California Small and Mid-Sized Private Fund Managers Face
Immediate Compliance Burdens

By Tim Coxon
08 February 2012

California private fund managers with assets under management of $100 million or less must act immediately to ensure compliance with Dodd-Frank and corresponding rules in California. Dodd-Frank repealed the widely-relied upon “private adviser” exemption to SEC registration, and replaced it with a narrower private fund adviser exemption that carries significant SEC reporting requirements. The California Department of Corporations (“DOC”) is in the process of making analogous changes at the state level. These changes will require most California private fund managers to register or report to either the SEC or the DOC as early as March 31, 2012.

Investment Adviser Registration Requirement

Section 202(a)(11) of the Investment Advisers Act of 1940 (“IAA”) defines “investment adviser” as “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.” Section 25009 of the California Corporations Code (“CCC”) provides a similar definition.

Generally, a private fund manager or general partner that receives management fees or a carried interest from the private fund is considered an investment adviser to the fund.

Investment advisers are required by IAA §203(a) to register with the SEC unless exempt or prohibited from doing so. Similarly, investment advisers conducting business in California are required by CCC §25230(a) to obtain a license from the DOC unless they are registered with the SEC or otherwise exempt under California law.

Repealed Exemptions at State and Federal Level

Private fund managers in California have generally avoided both SEC registration and DOC licensing by relying on broad “private adviser” exemptions under both federal and state rules. Dodd-Frank has repealed the federal private adviser exemption and California is in the process of repealing the state private adviser exemption.

The old federal private adviser exemption of former IAA §203(b)(3) (“Former SEC Private Adviser Exemption”) exempted an investment adviser from SEC registration if the adviser had fewer than 15 clients in the previous 12 months, did not hold itself out to the public as an investment adviser and did not advise a SEC-registered investment company or business development company. Because a private fund is (by definition) not an investment company, and because each such fund is considered a single client, advisers who managed a handful of private funds typically qualified for this private adviser exemption from SEC registration. Dodd-Frank repealed this exemption as of July 21, 2011.

Current section 260.204.9 of the California Code of Regulations (“CCR”) exempts from the California state licensing requirement an adviser who satisfies the Former SEC Private Adviser Exemption discussed above and either manages at least $25 million in assets or advises only venture capital companies (see below for California’s definition of a venture capital company). This California private adviser exemption (“DOC Private Adviser Exemption”) first expired on July 21, 2011, but has since been extended twice by emergency regulation and is now set to expire on April 17, 2012. Further, a proposed California exemption discussed below would effectively extend it again to June 28, 2012.

New Federal Private Fund Adviser Exemption

Dodd-Frank and the Investment Adviser Rules (“IAR”) promulgated by the SEC provide for a new exemption from SEC registration that is likely to be relied upon by managers of private funds with assets under management of $100 million or less. IAR §203(m)-1 sets forth this new “SEC Private Fund Adviser Exemption”. These rules also set forth a separate “SEC VC Fund Adviser Exemption” in IAA §203(l) and IAR §203(l)-1.

This article focuses on California private fund managers with assets under management of $100 million or less. Because the SEC VC Fund Adviser Exemption imposes criteria specific to venture capital funds, and because it exempts only a special subset of private fund managers who can also rely on the SEC Private Fund Adviser Exemption unless they have over $150 million in assets under management, this article only discusses the SEC Private Fund Adviser Exemption in detail.

The SEC Private Fund Adviser Exemption exempts a US-based investment adviser from SEC registration if the adviser acts “solely as an investment adviser to one or more qualifying private funds” and has regulatory assets under management attributable to those funds of less than $150 million.

A “qualifying private fund” is generally an issuer engaged primarily in the business of investing, reinvesting or trading in securities that is not a SEC-registered investment company, has not elected to be treated as a business development company under the Investment Company Act, does not make a public offering, and is beneficially owned exclusively by qualified purchasers or 100 or fewer persons.

The value of “regulatory assets under management” for advisers solely to private funds includes the portion of the assets of those private funds, including uncalled capital commitments, for which the adviser provides regular supervisory or management services. The value of such assets is the current market value or fair value of the fund’s assets plus the contractual amount of any uncalled capital commitment.

New Federal Exempt Reporting Adviser Obligations

Investment advisers that rely on either the SEC Private Fund Adviser Exemption or the SEC VC Fund Adviser Exemption to avoid SEC registration are deemed “Exempt Reporting Advisers” pursuant to IRA §204-4(a). Exempt Reporting Advisers are not required to register with the SEC, but are nonetheless subject to SEC oversight, reporting and recordkeeping requirements that significantly narrow the distinction between registered and unregistered status.

Exempt Reporting Advisers must file with the SEC certain sections of Form ADV – the same form that SEC-registered advisers must file with the SEC. After the initial filing of this report, Exempt Reporting Advisers must update the filing at least annually, and must update certain information as it changes.

