On June 22, 2011, the Securities and Exchange Commission (the SEC ) adopted

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1 November 4, 2011 Venture Capital Fund Adviser Exemption If you have any questions regarding the matters discussed in this memorandum, please contact the following attorneys or call your regular Skadden contact. Anastasia T. Rockas New York Lawrence D. Frishman New York Heather Cruz New York John M. Caccia New York * * * This memorandum is provided by Skadden, Arps, Slate, Meagher & Flom LLP and its affiliates for educational and informational purposes only and is not intended and should not be construed as legal advice. This memorandum is considered advertising under applicable state laws. On June 22, 2011, the Securities and Exchange Commission (the SEC ) adopted rule 203(l)-1 (the Venture Capital Rule ), 1 codifying the exemption for venture capital fund advisers from registration under the Investment Advisers Act of 1940, as amended (the Advisers Act ), 2 as amended by the Private Fund Investment Advisers Registration Act of 2010 (the Registration Act ). 3 In a notable change from the SEC s proposed rule on November 19, 2010 (the Proposed Rule ), 4 and in response to comments requesting additional flexibility, the Venture Capital Rule allows a qualifying venture capital fund to invest up to 20 percent of a venture fund s capital commitments in nonqualifying investments. The Venture Capital Rule became effective on July 21, Prior to the Dodd-Frank Act, many hedge fund and private equity fund investment advisers were exempt from registration with the SEC by virtue of the private adviser exemption under the Advisers Act, which provided that an investment adviser was exempt from registration if the adviser (i) had fewer than 15 clients during the course of the preceding 12 months and (ii) neither held itself out generally to the public as an investment adviser nor acted as an investment adviser to any registered investment company or business development company. 6 The Registration Act eliminated the private 1 See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No (June 22, 2011) (to be codified at 17 C.F.R (a)(30)-1, (l)-1, (m)-1) (the Exemptions Release ), The Exemptions Release has been published in the Federal Register. See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3222, 76 Fed. Reg. 39,646 (July 6, 2011) (to be codified at 17 C.F.R (a)(30)-1, (l)-1, (m)-1), available at Citations to the Exemptions Release herein are to the text on the SEC s website at rules/final/2011/ia-3222.pdf. The Exemptions Release sets forth rule 203(l)-1 above. See Exemptions Release at (to be codified at 17 C.F.R (l)-1) U.S.C. 80b-1 to 80b The Registration Act comprises Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act, Pub. L. No , 124 Stat (2010) (the Dodd-Frank Act ), which was signed into law by President Barack Obama on July 21, See Dodd-Frank Act 401 to 419, 124 Stat. at (amending Advisers Act 202, 203, 203A, 204, 205, 210, 211, 223, 224, 15 U.S.C. 80b-2, 80b-3, 80b-3a, 80b-4, 80b-5, 80b-10, 80b-11, 80b-18b, 80b-18c). 4 See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No (proposed Nov. 19, 2010) (to be codified at 17 C.F.R (a)(30)-1, (l)-1, (m)- 1) (the Proposing Release ), The Proposing Release has been published in the Federal Register. See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Investment Advisers Act Release No. 3111, 75 Fed. Reg. 77,190 (proposed Dec. 10, 2010) (to be codified at 17 C.F.R (a)(30)-1, (l)-1, (m)- 1), available at Four Times Square, New York, NY Telephone: Citations to the Proposing Release herein are to the text on the SEC s website at rules/proposed/2010/ia-3111.pdf. 5 Exemptions Release at 1. 6 See 15 U.S.C. 80b-3(b)(3) (2006) (repealed effective July 21, 2011, by Registration Act 403, 419, 124 Stat. at 1571, 1580). Beijing Boston Brussels CHICAGO Frankfurt Hong Kong Houston London Los Angeles Moscow MUNICH New York palo alto Paris SÃo paulo Shanghai SINGAPORE Sydney Tokyo Toronto vienna Washington, D.C. Wilmington

2 2 adviser exemption and in its place introduced certain narrower exemptions from registration, including an exemption for advisers that only advise one or more venture capital funds. A. Exemption for Venture Capital Fund Advisers New section 203(l) of the Advisers Act provides that an investment adviser that solely advises venture capital funds is exempt from registration under the Advisers Act. 7 This exemption is available without regard to the number or size of such venture capital funds. The SEC modified the definition of venture capital fund in response to numerous comment letters requesting the SEC to expand the definition and modify the proposed criteria. In addition, consistent with the Proposed Rule, the Venture Capital Rule also grandfathers any pre-existing fund as a venture capital fund if it satisfies criteria under the grandfathering provision Definition of Venture Capital