California Finalizes Investment Adviser Exemption

By Tim Coxon

The California Corporations Commissioner filed the final draft of the state’s proposed private fund adviser exemption with the Office of Administrative Law on July 16, 2012. The Office of Administrative Law has until August 27 to file the exemption with the Secretary of State, at which point the exemption will become law.

The new law will exempt from the California investment adviser certificate requirement an investment adviser to certain kinds of private equity funds. The exemption defines two classes of private equity funds – qualifying private funds and retail buyer funds – and imposes different requirements on advisers to funds from each class.

A “qualifying private fund” is an issuer that qualifies for exclusion from the definition of an investment company under any of sections 3(c)(1), 3(c)(5) or 3(c)(7) of the Investment Company Act.

A “retail buyer fund” is a qualifying private fund that qualifies for exclusion from the definition of an investment company under any of sections 3(c)(1) or 3(c)(5) of the Investment Company Act and is not a “venture capital company.”

An investment adviser solely to one or more qualifying private funds is not required to obtain the California investment adviser certificate if it files certain portions of Form ADV with the California Commissioner, pays an annual fee and is not subject to certain statutory “bad boy” disqualifications.

In addition, with respect to any retail buyer funds advised, an exempt adviser must ensure (1) the fund only sells securities to accredited investors and the adviser’s own managers, directors, officers and employees, (2) the fund’s investors receive annual audited financial statements and certain other written disclosures, and (3) the adviser does not earn compensation based on capital gains or capital appreciation from fund investors who are not “qualified clients” under SEC Rule 205-3(d).

Venture Capital Company
Because the additional requirements for advisers to retail buyer funds are potentially burdensome, an adviser to a 3(c)(1) or 3(c)(5) fund that relies on the new exemption would prefer the fund come within the statute’s definition of “venture capital company” and thereby avoid being classified as a retail buyer fund.

Prior drafts of the exemption limited the venture capital company definition to funds that held at least 50% of their assets (other than short-term investments) in venture capital investments or derivative investments.

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

The final draft of the exemption expands the definition of venture capital company to include a fund that either (1) satisfies the above definition, (2) satisfies the ERISA definition of a “venture capital operating company” or (3) satisfies the SEC Rule 203(l)-1 definition of a “venture capital fund.”

The SEC Rule 203(l)-1 definition, unlike the ERISA definition and the definition outlined above, does not require a fund to obtain management rights. Thus, the expanded definition in the final California exemption permits exempt advisers to pursue a wider range of venture capital strategies, including strategies that do not involve securing board seats or other management rights in portfolio companies, without having to satisfy the additional requirements related to retail buyer funds.

Form ADV
Investment advisers relying on the state exemption must file the same parts of Form ADV that “exempt reporting advisers” under SEC Rule 204-4 must file. These sections 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.

State or Federal Regulation
Under new SEC rules promulgated in connection with Dodd-Frank, an investment adviser with assets under management of less than $25M (a “Small Adviser”) is prohibited from SEC registration if it is regulated or required to be regulated in the state where it maintains its principal place of business. A California-based Small Adviser to private funds is “regulated” by the state of California and is thus prohibited from registering with the SEC, regardless of whether such adviser obtains a state certificate or relies on the new state exemption.

The SEC rules also provide that an adviser with assets under management of $25M to $100M (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 SEC registration.

A Mid-Sized Adviser to private funds that relies on the new state exemption, by virtue of that reliance, is not “required to register” in California and thus is required to register with the SEC or rely on a federal exemption from SEC registration. The likely exemption from SEC registration for such an adviser would be the private fund adviser exemption provided in SEC Rule 203(m)-1. And reliance upon that federal exemption carries the same Form ADV reporting obligations as are required by the California exemption.

California-based investment advisers to private funds, whether exempt or registered at either the state or federal level, must file at least portions of Form ADV. All such filings are required to be made electronically through the Investment Advisor Registration Depository ( Investment advisers who plan to rely on the new California exemption have 60 days from the effective date of the exemption to file their initial Form ADV with the state.

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Roger Royse

Roger Royse, the founder of the Royse Law Firm, works with companies ranging from newly formed tech startups to publicly traded multinationals in a variety of industries. Roger regularly advises on complex tax structuring, high stakes business negotiations and large international financial transactions. Practicing business and tax law since 1984, Roger’s background includes work with prominent San Francisco Bay area law firms, as well as Milbank, Tweed, Hadley and McCloy in New York City.
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