On August 27, 2012, the California Department of Corporations adopted a new Rule 206.204.9, which was intended to encourage capital investment in private investment funds by providing an exemption from investment adviser registration requirements for the managers of these funds. However, the new Rule imposes so many new requirements that it may be a shock to managers of many private investment funds, particularly real estate related investment funds. This article describes what types of private investment funds are subject to the new Rule, what requirements apply under the new Rule, and some of the special issues that affect funds that invest in real estate assets as a result of this new Rule.
The new Rule applies to “private fund advisers”. The new Rule provides that “private fund advisers” are exempt from registration as investment advisers under California law if they comply with the restrictions and requirements of the Rule. Private fund advisers are persons who provide advice solely to one or more “qualifying private funds,” which are defined as funds that qualify for the exclusion from the definition of an investment company under one or more of sections 3(c)(1), 3(c)(5) and 3(c)(7) of the Investment Company Act of 1940. In order to determine if a manager of an investment fund is required to comply with the new Rule, the manager first has to determine if the manager is an adviser to a “qualifying private fund.”
What is a “qualifying private fund”? According to the new Rule, a “qualifying private fund” is any fund that is not required to register under the Investment Company Act of 1940 because (1) it has fewer than 100 beneficial owners, (2) it invests primarily in real estate and real estate related assets, or (3) it admits only “qualified clients” as investors. .What the Rule doesn’t say – and this is crucial to deciding whether the Rule applies to real estate investment funds – is that the only funds that are subject to registration under the Investment Company Act of 1940 are funds that invest in “securities.” So, if a private investment does not invest in securities, and instead invests in real estate, then the fund should not be covered under the new Rule, although there is no specific exemption that applies to these funds. However, not every fund that invests in real estate does so directly – some funds invest in the securities of other partnerships, LLCs or other entities that invest in real estate. It is up to the manager of each investment fund to determine if the fund is investing in securities or in real estate. If the fund invests in securities, then the new Rule does apply.
How does a manager determine if the fund is investing in securities or in real estate? There are no laws or regulations that clearly state that a fund investing in real estate is not investing in securities. However, the Securities and Exchange Commission (“SEC”) and the California Commissioner of Corporations have generally taken the position in various interpretive letters that direct investments by a fund in real estate are not securities. However, investments in limited partnership interests or limited liability company interests in companies that own real estate are generally considered investments in securities. In addition, investments by a fund in loans secured by real estate are generally considered to be investments in securities. What about a fund that is formed for the sole purpose of investing in the securities of one entity that invests directly in real estate? It could be argued that the investors in the fund are essentially investing in the real estate of the one entity in which the fund’s assets are invested. However, the new Rule does not provide any guidance on this issue. The staff of the Department of Corporations indicated that it would be willing to issue interpretations of the Rule upon written request, but it will probably be several months before any interpretations of the Rule are issued. In the meantime, managers of private investment funds need to examine carefully whether they will likely be covered by the Rule.
What are the requirements for the exemption under the Rule? If the new Rule does apply to a fund, then the adviser of the fund, which would typically be the general partner or manager of the fund, will either need to register as an investment adviser under California law, or the adviser and the fund will need to comply with the following requirements stated in the Rule in order to qualify for exemption from registration:
1. The fund must limit sales to accredited investors only. Most advisers are already familiar with this requirement, because it has been part of the private securities offering rules for many years. However, the private securities offering rules permit up to 35 non-accredited investors in a private offering, but the new Rule will not allow any non-accredited investors. Therefore, some funds will have to change their policies to no longer admit any non-accredited investors in order to qualify for exemption. This means that all investors in a “qualifying private fund” must be natural persons who have at least $1 million net worth, exclusive of their primary residence and mortgage debt up to the value of the residence, or annual income of at least $200,000, or $300,000 jointly with the investors spouse, or a partnership, limited liability company, trust or other entity with $5 million of total assets..
2. The fund must have a private placement memorandum that provides full disclosure of the services the adviser provides and the duties it has to the fund and the investors. Some funds already use private placement memorandums (or PPMs) that have these disclosures, so this will not be a problem for them, but some real estate investment funds do not use PPMs, because it is not a legal requirement that they do so. With the new Rule, however, it will be a requirement for any adviser to a private investment fund who wants to rely on the exemption provided in the new Rule .
3. The adviser cannot receive a carried interest in profits of the fund for any investors who are not “qualified clients.” This could be a big change for a lot of private investment funds, because the definition of “qualified clients” is much higher than for “accredited investors.” A “qualified client” is one who meets one of the following criteria:
a. Natural persons or companies with at least $1 million in investments under management with the advisor, or at least $2 million net worth, exclusive of primary residence and mortgage debt secured by the primary residence up to the fair market value of the residence;
b. Any person that invests for its own account or the account of others not less than $25 million,
d. Qualified institutional buyers under SEC Rule 144A,
e. Knowledgeable employees of the adviser; and
f. certain other types of institutional buyers.
