On June 22, the U.S. Securities and Exchange Commission (SEC) adopted several rules implementing changes to the Investment Advisers Act of 1940 (Advisers Act) made by Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act). The new rules were adopted under a pair of companion releases: the first implemented changes for "mid-size" advisers and outlined reporting requirements of "exempt reporting advisers" (Implementing Release) and the second promulgated exemptions from SEC registration for venture capital fund advisers, private fund advisers, and foreign private advisers (Exemptions Release).
As a result of the new rules, previously unregistered advisers may have to register with the SEC or one or more state regulators absent an exemption from registration. Both venture capital advisers newly registering with the SEC or exempt from registration but subject to reporting requirements will have to file Form ADV (which will now cover both registered and exempt advisers) by March 30, 2012. For venture capital fund advisers exempt from registration, these reporting requirements will nonetheless include, among other things, disclosure of affiliated entities and extensive information about each of the adviser's venture capital funds.
Section 203(l) and Rule 203(l)-1: Exemption for "Venture Capital Fund Advisers"
The Dodd-Frank Act amended Section 203(l) of the Advisers Act to provide an exemption from SEC registration requirements for any investment adviser that solely advises venture capital funds. There is no limit on the number of venture capital funds a venture capital fund adviser may advise and still qualify for the exemption; however, any non-venture capital fund client will disqualify an adviser from the exemption. In general, venture capital funds, according to Congress, are a subset of private investment funds and are typically unleveraged long-term investors in early stage or small, privately held companies, thereby limiting their ability to contribute to systemic financial risk.
The Dodd-Frank Act also directed the SEC to issue final rules to define the term "venture capital fund" for the purposes of the exemption and to require venture capital fund advisers to maintain records and provide the SEC with annual or other reports as the SEC determines necessary or appropriate in the public interest or for the protection of investors.
In the Exemptions Release, the SEC adopted Rule 203(l)-1 under the Advisers Act, which (1) defines the term "venture capital fund," (2) sets forth a grandfathering provision for existing venture capital funds, and (3) defines additional terms used in the definition of "venture capital fund."
Definition of "Venture Capital Fund"
Under Rule 203(l)-1(a), a fund would have to meet all of the following five criteria in order to be considered a "venture capital fund":1. The fund must be a private fund.
In order to meet the definition of "venture capital fund" set forth in Rule 203(l)-1(a), the fund must be a "private fund," as defined in Section 202(a)(29) of the Advisers Act, as revised by the Dodd-Frank Act. Under Section 202(a)(29), a "private fund" is an issuer that would be an investment company, as defined in Section 3 of the Investment Company Act of 1940 (1940 Act), but for the exclusions from the definition of "investment company" set forth in Section 3(c)(1) or 3(c)(7) of the 1940 Act. The fund cannot be an investment company registered under Section 8 of the 1940 Act or elect to be treated as a business development company under Section 54 of the 1940 Act.2. The fund must hold itself out to investors and potential investors as pursuing a venture capital strategy.
In order to meet the definition of "venture capital fund," a fund must represent itself to the investing public as pursuing a venture capital strategy. As initially proposed, the exemption would have required funds to represent themselves as "venture capital funds." In the Exemptions Release, however, the SEC noted that a fund that does not refer to itself as a "venture capital fund," but nonetheless pursues a venture capital strategy, could still rely on the exemption from registration.
Determining whether a fund represents itself as pursuing a venture capital strategy will depend on the particular facts and circumstances, including all of the fund's statements and omissions made to investors and prospective investors in light of the circumstances under which they were made. Unlike the guidance surrounding the proposed rule, the adopted rule indicates that a fund that does not use the words "venture capital" in its name and is not inconsistent with pursuing a venture capital strategy would not be precluded from satisfying the definition of a venture capital fund by virtue of its name. Rather, a fund could still be considered a venture capital fund if the fund, through its statements, omissions, and representations, taken together, holds itself out as pursuing a venture capital strategy.3. No more than 20% of the fund's assets may be invested in assets other than qualifying investments or short-term holdings.
In order to be defined as a "venture capital fund," a fund can only invest up to 20% of its aggregate capital contributions and uncalled committed capital in assets other than "qualifying investments" and short-term holdings. This approach signals a change from the proposed definition, which required a fund to invest solely in qualifying investments and short-term holdings. The change was prompted by commenters that urged the SEC to permit venture capital funds the flexibility of investing a portion of their assets in debt instruments, publicly traded securities, shares of venture capital funds acquired on the secondary market, or other instruments that would not be "qualifying investments" but still be able to fit the definition of "venture capital fund." The 20% basket will also permit a venture capital fund to invest in nonqualifying securities as a means of providing bridge financing to portfolio companies between equity financings or for tax or structuring reasons.
