Tuesday, 25 April 2017
Last updated 3 hours ago
Oct 17 2007 | 11:20am ET
By Donald S. Davidson and Cortney Scott
The California Department of Corporations (the “Department”) recently announced plans to delete an exemption from registration for certain investment advisers that has been on the books since 2002. The proposed rule change is aimed at California hedge fund advisers, but other investment advisers to pooled investment vehicles may be affected as well. Private equity managers in particular also may be required to register with the Department as investment advisers if the funds they manage do not meet California’s definition of a venture capital company.
The Department plans to amend California Corporate Securities Law of 1968 (“CSL”) Rule 260.204.9 to limit the adviser registration exemption established therein solely to advisers who work for “venture capital companies” (the “Proposed Amendment”). The Proposed Amendment would require any other person who meets California’s definition of an “investment adviser” to register with the Department if the adviser: a) has a place of business in California or has six or more “clients” in California; and b) is exempt from registration with the SEC by virtue of the so-called “de minimis exemption” contained in Section 203(b)(3) of the Investment Advisers Act of 1940 (“IAA”).
Citing only the somewhat dated 2003 Securities and Exchange Commission (“SEC”) hedge fund study and the SEC’s failed 2004 bid to require hedge fund advisers to register with it, the Department claims that the growth of hedge funds, the increase in fraud related to hedge fund activities and the increased participation in hedge funds by retail investors all warrant state action. The Department did not acknowledge any dissenting views — most notably those of the President’s Working Group on Financial Markets — suggesting that additional regulatory oversight of hedge funds and their advisers is unnecessary.
Interested parties may request a public hearing on the Proposed Amendment by submitting a written request no later than November 11, 2007, and may submit written comments on the proposal until November 26, 2007.
Background and Brief History
In pertinent part, Section 25009 of the CSL defines an “investment adviser” as “any person who, for compensation, engages in the business of advising others... as to the advisability of investing in, purchasing or selling securities...” Section 25230 of the CSL requires investment advisers to register with the Department unless they are exempt. CSL Section 25202, adopted in 1997, provides that an adviser is not subject to registration if the adviser does not have a place of business in California and had no more than five California clients during the preceding 12-month period. An adviser who failed to meet both conditions would be required to register with the Department unless the adviser was registered with the SEC under IAA Section 203(b).
In 2002, the Department adopted Rule 260.204.9, which exempts any investment adviser from the registration requirements of Section 25230 if the adviser:
1. does not hold itself out generally to the public as an investment adviser;
2. has fewer than 15 clients;
3. is exempt from SEC registration by virtue of IAA Section 203(b)(3); and
(i) has assets under management of at least $25,000,000; or
(ii) provides investment advice to venture capital companies only.
The Department’s Statement of Reasons supporting the original adoption of Rule 260.204.9 made it clear that the intended beneficiaries were advisers to venture capital companies. However, the use of the disjunctive “or” in subsection (4) allowed other advisers to be exempted from registration if they met conditions (1) through (3) and had assets under management of $25,000,000 or more.
Satisfying conditions (1) and (3) is usually easy for hedge fund and private equity managers. Subsection (2) also is generally not a problem since CSL Section 25202(b) borrows the federal definition of “client” used in IAA Section 222(d) and IAA Rule 203(b)(3)-1, which counts the fund itself, rather than the individual investors in the fund, as the “client” for purposes of IAA Section 203(b)(3). As a result, hedge fund and private equity managers could avoid registering with the Department if their funds were large enough.
Nor, at that time, did federal law require most hedge fund and private equity managers to register with the SEC, because they were able to rely upon the “de minimis” exemption set forth in IAA Section 203(b)(3). That exception applies if the adviser: (i) had fewer than fifteen “clients” during the preceding twelve months, (ii) does not hold itself out generally to the public as an investment adviser, and (iii) is not an adviser to any investment company registered under the Investment Company Act of 1940. As noted in the preceding paragraph, IAA Rule 203(b)(3)-1 allowed managers of pooled investment vehicles organized as limited partnerships to treat the partnership itself, rather than the limited partners who invested in the partnership, as the “client” for purposes of IAA Section 203(b), provided that the adviser was not taking individual investor objectives into account in managing the fund.
