While you were touring the Champagne region or sipping umbrella drinks at the beach this summer, the California Department of Corporations (the “DOC”) was busy overhauling the rules applicable to investment advisers. On August 27, 2012, the DOC adopted final rules, available here, that provide for an exemption from registration for certain private fund managers pursuant to specific conditions. This exemption, along with the rules previously adopted by the Securities and Exchange Commission (the “SEC”), now permits certain investment advisers that provide advice only to private funds to operate without being fully registered with either the SEC or the State of California.
Unlike the SEC rules, this exemption does not prohibit a fund manager from registering with the DOC—it simply allows the fund manager to decide whether it would like to register or rely on the exemption. To rely upon this exemption, a California based adviser must complete and file the Form ADV (required under Rule 204-4 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”)) with the DOC that is required of an adviser that files for “exempt reporting adviser” status with the SEC. But why would any adviser that is eligible to take advantage of the exemption decide to register?
If a fund manager intends only to seek capital from “friends and family,” subjecting itself to the full registration requirements and the more complete compliance rules that are expected soon from the DOC could represent a significant expense to the manager. Or, if a manager is leaving another organization and must quickly get to market, the three to four month process associated with the DOC review of an investment adviser application may be viewed as too long to wait. But if a fund manager expects to target more institutional capital, or other investors that would have a reasonable expectation that the manager is subject to some regulatory oversight, the manager may very well decide that a California investment adviser registration is not so burdensome. After all, a manager that seeks to rely on the exemption must still file the Form ADV, prepare a private placement memorandum, and have the fund audited, among other requirements discussed below. The analysis that each fund manager must undertake in order to make this decision is multi-faceted and is ultimately one that is unique to each adviser and its own circumstance.
To briefly summarize the results of the DOC rulemaking, an investment adviser located in California may conduct its business without being a fully registered and regulated investment adviser under the DOC regulations so long as:
- the adviser only advises private funds that rely on either Section 3(c)(1) or Section 3(c)(5) of the Investment Company Act of 1940, as amended, (which the DOC defines as “Retail Buyer Funds”) the investors of which are all “accredited investors”;
- the adviser is not subject to any statutory disqualifications;
- the adviser files certain periodic reports and notices; and
- the adviser pays the annual registration fee of $125.
Additionally, with respect to Retail Buyer Funds:
- the adviser may only charge performance fees to investors that meet the Advisers Act definition of a “qualified client”;
- the Retail Buyer Fund must be audited annually by a Public Company Accounting Oversight Board (“PCAOB”) registered accounting firm and deliver a copy of the audited financial statements to each beneficial owner; and
- the adviser must provide “material disclosures” to fund investors that adequately and accurately describe the investment program of the fund and the relationship of the adviser to the fund (e.g., the type of disclosures that competent counsel drafts on behalf of fund managers now).
When an adviser that is eligible for the California exemption reaches $100 million in assets, it would become an exempt reporting adviser with the SEC and would need to switch its status over to the SEC. And when it reaches $150 million it must become a fully registered investment adviser with the SEC; accordingly, investment advisers can operate without being fully registered with the SEC or the State of California so long as they have less than $150 million in assets and satisfy the conditions discussed above.
The California exemption contains a “grandfathering” provision for Retail Buyer Funds formed prior to the release of the exemption, as the additional requirements listed above are deemed satisfied if the Retail Buyer Fund: (i) distributes annual audited financial statements; (ii) pre-existing investors receive the “material disclosures” discussed above; (iii) from August 27, 2012 on, the Fund only sells interests to “accredited investors”; and (iv) the adviser receives performance-based compensation only from pre-existing investors or “qualified clients.”