On this episode of Ropes & Gray's California Law for Asset Managers podcast series, asset management partner Catherine Skulan and counsel Colleen Meyer provide an overview of SB 54, a new California law intended to provide transparency with respect to the diversity of founders in which "venture capital companies" make venture capital investments. The law, while highly relevant for traditional venture capital funds, could implicate traditional private equity and other investment vehicles as well.
Transcript:
Catherine Skulan: Hello, and welcome to another install
Transcript:
Catherine Skulan: Hello, and welcome to another installment of our Ropes & Gray podcast series on California Law for Asset Managers. I'm Catherine Skulan, and I'm joined today by Colleen Meyer—I am a partner and Colleen is counsel in the Ropes & Gray asset management group in San Francisco.
There were a number of bills signed into law in California this year that focus on environmental, social and governance (ESG) issues that do or could impact asset managers and their portfolio companies. We'll devote the next few installments of this series to a discussion of some of these new laws, including California's new climate disclosure requirements. Today, though, let's speak about legislation called Fair Investment Practices by Investment Advisers, or SB 54, which was signed into law by California Governor Gavin Newsom on October 8, 2023. SB 54 is intended to provide transparency with respect to venture capital investments by venture capital companies. According to its supporters, the law is an attempt to address the lack of diversity and equitable distribution of funding to venture capital-backed companies. But, while traditional venture capital funds were clearly in the sites of this law—and is highly relevant to VC managers—it is notable that SB 54 covers more than that and could also implicate traditional private equity and other investment vehicles as well. Let's talk about this and other key topics regarding SB 54 that we think will be of particular interest to our listeners.
Colleen Meyer: This is the first law of its kind in the U.S., so this will all be very new to affected entities. And as a threshold question, that's a great entry point to this conversation— namely identifying who is a "covered entity" under this law. Well, "covered entities" are "venture capital companies" (or VCCs) that meet certain criteria. First, we need to define VCC. Under SB 54, a VCC means one or more of (i) an entity that has, on at least one occasion during the annual period commencing with the date of its initial capitalization, and on at least one occasion during each annual period thereafter, at least 50% of its assets, valued at cost, comprising "venture capital" investments, (ii) a "venture capital fund" as defined under the Investment Advisers Act, or (iii) a "venture capital operating company" as defined under ERISA.
Catherine Skulan: Now, the first and the third prongs are actually quite similar. Under the third prong—the ERISA VCOC criteria—a venture capital operating company needs to have at least 50% of its fund assets in operating companies in which the fund has direct contractual "management rights." Similarly, the first prong of SB 54 has a 50% test with respect to "VC investments."
Colleen Meyer: A "VC investment" for purposes of SB 54 means an acquisition of securities in an operating company in which the investment adviser or its affiliates obtain "management rights." Interestingly, this definition does not mention investing in startup, early-stage or emerging growth companies.
Catherine Skulan: Okay, so having discussed the definition of venture capital company, we next need to look at the two criteria that a VCC must meet in order to fall under the law.
First is a prong looking at investment activity. The VCC must either (i) primarily engage in the business of investing in, or providing financing to, startup, early-stage, or emerging growth companies or—and this one's important—(ii) manage assets on behalf of third-party investors. Note the breadth of this second requirement—where simply managing assets on behalf of third-party investors, including investments made on behalf of state or local retirement or pension systems, would get a VCC quite far along the path of being a "covered entity." And the second criteria is a California-nexus test under which, the VCC must either (a) be headquartered in California, (b) have a significant presence or operational office in California, (c) make VC investments in businesses that are located in, or have significant operations in, California or (d) solicit or receive investments from a person who is resident of California.
Colleen Meyer: That's a lot to unpack. It sounds like a flow chart would be helpful in working through whether a particular investing entity would be subject to SB 54. One big take-away, though, that I see after emerging from this maze of definitions and tests, is that the drafting of SB 54 is certainly broad and captures more than traditional "venture capital funds" as covered entities. For example, given the VCOC definition or the similar breadth of the VC investment definition—both of which pick up more than just traditional "venture capital" investments—it appears that private equity funds and other investment vehicles that manage assets on behalf of third-party investors would be "covered entities" if they have management rights in at least 50% of their portfolio companies and the requisite California nexus, regardless of whether they hold any traditional VC investments in their portfolios. This result goes far beyond the stated intent of the SB 54 authors and is potentially relevant to funds and managers that do not think of themselves as venture capital companies.
Catherine Skulan: Which brings up an interesting point. Although SB 54 was first drafted to capture venture capital advisers, it was revised to impose the reporting requirement on funds themselves. As a result, the focus shifts to a fund-by-fund analysis. Since it is possible for one fund to fall under the law and not another, managers will have to look carefully at each fund they manage to determine whether that fund, based on its characteristics, is a covered entity under the law.
Colleen Meyer: That's right. And this leads to the natural next question people ask if there is a good chance they will be a covered entity: When does SB 54 go into effect?
Catherine Skulan: Well, starting March 1, 2025, and annually thereafter, SB 54 requires a "covered entity" to report to the California Civil Rights Department (CRD) specified demographic information about the founding teams of all businesses in which the covered entity made a VC investment in the prior calendar year and certain portfolio-level investment information. Therefore, covered entities must attempt to collect the required information with respect to in-scope companies in which they make investments starting on January 1, 2024—meaning, investments that are made from January 1, 2024. When in-scope companies choose to actually collect this information is up to them, provided that it is done by March 1, 2025.
Colleen Meyer: Thanks, Catherine. Let's move on now to the disclosure requirements. First, SB 54 requires certain reporting about the "founding team members" of companies in which VC investments are made. A "founding team member" covers anyone who (i) owned initial ownership interests in the business, contributed (conceptually or developmentally) to the business before such initial shares were issued and was not a passive investor in the business, or (ii) is an officer, manager or person of similar authority in the business.
