In the aftermath of the sweeping Dodd-Frank Act, the word “exempt” is a misnomer when it is applied to various classes of advisers, including Exempt Reporting Advisers with and without a U.S. presence. Don Andrews and Philip von Mehren, both Partners at Venable, explore the complex requirements of foreign Exempt Reporting Advisers (e.g. either Latin American funds with no U.S. office or with a U.S. office but less than $150 million under management) to abide by many of the same rules as Registered Investment Advisers.

By Don Andrews, Partner, Venable and Philip von Mehren, Partner, Venable

Five years have passed since the imposition of new requirements for Exempt Reporting Advisers under the Dodd-Frank Act in the U.S. At the time the rules were enacted, they were controversial in that the burden imposed on foreign Exempt Reporting Advisers (e.g. either Latin American funds with no U.S. office or with a U.S. office but less than $150 million under management) was substantially similar to that of Registered Investment Advisers. Even with the passage of time, they have become no less controversial or cumbersome.

What Does “Exempt” Mean, Anyway?

Typically, in a regulatory setting, the word “exempt” means free from obligation. But when the Securities and Exchange Commission uses the term with respect to “Exempt Reporting Advisers,” “exempt” means, ironically, that the entity in question has an obligation to report. This new designation came about as a result of Dodd-Frank requirements promulgated in 2011, which created a class of foreign advisers that were exempted from the need to register with the SEC, but are still subject to the same federal requirements as registered investment advisers in terms of SEC examinations, “pay-to-play” requirements, Patriot Act requirements, reporting requirements including books and records, and the general anti-fraud provisions of the Investment Advisers Act.

This article focuses on two types of foreign Exempt Reporting Advisers:

1) Exempt Reporting Advisers with no U.S. presence and
2) Exempt Reporting Advisers with a U.S. presence.¹

Neither is, unfortunately, truly exempt.

Investment advisers to a private equity fund with over $100 million in regulatory assets under management generally must register with the SEC as a Registered Investment Advisor. If you are required to register with the SEC, the regulatory burden is considerable. Initially, you must file Form ADV and keep it current by filing periodic amendments. You must also comply with the brochure rule, which requires most advisers to provide clients and prospective clients with information about the adviser’s business practices and educational and business background. The fund must also maintain accurate and current books and records, as specified by SEC rules. Not only must the adviser have a compliance manual, but annually the Chief Compliance Officer must certify that there are policies, procedures, and controls reasonably designed to prevent and detect violations of law. In addition, the fund must comply with other requirements, such as the “pay-to-play” rule and the anti-fraud provisions of the federal securities laws. Finally, the SEC can inspect and examine the fund at any time.

How Does This Affect Latin American Fund Managers (Foreign Exempt Reporting Adviser)?

A private equity manager based in, for example, Mexico or Brazil with no U.S. office may manage an unlimited number of U.S. assets from an unlimited number of U.S. investors without having to become a registered investment adviser. As such, a foreign adviser qualifies for the Private Fund Adviser Exemption as an “Exempt Reporting Adviser.” However, the regulatory burden placed on a foreign Exempt Reporting Adviser is not that different from that of a Registered Investment Adviser.

Reporting Requirements for Foreign Exempt Reporting Advisers

Since Dodd-Frank imposed new requirements on foreign advisers, the actual benefit foreign advisers receive from the “exempt” status is a matter of debate. In fact, at the time the new rules were enacted, two dissenting SEC Commissioners raised concerns that the requirements for Exempt Reporting Advisers generally are too similar to those for Registered Investment Advisers. However, there has been no relaxation of these requirements to date.

While a foreign manager has an exemption from registration under the Advisers Act, there still are numerous requirements they need to satisfy. For example, Exempt Reporting Advisers are:

• Required to file annual updating amendments to Form ADV within 90 days of the firm’s fiscal year end, and also when there is a material change in circumstances for the firm.
• While Exempt Reporting Advisers are not required to fill out a complete Form ADV, they must complete many items within the form.⁴
• Exempt Reporting Advisers with a nonresident general partner must go through a slightly more cumbersome process and submit a separate form ADV-NR, as distinguished from the standard form ADV submitted via the IARD/FINRA system.

SEC Examinations and Other Federal Requirements

The combination of reporting requirements, recordkeeping requirements, and the SEC’s jurisdiction for examination purposes means that Exempt Reporting Advisers, including foreign Exempt Reporting Advisers, face regulatory burdens similar to those of their registered counterparts for compliance and risk purposes.

Section 204A of the Advisers Act includes a general requirement that all advisers develop policies and procedures reasonably designed to prevent the misuse of “material, non-public information by such investment adviser or persons associated with such investment adviser.” Exempt Reporting Advisers are also subject to the same federal requirements as registered investment advisers as mentioned above.

Compliance

Exempt Reporting Advisers should carefully consider creating and periodically updating a compliance manual that covers all of these requirements. Apart from pure regulatory considerations, limited partners have expressed concern about the nature of compliance and risk controls for funds in which they invest. Accordingly, more robust internal controls, such as compliance manuals and operating procedures, generate both regulatory and practical benefits.

