To avoid serious legal consequences, every hedge fund manager needs to know whether their fund management company qualifies as an investment adviser according to the Investment Advisers Act (IAA) or the rules thereunder.

If the hedge fund will only invest in commodities (including digital currency commodities such as Bitcoin) and/or other assets which are not securities, then the hedge fund manager is not an investment adviser and can ignore the Investment Advisers Act and most likely also the Investment Company Act (although they may still be subject to the Commodities Exchange Act and may need to register with the CFTC as a commodity pool operator and/or a commodity trading advisor).

However, if the fund will invest any of its capital into securities (including any digital currencies or assets which are deemed securities), then the fund manager will qualify as an investment adviser under the IAA. In that situation, the manager must legally operate in one of three roles: (1) an SEC registered investment adviser, (2) an SEC exempt reporting adviser, or (3) an exempt non-reporting investment adviser.

Three Categories of Investment Advisers

The first category (registered investment adviser or “RIA”) is the most difficult and expensive route. It requires credentials, a lot of paperwork and filings with the SEC, fees, strict record-keeping, audits, and compliance with various rules around how you can structure your fund management contracts, how you can advertise, etc. If you’re just getting into the hedge fund business, then you almost certainly can avoid this option and go for category (2) or (3) listed before. Consequently, this article will heavily focus on what it takes to qualify for and maintain compliance within those latter categories, and we will not go into much detail on the requirements for RIAs.

The second category (exempt reporting adviser or “ERA”) is somewhat deceptively named for those not already steeped in the jargon of securities law. As an exempt reporting adviser, you still need to make certain initial and periodic filings with the SEC and you need to create an account on the SEC’s IARD system. That sounds like “registration” to most English speakers, but for purposes of the Investment Advisers Act, it isn’t. The main differences between a registered investment adviser and an exempt reporting adviser are (1) once initial filings are submitted to IARD, they are automatically deemed accepted for an exempt reporting adviser whereas a registered investment adviser must wait for an “effective order”, (2) the initial and ongoing filing requirements for exempt reporting advisers are shorter and less regulated than those of RIAs, and (3) the IAA binds RIA’s to operate their business according to lots of specific rules which don’t all apply to exempt reporting advisers (more on this to come). It is important to note that ERAs must still comply with certain record-keeping requirements and that the SEC does have the authority to audit these records, although typically the SEC only does this for cause.

The third category (exempt non-reporting adviser) is usually the most desirable category for fund managers as it typically comes with the smallest compliance burden. These investment advisers must qualify for one of the exemptions listed in 80b-3(b) or 80b-3a(a) of Title 15 of the U.S. Code. We’ll cover exactly what those exemptions are later in the article.

Note: This article only covers the Investment Advisers Act and the SEC regulations promulgated thereunder. However, individual states often have their own laws for investment advisers which may or may not be preempted by the federal law of the Investment Advisers Act. Further complicating the situation is the fact that states may use slightly different definitions of “investment adviser”, so it’s important to know what the situation is for your state and any states you have investors in.

Also, it is important to remember that many terms have different definitions even in different parts of federal law (e.g. “security” has a very different meaning in the tax rules regarding wash sale trading than it does in the Investment Advisers Act). Any definitions provided in this article should only be interpreted as relevant to the Investment Advisers Act and no other section of law unless explicitly stated.

Finally, throughout this article, the term “person” means either an individual (often called a “natural person”) or a company.

Investment Adviser Registration & Exemptions

The first and most important determination for a fund manager to make under the IAA is whether or not they must register with the SEC as an investment adviser. Investment adviser registration is described in section 203 of the Act (codified as section 80b-3 of U.S.C. title 15), and the exemptions from registration are broken up across that section as well as section 203A.