Catherine Skulan: And to delve into the details of reporting with respect to those founding team members: SB 54 requires a covered entity to report, at an aggregated level, all of the following information for the founding teams of all of the businesses in which the covered entity made a venture capital investment in the prior calendar year to the extent that information was provided pursuant to a prescribed survey the VCC must deliver to those team members. That information with respect to each member of the founding team covers: such person's gender identity; race; ethnicity and disability status. Covered entities must also report whether any member of the founding team identifies as LGBTQ+, is a veteran or a disabled veteran, is a resident of California or declined to provide any of the preceding information.
Colleen Meyer: SB 54 also requires disclosure of the total number and dollar amount (each, as a percentage of total VC investments made) of VC investments to businesses "primarily founded by diverse founding team members," aggregated and broken down by most of the categories mentioned above. "Primarily founded by diverse founding team members" means, for purposes of this report, more than half of the founding team members responded to the survey, and at least half of the founding team members self-identify as a woman, nonbinary, Black, African American, Hispanic, Latino-Latina, Asian, Pacific Islander, Native American, Native Hawaiian, Alaskan Native, disabled, veteran or disabled veteran, lesbian, gay, bisexual, transgender, or queer. Survey results must be collected and reported in a manner that disassociates the responses from individual founding team members.
Catherine Skulan: Finally, SB 54 requires the covered entity to disclose the total amount of money invested in each company that is a VC investment during the prior calendar year and the principal place of business of each company in which it made a VC investment during the prior calendar year. We're waiting to see exactly what level of detail will be required with respect to the principal place of business—depending on this and the other information that must be disclosed under the law, the public may be able to determine the actual business in question, which is an outcome that, I think, many firms will find troubling if they don't otherwise make that information public already.
Colleen Meyer: Also, something else of note is that SB 54 is not limited to California formed or operated businesses. Therefore, a VCC to whom SB 54 applies will also be required to attempt to gather the same information we discussed from non-California portfolio companies, regardless of their jurisdiction of formation or principal place of business, which will increase the compliance costs of covered entities.
Catherine Skulan: Yes, that's right. Importantly, covered entities must use a standardized survey form provided by the CRD to collect information and must provide each founding team member of a business that has "received funding from a VCC" with an opportunity to participate in the survey—note that the form of that survey has not yet been made public by CRD. Critics of this law say that founders from diverse backgrounds would be more likely to participate in the voluntary surveys, exaggerating their representation in investments, which would have the effect of producing misleading data.
Colleen Meyer: Another aspect that's important to consider is that covered entities can only collect survey information after the covered entity has executed an investment agreement with the business and made the first transfer of funds. Therefore, covered entities looking to increase efficiency by, for example, asking survey questions as part of their pre-investment diligence programs, will be disappointed in being unable to use this approach.
Catherine Skulan: Now, let's move on from information gathering under SB 54 to public disclosure of information and use of the information. The CRD must make the information collected from covered entities readily accessible, easily searchable and easily downloadable on the CRD's website. CRD may publish aggregated data from the survey results submitted to it. And, while the disclosure of information and the benefits that flow from the intended use of the information is to shine light on VC funding practices, the CRD may also use the information in a civil action under any law.
Colleen Meyer: Also, SB 54 allows the CRD to take companies that do not comply with the reporting requirements to court to compel compliance or charge a penalty sufficient to deter failure to comply. The court may also award reasonable attorneys' fees and costs incurred in pursuing the action and any other relief that the court deems appropriate.
Catherine Skulan: Now, let's step back a little to briefly consider the interplay of this law with other laws advisers and funds may be subject to. Colleen, would you like to touch on how privacy laws play into this?
Colleen Meyer: Of course. Managers' and funds' obligations under privacy laws will need to be considered here, particularly with respect to state privacy laws like California's that are more comprehensive. For example, managers and funds should consider updating their privacy policies with additional disclosures.
Catherine Skulan: And then there's always the question of amendments to the law and possible legal challenges to it. Regarding whether the law will be revised, Governor Newsom mentioned in his signing remarks that the law contains some "problematic provisions" and "unrealistic timelines," which he proposed to address as part of his 2024-2025 Governor's Budget. Governor Newsom typically releases the budget in January, and it is finalized in the summer, so we will know relatively soon what his proposed changes are. We are hopeful that this budget process will provide some clarification around the law in time for covered entities to take actionable steps, but it is still prudent for in-scope entities to be aware of this law knowing that absent changes to the law, there will be some compliance burden involved.
Colleen Meyer: And on the question of possible legal challenges: While we are not aware of any filed suits at this time, it is not uncommon for industry trade groups and others to assert legal challenges to potentially burdensome new state law requirements like SB 54. When the requirements have been adopted via statute, such challenges are frequently grounded in federal constitutional law. Now, as a general matter, federal doctrine is fairly deferential to a state's regulation of commercial activity within its borders, even where the regulation also has impacts in other states and/or imposes requirements that are more burdensome than federal law. That said, there are certain principles that courts will on occasion invoke to strike down state regulation of commercial activity. Of note, in November, the Ninth Circuit Court of Appeals struck down California's warning label requirement for herbicides as unconstitutional "compelled speech" under the First Amendment.
Catherine Skulan: That's all the time we have for today—I hope this discussion on the ins and outs of SB 54 has been helpful. For our listeners, please visit www.ropesgray.com for additional news and commentary about other important asset management developments as they arise. You can also subscribe and listen to this series wherever you regularly listen to podcasts, including on Apple, Google and Spotify. If you'd like to learn more about any of the topics we discussed today, or if we can help you to navigate SB 54 in a more tailored way, please do not hesitate to contact us. Thanks again for listening.
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.