There things stood until 2004 when the SEC adopted IAA Rule 203(b)(3)-2, which required many hedge fund advisers to count each individual investor in their funds as a separate “client” for purposes of determining whether SEC registration was required. This was a complete “about face” from the SEC’s prior position and was intended to require virtually all hedge fund managers to register as investment advisers. The SEC’s effort, though, was short-lived. In 2006, the U.S. Court of Appeals for the D.C. Circuit vacated IAA Rule 203(b)(3)-2 in Goldstein, et al. v. SEC,8 holding that the SEC’s reversal of its position on counting hedge fund investors as individual “clients” solely for adviser registration purposes was both arbitrary and unsupported by the IAA. Consequently, hedge fund advisers are once again exempt from federal registration requirements if they meet the standards of IAA Section 203(b)(3).
The Department’s Proposed Amendment to Rule 260.204.9
The Department’s proposal to amend CSL Rule 260.204.9 is an attempt to require the registration of hedge fund managers who are no longer subject to federal registration under IAA Rule 203(b)(3)-2 due to the Goldstein decision. The Proposed Amendment would eliminate the fifteen client cap and the $25 million minimum assets provisions so that Rule 260.204.9 would exempt from Section 25230 registration only those investment advisers that:
1. do not hold themselves out generally to the public as investment advisers;
2. are exempt from SEC registration by virtue of the “de minimis” exception carved out by IAA Section 203(b)(3); and
3. provide investment advice to venture capital companies only.
Thus, under the Proposed Amendment, investment advisers other than those that advise only venture capital firms would be required to register with the Department if they are: a) not registered with the SEC; and b) either have a place of business in California or have more than five California “clients.” Since California must and does use the federal definition of “client” set forth in IAA Section 222(d) and IAA Rules 203(b)(3)-1 and 222-2 (which, as noted above, treats the hedge fund itself as the adviser’s “client” rather than the individual investors in the fund), hedge fund managers who do not have a place of business in California will not have to register with the Department, regardless of how many California residents may be investors in their funds.
Private Equity Funds
It is unclear whether the Proposed Amendment will require private equity managers to register with the Department as investment advisers. The answer may well turn on whether the private equity fund qualifies for the “venture capital company” exemption under Rule 260.204.9(b)(3), et seq. In order to qualify, the entity must have at least half of its long-term assets invested in “venture capital investments” or “derivative investments.” A venture capital investment is defined as “an acquisition of securities in an operating company as to which the [investor]... has... management rights,” i.e., the right to “substantially influence the conduct of, or 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.” To qualify as an “operating company,” the entity in which the fund owns an equity stake and has management rights must be “primarily engaged... in the production or sale... of a product or service other than the management or investment of capital.”
If the private equity fund has the right to play an active role in managing the “operating company” in which the fund has invested capital, the fund manager may be exempt from registering as an investment adviser under the venture capital company exception. If, on the other hand, the entity in which the fund has invested does not qualify as an “operating company” the investment may not be a “venture capital investment” and the registration exemption will not apply. Similarly, if the fund is not a lead investor (and thus lacks management rights), or the investment is “late stage” venture capital when new investors may not get board seats or other management rights, or the fund’s investment in the entity is otherwise too passive, the investment will not qualify as a “venture capital investment” within the meaning of the rule. This means that if the Proposed Amendment is adopted, private equity managers will have to carefully examine and monitor their investments to see if they meet the venture capital registration exemption.
If adopted, the Proposed Amendment to Rule 260.204.9 will put California on an equal footing with neighboring states that require hedge fund managers who maintain a place of business in their respective jurisdictions to register with their state securities regulator. It may, however, create a strong incentive for hedge funds and private equity funds to flee California to states, such as New York and Connecticut, that do not require most hedge fund managers to register as investment advisers. A compelling argument can be made that a high-cost state like California needs all the advantages it can garner in attracting and keeping well-paying financial jobs such as those provided by these entities. By relying solely on the SEC’s 2003 hedge fund report and ignoring more recent dissenting voices suggesting that additional regulation of pooled investment vehicles is unnecessary, the Department has not made a convincing case for the Proposed Amendment. As recent court cases make clear, state and federal regulators in California are fully capable of pursuing suspected instances of financial fraud, including those involving pooled investment vehicles, without the need for any new registration regime.
We recommend that interested parties send comments to the Department before the November 26 deadline urging reconsideration of the Proposed Amendment.
This alert was authored by Donald S. Davidson, partner, broker-dealer at Bingham, and Cortney Scott, associate.
For more on this rule as well as proposed changes to rules and reporting requirements for broker dealers, see Bingham's Web Site.