Fund The Venture Capital Rule defines a venture capital fund as a private fund that: (i) holds no more than 20 percent of the fund s capital commitments in non-qualifying investments (other than short-term holdings); (ii) does not borrow or otherwise incur leverage, other than limited short-term borrowing (excluding certain guarantees of qualifying portfolio company obligations by the fund); (iii) does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances; (iv) represents itself as pursuing a venture capital strategy to its investors and prospective investors; and (v) is not registered under the Investment Company Act of 1940, as amended (the Investment Company Act ) and has not elected to be treated as a business development company ( BDC ). 9 The definition is intended to distinguish venture capital funds from other types of private funds, such as hedge funds and private equity funds, and to address Congressional concerns regarding the potential for systemic risks. 10 Qualifying Investments. Under the Venture Capital Rule, the fund must hold immediately after the acquisition of any asset (other than qualifying investments or short-term holdings), no more than 20 percent of the fund s capital commitments in non-qualifying investments (other than short-term holdings). 11 A qualifying investment consists of any equity security issued by a qualifying portfolio company that directly is acquired by a qualifying fund and certain equity securities exchanged for the directly acquired securities See 15 U.S.C. 80b-3(l). 8 Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at 19; see also id. at 203 (to be codified as rule 203(l)-1(a)(2), 17 C.F.R (1)-1(a)(2)). 12 Exemptions Release at 20.

3 3 Non-Qualifying Basket. The SEC defines a venture capital fund to include a fund that invests up to 20% of its capital commitments that otherwise would not satisfy all of the elements of the rule ( non-qualifying basket ). This approach allows advisers the flexibility to choose the types of nonqualifying investments they wish to make. 13 A fund needs only to calculate the percent limit at the time it acquires a non-qualifying investment, other than short-term holdings. 14 After the acquisition of a non-qualifying investment the fund does not need to dispose of a non-qualifying investment simply because of a change in the value of the investment. However, a fund may not acquire additional non-qualifying investments if the value of its non-qualifying investments exceeds 20 percent of committed capital. 15 To determine if a fund satisfies the 20 percent limit for non-qualifying investments, the fund may use either historical cost or fair value, as long as the same method is used for all investments over the term of the fund. 16 The SEC s view is that a 20 percent limit will provide the additional flexibility sought by many of the commenters, while also limiting the scope of the exemption. 17 Short-Term Holdings. A qualifying fund also may invest in cash and cash equivalents, U.S. Treasuries with a remaining maturity of 60 days or less and shares of registered money market funds. 18 The SEC has expanded the definition of short-term holdings from the Proposed Rule to include shares of registered money market funds that are regulated under rule 2a-7 of the Investment Company Act. 19 Equity Securities. The SEC has adopted the definition of equity security in section 3(a)(11) of the Exchange Act and rule 3a11-1 thereunder, as proposed. 20 The SEC is of the view that this definition is broad and includes various securities in which venture capital funds typically invest and provides venture capital funds with flexibility to determine which equity securities in the portfolio company capital structure are appropriate for the fund. 21 The SEC s definition does not allow for any investment in debt securities (unless they meet the equity security definition), although it does include common stock, preferred stock, warrants, certain convertible securities and limited partnership interests. 22 Capital Used for Operating and Business Purposes. Under the Venture Capital Rule, qualifying investments are generally equity securities that were acquired by the fund in one of three ways that suggest that the fund s capital is being used to finance the operations of businesses rather than for trading in secondary markets. A qualifying investment is defined as: (i) any equity security issued by a qualifying portfolio company that directly is acquired by the private fund from the company 13 Exemptions Release at Exemptions Release at Id. 16 Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at & n.95. See Securities Exchange Act of 1934, 3(a)(11), 15 U.S.C. 78c(a)(11) (defining equity security as any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security ); 17 C.F.R a11-1 (2011) (defining equity security to include any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so ). 21 Exemptions Release at See id.

