On June 22, 2011, the Securities and Exchange Commission (the “SEC”) issued a release (the “Exemptions Release”) [1] approving final rules implementing certain provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “DoddFrank Act”) that created exemptions from registration under the Investment Advisers Act of 1940 (the “Advisers Act”) for advisers to venture capital funds, private fund advisers with less than $150 million in assets under management, and foreign private advisers. In a companion release issued the same day (the “Registration Release”), [2] the SEC implemented certain other amendments to the Advisers Act, as mandated by the Dodd-Frank Act. Further, the SEC extended the registration deadline for advisers currently relying on the private adviser exemption [3] to March 30, 2012.

Among other things, the Exemptions Release:

• defines “venture capital fund” for purposes of the new exemption for advisers that advise solely venture capital funds;
• provides an exemption from registration for certain private fund advisers with less than $150 million in total assets under management in the United States; and
• clarifies the meanings of certain terms included in a new exemption from registration for “foreign private advisers.”

Among other things, the Registration Release details:

• the increased threshold for adviser registration with the SEC ($100 million for most U.S. advisers);
• reporting requirements for certain advisers exempt from registration; and
• certain rule amendments, including amendments to the SEC’s “pay-toplay” rule.

EXEMPTIONS RELEASE

Venture Capital Fund Advisers Exemption

New Section 203(l) of the Advisers Act, added by the Dodd-Frank Act, provides a registration exemption for advisers that advise solely venture capital funds (the “Venture Capital Fund Advisers Exemption”). The exemption is from SEC registration only; funds relying on this exemption will have certain reporting requirements. See “Exempt Reporting Advisers” below. The Exemptions Release defines “venture capital fund” as a fund that generally:

• holds no more than 20 percent of the fund’s aggregate capital commitments in “non-qualifying investments”; [4]
• does not borrow aside from a limited amount of short-term borrowing;
• does not offer investors redemption or other liquidity rights;
• represents itself to investors as pursuing a venture capital strategy; and
• is a private fund.

Under this definition, a venture capital fund may invest up to 20 percent of its aggregate capital commitments in non-qualifying investments. Aside from this allowance, venture capital funds must generally hold only qualifying investments, which are:

• equity securities acquired by the fund directly from an issuing qualifying portfolio company (“Directly-Acquired Securities”);
• equity securities issued by a qualifying portfolio company in exchange for Directly-Acquired Securities; or
• equity securities issued by a company of which a qualifying portfolio company is a majority-owned subsidiary or predecessor and that are acquired by the fund in exchange for Directly-Acquired Securities issued by such qualifying portfolio company.

Eligible venture capital funds generally may not borrow funds, issue debt obligations, provide guarantees or otherwise incur leverage in excess of 15 percent of the fund’s contributed capital and uncalled capital commitments. Any permitted borrowing generally must be for a non-renewable term of no longer than 120 calendar days, except that a venture capital fund’s guarantee of a qualifying portfolio company’s obligations, up to the value of the fund’s investment in the qualifying portfolio company, is not subject to the 120-day limit.

Eligible venture capital funds may not issue securities that grant investors a right to withdraw, redeem, or require the repurchase of such securities, except in extraordinary circumstances (e.g., material change in tax law after an investor invests in the fund or the enactment of a law prohibiting an investor’s participation in the fund’s investments in certain industries or countries). Investors, however, may be entitled to receive pro rata distributions from the fund.

In addition to representing to investors that it has a venture capital strategy, an eligible venture capital fund must also be a private fund, as defined in the Advisers Act (e.g., a 3(c)(1) or 3(c)(7) fund) and must neither be registered as an investment company under the Investment Company Act of 1940 (the “Investment Company Act”) (e.g., the fund must not be a “mutual fund”) nor have elected to be a business development company under the Investment Company Act (a “BDC”).

The Venture Capital Fund Advisers Exemption became effective July 21, 2011. Under the grandfather rule, however, a fund will be deemed an eligible venture capital fund, despite not satisfying the general requirements, if it:

• represents to its investors and potential investors at the time it offers its securities that it pursues a venture capital strategy;
• sold securities to one or more investors prior to December 31, 2010; and
• does not sell any securities to, or accept additional capital commitments from, any person after July 21, 2011.

Funds would thus be grandfathered funds so long as they accepted all capital commitments by July 21, 2011 (including capital commitments from existing and new investors). The calling of capital commitments after July 21, 2011 is permissible so long as the investor becomes obligated to make such capital contribution on or prior to July 21, 2011.

Private Fund Advisers Exemption.

