One of the first questions that new private fund advisers often ask me is whether they will need to “register” with the SEC. They are often thinking in terms of registration as an investment adviser. However, even if a fund adviser is exempt from registration as an investment adviser with the SEC, he or she also needs to understand the impact of other federal securities laws, such as the Securities Act of 1933 and the Investment Company Act of 1940, as well as the impact of state securities laws, including state investment adviser registration requirements. I often hear new fund advisers say that they intend to rely on a particular exemption from one law and assume this exemption applies across the board to all securities laws. This post will explore the different statutes and regulations that govern private fund advisers and the registration exemptions which are usually relied upon.
The Securities Act of 1933
The Securities Act of 1933 was passed after the market crash of 1929 and the ensuing Great Depression. The Securities Act was the first federal legislation used to regulate the sale of securities. Generally, the Securities Act prohibits the offer and sale of securities to the public which are not registered with the Securities and Exchange Commission. As we have discussed previously, the definition of “security” is broad, which means the Securities Act applies to more transactions than you would ordinarily think and interests in private funds would be considered securities (see this post on a discussion of the treatment of limited partnership and limited liability company interests under securities laws). Due to the expense of registering an offering of securities with the SEC, private funds must rely on certain exemptions from registration under the Securities Act to sell their interests to investors.
Private funds almost always rely on one of two exemptions, Rule 506(b) or Rule 506(c), both of which are part of Regulation D, promulgated under the Securities Act. An offering is exempt from registration under Rule 506(b) if (i) the issuer does not solicit or advertise to market the securities (also known as a general solicitation), (ii) the issuer only offers or sales securities to accredited investors1, and (iii) the issuer takes reasonable care to ensure that the purchasers aren’t buying the securities with the intent to resell them. Rule 506(c) is similar to Rule 506(b), except that (i) the prohibition on general solicitation described above does not apply and (ii) the issuer takes reasonable steps to ensure that each purchaser is an accredited investor. These reasonable steps usually involve verifying the investor’s net worth or income, either by directly reviewing appropriate documents or by getting a verification letter from their accountant. This verification process can be burdensome and may discourage people from investing in the fund. As a result, most funds use Rule 506(b).
Securities purchased under a Rule 506 exemption need not be registered with the SEC. Instead, the fund must file Form D with the SEC within 15 days after the first sale.
Besides the federal registration requirements in the Securities Act, each state has its own registration requirements. One benefit of relying on Rule 506(b) or Rule 506(c) is that state registration requirements are preempted and therefore the fund need not find a separate exemption with each state. However, the fund must file a copy of Form D with each state where there are purchasers of the fund’s interests and also, potentially, the state where the fund adviser is located.2
Investment Company Act of 1940
The Investment Company Act of 1940 requires that issuers of securities that are in the business of holding and investing in other securities register with the SEC as an “investment company.” Registering an investment company with the SEC comes with numerous restrictions and additional statutory and regulatory hurdles. For example, registered investment companies must provide ongoing public reporting for investors on their investment holdings and be subject to restrictions on what those holdings can be.
The reporting requirements and investment restrictions in the Investment Company Act are incompatible with operating a private fund. Therefore, private fund advisers must find an exemption from the Investment Company Act. The two most common exemptions are Sections 3(c)(1) and 3(c)(7). Generally, private funds that rely on Section 3(c)(1), must (i) not make, or propose to make, a public offering of its securities (complying with Rule 506(b) or Rule 506(c) described above complies with this requirement) and (ii) limit the number of investors to no more than 100 investors. However, please note that counting the number of investors can actually be quite complex if some of the investors are entities rather than individuals (See this post for more information.) To rely on Section 3(c)(7), the fund must (i) not make, or propose to make, a public offering of its securities (same as for Section 3(c)(1)) and (ii) limit the offering to “qualified purchasers” (see this post for more information). For a further discussion on this exemption and the distinctions between Section 3(c)(1) and 3(c)(7), see this post.
Investment Advisers Act of 1940
Under the Investment Advisers Act of 1940, investment advisers, including private fund advisers may be required to register with the SEC. Generally, the Advisers Act defines an “investment adviser” as a person or firm that, for compensation, is engaged in the business of providing advice, making recommendations, issuing reports, or furnishing analyses on securities. Private fund advisers are considered investment advisers, and thus, they must register unless they fit within an exemption from registration.
New fund advisers rarely need to register with the SEC from the outset. Investment advisers located in a U.S. state with less than $25 million in assets under management and do not advise registered investment companies are prohibited from registering with the SEC, based on the policy goal of having such small advisers be regulated mainly by the states. (This prohibition is frequently known as the small adviser exemption.)
Beyond that, the most common exemption for private fund advisers is the private fund adviser exemption, which exempts from registration an investment adviser that only advises private funds and has less than $150 million in assets under management. Another commonly used exemption is the venture capital fund adviser exemption, which exempts an investment adviser that only advises venture capital funds, as described further in this post. A third exemption available to certain fund advisers is the foreign private adviser exemption, which exempts an investment adviser that: (i) has no place of business in the United States, (ii) has, in total, fewer than 15 clients in the United States and investors in the United States in private funds advised by the investment adviser, (iii) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser of less than $25 million; and (iv) does not hold itself out generally to the public in the United States as an investment adviser.
Fund advisers relying on the private fund adviser exemption and the venture capital fund adviser exemption are considered exempt reporting advisers and must file a truncated Form ADV (which is the form also used to register as an investment adviser with the SEC). Investment advisers using the foreign private adviser exemption or the small adviser exemption are not required to file as an exempt reporting adviser but doing so may be needed to take advantage of certain state exemptions from registration as an investment adviser (as discussed below).
As with the sale of securities, state law also plays an important role in regulating private fund advisers. Each state has its own investment adviser registration requirements, along with exemptions from those requirements. Many states have exemptions that may apply to private fund advisers. Some, however, do not, and it is possible to be exempt from SEC registration but nonetheless, be required to register with a state. Also, investment advisers with assets under management in the range of $25 million to $110 million that are required to register under the Investment Advisers Act may be required to register with the state they are located in, rather than with the SEC. This interaction between federal and state law is complex and is described in more detail here.
Conclusion
The term “exemption” is often misunderstood in the context of private fund regulation, leading to misunderstandings for new fund advisers. An exemption from registration under one law or with one regulator does not mean an exemption from the requirement of other laws or regulatory. In addition, some exemptions may still require a filing with the SEC or a state agency. A complete understanding of the laws applicable to private funds and the available exemptions from registration under those laws is an essential precondition to launching a new fund.
Footnotes
- The text of the rule also permits sales to up to 35 non-accredited investors, but this is rarely actually used due to the factors described in this post.
- Sometimes it’s possible to rely upon a separate state exemption for a particular state that doesn’t require a filing, allowing the fund adviser to avoid making the Form D filing in that state.
This article is for general information only. The information presented should not be construed to be formal legal advice nor the formation of a lawyer/client relationship.
