On December 15, 2011, the California Department of Corporations proposed revised regulations exempting certain private fund managers from investment adviser registration with the state of California.
Background
Previously, under Cal. Code Regs. tit. 10, § 260.204.9, private fund managers in California were exempt from investment adviser registration if they met the federal 15 client exemption, and they had assets under management of $25 million or more or they provided investment advice solely to “venture capital companies.” On June 13, 2011, the California Department of Corporations amended this rule to remove the reference to the federal 15 client exemption. Under this change, a private fund manager is exempt if it “(1) does not hold itself out generally to the public as an investment adviser, (2) during the course of the preceding twelve months has had fewer than 15 clients, (3) does not act as an investment adviser to any investment company registered under… the Investment Company Act of 1940…, and (4) either (i) has assets under management… of not less than $25,000,000 or (ii) provides investment advice to only venture capital companies…”[1]
However, the June 13, 2011 rule was temporary and the exemption automatically expired on January 21, 2012. The California Department of Corporations stated that it intended to “study how best to regulate advisers to alternative investment vehicles, while balancing the regulatory burden on such advisers, with any corresponding investor protections issues.” Now it appears that the California regulators have acted.
The New Rule
The new December 15, 2011 rule did two things. First, it extended the temporary June 13, 2011 rule described above until June 28, 2012. Second, it proposes for comment, a new private fund adviser exemption based on the NASAA model rule.
The new proposed regulations provide for an exemption from registration for “private fund advisers.” A private fund adviser is any investment adviser who provides advice solely to one or more private funds (i.e. a 3(c)(1) fund or a 3(c)(7) fund).[2] A private fund adviser must not be subject to disqualification from prior bad acts such as fraud or other securities law violations. The private fund adviser must also make the same Form ADV filings as an exempt reporting adviser would. In addition, the private fund adviser must pay a filing fee to the California Department of Corporations.
Any private fund adviser that advises a 3(c)(1) fund (other than venture capital funds, using the California definition not the Federal one) must also comply with additional restrictions. All investors in these funds must be accredited investors. The fund manager must also disclose in writing all services that are provided to individual owners (if any), all duties owed to individual owners (if any), and any other material information affecting the rights or responsibilities of owners. The fund manager must provide audited financial statements to each investor. Finally, the fund manager must comply with California rules on incentive allocations, which essentially means that all investors will also need to be “qualified clients”[3] in addition to being accredited investors.
Fund managers registered with the SEC will be required to make applicable notice filings to the California Department of Corporations even if they would otherwise qualify for the private fund adviser exemption.
The new rule also provides grandfathering provisions for fund managers of 3(c)(1) funds that existed before the effective date of the new regulations but cease accepting non-accredited investors after the date, as long as the fund manager does comply with the disclosure and audit requirements of the new exemption. There is a technical problem here: the grandfathering provision makes no mention to the “qualified client” requirement, so it is unclear how it would apply to funds that are owned exclusively by accredited investors but not by qualified clients (a very common situation).
One other issue I have with the rule is that it uses the old California definition of “venture capital company” to determine whether a fund is a venture capital fund, rather than the new Federal definition, as many states are using in their exemptions. Funds that meet one definition may not meet another. It seems counterproductive to make venture capital fund managers have to deal with two conflicting standards.
Interested parties may submit comments until 5:00pm, February 20, 2012. I suspect that some of these technical issues may get resolved prior to the rule being finalized.
Footnotes
[1] California has its own definition of “venture capital company,” not to be confused with the federal definition of “venture capital fund.” Under California law, an entity is a “venture capital company” if, on at least one occasion during the annual period commencing with the date of its initial capitalization, and on at least one occasion during each annual period thereafter, at least fifty percent (50%) of its assets (other than short-term investments pending long-term commitment of distribution to investors), valued at cost, are “venture capital investments” or investments derived therefrom. A “venture capital investment” is an acquisition of securities in an “operating company” as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person of either has or obtains management rights. An “operating company” means an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale (including any research or development) of a product or service.
[2] A 3(c)(1) fund is a fund which has not more than 100 investors. A 3(c)(7) fund is a fund which is limited to qualified purchasers, which are defined roughly as a person with at least $5 Million in investment assets or a company with at least $25 Million in investment assets.
[3] A “qualified client” is defined as an individual or company that has at least $1 Million under the management with the investment adviser or has a net worth (together with assets held jointly with a spouse, but not including the value of the individual’s primary residence) of more than $2 Million.
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© 2012 Alexander J. Davie — This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
