Tuesday, August 28, 2012

California Adopts Permanent Private Fund Adviser Exemption

A permanent private fund adviser exemption was adopted by the California Department of Corporations, effective August 27, 2012, following public comments first received between February 20 and March 25 of 2012 and more recently received during a 15-day period after final amendments were made to the rule on June 18, 2012.

Changes made to the final rule following comments received include:

1. The following amendments made to the definitions section:

*  Adding the definition of a "fund of funds" and "retail buyer fund." A fund of funds is a qualifying private fund that invests a majority of its assets in one or more qualifying private funds. A retail buyer fund is a qualifying private fund that is not a venture capital company and that qualifies for the exclusion from the definition of an investment company under either (or both) section 3(c)(1) or 3(c)(5) of the Investment Company Act of 1940, as amended.

*  Expanding on the definition of a "venture capital company" to include the federal definitions of a "venture capital fund" and "venture capital operating company."

*  Redefining an "advisory affiliate" and  "qualifying private fund."

2. The following amendments made to the exemption itself:

* Replacing "3(c)(1)" fund with "retail buyer fund."

* Clarifying that financial statements must be delivered annually, and adding that the annual financial statements must be delivered to the beneficial owners of the retail buyer fund within 120 days following each fiscal year-end (or within 180 days if the retail buyer fund is a fund of funds).

* Requiring that financial audits be performed by firms registered with, and subject to regular inspection by, the Public Accounting Oversight Board (PCAOB).

* Establishing a "materiality" threshold for any disclosures made to retail buyer fund investors; that the disclosures be tailored to fund investors and provided in plain English; and that negative disclosures, e.g., obligations and duties to investors, as well as affirmative disclosures be included to ensure that investors have enough notice about who the "client" of the investment adviser is, and what legal consequences flow from that advisory relationship.

The final adopted rule appears below followed by the public comments received:

