other investors and markets

The registration of hedge fund advisers will benefit not only hedge fund investors but also other investors and the securities markets, to the extent that the Commission’s oversight eliminates opportunities for hedge fund advisers to engage in other types of unlawful conduct in the securities markets. Commenters also saw this as a benefit to adviser registration.³⁰⁵ The mutual fund scandals have shown us that hedge fund advisers’ improper or illegal activities can cause harm beyond the hedge funds’ own investors. There may be other fraudulent activities by hedge fund advisers of which we are unaware because we cannot examine these advisers regularly. Adviser registration, as discussed above, should lead to earlier discovery of fraudulent activities and thus enhance protections to all investors in the securities markets.

4. Benefits to regulatory policy

Registration of hedge fund advisers will benefit all investors and market participants by providing us and other policy makers with better data. We have limited information about hedge fund advisers and the hedge fund industry, and much of what we do have is indirect information extrapolated from other data. This hampers our ability to develop regulatory policy for the protection of hedge fund investors and investors in general.³⁰⁶ Hedge fund adviser registration would provide the Congress, the Commission and other government agencies with important information about this rapidly growing segment of the U.S. financial system. While some commenters agreed with our assessment of this benefit,³⁰⁷ others suggested that, instead of registering hedge fund advisers, we compile information about them from a variety of scattered regulatory filings currently made by hedge funds, their advisers, and broker-dealers.³⁰⁸ We have considered this alternative, but the reports and information currently available would provide at best a partial and inadequate view of the activities of hedge fund advisers.³⁰⁹

5. Benefits to hedge fund advisers

Mandatory registration will provide a level playing field for hedge fund advisers. Many hedge fund advisers have already registered with us, and have organized their compliance procedures under the Advisers Act. ³¹⁰ Unregistered hedge fund advisers, however, vary substantially in their compliance practices.³¹¹ While many of them have adopted sound compliance practices, many others, against whom they and the registered advisers compete, have not allocated resources to implement an effective compliance infrastructure. We received comments noting that mandatory registration would ensure that all hedge fund advisers compete on the same basis in this regard.³¹²

Registering hedge fund advisers may enhance investor confidence in a growing and maturing industry. As discussed above, the hedge fund industry has been growing at an extraordinary pace in the past decade.³¹³ Registration under the Advisers Act will bring hedge fund advisers to the same compliance level as other SEC-registered advisers, thus providing hedge fund investors with additional protections with respect to conflicts of interest addressed by the funds’ advisers.³¹⁴

Some commenters, however, argued that registration would create a “moral hazard” by providing hedge fund investors with a false sense of enhanced investor protection that might cause them to be less diligent in their own investigations.³¹⁵ We disagree. Such argument could have been used against registration of any kind of investment adviser and against any regulation of the securities industry.³¹⁶ In addition, without the new rule requiring registration, a hedge fund adviser can now choose to register under the Advisers Act but then withdraw its registration, for example, at the prospect of an examination. Thus, without a registration requirement, any “moral hazard” would already exist, but without necessarily providing hedge fund investors the benefit of our oversight of their advisers.

B. Costs

As we discussed in the Proposing Release, registration of hedge fund advisers under the Advisers Act would not impede hedge funds’ operations. Comments from registered hedge fund advisers agreed.³¹⁷ The Act does not prohibit any particular investment strategies, nor does it require or prohibit specific investments. Instead of imposing specific procedures on registrants, the Advisers Act is principally a disclosure statute that requires registrants to fully inform clients of conflicts so that those clients can determine whether to give their consent. For the same reasons, registering hedge fund advisers should not impair the ability of hedge funds to continue their important roles of providing price information and liquidity to our markets.³¹⁸

Nevertheless, registration imposes certain costs. In the Proposing Release, we analyzed various costs that hedge fund advisers would incur in connection with registration. Commenters representing the views of unregistered hedge fund advisers generally challenged our cost estimates and predicted the costs of compliance would be burdensome.³¹⁹ Comments from registered advisers generally characterized the costs as being significant, but reasonable in light of the nature of the advisory business.³²⁰ As we discussed in the Proposing Release, the costs of compliance for a new registrant can vary widely among firms depending on size, activities, and the sophistication of the existing compliance infrastructure. Investment advisers, whether registered with us or not, place the future of their business at peril if they do not establish a sound compliance infrastructure to fulfill their fiduciary duties towards their clients under the Act. Registered hedge fund advisers estimated that advisers with good compliance infrastructures in place would incur much less incremental cost than those that did not have good compliance infrastructures.³²¹

