Alert November 24, 2010

SEC Releases Proposed Rules to Implement New Exemptions from Investment Advisers Act Registration and Other Aspects of Dodd-Frank

On November 19, 2010,1 the Securities and Exchange Commission (the “SEC”) released proposed rules (the “Exemptive Rules”) to define and clarify key aspects of the new statutory exemptions from registration under the Investment Advisers Act of 1940 (the “Advisers Act”) for:

  • Venture capital fund advisers (the “Venture Capital Exemption”);
  • Private fund advisers with less than $150 million in assets under management in the United States (the “Private Fund Adviser Exemption”); and
  • Foreign private advisers (the “Foreign Private Adviser Exemption”).

The SEC also issued a companion release proposing rules and rule amendments (the “Implementing Rules”)2 that would require advisers who are exempt from registration under either the Venture Capital Exemption or the Private Fund Adviser Exemption (“Exempt Reporting Advisers”) to file reports with the SEC and would give effect to other provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Both the Exemptive Rules and the Implementing Rules are open for public comment and the SEC has requested input on a variety of questions and details. 


Effective July 21, 2011, most private fund managers will be required to register as “investment advisers” under the Advisers Act and, as such, comply with substantial disclosure, reporting, recordkeeping, operational and SEC examination obligations.3  However, the Advisers Act includes three new exemptions from registration for advisers that: (i) manage solely venture capital funds; (ii) have less than $150 million in private fund assets under management in the United States; or (iii) manage relatively few assets attributable to U.S. investors.  The Exemptive Rules address the scope and nature of these exemptions and the Implementing Rules impose specific reporting obligations on certain advisers relying upon these exemptions. The SEC also plans to propose additional recordkeeping requirements in the future. 

When finalized, the Exemptive Rules will fulfill the obligation of the SEC under the Dodd-Frank Act to define “venture capital fund” and provide an exemption for advisers with less than $150 million in private fund assets under management in the United States. The Exemptive Rules define “venture capital fund” in a manner that may exempt from registration under the Advisers Act most firms generally considered to be “venture capital firms” under common industry usage, although certain practical details will require additional consideration and revision through the comment process if this goal is to be met. The Private Fund Adviser Exemption would largely preserve a broad registration exemption for non-U.S. advisers because it focuses on the location from which assets are “managed” – a territorial approach similar to the SEC staff’s administration of the prior private adviser exemption.  The Foreign Private Adviser Exemption would provide a registration exemption primarily to foreign private advisers that have no place of business, and few sources of capital (i.e., clients and investors), in the United States. 

The Implementing Rules, which include amended Form ADV Part 1A and related materials, set forth new, detailed reporting requirements focused on private funds managed by registered investment advisers. The Implementing Rules would also require Exempt Reporting Advisers to complete and file significant portions of Form ADV Part 1A, a requirement that SEC Commissioner Casey, in voting against the Implementing Rules, characterized as having “collapsed the carefully wrought distinction between registered advisers and exempt advisers” and, as a result, having “effectively rendered empty” the exemptions for Exempt Reporting Advisers. The detailed proposals in the Implementing Rules are likely to generate significant comments. 

This Alert is focused upon the Exemptive Rules and those aspects of the Implementing Rules most applicable to Exempt Reporting Advisers.  We also note that the Dodd-Frank Act itself was structured in a manner that causes Exempt Reporting Advisers to remain subject to the SEC’s authority to require recordkeeping and reporting and, perhaps most significantly, to the SEC’s examination authority, a fact that was observed by the SEC in both releases although the SEC did not specify the extent or nature of any examination process that would be applicable to Exempt Reporting Advisers. The SEC also noted that Exempt Reporting Advisers may in any event be subject to state registration and other requirements. 

Venture Capital Exemption

 As noted above, the Venture Capital Exemption is available to advisers that manage solely venture capital funds.  The Exemptive Rules define “venture capital fund” on a prospective basis and provide a relatively generous “grandfather” rule for certain existing funds. 

Definition of Venture Capital Fund.   Under the Exemptive Rules, a venture capital fund is any private fund4 that has all of the following attributes. 

