By Jim Verdonik
Jim Verdonik
Founder of Innovate Capital Law
Contact me at:
(919)616-3225
or read my newspaper articles
at
This article is one of
14 articles in a series of articles about Deal-Makers called:
LET'S MAKE A DEAL: REGULATING DEAL-MAKERS ON WALL STREET, MAIN
STREET AND IN SILICON VALLEY IN THE CROWDFUNDING ERA
In article (11) of this series of
articles, we examined "dealers" and why most issuers do not have to
register as either a "broker" or as a "dealer" under
Section 15 (a) (1) of the Exchange Act.
There are many kinds of issuers. Most issuers are not in the securities
business. They sell securities to raise
capital to conduct businesses that have nothing to do with buying or selling
securities. What distinguishes
investment funds like venture capital, private equity and hedge funds is that
such investment funds are issuers that use the money they raise to purchase and
eventually re-sell securities, entire businesses, real estate and other
investments.
Such
investment funds have to comply with the Securities Act when they sell
securities to raise capital just like other issuers. But investment funds also have to comply with
other securities laws, because their primary business involves securities. That means we have to deal with special
securities issues whenever we deal with investment funds and the people who
manage or advise investment funds. These
issues include:
·
How do we apply the
broker-dealer rules we have been discussing to these investment funds?
·
How do other laws like
the Investment Company Act and the Investment Advisers Act apply to these
investment fund deal makers?
·
How are the JOBS Act,
other regulatory reforms and technology changing the role of investment funds
and their advisers, managers and general partners?
·
In particular, how are
special purpose entities that are organized to make a single investment or to
purchase a single business becoming more powerful players by using technology
to change the deal-making world and what regulations apply to their activities?
·
If anyone can organize
an investment fund, can issuers be proactive in helping someone to organize an
investment fund that is dedicated to investing in the securities of that
issuer?
·
How can issuers use
these changes to their advantage by taking an active role in organizing an
investment fund to do their transaction?
·
How can unregistered
finders reduce their regulatory risks and expenses by changing their roles from
being an agent to being a principal in securities transactions by organizing
and managing special purpose investment funds that invest in or purchase one
business?
·
What legal issues do
special purpose investment funds that invest in or purchase one business have
to navigate?
Broker-Dealer
Registration Issues for Investment Funds
The first regulatory issues are what the
words "for the account of others" mean and what benefits you are
permitted to derive from a securities transaction when you are acting for the
account of others or for your own account.
All of the exemptions from requirements to
register as a broker we discussed in earlier articles in this series of
articles deal with the issues of:
- The fees
you can charge, if you act as an agent or provide other services in
connection with the offer, purchase or sale of securities?
- What services are you allowed to provide to issuers and investors?
Let's review the general rules about
compensation we have discussed:
- You
cannot charge a "success fee" in connection with the sale of
securities, unless you are a registered broker, unless you rely on court
cases that say that introducing investors to issuers is not the same as
"effecting transactions" in securities.
- Sometimes
other transaction based compensation that is not a "success fee"
can trigger broker registration requirements, if the services you provide
constitute "effecting transactions" in securities.
Now, let's discuss the roles people play
when they earn fees.
Success fees are paid to agents for
arranging a transaction between two or more principals – usually the principals
are an issuer of securities and one or more investors. To be an agent, you do not have to have the
power to make decisions. Most brokers in
private placements and other investment transactions act as advisers and do not
have discretionary power to act on behalf the principals. Essentially, being an agent means that you
provide services.
But, what if you are not an
"agent" at all? What if you
don't provide services? What if you are
a principal in the deal? What if you are
making decisions about how you will invest the money of an investment fund of
which you are a part owner? Do broker
registration rules apply to people and entities that invest in securities and
the people who manage the purchasers who are not paid a fee by issuers that
sell securities?
Investment
Funds and Their Managers
Now, let's compare the roles investment
funds and their managers play and the benefits they receive more closely match
issuers and the owners of issuers who engage in a business other than investing
in securities or are the roles and benefits of investment funds and their
managers more like the roles brokers play and the benefits brokers receive.
