Lending Law Report : Corporate Finance Lawyer & Attorney : Reed Smith Law Firm : Lending Transactions, Secured Investments

It's now been several months since Dodd-Frank was enacted, and the regulators have been busy.  There have been several proposed rules sent out for comment, and various agencies have produced studies, reports and final rules. 

All this activity would be too much for most of us to keep up with, but my colleague Michael Bleier, former general counsel of Mellon Bank and now a partner in our financial services regulatory practice here at Reed Smith, has been keeping a close eye on the developments in this area.  He's put together a handy summary of all the rulemaking.   If you've been following the developments in this area - or if you haven't been but want a chance to catch up now - you'll want to check it out.

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I've just finished reading Andrew Ross Sorkin's excellent book Too Big To Fail (Penguin, 2009).  If you haven't read it yet, put it on your list, because this one is really worth it.  The book tells the gripping tale of the financial crisis, beginning with the downward slide of Bear Stearns and Lehman and continuing through to adoption of the TARP program.   With particular focus on Tim Geithner, then President of the Federal Reserve Bank of New York, and Hank Paulson, then Secretary of the Treasury, who - along with many others in government and the private sector - worked tirelessly to try to fix a seemingly unending parade of problems, Sorkin captures the intensity of the times and offers insights into why things happened the way they did.   It's a real page-turner, and suprisingly so given that the primary elements of the story are already well known.

As we now try to figure out how to deal with the Dodd-Frank Act (pdf) and its potential impact on financial institutions, it's helpful to look back at what happened in 2008, as described in Sorkin's book.  It's striking to see how similar certain provisions of the Act (and the language used in the congressional committee's report about the Act) are to the ideas expressed by people in government during the crisis itself. 

In particular, concerns about moral hazard (the idea that undue risk-taking is promoted when managers and shareholders know they can be insulated from negative consequences) and about the real need for an alternative to the bankruptcy process for large financial institutions, were often voiced.  As quoted in Sorkin's book, both Paulson and Ben Bernanke, Chairman of the Federal Reserve, expressed on multiple occasions the need for the government to have authority to resolve or wind-down complex financial institutions outside of bankruptcy.  Bernanke also spoke of the need to mitigate moral hazard  "by allowing the government to resolve failing firms in a way that is orderly but also wipes out equity holders and haircuts some creditors."

And sure enough, in adopting Dodd-Frank, Congress explained that the "too big to fail" provisions address both of these issues front and center.  The Act provides for "orderly liquidation authority" if the Secretary of the Treasury (in consultation with the President,  and with the wrritten recommendation of two additional  federal regulators) finds that liquidation is necessary to mitigate "serious adverse effects on financial stability" in the nation.  The liquidation is to be carried out in a manner that "minimizes moral hazard," with costs being borne first by shareholders and unsecured creditors -- and protecting taxpayers from these losses.

Several other provisions of Dodd-Frank can find their beginnings in the events of 2008 as well --  short sales, hedge fund regulation, derivatives, rating agencies, etc.  Turns out that Sorkin's book, though likely not intended for this purpose, provides a fascinating background story and explanation for much of the content of the Dodd-Frank Act.

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My law partners Sandra Poe (of Reed Smith's New York office) and Alicia Powell (from Pittsburgh), along with other colleagues, wrote the following summary of the Private Fund Investment Advisers Registration Act of 2010.  As part of the larger Dodd-Frank financial reform legislation, this Act significantly changes the rules for funds.  If you manage a hedge fund or private equity fund, or work with (or make loans to) these funds, you'll want to know about these new rules.  Of course, this is just one of many important changes affecting the financial industry -- we'll have a lot more to say about other aspects of Dodd-Frank in future posts. 

In the Private Fund Investment Advisers Registration Act of 2010, Congress adopted changes to the Investment Advisers Act of 1940 that greatly increase the chances that managers of hedge funds or private equity funds will now have to register as investment advisers.  Advisers who are required to register will have about a year to do so -- until July 21, 2011.  Widely covered in the news as “hedge fund registration” requirements, these amendments actually primarily affect the status of the fund managers, rather than the funds themselves.