New rule 203(m)-1 implements Section 203(m) of the Advisers Act, which provides a registration exemption for an investment adviser that advises solely private funds and has less than $150 million in total assets under management in the United States (the “Private Fund Advisers Exemption”). As is the case with the Venture Capital Fund Advisers Exemption, funds relying on the Private Fund Advisers Exemption are exempt from SEC registration, but have reporting requirements. See “Exempt Reporting Advisers” below. This narrow exemption applies differently to U.S. advisers than it does to non-U.S. advisers. An adviser whose principal office and place of business is in the United States (a “U.S. Adviser”) may advise an unlimited number of funds and still qualify for the exemption, provided the value of private fund’s aggregate assets under management is less than $150 million. An adviser whose principal office and place of business is outside the United States (a “Non-U.S. Adviser”) may rely on the exemption so long as:

• all of the adviser’s clients that are U.S. persons, are qualifying private funds; and
• all assets managed by the adviser from a place of business in the United States are attributable solely to private fund assets, the total value of which is less than $150 million.

As a consequence, Non-U.S. Advisers may enter the U.S. market and take advantage of the exemption without regard to the type or number of its non-U.S. clients and the amount of assets it manages outside of the United States. A “U.S. person” for purposes of the Private Fund Advisers Exemption is one who constitutes a “U.S. person” under Regulation S. A “private fund” means any private fund (e.g., 3(c)(1) or 3(c)(7) fund) that is not a mutual fund and has not elected to be treated as a BDC. “Place of business” means any office where an investment adviser regularly provides advisory services, solicits, meets with, or otherwise communicates with clients, and any location held out to the public as a place where the investment adviser conducts any such activities. The Private Fund Advisers Exemption also became effective July 21, 2011.

Foreign Private Advisers Exemption

New Section 203(b)(3) of the Advisers Act, added by the Dodd-Frank Act, replaces the private adviser exemption with a limited exemption for “foreign private advisers” (the “Foreign Private Advisers Exemption”). Unlike those advisers relying on the Venture Capital Fund Advisers Exemption or the Private Fund Advisers Exemption, advisers relying on the Foreign Private Advisers Exemption are exempt from both registration and reporting requirements. A foreign private adviser:

• has no “place of business” in the United States;
• has, in total, fewer than 15 clients and investors in the United States in private funds advised by it;
• has less than $25 million in aggregate assets under management attributable to such U.S. clients and investors in private funds advised by it; and
• neither holds itself out to U.S. investors as an investment adviser nor acts as an investment adviser to any mutual fund or BDC.

“Place of business” has the same meaning it does under the Private Fund Adviser Exemption. New Rule 202(a)(30)-1 also defines certain terms in the Foreign Private Advisers Exemption, including: (i) “client;” (ii) “investor;” (iii) “in the United States;” (iv) “place of business;” and (v) “assets under management.” An adviser may treat as a single “client” a natural person and:

• that person’s minor children;
• any relative, spouse, spousal equivalent or relative of the spouse or spousal equivalent who has the same principal residence;
• all accounts of which the natural persons referenced in the rule are the only primary beneficiaries; and
• all trusts of which the persons referenced in the rule are the only primary beneficiaries.

Additionally, the SEC adopted new Rule 202(a)(30)- 1, which includes a safe harbor for counting clients. This safe harbor, however, is much more limited than the safe harbor included in the former private adviser exemption because it requires an adviser to count U.S. investors of an issuer that is a private fund. The SEC included two provisions clarifying that advisers need not double-count private funds and their investors under certain circumstances. First, an adviser need not count a private fund as a client if the adviser counts any investor, as defined in the rule, in that private fund as an investor in that private fund for purposes of determining the availability of the Foreign Private Advisers Exemption. Additionally, an adviser may treat as a single investor any person who is an investor in two or more private funds advised by the adviser. Second, an adviser need not count a person as an investor if the adviser counts such person as a client. This provision allows the adviser to count only once a client who is also an investor in a private fund advised by the adviser.

An “investor” in a private fund is any person who would be included in determining: (i) the number of beneficial owners of the outstanding securities of a private fund under Section 3(c)(1) of the Investment Company Act; or (ii) whether the outstanding securities of a private fund are owned exclusively by qualified purchasers under Section 3(c)(7) of the Investment Company Act.

The SEC provided guidance on whether a client or investor is “in the United States” by referencing definitions of “U.S. person” and “United States” under Regulation S, to be evaluated at the time the entity or individual becomes a client or an investor. Finally, “assets under management” are defined by reference to the calculation of “regulatory assets under management” for Item 5 of Form ADV: all securities portfolios for which the adviser provides continuous and regular supervisory or management services, regardless of whether they are proprietary assets, assets managed without receiving compensation, or assets of foreign clients. The Foreign Private Advisers Exemption became effective July 21, 2011.