·
Transaction Roles: Like
issuers, investment funds and their managers make decisions and exchange cash
for securities. They do not provide
advice to other participants in the securities transaction or act as an agent
like brokers do.
·
Post-Transaction Roles. Like
issuers, investment funds and their managers are beginning a relationship with
the other party to the securities transaction – the issuer. The investment fund and its manager do not
walk away from the relationship like a broker does. The relationship lasts as long as the
investment fund owns the issuer's securities.
The investment fund's managers often serve on the
issuer's Board of Directors or otherwise provide advice or assistance to the
issuer to help increase the investment's value.
·
Transaction Benefits: The
investment fund's managers usually earn nothing or very little, unless the
securities they purchase appreciate in value.
The people who manage investment funds usually earn a carried interest (a
percentage of the investment fund's future profits, if any, from the
investment) and may collect periodic management fees (usually a small percentage
of the investment fund's value). Management
fees are usually large enough to pay expenses and salaries, but are usually
small enough that they do not constitute the manager's primary economic benefit
if the investment is a success. The
carried interest is worthless, if the deal does not make money for investors. This gives investment fund managers a vested
interest in making the deal work for all the investors. The fund mangers' upside interest is also
usually a long-term proposition - especially if the
investment is in an issuer whose securities are not publicly traded. Unlike a broker-dealer, investment fund
managers do not usually walk away from the closing table with an immediate
profit.
So, if unregistered deal makers want to
earn a long-term success fee, they could form a limited liability company or
other entity to purchase a business or to invest in a capital‑raising
offering. Then, the limited liability
company could raise capital to buy the business or invest. In that case, the deal maker who manages the
buyer would then be a principal instead of an agent.
Neither the investment fund nor the
investment fund's manager would be required to register as a broker-dealer
under Section 15 (a) (1) of the Exchange Act.
Competition
Between Blind Pool Funds and Brokers
Now, let's focus on project finance and
single purpose investment funds and how they differ from other investment funds.
Most investment funds we are familiar with
invest in pools of securities. Because
the contents of the pool are unknown at the time investors invest in the pool,
we call them "blind pools."
For example, a venture capital fund might invest in the securities of a
dozen or two dozen securities over the course of a ten-year period. The venture fund's managers might tell
investors that they intend to focus investments on one or more industries, or on
investments in a specific geographic area or on investments in businesses that
have reached a specified size or stage of development, but investors do not
know the specific businesses the investment fund will invest in when they write
checks to invest in the blind pool investment fund.
The
managers of investment fund blind pools and registered brokers often compete
with one another for the business of institutional investors and high net worth
individuals. Investing in a blind pool
is not the only way to achieve diversification.
Brokers could provide investors with the diversification investment
funds offer by selling investors offerings from multiple issuers. The primary difference is that with a blind
pool the investor makes one investment decision instead of multiple investment
decisions when they buy investments in multiple issuers from brokers.
Project
Finance and Single Purpose Investment Funds
So far, most of the things we have
discussed about investment funds would apply to both blind pools and special
purpose entities.
Some
of the people who invest in investment funds are institutional money managers
who owe fiduciary duties to their clients, because they invest other peoples'
money - like pension funds and insurance companies. How is investing in a "blind pool"
consistent with anyone's "fiduciary duties?"
What motivates people (especially
fiduciaries) to invest in "bind pools?"
Blind pools are usually sold based on the
reputations of the investment fund's managers.
If the managers have managed other funds in the past, the ROI they
earned for investors in their prior funds is usually used to sell new funds to
investors. This historic ROI is used
despite the fact that the SEC requires disclosure to investors that "past
performance in not a guaranty of future results." Like many things the SEC requires people to tell
investors, investors routinely ignore these warnings about past performance and
future results.
What business strategies do most
"blind pools" pursue? Most
blind pools tell investors that their investment is safer than investing in a
specific identified issuer, because the investment fund's managers will:
·
Diversify risk across a
number of unknown businesses in the portfolio.
