Dodd-Frank & the Volcker Rule- Key concerns for UK investment advisors

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What is Dodd-Frank?

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) was passed into law on 21 July 2010.  It is the US Government’s primary legislative response to the financial crisis. It seeks to promote the financial stability of the US, to protect the US economy, US consumers, US investors and US businesses, and to end taxpayer funded bailouts of financial institutions, by: 

  • changing the US regulatory structure and streamlining the US regulatory process;
  • establishing rigorous standards and supervision in the financial markets;
  • increasing the oversight of specific institutions regarded as a “systemic risk”;
  • amending the Federal Reserve Act (the principal US banking law);
  • promoting transparency and improving accountability;
  • providing for an advanced warning system on the stability of the US economy;
  • creating rules on executive compensation and corporate governance; and
  • eliminating various loopholes that contributed to the economic recession.

Few provisions of the Act became effective when the Bill was signed but these will become effective as the various regulatory agencies write detailed implementation rules.

Impact on UK investment advisors

Under the previous rules, investment advisers were exempt from registration with the US equivalent of the FSA, the Securities and Exchange Commission (the “SEC”), if they advised fewer than 15 “US clients” over a 12 month period.

Broadly speaking, each fund counted as one “client” with the number of individual investors in the fund being irrelevant.  Therefore, UK managers with fewer than 15 US fund vehicles were exempt from any requirement to register with the SEC.

As a result of Dodd-Frank, all “investment advisors” with US investors in their funds will be required to register with the SEC by 21 July 2011 unless a relevant exemption applies.  The definition of investment adviser is broad and potentially covers general partners, advisers and sub-advisers in addition to the main fund manager.

Exemptions

There are various exemptions from the requirement to register as set out below although it should be noted that there are points of detail that remain outstanding and it is, therefore, still unclear as to exactly how these exemptions will apply in practice.

( a ) The Foreign Private Advisor Exemption

In order to qualify for this exemption a firm must meet all four of the following conditions:

  • it must have no place of business in the US;
  • it must have fewer than 15 clients and investors in the US;
  • it must have aggregate assets under management (“AUM”) attributable to clients and investors in the US of less than USD25 million (but see below); and
  • it must not hold itself out to the public in the US as an investment adviser or act as an investment adviser to a “registered investment company” or “business development company”.

The SEC has the authority to increase the USD25m limit and it is understood that they are considering raising it to USD100m.

( b ) Mid-sized Private Fund Advisor Exemption

This applies to firms that only advise “private funds” with less than USD150m of AUM in the US.  It is not clear yet whether this exemption will apply to non-US firms.

( c ) Venture Capital Fund Exemption

This applies to firms that act as investment adviser solely to “venture capital funds”.  “Venture capital fund” has not yet been defined but is expected to be narrowly drawn.

( d ) Exemption from certain obligations

Historically, the SEC has exempted non-US entities registered with the SEC from full compliance in relation to their non-US funds. It has not yet been confirmed whether any relief will be given to non-US firms under the new regime either in relation to their non-US funds or for those funds with no US investors.

Registration

In order to register with the SEC, firms must submit on-line Form ADV. The form requires, amongst other things, detailed information on the owners of the adviser, services provided, relevant risks and conflicts, fees, and AUM.

Once submitted, the SEC have up to 45 days to review and respond to the application.  However, the process of preparing to register, which includes implementing a full SEC compliance programme, can take some considerable time. Failure to register when required is likely to lead to severe consequences for the manager including possible SEC enforcement action and breach of covenants and/or contracts with the fund which could lead, for example, to mandate termination or the refund of management fees.

Ongoing obligations

A registered firm must appoint a Chief Compliance Officer who becomes responsible for the firm’s SEC compliance policies and procedures.  The policies and procedures must be in writing and reviewed at least annually.  Many will be similar to those required by FSA authorised firms (e.g. compliance manual, personal trading policy, code of ethics, disaster recovery policy etc.) although some changes may be required to make them SEC compliant.  Others, such as the proxy voting policy, which seeks to ensure that advisers vote proxies in the best interest of their clients and provide clients with information about how their proxies are voted, will be new.

In addition, registered firms will be subject to certain restrictions and continuing obligations such as the maintenance of an appropriate system for record keeping (e.g. in respect of marketing materials, proxy voting, personal trading, etc.) some of which may be unfamiliar to non-US firms.

Systemic risk oversight

Dodd-Frank also imposes information collection and reporting requirements on private fund managers (whether registered with the SEC or not), obliging firms to provide the SEC and the new US Financial Stability Oversight Council with information about matters that are considered to impact overall financial stability, such as AUM, use of leverage, trading and investment positions, side letters and valuation policies.

Representation

The UK and European representative bodies (e.g. EFAMA, IMA, AIMA and BVCA) are in dialogue with the SEC to seek to minimise the impact of this extra regulation on their members. 

The Volcker Rule

The so-called Volcker Rule was added to Dodd-Frank in January 2010 as a further measure to deal with systemic risk caused by the banking sector and to protect consumer deposits made to US banks. 

The Volcker Rule prohibits deposit-taking US banks from carrying out “proprietary trading” (i.e. where the bank buys or sells financial assets for its own account and, therefore, bears the risk of trading losses) unless it’s at the behest of its clients.

The Volcker Rule also limits a US bank’s ownership of hedge or private equity funds in aggregate to 3% of its Tier 1 capital and to 3% of one private equity group or hedge fund. It is not clear whether banks will only be allowed to make such de minimis investments if they also "organise and offer" the fund (i.e. whether investments in third party funds will be prohibited).

It is considered that proprietary trading played a key role in creating the financial crisis and there is concern that unlimited investments in hedge and private equity funds may be used to replicate what would otherwise be unauthorised proprietary trading activity.  In short, the Volcker Rule is meant to cause the banks to focus on serving their client’s requirements rather than using client deposits for speculative trading.

Dodd-Frank provides the legislative framework for the Volcker Rule but the detailed provisions are still being written by the regulators and many of the rules will be implemented over an extended period rather than with immediate effect.   In particular, the definition of “hedge fund” is eagerly anticipated and there is still much uncertainty as to exactly what constitutes proprietary trading as opposed to say “hedging”, “trading on account of client activity“, or “principle investing” (i.e. investing in longer term securities, property and other assets that have an increased regulatory capital requirement) but will not be prohibited.

Impact of the Volcker Rule on the alternative investment market

The restriction on short-term proprietary trading, especially when coupled with significant restrictions on immediate remuneration, is likely to provide the alternative investment market with an increased volume of talent as it will encourage individual or groups of traders to leave banks and join existing, or establish new, hedge funds.  On the other hand, banks have been significant providers of seed capital to the alternative investment market and so the restrictions imposed on them investing in funds is likely to make fund-raising even more difficult.  

It is not yet clear what impact the 3% holding rule will have on funds in which individual banks currently hold stakes in excess of 3%.   There is considerable concern that if banks are forced to sell their stakes in a short timeframe this could cause reputational damage with funds’ other investors and liquidity problems causing them to sell fund assets below their market value in order to meet redemption requirements: such issues may ultimately cause some hedge funds to close

However, on the positive side for the industry, according to some high profile market participants the Volcker Rule and other regulatory changes that force banks to divest assets and unwind trades will be good news for funds, because this will present a buying opportunity and reduce competition for returns.
 

Trevor Brown
19 November 2010



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