  1. The fund must represent to investors and potential investors that it is a venture capital fund. While many funds within the venture capital industry will easily satisfy this requirement, it is less clear how it would apply to funds that engage in venture capital-style investing but use different terminology in their marketing materials (e.g., “growth” funds).  One possible result is that industry participants will adopt a variety of new labels designed to qualify for the Venture Capital Exemption and still identify their particular segment within the venture capital market (e.g., “late stage venture capital” or “growth stage venture capital”). Another possible result is that funds will represent that they will be managed in compliance with the elements of the Venture Capital Exemption, an approach that is expressly approved in the Exemptive Rules. 
  2. The fund must own solely (i) equity securities issued by qualifying portfolio companies and (ii) cash, certain cash equivalents and U.S. treasury securities with a remaining maturity of 60 days or less.

    a.         Equity Securities.  In general, equity securities include: (i) common and preferred stock; (ii) warrants, convertible debt (e.g., convertible bridge loans), and other securities that are convertible into stock; and (iii) certain limited partnership interests.5  Significantly, “straight” (i.e., non-convertible) debt generally would not be treated as an equity security for this purpose.  Also, the proposing release setting forth the Exemptive Rules (the “Proposing Release”) does not affirmatively discuss the many types of hedges and other arrangements commonly used by venture capital funds to mitigate the risk of changes in the value of equity securities held, or currencies used, by such funds, thereby creating the possibility that venture capital fund advisers will be incentivized to avoid hedging and similar risk-mitigation techniques in the future. With respect to each qualifying portfolio company, at least 80% of the equity securities held by the fund must have been acquired directly from the company, rather than on a secondary basis.

    b.         Qualifying Portfolio Companies.  In general, a qualifying portfolio company: (i) is not “publicly traded,” or controlling, controlled by or under common control with a company that is “publicly traded,” at the time of investment by the fund; (ii) does not borrow or issue debt obligations, directly or indirectly, in connection with the fund’s investment; (iii) does not redeem, exchange or repurchase its securities, or make distributions to pre-existing security holders, in connection with the fund’s investment; and (iv) is not itself an investment company, private fund, commodity pool or exempt asset-backed securities vehicle. For this purpose, “publicly traded” companies include U.S. “reporting companies” (e.g., companies traded on U.S. exchanges, etc.) as well as companies with securities listed or traded on foreign exchanges or markets.

    As discussed in the Proposing Release, borrowing by a portfolio company in the ordinary course of its business to finance inventory, capital equipment, payroll, etc. will not be treated as borrowing “in connection with” the fund’s investment.

    The focus of the Exemptive Rules on the actions of portfolio companies may place significantly more pressure on representations and covenants regarding a prospective portfolio company’s use of proceeds, and a greater need for diligence regarding any possible borrowing, redemption, exchange or similar transaction.  It also may preclude certain common uses of proceeds, such as repayment of indebtedness incurred by a start-up company attempting to “bootstrap” itself prior to, or while seeking, investment from a venture capital fund.

    The Proposing Release clarifies that a company will not cease to be a qualifying portfolio company solely by virtue of becoming publicly traded after the fund’s investment (although follow-on investing in the “now public” company would not be permitted).  However, the Proposing Release does not discuss the status of publicly traded securities received by the fund pursuant to a portfolio company merger or acquisition.  It appears clear that a venture capital fund could not invest in PIPEs or similar securities issued by public companies without subjecting its adviser to registration.

    It is unclear how strongly the SEC intends to interpret the word “solely” in this context.  Venture capital funds routinely own assets that are not equity securities, cash, cash equivalents or U.S. treasuries.  Examples include rights and interests in escrows, lawsuits, intellectual property, and miscellaneous proceeds from the liquidation of portfolio companies.  Also unclear is a venture capital fund’s ability to invest in otherwise qualifying portfolio companies through holding companies or special purpose vehicles.  Under a strict interpretation of the proposed rule, it would appear that even a single investment in a company that is not a “qualifying portfolio company” could cause a fund not to be a venture capital fund, and an adviser to become subject to registration. 
  3. With respect to each qualifying portfolio company, a venture capital fund must either: (i) offer to provide (and, if such offer is accepted, actually provide) significant guidance and counsel concerning the management, operations, or business objectives and policies of the company; or (ii) control the company. 

    The Proposing Release does not specify the definitive attributes of such guidance and counsel, although it appears that “mentoring” or similar activities may be sufficient (if “significant”), even in the absence of board participation.  The Proposing Release notes that this requirement is a modified version of the requirement that business development companies make available “significant managerial assistance” and observes that it does not address “how managerial assistance is determined for funds that invest as a group.”  The Proposing Release also does not define “control.” 
  4. The fund must not issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15% of its aggregate capital contributions and uncalled committed capital, and any such borrowing, guarantee or leverage must be for a non-renewable term of 120 days or less.

