Exempt Reporting Advisers: Registration With the SEC or With the State?

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Sep 27, 2022 9:53:06 AM | Assure

Investment fund organizers acting as investment advisers are subject to registration with the appropriate regulatory authority. The determination of which regulatory authority the adviser is subject to is based on an analysis of Assets Under Management (“AUM”) and comparison to three registration thresholds detailed below.

Investment Adviser Registration Analysis

An Investment Adviser seeking to be an ERA is generally required to register with a regulatory authority in one of two ways:

(1) SEC and notice file applicable state securities regulator(s);

(2) State security regulator(s).

The determination of where an investment adviser is primarily regulated is based on a calculation of the adviser's total regulatory AUM and a comparison to the applicable thresholds for registration.

Calculating Regulatory Assets Under Management

Security-01The SEC defines regulatory AUM as “securities portfolios for which you provide continuous and regular supervisory or management services as of the date of filing.” An account is a security portfolio “if at least 50% of the total value of the account consists of securities.” The SEC indicates that all assets of a private fund are treated as securities, including any uncalled capital commitments. However, an investment adviser is only required to include the value of the portion of securities portfolio that it provides advisory services to. An investment adviser is considered to “provide continuous and regular supervisory or management services” if:

(1) the advisor has discretionary authority over the account and provides ongoing supervisory or management services with respect to the account; or

(2) the advisor does not have discretionary authority over the account but has an ongoing responsibility to select or make recommendations, based upon the needs of the client, as to specific securities or other investments the account may purchase or sell and, if such recommendations are accepted by the client, is responsible for arranging or effecting the purchase or sale.

These two standards are met if the adviser provides advice and is responsible for effecting securities transactions on behalf of the client either with full discretion or consent.

Additional factors to consider are the terms of the advisory contract and related advisory management practices of the organizer in its role as an adviser to a fund. Organizers typically sign an advisory agreement specifying their obligation to provide on-going discretionary investment advice to their funds. Actions organizers often perform in this capacity include, sourcing investment opportunities, executing transactions on a discretionary basis, and providing regular voting decisions with respect to shareholder corporate action requests, asset conversions, follow-on financings, distributions, and liquidation events. Once the adviser determines the portfolio of securities it has discretionary authority over then it must determine the valuation method it will use to calculate its portfolio AUM.

Fair Market or Fair Value

The SEC provides that the value of an adviser's regulatory AUM is “based on the current market value of the assets as determined within 90 days” of the adviser’s registration. For private funds, an organizer must use the “current market value (or fair value) of the private fund’s assets and the contractual amount of any uncalled commitments” of those funds. The value of the advisers AUM may be calculated under a fair market or fair value standard. As such organizers should take into consideration the differences in calculating the value of their AUM under each standard as they are required to report those values consistently.

Fair Market Value

In Revenue Ruling 59-60 the Internal Revenue Service defines fair market value as “the price at which the property would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, both parties having reasonable knowledge of relevant facts.” Fair market valuation for securities is essentially the expected price of the security considering the following eight factors:
(1) Nature of the business and the history of the company;
(2) General economic outlook and specific industry outlook;
(3) The book value of the interest and the financial condition of the company;
(4) The company’s earning capacity;
(5) The company’s dividend-paying capacity;
(6) Company Goodwill and other intangible value;
(7) Previous sales of the stock and size of stock to be valued;
(8) Market prices of comparable stocks.

The distinguishing feature of fair market valuation from other forms of valuation is the consideration of discounts for bringing the interest to market and the lack of control the seller has regarding minority interest holders.

Fair Value

GAAP-01Fair value is generally defined by state law and legal precedent for purposes of shareholder dispute resolution, as such the applicable definition may vary by state. Under the U.S. Generally Accepted Accounting Principles (“GAAP”) Standards No. 157 fair value is “the price that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date”. The major difference between fair market and fair value is the latter’s focus on a shareholder’s proportionate share of its interest without regard to market or control considerations. Specifically, fair value would generally not take into consideration market or control discounts.

Whichever method the organizer uses to determine the value of its securities portfolio, it should use the same valuation method to report values to clients and to calculate its advisory fees. Once the adviser has determined its AUM portfolio valuation then it can determine if it should register with the SEC or a state regulatory authority.

State and Federal Adviser Registration Thresholds

Section 203(a) of the Investment Advisers Act of 1940 (“Advisers Act”) provides several AUM thresholds for advisers to determine where they are required to register:

Small Advisers:
Section 203A (a)(1) of the Advisers Act prohibits any “adviser from registering with the SEC that is regulated or is required to be regulated in the state in which it maintains its principal office and place of business.” Small Adviser’s (advisers with less than $25M in AUM) are prohibited from registering with the SEC and must register with the state regulatory authority where their principal place of business is located. The only state that currently does not regulate Small Advisers is Wyoming (advisers with less than $25M in AUM operating out of Wyoming are required to register with the SEC).

Mid-Sized Advisers:
Section 203A (a)(2) of the Advisers Act prohibits a mid-sized adviser (advisers with between $25M and $100M in AUM) from registering with the SEC if the adviser is required to be registered as an adviser in the state where it conducts its advisory business. If the state does not require registration, then the adviser must register with the SEC (advisers with principal places of business in New York and Wyoming). Under Dodd-Frank, a mid-sized adviser may register with the SEC when it reaches $100M AUM and must do so when it reaches $110M AUM, and it is not required to deregister until it has less than $90M AUM (at which point it may need to register with the state authority).

Large Advisers:
OnboardInvestors-01Section 203(a) of the Advisers Act requires registration with the SEC for Large Advisers (firms with $100M or more in AUM). Section 203A (b) provides for preemption of state law regarding Large Advisers in most circumstances. However, Large Adviser ERA’s, as a condition of relying upon the exemption, are required to notice file the state regulator(s) where their principal place(s) of business are located.

An investment adviser does not need to register if it is excluded by statute (banks, publishers, lawyers, broker-dealers, governments, etc.) or qualifies for a specific exemption (de minimis exemption) other than those provided for ERAs. ERAs are still required to register with the applicable securities regulator but are given truncated filing requirements. A fund organizer acting as an investment adviser should calculate its AUM as part of the overall determination of which regulatory authority they must register with.

Why Should I Engage Assure for ERA Compliance Services?

ERA-01Assure provides expert assistance related to the set-up, management, and reporting associated with SEC and state ERA registration. Assure consults with client’s and provides services related to ERA registration, including IARD account set-up and maintenance, the filing of annual and other-than-annual amendments to Form ADV, and on-going advisory firm training and consulting. Assure’s ERA Compliance Service complements and supplements fund organizer’s special purpose vehicle administration and ensures compliance with applicable rules and regulations.