Noteworthy Provisions of the Dodd-Frank Act for Private Equity

 

On July 21, 2010, President Obama signed into law the Dodd-Frank Wall Street Reform and Consumer Protection Act (Act). The Act implements sweeping reform throughout the system, reaching from consumer protection to regulation of transparency and accountability for Wall Street players. A number of the provisions of the Act will directly impact private equity funds. Several of those provisions are summarized below.

 

1.                  Definition of Accredited Investor.

 

The Act revised the definition of the phrase "accredited investor" with respect to individuals. Previously, in order to be considered accredited investors, individuals had to pass one of two tests: (i) the net worth test (Net Worth Test), or (ii) the income test (Income Test). The Net Worth Test required that an individual have at least $1 million in net worth, including the value of his or her primary residence. However, effective immediately on the passing of the Act, an individual's primary residence is excluded from the $1 million Net Worth Test. The Income Test remains unchanged.

 

Many commentators anticipate that the Securities and Exchange Commission (SEC) will not include any mortgage or other debt secured by the primary residence; however, that remains to be seen. In addition, it is expected that, to the extent any debt secured by the primary residence exceeds the value of the residence and the loan is full recourse to the individual for the amount of any deficiency, the excess must be deducted from the net worth calculation.

 

It is important to note that these changes to the definition of accredited investor are effective immediately. Private equity firms, firms raising capital and their advisors should immediately revise disclosure documents, subscription agreements, and any other documents containing a definition of the phrase "accredited investor." If such documents have already been received or circulated, private equity funds and firms raising capital should strongly consider circulating new disclosure documents and requesting new investor representations in order to ensure that all investors meet the new definition of accredited investor.

 

In addition, after the first four years following enactment of the Act, the SEC is empowered to periodically review the definition of accredited investor (including both the Net Worth Test and Income Test) as it applies to individuals and to make changes thereto for the protection of investors, in light of then current economic conditions and in the public interest. Moreover, within three years after the passage of the Act, the Comptroller General must conduct a study to determine the appropriate thresholds for qualification as an accredited investor and otherwise for eligibility to invest in private funds. As a result of these two provisions of the Act, further changes may be coming in the next few years relating to qualifications required to make private investments.

 

2.                  Registration of Advisors to Private Equity Funds.

 

The Act generally sets forth registration and reporting requirements for advisors to private funds, which were previously exempt from such requirements. Notwithstanding those requirements, which are described below, pursuant to Section 408 of the Act, no investment advisor solely to a private fund or funds with assets under management of less than $150 million will be subject to the registration or reporting requirements described. Nevertheless, the SEC is empowered to require advisors to private funds to maintain such records and provide such annual or other reports to the SEC as it shall determine to be necessary or appropriate in the public interest or for the protection of investors. In promulgating such regulations, the SEC must take into account the size, governance structure and investment strategy of such funds to determine whether they pose systemic risk, and shall provide for registration and examination procedures with respect to the investment advisors of such funds which reflect the level of systemic risk posed by such funds. In other words, different advisors to these mid-size funds will be subject to different requirements for record-keeping and reporting.

 

Section 407 of the Act exempts investment advisors to "venture capital funds" from the registration and reporting requirements of the Act. The term has not yet been defined, but the SEC is required to formulate a definition within one year after enactment of the Act.

 

As noted above, effective one year after the date of enactment of the Act, Section 403 of the Act eliminates the exemption for "private funds" from the requirement of registration under the Investment Advisors Act of 1940. A private fund is an issuer that would be considered an investment company under Section 3 of the Investment Company Act of 1940 but for Section 3(c)(1) (which exempts issuers with no more than 100 security holders – an exemption frequently relied upon by private equity funds), or Section 3(c)(7) (which exempts issuers owned exclusively by qualified purchasers). As a result of the elimination of these exemptions, many advisors to larger private equity funds (including general partners) will be required to register as investment advisors with the SEC.