Foreign Exempt Reporting Advisers with U.S. Presence

Foreign advisers who advise “qualifying private funds” with less than $150 million in U.S. assets qualify for the Private Fund Exemption and thus also become Exempt Reporting Advisers. The trade-off is a $150 million cap in exchange for the ability to maintain a domestic presence. For example, an adviser that is based in Mexico or Brazil with a Miami office may avail itself of the Private Fund Exemption if it maintains assets under $150 million.

From a compliance and risk standpoint, the effect for foreign advisers with a domestic presence is largely the same as that for foreign advisers managing unlimited assets with no U.S. presence. They are exempt for purposes of registration; however, all of the reporting, books and records, examination, pay-to-play, Patriot Act, and anti-fraud provisions still apply. In both instances, these foreign advisers are, for the most part, regulated entities subject to (i) ongoing requirements, (ii) the possibility of SEC on-site examination, and (iii) the same manner of SEC testing of their books and records and controls as a Registered Investment Adviser.

Best Practices for Foreign Exempt Reporting Advisers

As foreign Exempt Reporting Advisers are subject to many of the same requirements as their registered domestic counterparts, a prudent practice is for the adviser to develop an infrastructure that can withstand the eventual regulatory scrutiny by the SEC. Over the last few years, the SEC has elevated its surveillance and examination techniques, resulting in a record number of enforcement actions. Its jurisdiction has increased considerably across the board, not only with respect to foreign Exempt Reporting Advisers. Because we expect the trend toward stronger regulation and increased jurisdiction to continue, we recommend that foreign Exempt Reporting Advisers take steps to improve internal controls regarding retention of requisite books and records, anti-fraud and pay-to-play provisions, and conflict of interest and insider trading rules, and put a program in place to ensure they can perform effectively during a regulatory examination.

With respect to the books and records requirements as they apply to Exempt Reporting Advisers, the better practice, in our view, is to conform to the books and records requirements in Section 204 of the Investment Advisers Act. In other words, foreign Exempt Reporting Advisers should retain records of communications, as well as financial records, purchase and sales journals, code of ethics policies, bank and custodial statements, documentation of decisions regarding the purchase or sale of securities, evidence of political contributions, disciplinary records, policies and procedures, supervisory or operational procedures, and anything else one would expect an SEC examination team to request during an on-site inspection.

Foreign Exempt Reporting Advisers should also develop compliance manuals that are tailored to their business. Although some commentators point out that a compliance manual is not specifically mentioned in the requirements for Exempt Reporting Advisers, written compliance policies and procedures are a required record under Rule 204-2. Moreover, it would be difficult – if not impossible – for any adviser, exempt or otherwise, to demonstrate adherence to the anti-fraud provisions, insider trading rules, conflict of interest rules, record-keeping provisions, or pay-to-play requirements without corresponding written policies and procedures and a system of controls.

Conclusion

In the aftermath of the sweeping Dodd-Frank Act, the word “exempt” is a misnomer when it is applied to various classes of advisers, including Exempt Reporting Advisers with and without a U.S. presence. Foreign Exempt Reporting Advisers are required to abide by many of the same requirements as Registered Investment Advisers. Given the fact that the books and records, as well as business practices, of these advisers are subject to inspection and examination by the SEC, a “best practices” approach argues for a compliance program that is robust enough to withstand SEC scrutiny. In addition, limited partners expect fund managers, whether registered or exempt, to create and maintain a professional and thoughtful internal compliance program.

^{1 A third type of foreign Exempt Reporting Adviser is one that maintains U.S. assets below $25 million, a so-called small foreign Exempt Reporting Advisor. Unlike Exempt Reporting Advisers, they are not legally required to maintain their books and records and submit to SEC examination. However, they must conform, in addition to the $25 million threshold, to narrow standards: 1) have no U.S. place of business, 2) have fewer than 15 clients and/or investors in private funds, 3) do not hold themselves out to the public as an investment adviser, 4) and do not advise registered investment or business development companies.
2 State regulations may also be relevant to a registered investment adviser.
3 While the majority of Commissioners voted to approve the new requirements in 2011, two dissenting Commissioners expressed concern about the extent of the reporting obligations for Exempt Reporting Advisers and the possibility that, over time, there may be no meaningful distinction between the reporting obligations of an Exempt Reporting Adviser and a Registered Investment Adviser.
4 Exempt Reporting Advisers are required to complete Form ADV Items 1 (Identifying Information), 2.B (SEC Reporting by Exempt Advisers), 3 (Form of Organization), 6 (Outside Business Activities), 7 (Financial Industry Affiliations and Private Fund Reporting), 10 (Control Persons), and 11 (Disclosure Information), along with the corresponding sections of Schedules A, B, C, and D.
5 States may also require notice filings and fees for Exempt Reporting Advisers, depending upon the firm’s nexus within that particular state.
6 A “qualifying private fund” means any private fund that is not registered under Section 8 of the Investment Company Act and has not elected to be treated as a “business development company” pursuant to Section 54 of the same act.
7 For purposes of calculating assets under management in accordance with this exemption, the SEC has referred to Item 5 of Form ADV, which would include the amount of any uncalled capital commitments and impose fair valuation of assets when no market value is available.
8 See 17 CFR 275.204-2, books and records to be maintained by investment advisers.}