1. Registration costs

In our Proposing Release, we estimated that the costs of preparing adviser registration submissions, including preparation and submission of Part 1A of Form ADV, would not be high. Although one commenter suggested the costs of preparing a Part 1A submission can be quite high, we believe the commenter’s example does not reflect the experience of other advisers, none of whom made similar comments.³²² Part 1A requires advisers to answer basic questions about their business, their affiliates and their owners, and Part 1A can be completed using information readily available to hedge fund advisers. Numerous hedge fund advisers have already registered with the Commission using Part 1A, and none has reported to us that its business model presents any difficulty in using the form.³²³ Advisers must also complete Part II of Form ADV and deliver a copy of Part II or a disclosure brochure containing the same information to clients.³²⁴ Part II requires disclosure of certain conflicts of interest, which even unregistered advisers have a fiduciary duty to disclose to their clients. We expect that hedge fund advisers will face relatively small internal costs in preparing a Part II, and will be likely to include their Part II disclosure as part of their private placement memoranda for their hedge funds, reducing their overall costs even further. We received no comments to the contrary.

2. Cost of establishing a compliance infrastructure

New hedge fund adviser registrants will also face costs to bring their operations into conformity with the Advisers Act and the rules under the Act. In the Proposing Release, we estimated the cost of establishing a compliance infrastructure would primarily consist of establishing procedures and systems that address rules under the Advisers Act such as the books and records rule,³²⁵ the custody rule,³²⁶ the proxy voting rule,³²⁷ the compliance rule,³²⁸ and the code of ethics rule.³²⁹ While some commenters also focused on these factors,³³⁰ others identified additional cost considerations, as we discuss below.

Many unregistered hedge fund advisers have already built sound compliance infrastructures because their business compels it. These firms already have procedures designed to keep good records of all transactions, to keep their clients’ assets safe, to provide fair and full disclosure of conflicts of interest, and to prevent their supervised persons from breaching fiduciary duties.³³¹ In the Proposing Release, we estimated these advisory firms should face little cost to modify their current compliance practices to comply with the Advisers Act rules. Comments from registered hedge fund advisers agreed.³³² For other hedge fund advisers that have not yet established sound compliance programs, however, the costs will be higher.

In the Proposing Release, we estimated the cost for hedge fund advisers to establish the required compliance infrastructure will be, on average, $20,000 in professional fees and $25,000 in internal costs including staff time.³³³ These estimates were prepared in consultation with private attorneys who, as part of their practice, counsel hedge fund advisers establishing their registrations with the SEC. The estimates are averages, premised on the understanding that the costs will likely be less for new registrants that have already established sound compliance practices and more for new registrants that do not yet have good compliance procedures. Several law firms and attorneys representing hedge fund advisers challenged these estimates as being too low, but these firms did not provide any estimates of their own.³³⁴ The ICAA, based on the experience of its adviser members generally, commented that the costs of a compliance infrastructure are considerable, but that they are justified, especially considering the relative risks of hedge fund activities as compared to many other investment advisory activities.

Several hedge fund advisers estimated the costs to be in the range of $300,000, but most or all of the cost was attributable to compensation costs for hiring a dedicated chief compliance officer (CCO).³³⁵ Our compliance rule does not require firms to hire a new individual to serve as a full-time CCO, and the question of whether an advisory firm can look to existing staff to fulfill the CCO requirement internally is firm-specific. Firms may consider factors such as the size of the firm, the complexity of its compliance environment, and the qualifications of current staff.

While we recognize some hedge fund advisers will need to designate someone to serve as CCO on a full-time basis, we expect these will be larger firms – those with many employees and a sizeable amount of investor assets under management. Because there is no currently-available comprehensive database of hedge fund advisers, we cannot determine the number of these larger hedge fund firms in operation, but our staff estimates it is relatively few. Staff estimates approximately half of these hedge fund advisers are already registered with us, and have already designated a CCO. While the remaining, unregistered, larger hedge fund advisers may not have designated a CCO as such, many of these firms likely already have personnel who perform similar functions to a CCO, in order to address the firm’s liability exposure and protect its reputation.

In smaller hedge fund advisers, the designated CCO will likely also fill another function in the firm, and perform additional duties alongside compliance matters. Firms designating a CCO from existing staff may experience costs to the extent the individual is taking on additional compliance responsibilities or giving up other non-compliance responsibilities. These costs may include costs of shifting responsibilities among employees, and might in some cases include additional compensation costs. Some of these firms may need to add compliance capacity to their staffs. Costs will vary from firm to firm, depending on the extent to which firm staff is already performing some or all of the requisite compliance functions, the extent to which the CCO’s non-compliance responsibilities need to be lessened to permit allocation of more time to compliance responsibilities, and the value to the firm of the CCO’s non-compliance responsibilities. We do not have access to information that would allow us to determine these costs, and commenters did not provide estimates.

3. Ongoing costs of compliance and examination

Several comments on our Proposing Release identified additional cost