Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), referred to as the Private Fund Investment Advisers Registration Act of 2010, effected fundamental changes in the Investment Advisers Act of 1940 (Advisers Act) that will result in many previously unregistered advisers, such as advisers to private funds, having to register with the U.S. Securities and Exchange Commission (SEC) or one or more state regulators absent an exemption from registration. When the Dodd-Frank Act was signed into law on July 21, 2010, most of its impact had not yet been determined, as the implementation was left in the hands of industry regulators.
Now the SEC has spoken. At an open meeting on November 19, 2010, the SEC voted to propose rules that would implement registration exemptions and reporting requirements for certain advisers, as required by the Dodd-Frank Act. In two companion releases, the SEC sets forth proposals to adopt registration exemptions for venture capital fund advisers, private fund advisers, and foreign private advisers (Exemptions Release), and also proposes a new rule requiring exempt private fund advisers to file public reports on an expanded version of Form ADV (Reporting Release). Comments on the proposals must be submitted to the SEC by January 24 and may be submitted online at the SEC's website.
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 acts as an investment adviser solely to one or more 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. In general, venture capital funds, according to the SEC, are a subset of private equity funds and are typically unleveraged long-term investors in early-stage or small privately held companies, thereby limiting their ability to contribute to systemic 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 by July 21, 2011, and further directed the SEC 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 sets forth Proposed Rule 203(l)-1 under the Advisers Act, which would define the term "venture capital fund," sets forth a grandfathering provision for existing venture capital funds, and defines additional terms used in the definition of "venture capital fund."
Under Proposed Rule 203(l)-1(a), a fund would have to meet all of the following criteria in order to be considered a "venture capital fund."
In order to meet the definition of "venture capital fund" set forth in Proposed 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 exemptions 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.
In order to meet the definition of "venture capital fund," a fund must represent itself to the investing public as a venture capital fund. In the Exemptions Release, the SEC indicated that a fund that describes its investment strategy as "venture capital investing" or "investing in compliance with Rule 203(l)-1" would be deemed to be representing itself to investors and potential investors as a venture capital fund. The SEC further stated that a fund could not identify itself as a hedge fund or a multistrategy fund (i.e., a fund where venture capital is one of several investment strategies) and still fulfill this requirement. Further, the fund's adviser would not be able to include the fund in a hedge fund database or index of hedge funds.
In order to be defined as a "venture capital fund," a fund can only own equity securities of QPCs and cash, cash equivalents, or U.S. Treasury instruments with a remaining maturity of 60 days or less.
A fund cannot invest in debt instruments of a QPC unless such instruments can be considered "equity securities" under Section 3(a)(11) of the Securities Exchange Act of 1934 (1934 Act) and Rule 3a11-1 thereunder. Eligible securities offered by a QPC in which a fund may invest are common or preferred stock, warrants, convertible securities, or interests in a limited partnership. Further, the SEC noted that 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. Any bridge financing by a fund to a QPC in exchange for an instrument that is not an "equity security" would disqualify the fund from the definition of "venture capital fund" and thereby disqualify the fund's adviser from the exemption from registration. A fund may also invest in cash and cash equivalents, as defined in Rule 2a51-1(b)(7)(i) under the 1940 Act.
Under Proposed 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 publicly traded and did not control, was not controlled by, and was not under common control with another company, directly or indirectly, that is publicly traded.
A fund may continue to hold securities of a company that goes public after the fund's investment, but the fund cannot make additional investments in the company after it goes public and still qualify as a "venture capital fund." In the Exemptions Release, the SEC acknowledged that a fund's portfolio could consist entirely of publicly traded securities and the fund could still qualify as a "venture capital fund" under Proposed Rule 203(l)-1 so long as the fund acquired all of the securities prior to their being publicly traded. The SEC noted that although venture capital funds typically invest in small, startup companies, these concepts were not built into the proposed definition of "venture capital fund" because the SEC was concerned that too many companies would be eliminated from possible investment by venture capital funds as a result. The SEC also did not include any length-of-existence, number-of-employees, or revenue thresholds under the definition of QPC. 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). In rejecting this approach, the SEC referenced Congress's concern that fund-of-funds structures present systemic risk concerns.
b. The company does not borrow or issue debt obligations, directly or indirectly, in connection with 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. A company may, however, borrow money as part of its normal course of business (i.e., to invest in infrastructure 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 SEC noted that any financing or loan to a company that is provided by a fund that invests in the company or is a condition of a contractual obligation with the fund (or adviser) would be viewed as a loan in connection with the fund's investment and would thus disqualify the company from the definition of a QPC and the fund from the definition of a venture capital fund.
c. The company does not redeem, exchange, or repurchase any of its securities, or distribute to pre-existing security holders cash or other assets, directly or indirectly, in connection with the fund's investment.
