On November 19, 2010, the US Securities and Exchange Commission ("SEC") proposed rules (the "Release")1 interpreting certain exemptions from the registration requirements of the Investment Advisers Act of 1940, as amended (the "Advisers Act") for advisers to privately offered investment funds. The registration exemptions - covering venture capital funds, advisers to private funds with a limited amount of assets under management in the US, and certain foreign advisers - were originally signed into law by President Obama on July 21, 2010 as part of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (the "Dodd-Frank Act").2
This note focuses on the registration exemption available to advisers to venture capital funds.3 The Dodd-Frank Act provides that an investment adviser that solely advises venture capital funds is exempt from registration under the Advisers Act and directs the SEC to define the term venture capital fund (the "Venture Capital Exemption"). The Release proposes a new rule providing a definition of the term "venture capital fund" and seeks commentary on how the Venture Capital Exemption will apply to non-US investment advisers.
The SEC has requested comments on the Release on or before 45 days after the publication of the Release in the Federal Register, which we expect will occur sometime this week. During its open meeting to propose the Release, the SEC encouraged all affected US and non-US advisers to participate in the comment process. Investment advisers that are not able to satisfy a registration exemption will be required to register with the SEC under the Advisers Act by the expiration of the statutory transition period on July 21, 2011.
Elimination of the Private Adviser Exemption
The Dodd-Frank Act eliminates the so-called "private adviser exemption" effective July 21, 2011, and in its place, provides several limited registration exemptions.4 Many US and non-US investment advisers to privately offered investment funds (including hedge funds, private equity funds, and most securitization vehicles) currently rely upon the private adviser exemption, pursuant to which advisers who (i) have less than 15 clients during the preceding 12 months, (ii) do not hold themselves out to the public as investment advisers, and (iii) do not act as investment advisers to a registered investment company or business development company, are exempt from the registration requirement under the Advisers Act. Because the term "clients" currently includes only a privately offered investment fund and not the investors in the fund, an investment adviser could rely on the private adviser exemption and sponsor up to 14 privately offered investment funds without limitation on the number of investors in the funds or the assets under management.
Registration Exemption for Investment Advisers to Venture Capital Funds
Under the Release, investment advisers that solely5 advise venture capital funds will be exempt from registration under the Advisers Act. The Release defines a venture capital fund as a private fund6 that:
- invests in "equity securities" of "qualifying portfolio companies" in order to provide operating and business expansion capital, and at least 80 percent of the company's securities owned by the private fund were acquired directly from the company7;
- directly, or though its investment advisers, offers or provides significant managerial assistance to, or controls, each of the qualifying portfolio companies;
- does not borrow or otherwise incur leverage (other than limited short-term borrowing) in excess of 15 percent of the private fund's aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee, or leverage is for a non-renewable term of no longer than 120 calendar days;
- does not offer its investors redemption or other similar liquidity rights except in extraordinary circumstances, but may entitle investors to receive distributions made to all investors pro rata;
- represents itself as a venture capital fund to investors8; and
- is not registered under the Investment Company Act of 1940, as amended (the "1940 Act") and has not elected to be treated as a business development company under the 1940 Act.
Each of the foregoing requirements to qualify as a venture capital fund is discussed in detail below.
Equity Securities
In order to qualify as a "venture capital fund" for purposes of the Venture Capital Exemption, a fund may only invest in the equity securities9 of qualifying portfolio companies, cash and cash equivalents, and US Treasuries with a remaining maturity of 60 days or less. Consequently, in the event an investment adviser seeks to qualify for the Venture Capital Exemption, none of its private funds may invest in debt instruments (unless they meet the definition of "equity security" under the Exchange Act) of a portfolio company or otherwise lend money to a portfolio company.
Qualifying Portfolio Companies
The proposed rules provide that in order to qualify for the Venture Capital Exemption, a private fund may only invest in the securities of qualifying portfolio companies. The SEC has proposed to define the term "qualifying portfolio company" as any company that (i) is not publicly traded, (ii) does not incur leverage in connection with the investment by the private fund, (iii) uses the capital provided by the private fund for operating or business expansion purposes rather than to buy out other investors, and (iv) is an operating company and is not itself an investment vehicle.
- Private Portfolio Companies. A qualifying portfolio company may not be publicly traded or affiliated with a publicly traded company. However, the SEC has provided flexibility for venture capital funds advising portfolio companies that engage in initial public offerings of their securities by allowing a venture capital fund to continue to hold the securities of a company that was private at the time of acquisition but subsequently became public.
- Portfolio Company Leverage. A qualifying portfolio company may not borrow, issue debt obligations, or otherwise incur leverage in connection with the venture capital fund's investments. In including this limitation, the SEC has targeted a blanket exclusion on leveraged buyout funds that use leverage or finance their investments in portfolio companies or the buyout of existing investors with borrowed money.
- Capital Used for Operating or Business Purposes. A venture capital fund must invest its capital in qualifying portfolio companies for the purpose of funding the expansion and development of the portfolio company's business. The investment in the portfolio company cannot be effected for the purpose of buying out existing security holders, purchasing securities from other shareholders, or leveraging the capital investment with debt financing, each of which are indicia of leveraged buyout fund activity.