The sections of Form ADV required to be filed by Exempt Reporting Advisers include disclosures covering basic identifying information about the adviser and its control persons, financial industry affiliations of the adviser, other business activities of the adviser, certain disciplinary items related to integrity, and certain information about the private funds the adviser manages. These filings will be publicly available on the SEC website.

California License Requirement and Exemptions

The current DOC Private Adviser Exemption in CCR §260.204.9 is set to expire on April 17, 2012, and the DOC has proposed a successor exemption that roughly parallels the new SEC Private Fund Adviser Exemption. Unless a California adviser is registered with the SEC or otherwise exempt under California law, the adviser is required by CCC §25230(a) to obtain a license from the DOC.

California DOC License Requirements

DOC-licensed advisers must satisfy certain qualifications, meet periodic reporting obligations, maintain a certain minimum net worth, and may face restrictions on the terms in their advisory contracts (including on the ability to charge a carried interest to certain clients).

The qualification requirements for DOC-licensed advisers are a mix of experience, professional designations and FINRA series examinations. Generally, within two years prior to applying for a license, an adviser must have passed either the 2000 Series 65 Exam or both the Series 7 Exam and the 2000 Series 66 Exam. There are exceptions to this general rule for advisers who passed these exams more than two years prior to applying and have passed other exams, have been registered as an investment adviser in another state for two consecutive years prior to applying, or currently hold CFA, ChFC, CIC or PFS professional designations.

A DOC-licensed adviser is required to report to the DOC on Form ADV, and must submit other financial information (including possibly audited financial statements), the terms of its advisory contracts, and an annual $125 fee. California licensed advisors cannot charge advisory fees based on a share of capital gains or appreciation of client funds to certain clients, and must maintain a net worth ranging from $0 to $35,000 depending on their client fee schedules and degree of control over client funds.

Current California DOC Private Adviser Exemption

The current DOC Private Adviser Exemption under CCR§260.204.9 exempts from the California state licensing requirement an adviser who had fewer than 15 clients in the previous 12 months, does not hold itself out to the public as an investment adviser, does not advise a registered investment company or business development company, and either has assets under management (which include uncalled capital commitments) of at least $25 million or advises only venture capital companies. This exemption has been extended twice by emergency regulation and will expire on April 17, 2012, but would effectively be further extended until June 20, 2012 under the proposed regulation discussed below.

Proposed California DOC Private Fund Exemption

On December 15, 2011 the DOC released Document PRO 02/11 – B, which proposes a private fund adviser exemption in California (“DOC Private Fund Adviser Exemption”). The proposal would exempt from state licensing an adviser who advises solely “qualifying private funds,” files with the DOC the same parts of Form ADV that an Exempt Reporting Adviser must file with the SEC, is not subject to certain statutory “bad boy” disqualifications under SEC and DOC rules, and pays an annual $125 fee. The applicable definition of “qualifying private fund” is set forth in IAR 203(m)-1 (see above definition under the New Federal Private Fund Adviser Exemption header).

An adviser to at least one “3(c)(1) fund” that is not a venture capital company must satisfy additional requirements to qualify for the DOC Private Fund Adviser Exemption. A “3(c)(1)” fund is a qualifying private fund that qualifies for exclusion from the definition of investment company under ICA §3(c)(1) by being owned by 100 or fewer persons. The California definition of “venture capital company” is discussed below.

In addition to the requirements above, an adviser relying on the proposed DOC Private Fund Adviser Exemption can only advise a 3(c)(1) fund other than a venture capital company if the fund is owned entirely by accredited investors (or does not accept unaccredited investors after the effective date of the exemption), the adviser discloses to the owners certain material information, the adviser delivers annual audited financial statements of the fund to the owners, and the adviser only charges compensation based on capital gains to the fund’s owners that are “qualified clients” under IRA §205-3(d).

A “qualified client” is a person with at least $750,000 under the adviser’s management at the time of contracting with the adviser, a natural person that is a qualified purchaser or has a net worth of more than $1.5 million at the time of contracting with the adviser, or certain control persons and employees of the adviser.

Finally, the proposed DOC Private Fund Adviser Exemption creates an exemption equivalent to the current DOC Private Adviser Exemption that would expire on June 28, 2012.

California Definition of “Venture Capital Company”

For purposes of both the current DOC Private Adviser Exemption and the proposed DOC Private Fund Adviser Exemption, a fund is a “venture capital company” if, at least once per year, at least 50% of its assets (other than certain short-term investments), valued at cost, are “venture capital investments” or “derivative investments.”

A “venture capital investment” is an acquisition of securities in an “operating company” pursuant to which the investment adviser or its affiliate obtains “management rights.” A “derivative investment” is an acquisition of securities acquired upon conversion of a venture capital investment or in connection with a public offering, merger or reorganization of the operating company to which a venture capital investment relates.

