Client Alert July 21, 2010

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1 Corporate & Securities North America Client Alert July 21, 2010 For additional information, please see our Dodd-Frank Wall Street Reform And Consumer Protection Act website at ancialreform/. Unprecedented US Regulation of Private Fund Activities President Obama signed into law one of the most sweeping financial reform initiatives since the Great Depression - the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the Dodd Frank Act ). Among the areas affected are private funds. For the first time, private fund activity will be regulated under US law through (i) the registration of certain private fund advisers and (ii) the limitation of private fund activities of banks and their affiliates. The regulations are designed to address concerns with investor and systemic risks potentially created by private funds. These provisions are intended to end what has been described by some in Congress as a shadow financial system involving private funds. Previously, private fund activity was largely unregulated as long as it was conducted in accordance with various easily-achieved exemptions. The changes affect managers of all types of private funds, including among others, hedge, private equity, and venture capital funds, and both US and non-us managers, subject to a few limited exemptions. Executive Summary This Alert focuses on two portions of the of the Dodd-Frank Act of special interest to private fund advisers and sponsors: (i) the Private Fund Investment Advisers Registration Act of 2010 (the Act ) and (ii) the Volcker Rule. The Act is the first US securities law that specifically regulates private fund managers. It also creates a fundamentally new regime to regulate investment advisers, covering US and non-us advisers to all types of private funds and other types of advisers. Under the Act, private funds will be regulated through the registration and regulation of their advisers by the Securities and Exchange Commission (the SEC ). Key provisions of the Act will become effective in one year, although advisers that will become required to register under its provisions may register sooner. The Volcker Rule, which imposes limits on certain relationships between banking organizations (or certain nonbank financial companies) and private equity and hedge funds, and proprietary trading by banking organizations and these nonbank financial companies, will generally take effect on the earlier of either (i) 12 months from the date of issuance of regulations implementing its terms or (ii) 2 years from the passage of the Volcker Rule. Certain provisions of the Volcker Rule permit a longer period for firms to bring their activities into conformity with the new requirements. The Act and the Volcker Rule reflect the first effort by the US Government to impose a certain level of US regulation over private funds.

2 The Private Fund Investment Advisers Registration Act of 2010 The Act modifies the Investment Advisers Act of 1940 (the Advisers Act ) in several critical respects summarized below. Most of the modifications focus on private fund advisers; however, several changes affect all types of advisers, including US and those non-us advisers with certain types of contacts with the United States. Highlights of the Act include the following: Private Fund. The Act defines for the first time the concept of a private fund for purposes of regulation under the Advisers Act. The definition encompasses any private fund that is relying on either of the private investment company exemptions from SEC fund registration under Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the Investment Company Act ). Given that these exemptions are those routinely used by private equity, hedge, venture, real estate and all other types of private funds, including privately offered US and (through SEC interpretations) non-us funds, the definition is expansive and, unless one of the limited exemptions is available under the Act, many private fund advisers will now face registration with the SEC for the first time. Registration and Exemptions. The Act eliminates the private adviser exemption from SEC registration under the Advisers Act, which has been routinely relied upon by private fund advisers and other types of advisers with a limited number of clients. Under this previously available exemption, an investment adviser (e.g., the general partner of a fund) was not required to register with the SEC if it did not publicize its advisory business, had fewer than 15 clients, counting each fund as a single client (for non-us advisers, counting only US funds) and did not advise any investment companies registered under the Investment Company Act or business development companies (as defined in the Investment Company Act). Foreign Private Adviser Exemption. The Act adds an exemption from SEC registration for a foreign private adviser (a non-us adviser), defined as any investment adviser who meets each of the following conditions: no place of business in the US a new requirement not previously imposed on non-us advisers that were able to establish US offices for limited purposes such as research; fewer than 15 US clients and US investors (i.e., limited partners) in the private funds it advises in the aggregate. Generally, this headcount calculation will compel registration of most non-us private fund advisers offering funds to US investors unless another exemption is available, since they would typically be seeking more than 14 US investors for their funds; less than $25 million in assets under management from its US clients and US private fund investors in the aggregate, although the SEC may set a higher dollar amount a new requirement not previously imposed on non-us advisers that were able to manage the assets of a limited number of US clients without any limitation on the amount of assets; no marketing in the US as an investment adviser; and 2 Corporate & Securities July 21, 2010

