Dodd-Frank Act Is it really significant?

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Dodd-Frank Act – Is it really significant?

Impact of US Regulation on Foreign Investment

Managers and Funds

May 2011


With as many as 11 federal regulatory agencies required to write nearly 250 new rules

during the next year or more, the Dodd-Frank Act

will continue to present challenges for financial

services firms.


The far-reaching implications of the Dodd-Frank Act on US financial services organisations, has been widely discussed.

Clearly these rules are having a direct impact on US firms, but could also mean big changes for foreign firms. With up to 386 rules required to be enacted by the various regulatory agencies, and the rule making falling behind 2011 targets for completion, firms with any business interest in the US are facing a period of significant change and uncertainty. Foreign funds and investment managers will have to reassess how they run their businesses interests, but ultimately the impact of Dodd-Frank has to be assessed in the wider context of global regulatory initiatives, and the specific rules of each jurisdiction firms operate in.

The new rules under Dodd-Frank are in various stages of drafting and adoption, but a number are already having a big impact on the investment management and funds industry. Many investment managers will be required to register as investment advisers with the SEC (Securities and Exchange Commission), by 21 July 2011. However, the SEC has informally communicated that the deadline for registration will be

extended until the first quarter of 2012.

Proposed regulations to provide additional oversight of market participants and the activities of investment advisers will affect those who trade in OTC derivatives. Executive compensation is an ongoing area of debate. Though rules under Dodd-Frank are less severe than those proposed in the EU, they will still drive increased transparency and more restrictive pay practices. Finally the volcker Rule opens business and recruitment opportunities for the industry, but the price of these is likely to mean increased regulatory scrutiny. This update explores the implications these rules will have for foreign investment and fund managers and what is to come.

Dodd-Frank Act – Is it really significant? | May 2011

Investment Adviser Registration

Many investment managers, particularly larger ones, operating in the US are now required to register with the SEC. This is a major change for many managers who have taken advantage of certain registration exemptions in the past.

All foreign investment managers fall into one of two groups:

A. Previously Registered: Those who are already registered with the SEC.

These SEC Registered Investment Advisers (RIAs) can remain registered and will be impacted by other

emerging rules around executive compensation, OTC derivatives, and others as a result of Dodd-Frank Act requirements.

B. Never Registered: Those who were never registered, but had US clients or US investors, and were previously exempt under the Investment Advisers Act of 1940.

For Group B, the ‘Private Adviser Exemption’, previously widely used, has been removed under the Dodd- Frank Act. The two newly adopted exemptions for non-US advisers are either nearly impossible to meet or will still result in some degree of SEC reporting requirement. While technical, these exemptions are important so we set them out in the box.

The impact on Group A…

Previously registered foreign investment managers will not be impacted by this particular provision of Dodd-Frank, but emerging rules around executive compensation, OTC derivatives, and others which are more broadly applicable to financial institutions could have a large impact.

It is anticipated the US SEC will issue the final rules for investment manager registration in advance of 21 July 2012 (the stated deadline for initial

registration). However, given registration documents must be submitted no later than 45 days prior to this deadline, and the time needed to become fully compliant with the obligations, the SEC now expects to extend the registration deadline to the first quarter of 2012.

New proposed exemptions:

• ‘Private Fund Adviser Exemption’:

A possible exemption for advisers to solely private funds and with less than US$150 million in private fund assets under management in the US. This includes a provision that only assets which are managed from a place of business within the US count towards the US$150 million threshold. Exemption is not available to any adviser that manages any separate accounts for a US client.

• ‘‘Foreign Private Adviser

Exemption’: A possible exemption for foreign advisers who meet ALL the following criteria:

1. No place of business in the US;

2. Has fewer than 15 US advisory clients and US investors in private funds advised by the investment adviser;

3. Has less than US$25 million Assets under Management (AUM) attributable to US clients and US investors in private funds advised; and

4. Does not present itself as an

investment adviser to the

US public or advise a US

registered fund.


Significant impact on Group B…

Many foreign investment managers are likely to be caught by US registration rules because their business cannot meet the criteria for the more limited new exemptions. The new exemptions require that an adviser either:

1. Under the Private Fund Manager Exemption, advise assets exclusively through private funds and meet certain Assets under Management (AUM) thresholds; or

2. Under the Foreign Private Adviser Exemption, have fewer than 15 US investors, less than US$25million in AUM from US investors, and have no place of business in the US.

As an investment adviser, registration with the US SEC will bring significant levels of work around building and implementing a compliance program and code of ethics, maintenance of extensive books and records, reporting requirements to the SEC, and hiring or designating a chief compliance officer.

Another significant challenge to becoming a US RIA is the applicability of the US Custody Rule. For foreign firms that have been registered with the SEC before, the registration process will be familiar.

Understanding whether it applies to your organisation and whether its requirements result in the need for a surprise examination of securities held, or even more costly, an Internal Controls Report, is critical. If you are subject to the Custody Rule, it is important that your external auditors are registered with and subject to regular inspection by the Public Company Accounting Oversight Board (PCAOB). They must also be compliant with US SEC Independence rules, which are much more restrictive than Accounting Principles Board (APB) rules. In addition, the financial statements of the underlying funds will likely need to be completed in US Generally Accepted Accounting Principles (US GAAP) and auditing standards. All of these considerations could result in a change in accounting or

tax provider and additional pre-approval requirements by the Board.

Any foreign investment manager meeting the exemption criteria under the Private Fund Manager Exemption will be considered exempt but will still need to comply with some SEC requirements albeit significantly less onerous than those of a RIA. These requirements are expected to include shortened form ADv reporting, recordkeeping requirements, and potential SEC examination, but will not include the applicability of the US Custody Rule.