In order to qualify as a QPC, a company must use the fund's investment for operating and business purposes and for facilitating the expansion and development of the company. The definition of "venture capital fund" requires that at least 80% of a QPC's securities held by the fund must have been acquired directly from the QPC and not from existing shareholders, either directly or indirectly. This 80% test is aimed at preserving the existing rights, priority, and economic terms of the QPC's beneficial owners while still permitting the QPC to benefit from the fund's investment. The 80% test would prohibit a company from using the capital inflow from the fund's investment to buy out all existing shareholders or reconstitute its capital structure to subordinate the rights of its existing shareholders. The SEC noted that Proposed Rule 203(l)-1 would permit a fund to acquire up to 20% of the securities of a QPC from shareholders, which would allow a QPC to use a fund's investment to redeem a certain number of its outstanding securities, thus providing some liquidity to its angel investor(s), if any. Further, the SEC stated that the 80% test is not intended to preclude capital reorganizations by a company that would not change the rights, priority, or economic terms of existing beneficial owners. The SEC also noted that the 80% threshold is consistent with certain tax treatment typically relied on by venture capital funds.
d. The company is not an investment company, a private fund, an issuer that would be an investment company but for the exemption provided by Rule 3a-7 under the 1940 Act, or a commodity pool.
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. The SEC noted that Congress provided no indication that the venture capital fund exemption was meant to apply to funds-of-funds. There is no requirement that the QPC be a U.S. company.
For each QPC in which the fund invests, the fund (or its adviser) must either control the QPC or offer to provide significant guidance and counsel to the QPC regarding its management, operations, or business objectives and policies. If the QPC accepts the fund's (or adviser's) offer to provide such guidance and counsel, the fund (or adviser) must actually provide guidance and counsel to the QPC. The Exemptions Release states that the fund's (or adviser's) guidance and counsel must be more than a mere contribution of capital and instead must entail active involvement in the business, operations, or management of the QPC or less active "control" through board representation or similar voting rights. The SEC also stated that the extent of the fund's (or adviser's) managerial assistance may evolve over time as the QPC expands and develops. On the assumption that if control exists it will likely be exercised, Proposed Rule 203(l)-1 does not require a fund (or adviser) that controls a QPC to offer to provide managerial assistance. Proposed Rule 203(l)-1, however, does not provide any direct guidance on the meaning of "control." Additionally, if the fund invests as a group of funds, each fund (or its adviser) would have to either exercise control over the QPC or offer to provide managerial assistance to the QPC and, if accepted, actually provide managerial assistance to the QPC.
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 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. The SEC noted that a fund cannot avoid the prohibition on QPC borrowing by incurring debt at the fund level.
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. Proposed Rule 203(l)-1 does not set forth any specific time period for which fund interests must be held, though the SEC noted that industry practice is usually 10 years.
Proposed Rule 203(l)-1 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 was a venture capital fund, (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. Further, the SEC noted that it does not expect that advisers to private equity or hedge funds will be able to rely on the grandfathering exemption.
The SEC noted that Proposed Rule 203(l)-1 does not require an adviser to provide a capital contribution to its fund, does not specify a minimum investment term, and does not exclude funds that permit investment by retail investors. The SEC also stated that an adviser with its principal place of business outside the United States may rely on the exemption if all of its clients-whether U.S. or non-U.S. clients-are venture capital funds.
The exemption provided to advisers to venture capital funds under Proposed Rule 203(l)-1 is not mandatory and such advisers may voluntarily register. Unregistered venture capital fund advisers may still be subject to state registration requirements, as Section 203A(b)(1) of the Advisers Act only provides an exemption from state registration requirements to advisers that are registered with the SEC.