§ 260.204.9.  Exemption for Certain Investment Advisers with Fewer than 15 Clients.Certificate Exemption for Investment Advisers to Private Funds.
(a) An exemption from the provisions of Section 25230 of the Code is hereby granted, as being necessary and appropriate in the public interest, to any person who (1) does not hold itself out generally to the public as an investment adviser, (2) during the course of the preceding twelve months has had fewer than 15 clients, (3) does not act as an investment adviser to any investment company registered under title I of the Investment Company Act of 1940, or a company that has elected to be a business development company pursuant to section 54 of title I of the Investment Company Act of 1940 and has not withdrawn its election, and (4) either (i) has assets under management, as defined in subsection (b)(2), of not less than $25,000,000 or (ii) provides investment advice to only venture capital companies, as defined in subsection (b)(3).
(b)(a) Definitions.  For purposes of this rule section 260.204.9 (this “rule”), the following definitions shall apply:
(1) Client shall have the same meaning as defined by the Securities and Exchange Commission under the rule adopted pursuant to Section 222(d) of the federal Investment Advisers Act of 1940, as amended.”Private fund adviser” means an investment adviser who provides advice solely to one or more qualifying private fund(s).
(2) “Assets under management” means the securities with respect to which an investment adviser and its affiliated persons provide continuous and regular supervisory or management services; provided, that in the case of securities managed for an entity which is excluded from the definition of investment company by the exclusion provided in Section 3(c)(1) or Section 3(c)(7) of the federal Investment Company Act of 1940, as amended, assets under management shall also include any amount payable to such entity pursuant to a firm agreement or similar binding commitment pursuant to which a person has agreed to acquire an interest in, or make capital contributions to, the entity upon demand of such entity. “Qualifying private fund” means an issuer that qualifies for the exclusion from the definition of an investment company under one or more of sections 3(c)(1), 3(c)(5), and 3(c)(7) of the Investment Company Act of 1940, as amended (15 U.S.C. 80a-3(c)(1), (5) and (7)).
(3) “Retail buyer fund” means a qualifying private fund that is not a venture capital company and that qualifies for the exclusion from the definition of an investment company under one or both of sections 3(c)(1) and 3(c)(5) of the Investment Company Act of 1940, as amended (15 U.S.C. 80a-3(c)(1) and (5)).
(3)(4) An entity is avVenture capital company” if, means an entity that satisfies one or more of the conditions below:
(A) 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 fifty percent (50%) of its assets (other than short-term investments pending long-term commitment ofor distribution to investors), valued at cost, are venture capital investments, as defined in subsection (b)(4)(a)(5) of this rule, or derivative investments, as defined described in subsection (b)(5)(a)(6) of this rule; or
(B) the entity is a “venture capital fund” as defined in rule 203(l)-1 adopted by the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended (17 C.F.R. 275.203(l)-(1)); or
(C) the entity is a “venture capital operating company” as defined in rule 2510.3-101(d) adopted by the U.S. Department of Labor under the Employee Retirement Income Security Act of 1974 (29 C.F.R. § 2510.3-101(d)).
(4)(5) A vVenture capital investment” means is an acquisition of securities in an operating company as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person of either has or obtains management rights as defined in subsection (b)(6)(a)(7) of this rule.
(5)(6) An acquisition of securities is adDerivative investment” means an acquisition of securities if it is acquired by a venture capital company in the ordinary course of its business in exchange for an existing venture capital investment either (i) upon the exercise or conversion of the existing venture capital investment or (ii) in connection with a public offering of securities or the merger or reorganization of the operating company to which the existing venture capital investment relates.
(6)(7) “Management rights” means the right, obtained contractually or through ownership of securities, either through one person alone or in conjunction with one or more persons acting together or through an affiliated person, to substantially participate in, to substantially influence the conduct of, or to provide (or to offer to provide) significant guidance and counsel concerning, the management, operations or business objectives of the operating company in which the venture capital investment is made.
(7)(8) An “operating company” means an entity that is primarily engaged, directly or through a majority owned subsidiary or subsidiaries, in the production or sale (including any research or development) of a product or service other than the management or investment of capital, but shall not include an individual or sole proprietorship.
(8)(9) “Affiliated person” means a person that controls, is controlled by, or is under common control with the other specified personsperson(s). 
(10) “Control means possessing, directly or indirectly, the power to direct or cause the direction of management and policies.
(11) “Advisory affiliate” means an “advisory affiliate” as defined in the Glossary of Terms to Form ADV (Uniform Application for Investment Adviser Registration (17 C.F.R. § 279.1).
(12) “Fund of funds” means a qualifying private fund that invests a majority of its assets in one or more qualifying private funds.
(b) Exemption for private fund advisers.  Subject to the additional requirements of subsection (c) of this rule below, a private fund adviser shall be exempt from the certificate requirement of Section 25230(a) of the Code if the private fund adviser satisfies each of the following conditions:
(1) neither the private fund adviser nor any of its advisory affiliates are subject to a disqualification as described in Rule 262 of Regulation A adopted by the Securities and Exchange Commission under the Securities Act of 1933, as amended (17 C.F.R. § 230.262); or have done any of the acts, satisfy any of the circumstances, or are subject to any order specified in Section 25232(a) through 25232(h) of the Code; and
(2) the private fund adviser files with the Commissioner:
(A) each report and amendment thereto that an investment adviser is required to file with the Securities and Exchange Commission pursuant to Rule 204-4 (“Rule 204-4”) adopted by the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended (17 C.F.R. § 275.204); or
(B) if the private fund adviser is not required to submit such filings to the Securities and Exchange Commission, the private fund adviser prepares and files the reports and amendments referenced in paragraph (2)(A) immediately above (on or before the date(s) such reports would be required to be filed pursuant to Rule 204-4) directly with the Commissioner.
(3) The private fund adviser has paid the fee required by Section 25608(q) of the Code for each calendar year in which it relies upon the exemption established by this rule.  If the private fund adviser has paid an initial fee pursuant to this rule and it intends to rely on the exemption in a succeeding calendar year, it must pay the renewal fee specified by Section 25608(q) before January 1 of the succeeding year.
(c) Additional requirements for private fund advisers to certain retail buyer funds.  In order to qualify for the exemption described in subsection (b) of this rule, a private fund adviser who advises at least one retail buyer fund shall, except as otherwise provided in subsection (h) of this rule, in addition to satisfying each of the conditions specified in subsections (b)(1) through (b)(3) of this rule, comply with each of the following requirements with respect to each retail buyer fund advised by the private fund adviser:
(1) The private fund adviser shall advise only retail buyer funds  whose outstanding securities (other than short-term paper) are beneficially owned entirely by:
(A) persons who, at the time the securities were sold, either (i) met the definition of “accredited investor” in Rule 501(a) of Regulation D adopted by the Securities and Exchange Commission under the Securities Act of 1933, as amended (17 C.F.R. § 230.501(a)), or (ii) were managers, directors, officers, or employees of the private fund adviser; or
(B) any person that obtains the securities through a transfer not involving a sale of that security. 
(2)
(A) At or before the time of purchase of any ownership interest in a retail buyer fund, the private fund adviser shall prominently and in plain English disclose (in a private placement memorandum or similar written document) to the purchaser of such ownership interest all material facts regarding the following:
(i) all services, if any, to be provided by the investment adviser to a beneficial owner of the fund, and to the fund itself; and
(ii) all duties, if any, the investment adviser owes to a beneficial owner of the fund, and to the fund itself.
(B) Compliance with subparagraph (2)(A) immediately above shall not relieve the private fund adviser of any disclosure obligation under any other state or federal law.
(3)
(A) The private fund adviser shall obtain, on an annual basis, financial statements of each retail buyer fund advised by the private fund adviser, audited by an independent certified public accountant (CPA) that is registered with, and subject to regular examination by, the Public Company Accounting Oversight Board (PCAOB), and shall deliver a copy of such audited financial statements to each beneficial owner of the retail buyer fund within 120 days after the end of each fiscal year (or within 180 days if the retail buyer fund is a fund of funds);
(B) if a retail buyer fund begins operations more than 180 days into a fiscal year, the investment adviser need not comply with suparagraph (3)(A) immediately above for that initial fiscal year, provided that the financial audit (conducted in accordance with the qualitative requirements set forth in subparagraph (3)(A) immediately above) for the fiscal year immediately succeeding this period is supplemented by, or includes, a financial audit of the initial fiscal year.
(4) A private fund adviser may not enter into, perform, renew or extend an investment advisory contract that provides for compensation to the investment adviser on the basis of a share of the capital gains upon, or the capital appreciation of, the funds, or any portion of the funds of an investor that is not a “qualified client” as defined in Rule 205-3(d) (17 C.F.R. 275.205.-3(d)) adopted by the Securities and Exchange Commission under the Investment Advisers Act of 1940, as amended (15 USC 80b-1 et seq.).
(d) Federal covered investment advisers.  If a private fund adviser is registered with the Securities and Exchange Commission, the adviser is not eligible for this exemption and shall comply with the state notice filing requirements applicable to federal covered investment advisers in Section 25230.1 of the Code.
(e) Investment adviser representatives.  A person is exempt from the requirements of Section 25230(b) of the Code if he or she is employed by or associated with an investment adviser that is exempt from registration in this state pursuant to this rule and does not otherwise act as an investment adviser representative.
(f) Electronic filing.  The report described in subsection (b)(2) of this rule above shall be filed electronically through the IARD (Investment Advisor Registration Depository).  A report shall be deemed filed when the report and the fee required by Section 25608(q) of the Code are filed and accepted by the IARD on the state's behalf.
(g) Transition.  An investment adviser who becomes ineligible for the exemption provided by this rule shall comply with all applicable laws and rules requiring registration or notice filing within ninety (90) days after the date the investment adviser’s eligibility for this exemption ceases.
(h) Grandfathering for investment advisers to retail buyer funds.  An investment adviser to a retail buyer fund that existed prior to the effective date of this rule and that does not satisfy the conditions set forth in subsection (c)(1) or (c)(4) of this rule, on the effective date, may nevertheless be eligible for the exemption contained in subsection (b) of this rule if the following conditions are satisfied:
(1) as of the effective date of this rule, the retail buyer fund ceases to sell interests to investors other than those described in subsection (c)(1)(A) of this rule.
(2) the investment adviser complies with subsection (c)(4) of this rule for every beneficial owner who purchases an ownership interest from the retail buyer fund on or after the effective date of this rule.
(3) the investment adviser discloses in writing the information described in subsection (c)(2) of this rule to every beneficial owner of the fund within 90 days after the effective date of this rule; and
(4) for every fiscal year ending after the effective date of this rule, the investment adviser delivers audited financial statements to each beneficial owner as required by subsection (c)(3) of this rule.
(i) Temporary Filing Extension.  Any initial report required to be filed pursuant to subsection (b)(2) of this rule shall be filed no later than 60 days from the effective date of this rule.
Note: Authority cited: Sections 25204 and 25610, Corporations Code. Reference: Section 25230, Corporations Code.