The IAA essentially starts from the position that any investment adviser must register, and then the IAA works backwards by exempting various types of advisers from the registration requirement. The following is a list of types of investment advisers that are exempted from the need to register with the SEC (some exemptions are not listed since they are unlikely to apply to fund managers of any type):

• (Per section (b)(1) of 80b-3) Any investment adviser, other than an investment adviser who acts as an investment adviser to any private fund, all of whose clients are residents of the state within which such investment adviser maintains his or her principal office and place of business, and who does not furnish advice or issue analyses or reports with respect to securities listed or admitted to unlisted trading privileges on any national securities exchange
• (Per section (b)(2) of 80b-3) Any investment adviser whose only clients are insurance companies
• (Per section (b)(3) of 80b-3) Any investment adviser that is a foreign private adviser
• (Per section (b)(6)(A) of 80b-3) Any investment adviser that is registered with the CFTC as a commodity trading advisor whose business does not consist primarily of acting as an investment adviser and that does not act as an investment adviser to (1) a registered investment company or (2) a company that has elected to be a business development company pursuant to section 80a-53 of the Investment Company Act and has not withdrawn its election
• (Per section (b)(6)(B) of 80b-3) Any investment adviser that is registered with the CFTC as a commodity trading advisor and advises a private fund, provide that, if after July 21, 2010, the business of the advisor should become predominately the provision of securities-related advice, then such adviser shall register with the SEC
• (Per section (l)(1) of 80b-3) “Exempt reporting advisers to VC funds”. Any investment adviser that acts as an investment adviser solely to 1 or more venture capital funds (as defined here).
• (Per section (m)(1) of 80b-3) “Exempt reporting advisers to AUM-limited private funds”. Any investment adviser that only acts as investment adviser to private funds and that has assets under management in the United States of less than $150 million. However, investment advisers taking advantage of this exemption must still comply with the record-keeping and reporting requirements authorized by section (m)(2).
• (Per section (a)(1) of 80b-3a) “Small advisers”. Any investment adviser that is regulated or required to be regulated as an investment adviser in the state in which it maintains its principal office and place of business, unless the investment adviser (A) has assets under management of at least $25 million, or such higher amount as the SEC by by rule deem appropriate, or (B) is an investment adviser to a registered investment company
• (Per section (a)(2) of 80b-3a) “Mid-size investment advisers”. Any investment adviser that (1) is not an investment advisor to any registered investment company or company which has elected to be a business development company pursuant to section 54 of the Investment Company Act, (2) is required to be registered as an investment adviser with the securities commissioner (or any agency or office performing like functions) of the state in which it maintains its principal office and place of business, and that, if registered, would be subject to examination as an investment adviser by any such commissioner, agency, or office, and (3) has assets under management between $25 million (Or the higher number specified by the SEC in accordance with section (a)(1)) and $100 million (or such higher numer as the SEC may deem appropriate). However, if by effect of this paragraph, an investment adviser would be required to register with 15 or more states, then the adviser may register with the SEC under the Investment Advisers Act.

For U.S.-based private fund managers, the most useful exemptions are typically (1) The registered commodity trading advisor exemptions in 80b-3(b)(6)(A) and (B), (2) the capped private fund exemption in 80b-3(m)(1), (3) the state-regulated small advisor exemption in 80b-3a(a)(1), and (4) the state-registered mid-sized advisor exemption in 80b-3a(a)(2).

SEC Exempt Reporting Advisers

If you are a fund manager taking advantage of either the 203(l) (i.e. 80b-3(l)(1) for venture capital fund advisers) or 203(m) (i.e. 80b-3(m)(1) for private fund advisers with under $150 million in AUM) exemptions previously mentioned, then you must comply with the reporting requirements specified in 17 CFR 275.204-4. These types of investment advisers are known as “SEC Exempt Reporting Advisers” (ERAs) rather than “SEC Registered Investment Advisers” (RIAs).

ERA Reporting Requirements

Exempt reporting advisers must submit an abbreviated form ADV but are not required to prepare or deliver a brochure to clients. After the initial form has been submitted through the IARD system, exempt reporting advisers must update the form at least once a year within 90 days of the firm’s fiscal year end (and more frequently in certain circumstances based on material developments, in accordance with the form ADV instructions).

ERA Record-Keeping Requirements

The SEC is authorized to require exempt reporting advisers to maintain certain books and records. There is slight ambiguity as to what exactly those requirements are, but the conservative answer is that exempt reporting advisers should maintain all records described in rule 204-2.