Exemption for Private Fund Advisers
As amended by the Dodd-Frank Act, Section 203(m) of the Advisers Act requires the SEC to provide an exemption from registration to any investment adviser that acts solely as an adviser to private funds and has assets under management in the United States of less than $150 million. In the Exemptions Release, the SEC issued Proposed Rule 203(m)-1, which would bring this private fund adviser exemption into effect.
Section 202(a)(29) of the Advisers Act, as amended by the Dodd-Frank Act, defines a "private fund" as an issuer that would be an investment company under Section 3 of the 1940 Act but for Section 3(c)(1) or 3(c)(7). This definition of "private fund" would also include a private fund that invests in other private funds. The SEC explained in the Exemptions Release that a fund organized under the laws of the United States or a state is a "private fund" if it is excluded from the definition of "investment company" pursuant to Section 3(c)(1) or 3(c)(7) of the 1940 Act, and that a non-U.S. fund that offers its securities in the United States and relies on Section 3(c)(1) or 3(c)(7) of the 1940 Act would be a "private fund" under Section 202(a)(29) of the Advisers Act. Thus, a non-U.S. fund may conduct a private offering of its securities in the United States without first obtaining an order permitting registration under Section 7(d) of the 1940 Act if the fund complies with either Section 3(c)(1) or 3(c)(7) with respect to its U.S. investors.
Assets Under Management
A private fund adviser may advise an unlimited number of private funds and still qualify for the exemption from registration under Proposed Rule 203(m)-1, provided that the adviser's U.S. assets under management are less than $150 million. Any uncalled capital commitments would be counted toward this $150 million threshold. An adviser would have to determine its private fund assets under management quarterly, using fair-value and not cost-basis accounting. If an adviser exceeds the $150 million threshold, it will be given a one-calendar-quarter period to register with the SEC. This one-calendar-quarter grace period would ease the burden of registration and the corresponding requirement to adopt and implement compliance policies and procedures, but would only be available to advisers that otherwise complied with SEC reporting requirements during the period in which they were exempt from registration.
Due to the exemption, an adviser solely to private funds that would otherwise need to register with the SEC once it had reached $100 million of assets under management would in fact not need to register with the SEC until it has acquired an additional $50 million of U.S. assets under management. Advisers to private funds with less than $150 million of U.S. assets under management will still need to comply with applicable state investment adviser registration requirements. Private fund advisers based in states where they would not be required to register with and be supervised by a state securities authority will still need to register with the SEC if they manage private funds with $25 million or more of assets.[11
U.S. and Non-U.S. Advisers
The exemption would count U.S. assets under management differently for advisers with a principal office and place of business in the United States (U.S. advisers) versus advisers with a principal office and place of business outside the United States (non-U.S. advisers). For U.S. advisers, all of the private fund assets managed by an adviser would be counted toward its U.S. assets under management, even if the adviser has offices outside the United States. Non-U.S. advisers would only need to count those assets managed from a location within the United States toward the $150 million threshold.
A non-U.S. adviser may rely on the exemption if all of its clients that are U.S. persons are "qualifying private funds," regardless of the type or number of the adviser's non-U.S. clients. In other words, non-U.S. advisers may advise clients that are not "qualifying private funds" so long as those clients are not U.S. persons. In addition, a non-U.S. adviser could still rely on the exemption from registration if it advised U.S. funds (such as a U.S. master fund in a master-feeder structure) so long as all of the funds are "qualifying private funds." Further, a non-U.S. adviser would only be required to count private fund assets managed from a place of business in the United States toward the $150 million threshold. Any assets managed by a non-U.S. adviser outside the United States (whether investment funds or managed accounts) would not count toward the $150 million limit. However, if the non-U.S. adviser manages any assets from a U.S. place of business for clients that are not qualifying private funds, the non-U.S. adviser would be disqualified from the exemption.
Because Proposed Rule 203(m)-1 would deem all assets managed by a U.S. adviser to be managed in the United States, a U.S. adviser may rely on the exemption only if all of its clients are qualifying private funds. If a U.S. adviser has any client that is not a qualifying private fund, it would be disqualified from the exemption, even if the client is a non-U.S. person.
