New private fund advisers frequently ask me if they need to register with the SEC. Many of them think in terms that they will need to register as investment advisers. Even if a fund advisor is exempted from registration with the SEC as an investment advisor, they need to be aware of the impact of federal securities laws such as the Securities Act of 33 and the Investment Company Act of 40. They also need to be familiar with state securities laws including the state registration requirements for investment advisers. Many new fund advisers claim that they will rely on one exemption and assume that it applies to all securities laws. This article will discuss the various statutes and regulations that govern private funds advisers, and the registration exemptions that are often relied upon.
Securities Act of 1933
After the 1929 market crash and subsequent Great Depression, the Securities Act of 1933 was adopted. The Securities Act was the first federal law to regulate the sale securities. The Securities Act generally prohibits the sale and offer of securities to the public that aren’t registered with the Securities and Exchange Commission. As we’ve discussed, the definition of security is broad. This means that the Securities Act can be applied to many transactions more than you might think. Private funds interests would also be considered securities. (See this post for a discussion on the securities laws treatment of limited partnerships and limited liability companies). Private funds cannot sell securities to investors without registering them with the Securities Commission. This is because of the high cost of doing so.
Private funds almost always use one of the two exemptions, Rule 506(b) or Rule 506.(c), which both are part of Regulation D. These exemptions are set forth under the Securities Act. A Rule 506(b), exempts an offering from registration if the issuer doesn’t solicit or advertise the securities for sale (also known by general solicitation), (ii), the issuer offers securities only to accredited investors1, (iii), the issuer takes reasonable precautions to ensure that purchasers aren’t purchasing securities in the intention to resell them, and (iv) the issuer isn’t soliciting or advertising the securities for sale. Rule 506 (c) is the same as Rule 506 (b), except that (i), the prohibition against general solicitation does not apply, and (ii), the issuer takes reasonable measures to ensure that each purchaser are accredited investors. This usually involves verifying the net worth and income of the investor by reviewing relevant documents or getting a verification letter by their accountant. This process can be time-consuming and discourage investors from investing in the fund. Most funds follow Rule 506(b).
Securities bought under Rule 506 exemption do not need to be registered with SEC. Instead, the fund must file Form D to the SEC within 15 calendar days of the first sale.
Each state has its own registration requirements, in addition to the Securities Act’s federal requirements. The benefit of using Rule 506 (b) or Rule 506(c) to register your fund is that the state registration requirements are not preempted. Therefore, each state does not need to file a separate exemption. The fund must still file a copy the Form D with every state where purchasers of the fund’s interests are located, and possibly the state where the adviser to the fund is located.
1940 Investment Company Act
The 1940 Investment Company Act requires that securities issuers that hold or invest in securities must register with the SEC. There are many restrictions to this registration and additional regulatory hurdles. Among other things, investors must be able to see the investment holdings of registered investment companies and they can also be subjected to certain restrictions.
Private fund operation is not possible due to the Investment Company Act’s reporting requirements and investment restrictions. Private fund advisers will need to find an exemption from Section 3(c)(1) and (3) of the Investment Company Act. Section 3(c),(1) and (3) are the most popular exemptions. The two most common exemptions are Sections 3(c),(1) and 3(c),(7). Private funds that rely upon Section 3(c),(1) must: (i) not make or propose to make a public offering (complying to Rule 506 (b) or Rule 506(c) above fulfills this requirement); and (ii). limit the number to 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.
The 1940 Investment Advisers Act
Investment advisers, including those who are private fund advisors, may need to register with SEC under the 1940 Investment Advisers Act. The Advisers Act generally defines an “investment advisor” as any person or company that is paid to provide advice, make recommendations, issue reports or furnish analyses on securities. Investment advisers include private fund advisors. They must register unless they are exempt from registration.
The SEC rarely requires new fund advisers to register from the beginning. The policy of having small investment advisers primarily regulated by states is prohibited from investing advisers located in the United States with assets under $25 million. This prohibition is commonly known as the exemption for small advisers.
The private fund advisor exemption is the most popular exemption for private-fund advisers. This exempts investment advisers that advise private funds only and have less than $150,000,000 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. The foreign private adviser exemption is another exemption that applies to certain fund advisors. This exempts investment advisers who: (i) have no business location in the United States; (ii), have fewer than 15 clients in America and investors in the United States for private funds they advise; (iii); have assets under management that are attributable to clients in USA and investors in US in private funds managed by the adviser and less than $25,000,000; and (iv). Do not openly represent themselves as an investment advisor to the United States
Fund advisers who rely on the exemption for private fund advisors or the exemption for venture capital fund advisors are exempt from filing a Form ADV. This is also the form used to register with the SEC as an investment adviser. However, investment advisers who use the exemption for foreign private advisers or the exemption for small advisers are not required to file an exemption reporting form. However, they may need to do so to be eligible to receive certain state exemptions to registration as an investor adviser.
State law plays an important part in the regulation of private fund advisors, just as it does with securities sales. Each state has its own requirements for investment adviser registration, as well as exemptions. Private fund advisers may be exempted by many states. Some states have exemptions that may apply to private fund advisers. It is possible to be exempted from SEC registration, but still be required to register with the state. Investment advisers who have assets under management of between $25 million and $110 million may need to register under the Investment Advisers Act. This interaction between federal and state law is complex and is described in more detail here.
In the context of private funds regulation, the term “exemption” can be misunderstood. This leads to confusions for new advisers. A waiver from registration with one regulator or under one law does not exempt you from other regulatory or laws. Some exemptions might still require filing with the SEC and/or a state agency. It is essential to have a thorough understanding of the laws governing private funds as well as the exemptions available from registration to launch a new fund.