A new SEC proposed Regulation, SEC Rel. No. 1 A-2266, requires hedge fund advisers to register under the Investment Advisers Act of 1940. Herewith remarks from various sources on the Proposed Reg., with emphasis on the carve out for private equity funds.
(a) First Issue: Does Private Equity Need to Worry?
The former law firm Testa Hurwitz's Venture Update (Summer 2004 edition), contains a piece by Michael Collins, entitled, "Creeping Regulation of Private Equity Fund Managers?" in which the following point, among others, is made.
"The current wave of legislation, regulation and enforcement actions by the SEC and other agencies tends to regard all private investment activities generically so as to include private equity funds together with hedge funds, mutual funds and other investment vehicles without any distinction. The recent SEC report recommending the regulation of hedge fund managers raises particular concerns for Private Fund Managers...
"Most recently, SEC staff members and Chairman Donaldson have stated publicly that the SEC does not intend to regulate Private Fund Managers as such; but the lack of a clear delineation by the SEC between hedge funds and private equity funds raises the possibility that, at some point, hedge fund regulation may affect all Private Fund Managers."
In the same vein are remarks by dissenting Commissioner Atkins on the new proposed Regulation:
"I would recommend that advisers to venture capital and private equity funds ask themselves: Why are you so special? Why are you not inevitably next? Advisers to these funds should realize that, if worries bout proper valuation are driving t his rulemaking at least in part, why are those issues not equally as valid for your funds?"
(b) Private Equity Fund Carve Out.
The new Reg. distinguishes between hedge funds and private equity funds by borrowing the distinction first announced in The Patriot Act...that neither regulation applies to private equity funds if the investors are not "permitted" to redeem their investments within two years from the date of "purchase." As far as I am aware, this distinction has not yet been tested in an agency or a court proceeding; but there are, as with any definition, questions which ultimately will need to be answered. The following include a sampling of the issues occurring to me and others, the first two raised at the time of the Patriot Act announcement by Steve Block of Fish & Richardson.
(i) What if LPs (Allegedly) Have a Controlling Influence Over the GP.
Quoting Steve's piece:
"The proposed rule is unclear whether it means that the investor has to be specifically given the right to demand a redemption or if it includes situations where there is even a possibility of redemption within the first two years of the investment. One scenario to consider is if the general partner is somehow influenced into allowing the redemption by the limited partner. Even the possibility that a limited partner could obtain his funds inside the two year restriction contemplated by the rules may be exactly the type of situation the Treasury was seeking to include in its drafting of the proposed rule.
(ii) What if the LPs Retain the "Right" (Limited As it May Be) to Transfer their Ownership Interests"?
Again, quoting Steve:
"While the proposed rule focuses on whether the investor has the right to 'redeem,' it does not mention the ability of a limited partner to transfer its ownership to another party inside the two- year period from the date of purchase of the investment.
"To bolster an argument that the right to redeem does not include transfers to third parties, footnote 16 to the proposed rule states that, if the unregistered investment company "permits an owner to redeem," the proposed rule would apply regardless of whether its investors have the opportunity to (or do) sell the fund's securities in secondary market transactions. It goes on to state: "[t]he existence of an informal or formal secondary market for the fund's securities would not affect the applicability of the definition."
"Further, on December 31, 2002, the Secretary of the Treasury, the Board of Governors of the Federal Reserve System, and the Securities and Exchange Commission submitted a joint report to Congress regarding effective regulations to apply to investment companies (attached hereto as Exhibit "B"). The report noted that private equity funds are long-term investments that provide little, if any, opportunity for investors to redeem their investments. The report went on to note that there is not a formal secondary market for shares in private equity funds, but a small informal secondary market that consists of private equity funds buying interests in established funds. The report also mentioned that in 1999 five private equity funds raised $1.6 billion for purchases of secondary interests in other private equity funds.
"In contrast, however, and to support that the right to redeem does include transfers to third parties, an article discussing the proposed rule was published in November 2002 after the rule's release but before the December 2002 report to Congress. The article mentioned informal discussions with Treasury staff on the meaning of "right to redeem":
"Based upon informal discussions with Treasury staff, however, it appears that Treasury may be considering construing redemption more broadly to include the right of an investor to transfer or sell an interest in the fund to another investor in the fund or to a third party.