An “operating company” is an entity primarily engaged in the production or sale of a product or service other than the management or investment of capital. “Management rights” are rights to substantially participate in, influence, guide or counsel the operating company with respect to its operations or business objectives.

Federal or State Regulation … or Both

An investment adviser with its principal place of business in California that has assets under management of $100 million or less must decide whether it must register with the SEC, obtain a license from the DOC, or rely on exemptions from either or both requirements. Further, reliance on certain exemptions at either the state or federal level may subject advisers to the Form ADV reporting obligations of an Exempt Reporting Adviser.

California Small Private Fund Managers

An investment adviser with assets under management of less than $25 million (“Small Adviser”) is prohibited by IAR §203A(a)(1) from SEC registration if it is regulated or required to be regulated in the state where it maintains its principal place of business unless it advises a SEC-registered investment company. Because California has enacted an investment adviser regulatory statute, a Small Adviser with its principal place of business in California is considered “regulated or required to be regulated” by the State of California for purposes of this rule.

Thus, a Small Adviser based in California that does not advise a SEC-registered investment company is prohibited from registering with the SEC and, as a corollary, cannot be an Exempt Reporting Adviser because it does not need to rely on the Private Fund Adviser Exemption or the VC Fund Adviser Exemption to be exempt from SEC registration. Such an adviser, however, must either obtain a DOC license in California or rely on a California license exemption. If that adviser relies on the proposed DOC Private Fund Advisor Exemption, it would have the same Form ADV reporting obligations to the DOC as an Exempt Reporting Adviser has to the SEC.

California Mid-Sized Private Fund Managers

An investment adviser with assets under management of $25 million to $100 million is considered a “Mid-Sized Adviser” under the new SEC rules. A Mid-Sized Adviser that is required to register with the state where it maintains its principal place of business, and if so registered, would be subject to examination by the authorities in such state, is prohibited from registering with the SEC unless it advises a registered investment company, a business development company, or would otherwise have to register with 15 or more states. Because California’s investment adviser regulatory statute provides for DOC examinations, an adviser required to obtain a DOC license is deemed required to register and subject to examination.

Accordingly, a Mid-Sized Adviser in California whose adviser activities do not require registering with at least 15 states, and which does not advise a SEC-registered investment company or a business development company, is prohibited from registering with the SEC if it is required to register in California. If such an adviser is not registered in California in reliance on an exemption, however, it must register with the SEC unless a federal exemption is available.

A California Mid-Sized Adviser that would rely on the proposed DOC Private Fund Adviser Exemption would likely also rely on the SEC Private Fund Adviser Exemption, and would be required to report to both the SEC and DOC on Form ADV.

Reporting and Qualification Summary

See the Reporting and Qualification Summary table below. The table summarizes the reporting and qualification requirements for a Small Advisor or Mid-Sized Advisor based in California under the new and proposed regulatory landscape, assuming the adviser can rely on the new SEC Private Fund Adviser Exemption and is not required to register with 15 or more states. In reading the table, the threshold question is whether the adviser is required to obtain the California license or instead qualifies for a California exemption.

Important Dates

Small Advisers and Mid-Sized Advisers in California can rely on the DOC Private Adviser Exemption at least until it expires on April 17, 2012, and may be able to rely on its equivalent in the proposed DOC Private Fund Adviser Exemption until June 28, 2012. Upon expiration of the DOC Private Adviser Exemption in April (or its proposed equivalent in June), such advisers will either need to qualify for a new California exemption or obtain a DOC license.

Meanwhile, Exempt Reporting Advisers – including California Mid-Sized Advisers exempt from the DOC license requirement in reliance on the current DOC Private Adviser Exemption – must file their initial Form ADV reports with the SEC by March 30, 2012.

If California does not finalize its proposed exemption before March 30, 2012, a Mid-Sized Adviser relying on the current DOC Private Adviser Exemption who does not satisfy the California exemption ultimately enacted, will have to report to the SEC on Form ADV by March 31, 2012 and soon thereafter obtain a DOC license.

Conclusion

The bottom line for a California private fund adviser managing $100 million or less, assuming the proposed DOC Private Fund Adviser Exemption is enacted in its current form, is that it will be required to file at least portions of Form ADV with the DOC, the SEC or both, as early as March 31, 2012. For assistance complying with these new regulatory obligations, please contact the Royse Law Firm.

For additional information on this topic, contact Tim Coxon.

Please see www.RroyseLaw.com or contact Royse Law Firm, PC at rroyse@rroyselaw.com for additional information.
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Reporting and Qualification Summary

This table summarizes the reporting and qualification requirements for a Small Advisor or Mid-Sized Advisor based in California under the new and proposed regulatory landscape, assuming the adviser can rely on the new SEC Private Fund Adviser Exemption and is not required to register with 15 or more states. In reading the table, the threshold question is whether the adviser is required to obtain the California license or instead qualifies for a California exemption.