COMMENTS RECEIVED DURING THE INITIAL COMMENT PERIOD

            The Department received 13 public comment letters during the initial public comment period.  Those comments are summarized below, together with the Department’s response.
             
            1.  Commentor:  E-mail letter dated January 11, 2012, from Sean Caplice with Gunderson, Dettmer Stough, Villeneuve, Franklin & Hachigian, LLP (Gunderson Letter”).

Comment No. 1:  Commentor suggests clarifying the definition of a 3(c)(1) Fund.

Response:  The Department has revised the Final Rule to reflect the concerns raised in this letter. Specifically, the rule has been clarified to state that 3(c)(1) funds are those that exclusively qualify for the 3(c)(1) exemption from the ICA.

Comment No. 2:  Commentor suggests broadening the definition of the term “Venture Capital Company” to include similar and/or corresponding federal definitions.  Specifically, Commentor suggests including similar SEC and U.S. Department of Labor Definitions.

Response: In light of certain similar definitional parameters, and generally consistent policy aims, the Department has expanded the definition of the term “Venture Capital Company” to include the SEC and Department of Labor definitions.

Comment No. 3: Commentor suggests broadening the pool of eligible persons (even though those persons may not meet the accredited investor standard) that may invest in a 3(c)(1) fund, to include (1) certain staff of the fund (or an affiliate of the adviser), and (2) persons receiving an interest in the fund as a result of the original investor’s death, divorce, legal separation or bona fide gifting.

Response:  The Department has revised the proposal to fully clarify that ownership by certain staff persons that do not meet the accredited investor standard, or transfer of an investor's interest as a result of the original investor's death, divorce, legal separation or bona fide gifting would not be a bar to exemptive treatment.

Comment No. 4:  Commentor suggests that the exemption’s disclosure requirements result in vague, unnecessary and confusing obligations.  Commentor recommends clarifying the terms “services”, “duties”, and “material information” and providing additional guidance regarding the specific requirements of such disclosure items.

Response:  In response to the concerns raised by Commentor, the Department has clarified the scope and extent of the required disclosures most notably by included a “materiality” threshold, and providing general guidance in this document.[1]  The Final Rule has also been revised to clarify instances (such as the examples cited by Commentor) when these disclosures are not required to be met.  Lastly, the Department concurs with Commentor that the intent of the rule is not to encourage laundry list boilerplate disclosures.  Instead, the rule aims to provide key distilled disclosures.

Comment No. 5:  Commentor suggests allowing a waiver of the financial audit requirement if a majority of the fund investors waive this requirement.