·
Be able to capitalize
on good investment opportunities by being able to invest quickly instead of
trying to sell investors on each portfolio company.
·
Add value to portfolio
companies through advice and management.
·
Retain money for follow
on rounds in portfolio companies.
This is an efficient system for the
managers of blind pools. The investment
fund managers have a lot of investment discretion and the managers spend less
time raising money, because in one offering they usually raise all the money
they need for five or more years. But
let's compare blind pools and single purpose investment funds from the
perspective of investors.
Remember the investors? Securities laws are supposed to protect
investors while investors try to achieve their investment goals. So, the important questions are how do
special purpose entities compare to blind pool investment funds:
- In
promoting investor ROI goals?
- Increasing
or decreasing investor risk?
- Increasing or decreasing investor management and transaction costs?
The primary difference between doing
specific project financing and raising a pool of money in advance to invest in
a dozen portfolio companies over time is that investors lose the
diversification of an investment pool like a traditional venture, hedge or
private equity fund. But single purpose
investment transactions offer investors other advantages in exchange for not
providing diversification:
·
Investors can invest in
a "pure play."
·
Investors know what
they are investing in.
·
Investors are not
required to commit large amounts of capital over long periods of time without knowing
when the capital will be invested.
·
Investors receive more
detailed disclosures when they are not investing in a blind pool, because a
single purpose fund knows more about what it is investing in or purchasing.
Given these advantages to investors, the
SEC should have no legitimate interest in squelching the growth of this type of
special purpose entity investment vehicle by placing unnecessary road blocks in
the way of special purpose entities competing with blind pools for investors.
Technology
and Regulatory Change Cause Changes in Special Purpose Entity Market
What has changed is that deal makers are
now permitted to use Rule 506 (c) to advertise their deals and the Internet
provides a fast and cost efficient way to solicit investors to invest in
specific deals in many different industries.
Being able to advertise to investors can
reduce the time it takes to raise capital.
Since the ability to use a pool of money to invest quickly is one of the
primary advantages offered by traditional "blind pool" funds, the
ability to solicit many investors through advertising has substantially reduced
the value of one of the primary advantages blind pool funds provide to both
investors and issuers trying to raise capital or people trying to sell their
business.
This reduction in value is the financial
equivalent of increases in how quickly software can be developed now compared
to the past. By reducing the lead time
to market advantage that a first market entrant has over follow-on competitors,
all software became less valuable.
Investors increasingly value software companies on the basis of how many
users the software attracts. The
software's features are less important now than in the past, because it has
become much faster and cheaper to develop features now than a decade ago. So, investors expect you to have users at an
earlier stage. Even if the initial
product is free, users demonstrate the product has some market appeal. Investors in software businesses generally do
not like to wait long periods for market reality tests when it's quick and easy
to test the market with a product that will evolve over time. Likewise, tying money up in blind pools has
become less attractive to investors, now that deals can be quickly sold over
the Internet.
Blind pools run counter to human
nature. Most people don't buy something
unless you tell them what you are selling.
So, blind pools have a burden of proving to investors that the advantages
they offer outweigh the risks of not knowing what you are investing in.
Blind pools will always play a role, because
some investors (especially large financial institutions) will prefer making one
investment decision over making ten investment decisions to deploy the same
amount of money. But some money that
went into blind pools in the past will be diverted to special purpose investment
entities by investors who want to build their own investment portfolios one
piece at a time instead of relying on blind pool managers.
As
technology platforms for Rule 506 offerings evolve, these deal-specific
investment funds will also use technology platforms that host multiple offerings.
We are likely to see offerings being
made by managed deal-specific investment funds that compete side-by-side on the
same technology platforms with direct unmanaged investments in offerings made by
issuers that are not investment funds.
Competition Between Registered
Brokers and Special Purpose Entities
Thus far, we have talked about competition
between blind pools and special purpose entities and between blind pools and
brokers. Now, let's shift to talking
about how special purpose entities will compete with both unregistered finders
and registered brokers.