Most advisors of private investment funds will have a carried interest of some kind in the profits of the company, and this new Rule will put restrictions on their ability to receive that carried interest. There are a couple of ways the advisor could meet this requirement: (i) only sell interests in the fund to “qualified clients”, which could reduce the number of qualified buyers, or (ii) only charge the interest in profits against the accounts of those investors who are “qualified clients.” Either way, any advisor currently selling interests in a fund in which the advisor receives an interest in profits of the fund will need to amend their PPM to include this restriction. This new requirement will not apply to any investors accepted before the effective date of the rule, which was August 27, 2012, but it will apply to new investors accepted after that date.
4. A private investment fund must provide annual audited financial statements to its investors. The Rule requires that the audited financial statements be provided within 120 days after the end of each year, and that they be audited by an accounting firm registered with and subject to regular examination by the Public Company Accounting Oversight Board (“PCAOB”). Not every private investment fund obtains audits, and even those that do often obtain them from small firms that are not registered with or subject to regular examination by the PCAOB. This requirement could impose a significant expense on many private investment funds.
5. The private fund advisor is required to file a Form ADV to qualify for the exemption from investment adviser registration. The Rule requires the private fund advisor to file the same reports that required under Securities and Exchange Commission (“SEC”) Rule 204-4 with the California Commissioner of Corporations if the advisor is not required to file with the SEC. The SEC Rule essentially requires that an exempt advisor file annually a Part 1 of the Form ADV, which is a portion of the same form an advisor would file to register as an investment advisor, but does not include the Part 2 of the Form ADV, which is the part that describes in narrative detail the business of the advisor. This filing can only be made electronically, using the federal IARD filing system, and there are fees associated with the filing. Even though the Form ADV is filed, the advisor will not become subject to all of the rules applicable to a registered investment advisor as a result of filing the form.
How does the new California Rule fit in with the federal requirements for investment adviser registration? The regulation of investment advisers is divided between the SEC and the state regulatory authorities, depending upon the amount of “assets under management” that an advisor is deemed to have under regular and continuous supervision. Until recently, the dividing line was $25 million in assets under management, with those over that amount subject to SEC jurisdiction, and those under $25 million subject to state regulation. As part of the Dodd-Frank Wall Street Reform and Consumer Protection Act passed in 2010, the dividing line between federal and state regulation of investment advisers increased to $100 million. An advisor with assets under management above that amount is subject to SEC regulation, and an advisor with assets under management below that amount is subject to state regulation. As referred to above, the SEC adopted its own rules providing for an exemption for certain advisors of private funds with assets under management between $100 million and $150 million. The SEC’s exemption specifically did not include real estate funds under section 3(c)(5) as a type of fund that was required to comply with the requirements for the exemption, which means that all funds that invest in real estate and real estate related assets are not subject to the SEC private fund adviser rules.
What if a private fund advisor is exempt under SEC rules – does it have to comply with the new California Rule? California law states that investment advisers who are registered with the SEC are not required to register under California law (though there is a notice filing requirement), but what about a private fund advisor that manages a fund between $100 million and $150 million, or a fund over $150 million that is not subject to SEC registration because it qualifies for another exemption from registration under SEC rules? The California Rule does not exempt those private fund advisors from the requirements of state registration or compliance with the new Rule requirements. This means that every private fund adviser which is exempt under federal law will have to comply with the California Rule or become registered as an investment adviser under California law.
When is compliance required under the new California Rule? Every private fund adviser that is subject to the new California Rule must meet the requirements of the exemption effective immediately upon the effective date of the new Rule, which was August 27, 2012, except for the filing of the Form ADV Part 1, which is required by October 26, 2012.
What are the consequences of not complying with the new California Rule? A private fund adviser that does not comply with the new Rule will be required to register as an investment adviser. If the private fund adviser does not comply with the new Rule or register as an investment adviser, the private fund adviser will be subject to civil penalties, which could include a return of the carried profits interest of the adviser in the fund. Therefore, managers of private investment funds should take a careful look at their business to determine if the new California Rule will apply to their private funds, and if so take steps immediately to comply with the requirements of the new rule.
Catherine DeBono Holmes is the chair of JMBM’s Investment Capital Law Group, and has practiced law at JMBM for over 30 years. She specializes in EB-5 immigrant investment offerings and hotel and real estate transactions made by Chinese investors in the U.S. Within the Investment Capital Law Group, Cathy focuses on business formations for entrepreneurs, private securities offerings, structuring and offering of private investment funds, and business and regulatory matters for investment bankers, investment advisers, securities broker-dealers and real estate/mortgage brokers. Contact Cathy at CHolmes@jmbm.com or 310.201.3553.