3 no clients that are investment companies registered under the Investment Company Act or business development companies. Exclusion for Venture Capital Fund Advisers. Although the Act does not generally differentiate between different types of private funds, it does provide an important exemption from registration with the SEC for general partners or other advisers solely of venture capital funds. However, the fund managers will be subject to SEC reporting and recordkeeping requirements to be determined by SEC rulemaking. Interestingly, the Act directs the SEC to define the term venture capital fund for purposes of this exemption. No Private Equity Fund Advisers Exclusion The Act does not provide an exclusion specifically for private equity fund advisers, although such a provision was considered. Nonetheless, private equity fund advisers may be exempt from registration if they are able to rely on one of the general exemptions, including the exemption for smaller private fund advisers (described below). Exclusion of Smaller Private Fund Advisers. Smaller private fund advisers are exempt from SEC registration provided that their only clients are private funds and they advise in the aggregate less than $150 million in assets in the US. Nonetheless, these advisers are subject to SEC recordkeeping and reporting requirements to be determined by the SEC. This exemption is available to advisers of any type of private fund. Special Treatment of Mid-Sized Private Fund Advisers. Although advisers to private funds referenced as mid-sized funds may be required to register with the SEC if they are not otherwise exempt, the Act directs the SEC to take into account the level of systemic risk these funds pose in establishing appropriate registration and examination procedures. Mid-Sized Investment Advisers: Allocation of Federal and State Responsibilities The Act limits the right of a mid-sized investment adviser to register with the SEC rather than state securities regulators. An adviser may not register with the SEC if the adviser (i) is required to register with the state regulator in the state in which it maintains its principal place of business, (ii) would, if registered, be subject to examination by the state regulator and (iii) has assets under management between $25 and $100 million (or such higher amount set by the SEC), unless the adviser would be required to register with 15 or more states. In any event, the adviser is required to register with the SEC if it has a client that is an investment company registered under the Investment Company Act or a business development company. Certain Other Changes to Exemptions from SEC Registration Intrastate Advisers. An adviser to a private fund may not rely on the exemption for intrastate advisers even if the adviser, the private funds it advises, and all of the fund investors are located in the same state. Advisers registered with the Commodity Futures Trading Commission ( CFTC ). An adviser registered with the CFTC as 3 Corporate & Securities July 21, 2010

4 a commodity trading advisor that advises a private fund is exempt from SEC registration, provided that the adviser s business is not predominately the provision of securities related advice. Investment Advisers to Small Business Investment Companies: Investment advisers whose clients are limited to small business investment companies that are licensees under the Small Business Investment Act of 1958 ( SBIA ), or have received notice to qualify under the SBIA or certain affiliated companies are exempt from registration. Exclusion of Family Offices. The Act excludes family offices (to be defined by the SEC) from the definition of investment advisers subject to the Advisers Act. This is intended to reflect established SEC policy and will be defined through required SEC rulemaking. Even if an adviser is exempt from SEC registration in accordance with the new exemptions provided by the Act, the adviser needs to consider whether it may be required to register with one or more states under state adviser laws. The Act does not change a state s power to require registration of a private fund adviser or other investment adviser that may be exempt from SEC registration provided that the adviser has certain contacts with that state. Private Fund Records, Reporting and Examination. The Act contains substantial recordkeeping, reporting and examination requirements specifically for registered private fund advisers, including: Private Fund Records and Reports. For each private fund, the adviser must maintain certain records and reports which will be subject to SEC inspection. The required information will include information such as the amount and types of assets under management, use of leverage (including off-balance sheet leverage), side letter arrangements, and valuation policies. Several of these areas reflect longstanding SEC concerns particular to hedge funds. The Act authorizes the SEC, in consultation with the Financial Stability Oversight Council (the Council ) to require additional information and reports beyond what is specified in the Act as necessary and appropriate in the public interest for investor protection or assessment of systemic risk. Additional reporting requirements may be established for different classes of fund advisers, based on the type of private fund (e.g., hedge fund or private equity fund) or size of private fund being advised. The Act directs the SEC to issue rules concerning the required reports to be filed by private fund advisers. SEC Examination of Private Fund Records. All records and reports of any private fund advised by a registered adviser, not only specific SEC required reports, will be considered the records and reports of the registered adviser, subject to SEC examination. The SEC is required to conduct periodic examinations of private fund records, and may also conduct additional special or other examinations. 4 Corporate & Securities July 21, 2010

