This article is appearing simultaneously on The Venture Alley and on Startup Law Blog. Readers may feel free to re-post this content elsewhere as well.
The world is changing for venture funds and similar funds in Washington State, and not necessarily for the better. It used to be the case that managers of venture or other private funds did not need to file anything with the SEC or state securities regulators (other than Forms D incident to their fundraisings). Dodd-Frank changed all that – but provided that investment advisers solely to venture capital or other small private funds may be exempt (based on Congress’ belief that these funds posed no systemic risk to the nationwide financial system).
There are now SEC regulations that define the new exemptions for the managers of venture funds and for the managers of private funds with less than $150M management. Even if exempt, however, managers of venture funds and private funds with AUM of less than $150M now must publicly report certain high-level information, which becomes publicly available. For example, here is the exempt reporting adviser Form ADV for Union Square Ventures.
These rules settled out a few years ago. Right now, the bigger issue is with state regulators. State regulatory regimes need to be updated in order to conform to Dodd-Frank. The North American Securities Administrators Association (NASAA) created model rules for state regulators to follow, which adopted the same venture capital and private fund exemptions. Many states, including California, have now adopted the NASAA model rules.
In Washington State, the Securities Division (Division) of the Washington State Department of Financial Institutions (DFI) is in the process of updating its rules to conform to Dodd-Frank. Unfortunately for fund managers, DFI does not believe the SEC and NASAA Model Rules are enough regulation. Their proposed rules provide that, if you don’t fall within the definition of a “venture capital fund” (as defined in the federal rule), you will generally have to register as an investment advisor in Washington State unless you are managing funds comprised only of super accredited investors (think $5M instead of $1M for individuals) – known as “qualified purchasers”. This is going to create significant problems for funds that don’t fit the narrow confines of the “venture capital fund” definition (below). We are actively trying to get these proposed rules changed before they are adopted, urging conformity with the federal rules, but so far the DFI has not agreed to make this change.
Here is more information on the Washington State proposed rules, from the DFI website:
Rulemaking: Investment Adviser Rules
The Securities Division is soliciting comments on proposed amendments to the investment adviser rules set forth in Chapter 460-24A WAC.
The proposed amendments would update various provisions of the investment adviser rules, including the rules regarding financial reporting requirements, custody, books and records, and unethical practices. The proposed amendments would add new rule sections addressing proxy voting, advisory contracts, and compliance procedures and practices, and would create exemptions from registration for certain private fund advisers and venture capital fund advisers. Many of these changes would make Washington’s rules consistent with current federal law and NASAA model rules.
Please find a copy of the proposed rule making notice and the text of the proposed rules below.
Public Hearing – May 21, 2013 – 1 PM
A hearing will be held on the proposed rulemaking on May 21, 2013 at 1:00 pm at the Department of Financial Institutions office in Tumwater, Washington. See:Directions to DFI.
Documents
Submit Your Comments
If you have any questions or comments, please contact Jill Vallely at (360) 902-8801 or by email at jill.vallely@dfi.wa.gov.
Below is the relevant text from the Washington proposed rules, and a summary of the federal rules and filing requirements.
Proposed Washington Regulations
Here is the relevant WAC provision in the proposed rules regarding exemption for venture capital fund managers:
WAC 460-24A-072 Registration exemption for investment advisers to venture capital funds.
(1) Exemption for venture capital fund advisers. You are exempt from the registration requirements for investment advisers in RCW 21.20.040 if you are exempt from registration under Section 203(l) of the Investment Advisers Act of 1940, 15 U.S.C. 80b-3(l), and Rule 203(l)-1 adopted thereunder, 17 C.F.R. 275.203(l)-1, provided you satisfy each of the following conditions:
(a) Neither you nor any of your advisory affiliates are subject to a disqualification as described in WAC 460-44A-505(2)(d); and
(b) You file with the division each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to Securities and Exchange Commission Rule 204-4, 17 C.F.R. 275.204-4.
The tricky thing here is the rules surrounding what constitutes a venture capital fund. There are mathematical tests, prohibitions on leverage, redemption prohibitions, etc.:
Venture Capital Fund Defined
Under the SEC’s regulations, a venture capital fund is any private fund that:
(1) Represents to investors and potential investors that it pursues a venture capital strategy;
(2) Immediately after the acquisition of any asset, other than “qualifying investments” (see definition below) 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, valued at cost or fair value, consistently applied by the fund;
(3) Does not borrow, issue debt obligations, provide guarantees or otherwise incur leverage, in excess of 15 percent of the private fund’s aggregate capital contributions and uncalled committed capital, and any such borrowing, indebtedness, guarantee or leverage is for a non-renewable term of no longer than 120 calendar days, except that any guarantee by the private fund of a qualifying portfolio company’s obligations up to the amount of the value of the private fund’s investment in the qualifying portfolio company is not subject to the 120 calendar day limit;
(4) Only issues securities the terms of which do not provide a holder with any right, except in extraordinary circumstances, to withdraw, redeem or require the repurchase of such securities but may entitle holders to receive distributions made to all holders pro rata; and
(5) Is not registered under section 8 of the Investment Company Act of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a business development company pursuant to section 54 of that Act (15 U.S.C. 80a-53).
A lot of funds in the area are going to be what can be thought of as so-called “hybrid” funds. Those funds are going to be in a tough spot under the new proposed rules if they have plain old fashioned “accredited investor” LPs, since they will not qualify as managers of “qualifying private funds” and may have to register as investment advisors in Washington State.
Here is the relevant WAC provision in the proposed rules regarding exemption for qualifying private fund managers:
WAC 460-24A-071 Registration exemption for investment advisers to private funds. (1) Exemption for private fund advisers. You are exempt from the registration requirements for investment advisers in RCW 21.20.040 if you are a private fund adviser as defined in WAC 460-24A-005 and you satisfy each of the following conditions:
(a) Neither you nor any of your advisory affiliates are subject to a disqualification as described in WAC 460-44A-505 (2)(d); and
(b) You file with the division each report and amendment thereto that an exempt reporting adviser is required to file with the Securities and Exchange Commission pursuant to Securities and Exchange Commission Rule 204-4, 17 C.F.R. 275.204-4.
WAC 460-24A-005 Definitions. For purposes of this chapter: * * *
(8) “Private fund adviser” means an investment adviser who provides advice solely to one or more qualifying private funds.
(9) “Qualifying private fund” means a private fund that meets the definition of a qualifying private fund in Securities and Exchange Commission Rule 203(m)-1, 17 C.F.R. 275.203(m)-1, other than a private fund that qualifies for the exclusion from the definition of “investment company” provided in section 3(c)(1) of the Investment Company Act of 1940, 15 U.S.C. 80a-3(c)(1).
Exempt Reporting Adviser
Under the Washington proposed rules, even if you meet the above definition, you will still have to file report as an exempt reporting adviser.
Conclusion
We should know more in the coming weeks but please contact us if you share our concerns with the proposed rules or would like more information on how to provide comments.
Asher Bearman asher.bearman@dlapiper.com
Joe Wallin JoeWallin@dwt.com
Thank you, Andrew Kinzer, for the image.