The calculation of a fund's 20% basket occurs whenever a fund acquires such a nonqualifying asset. The SEC noted that a fund "need not dispose of a non-qualifying investment simply because of a change in the value of that investment." Therefore, a nonqualifying investment that subsequently becomes worth more than 20% of the fund's assets will not disqualify the fund from venture capital fund status. In calculating its 20% basket, a fund may value such nonqualifying assets at either cost or fair value, but must consistently apply the selected valuation methodology. In other words, a fund cannot alternate between valuation methodologies in order to circumvent the limitations of the 20% basket.
Short-term holdings. A venture capital fund must invest at least 80% of its assets in "qualifying investments" and short-term holdings. Under Rule 203(l)-1(c)(6), "short-term holdings" are defined as cash, cash equivalents, U.S. treasuries with remaining maturity of 60 days or less, and shares of registered money market funds. This definition expands the proposed definition, which would not have permitted a venture capital fund to invest in money market funds.
Qualifying investments. In general, a "qualifying investment" is any equity security of a "qualifying portfolio company" (QPC). "Equity security," in turn, is defined by reference to Section 3(a)(11) of the Securities Exchange Act of 1934 (1934 Act) and Rule 3a11-1 thereunder. Therefore, eligible securities offered by a QPC in which a fund may invest include, among others, common or preferred stock, warrants, convertible securities, or interests in a limited partnership. The proposed definition of "venture capital fund" would have required a fund to obtain at least 80% of its qualifying investments directly from the QPCs. As adopted, the rule permits a fund to acquire three types of qualifying investments, each of which suggests that the fund is financing a QPC's business operations rather than trading in secondary markets. Under Rule 203(l)-1(c)(3), "qualifying investments" include the following:
This definition permits a fund to participate in the reorganization of the capital structure of the fund's portfolio companies (e.g., to exchange old shares for new shares of the same QPC) or to acquire securities in connection with the acquisition or merger of the fund's portfolio companies (e.g., to exchange shares of the QPC in exchange for shares of the surviving company that has acquired the QPC), or both.
If a fund invests in debt instruments of a QPC that cannot be characterized as "equity securities" under the 1934 Act, then such debt instruments would count toward the fund's 20% basket. A fund could provide a QPC with "bridge financing" in anticipation of future investment in exchange for instruments that are ultimately convertible into stock of the QPC without having to count such convertible instruments toward the fund's 20% basket. Any bridge financing by a fund to a QPC in exchange for an instrument that is not an "equity security," however, would have to be counted toward the fund's 20% basket, as previously mentioned.
Qualifying portfolio companies. Under Rule 203(l)-1(c)(4), a company would have to meet all of the following criteria in order to be considered a QPC:
a. At the time of any investment by the fund, the company was not reporting or foreign traded and did not control, was not controlled by, and was not under common control with another company, directly or indirectly, that is reporting or foreign traded.
A QPC cannot be a "reporting or foreign traded" company, or control, be controlled by, or be under common control with a reporting or foreign-traded company, at the time of the fund's initial investment in the company. "Reporting company" means a company subject to the reporting requirements of Section 13 or 15(d) of the 1934 Act. "Foreign traded company" means a company with securities listed or traded on a foreign exchange or organized foreign market.
A fund may continue to hold securities of a QPC that goes public after the fund's investment and thereby becomes a reporting company. In addition, a fund can make additional investments in a QPC after it goes public. The ability to continue investing in a QPC after it goes public deviates from the proposed rule, which would have required a fund to dispose of a QPC's securities once it went public in order to still qualify as a "venture capital fund." In the Exemptions Release, the SEC acknowledged that "an existing investment in a portfolio company that ultimately becomes a successful venture capital investment (such as when the company issues it securities in a public offering or becomes a reporting company) should not result in the investment becoming a non-qualifying investment." The SEC noted that a fund's portfolio could consist entirely of securities of reporting companies and the fund could still qualify as a "venture capital fund" under Rule 203(l)-1 so long as the fund invested in the QPCs' securities prior to each QPC becoming a reporting company.
