Thursday, September 24, 2015

Staff Concedes Unintended Consequences to Literal Reading of Investment Adviser Rule

By John Filar Atwood

The staff has agreed with the law firm Willkie Farr & Gallagher that in certain situations the application of the literal wording of Investment Advisers Act Rule 203(l)-1 may have unintended consequences. As a result, the staff agreed not to recommend enforcement action against an investment adviser that relies on the exemption from registration in Section 203(l) and the definition of “venture capital fund” in Rule 203(l)-1 if all of the requirements of the rule are met, except that a company fails to meet the definition of a “qualifying portfolio company” in the situations outlined by Willkie Farr.

Background. Section 203(l) provides that a person meeting the Investment Advisers Act’s definition of “investment adviser” is exempt from registering as an adviser if he or she acts as an investment adviser solely to one or more venture capital funds. Rule 203(l)-1 implements Section 203(l) by defining a venture capital fund, in part, as a private fund that immediately after the acquisition of any asset, other than qualifying investments or short-term holdings, holds no more than 20 percent of the amount of the fund’s aggregate capital contributions and uncalled committed capital in assets (other than short-term holdings) that are not qualifying investments.

Under the rule, a “qualifying investment” is defined as an equity security issued by a qualifying portfolio company that has been acquired directly by a private fund from the qualifying portfolio company. Under Rule 203(l)-1(c)(4), a “qualifying portfolio company” is defined as any company that at the time of any investment by the private fund is not “reporting” or “foreign traded” and does not control, is not controlled by, or under common control with another company, that is reporting or foreign traded.

Willkie’s first example. In its letter to the Commission, Willkie Farr provided two examples to illustrate the unintended consequences of the rule. In the first example, a private fund whose manager is seeking to rely on the rule makes an investment in a qualifying portfolio company that is not a reporting or foreign traded company for purposes of the rule at the time of the investment. The law firm pointed out that if the investment causes the fund to have control over the non-reporting company, the fund manager could be deemed to have indirect control of the non-reporting company by virtue of the manager being considered to control the private fund.

In this example, Willkie Farr noted that if the non-reporting company were subsequently to conduct a public offering in the U.S. or abroad and became a reporting or foreign traded company, it would continue to be a “qualifying investment” of the private fund for purposes of the rule. A detrimental effect could arise, however, if the private fund makes an investment in a portfolio company meeting the definition of a qualifying portfolio company that provided the private fund with control over the portfolio company. Upon making that second investment, Willkie Farr said, control issues could arise that would make any follow-on investment by the fund manager in the second portfolio company a non-qualifying investment under a literal reading of the rule.

Willkie’s second example. In Willkie Farr’s other example, a second manager seeking to rely on the rule causes a private fund that it advises to make an investment in a portfolio company. The portfolio company was, at the time of investment, a company under common control with a reporting or foreign traded company because of direct controlling interests held by a fund that is advised by a manager that is not an advisory affiliate of the second manager and is not seeking to rely on the rule. In this case, according to Willkie Farr, an investment by the private fund in the portfolio company would appear to be a non-qualifying investment not only with respect to the private fund, but also any private fund advised by any other firm seeking to rely on the rule.

In its response to Willkie Farr, the staff noted the law firm’s assertion that the examples are inconsistent with the Commission’s intent in adopting the terms of the rule and its understanding of congressional intent in enacting Section 203(l). A literal reading of the rule could potentially significantly constrain the operations of the manager in managing the fund, according to the law firm.

Follow-on investments. Willkie Farr argued that it is consistent with the operations of a traditional venture capital fund for the fund to assume and maintain a controlling investment position in multiple portfolio companies. As a result, it would not be atypical for a venture capital fund to have investments in multiple qualifying portfolio companies that are under common control with a reporting or foreign traded company that is a qualifying portfolio company of the fund and/or the fund’s manager. A literal application of the rule, the law firm stated, would render a venture capital fund’s follow-on investment in each common controlled company a non-qualifying investment, a result that would be inconsistent with the Commission’s recognition generally of the importance of follow-on investments in the venture capital business.