5 Information Sharing and Confidentiality. The SEC will share any information filed with or provided to it by an adviser with the Council for an assessment of the systemic risk posed by a private fund. The SEC, the Council and other departments, agencies and self regulatory organizations receiving this information from the SEC must keep such information confidential except that it may be disclosed to: (i) Congress (upon an agreement of confidentiality), or a federal department or agency or self regulatory organization acting within its scope of jurisdiction, or (ii) by court order in an action brought by the United States or the SEC. Information provided to the SEC or shared by the SEC is not subject to disclosure under the Freedom of Information Act. There is additional protection of proprietary information concerning the adviser that is contained in any report filed with the SEC. SEC Report. The SEC is to report annually to Congress on how it has used the data collected from advisers for purposes of investor protection and market integrity. Disclosure of Client Identity. The SEC may now require disclosure of the identity, investments and affairs of a client for purposes of assessment of potential systemic risk in addition to its prior powers to compel this disclosure. Joint SEC and CFTC Reporting Standards for Advisers. Within one year, the SEC and CFTC (after consultation with the Council) are to jointly adopt rules for the form and content of reports to be filed by advisers registered with both agencies. Custody. The Act requires that advisers with custody of client assets have the client assets verified by an independent public accountant and take such other steps as determined by the SEC. The Comptroller General will prepare a report for Congress on the compliance cost impact of the SEC Rule 206(4)-2, the current custody rule for advisers. Qualified Client Standard. The SEC is required to adjust any dollar amount used in the definition of qualified client for inflation periodically. This definition is of importance to advisers receiving performance or incentive fees, including in particular advisers to private funds that rely on the private fund exemption in Section 3(c)(1) of the Investment Company Act. Generally, each investor in such funds must be a qualified client if the adviser receives such fees. Regulation D and Accredited Investor. The Act modifies the definition of accredited investor in Regulation D, setting the minimum net worth requirement for individual investors at $1 million, excluding the value of the investor s primary residence, among other changes. This requirement is subject to increase. For more information about the modifications to Regulation D under the Securities Act of 1933, see our Client Alert dated July 16, 2010 available at ca/securities/al_nacs_executivecompensationcorporategovernance_jul10.pdf. 5 Corporate & Securities July 21, 2010