In the proposed rule, the SEC sought to limit QPCs to companies that were not "publicly traded," but the adopted Rule 203(l)-1 uses the term "reporting or foreign traded" to clarify that certain companies that have issued securities that trade on a foreign exchange are also covered by the definition.
In response to comments received on the proposing release, the SEC noted that although venture capital funds typically invest in small, startup companies, these concepts were not built into the definition of "venture capital fund" due to a lack of consensus in defining such concepts, the possibility of ignoring business complexities by putting in place standardized metrics (e.g., net income, number of employees), and a concern that promising companies would be eliminated from possible investment by venture capital funds as a result. Finally, the SEC considered, but did not adopt, the definitions of "venture capital fund" used by the California Corporations Commission and U.S. Department of Labor, both of which permit a fund to invest in publicly traded companies and permit a fund to invest up to 50% of its assets in nonoperating companies (i.e., investment funds).
b. The company does not borrow or issue debt obligations in connection with the fund's investment and then distribute to the fund the proceeds of such borrowing or debt issuance in exchange for the fund's investment.
A company will not meet the definition of a QPC if it borrows money, issues debt, or otherwise incurs leverage in connection with the fund's investment and also distributes the proceeds of such borrowing or debt issuance to the fund in exchange for the fund's investment. A company may, however, borrow money as part of its normal course of business (i.e., to invest in infrastructure, finance inventory, or make payroll) and still qualify as a QPC. This "in connection with the fund's investment" requirement is aimed at preventing advisers to leveraged-buyout funds from relying on the venture capital fund advisers exemption since, according to the SEC, leveraged-buyout funds present a greater systemic risk than venture capital funds. The same rationale was the basis for an additional prong of the proposed rule's definition of "QPC" that was not adopted, which would have prohibited a QPC from redeeming, exchanging, or repurchasing its securities, or distributing cash or other assets to preexisting security holders, directly or indirectly, in connection with a fund's investment. In creating the 20% basket, the rule, as adopted, effectively moved these limitations from the definition of "QPC" to the definition of "venture capital fund."
c. The company is an operating company.
In order to meet the definitional requirements of a QPC, a company cannot be a private fund or other pooled investment vehicle, including an investment company, an investment company relying on Rule 3a-7 under the 1940 Act, or a commodity pool. In short, the company must be an operating company in order to qualify as a QPC. The SEC dismissed the application of the venture capital fund adviser exemption to venture capital fund-of-funds structures, noting that Congress provided no indication that it intended the scope of the exemption to reach such structures. Nonetheless, a fund many invest in other investment vehicles with its 20% basket. The SEC also noted that a fund may disregard a wholly owned intermediate holding company formed solely for tax, legal, or regulatory reasons to hold the fund's investment in a QPC. There is no requirement that the QPC be a U.S. company, although a fund may not make an initial investment in a company traded on a foreign exchange or organized market operating in a foreign jurisdiction.
4. The fund cannot borrow, 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, indebtedness, guarantee, or leverage must be for a nonrenewable term of no longer than 120 calendar days, except that any guarantee by the fund of a QPC's obligations up to the amount of the fund's investment in the QPC is not subject to the 120-calendar-day limit.
In order to meet the definition of "venture capital fund," a fund cannot borrow, issue debt obligations, provide guarantees, or otherwise incur leverage in excess of 15% of its aggregate capital contributions and uncalled committed capital. If the fund does conduct such leveraging activities, it must be for a nonrenewable term of no longer than 120 calendar days. The SEC noted in the proposing release that a fund may issue short-term debt, such as commercial paper, and still be considered a "venture capital fund."
Because the 15% threshold is calculated as 15% of the fund's aggregate capital contributions and uncalled capital commitments, it would be possible for the fund to leverage an acquisition of QPC securities up to 100% so long as the invested amount does not exceed 15% of the fund's total capital commitments. All such leverage would still be limited to 120 days or less. Excluded from the 120-calendar-day limit, however, are guarantees by the fund as to a QPC's obligations up to the amount of the fund's investment in the QPC. This change from the proposed rule was based on the rationale that a fund's guarantee of a QPC is for operational purposes (i.e., assisting the QPC in obtaining credit) and not used to leverage the fund's investment in the QPC.
5. The fund must only issue securities that do not provide investors with any right (except in extraordinary circumstances) to withdraw, redeem, or require the repurchase of such securities.