    While venture capital funds typically do not engage in long-term borrowing to make investments (i.e., leveraged investing), this proposed requirement may interfere with a number of routine fund operations.  For example, many funds maintain a revolving line of credit to “bridge” outstanding capital calls, and guarantees of portfolio company indebtedness often remain outstanding for more than 120 days. The Proposing Release requests comment on the typical borrowing practices of venture capital funds, and notes that this aspect of the definition is designed to address concerns linking financial leverage and systemic risk.
  5. The fund must not redeem the interests of its own equityholders absent extraordinary circumstances, but may make distributions to all holders on a pro rata basis. As described in the Proposing Release, “extraordinary circumstances” should include common triggers for redemption rights that typically are beyond the control of the adviser, such as illegality, changes in law, etc. However, the Proposing Release does not discuss the meaning of “pro rata” in the context of a fund manager’s carried interest. 
  6. The fund must not be registered as an investment company under the Investment Company Act of 1940 (i.e., the fund must not be a mutual fund) or have elected to be a business development company under such Act.

Grandfather Rule for Existing Venture Capital Funds.   Under the Exemptive Rules, the term “venture capital fund” also includes any existing private fund having all of the following attributes:

  1. At the time of offering its securities, the fund must have identified itself to investors and potential investors as a venture capital fund. Similar to the requirement for new funds described above, it is not clear how this requirement would apply to existing funds that engage in venture capital-style investing but used different terminology when referring to themselves in their marketing materials.  However, for existing funds, such ambiguity cannot be addressed through the adoption of new “labels” or more limited strategies, since most existing funds’ marketing materials cannot be changed retroactively.  Thus, as drafted, this requirement may exclude many advisers from the grandfather rule if their marketing materials describe potential investments other than classic venture capital investments or simply used alternative terminology (e.g., “growth investing”). 
  2. Prior to December 31, 2010, the fund must have sold securities to one or more persons unrelated to the fund’s adviser.
  3. The fund must not sell securities, or accept additional capital commitments, after July 21, 2011, although the fund may call unfunded capital commitments after such date for an unlimited time. Existing funds that qualify under the grandfather rule would not need to satisfy the more detailed definition of venture capital fund described above. 

Private Fund Adviser Exemption

U.S. Advisers.   Under the Exemptive Rules, an adviser with its principal office and place of business6 in the United States would be exempt from registration under the Advisers Act if it: (i) acts solely as an adviser to “Qualifying Private Funds” (i.e., funds that have not registered as investment companies or elected to be business development companies under the Investment Company Act of 1940); and (ii) manages private fund assets of less than $150 million.7  Such advisers generally would be required to include all assets under management for purposes of determining whether this threshold had been reached, including assets managed from outside the United States.

Non-U.S. Advisers.   Under the Exemptive Rules, an adviser with its principal office and place of business outside the United States (a “non-U.S. adviser”) would be exempt from registration under the Advisers Act if: (i) all of its clients that are U.S. persons8 are Qualifying Private Funds; and (ii) all assets it manages from any place of business9 in the United States are solely attributable to Qualifying Private Funds and have a total value of less than $150 million. Any assets managed from a U.S. place of business for clients other than Qualifying Private Funds would render the exemption unavailable.

In this proposal, the SEC focuses on the geographic location at which management services are based (i.e., a territorial approach), rather than focusing on the “source” of assets under management.  If an adviser has its “principal office and place of business” in the United States, it is deemed to manage10 within the United States all of its assets under management, whereas an adviser that has its principal office and place of business outside the United States is analyzed on the basis of its actual activities in the United States.  As a result, non-U.S. advisers would be subject to a rule that is similar in scope to existing exemptive relief.  For example, an adviser with its principal office and place of business outside the United States would not be required to register under the Advisers Act, even if it:

  1. Manages from outside of the United States Qualifying Private Funds with an unlimited amount of investment from U.S. investors;
  2. Advises non-U.S. clients that are not Qualifying Private Funds; or
  3. Relies upon extensive research or other advisory services that are not considered “management” and are provided by its own employees from within the United States.