4 4 ( directly acquired equity ); (ii) any equity security issued by a qualifying portfolio company in exchange for directly acquired equity issued by the same qualifying portfolio company; and (iii) any equity security issued by a company of which a qualifying portfolio company is a majority-owned subsidiary, or a predecessor, and that is acquired by the fund in exchange for directly acquired equity. 23 The SEC has expanded the definition of a qualifying investment in the Venture Capital Rule to include (ii) and (iii) above. The revision in (ii) was suggested by a number of commenters in order to allow a qualifying fund to participate in the reorganization of the capital structure of a portfolio company, which may require the fund, along with other existing security holders, to accept newly issued equity securities in exchange for previously issued equity securities. 24 The revision in (iii) is intended to enable a qualifying fund to acquire securities in connection with the acquisition (or merger) of a qualifying portfolio company by another company without jeopardizing the fund s ability to satisfy the venture capital fund definition. 25 The SEC has eliminated the 20 percent limit for equity securities acquired in secondary market transactions from the Proposed Rule, and instead the Venture Capital Rule includes the broader 20 percent limit for assets that are non-qualifying investments. 26 Qualifying Portfolio Companies. The SEC has defined a qualifying portfolio company as any company that: is not a reporting or foreign traded company and does not have a control relationship with a reporting or foreign traded company; does not incur leverage in connection with the investment by the private fund and distribute the proceeds of any such borrowing to the private fund in exchange for the private fund investment; and is not itself a fund (i.e., is an operating company). 27 The SEC has adopted the definition of qualifying portfolio company substantially as proposed, with modifications to the leverage criterion in order to address concerns raised by commenters, 28 as described below. Private Companies. Consistent with the Proposed Rule, a venture capital fund is permitted to continue to hold securities of a portfolio company that subsequently becomes public, but at the time of each investment by the venture capital fund, the portfolio company may not be publicly traded (or in a control relationship with a publicly traded company). 29 Portfolio Company Leverage. Under the Venture Capital Rule, which is slightly modified from its proposed form, a qualifying portfolio company is one that does not borrow or issue debt obligations in connection with the venture capital fund s investment in the company and distribute to the fund the proceeds of such borrowing or issuance in exchange for the fund s investment. 30 Thus, certain types of funds that use leverage or finance their investments in portfolio companies or the buyout of 23 Exemptions Release at 23; see also id. at 205 (codified as rule 203(l)-1(c)(3), 17 C.F.R (l)(c)(3)). 24 Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at See Exemptions Release at The SEC recognized that venture capital funds invest in companies with a goal of eventually selling or taking the companies public. Id. at Exemptions Release at 41.

5 5 existing investors with borrowed money (i.e., leveraged buyout funds) would not meet the Venture Capital Rule s definition of a venture capital fund. 31 At the suggestion of commenters, the Proposed Rule s requirement that a qualifying portfolio company not participate in an indirect buyout involving a qualifying fund was eliminated because the introduction of the non-qualifying basket does not exclude secondary market transactions or other buyouts of existing security holders. 32 In contrast to the Proposed Rule, the Venture Capital Rule more specifically delineates the types of leveraged transactions involving a qualifying fund (i.e., a company s distribution of proceeds received in a debt offering to the qualifying fund) that would result in the company being excluded from the definition of a qualifying portfolio company. 33 The SEC believes this modification clearly distinguishes between venture capital funds and leveraged buyout funds and provides a simpler approach to determining whether or not a qualifying portfolio company satisfies the definition. 34 The Venture Capital Rule would not exclude a company that borrows in the ordinary course of its business. 35 Operating Companies. The definition of qualifying portfolio company has been adopted as proposed to exclude any private fund or other pooled investment vehicle. The SEC is of the view that Congress did not intend the venture capital exemption to apply to venture capital funds of funds. 36 However, a fund may disregard a wholly owned intermediate holding company formed solely for tax, legal or regulatory reasons to hold the fund s investment in a qualifying portfolio company. 37 Management Involvement. The SEC did not adopt a managerial assistance element in the Venture Capital Rule, as originally proposed. 38 In the Proposed Rule, the SEC would have required that advisers have a significant level of involvement in managing a fund s portfolio companies. 39 The SEC was persuaded by commenters who had several problems with the application of the managerial assistance criterion and its intended scope. 40 As a result, a qualifying fund is not required to offer (or provide) managerial assistance to, or control, any qualifying portfolio company in order to satisfy the definition. 41 Limitation on Leverage. Consistent with the Proposed Rule, in addition to the portfolio company leverage limitation imposed under the definition of qualifying portfolio companies, an eligible venture capital fund does not borrow funds, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the fund s capital contributions and uncalled capital commitments. 42 Also, any permitted fund-level leverage must be for a non-renewable term of no longer than 120 calendar days. 43 However, the SEC modified the leverage criterion in the Venture Capital Rule to exclude from the 120 calendar day limit any guarantee of qualifying portfolio company obligations 31 Id. 32 See Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at Exemptions Release at See Exemptions Release at Proposing Release at Exemptions Release at Exemptions Release at Exemptions Release at Id.