6 SEC Rulemaking Power. The SEC s rulemaking powers are expanded; however, they specifically exclude the power to define a fund investor as a client of a private fund adviser if the adviser has entered into an advisory agreement with the fund for purposes of certain antifraud provisions of the Advisers Act. This is an important clarification as it limits the SEC s ability to extend certain client related duties of the adviser to each fund investor. Volcker Rule The Volcker Rule adds to the Bank Holding Company Act of 1956 prohibitions on certain activities by banking entities ( Banking Entities ) and, to a limited extent, on nonbank financial companies supervised by the Federal Reserve Board ( Nonbank Financial Companies ) related to: Proprietary trading ( Proprietary Trading Limitation ); and Certain relationships with a hedge fund or a private equity fund (the Fund Limitation ). Proprietary Trading Limitation The general prohibition on proprietary trading is defined to include: trading by the Banking Entity as principal for its own trading account in any transaction to purchase or sell any security, any derivative, any contract of sale of a commodity for future delivery, any option on these instruments, or any other security or financial instrument designated by the banking regulators with the SEC and CFTC. The prohibition is targeted at trading in trading accounts which are defined to include accounts used for acquiring and taking positions in these securities and instruments principally for the purpose of selling in the near term (or otherwise to resell to profit from short term price movements). This definition appears to exclude investment accounts. There are several exceptions to this prohibition, including among others, investments in obligations of the United States or its agencies, or of any state, underwriting or market making related activities to the extent that they are designed not to exceed the reasonably expected near term demands of clients, customers and counterparties, and trading activity outside of the United States by non-us Banking Entities. Provisions of the Fund Limitation A ban on sponsoring or investing in hedge funds or private equity funds. Banking Entities are generally prohibited from sponsoring or investing in hedge or private equity funds. Investing is permitted subject to certain de minimis limitations. There are exemptions allowing permitted activities, including, among others, exemptions for certain fiduciary related activity and non-us activity of non- US firms as discussed below. Non-US Banking Entity Exemption. There is an exemption for non-us banking firms that invest in or sponsor hedge or private equity funds solely outside of the US provided that the funds are not offered or sold to US investors (US residents). It is not clear how this geographic requirement may be interpreted to impose additional limitations on a fund s US contacts. The US investor ban is a significant limitation on the usefulness of this exemption for firms doing global fund offerings. 6 Corporate & Securities July 21, 2010

7 Fiduciary Exemption. A Banking Entity is permitted to organize and sell a private equity or hedge fund, including serving as a general partner, managing member, or trustee of the fund and selecting or controlling a majority of the directors, trustees, or management of the fund, if each of the following requirements are met (the Fiduciary Exemption ): (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) the Banking Entity provides, as part of its overall services, trust, fiduciary, or investment advisory services; the fund is organized and offered only in connection with the provision of those services to customers of the Banking Entity; the Banking Entity does not have an ownership interest in the funds except in compliance with certain de minimis limitations (described below); the Banking Entity complies with other limitations on fund related transactions relating to covered transactions, affiliate transactions and prime brokerage transactions (as described below); the Banking Entity does not guarantee, assume, or otherwise insure the obligations or performance of the fund or any fund in which such fund invests; the Banking Entity does not share with the fund the same name or a variation thereof; only a director or employee of the Banking Entity who is directly providing services to the fund may have an ownership interest in the fund; and the Banking Entity discloses to prospective and actual investors in the fund that the fund s losses are borne solely by fund investors and not by the Banking Entity, and otherwise complies with any additional rules. Exceptions to the Proprietary Trading Limitation and the Fund Limitation are subject to further restrictions including (i) maintaining the absence of any material conflict of interest between the Banking Entity and its clients, customers or customers; and (ii) avoiding material exposure of the Banking Entity to high risk assets or a high risk trading strategy. De Minimis Exemption. A Banking Entity may invest in the hedge and private equity funds that it organizes and offers. Such investments may not exceed: (i) 3% of the total ownership interests of the fund not later than one year after the fund s establishment (subject to a two year extension as determined by the Federal Reserve), and (ii) an amount that is immaterial to the Banking Entity (to be defined by the regulators), in no event exceeding in the aggregate 3% of the Banking Entity s Tier 1 capital. Additional limitations on transactions between Funds and Banking Entities. There are a number of limitations on transactions between Banking Entities and related private funds. If a Bank Affiliate advises, manages, or sponsors a private equity or hedge fund or organizes and offers a fund under the Fiduciary Exemption (described above), certain transactions will be subject to affiliate related limitations imposed under the Federal Reserve Act. A Banking Entity and its affiliates may not enter into any covered transaction (certain prohibited 7 Corporate & Securities July 21, 2010

