IA brief: California broadens scope of private-adviser exemption

September 12, 2012

By Jason Wallace

NEW YORK, Sept. 12 (Thomson Reuters Accelus) – California has broadened registration exemptions for private-fund advisers in a final rule adopted by the state Department of Corporations that considers the manager and its fund-investor characteristics rather than “assets under management” (AUM) or the number of clients.

The move aims to minimize regulatory requirements on a venture-capital industry considered to be a lifeblood for the emerging firms that fuel California’s high-tech economy, and responds to changes in registration requirements under national Dodd-Frank Wall Street reforms.

“The final rule encourages and enables capital formation in California,” said Mark Leyes, Director of Communications for the California Department of Corporations. “The final rule seeks to achieve an appropriate regulatory balance on an asset class that has historically been subject to minimal regulatory oversight,” he said.

The Dodd-Frank act eliminated the so-called “private-adviser exemption” in section 203(b) of the Investment Advisers Act of 1940. The exemption allowed certain advisers to avoid registration with the Securities and Exchange Commission and certain states.

The exemption had applied to any adviser with less than 15 clients in any 12-month period or whose clients are all located in the firm’s state, as long as the adviser does not advise a mutual fund or a business development company and does not hold itself out to the public as an adviser. Advisers to private funds managing fewer than 15 funds relied on the exemption because each fund was considered a single client without regard to the number of underlying investors in the fund.

The elimination of the widely used “private adviser exemption” forced many states, including California, to create emergency regulations to preserve the existing exemption from state registration for advisers who relied on the expiring federal exemption. The North American Securities Administrators Association (NASAA) did offer a model rule for its members, although California’s new standard is looser.

Why broaden the scope?

A “Statement of Reasons” document that accompanied the final release stated that “the exemption is intended to minimize regulatory burdens on an asset class that provides an increasingly critical source of funding for private California companies, while providing for robust investor protection through investment disclosures and annual financial reporting.”

The statement cited statistics from various associations to show how important venture capital is to the state and how the updated and expanded rule can help it. Venture capital funds invested $132 billion into California companies; 50 percent of which came from venture-capital firms headquartered in California.

In addition, public companies backed by venture-capital funds account for more than 2 million jobs and over $800 billion in revenue. In terms of private equity or hedge funds, there are approximately 1,777 private equity-backed companies headquartered in California, employing approximately 746,800 workers while the state is receiving 10.9% of all U.S. private equity investments.

Qualifying for the exemption & notable items

In general, advisers will be exempt from California investment adviser registration provided they have not violated securities laws, they file periodic reports with the state, pay the existing investment adviser registration and renewal fees, and comply with additional safeguards when advising funds organized under Section 3(c)(1) and/or 3(c)(5) of the Investment Company Act of 1940.

Notable items include some of the changes from the emergency rulemaking. They include:

  • In an attempt to increase financial transparency, California now requires that any financial audits for typical 3(c)(1) or 3(c)(5) type funds be performed by a Certified Public Accountant that is registered with, and subject to regular inspection by, the Public Company Accounting Oversight Board (PCAOB). In addition, the audit of each private fund it manages is delivered to each investor annually.
  • California expanded the definition of the term “venture capital company” to include corresponding federal definitions.
  • An adviser to a typical 3(c)(1) or 3(c)(5) type fund must provide investors certain written disclosures about the services it provides, its duties, and other material information.
  • The term “qualifying private fund” now includes an issuer that qualifies for the exclusion of an investment company exclusively under section 3(c)(5) of the Investment Company Act of 1940.
  • An exempt adviser will be required to pay renewal fees of $125.00.
  • An exempt adviser in California, going forward, can only accept “accredited investors” in a typical 3(c)(1) or 3(c)(5) type fund. This is a case when California eased the requirements from those proposed by NASAA. NASAA was proposing that an adviser exempt from registration only accept “qualified clients”.
  • California will allow an adviser to include persons that are not “accredited investors” in a typical 3(c)(1) or 3(c)(5) type fund as long as they are professionally associated with the adviser.
  • California reiterated the SEC rule that a person cannot be charged a performance fee unless they are “qualified clients.” This is a requirement for all registered investment advisers and a practice for most of the community, even those that are unregistered, but now it has been codified in the California exemption requirements.
  • An individual associated with an adviser relying on the state’s private adviser exemption and does not otherwise act as an investment adviser representative (IAR) is not required to register or qualify as an IAR in the state.
  • An adviser relying on the exemption must now file a report directly with the IARD (Investment Advisory Registration Depository). The first report or claim of the exemption must be done before the end of the 60-day grace period from the effective date of rule, late October. The $125.00 fee will be required as well.


The rule is now in effect but allows a 60 day grace period for advisers to prepare for their first filing as an exempt adviser in California.

A grandfathering provision has been created, and generally if advisers operated under the old exemption and do not satisfy the new rule prior to the effective date, they are grandfathered. Going forward and after August 17, the new rule is in effect. It’s suggested to review the firm’s current practices and ensure they are in line with the exemption to ensure strict adherence.

Keep in mind, California did not specifically say it will conduct “for cause” exams on the new exempt advisers, like the SEC did. But Mr. Leyes did say that “Pursuant to Section 25531, the Commissioner reserves the right to undertake investigations against any investment adviser regardless of its registration status in California.”

(This article was produced by the Compliance Complete service of Thomson Reuters Accelus. <a href=”http://accelus.thomsonreuters.com/solut ions/regulatory-intelligence/compliance- complete/” target=_new”>Compliance Complete</a> provides a single source for regulatory news, analysis, rules and developments, with global coverage of more than 230 regulators and exchanges.)


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