- Operating Companies. The Venture Capital Exemption is intended to apply to investments in operating companies that are engaged in the production of goods or provision of services. The Venture Capital Exemption is not intended to include investments by a private fund in another pooled investment vehicle (e.g., a fund of funds).
Significant Managerial Assistance
To qualify as a venture capital fund, the fund or its investment adviser must (i) have an arrangement under which the adviser or its affiliates offer to provide significant guidance and counsel concerning the management, operations or business objectives and policies of the qualifying portfolio company or (ii) control the qualifying portfolio company.
The SEC has advised that investment advisers could satisfy this test through active involvement in the business, operations or management of the portfolio company, or through less active forms of control such as board of director representation or other arrangements providing similar voting rights.
Limitations on Leverage
A venture capital fund may not borrow, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the fund's capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days. Under the proposed definition, a private fund could borrow and still qualify as a venture capital fund provided it did not borrow or otherwise use leverage in excess of the specified threshold.
Application to Non-US Advisers
The Release currently proposes that non-US advisers10 may rely on the Venture Capital Exemption if all of its clients, whether US or non-US, are venture capital funds. However, the SEC is seeking comments as to whether it should provide that a non-US adviser may avail itself of the Venture Capital Exemption even if it advises clients other than venture capital funds, provided such clients are not US persons.11 Further, the SEC is seeking comments on whether a non-US adviser may rely on the Venture Capital Exemption if it advises non-US clients other than venture capital funds from within the US.
Grandfathering Provision
The SEC has included in the definition of "venture capital fund" any private fund that (i) represented to investors and potential investors at the time the fund offered its securities that it is a venture capital fund; (ii) has sold securities to one or more investors prior to December 31, 2010; and (iii) does not sell any securities to, including any additional capital commitments from, any person after July 21, 2011. The grandfathering provision includes any private fund that has accepted capital commitments by the specified dates even if none of the commitments has been called.
Footnotes
1. A complete copy of the Release is available here.
2. A copy of the July 21, 2010 O'Melveny & Myers LLP client alert addressing the Dodd-Frank Act is available here.
3. An O'Melveny Client Alert addressing the exemptions for advisers to private funds with a limited amount of assets under management and certain foreign advisers is available here.
The SEC also proposed rules, that among other things, increase the statutory threshold for registration by investment advisers with the SEC, introduce reporting requirements for certain investment advisers that are exempt from registration, and amend Form ADV, the investment advisers registration statement under the Advisers Act. These proposed rules will be the subject of a forthcoming O'Melveny & Myers LLP client alert. A full copy of the rules proposed by the SEC is available here.
4. 15 U.S.C. 80b-3(b)(3) as in effect before July 21, 2011.
5. Investment advisers that advise (i) private funds other than venture capital funds or (ii) single investor managed accounts generally will not qualify for the Venture Capital Exemption under the Release. Note, however, that the SEC is evaluating the application of the Venture Capital Exemption to the non-US clients of a non-US investment adviser.
6. The Dodd-Frank Act defines a "private fund" as a fund that would be an investment company under the Investment Company Act of 1940, as amended (the "1940 Act") but for the exceptions in Section 3(c)(1) or Section 3(c)(7) of the 1940 Act.
7. Venture capital funds are also permitted to own cash and cash equivalents and US Treasuries with a remaining maturity of 60 days or less.
8. A venture capital fund may not identify itself as a hedge fund or multi-strategy fund. A venture capital fund should describe its investment strategy as venture capital investing or as a fund that is managed in compliance with the Venture Capital Exemption.
9. Section 3(a)(11) of the Securities Exchange Act of 1934, as amended (the "Exchange Act") defines an equity security 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 SEC 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. Rule 3a11-1 under the Exchange Act expands the definition of equity security 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.
10. A non-US adviser is an investment adviser with a principal office and place of business (e.g., the location where the advisor controls, or has ultimately responsibility for the management of client assets) outside of the United States.
11. For purposes of determining whether a client is a "US Person", the SEC has adopted the definition set forth in Rule 902(k) under Regulation S of the Securities Act of 1933, as amended (the "Securities Act"). Rule 902(k) defines a US Person as (i) any natural person resident in the US; (ii) any partnership or corporation organized or incorporated under the laws of the US; (iii) any estate of which any executor or administrator is a US Person; (iv) any trust of which any trustee is a US Person; (v) any agency or branch of a foreign entity located in the US; (vi) any non-discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary for the benefit or account of a US Person; (vii) any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organized, incorporated or (if an individual) resident in the US; and (viii) any partnership or corporation if (a) organized or incorporated under the laws of a foreign jurisdiction; and (b) formed by a US Person principally for the purpose of investing in securities not registered under the Securities Act, unless it is organized or incorporated, and owned, by accredited investors who are not natural persons, estates or trusts.
O'Melveny & Myers LLP routinely provides advice to clients on complex transactions in which these issues may arise, including finance, mergers and acquisitions, and licensing arrangements. If you have any questions about the operation of the applicable statutory provisions or the case law interpreting these provisions, please contact any of the attorneys listed on this alert.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