What Will Change

Currently, advisers that have fewer than 15 clients generally are exempt from
registration.  Advisers that manage private funds can count each fund as a single client.  Most private equity and hedge fund managers have been entitled to rely on this exemption.  The law change eliminates this so-called “private adviser exemption” in its entirety, and provides that the SEC will replace it with a much narrower exemption for advisers with assets under management of less than $150 million, and who exclusively advise private funds (as defined in the Act).   As a result, private fund advisers with $150 million or more in assets under management will be required to register with the SEC.  Private fund advisers falling beneath the $150 million threshold must determine whether they are required to register with the securities regulators in one or more states (we note that all states other than Wyoming have some sort of registration requirements).

The New Rules

• Registration on Form ADV — To register, advisers must complete Form ADV, which requires substantial disclosures to the SEC and to the adviser’s clients. Form ADV must be updated at least annually and, with respect to certain key information, at the time of certain changes in the reported information.
• Disclosures to Adviser’s Clients — “Part II” of Form ADV, or the “brochure,” calls for substantial narrative description of the adviser’s business, products, management, material adverse financial or disciplinary matters, conflicts of interest and policies designed to address conflicts of interest.  Advisers are required to deliver their brochure to advisory clients annually. The brochure is often used as a means of conveying other required disclosures such as privacy policies.
• Adoption of a Comprehensive Compliance Program — Registered advisers must adopt written policies and procedures designed to prevent violation of the Act and its rules. Such written policies must be reviewed at least annually for adequacy and effective implementation, and a chief compliance officer must be appointed to oversee their administration.
• Adoption of an Anti-Insider Trading Policy — A policy must be designed to ensure that material, non-public information is not misused in violation of the Act or the U.S. Securities Exchange Act of 1934 (the “1934 Act”), and may entail (i) circulating a written policy to all employees, (ii) employee training programs, (iii) creating physical and organizational information barriers, (iv) maintaining restricted lists, watch lists, and rumor lists, and (v) maintaining a procedure for monitoring client and personal trades.
• Adoption of Code of Ethics and Personal Trading Policy for Access Persons — Access persons must report their personal securities holdings and transactions.  Some access persons must also obtain pre-clearance before participating in, and may be barred from investing in, initial public offerings and limited offerings.
• Subject to SEC Examination Authority — The SEC conducts periodic examinations of registered advisers.  You'll want to stay abreast of “hot topics” and periodic SEC staff
  statements about the focus of the SEC’s examination program.
• Substantial Recordkeeping Obligations — The Act imposes requirements with respect to
  adviser records substantiating the basis of performance claims and other records reflecting
  the relationship between the adviser and its clients.  New legislation would add to these
  records for each private fund under management.  These records include AUM, the use of
  leverage, counterparty credit risk exposure, trading and investment positions, valuation policies, side arrangements or side letters, trading practices, and any other subjects that the SEC, in consultation with the Financial Stability Oversight Council, deems necessary for the public interest, investor protection or the assessment of systemic risk.
• Compliance with Anti-Fraud Laws — The Act generally prohibits an investment adviser from
  employing a “device, scheme or artifice” to defraud clients or engaging in a “transaction, practice or course of business” that operates as a “fraud or deceit” on clients. The Act’s anti-fraud provisions also prohibit certain securities transactions absent disclosure to clients, as well as any “act, practice or course of business which is fraudulent, deceptive or manipulative.” Rules under the Act extend these protections to investors in the adviser’s private funds. In addition to the antifraud provisions of the Act, you may also be subject to the anti-fraud and manipulation provisions of the other federal securities laws, such as section 17(a) of the U.S. Securities Act of 1933, as amended, and Rule 10b-5 under the Securities Exchange Act of 1934, as amended.
• Custody Rules — The Act imposes specific measures registered advisers must take to safeguard client assets over which the adviser has, or is deemed to have, custody. These steps include maintenance of client assets with a “qualified custodian” and submission to an annual surprise examination by an independent public accounting firm (or the issuance of annual audited financial statements by private funds advised by the adviser). 

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