Response:  The Department deems the financial audit requirement a key condition to exemptive treatment.  Furthermore, while the financial audit provides fund financial information to investors, it also serves a strong regulatory oversight purpose, by providing the Department, as necessary, with a financial tool to review fund financial transactions.  Consequently, the audit requirement may not be waived by a majority of (or even all) fund investors.  The audit requirement provides a meaningful safeguard that will promote financial transparency for investors and the Department. In this respect, similar to the proposed Custody Rule[2] the Department is requiring that financial audits be performed by CPAs that are registered with, and subject to regular inspection by the PCOAB.

Comment No. 6:  Commentor suggests clarifying that the limitations set forth in Rule 260.234 are not applicable to venture capital entities.

Response:  The Department has revised the proposal to fully clarify that the performance fee limitation does not apply to a venture capital entity.

Comment No. 7:  Commentor recommends amending the subdivision (h) grandfathering provision to make it available to all 3(c)(1) Funds that existed prior to the effective date of this regulatory action.

Response:  See response to Comment No. 3 of Commentor 7, of the Seward Letter.

            2.  Commentor:  E-mail letter dated February 8, 2012, from Matthew Schwartz with Financial Services Institute, Inc. (“FSI”).

Comment No. 1:  Commentor recommends amending the proposed regulatory action to adopt the entire NASAA Model Rule including adoption of the “qualified client” minimum for 3(c)(1) funds, and the adoption of the SEC’s definition of “Venture Capital Fund.”  Commentor further states that by adopting the entire NASAA Model Rule aids in creating a uniform regulatory framework in the states and removes compliance hurdles for firms subject to this regulatory action.

Response:  While the Department agrees with FSI that increased uniformity among blue-sky laws provides for a more efficient legal framework, California has deviated from the NASAA Model Rule in that the proposal would allow accredited investors (and under some circumstances persons that do not meet the accredited investor standard)[3] to invest in 3(c)(1) Funds managed by exempt advisers.  This standard provides flexibility for fund managers that wish to allow staff that do not meet the qualified client or accredited investor standards (either because they do not meet the financial criteria, or because they do not meet the parameters of eligible employees) to invest in a fund.  Importantly, these individuals may not be charged performance based fees; accordingly, there is a strong financial disincentive for advisers to allow persons that do not meet the qualified client standard to invest in a Retail Buyer Fund.  While the Final Rule deviates from the Model Rule, it does so by providing more flexibility, and thus any adviser who meets the exemption in the Model Rule would be eligible for the California exemption.  Moreover, the deviation does not unnecessarily complicate the structure of the rule; and thus, we do not anticipate that the deviation will cause confusion in this respect.

In response to FSI's, and others', concerns regarding the need for uniformity when defining venture capital-type entities, the Department has amended the proposal to also include the definition of "Venture Capital Fund" as defined by the SEC.[4]

            3.  Commentor:  Letter dated February 10, 2012, from Charles Flynn with Marin Mortgage Bankers.

Comment No. 1:  Commentor is licensed by the Department of Real Estate and currently issues securities that are exempt from qualification requirement under Section 25102.5 and the exemptions provided in Sections 25102(f) and 25102.1(d) of the Corporate Securities Law.  Commentor is concerned that the proposed regulatory action will require licensed real estate brokers to register as investment advisers because the mortgage loans that they fractionalize or manage through funds fall within the definition of “securities” under Section 25019 of the Corporations Code.  Commentor recommends amending the proposed regulations to provide an exemption from registration as an investment adviser applicable to licensed California real estate brokers and their agents.

Response:  See Response to Comment No. 1 of Commentor 11, the CMA Letter.

            4.  Commentor:  E-mail letter dated March 12, 2012, from Gerald Lopatin.

Comment No. 1:  Commentor states that the proposed temporary exemption timeframe is insufficient and recommends that the exemption be extended to June 28, 2013 to provide an adequate amount of time for the transition period. 

Response:  To ensure that affected persons had sufficient time to familiarize themselves with the final rule, and to allow the Department to fully study how best to regulate this class of advisers, the Department extended the private adviser exemption[5] until July 16, 2012.  Furthermore, the Final Rule provides for further filing extensions and grandfathering provisions.

            5.  Commentor:  E-mail letter dated March 15, 2012, from Matthew Giles with Goodwin Procter (“Goodwin Letter”).

Comment No. 1:  Commentor recommends amending the definition of qualifying private fund to mean an issuer that qualifies for the exclusion from the definition of an investment company under one or both of section 3(c)(1) and section 3(c)(7) of the ICA rather than limiting the proposed regulatory action to advisers that rely on SEC Rule 203(m)-1.  Commentor provided language that would clarify the scope of the existing proposal.

Response:  In order to fully clarify the scope of eligible funds, the Department adopts Commentor’s suggested language (subject to certain changes as a result of the expansion of the exemption to 3(c)(5) Funds).

            6.  Commentor:  Letter e-mailed and facsimile dated March 25, 2012, from Andrew Springer with Resolve, Inc.

Comment No. 1: Commentor states the proposed regulatory action does not adequately protect investors in 3(c)(1) Funds and that it fails to meet the legislative intent of Dodd-Frank, in that it provides less transparency and oversight than the Private Adviser Exemption Regime. Accordingly, Commentor recommends the department amend the proposed regulatory action to apply exclusively to investment advisers of 3(c)(7) Funds, which will require all advisers to 3(c)(1) Funds not registered with the SEC to apply for a license from the Department.