As single purpose investment vehicles and
crowdfunding proliferate, it will quickly become apparent that the primary
difference between investment funds dedicated to investing in a specific
company and an investment banker who charges a fee to invest in specific deals
is the form of compensation:
·
Short-term success fees
for broker-dealers, who are acting as agents for the seller.
·
Longer-term "carried
interests" for fund managers, who are acting as principals.
Venture funds, private equity, hedge funds
and other funds that invest in businesses for which there is no public trading
market and their managers generally are not brokers, because they act as
principals and not for the account of others, which is a primary part of the
definition of the term "broker."
Likewise, such funds and their managers
are not "dealers" for either securities law or tax purposes. Such investment funds invest to capture of
the appreciation of the securities they purchase. Usually, there is no trading market to
measure short-term gains or losses.
Dealers on the other hand primarily focus on profiting from shorter term
fluctuations in prices where there is an established trading market.
To compete with investment bankers and
registered brokers without the same regulatory burden, online venture capital
funds, buyout funds and the managers of other special purpose entities must be
careful to model their activities and compensation arrangements on how
traditional blind pool venture funds, private equity and hedge funds
operate.
As we discuss in article (11) of this
series of articles, "persons associated with an issuer" can be deemed
to be subject to regulation as brokers.
SEC Rule 3a4-7 provides a safe harbor for persons associated with
issuers, including persons associated with special purpose entities.
We will not fully discuss Rule 3a4-7 here,
because we covered it in article (11) of this series of articles. Generally any special purpose entity investment
fund should avoid paying internal salesmen or owners any form of compensation
that resembles a success fee for selling securities, although they can pay
outside registered broker-dealers commissions to sell securities for them like
any other issuer can. Venture fund
managers sell securities to investors and are not compensated for selling
securities, because they perform many functions, including identifying portfolio
investments and managing portfolio companies by serving on Boards of
Directors. Online venture funds and
other special purpose entities should have their personnel perform similar
functions to avoid broker registration requirements for their managers.
Equity
Compensation for Deal Makers
The line between compensation for
registered brokers and compensation for managers of special purpose entities becomes
further blurred when broker-dealers take equity interests as all or part of
their success fees.
A broker who is paid a commission in stock
or warrants instead of cash does benefit from the future appreciation of the
securities the broker receives the same way a fund manager benefits from the
appreciation of the fund manager's carried interest. So, what is the difference between a
"success fee" paid in securities to a broker and the carried interest
of a fund manager?
The primary difference is that the
broker's securities have a definable value on the day the broker receives the
securities. Investors in the deal for
which the commission was earned paid real money for the same securities. The broker might be speculating that the
securities it receives will have a greater value later than on the closing
date, but the securities the broker receives have the same value as the
securities sold at the closing that investors receive.
Investment fund compensation for managers
is usually structured so that the investment fund manager's equity interest has
no value of the date the manager receives the equity interest or on the date
the fund purchases securities. This is
accomplished by giving fund managers a "carried interest," which is
also called a "profits interest" for tax purposes. That means that although the fund manager can
benefit from future profits, the fund manager's carried interest has no real
value on the date the fund manager receives the carried interest. If the investment fund were immediately
liquidated, the fund manager's carried interest would not entitle the fund
manager to receive any distributions. All distributions would go to the investors
whose capital was contributed to the investment fund.
This lack of immediate value is the reason
the fund manager does not have a taxable event when the manager receives the
carried interest. The broker on the
other hand is taxed on the value of the securities the broker receives in the
year the securities are earned by the broker.
This difference in tax treatment demonstrates that there are real
economic differences between the compensation systems for brokers and fund
managers.
Of course, anything that might entitle
someone to receive a payment at a later date has some value. The value is never reduced to zero. Both the time period until the value is
realized and the level of risk that the investment might not appreciate in value
affect how you would calculate that value.