 

Section 404(b) of the Act requires private funds to maintain records and provide reports to the SEC. These may include:

·              records and reports regarding private funds advised as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk;

·              a description of the amount of assets under management for each private fund advised and use of leverage, including off-balance sheet leverage;

·              counterparty credit risk exposure;

·              trading and investment positions;

·              valuation policies and practices of the fund;

·              type of assets held;

·              side arrangements or side letters providing certain investors more favorable rights or entitlements;

·              trading practices; and

·              such other information as the SEC determines to be necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisors, based on type or size of private fund being advised.

 

The registered advisor must maintain records prescribed by the SEC and make them available to the SEC. All such records will be subject to periodic and special inspection by the SEC. The advisor must also file reports with the SEC containing such information as the SEC may prescribe by rule. Rules must be promulgated within 12 months after the date of enactment of the Act regarding the form and content of the reports required to be filed with the SEC.

 

All such reports, documents, records and information filed with or provided to the SEC shall be made available to the Financial Stability Oversight Council (Council) as considered necessary by the Council for the purpose of assessing systemic risk posed by a private fund. Both the SEC and the Council are generally required to maintain all information received from a private fund in confidence, subject to certain exceptions for information requested by Congress under an agreement of confidentiality, information requested in a court order by a federal court in an action brought by the United States or the SEC, or a request from any other federal department or agency requesting information for purposes within the scope of its jurisdiction. Such department or agencies are required to maintain the confidentiality of the information to the same extent as the SEC.

 

3.                  Volcker Rule.

 

Section 619(c) of the Act prohibits insured depository institutions, companies that directly or individually control insured depository institutions or bank holding companies (or any of their respective subsidiaries) from sponsoring or investing in hedge funds or private equity funds. There are exemptions for, among other things, investments in small business investment companies and for investments designed primarily to promote the public welfare. Any such company that takes or retains an ownership interest in or sponsors a private equity fund will be subject to additional capital requirements and additional quantitative limits with regard to such ownership or sponsorship.

 

The term "sponsoring" in this context means:

·              serving as a general partner, managing member or trustee of the fund;

·              in any manner directly or indirectly selecting or controlling a majority of the directors, trustees or management of the fund; or

·              sharing with the fund, for corporate, marketing, promotional or other purposes, the same name or a variation of the same name.

 

There is also an exemption for a banking entity organizing and offering a private equity 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 certain conditions are met, including that, within one year after establishment of the fund, the investment be reduced to no more than three percent of the total ownership interests of the fund. The investment must also be immaterial to the banking entity, but in no case may the aggregate of all the interests of the banking entity in all such funds exceed three percent of the Tier 1 capital of the banking entity. Additional rulemaking will occur in order to ensure compliance with these rules.

 

A banking entity that serves, directly or indirectly, as the investment manager, investment advisor or sponsor to a private equity fund, or any of their respective affiliates, may not enter into a transaction with the fund, or any other fund controlled by such fund, that would be a covered transaction under Section 23A of the Federal Reserve Act as if such banking entity were a member bank and the private equity fund were an affiliate thereof. However, a banking entity may enter into a prime brokerage transaction with a private equity fund in which a private equity fund managed, sponsored or advised by such banking entity has taken an ownership interest if certain conditions are met.

 

Within six months after the date of enactment of the Act, the Council is required to complete a study regarding the foregoing rules. Within nine months after completion of such study, final regulations will be promulgated implementing these rules. Within two years after such final regulations are implemented, entities prohibited from holding investments under these rules must dispose of any such investments. That time period may be subject to extension upon application by the applicable company.

 

For further information, or to discuss the implications of these provisions, please contact Stephen Hackman or John Thornburgh of Ice Miller's Business Group.

 

Aug. 9, 2010

 

This publication is intended for general information purposes only and does not and is not intended to constitute legal advice.  The reader must consult with legal counsel to determine how laws or decisions discussed herein apply to the reader's specific circumstances.