REGISTRATION RELEASE

Increased Threshold for SEC Registration – “Mid-Sized Advisers.” Generally, Section 203A of the Advisers Act prohibits any investment adviser regulated or required to be regulated as an investment adviser in the state in which it has its principal office and place of business from registering with the SEC, unless it has at least $25 million of assets under management. Section 410 of the Dodd-Frank Act amends Section 203A of the Advisers Act to prohibit an investment adviser with assets under management between $25 million and $100 million (“Mid-Sized Advisers”) from registering with the SEC if it is required to be registered as an investment adviser in the state in which it has its principal office and place of business. The effect of this amendment is to raise the minimum assets under management threshold for SEC registration to $100 million, except that a Mid-Sized Adviser must register with the SEC if it:

• is an adviser to a mutual fund or a BDC;
• is not required to be registered in the state in which it has its principal office and place of business; or
• would not be subject to examination by a securities commissioner or other like authority, even if it were registered with a state.

The SEC estimates that 3,200 SECregistered advisers will be required to withdraw their federal registration and reregister with the states, which withdrawal must occur by June 28, 2012. A Mid-Sized Adviser may register with the SEC if it is required to register with 15 or more states. Mid-Sized Advisers registered with the SEC on July 21, 2011 must remain registered with the SEC until January 1, 2012. All investment advisers registered with the SEC on January 1, 2012 – regardless of size and regardless of whether they will remain registered with the SEC – must file amendments to Form ADV by March 30, 2012. [5] While the SEC received comments arguing that advisers unaffected by the statutory changes effected by the Dodd-Frank Act should not be required to complete and file all of Form ADV, the SEC’s stance is that: (1) such a filing is necessary for each adviser to confirm its eligibility for SEC registration in light of the multiple statutory changes that could affect whether the adviser may register with the SEC; and (2) March 30, 2012 coincides with most advisers’ required annual updating amendment deadlines (90 days from most advisers’ December 31, 2011 fiscal year end), eliminating the requirement that they file an additional amendment to their Forms ADV.

“Exempt Reporting Advisers.” As discussed, investment advisers relying on the Venture Capital Fund Advisers Exemption or the Private Fund Advisers Exemption (“Exempt Reporting Advisers”) are exempt from registration, but still have reporting requirements. This generally entails completing certain items in Part 1 of Form ADV and filing publicly Form ADV with the SEC. Among the items on Form ADV that Exempt Reporting Advisers are required to complete are:

• Item 1 (Identifying Information);
• Item 2B (SEC Reporting by Exempt Reporting Advisers);
• Item 3 (Form of Organization); • Item 6 (Other Business Activities);
• Item 7 (Financial Industry Affiliations and Private Fund Reporting);
• Item 10 (Control Persons); and
• Item 11 (Disclosure Information).

Amendments to the “Pay-to-Play” Rule

Generally, the SEC’s “pay-to-play” rule, Rule 206(4)-5 under the Advisers Act, prohibits registered and certain unregistered advisers from providing advisory services for compensation for the two-year period following the adviser’s political contribution to an elected official in a position to influence selection of the adviser to manage public plans. For more on the SEC’s pay-to-play rule, see our July 2010 Securities Update: SEC Enacts Rules to End “Pay-to-Play” Practices of Investment Advisers. Among other things, the Registration Release extends the pay-to-play rule to apply to Exempt Reporting Advisers and confirms that it also applies to foreign private advisers.

[1] The Exemptions Release is available at: http://www.sec.gov/rules/final/2011/ia-3222.pdf.

[2] The Registration Release is available at: http://www.sec.gov/rules/final/2011/ia-3221.pdf.

[3] Also called the “fewer than 15 clients” exemption contained in Section 203(b)(3) of the Advisers Act. For more on the Private Fund Advisers Registration Act of 2010, codified in Title IV of the Dodd-Frank Act, which repealed the private adviser exemption as of July 21, 2011, see our July 2010 Securities Update: New Requirements for Advisers to Private Funds.

[4] Calculated immediately after acquiring any non-qualifying investment. Non-qualifying investments are any investments that are not “qualifying investments” (or short-term holdings). Funds may value non-qualifying investments at either cost or fair value so long as they apply such chosen methodology consistently

[[5] Because initial applications for registration can take up to 45 days for approval, the Registration Release notes that these advisers should file applications by February 14, 2012.