Exempt Non-Reporting Advisers

If you operate your hedge fund in a way that you do qualify as an investment adviser under the IAA but you fall under one of the exemptions listed in 80b-3(b) or 80b-3a(a), then you are not required to either register or perform the reportings that ERAs have to do. You must still comply with the anti-fraud provisions of the IAA, but those requirements don’t impose the same type of burden that registration or reporting do. Additionally, you may or may not need to register and comply with various state-imposed record-keeping and reporting requirements, but those topics will not be covered in this article.

National De Minimis Standard

Having now covered the three categories of investment advisers under the IAA, I will turn to another issue which is that of federal preemption of state law. A priori, it is possible that an investment adviser may be regulated by different rules in every single state in which the adviser operates or has a client or even an investor to a private fund. That could impose an enormous compliance burden which would have the effect of stifling small businesses acting as investment advisers. The authors of the IAA thought of this, and they included in the IAA a provision, the “national de minimis standard”, to reduce the amount of multi-jurisdiction regulation that an investment adviser must comply with.

Essentially, the IAA provides a uniform standard for the amount of business that an investment adviser must be conducting in a state before that state is allowed to require registration of the investment adviser. The law (section 222(d) of the Act, or equivalently, 15 U.S.C. 80b-18a(d)) is as follows:

No law of any state or political subdivision thereof requiring the registration, licensing, or qualification as an investment adviser shall require an investment adviser to register with the securities commissioner of the state (or any agency or officer performing like functions) or to comply with such law (other than any provision thereof prohibiting fraudulent conduct) if the investment adviser satisfies the following two conditions:

• The investment adviser does not have a place of business located within the state
• During the preceding 12 month period, the investment adviser has had fewer than 6 clients who are residents of that state

Investment Adviser vs Investment Adviser Representative

One common confusion for people new to securities law is confusion as to what the difference is between an “investment adviser” and an “investment adviser representative” and whether an investment adviser is always a company or whether a person employed by an investment adviser company is also an investment adviser. I’ll do my best to answer those questions here.

Per the definition of investment adviser and the definition of company, an investment adviser can be any of the following:

• An individual human
• A corporation
• A partnership
• An association
• A joint-stock company
• A trust
• Any organized group of persons (whether incorporated or not)
• Any receiver, trustee in a case under title 11 (bankruptcy), or similar official
• Any liquidating agent for any of the foregoing, in his capacity as such

However, in the realistic situation where you operate all investment adviser services through an official business entity (you should never do anything else for liability reasons), then the business entity is the investment adviser, and the individuals owning or working for the investment adviser are not. In that situation, the individuals controlling or working for the investment adviser may be classified as “investment adviser representatives” (IARs) though. As a rough rule of thumb, unless the employee of the investment adviser is doing secretarial or other work that has no influence on investment decisions, then the employee is an investment adviser representative for the investment adviser company. You can find a more precise definition of investment adviser representative in the glossary at the end of this article.

Normally, investment adviser representatives are individual humans. However, the legal definition (the same definition as in the glossary) of IAR leaves open the possibility of convoluted scenarios where you may have one company providing the investment advice on behalf of another controlling company, and in such scenarios, one company could be deemed an IAR of the other. As a startup hedge fund, you almost certainly won’t have such a scenario so you can consider your company that manages the fund as the investment adviser and the key employees of the company as the investment adviser representatives.

Investment adviser representatives of RIAs or ERAs may have to be listed on parts of the reports or registrations submitted to the SEC, but they will not themselves be required to register as individuals with the SEC. However, IARs of any investment adviser (including RIAs, ERAs, and exempt non-reporting advisers) may need to be licensed, registered, and/or regulated by state laws and regulations. Be sure to check the specific laws and regulations regarding investment advisers and their representatives in every state in which your business either has a client, investor, employee, or place of business.

Glossary: Key Investment Advisers Act Definitions

This next section is intended as a reference guide where you can find the definitions of various important terms mentioned in the Investment Advisers Act. Don’t feel you need to read the entire section at once.

What is a “client”?

For purposes of the Investment Advisers Act, a private fund is a single “client” of the fund manager acting as investment adviser, regardless of how many investors the fund has. This can be very useful to fund managers, and the Act specifically guarantees that the SEC cannot reinterpret this definition (see section (a) of 15 U.S.C. 80b-11).