Response:  In contrast to the Private Adviser Exemption Regime, the Final Rule would result in increased financial transparency, oversight and investor safeguards, and consequently the Commissioner has determined that the Final Rule adequately balances a moderate level of regulatory oversight over 3(c)(1) Funds (and Retail Buyer Funds generally)  with the competing need of facilitating a critical source of funding for private California companies.  The Private Adviser Exemption Regime failed to include any reporting requirements, statutory disqualifications, mandatory disclosures or direct limitations on investor characteristics (e.g. even a limited number of non-accredited investors could participate in these offerings), while the current proposal would increase contractual and financial transparency and include significant investor safeguards.  Nevertheless, Commentor rightfully emphasizes the need for increased transparency in this asset class; and in response to this and other comments[6]; the Amended Proposal and Final Rule include a requirement that financial audits be performed by PCAOB firms.

With regard to advisers to 3(c)(1) and 3(c)(5) Funds exemption eligibility, we emphasize that such eligibility is conditioned on the strict compliance with the heightened standards set forth in the exemption.

Commentor also notes that the accredited investor or qualified client standards do not indicate financial sophistication on the part of investors.  The Department concurs with this statement, insofar as the inclusion of any net worth standard is not a perfect proxy for financial sophistication.  This is true regardless of the standard that is employed (e.g., qualified purchaser).  However, the standards’ wide use across state and federal securities laws; convenience, predictability and clarity for investors, issuers and investment advisers; and recent enhancements as a result of Dodd-Frank, result in the metric being a more realistic proxy for sophistication than any other known standard.  In general, the proposal seeks to ensure that only investors that are generally capable of shouldering the financial risk of the offerings are permitted to participate in the offerings, while allowing this segment of the capital markets to develop.  In this respect, and in the context of the exemption more generally, the Department seeks to achieve an optimum balance between investor protection and overly intrusive regulations. 

Lastly, the Department will continue to closely study this sector to ensure that the current safeguards provide sufficient protection to investors in these funds.  In particular, the Department will consider whether the application of certain rules applicable to registered investment advisers should be amended to be applicable to exempt advisers.

            7.  Commentor:  E-mail letter dated March 26, 2012, from Robert Van Grover with Seward & Kissel LLP (“Seward Letter”).

Comment No. 1:  Commentor recommends amending the proposed regulation to permit a limited number of investors who may not meet the financial requirements of the accredited investor standard but who are knowledgeable and experienced in financial and business matters to invest with an exempt adviser without causing the exempt adviser to be required to obtain a certificate under Corporations Code Section 25230(a).  Commentor father suggest limiting the exempt advisers to no more than 35 investors in each 3(c)(1) fund that are not accredited investors.

Response:  As discussed in the Initial Statement of Reasons and in the response to the ABA Letter, the Department views the exemption for registration as conditioned on increased investor safeguards; one of the critical safeguards is the financial suitability standards set forth directly (i.e., accredited investor, qualified purchaser) and indirectly (i.e., qualified client) in the Final Rule.  The ability to financially shoulder the risk inherent in these investment classes amply justifies a minimum financial standard.  Additionally, we note that the Final Rule deviates from the NASAA Model Rule in that, in the interest of flexibility for fund managers, it permits accredited investors to participate in these private funds (so long as they are not charged a performance fee).  The Final Rule also provides flexibility to advisers in regard to incentivizing staff, by allowing certain staff persons that do not meet the accredited investor standard to invest in the fund (see response to the Gunderson Letter).

Comment No. 2:  Commentor recommends the proposed regulation should permit exempt advisers to receive performance-based compensation regardless of whether investors are qualified clients.

Response:  The prohibition on performance fees will significantly increase clarity and consistency in this investment class, by ensuring that exempt advisers are subject to the same compensation structure limitations as registered investment advisers.

Comment No. 3:  Commentor recommends the proposed regulation should permit exempt advisers to receive performance-based compensation from existing investors on a grandfathered basis.

Response:  With regard to Section III of the Comment Letter, the Department understands the Commentor’s concerns regarding existing contractual arrangements and accordingly has significantly revised the "grandfathering" provisions to ensure that existing funds are allowed to continue operating under existing compensation structure.

            8.  Commentor:  E-mail letter dated March 25, 2012, from Christopher Ainsworth with Maerisland Capital, LLC on behalf of the Public Policy Committee of the California Hedge Fund Association (“California Hedge Fund Association Letter”).

Comment No. 1:  Commentor recommends amending the definition of 3(c)(1) Fund to be consistent with the approach the SEC took in describing 3(c)(1) Funds in Rule 205-3 under the Advisers Act.

Response:  See response to Comment No. 1 of Commentor 1, the Gunderson Letter.

Comment No. 2:  Commentor states that recent amendments to the definition of accredited investor in Rule 501(a) of Regulation D under the Securities Act of 1933 could create confusion regarding which definition must be applied to which investors.  Commentor recommends amending the accredited investor definition in subdivision (c)(1) of Section 260.204.9.

Response:  In order to promote clarity regarding which version of the accredited investor standard to apply.  Commentor’s suggested language has been included in the Final Rule.

Comment No. 3:  Commentor suggests that the disclosure requirements in subdivision (c)(2) of Section 260.204.9 of the proposed regulation are unclear and would not provide any investor protections that are not already provided by other securities laws and regulations.