8 transactions with affiliates, such as loans to and a purchase of securities issued by fund) with such a fund. Additional limitations include those imposed under Section 23B of the Federal Reserve Act ( Section 23B ) on affiliate transactions applied to any transactions between the funds and a Banking Entity as if the fund is an affiliate, which generally require terms comparable to third party terms. Prime brokerage transactions between a Banking Entity and a hedge fund in which a hedge fund or private equity fund managed by the Banking Entity has invested may be permitted, but only with Federal Reserve permission, subject to various conditions, e.g., compliance with Section 23B and a certification by the Banking Affiliate that it has not guaranteed obligations of hedge or private equity funds in compliance with the terms of the Fiduciary Exemption. The impact of these limitations will depend in large part on the definitions of key terms. Banking entity includes any insured (FDIC) depository institution (excluding certain trust companies), any company that controls such an institution, a bank holding company under the International Banking Act, and any affiliate or subsidiary of such entities. This definition is broad enough to include non-us based banking organizations with certain types of US operations. Hedge Fund and Private Equity Fund are defined to include any private fund relying upon the private fund exemptions from SEC registration provided in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act or similar funds as determined by the banking regulators, the SEC and the CFTC. The reference to similar funds and the role of the banking regulators in defining these funds may result in some differences between the SEC, CFTC and banking regulators approaches to private fund regulation. There are indications that this definition should be limited to what is typically considered a hedge or private equity fund and not expanded to include other types of pooled vehicles. For example, the rules of construction include a statement that nothing should be construed to limit or restrict the ability of a Banking Entity or a Nonbank Financial Company to sell or securitize loans in a manner that is otherwise permitted. Illiquid Fund means a hedge or private equity fund that, as of May 1, 2010, was principally invested in or committed to invest in illiquid assets, such as portfolio companies, real estate or venture capital investments, and whose principal investment strategy is to invest in illiquid assets. To sponsor a fund means to have a certain relationship with the fund, including: (i) serving in a certain key capacity such as general partner, managing member, or trustee; (ii) controlling (or having employees or others who constitute) a majority of the directors, trustees, or management of the fund; or (iii) sharing with the fund, for corporate, marketing, promotional, or other purposes, the same name or a variation of the same name. Nonbank Financial Companies. The Federal Reserve is required to adopt additional capital requirements and quantitative limits applicable to the proprietary trading and hedge and private equity fund activities of Nonbank Financial Companies that are not otherwise permitted activities. 8 Corporate & Securities July 21, 2010

9 Study, Rulemaking and Transition. The Council is to complete a study within 6 months with recommendations for implementing the Volcker Rule to achieve its objectives. Banking regulators, the SEC and the CFTC are to complete their required rulemakings within nine months of the completion of the Council s study, taking into account its findings, and coordinate their rules. The Council s Chairman is appointed as coordinator. Banking Entities and Nonbank Financial Companies are to comply with the new requirements within two years of the effective date of the requirements or of the date on which a firm is designated as a Nonbank Financial Company. The Federal Reserve may grant one year extensions of this deadline, for a total extension of no more than 3 years. The Federal Reserve may grant an extension of up to five years to a Banking Entity to allow it to fulfill a contractual obligation in effect on May 1, 2010 to take or retain its interest in or provide additional capital to a fund that is an illiquid fund. Unless exempt under the Fiduciary Exemption, the Banking Entity must comply with the Fund Limitation no later than the earlier of the date of any extension or the date on which the contractual obligation to invest in the illiquid fund terminates. Frequently Asked Questions: The Act and the Volcker Rule Are most private fund advisers required to register with the SEC under the Act? Yes. There are very few exemptions now available for most private fund managers. Generally, unless an adviser advises only venture capital funds or is managing private funds with less than $150 million in assets under management in the US, SEC registration is likely to be required unless one of the other very limited exemptions is available. Although it is not clear how the $150 million amount will be calculated, it is likely that for US fund advisers, all of the assets they manage will be considered and for non-us advisers (assuming availability of the exemption), only the assets from US fund investors will be considered. The foreign private adviser exemption is very restrictive and (at least initially) will be limited to a $25 million US asset limit, although other exemptions may be available to non-us private fund advisers subject to SEC clarification. The new terms of the exemptions and related SEC guidance to be issued in the coming year will need to be carefully reviewed to assess availability of the exemptions. For some advisers, restructuring may be a response, such as closing a US office, or combining affiliated registered and unregistered advisory units. Even if SEC registration is not necessary (or permitted for smaller advisers), relevant state registration requirements should also be reviewed. What is the impact of the loss of the previous private adviser exemption on non-us advisers that are not private fund managers? All but the smallest of these advisers will also likely be required to register with the SEC because of the additional requirements of the foreign private adviser exemption, in particular the limitation on the aggregate amount of assets that may be managed for US clients and fund investors (initially set at $25 million). 9 Corporate & Securities July 21, 2010