"The article went on to note that because many real estate partnerships and private equity funds generally permit investors to transfer their interest to third parties, such an interpretation would expand substantially the coverage of the proposed rule and undermine the exception. It is important to note, however, that the report to Congress was issued after the article mentioning this possible expansion of the definition. The report made no mention of such inclusion of transfers in the meaning of "right to redeem." Further, the fact that the report acknowledged the existence of secondary markets, yet made no attempt to say that transfers in these secondary markets were a significant concern or were to be construed within the meaning of the proposed rule, leads to a possible conclusion that such transfers would not be considered as a "right to redeem."
"The structure of the proposed rule and the acknowledgement of the existence of secondary markets would seem to imply that, as long as an investor does not have the right to "redeem" its investment, a transfer would be acceptable and would not be considered a redemption. Since the proposed rule is unclear, however, and since the general partner does have the discretion to disallow the transfer, one solution could be to add language that the general partner would not approve transfers within two years of the date of purchase, or such longer or lesser time period as set forth in the final rule, so as to remain outside the requirements of the proposed rule."
Herewith follow two additional questions occurring to me.
The definition dating the two year period to the date of '"purchase of [the ownership] interests," could be a trap for the unwary. Let's assume a fund in which the investors' commitments can be called over a five year period, plus follow on investments thereafter and the fund is scheduled to begin liquidation proceedings on or before the seventh anniversary of the initial closing. If capital is called within two years of liquidation, is that a "purchase" within the two year period?
(iv) Right to Withdraw For Regulatory Reasons: ERISA; Bank Holding and FCC-Related Entities... "Foreseeable?"
The issue of permission to withdraw under, say, the ERISA (or Media Company or Bank Holding Company) "Kick Out," so called, turns on whether that event is so "extraordinary" that it was not "foreseeable." A facts and circumstances test?
The "Kick Out" provision is, of course, a familiar right in favor of regulated investors, either on a case-by-case or global basis, in the event of Fund activities which create regulatory infelicities. Query how foreseeable such an event might be.
How to Live with Ambiguity: "Regulation By Opinion"
The issue before the private equity fund bar is whether it is worthwhile pushing the SEC Staff to clear up these points when the Rule is, if it is, promulgated in final form. However, the current thinking of many experienced professionals (including me) is based on the principle of primum non nocere. That is to say, if various bar committees pester the SEC Staff to resolve the ambiguities (including but not limited to those cited above) surrounding the so-called "bright line" between hedge and private equity funds, we all may wind up worse off than when we started. Accordingly, it may be that the professionals and their clients should be content to allow the matters to be clarified by those entities which, as a matter of practical fact, enjoy de facto (although not de jure) regulatory status under our current scheme for enforcing the securities laws. I mean, of course, the opinion committees of the major law firms practicing in this area. Assume, as I do, that, from time to time, the organizers of, or investors in, a private equity fund want a formal and unqualified opinion of a leading US law firm on the exempt status of a private equity fund, is the "bright line" compromised by such as: (i) the fact that a supermajority of the investors have the right to discharge or otherwise punish the general partner without Cause (so-called "no fault divorce"), implying that the LPs have real power to compel the General Partner to take certain actions an influential limited partner wants to in fact occur...to permit withdrawal; (ii) the same situation as posited above but the right to transfer is involved...perhaps even including a liberal right to transfer to affiliates without the general partner's permission; (iii) the definition of "purchase" is ambiguous and it is likely that capital calls will be made within two years of the official liquidation date, at least for follow on investments. (iv) the question of "extraordinary" and "unforeseeable" implies a facts and circumstances test...and query whether a firm can deliver an opinion on a "facts circumstances" issue. Assuming as I do that the leading law firms get by these questions and deliver the clean opinions, then (at least until something else happens) the matter will be settled.