Response:  The Department has amended the disclosure requirements in light of this and other comments.  The Final Rule clarifies disclosure requirements, as stated in response to the Gunderson Letter.[7] 

Comment No. 4:  Commentor suggests adding additional requirements to the proposed financial audit requirement in subdivision (c)(3) of Section 260.204.9.

Response:  In light of the added clarity and quality of the financial audits that would result from adopting the Commentor’s suggestions, the comments regarding financial audit requirements and procedures are adopted in their entirety.  In order to balance the cost of requiring the PCOAB audit requirement, the Final Rule provides that financial audits should be provided after the fund’s first full fiscal year.  However, as noted in the comment letter, the audit of the first fiscal year will be required to cover the short year.

Comment No. 5:  Commentor suggests amending the grandfathering provisions to apply to the requirement in subdivision (c)(4) of Section 260.204.9 that exempt 3(c)(1) Fund advisers from complying with the performance-based compensation.

Response:  See response to Comment No. 3 of Commentor 7, the Seward Letter.

            9.  Commentor:  E-mail letter dated March 25, 2012, from Kerry Parker with California Hedge Fund Association.  Kerry Parker’s letter is the same letter the Department received from Christopher Ainsworth. 

Response: See comments and responses to Commentor 8, the California Hedge Fund Association Letter.

            10.  Commentor:  E-mail letter dated March 26, 2012, from Keith Bishop on behalf of the American Bar Association Committee (“Committee”) on State Regulation of Securities (“ABA Letter”).

Comment No. 1:  Commentor states that the definition of advisory affiliates is unclear and should be amended to meet the clarity standard set forth in Government Code Section 11349(c).  With respect to sections II, IV, VII and VIII of the Committee's comment letter, the Committee identified a number of instances where the Initial Proposal lacked clarity. The Committee provided language to remedy the areas of possibly confusion addressed in sections II, IV, VII and VIII of the Committee's comment letter.

Response:  The text of the exemption has generally been amended in the manner suggested by the Committee.  The Final Rule adopts much of the Committee's language verbatim.

Comment No. 2:  Commentor recommends amending the disqualification requirement in the proposed regulation because it is far broader than SEC Rule 262 and would make it difficult, if not impossible, for investment advisers to determine with certainty whether they and their advisory affiliates can rely on the exemption.

Response:  The statutory disqualification provisions included in the Final Rule mirror those included in a recent broker-dealer safe harbor,[8] and thus promote consistency among California “bad boy” provisions.  Moreover, it is reasonable for the Department to condition a registration exemption on the investment adviser not engaging in activity that gives rise to potential disciplinary action.  In order to increase investor safeguards, the reduced regulatory oversight requires that eligible investment advisers have conducted their business in a legal manner.  However, the Department will monitor this element of the exemption to study whether any regulatory changes are required in this respect.  The Department notes that for purposes of determining eligibility under the Final Rule, but not for purposes of interpreting Section 25232 more generally, the terms “violation” or “violated” would require a finding by a court or regulatory agency.

Comment No. 3:  Commentor suggests that the renewal fee is unclear as to what “it” is referring to.  Commentor recommends amending the renewal fee for clarity.

Response: See Response to Comment No. 1 of Commentor 10, the ABA Letter.

Comment No. 4:  Commentor suggests that the disclosure requirements are vague, overbroad, and will create uncertainty.  Commentor recommends amending the disclosure requirements so not to condition the availability of the exemption on satisfaction of specific disclosure requirements.

Response: The Department has revised the language to provide greater clarity surrounding the content and scope of the required disclosures.  These supplemental disclosure requirements will provide a meaningful informational tool for fund investors, and thus, remain a condition of the revised exemption.   See also note No. 29.

Comment No. 5:  Commentor states that it is unclear whether the proposed ban on performance compensation, except as permitted under Corporations Code Section 25234(a)(1) and Rule 260.234, only applies to 3(c)(1) Funds or all funds advised by the private fund adviser.  Commentor recommends that the exemption for advisers to these funds not be conditioned upon the non-receipt of performance compensation.

Response:  The Final Rule fully clarifies that the prohibition on performance compensation applies to individual funds that have at least one investor that does not meet the qualified client standard.  The prohibition does not carry-over to other funds advised by the exempt adviser.  However, the performance fee limitation is included in the Final Rule as it serves to financially incentivize managers to exclusively allow investors that meet the qualified client standard into the fund.  We emphasize that the Final Rule deviates from the NASAA Model Rule in that it allows persons that only meet the accredited investor standard to invest in these funds.  This deviation was created to allow flexibility for advisers with regard to providing employment compensation incentives.  However, the Department anticipates that the qualified client standard will serve indirectly as the default standard for participation in a Retail Buyer Fund.

Comment No. 6:  Commentor recommends amending the definition of qualified private fund to be identical to the definition provided for in Rule 203(m)-1 under the Advisers Act.

Response:  See Response to Comment No. 1 of Commentor 10, the ABA Letter.