6 6 by the qualifying fund, up to the value of the fund s investment in the qualifying portfolio company. 44 Like the limitation on leverage for portfolio companies, this element of the definition is intended to respond to Congressional concern about the connection between leverage and systemic risk but has been revised by the SEC to better reflect industry practices. No Redemption Rights. The SEC has adopted, as proposed, the definitional element under which an eligible venture capital fund cannot provide investors with redemption rights except in extraordinary circumstances, but the fund may make pro rata distributions from time to time as investments mature. 45 Although the SEC has not provided an exhaustive list of what constitutes extraordinary circumstances, the SEC s general view is that a fund may provide for an investor to withdraw from the fund under foreseeable but unexpected circumstances that typically are beyond the control of the adviser and fund investor, such as changes in regulatory, tax or other legal requirements. 46 Although some commenters sought more clarification on its application, the SEC believes that the term extraordinary circumstances is sufficiently clear and declined to modify the rule to include additional conditions for fund redemption. 47 Representing Itself as Pursuing a Venture Capital Strategy. The Proposed Rule defined a venture capital fund as a private fund that represents itself as being a venture capital fund to its investors and potential investors. 48 At the suggestion of commenters who argued that historically, some funds have refrained from referring to themselves as venture capital funds, the SEC has modified the holding out element to refer to the way a qualifying fund describes its investment strategy to investors and prospective investors. 49 The SEC notes that whether a fund represents itself as pursuing a venture capital strategy depends on the particular facts and circumstances, which may include but are not limited to the fund name. 50 The holding out criterion looks to all relevant statements made by the qualifying fund regarding its investment strategies. The SEC notes that any adviser that manages its fund in such a way that renders the representation to investors that the fund pursues a venture capital strategy an untrue statement of material fact would violate the antifraud provisions of the Advisers Act. 51 Is a Private Fund. The SEC has defined a venture capital fund as a private fund pursuant to section 3(c)(1) or 3(c)(7) of the Investment Company Act (including offshore funds that rely on section 3(c) (1) or 3(c)(7) with respect to their United States investors), but investment companies registered under the Investment Company Act and BDCs explicitly are excluded. 52 The SEC has adopted this provision as proposed. 44 Id. The SEC believes this guarantee may help a qualifying portfolio company obtain credit for working capital purposes and would not be used by the fund to leverage its investment in the company and therefore does not present the potential for systemic risks. See id. at Exemptions Release at See Exemptions Release at See Exemptions Release at Proposing Release at 50; see also id. at (proposed rule 203(l)-1(a)(1)). 49 Exemptions Release at Exemptions Release at Exemptions Release at 29. The SEC does not need to establish scienter in connection with this violation. Id. at 29 n See Exemptions Release at 68, 70-71; 15 U.S.C (a) (29) (enacted by Registration Act 402(a), 124 Stat. at 1570).