That's why the IRS is skeptical of carried
interests in entities that purchase real estate or other assets that can be
quickly flipped for a profit or that generate predictable income streams. The more concrete, certain and quantifiable
the value is, the less economic justification there is for saying a carried
interest has no current value. Time and
risk might not eliminate all value, but they can reduce value
substantially. For example, even a
lottery ticket has some value until the lottery occurs and it is determined
that the ticket did not win. A winning
lottery ticket might be worth $1 million dollars on the date the lottery is
held, but it's only worth $1 dollar when you purchase the ticket. For tax purposes, the fund's carried interest
is deemed to be worth less than a lottery ticket. Brokers, on the other hand, have to report
the value of the securities received as a fee as taxable income to the broker.
Although these valuation principles relate
primarily to tax issues, online venture capital funds and other special purpose
entities risk being considered brokers, if the economic argument that their
compensation is different from brokers who receive equity instead of cash
erodes.
The other difference between a broker and
an investment fund manager is that when the deal closes, the broker's job has
been completed. The broker usually has
no further duties to the business that issued the securities. For the broker, the "closing"
usually signals the end of the relationship and he end of the broker's work. The investment fund manager on the other hand
must continue to manage the investment fund to earn value through the carried
interest. For the fund manager, the
closing is usually just the beginning of a long-term relationship with
investors and with the portfolio company in which the find invests.
Increased
Competition between Brokers and Special Purpose Entity Investment Funds
What will the SEC do when online venture
capital funds and other special purpose entities compete with registered
broker-dealers to sell deals?
Will the SEC side with the regulated
investment bankers over the less regulated online venture capital funds and
require them to register as broker-dealers?
Or will the SEC recognize that online
venture funds and other single purpose funds offer investors greater protection,
because:
- Online
venture capital funds represent the interests of investors because their
compensation contract is with investors.
- The nature of the compensation structure aligns the online venture capital industry with investors, because the managers of online venture capital funds will only make money if their investors make money.
So far, we have discussed three primary
factors that distinguish the emerging online venture capital industry from
brokers who are required to register under Section 15 (a) (1) of the Exchange
Act:
- Acting
as a principal and not as an agent.
- Not
receiving a short-term success fee for closing the transaction.
- The ongoing duties of a fund manager begin after the investment transaction closes.
Now, let's consider how the other regulations that apply to
investment funds and their managers will apply to special purpose entities that
are online venture capital and buy-out funds.
Investment
Company Act and Investment Advisers Act Issues
Investment funds established to invest in
securities offerings or to purchase businesses and the people who manage these
funds must carefully navigate the Investment Advisers Act and the Investment
Company Act. Both statutes regulate the
investment industry.
Generally, the Investment Company Act
regulates the entities that hold the money and investments, while the
Investment Advisers Act regulates the people and entities that make investment
decisions on behalf of the investment entity.
Investment
Company Act Exclusions from Definition of Investment Company
·
Section 3 (c) (1) of the
Investment Company Act excludes investment funds that have fewer than 100 owners from the definition of
"investment company."
·
Section 3 (c) (7) of the
Investment Company Act excludes from the definition of "investment
company" investment funds that have any
number of owners from registering as an investment company, if all the
investors who purchase the investment fund's securities are "Qualifying Purchasers." Qualifying Purchasers include (i) individuals
or married couples with at least $5 million of investments; (ii) a company
owned by two or more related natural persons that has at least $5 million of
investments; (iii) certain trusts that are formed by and managed by qualifying
purchasers, if the trust was not formed for the purpose of investing in this
particular investment and (iv) institutional investors with at least $25
million of investments.
Dodd-Frank
Act Changes
The
Dodd-Frank Act of 2010 amended the Investment Company Act to provide that
investment funds that are excluded from the definition of "investment
company" under Section 3 (c) (1) or Section 3 (c) (7) of the Investment
Company Act are "private funds."
The term "private fund" is important, because two exemptions
from the requirement that fund managers register with the SEC as investment advisers
pursuant to Section 203 (a) of the Investment Advisers Act are available only
if the fund managers solely manage one of the two types of "private
funds."