Foreign Private Adviser Exemption

In general, a foreign private adviser would be exempt from registration11 under the Advisers Act if it: (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients and investors in the United States in private funds managed by the adviser; (iii) has less than $25 million of aggregate assets under management attributable to such clients and investors;12 and (iv) neither holds itself out to the public in the United States as an investment adviser nor advises mutual funds or business development companies.

  1. Client.  The following generally may be deemed to constitute a single “client” of an adviser: (a) a natural person (and such person’s relatives and trusts); and (b) a partnership, corporation or other legal organization (or two organizations with identical ownership) to which the adviser provides advice based on the organization’s investment objectives, rather than the individual objectives of the organization’s owners.13  These rules are non-exclusive safe harbors and there may be other situations in which multiple persons constitute a single “client”; however, the Proposing Release states that an adviser would not be allowed to disregard a person for whom the adviser provides services without compensation.
  2. Investor.  An “investor” of a private fund generally includes a classic “limited partner” as well as any other person that would be taken into account when determining whether the private fund came within the exclusions from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940, although “knowledgeable employees” and holders of short-term paper issued by a fund would count as “investors” (even if they are not counted for purposes of Section 3(c)(1) or Section 3(c)(7)).  By counting knowledgeable employees toward the 15 investor threshold, the Exemptive Rules narrow an already narrow exemption, particularly for non-U.S. advisers with senior managers based in the United States.
  3. In the United States.  An investor or client generally is treated as being “in the United States” if that investor or client is a “U.S. person” for purposes of Regulation S, except with respect to certain discretionary accounts for U.S. persons.  However, if a person was not actually in the United States at the time the person became an investor or client, that person may be treated for purposes of this rule as not being in the United States.  Under this exception, if subscriptions for private fund interests were submitted and accepted when the applicable investors were outside the United States, those investors (and the related subscription amounts) presumably could be excluded from the adviser’s assets and investors attributable to the United States even if, for example, the investors subsequently relocated to the United States (although future subscriptions would be analyzed by reference to the location of the investors at the time such subscriptions were submitted and accepted).  Also, an adviser need not count a particular private fund it manages as a client if the adviser already counts any investor in that fund as an investor “in the United States” for purposes of the Foreign Private Adviser Exemption.

New Obligations for Exempt Reporting Advisers

The Implementing Rules would require Exempt Reporting Advisers to submit to the SEC by August 20, 2011, and periodically update thereafter, reports consisting of a subset of the items on Form ADV.  Those reports would be submitted electronically through the online Investment Adviser Registration Depository and would be publicly available on the SEC website.

Specifically, an Exempt Reporting Adviser would be required to report the following information in Part 1A on Form ADV:

  1. Certain identifying information regarding the Exempt Reporting Adviser, including its name, address, contact information and non-U.S. registration (if any), as well as an indication of whether the adviser itself (not its clients) has $1 billion or more in assets as of its most recent fiscal year end (to identify advisers covered by Section 956 of the Dodd-Frank Act addressing certain incentive-based compensation arrangements);
  2. The form of its organization;
  3. Whether it is claiming the Venture Capital Exemption or the Private Fund Adviser Exemption;
  4. Certain details regarding other business activities in which the Exempt Reporting Adviser and its affiliates are engaged;
  5. Certain details regarding its financial industry affiliations (including through portfolio companies that constitute “related persons”) and private funds it manages (as described in more detail below);
  6. The identity of owners, officers and controlling persons of the adviser (including the ownership percentage, within certain ranges, of the firm by such persons); and
  7. Disciplinary history for the Exempt Reporting Adviser and its non-clerical/administrative employees, directors, officers, partners and certain controlled or controlling persons.

In addition, Exempt Reporting Advisers will be required to amend their reports on Form ADV at least annually, within 90 days of their fiscal year end (and, in certain cases, promptly upon the reported information becoming inaccurate). 

