California Seeks Comments on Its Proposed Private Fund Adviser Exemption Rule

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1 January 24, 2012 Practice Groups: Investment Management Hedge Funds and Venture Funds California Seeks Comments on Its Proposed Private Fund Adviser Exemption Rule By J. Matthew Mangan and Yusef Alexandrine On December 21, 2011, the California Department of Corporations ( Department ) issued notice of a proposed rulemaking action to amend Rule of Title 10 of the California Code of Regulations ( Rule ) to provide for an exemption from the state investment adviser registration requirements for advisers that provide advice solely to certain private investment funds (the Proposed Exemption ). 1 If adopted, the Proposed Exemption would exempt many Californiabased investment advisers that solely advise eligible private funds from registration with the Department. The Department has requested comments on the Proposed Exemption by March 25, I. Background Many California-based private fund advisers rely on the current version of Rule for exemption from state registration. In its current form, Rule provides an exemption for any adviser that (i) has had fewer than 15 clients in the preceding 12 months, (ii) does not hold itself out to the public as an investment adviser, (iii) does not act as an investment adviser to a registered investment company or a company that has elected to be a business development company and (iv) either has assets under management ( AUM ) of $25 million or more or provides investment advice solely to one or more venture capital companies. 2 The current Rule exemption has been extended until April 17, 2012 by an emergency regulation. In addition, the Proposed Exemption contains a provision that would further extend the current exemption until June 27, II. California s Proposed Private Fund Adviser Exemption Rule The Proposed Exemption sets forth four basic requirements that an adviser would have to meet in order to claim exemption from California s registration requirements, and it also prescribes additional requirements for advisers to qualifying private funds that rely on the exclusion from the definition of an investment company contained in Section (3)(c)(1) of the Investment Company Act of 1940, as amended (the Investment Company Act ). A. Basic Requirements The four basic requirements for exemption under the Proposed Exemption are as follows: advisers must solely advise private funds ; 3 1 California Corporations Code Section requires investment advisers to apply for and secure from the Department a certificate authorizing the adviser to conduct business within the state, unless the adviser is eligible for an exemption. 2 For a description of venture capital companies, see Section II.C., infra. 3 Under Rule , private funds are generally defined as an issuer that would be an investment company as defined by Section 3 of the Investment Company Act, but for the exclusions contained in Sections 3(c)(1) or 3(c)(7) of the Investment Company Act.

2 advisers may not be subject to SEC or California disqualification; 4 advisers must file each report required to be filed by an exempt reporting adviser pursuant to Rule under the Investment Advisers Act of 1940, as amended (the Advisers Act ) (see Section IV below for a description of the Exempt Adviser Reporting Requirements); and advisers must pay the standard $125 California investment adviser registration and renewal fees for each year in which the exemption is sought. Notably, the Proposed Exemption does not include the $25 million in AUM minimum threshold or the 15 client limit contained in the current version of Rule B. Special Requirements for Advisers to 3(c)(1) Funds The Proposed Exemption sets forth additional requirements for advisers to qualifying private funds that rely on the exclusion from the definition of an investment company contained in Section (3)(c)(1) of the Investment Company Act ( 3(c)(1) Funds ) that are not venture capital companies. 5 Advisers to these 3(c)(1) Funds would be exempt from registration with the Department only if they adhered to the following requirements and restrictions: each investor in each 3(c)(1) Fund would be required to meet the accredited investor 6 standard at the time an investor purchases interests in a Fund; advisers would only be permitted to charge performance fees 7 to 3(c)(1) Fund investors that meet the higher qualified client standard; 8 advisers would be required to obtain, on an annual basis, audited financial statements for each 3(c)(1) Fund that is not a venture capital company; advisers would be required to annually distribute audited financial statements to investors in each 3(c)(1) Fund that is not a venture capital company; and at the time of purchase, advisers would be required to make the following written disclosures to investors in each 3(c)(1) Fund that is not a venture capital company ( 3(c)(1) Disclosures ): o all services to be provided to the investor; 4 SEC disqualification is described in Rule 262 of Regulation A under the Securities Act of 1933, as amended (the 1933 Act ). California disqualification is described in Sections (a) through (h) of the California Corporations Code. 5 For a description of a venture capital company, see Section II.C., infra. 6 The term accredited investor is defined in Rule 501 of Regulation D under the 1933 Act. The accredited investor standard looks to an individual s financial means to determine whether such person meets a minimum threshold. For natural persons, individual net worth, or joint net worth with a person s spouse, must exceed $1,000,000, excluding the value of the primary residence of such person or persons. A natural person will also be deemed an accredited investor if such person had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year. 7 The term performance fee refers to compensation to an investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds, or any portion of the funds, of a client. Performance fees are generally calculated as a percentage of investment profits (the increase in the fund's net asset value), often both realized and unrealized. Notably, the Proposed Exemption would permit advisers to charge a performance fee to certain institutional investors that do not meet the qualified client threshold. 8 Rule under the Advisers Act defines a qualified client as (i) a client with at least $1,000,000 under the management of the adviser immediately after entering into the advisory contract, or (ii) a client that the adviser reasonably believes (a) has a net worth (in the case of a natural person, together with assets owned jointly by his or her spouse) of more than $2,000,000 at the time the advisory contract is entered into or (b) is a qualified purchaser, as defined in Section 2(a)(51)(A) of the Investment Company Act. 2