Comment No. 7:  Commentor states that the grandfathering provision would prohibit a number of advisers from relying on the exemption because their funds include beneficial owners that are not qualified clients as suggested by the title.  Commentor points out that the SEC recently adopted a broad grandfathering provision in Rule 205-3(c) under the Advisers Act.  Commentor recommends amending the grandfathering provision to provide that investment advisers to 3(c)(1) Funds (other than venture capital companies) are eligible for the private adviser exemption so long as the subject fund existed prior to the effective date of the regulation.

Response:  See Response to Comment No. 1 of Commentor 10, the ABA Letter.

            11.  Commentor:  E-mail letter dated March 26, 2012, from K. Bradley Rogerson with Stein & Lubin LLP on behalf of the California Mortgage Association (“CMA Letter”).

Comment No. 1:  Commentor suggests that the Initial Proposal fails to exempt most private real estate lenders in California that fund their mortgage loans through affiliated mortgage funds because many private mortgage funds will be unable to meet the requirements of Section 3(c)(1) or 3(c)(7) of the ICA.  Commentor further states that historically private real estate lenders have been exempt from the certification requirements applicable to investment advisers under existing Section 260.204.9.  Commentor recommends amending the proposed regulation to exclude private real estate lenders from the certification requirements.

Response:  The Initial Proposal would have applied exclusively to investment advisers that advise 3(c)(1) Funds and/or 3(c)(7) Funds.  Both of these exclusions from the ICA include limitations on public offerings of the fund's securities; thus, the use of the term “private” when describing, or in some cases defining, these vehicles.  In contrast, Section 3(c)(5) of the ICA, which many real estate-oriented fund advisers rely on, does not contain a similar public offering limitation. The Initial Proposal, like the corresponding NASAA and SEC rules, was intended to provide registration relief to funds that are not publicly marketed. Historically, exemptive treatment (whether in the context of investment adviser/company registration, or securities offerings) has frequently been conditioned on the lack of public marketing of securities or advisory services[9] (or numerical limitations on the number of purchasers/clients).[10]  Consequently, 3(c)(5) Funds were not included in the pool of eligible funds, based on the lack of a “private” definitional element.

However, pursuant to post-Dodd-Frank federal legislation,[11] offerings conducted under Rule 506 of Regulation D may be made through general solicitation without being considered public offerings for purposes of federal law.[12]  This is a significant deviation from longstanding historical requirements.  It is the Department’s understanding that private funds frequently rely on Rule 506 to issue securities.  Thus, one of the important limitations of the Sections 3(c)(1) and 3(c)(7) ICA exclusions has been significantly narrowed.   Accordingly, it would appear that one of the primary policy reasons for excluding 3(c)(5) Funds from the scope of the exemption has been significantly diluted.

In response to the CMA’s Letter, and the passage of the JOBS Act, the Final Rule exempts 3(c)(5) Funds.  However, advisers and their respective funds will be required to comply with the heightened safeguards applied to Retail Buyer Funds.  For example, a 3(c)(5) Fund that primarily invests in real estate or in instruments secured by real estate will be required to obtain financial audits on an annual basis.

            12.  Commentor:  E-mail letter dated March 26, 2012, from Lexi Howard with California Mortgage Association.  Lexi Howard’s letter is the same letter the Department received from K. Bradley Rogerson.

            Response:  See comments and responses to the CMA Letter, Commentor 11.

            13.  Commentor:  E-mail letter dated March 26, 2012, from Eric Brill, Esq.

Comment No. 1:  Commentor is supportive of efforts to broaden the exemption, by moving away from the “asset under management” (“AUM”) distinction contained in an earlier proposal.[13]  The Department’s shift from an AUM-based requirement to a standard that instead looks to the fund investor characteristics is based on Commentor’s[14] and other earlier comments.

Comment No. 2:  Commentor asks: “Why is registration not deemed necessary for an investment adviser to advise a “qualified client” and “accredited investor” who invests in a “private fund,” but is deemed necessary if the very same client invests instead through a separate managed account arrangement?

Response:  Commentor rightfully emphasizes that the fund investors and managed account clients may have similar financial characteristics, yet only advisers to private funds are eligible for exemptive relief.[15]  However, the Department is providing registration relief for certain private funds based on public interest, and more specifically, (1) these funds’ direct and significant contributions to California capital market,[16] and (2) to maintain consistency with the regulatory landscape of federal and other states’ laws.  However, while the funds’ contributions appear significant, the Department has included robust investor safeguards to promote transparency and minimize fraud in this asset class.

Additionally, we note that while the contributions (from a capital perspective, investor education, and otherwise) of all investment advisers are significant, and provide an important asset to the California economy, the impact of managed accounts on direct financing for California businesses would likely be more dispersed, and not as readily quantifiable. 

In light of the important policy considerations raised by the comment letter, the Department will continue to monitor this issue in the context of investment adviser supervision.

Comment No. 3:  Commentor recommends clarifying disclosure requirements.

            Response:  See note No. 29.

COMMENTS RECEIVED DURING THE 15-DAY COMMENT PERIOD

            The Department received four public comment letters on the Amended Proposal during the 15-day public comment period, which ended on July 3, 2012.  Those comments are summarized below, together with the Department’s response.

            1.  Commentor:  E-mail dated July 3, 2012, from Sean Caplice with Gunderson Dettmer Stough Villeneuve Franklin & Hachigian, LLP.

Comment No. 1:  Commentor recommends that the Department provide guidance on the disclosure requirements.