Title
IV of the Dodd-Frank Act substantially changed how venture-capital funds, hedge
funds, private equity and their managers are regulated under the Investment
Advisers Act. Before the Dodd-Frank Act,
many investment fund managers relied on the exemption from registration as an
investment adviser afforded by Section 203 (b) (3) of the Investment Advisers Act,
which had provided an exemption from registration for advisers who managed 14
or fewer clients, including 14 or fewer investment funds if the funds are not
registered under the Investment Company Act, provided the fund managers did not
hold themselves out to the public as investment advisers.
Investment
Advisers Act Exemptions from Registration for Managers of Private Funds
Section 202 (a) (11) of the Investment
Advisers Act defines "investment adviser" as any person who:
·
"for compensation
·
engages in the business
·
of advising others . .
. as to the value of securities or as to the advisability of investing in,
purchasing or selling securities. . .
."
If you manage a "private fund" as
described above, you are an "investment adviser" under the Investment
Advisers Act even if you own part of the investment fund or other entity for
which you are providing investment advice, but you may have an exemption from
registration as an investment adviser, if you qualify for one of the Investment
Advisers Act's exemptions for certain "private fund managers.".
It
is important to note that the "private funds manager" exemptions are
exemptions from the requirement to register as an investment adviser. The Investment Company Act provisions
discussed above are exclusions from the definition of an "investment
company."
This
difference between an exclusion from the definition vs. an exemption from
registration is important, because some provisions of the Investment Advisers
Act apply to people who fall within the definition of "investment adviser"
– even if they are exempt from registration.
These two important exemptions for managers of certain types of
"private funds" apply to managers of:
·
Venture
capital funds under Section 203 (l) of the Investment Advisers Act.
·
And to managers of "qualifying private
funds" that have in the aggregate less than $150 million of total assets
under Section 203 (m) of the Investment Advisers Act.
Before we examine the venture capital
manager exemption under Section 203 (l)and the qualifying private fund manager
exemption under Section 203 (m) note that:
·
Neither exemption
limits the number of private funds someone can manage.
·
For managers of venture
capital funds under Section 203 (l) there is no dollar limit like there is for
other types of private funds under Section 203 (m).
Let's discuss the venture capital fund
exemption first.
Section 203 (l) of the Investment Advisers
Act exempts from registration any adviser to one or more "venture capital
funds," which under SEC Rule 275.203 (l) – 1 (issued in July 2011 in SEC
Release IA-3222) means any "private fund" that:
·
Represents to investors
that it "pursues a venture capital strategy."
·
Holds no more that 20%
of its assets in non-qualifying investments.
·
Does not borrow in
excess of prescribed amounts of its capital.
·
Does not give owners
redemption rights, except in "extraordinary circumstances."
·
And has not registered
as an investment company or elected to be treated as a "business
development company."
"Qualifying investments" referred
to in Section 203 (l) of the Investment Advisers Act are generally equity
securities of companies that:
- Are not
public reporting companies or foreign traded companies (or an affiliate of
a public reporting company or foreign traded company) when the fund makes
its investment.
- Do not
engage in certain prohibited borrowing and distributions.
- And are not "investment companies" or "private funds" or certain other prohibited entities.
The
SEC rule also limits the amount of qualifying investments the venture fund is
allowed to purchase from securities owners. In SEC Release IA-3222 (July 2011), the SEC
indicates that one of the primary distinctions between venture capital funds
and hedge funds or private equity is that venture capital investments are used
to grow businesses not to buy out existing owners of businesses.
Now,
let's discuss the "qualifying private funds" exemption provided by
Section 203 (m) of the Investment Advisers Act.
Section 203 (m) of the Investment Advisers
Act exempts from registration any adviser who only advises one or more "qualifying
private funds" and has less than $150 million of private funds
assets under management in the US. SEC
Rule 275.203 (m) – 1 (d) defines "qualifying private funds" as any "private
fund" that is not registered under the Investment Company Act and has not
elected to be treated as a "business development company."
In navigating these rules, investment funds
and their managers should consider beneficial ownership, integration,
aggregation and other rules that might cause funds to exceed the limits imposed
by exemptions under the Investment Company Act and under the Investment
Advisers Act. The business model of online
venture funds and their managers requires them to organize multiple investment
funds. Managing multiple funds requires
greater care to assure that beneficial ownership, integration, aggregation and
other rules do not cause them to fail to comply with these exemption rules. For example, individuals may be regulated
under the Investment Advisers Act, if they are an "associated person
"of an investment adviser.