A Final Note: It's About the Money
Finally, I will set out without comment (because I think it is, if nothing else amusing) the results of the Staff study on the likely expenses of funds registering under the Investment Advisors Act, as set forth in Bill Donaldson's opening testimony before the Senate Committee on Banking:
"Let me address the costs of registration, which are relatively low, and are today met by thousands of small advisory firms that have substantially less cash flow than many hedge fund advisers. The initial cost of registration is the fee associated with filing Part 1 of Form ADV electronically with the Commission and the preparation of Part II of Form ADV for delivery to clients. Filing fees range from $800 to $1,100 initially, with annual costs thereafter ranging from $400 to $550. of course, there are costs associated with preparing the Form for filing, but these also should be low.
"The principal ongoing cost is the development and maintenance of compliance policies and procedures, with which hedge fund advisers - whether or not registered - already need, in large measure, to comply under the Investment Advisers Act. In any event, on average per hedge fund adviser, we estimate the costs to establish this infrastructure to be approximately $20,000 in professional fees and $25,000 in internal costs, including staff time."As a parting thought, I'll let the reader determine the last time government regulators accurately predicted the cost of compliance.
 Testa Hurwitz &Theobold, LLP, Venture Update, 3 (Summer 2004).
 Statement by Comm'r Paul S. Atkins, To Open Meeting, July 14, 2004. The regulation was passed on a three to two vote. Commissioner Atkins posed a salient, if cynical, point when he stated that:
"Some large investors, particularly large pension funds because of ERISA and other reasons, specify that they only consider registered advisers when they choose their money managers. However, I am concerned that mandatory registration of hedge fund advisers will create the false impression among the general public that we are doing more than we actually are with regard to a particular fund. Registration does not guarantee that we will find problems or even spot potential risks. It does not mean that we have signed off on the fund's internal controls or its advisers. It can easily create false impressions, however, especially if hedge fund advisers seek to utilize SEC registration for competitive purposes." Atkins statement, ABA Business Law Section, March 2, 2004.
It will be interesting to see if hedge funds (and, indeed, private equity funds if they are ever required to register) go out to get investors on the theory that, by registering federally and being subject to "regulation," they will be entitled to the Good Housekeeping Seal of Approval.
 "Our approach to defining the scope of rule 203(b)(3)-2 is similar to that taken recently by the Department of Treasury in defining the scope of its proposed rule requiring 'private investment companies' to adopt anti-money laundering programs. Like the Treasury Department, we have tried to keep the definition simple, and provide a 'bright line' indicator of when an adviser must look through a client that is a legal organization. We have avoided alternative approaches that would turn on the nature of the investments made by the pooled investment vehicle because we do not want registration concerns to affect investment decisions of the adviser." SEC, Rel.No.1A-2266.
 Proposed Rule 203(b)(3)-2(d)(1)(ii) which states:
"(2) Notwithstanding paragraph (d)(1) of this section, a company is not a private fund if it permits its owners to redeem their ownership interests within two years of the purchase of such interests only in the case of:
"(i) Events you find after reasonable inquiry to be extraordinary and unforeseeable at the time the interest was issued; and
"(ii) Interests acquired with reinvested dividends."
In a footnote to the Release, the SEC says:
"Proposed Rule 203(b)(3)-2(d)(1)(ii). Private equity and venture capital funds may offer redemption rights under extraordinary circumstances. These extraordinary redemptions do not change the basic character of the investment pool into a hedge fund. Accordingly, an investment pool could offer redemption rights in extraordinary and unforeseeable situations, such as an owner's death or total disability, or circumstances that make it illegal or impractical for the investor to continue to own the interest in the fund, without becoming a 'private fund' under the new rule. Proposed rule 203(b)(3)-2(d)(2)(i). The proposed new rule would also provide an exception to the two-year redemption test for interests acquired with reinvested dividends. Proposed rule 203(b)(3)-2(d)(2)(ii) .The two-year redemption test would apply to each investment in the fund, not only the investor's initial investment, and could be used on a 'first in, first out' basis."
 Block, "The Application of the USA Patriot Act to Private Equity Funds, Buzz of the Week (8/12/2003), VC Experts; also available, The Encyclopedia of Private Equity, ¶õ10.1.10.a.
 Note that there is authority that, for purposes of the statute of limitations under Rule 10b-5, each capital call starts a new one to three year limitation period running.
 SEC Chairman William H. Donaldson, July 15, 2004.