For example, if a fund manager advises a single fund that has 85 investors, then that fund manager is an investment adviser with a single client for purposes of the Act.

NOTE: It’s useful to draw a comparison here to the Commodities Exchange Act since the two most common regulated classifications for a hedge fund manager are “investment adviser” as well as “commodity pool operator”. The definition of “client” under the IAA is critical to some of the SEC-registration & state-regulation exemptions available to investment advisers. Analogously, the Commodities Exchange Act uses the term “participant” to define somewhat similar registration exemptions for commodity pool operators, but do not be fooled. The exemptions are actually critically different with regard to hedge funds. As pointed out above, a fund with 85 investors would be a single “client” for IAA purposes and might qualify for many exemptions, but the same fund would have 85 “participants” for purposes of the Commodities Exchange Act, and as such, the fund manager would not qualify for certain commodity pool operator exemptions that cap out at 15 “participants”.

What is a “security”?

According to the Investment Advisers Act, “security” essentially means any type of stock, certificate of indebtedness, interest in a profit-sharing arrangement, investment contract, security future, fractional interest in oil, gas, or mineral rights, an option, straddle, or privilege on any security or group or index of securities or which relates to foreign currency and is entered into on a national securities exchange, any certificate of deposit of a security, any transferrable share, or any type of receipt, guaranty, warrant, or right to subscribe to or purchase any security, or any instrument commonly known as a “security”.

What is an “affiliated person”?

In both the Investment Company Act and Investment Advisers Act, a person Y is an “affiliated person” of another person X if any of the following are true:

• Y directly or indirectly owns, controls, or holds with power to vote, 5% or more of the outstanding voting securities of X (or vice versa with the roles of X and Y reversed)
• X is directly or indirectly controlling, controlled by, or under common control with Y (note: this is symmetric in X and Y)
• Y is any officer, director, partner, copartner, or employee of X
• X is an investment company, and Y is any investment adviser of X, OR Y is any member of an advisory board of X
• X is an unincorporated investment company not having a board of directors, and Y is the depositor of X

For purposes of the definitions above, an “advisory board” means a board, whether elected or appointed, which is distinct from the board of directors or board of trustees, of an investment company, and which is composed solely of persons who do not serve such investment company in any other capacity, whether or not the functions of such board are such as to render its members “directors” within the definition of that term, which board has advisory functions as to investments but has no power to determine that any security or other investment shall be purchased or sold by the investment company.

What is an “affiliated company”?

A person Y is an affiliated company of a person X if Y is both (1) a company and (2) an affiliated person of X.

Persons associated with an investment adviser

Within the Investment Advisers Act, the term “person associated with an investment adviser” means any partner, officer, or director of such investment adviser (or any person performing similar functions), or any person directly or indirectly controlling or controlled by such investment adviser, including any employee of such investment adviser (except that for the purposes of 15 U.S.C. 80b-3–the section of the Investment Advisers Act regarding registration of investment advisers–other than subsection (f) thereof, persons associated with an investment adviser whose functions are clerical or ministerial shall not be included in the meaning of such term).

The SEC may by rules and regulations classify, for the purposes of any portion or portions of the Investment Advisers Act, persons, including employees controlled by an investment adviser.

What is a “supervised person”?

The Act defines a “supervised person” as

• any partner, director (or other person occupying a similar status or performing similar functions), or employee (including an independent contractor who performs investment advisory services on behalf) of an investment adviser, OR
• any other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser

What is an “investment adviser representative”?

According to this SEC rule, an “investment adviser representative” (IAR) of an investment adviser company is any of the company’s supervised persons who meets all four of the following criteria:

• The supervised person does NOT only provide impersonal investment advice (impersonal investment advice consists of investment advisory services that do not purport to meet the objectives or needs of specific individuals or accounts)
• The supervised person regularly solicits, meets with, or otherwise communicates with the company’s clients
• The supervised person has more than five clients who are natural persons and not hight net worth individuals (where “high net worth individual” means an individual who is a “qualified client” under rule 205-3 of the IAA or a “qualified purchaser” as defined in section 2(a)(51)(A) of the Investment Company Act)
• More than 10% of the supervised person’s clients are natural persons and not high net worth individuals

NOTE: If the investment advisor (i.e. the company) is registered with a state securities authority rather than the SEC, then the company may be subject to a different state definition of “investment adviser representative”. Investment adviser representatives of SEC-registered advisers may be required to register in each state in which they have a place of business

What is a “dealer”?

