Massachusetts recently approved regulations relating to investment advisers, including the elimination of a frequently relied-on exclusion from the definition of investment adviser, and the adoption of a new exemption from the registration requirements for investment advisers to solely “private funds,” subject to certain conditions. The regulations were published in the Massachusetts Register on Feb. 3, 2012, and became effective on that day, but will not be enforced until Aug. 3, 2012. The regulations are intended to complement the rules enacted by the SEC pursuant to the Dodd-Frank Act that regulate investment advisers to private funds.
Change to Definition of Institutional Buyer
The new regulations revise the definition of “institutional buyer,” resulting in the elimination of an exclusion from the definition of investment adviser that many advisers to 3(c)(1) and 3(c)(7) funds had previously relied on to avoid registration in Massachusetts. An adviser solely to “institutional buyers” is excluded from the definition of “investment adviser” pursuant to Section 401(m) of the Massachusetts Uniform Securities Act and therefore is not required to register with the Massachusetts Securities Division (the “Securities Division”). Prior to the change on Feb. 3, 2012, “institutional buyer” was defined in the Securities Division regulations as including “an investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933…each of whom has invested at least $50,000.” Since investors in a 3(c)(1) or 3(c)(7) fund are typically limited to investors that are at least “accredited investors,” any such fund with a minimum investment requirement of $50,000 would have qualified as an “institutional buyer,” and the adviser to such fund was not required to register as an investment adviser in Massachusetts under the prior regulations.
The new regulations essentially remove this category of “institutional buyer” effective Feb. 3, 2012. The regulations allow advisers access to funds that existed prior to Feb. 3, 2012, who were relying on this exclusion to continue managing such funds without registering as an investment adviser in Massachusetts, provided that the funds cease accepting new beneficial owners as of that date.1 Therefore, an adviser cannot continue to rely on this exclusion if it advises any fund established on or after Feb. 3, 2012 or any fund that accepts new beneficial owners on or after that date. Instead, an adviser who anticipates launching a new fund or accepting new beneficial owners to an existing fund must look to the new private fund exemptions (and their associated conditions) described below to determine if it can continue to avoid registration in Massachusetts, or whether it will need to register with the Securities Division as an investment adviser.
Private Fund Exemption2
The new regulations exempt from the Massachusetts registration requirements, subject to certain conditions, investment advisers who are “private fund advisers.” A private fund adviser is defined in the regulations as an investment adviser who provides advice solely to one or more funds that qualifies for an exclusion from the definition of an investment company pursuant to Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act of 1940 (each a “Private Fund”). The exemption is available only to advisers whose only clients are Private Funds. If the adviser also advises a separately managed account, it would have to register as an investment adviser with the Securities Division, unless it could otherwise qualify for an exclusion from the definition of “investment adviser” in Massachusetts.
Private Fund Advisers Advising Solely 3(c)(7) Funds
Under the new regulations, an adviser solely to 3(c)(7) funds is exempt from registration in Massachusetts, provided that:
(i) Neither the adviser nor any of its advisory affiliates is subject to disqualification as described in Rule 262 of SEC Regulation A, which prohibits certain categories of issuers from relying on an exemption from registration under Regulation A of the Securities Act of 1933;
(ii) The adviser files with Massachusetts each report and amendment thereto that an exempt reporting adviser is required to file with the SEC pursuant to Rule 204-4 under the Investment Advisers Act of 1940 (the “Advisers Act”); and
(iii) The adviser pays a $300 reporting fee.
Private Fund Advisers Advising at Least One 3(c)(1) Fund
In addition to meeting the requirements applicable to advisers to 3(c)(7) funds listed above, advisers to at least one 3(c)(1) fund that is not a venture capital fund (as defined in SEC Rule 203(l)-1) must also satisfy a “qualified client” standard and comply with certain disclosure and audit obligations to avail itself of the exemption from registration.
Qualified client standard. To satisfy the “qualified client” standard, all of the outstanding securities (other than short-term paper) of the 3(c)(1) fund must be beneficially owned by persons, each of whom meets the definition of qualified client in Rule 205-3 under the Advisers Act at the time the securities are purchased from the fund. For purposes of the Massachusetts exemption, this means the person has a net worth of more than $2 million (after deducting the fair market value of the person’s primary residence, less the amount of debt up to fair market value secured by the property, from their net worth) at the time the contract is entered into, or has at least $1 million under the management of the adviser after entering into the contract.
Disclosure obligations. In addition, the adviser must disclose to each beneficial owner of a 3(c)(1) fund that is not a venture capital fund at the time of purchase:
(i) All services, if any, to be provided to individual beneficial owners, and if no services are to be provided to individual beneficial owners, that fact must be disclosed;
(ii) All duties, if any, the adviser owes to the beneficial owners, and if no duties are owed to individual beneficial owners, that fact must be disclosed; and
(iii) Any other material information affecting the rights or responsibilities of the beneficial owners.
Audit Requirement. The adviser must also obtain audited financial statements for each 3(c)(1) fund that is not a venture capital fund on an annual basis and deliver a copy of the audited financials to each beneficial owner of the fund.
Grandfathering for Private Fund Advisers With Non-Qualified Clients
The new regulations provide a grandfather provision for advisers to one or more 3(c)(1) funds that have beneficial owners who are not qualified clients. The adviser must satisfy the following:
(i) The subject fund(s) existed prior to Feb. 3, 2012;
(ii) The funds cease accepting beneficial owners who are not qualified clients as of Feb. 3, 2012; and
(iii) The adviser otherwise complies with the reporting, payment of fee, disclosure and audit requirements described above.
Under the grandfather provision, an adviser to an existing 3(c)(1) fund may allow existing beneficial owners who are not qualified clients to make additional investments in that fund, without losing the ability to rely on the exemption, provided it otherwise complies with the conditions to the exemption.
Complying With the New Regulations
To comply with the new regulations, advisers (including those that have a place of business in Massachusetts, or in the past 12 months had at least six “clients” who are residents of Massachusetts) who advise solely Private Funds, and who have regulatory assets under management of:
Copies of the final regulations are expected to be made available on the Secretary of the Commonwealth’s website, Securities Division.5
For assistance, please contact the following lawyers in the Financial Services Area:
Investment Management Partners:
L. Kevin Sheridan Jr.
1 These funds may continue to accept additional investments from existing investors who were beneficial owners as of Feb. 3, 2012 without jeopardizing the adviser’s ability to rely on the exclusion.
2 The exemption can be found at 950 CMR 12.205(2)(c).
3 This will require the adviser to register with the Investment Adviser Registration Depository (“IARD”), and to select to file both federally and with Massachusetts as an exempt reporting adviser on the IARD system.
4 For each of these categories of private fund adviser, we assume that the adviser cannot otherwise satisfy the criteria for an exclusion from the definition of investment adviser in Massachusetts. These exclusions are set forth in Section 401(m)(1) of Chapter 110A of the Massachusetts General Laws. If an adviser can satisfy one of these exclusions, it need not rely on (and comply with the associated conditions to) the private fund exemption. In addition, an adviser registered with the SEC would not be considered a “federal covered adviser” subject to the notice filing requirement in Massachusetts if it could satisfy one of these other exclusions.
5 Secretary of the Commonwealth, Securities Division website - http://www.sec.state.ma.us/sct/sctidx.htm
This article was originally published by Bingham McCutchen LLP.