Primary Investment
Advisers Act Compliance Issues
We
won't attempt to cover all of the Investment Advisers Act and Investment
Company Act here, but we will focus on some of the primary issues that the
managers of "private funds" (including online venture capital and
buyout funds) should consider:
·
The
same fund manager cannot rely on both Section 203 (l) and Section 203 (m) and
cannot combine either of these exemptions with any other exemption. All your investment adviser activity has to
fully comply with one of these exemptions, because both exemptions apply only
to managers who solely manage
one of the two types of "private funds."
·
The
fact that you might qualify for exemption under another provision of the
Investment Advisers Act, however, does not preclude you from relying on these
two exemptions as long as all the funds you advise comply with the same
exemption from registration.
·
Whether
an investment fund that has only one investor is a fund covered by Section 203
(l) or Section 203 (m) depends on the circumstances, but the SEC indicated in
release IA-3222 that it will be alert to advisers who create funds to advise
individuals or clients that are really not funds and thereby avoid registration.
·
One
test for whether someone is managing a fund (instead of each of the owners of
the fund) is whether investments are managed according to criteria designed for
the fund or whether the manager uses investment criteria for fund owners. So, for example, if the circumstances of one
or more of the fund's owners change, the fund manager may risk losing the
exemption, if the manager changes the fund's investment criteria to suit the
new circumstances of one or more owners of the fund.
·
Both
Section 203 (l) for "venture capital funds" managers and Section 203
(m) for "qualifying private funds" are exemptions from registration
as investment advisers. Neither is an exemption
from being an investment adviser.
·
Some
provisions of the Investment Advisers Act apply to investment advisers even if
the investment adviser is not required to register.
·
The
SEC has the power to issue rules with respect to investment advisers that are
exempt from registration under Section 203 (l) and Section 203 (m).
·
Fund
managers who rely on the venture-capital funds manager exemption from
registration afforded by Section 203(l) or on the qualifying private funds
manager exemption afforded by Section 203 (m) are required to file an abbreviated
version of Form ADV with the SEC, must amend the Form ADV not less frequently
than annually and are subject to periodic examinations of records by the SEC,
compensation rules and certain anti-fraud rules.
As
we discuss in more detail in article (12) of this series of articles, Section
203A (a) prohibits investment advisers are from registering with the SEC based
on the dollar amount of the assets they manage.
If an adviser (including a fund manager) manages assets that are less
than $25 million in the aggregate for all funds and other clients, the adviser is
prohibited from registering with the SEC, whether the adviser is subject to state
regulation or not. If the value of the
assets an adviser manages for all clients is between $25 million and $100
million, the adviser is prohibited from registering with the SEC, if the
adviser is required to register with its home state and is subject to state
examinations. Dollar amounts are
measured annually.
Such
advisers who are prohibited from registering with the SEC do not have to file
Form ADV with the SEC and are not subject to SEC periodic examinations like
advisers who are exempt from registration by reason of Section 203 (l) or
Section 203 (m). Only the compensation
and anti-fraud provisions and several other minor provisions of the Investment
Advisers Act apply to advisers who are
prohibited from registering with the SEC.
For advisers under $25 million in states that do not require
registration, the adviser has a regulatory free zone.
This
"regulatory free zone" provides deal makers with flexibility to
operate one or a series of small investment funds (whether special purposed
entities or blind pools) that are under $25 million in total assets. The managers of online venture capital funds
and other special purpose entities operate in this regulatory free zone.
Nothing
in the rules requires an owner to passively sit around waiting for an offer
from a fund a blind pool manager or for someone to organize an online venture
capital fund or other special purpose entity to invest in or purchase their
business.
Issuers
and their owners are free to encourage people to form funds and raise capital
to invest or purchase their businesses as long as disclosures are made to
investors and no compensation rules are violated.
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