Section 3 of the Securities Exchange Act of 1934 defines a “dealer” in the following way.

In general, the term “dealer” means any person engaged in the business of buying and selling securities (not including security-based swaps, other than security-based swaps with or for persons that are not eligible contract participants) for such person’s own account through a broker or otherwise.

However, the term excludes any person that buys or sells securities (with the same caveat as above for security-based swaps) for such person’s own account, either individually or in a fiduciary capacity, but does not do so as part of a regular business. Also excluded from the definition are banks engaged in certain banking activities.

The Investment Advisers Act uses the same definition but with two very important modifications: insurance companies and investment companies are excluded from the definition of “dealer“.

What is an “investment adviser”?

Investment adviser means any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. However, the following persons are explicitly excepted from the definition:

• A bank or bank holding company which is not an investment company and which does not serve as an investment adviser to any registered investment company
• Any lawyer, accountant, engineer, or teacher whose performance of the previously described investment advisory services is solely incidental to the practice of his/her profession
• Any broker or dealer whose performance of such services is soley incidental to the conduct of his business as a broker or dealer and who receives no special compensation therefor
• The publisher of any bona fide newspaper, news magazine, or business or financial publication of general and regular circulation
• Any person whose advice, analyses or reports relate to no securities other than securities which are direct obligations of or obligations guaranteed as to principal or interest by the United States, or securities issued or guaranteed by corporations in which the United States has a direct or indirect interest which shall have been designated by the Secretary of the Treasury, pursuant to section 3(a)(12) of the Securities Exchange Act of 1934, as exempted securities for the purposes of that Act
• Any nationally recognized statistical rating organization, as that term is defined in section 3(a)(62) of the Securities Exchange Act of 1934, unless such organization engages in issuing recommendations as to purchasing, selling, or holding securities or in managing assets, consisting in whole or in part of securities, on behalf of others
• Any family office, as defined by rule, regulation, or order of the SEC, in accordance with the purposes of the Investment Advisers Act of 1940 (the SEC has defined “family office” here)
• Such other persons not within the intent of the IAA, as the SEC may designate by rules, regulations, or orders

What are “investment supervisory services”?

Investment supervisory services mean the giving of continuous advice as to the investment of funds on the basis of the individual needs of each client.

What is a “place of business”?

As the term is used in the Investment Advisers Act (which is NOT the same as everywhere else in law that the term is used), a “place of business” of an investment adviser is (1) an office at which the investment adviser regularly provides investment advisory services or solicits, meets with, or otherwise communicates with clients or (2) any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.

What is a “principal office and place of business”?

The term “principal office and place of business” of an investment adviser means the executive office of the investment adviser from which the officers, partners, or managers of the investment adviser direct, control, and coordinate the activities of the investment adviser.

What is a “private fund”?

A private fund is an issuer that would be an investment company, as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3), but for section 3(c)(1) or 3(c)(7).

Section 3(c)(1) provides an exception from the definition of investment company for companies with 100 or fewer beneficial owners (or 250 persons for a qualifying venture capital fund) and which does not plan to make a public offering of securities. If “public offering” is interpreted in the same sense as in section 4(a)(2) of the Securities Act of 1933, then a fund that raises money from investors under rule 506(c) of the Securities Act would not be engaged in a public offering and therefore should still qualify as a private fund for purposes of the IAA. That may be important to a hedge fund that trades commodities in addition to securities because one of the commodity pool operator registration exemptions requires that pool participations be sold under rule 506(c).

Section 3(c)(7) provides an exception from the definition of investment companies for companies whose securities are only issued by qualified purchasers (there are some additional details). The most common types of qualified purchasers are (1) individuals or family-owned businesses or trusts with at least $5 million in investments or (2) any legal entity with at least $25 million in investments.

Disclaimer: This article does not constitute legal, accounting, or investment advice.