10 How will the new SEC requirements for registered private fund advisers impact their business? The increased SEC role will create a strong voice for the SEC in setting market standards for the industry on a variety of matters. It will likely raise new issues related to confidentiality of fund, US and non-us investor and proprietary information, despite provisions in the Act intended to address these concerns. For hedge fund managers in particular, additional SEC requirements may reflect longstanding areas of SEC concern such as side letters and systemic risk related regulatory controls for the larger funds are now possible. The global nature of the private fund industry and increasing non-us regulation of private funds also raise the prospect for many more conflict of law issues with increased US regulation. Are all private fund activities of Banking Entities and Nonbank Financial Companies prohibited under the Volcker Rule? No, there are a number of exemptions that should allow private fund activities to continue, such as the Fiduciary Exemption, subject to compliance with the de minimis limitations on private fund investments and the affiliate transaction limitations. Prime brokerage arrangements do face special approval requirements that could prove cumbersome. The non-us exemption for non- US based Banking Entities is of limited usefulness because of its ban on US investors. Will Banking Entities and Nonbank Financial Companies be required to divest and restructure activities and investments to meet requirements? Yes, if the activities are not within the exemptions for permitted activities and other limitations. The Volcker Rule requires that these firms bring their activities and investments into conformity with the new requirements within two years of the date of effectiveness of the new requirements, plus three years of extensions upon application to the Federal Reserve, or, for certain preexisting commitments to Illiquid Funds, an extension of five years. These divestitures and restructurings will create opportunities for joint ventures and strategic relationships between these firms and unaffiliated firms not subject to the Volcker Rule. Given the potential impact of these changes, it is essential for advisers to monitor and participate in the dialogue that will now begin with the SEC, the CFTC, the Council and the banking and other regulators charged with implementation of these changes. * * * 10 Corporate & Securities July 21, 2010

11 Editor: Jennifer Martella For more information about this, and any other questions pertaining to information in this Client Alert, please contact the Baker & McKenzie attorney with whom you work, or any of the following: Chicago One Prudential Plaza 130 East Randolph Drive Chicago, Ill Tel: Dallas 2300 Trammel Crow Center 2001 Ross Avenue Dallas, TX Tel: Attn: Craig A. Roeder Attn: Addison Braendel Attn: Michael Fieweger New York 1114 Avenue of the Americas New York, NY Tel: Attn: Margaret Paradis Attn: Philip von Mehren Attn: Jeffrey Cohen Attn: Thomas Rice Washington DC 815 Connecticut Avenue, N.W. Washington DC Tel: Attn: Marc R. Paul Attn: Pamela Dayanim Palo Alto Attn: Amar Budarapu Houston Pennzoil Place 711 Louisiana, Suite 3400 Houston, TX Tel: Attn: Jonathan B. Newton San Francisco Two Embarcadero Center, 11 th Floor San Francisco, CA Tel: Attn: Shane M. Byrne San Diego High Bluff Drive, Third Floor San Diego, CA Tel: Attn: Maria P. Sendra Miami Mellon Financial Center 1111 Brickell Avenue, Suite 1700 Miami, FL Tel: Attn: Roy J. Larson Hansen Way Palo Alto, CA Tel: Attn: Matthew R. Gemello 11 Corporate & Securities July 21, 2010

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