Response:  The Department does not view any additional changes to the rule as being required.  However, see note No. 29 for further clarification on the scope of required disclosures.


Comment No. 2:  Commentor suggests that clarification is needed regarding the meaning of the terms “beneficial owner” and “purchaser.” 

Response:  The Final Rule has been clarified in this regard.

2.  Commentor:  E-mail letter dated July 3, 2012, from K. Bradley Rogerson with Stein & Lubin LLP on behalf of the California Mortgage Association (“2nd CMA Letter”).

Comment No. 1:  CMA expresses support for the revisions to the Initial Proposal.

Comment No. 2:  CMA requests the addition of an alternative to the accredited investor standard applicable to Retail Buyer Funds that qualify the offer and sale of their securities with the Department under Corporations Code Sections 25111, 25112, or 25113.

Response:  Although Commentor rightfully points out Department’s suitability standards contain certain limitations not present in the accredited investor standard (e.g., 10% of the investor’s total net worth, exclusion of furnishings and automobiles), the Department views the accredited investor standard as the minimum financial floor for investment in a Retail Buyer Fund.  The Department’s core financial suitability standards, set forth in detail in Commentor’s letter, are generally lower than the accredited investor standard.  High-financial net worth is a central condition to the granting of exemptive registration relief. Moreover, as discussed in the response to Comment No. 1 of the Seward Letter, the Department has significantly relaxed financial net worth standards vis-a-vis the Model Rule by allowing accredited investors, and staff of the investment adviser, to invest in Retail Buyer Funds.  We also note that even after the Dodd-Frank increases to the accredited investor financial standards, the definition remains sufficiently broad so as to encompass, in 2007, approximately 8.3 million households (7.2% of U.S. households).[17] Accordingly, the Final Rule does not contain an alternative suitability standard. 
           
            3.  Commentor:  E-mail dated July 3, 2012, from John Graziano with BaySierra Financial, Inc.  Commentor’s e-mail is acknowledging receipt of Bradley Rogerson’s letter on behalf of the California Mortgage Association.

            4.  Commentor:  E-mail letter dated July 3, 2012, from Lexi Howard with California Mortgage Association.  Lexi Howard’s letter is the same letter the Department received from Bradley Rogerson. 

            Response:  See comments and response to the 2nd CMA Letter.


[1] Supra note No. 29.
[2] Supra note No. 28.
[3] See response to the Gunderson Letter.
[4] Id.
[5] Cal. Code Regs. Tit. 10, CCR § 260.204.9.
[6]  See California Hedge Fund Association Letter.
[7]  See response to Comment No. 4 of the Gunderson Letter. 

[8] Cal. Code Regs. tit. 10, § 260.004.1.
[9] In the SEC’s 2004 ultimately unsuccessful attempt at private fund registration, staff noted that: “in the context drafting the 3(c)(7) exclusion, for companies whose investors have an extremely high net worth, Congress, in the context of the 1996 National Securities Markets Improvement Act of 1996 (NSMIA) (143 Pub L. No. 104-290, 110 Stat. 3416 (1996), codified in scattered sections of the United States Code) left intact the public marketing prohibition. (Registration Under the Advisers Act of Certain Hedge Fund Advisers, SEC Release IA-2333 (2004), at note 143.)
[10] SEC Staff also noted that, “the legislative history of section 3(c)(1) of the Investment Company Act of 1940 [15 U.S.C. 80a-3(c)(1)], a parallel section to section 203(b)(3) that was enacted at the same time, reflects Congress’ view that privately placed investment companies, owned by a limited number of investors likely to be drawn from persons with personal, familial, or similar ties, do not rise to the level of federal interest. See 1940 Senate Hearings, supra note 73 [referencing: Investment Trusts and Investment Companies: Hearings on S.3580 Before the Senate Comm. on Banking and Currency, 76th Cong., 3d. Sess. (Apr. 22-23, 1940).”  (Id. at note 139.)
[11] On April 5, 2012, President Barack Obama signed the Jumpstart Our Business Startups (JOBS) Act (H.R. 3606) into law (“JOBS Act”) (Pub. L. No. 112-106.)Subject to rulemaking by the SEC, Title II of the JOBS Act repeals the prohibition on general solicitation in the context of offerings conducted pursuant to Rule 506 of Regulation D (17 C.F.R. § 230.506).
[12] Title II of the JOBS Act. 
[13] Invitation for Comments, PRO 02/11, March 15, 2011, text of the proposal available at:  http://www.corp.ca.gov/Laws/CSL/pdf/0211_InvitationText.pdf.
[14] Commentor submitted a comment letter in response to the Department’s Invitation for Comments (see comment letter from Eric Brill, dated April 11, 2011).
[15] We note that investment advisers to managed accounts frequently provide advisory services with regard to the totality of a client’s investable assets; in contrast, in the private fund context, standard investment diversification practices would dictate that investors only commit a portion of their overall financial assets into a specific private fund.  Thus, based on the broad impact to an investor’s entire portfolio, investment advisers to managed accounts would appear to merit heightened regulatory requirements in this regard.
[16] See Discussion, pp. 2-3.
[17] SEC Release Nos. 33-9287; IA-3341; IC-29891, note 72 (December 21, 2011).

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