Exempt Reporting Advisers would be required to report the following information about each private fund they advise, subject to certain exceptions:14

  1. The size of the fund (measured by both gross and net assets) and the securities law exemptions on which it relies;
  2. The fund’s investment strategy (based on seven categories);
  3. The assets and liabilities of the fund by class and categorization within the fair value hierarchy established under U.S. generally accepted accounting principles (“U.S. GAAP”), even if the fund is not a U.S. fund and does not report to investors under U.S. GAAP;
  4. The number and type of investors in the fund (including, in particular, the percentage owned by the adviser and its related persons, the percentage owned by non-U.S. persons and the percentage owned by specified types of institutional and individual investors) as well as the minimum amount an investor is permitted to invest;
  5. Information about fund characteristics that the SEC believes may present the adviser with potential conflicts of interest (such as whether the adviser’s clients are solicited to invest in the fund); and
  6. Information regarding five specific types of service providers to the fund (auditors, prime brokers, custodians, administrators and marketers) that the SEC considers to perform important roles as “gatekeepers.” This information will include whether the service provider is related to the adviser, information about the services provided and information about the service provider’s registration or other status.

In the release setting forth the Implementing Rules, the SEC acknowledges that reporting this information may be burdensome and costly, but states its belief that the reports will help the SEC identify industry practices that may harm investors and facilitate the earlier discovery of potential misconduct. 

What’s Next  

Upon publication in the Federal Register, the Exemptive Rules and Implementing Rules will be subject to a public comment period of 45 days.  We expect that participants in the private funds industry (both advisers and investors), as well as other interested parties, will submit numerous comments.  During the SEC’s open meeting on November 19, 2010, SEC Chairman Mary Schapiro affirmed her intention that the proposed rules be finalized well in advance of July 21, 2011 so that fund managers have sufficient time to arrange for their compliance with the Advisers Act, whether or not they qualify for any exemption.  Nevertheless, we recommend that fund managers consider the possibility that comments may (or may not) result in substantial revision to the proposed rules or that final rules may be delayed until very close to the registration deadline. 

We will continue to monitor developments in this area.  In the interim, please contact your Goodwin Procter LLP attorney with any questions or concerns.


1 This Alert expands upon Goodwin Procter’s November 19, 2010 Client Alert, “SEC Proposes Definition of ‘Venture Capital Fund’ for Purposes of Investment Advisers Act Registration Exemption.” 

2 The Exemptive Rules and Implementing Rules, together with SEC Staff explanatory notes and requests for comments, are available here and here

3 Please see Goodwin Procter’s July 23, 2010 Client Alert, “Private Fund Investment Advisers Registration Act of 2010 Signed Into Law.”

4 In general, the definition of “private fund” excludes publicly available funds such as registered investment companies (e.g., mutual funds) and “business development companies.” The definition of “private fund” also excludes non-U.S. funds that do not use U.S. jurisdictional means to conduct a U.S. private offering, with the potentially unintended consequence that an exclusively non-U.S. fund that otherwise satisfies the definition of a “venture capital fund” may cause its adviser to fail to meet the conditions of the exemption because the adviser would not be managing solely “venture capital funds.”

5 The Exemptive Rules do not address limited liability company interests.

6 “Principal office and place of business” means “the executive office of the investment adviser from which the officers, partners, or managers of the investment adviser direct, control, and coordinate the activities of the investment adviser.” 

7 For purposes of the $150 million threshold, U.S. and non-U.S. advisers would be required to determine the value of their assets at the end of each quarter in accordance with the revised Form ADV proposed in the Implementing Release. 

8 “U.S. person” generally has the meaning attributable to it in Regulation S, promulgated under the Securities Act of 1933 (“Regulation S”) (which can be found here), except with respect to certain discretionary accounts for U.S. persons. 

9 “Place of business” means “(i) an office at which the investment adviser regularly provides investment advisory services, solicits, meets with, or otherwise communicates with clients; and (ii) any other location that is held out to the general public as a location at which the investment adviser provides investment advisory services, solicits, meets with, or otherwise communicates with clients.”

10 I.e., to provide continuous and regular supervisory or management services as contemplated in the instructions to Item 5F of Form ADV Part 1A. 

11 The adviser also would not be an Exempt Reporting Adviser. 

12 Although Congress authorized the SEC to raise this $25 million threshold, the Exemptive Rules did not propose to do so. 

13 The Exemptive Rules use the description of legal organization currently found in Advisers Act Rule 203(b)(3)-1.

14 The following are exceptions to this reporting requirement: (i) an adviser with a principal office and place of business outside of the United States would not be required to provide this information in respect of a non-U.S. fund that is not offered to, or owned by, U.S. persons; (ii) certain information about master-feeder fund structures could be consolidated; and (iii) sub-advisers would not need to report this information about a particular fund if the primary adviser already reports the information.