3 o all duties the adviser owes to the investor; and o any other material information regarding the investor s rights or responsibilities. C. Advisers to Venture Capital Companies Under the Proposed Exemption, advisers solely to one or more venture capital companies would be exempt from registration with the Department if they were to meet the four basic requirements for exemption (described above in Section II.A.). Under Rule , venture capital company generally means an entity in which at least 50% of its assets (other than certain short-term investments) are interests in an operating company as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person of either has management rights. 9 III. Grandfathering Provision for 3(c)(1) Fund Advisers The Proposed Exemption provides a grandfathering provision for certain advisers to one or more 3(c)(1) Funds that are not venture capital companies. The exemption provides that if such 3(c)(1) Funds contain investors who do not meet the accredited investor 10 standard they would nonetheless be eligible for exemption from registration with the Department if the following conditions were satisfied: the 3(c)(1) Funds in question must have existed prior to the effective date of Rule (the Effective Date ); 11 as of the Rule s Effective Date, these 3(c)(1) Funds must cease to accept new investors who are not accredited investors ; the adviser must make the 3(c)(1) Disclosures (described above in Section II.B.) to all investors in each such 3(c)(1) Fund; and the adviser must distribute audited financial statements annually to all investors in each such 3(c)(1) Fund. IV. Exempt Adviser Reporting Requirements The Proposed Exemption would require exempt advisers to file all reports that advisers who are exempt from federal registration must file with the SEC pursuant to Rule Rule requires exempt advisers to complete and periodically update the relevant items required on the Form ADV Part 1A, including the following items: Item 1 (identifying information), Item 2.B. (SEC reporting by exempt advisers), Item 3 (form of organization), Item 6 (other business activities), Item 7 (financial industry affiliation and private fund reporting), Item 10 (control persons), Item 11 (disciplinary 9 This definition of venture capital company is contained in both the current version of Rule and the Proposed Exemption. Notably, venture capital company assets are to be valued at cost. In addition to interests in operating companies, the 50% of assets threshold may also take into account derivative investments, which are securities acquired in the ordinary course of business in exchange for an existing venture capital investment either (1) upon the exercise or conversion of the existing venture capital investment or (2) in connection with a public offering of securities or the merger or reorganization of the operating company to which the existing venture capital investment relates. 10 For a description of the accredited investor standard, see footnote 6, supra. 11 The term effective date, as used here, refers to the future date when the Department will adopt some version of the amendments to Rule that it has proposed in the Proposed Exemption. 3

4 history), as well as those sections of Schedules A, B, C and D that correspond to the items listed above. 12 Exempt advisers would not be required to complete a Form ADV Part 2A or 2B. V. Investment Adviser Representatives The Proposed Exemption would exempt from registration any person employed by or associated with an investment adviser that is exempt under Rule VI. Transition to State Registration The Proposed Exemption provides that advisers who become ineligible for the Rule exemption would be required to register with the Department within ninety (90) days from the date upon which an adviser ceases to be eligible for the exemption. VII. The Proposed Exemption Is More Permissive than the Proposed Model NASAA Rule Applicable to Private Fund Advisers On December 16, 2011, the North American Securities Administrators Association ( NASAA ), a voluntary association of state, provincial and territorial securities administrators, adopted a model rule on private fund adviser registration and exemption. Although the Proposed Exemption substantially tracks the NASAA model rule, the rules differ in two important respects. First, the NASAA model rule contains a requirement that all investors in each 3(c)(1) Fund under advisement must meet the definition of qualified client at the time interests in the Fund are purchased, which is different from the lower accredited investor standard used in the Proposed Exemption. Second, the NASAA model rule has adopted the definition of venture capital fund used by the SEC, which differs from the venture capital company definition contained in the Proposed Exemption. 13 VIII. Request for Comments Comments may be submitted electronically, by mail or by fax. Persons who submit comments electronically should send comments to regulations@corp.ca.gov, together with the following identifier: PRO 02/11. Persons who submit comments by mail should send their comments to the following address: California Department of Corporations, Office of Legislation and Policy, Attention: Karen Fong (PRO 02/11), 1515 K. St., Suite 200, Sacramento, CA Persons wishing to submit comments by fax may do so at (916) The written comment period for the draft Proposed Exemption ends on March 25, After consideration of comments to the Proposed Exemption, the Department will issue a final rule. 12 The SEC requires certain categories of advisers who are exempt from registration under the Advisers Act, including advisers to private funds, to provide it with the information listed above in notice filings. For a detailed discussion of the SEC s notice filing requirements, click here. 13 The SEC has defined venture capital fund in Rule 203(l)-1 under the Advisers Act. For a complete description of the SEC s definition, click here. 4

5 Authors: J. Matthew Mangan Yusef Alexandrine