OTC Derivatives

The Commodity Futures Trading Commission (CFTC) and the SEC have proposed regulations to provide additional oversight of market participants and the activities of investment advisers. The proposals would eliminate a registration exemption for commodity pool operators (CPOs


), which include a person that sponsors, solicits participation in, or operates a collective investment vehicle which trades exchange-traded future contracts, options thereon, or commodity options, swaps or other OTC derivatives, or other such commodity interests. This registration exemption was commonly used by sponsors of private investment funds, including hedge funds. The proposals would require CPOs to file new reports on their commodity trading activities. The proposed rules would only allow exemption from registration as a CPO with respect to a pool if interests in the pool are exempt from registration under US Securities Act of 1933 and are not marketed to the public in the US, among other requirements.

How are those trading in OTC derivatives impacted?

While the largest and most immediate impact will be on the dealers of these derivatives, any end user on the buy-side (e.g. pension funds and investment

managers) will also be impacted. Under the proposed rules, the OTC derivatives dealers may be forced to comply with daily tracking and monitoring requirements plus data collection and timely reporting of all transactions including those exempt from the mandatory clearing requirements.

In addition, they will face operational changes, including additional booking procedures, enhanced and more costly collateral management. All of the new requirements for dealers are expected to impact the processing, pricing, and availability of OTC derivatives which in turn will directly impact trading and thus have an effect on all buy-side market participants. Ultimately, under new regulations the use of OTC derivatives could become more costly and more laborious to execute than ever before.

How does this match up with EU regulations from the European Market Infrastructure Regulation (EMIR)? The EU and US have explicitly stated an intention to follow similar paths around OTC derivatives. Currently the US scope combines that of EMIR which proposes moving trades to Central Counterparties (CCPs) and mandates extended transaction reporting, with the trading platform transparency and conduct proposals covered in MiFID 2.

After the initial flurry defining policy framework, practical implementation.

Progress in both the EU and the US has slowed, noticeably; many market participants expect the US to act ahead of the EU which could impa ct decisions on which jurisdiction you should pursue trading and hedging activities.



Compensation has been a widely discussed issue in the media over the last 12 months, with much speculation around the balance between risk and reward. The EU has been quite prescriptive in its new requirements, whereas the US rules are more generalised focusing on personal liability. A proposed rule on incentive- based compensation arrangements would prohibit financial institutions with more than US$1billion in assets from adopting compensation programs that would expose them to inappropriate risk or material financial loss.

The largest and most immediate impact will be on the dealers of these derivatives, any end user on the buy-side e.g. pension funds and investment managers will also be impacted.

Dodd-Frank Act – Is it really significant? | May 2011


A significant impact…

The rules would apply to registered broker-dealers, RIAs, and insured US branches of foreign banks (as well as all US financial institutions). Incentive- based compensation will mean any variable compensation that serves as an incentive for performance and is paid to executive officers, directors, principal shareholders, or any individuals or groups whose activities may expose the financial institutions to a material financial loss (e.g. traders). The rule requires risks and financial rewards to be balanced but does not include specific provisions on how to achieve this balance, except for larger financial institutions (over US$50 billion in assets) who must defer payment of at least 50 percent of executive officers’

incentive-based compensation for at least three years.

Under the Financial Stability Board’s (FSB) Principles for Sound Compensation Practices and amendments to the Capital Requirements Directive, the EU is also addressing the issue of compensation. The concept is the same as in the US; to balance risk and reward, but the EU rules are more narrowly defined and restrictive, including specific rules on salary compensation, variable components of shares and cash, and deferral conditions. A similar set of firms will be affected (asset managers, brokers, and other financial institutions) and the definition of variable compensation is broadly the

same, impacting similar employees.

However, it is clear that there is a mis-match between the US and EU executive compensation rules which will result in some firms having to apply both sets of standards. Fund managers that face the European Alternative Investment Fund Managers Directive (AIFMD) will also be faced by stricter remuneration requirements as of 2013 when the Directive comes into force.

Volcker Rule

From April 2011, the volcker Rule provisions came into effect. These prohibit US banking entities from engaging in proprietary trading of certain financial instruments, and from investing in or sponsoring hedge funds or private equity funds within very limited parameters. The immediate impact on foreign investment managers and funds is likely to be significant.

What does this mean for foreign markets?

US banking entities will have two years to bring their activities into compliance under the volcker Rule, however the impact on the global investment management and funds industry is immediate. Banks are seeking to dispose of their proprietary trading desks and industry players in order to identify market opportunities. This could widen the talent pool available to investment managers – but at what cost and increased regulatory scrutiny?

What’s Next?

With as many as 11 federal regulatory agencies required to write nearly 250 new rules during the next year or more, the Dodd-Frank Act will continue to present challenges for financial services firms. Although the current focus for investment managers and funds is on investment adviser registration, the regulation of OTC derivatives, and executive compensation, other rules are being developed to address the concern over systemic risk and consumer protection. As new rules are released, it is critical that those in the foreign investment management and funds industry monitor and assess the impact for their business, and consider these alongside other key regulatory change initiatives to develop a coherent strategic and operational response.

1. In practice, a CPO is usually the general partner of a limited partnership, the managing member of a limited partnership, the managing member of a limited liability company, the directors of a corporation, the trustees of a trust, or the investment adviser of a non-US company.


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Dodd-Frank Act – Is it really significant?

Impact of US Regulation on Foreign Investment

Managers and Funds May 2011

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Publication name: Dodd-Frank Act – Is it really significant?

Publication number: 314670 Publication date: May 2011





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