Offshore Discretionary Accounts
Proposed Rule 203(m)-1 would also require that a non-U.S. adviser's discretionary or other fiduciary account be treated as a U.S. person if it is held for the benefit of a U.S. person by a non-U.S. fiduciary that is a related person of the adviser. That is, a non-U.S. adviser will not qualify for the exemption if it establishes offshore accounts for the benefit of U.S. clients held by an offshore affiliate of the adviser, where the offshore affiliate then delegates the management of the account back to the adviser, unless the aggregate amount of assets under management by the adviser in such accounts and other accounts of U.S. persons is less than $150 million. This aspect of Proposed Rule 203(m)-1 is aimed at curtailing attempts by non-U.S. advisers to circumvent the exemption. This treatment would not affect U.S. advisers because all assets managed by a U.S. adviser, regardless of client location, would already be counted toward the adviser's $150 million threshold.
 . 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.
 . 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.
 . In general, the exemptions provided in Sections 3(c)(1) and 3(c)(7) of the 1940 Act apply to private funds with fewer than 100 investors or investors who are qualified purchasers.
 . 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.”
 . “Cash and cash equivalents” are defined under Rule 2a51-1(b)(7)(i) as “[b]ank deposits, certificates of deposit, bankers acceptances and similar bank instruments held for investment purposes.” The SEC noted that cash and cash equivalents must be held for “investment purposes” as required by Rule 2a51-1(b)(7)(i), and that a fund may also invest in short-term obligations of the U.S. Treasury that mature in 60 days or less, which are not included in the definition of “cash and cash equivalents” under Rule 2a51-1(b)(7)(i).
 . In general, Section 1202 of the Internal Revenue Code provides a partial exclusion from a taxpayer’s gross income for gain from the sale or exchange of qualified small business stock held for more than five years. In order to be “qualified,” the small business must be an “active business.” Section 1202(e)(1)(A) of the Internal Revenue Code notes that if at least 80% of a company’s assets are used by the company in the active conduct of one or more qualified trades or businesses, then the company meets the “active business” requirement.
 . In the Exemptions Release, the SEC noted that the concept of providing guidance and counsel to the QPC regarding management, operations, or business objectives and policies is intended to be a more streamlined version of the concept of “managerial assistance” defined in Section 2(a)(47) of the 1940 Act, which applies to investment in business development companies. The SEC noted that Congress’s discussions of business development companies in the 1980s are instructive to the concepts in Proposed Rule 203(1)-1, though not directly considered by Congress in passing the Dodd-Frank Act.
 . Section 7(d) of the 1940 Act prohibits a non-U.S. fund from using U.S. jurisdictional means to make a public offering, absent an order from the SEC permitting registration.
 . Proposed Rule 203(m)-1 would not require private fund advisers to determine fair value in accordance with U.S. generally accepted accounting principles (GAAP).
 . The Dodd-Frank Act amended Section 203A(a)(2) of the Advisers Act to increase the assets-under-management threshold for mandatory registration with the SEC to $100 million.
 . Currently, Rule 203A-1(a) under the Advisers Act permits an adviser with between $25 million and $30 million in assets under management to not register with the SEC if the state in which the adviser maintains its principal office and place of business has enacted an investment adviser statute. Rule 203A-1(a) also includes a $5 million “buffer” that does not require a registered adviser to de-register with the SEC until its assets under management, as annually reported, decrease below $25 million. In the Reporting Release, the SEC proposed to amend Rule 203A-1 to remove the $5 million “buffer.” Combined with the Dodd-Frank Act’s amendment to Section 203A(a)(2) of the Advisers Act, Proposed Rule 203A-1 would essentially make registration for investment advisers with between $25 million and $100 million optional so long as the adviser is regulated or required to be regulated as an investment adviser in the state in which it maintains its principal office and place of business.
 . The SEC noted that, similar to the approach taken under Rules 203A-3(c) and 222-1 under the Advisers Act, an adviser’s principal office and place of business would be the location where the adviser controls, or has ultimate responsibility for, the management of private fund assets, even if day-to-day management of certain assets takes place at another location.
 . Proposed Rule 203(m)-1 would use the definition of “U.S. Person” set forth in Rule 902(k) of Regulation S under the Securities Act of 1933.
 . Rule 203(m)-1(e)(5) would define “qualifying private fund” as any private fund that is not registered under Section 8 of the 1940 Act and has not elected to be treated as a business development company under Section 54 of the 1940 Act.