7 7 2. Application to Non-U.S. Advisers Although the statutory text of section 203(l) and the legislative reports are silent as to whether Congress intended the venture capital exemption to be applied to non-u.s. advisers, the SEC has concluded that a non-u.s. adviser may rely on the venture capital exemption if all of its clients, whether U.S. or non-u.s., are venture capital funds as defined in the Venture Capital Rule. 53 The SEC modified the Proposed Rule by including a note in the Venture Capital Rule that a non-u.s. fund would not need to use U.S. jurisdictional means in offering its securities to qualify as a private fund and as a venture capital fund. 54 Therefore, an adviser may treat as a venture capital fund a non U.S. fund that is not offered through U.S. jurisdictional means but that would be a private fund if the issuer were to conduct a private offering in the United States. 55 B. Reporting by Exempt Reporting Advisers In order to implement the reporting requirements of the Venture Capital Rule, the SEC has adopted a new rule, as proposed, requiring advisers relying on the Venture Capital Rule ( Exempt Reporting Advisers ) to submit and periodically update reports that consist of a limited subset of items on Form ADV. 56 As part of the revised Form ADV, an Exempt Reporting Adviser would be required to identify the exemption(s) on which it is relying to report, rather than register, with the SEC. 57 Further, the SEC adopted, as proposed, a requirement that Exempt Reporting Advisers complete the following items of Part 1A of Form ADV: Items 1 (Identifying Information); 2.B. (SEC Reporting by Exempt Reporting Advisers); 3 (Form of Organization); 6 (Other Business Activities); 7 (Financial Industry Affiliations and Private Fund Reporting); 10 (Control Persons); and 11 (Disclosure Information). 58 In addition, the SEC is requiring, as proposed, that Exempt Reporting Advisers also complete corresponding sections of Schedules A, B, C, and D of Form ADV. 59 The SEC notes that most of the rules that apply to registered advisers do not apply to Exempt Reporting Advisers, such as the custody rule, but notes, for example, that the pay to play rule, rule 206(4)-5, does apply to Exempt Reporting Advisers. 60 The SEC does not anticipate conducting compliance examinations of Exempt Reporting Advisers on a regular basis, although it has the right to conduct such examinations and will do so if there are indications of wrongdoing, such as from tips or complaints. 61 The SEC has noted that a person claiming an exemption under the federal securities laws has the burden of proving that it is entitled to the exemption and that the Commission may examine the records 53 See Exemptions Release at See Exemptions Release at 72; see also id. at 206 (to be codified as rule 203(1)-1 note, 17 C.F.R. 203(1)-1 note). 55 See Exemptions Release at See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221, at (June 22, 2011) (to be codified at 17 C.F.R. pts. 279, 279) (the Implementing Release ), sec.gov/rules/final/2011/ia-3221.pdf; see also Implementing Release at (to be codified as rule 204-4, 17 C.F.R (reported by exempt reporting advisers)). The Implementing Release has been published in the Federal Register. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Investment Advisers Act Release No. 3221, 76 Fed. Reg. 42,950 (July 19, 2011) (to be codified at 17 C.F.R. pts. 279, 279), available at Citations to the Implementing Release herein are to the text on the SEC s website at Advisers relying on the new exemption for private funds are also considered exempt reporting advisers. See Implementing Release at Implementing Release at Implementing Release at Id. 60 Implementing Release at & n Implementing Release at & n.188.

8 8 of advisers relying on the Venture Capital Rule. 62 Exempt Reporting Advisers may choose to register with the SEC if they otherwise meet the requirements. Exempt Reporting Advisers need to evaluate whether they have any state investment adviser registration requirements. 63 Grandfathering Provision. The SEC has adopted the grandfathering provision substantially as proposed with the modification of the holding out criterion, as described above, that the private fund represent to investors and potential investors at the time it offered securities that it pursues a venture capital strategy. 64 A private fund seeking to rely on the grandfathering provision should examine all of the statements and representations made to investors and prospective investors to determine whether the fund has satisfied the holding out criterion. 65 A grandfathered private fund must have sold securities to one or more investors before December 31, In addition, a grandfathered fund must have accepted all capital commitments by July 21, 2011 (including such commitments from existing and new investors) even if none of the capital commitments had been called by such date. 66 Transition Rule The Registration Act became effective by its terms on July 21, In order to allow an orderly transition to registration for previously-unregistered advisers, the SEC adopted a transition period that exempts from registration until March 30, 2012 any adviser that was relying on, and entitled to rely on, the private adviser exemption in section 203(b)(3) on July 20, Because initial applications for registration with the SEC can take up to 45 days to be approved, the SEC recommends that advisers file a complete application no later than February 14, Exemptions Release at 29 n. 124; see also id. at 3 n See Exemptions Release at 7 & nn See Exemptions Release at Exemptions Release at Exemptions Release at See Implementing Release at 6 & n See Implementing Release at Id.