On March 15, the California Department of Corporations (the “DOC”) released an invitation for comment on a proposal (the “Proposal”) to amend the existing rules governing certain exemptions from California’s investment adviser licensing requirements to reflect changes to the federal statutory and regulatory scheme regulating the registration of and exemption of investment advisers under the Investment Advisers Act of 1940 (the “Advisers Act”).
The DOC has invited public comments on the Proposal through March 28, 2011 and has requested input on a variety of questions and details.
The Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), among other things, substantially revised the regulation of investment advisers under federal law by eliminating an exemption from registration widely used by many advisers and creating new exemptions.1 Specifically, the Dodd-Frank Act eliminates, as of July 21, 2011, the “private adviser” exemption under Section 203(b)(3) of the Advisers Act, which exempts from federal registration any investment adviser that has had fewer than 15 clients within the last 12 months and neither holds itself out to the public as an investment adviser nor acts as an investment adviser to any registered investment company.
Current California Rule
Section 260.204.9 of Title 10 of the California Code of Regulation currently exempts from California’s investment adviser licensing requirements any investment adviser that (i) does not hold itself out generally to the public as an investment adviser, (ii) has fewer than 15 clients, (iii) relies on Section 203(b)(3) under the Advisers Act, and (iv) either has not less than $25 million in assets under management, or only provides investment advice to “venture capital companies,” as defined in the exemption. This exemption currently applies to a broad range of venture capital funds, hedge funds, private equity funds and debt funds.
As a result of the Dodd-Frank Act, effective on July 21, 2011, Section 260.204.9 will no longer provide an exemption from California licensing requirements.
Revision to California Rule Under Consideration
The California Corporations Commissioner has invited comments on the following rule to replace the current exemption from licensing as an investment adviser in the state of California. The solicitation of comments is not a formal proposed rulemaking action, and the public will have an additional opportunity to comment on proposed changes if, after consideration of the comments from interested parties, the DOC proceeds with a notice of a proposed rulemaking action.
Under the Proposal, an adviser will be exempt from licensing as an investment adviser if the adviser satisfies all of the following conditions:
- The adviser only advises “private funds.”2
- The adviser files the same reports with the Commissioner that an “exempt reporting adviser” under the Advisers Act would be required to file with the Securities and Exchange Commission (the “SEC”).3
- The adviser either has assets under management4 of not less than $100 million or provides investment advice only to “venture capital companies.”5
- The adviser is exempt from federal registration under the Advisers Act because the adviser is either a “venture capital fund adviser” under Section 203(l) of the Advisers Act or a “private fund adviser” under Section 203(m) of the Advisers Act.6
If the Rule Is Adopted, How Will Regulation of California Fund Managers Differ from Regulation Today?
Under the Dodd-Frank Act, some California funds managers currently exempt from registration, both on the federal level and in California, will need to register with the SEC. Under federal law, these managers will be exempt from licensing in California (although not from all regulation by California), and will not be affected by the Proposal.
If the Proposal is adopted, California fund managers in the following categories will be required to file in California substantially the same information they are expected to be required to file with the SEC under the federal rules proposed pursuant to the Dodd-Frank Act:
- Fund managers that qualify for the federal exemption for advisers to venture capital funds.
- Fund managers that qualify for the federal exemption for advisers to private funds with less than $150 million of assets under management and that qualify under California’s existing standard of “providing advice only to venture capital companies” (which is considerably broader than requirements of the proposed federal exemption for venture capital fund managers).
- Fund managers that qualify for the federal exemption for advisers to private funds with less than $150 million of assets under management that have at least $100 million of assets under management.
If the Proposal is adopted, California fund managers for which each of the following is true will be required to be licensed in California: (i) they do not qualify under California’s existing standard of “providing advice only to venture capital companies”; (ii) they qualify for the federal exemption for advisers of private funds with less than $150 million of assets under management; and (iii) they have less than $100 million of assets under management.
The Proposal will be subject to a public comment through March 28, 2011. We expect that participants in the private funds industry (both advisers and investors), as well as other interested parties, will submit comments.
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 Please see Goodwin Procter’s November 24, 2010 Client Alert for a summary of the proposed exemptions and implementing rules.
2 “Private fund” means an issuer that would be an investment company, but for Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (the “Investment Company Act”).
3 The reports are described in Goodwin Procter’s November 24, 2010 Client Alert.
4 “Assets under management” means the securities with respect to which an investment adviser and its affiliated persons provide continuous and regular supervisory or management services; provided, that in the case of securities managed for an entity which is excluded from the definition of investment company by the exclusion provided in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act, assets under management shall also include any amount payable to such entity pursuant to a firm agreement or similar binding commitment pursuant to which a person has agreed to acquire an interest in, or make capital contributions to, the entity upon demand of such entity.
5 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 50% of its assets, valued at cost, are venture capital investments. 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. “Management Rights” means the right, obtained contractually or through ownership of securities, either through one person alone or in conjunction with one or more persons acting together or through an affiliated person, to substantially participate in, to substantially influence the conduct of, or to provide (or offer to provide) significant guidance and counsel concerning the management, operations or business objectives of the operating company in which the venture capital investment is made.
6 Both exemptions are discussed in more detail in Goodwin Procter’s November 24, 2010 Client Alert, which describes SEC rule proposals that would define and clarify these statutory exemptions and create reporting obligations for these “exempt reporting advisers.”