Outside of extraordinary circumstances, a fund cannot require investors to sell securities back to the fund or grant investors the right to redeem or withdraw their securities. Extraordinary circumstances could include changes in the law that would affect investors' tax treatment or ability to invest in particular countries and industries, or foreseeable but unexpected corporate events, such as mergers. If the fund offers quarterly or periodic withdrawal rights, it cannot qualify as a "venture capital fund," even if the fund has a temporary initial lock-up period or other restriction on the right to redeem. Rule 203(l)-1 does not set forth any specific time period for which fund interests must be held, though the SEC noted in the proposing release that industry practice is usually 10 years.
Rule 203(l)-1(b) also exempts an adviser to a fund that does not meet the definition of "venture capital fund" but that is a private fund that (1) represented to investors and potential investors at the time it offered its securities that it pursued a venture capital strategy, (2) sold securities to one or more investors prior to December 31, 2010, and (3) does not sell securities (including additional capital commitments) to any person after July 21, 2011. The SEC specified that in order to meet the grandfathered exemption, capital commitments from the fund's investors need not be called by July 21, 2011 as long as the investors became obligated by July 21, 2011 to make a future capital contribution. The grandfathering provision, as adopted, is slightly more expansive than the proposed grandfathering provision in that a fund need not have held itself out to be a "venture capital fund," but instead must have held itself out as pursuing a "venture capital strategy." Nonetheless, the SEC noted that it does not expect that advisers identifying themselves as "private equity" or "hedge" funds will be able to rely on the grandfathering provision.
. See Rules Implementing Amendments to the Investment Advisers Act of 1940, Advisers Act Rel. No. 3221 (June 22, 2011), available at http://www.sec.gov/rules/final/2011/ia-3221.pdf. For the proposing release, see Rules Implementing Amendments to the Investment Advisers Act of 1940, Advisers Act Rel. No. 3110 (Nov. 19, 2010), available at http://www.sec.gov/rules/proposed/2010/ia-3110.pdf.
. See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Advisers Act Rel. No. 3222 (June 22, 2011), available at http://www.sec.gov/rules/final/2011/ia-3222.pdf. For the proposing release, see Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, Advisers Act Rel. No. 3111 (Nov. 19, 2010), available at http://www.sec.gov/rules/proposed/2010/ia-3111.pdf.
. In general, the exclusions provided in Sections 3(c)(1) and 3(c)(7) of the 1940 Act apply to private funds with fewer than 100 investors or whose only investors are qualified purchasers.
. The SEC noted that venture capital funds undertaking nonpublic offerings in reliance on Regulation D must otherwise comply with the prohibitions on general solicitation and general advertising (i.e., statements made on a publicly accessible website).
. Exemptions Release at 27.
. Rule 203(l)-1(c)(6) refers to Rule 2a51-1(b)(7)(i) under the 1940 Act in defining "cash equivalents," which includes bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments held for investment purposes. Rule 2a51-1(b)(7)(ii), which includes the net cash surrender value of an insurance policy within the definition of "cash equivalents," is not included in the definition of "cash equivalents" for the purpose of defining "venture capital fund."
. Under Section 3(a)(11) of the 1934 Act, "equity security" is defined as "any stock or similar security; or any security future on any such security; or any security convertible, with or without consideration, into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any other security which the Commission shall deem to be of similar nature and consider necessary or appropriate, by such rules and regulations as it may prescribe in the public interest or for the protection of investors, to treat as an equity security." Under Rule 3a11-1, "equity security" is defined to include "any stock or similar security, certificate of interest or participation in any profit sharing agreement, preorganization certificate or subscription, transferable share, voting trust certificate or certificate of deposit for an equity security, limited partnership interest, interest in a joint venture, or certificate of interest in a business trust; any security future on any such security; or any security convertible, with or without consideration into such a security, or carrying any warrant or right to subscribe to or purchase such a security; or any such warrant or right; or any put, call, straddle, or other option or privilege of buying such a security from or selling such a security to another without being bound to do so."
. Although not specifically enumerated in the definition of "equity security" set forth in Section 3(a)(11) of the 1934 Act and Rule 3a11-1 thereunder, we note that membership interests in a limited liability company would, depending on the particular facts and circumstances, likely be considered "equity securities." Therefore, a membership interest in an LLC would typically be a satisfactory structure for a qualifying investment. In the event that such an LLC membership interest was not deemed an "equity security," a venture capital fund would have to count the value of its interest toward its 20% nonqualifying basket.
. Exemptions Release at 40.