California To Require Pooled Investment Vehicle Managers To Register As Investment Advisers And Also Proposes Changes In Its Books And Records Rules And Reporting Requirements For Broker-Dealers And Investment Advisers

1. The Investment Adviser Registration Amendment

The California Department of Corporations (the "Department") recently announced plans to delete an exemption from registration for certain investment advisers that has been on the books since 2002. The proposed rule change is aimed at California hedge fund advisers, but other investment advisers to pooled investment vehicles may be affected as well. Private equity managers in particular also may be required to register with the Department as investment advisers if the funds they manage do not meet California's definition of a venture capital company.

The Department plans to amend California Corporate Securities Law of 1968 ("CSL") Rule 260.204.9 to limit the adviser registration exemption established therein solely to advisers who work for "venture capital companies" (the "Proposed Amendment"). The Proposed Amendment would require any other person who meets California's definition of an "investment adviser" to register with the Department if the adviser: a) has a place of business in California or has six or more "clients" in California; and b) is exempt from registration with the SEC by virtue of the so-called "de minimis exemption" contained in Section 203(b)(3) of the Investment Advisers Act of 1940 ("IAA").

Citing only the somewhat dated 2003 Securities and Exchange Commission ("SEC") hedge fund study1 and the SEC's failed 2004 bid to require hedge fund advisers to register with it, the Department claims that the growth of hedge funds, the increase in fraud related to hedge fund activities and the increased participation in hedge funds by retail investors all warrant state action.2 The Department did not acknowledge any dissenting views most notably those of the President's Working Group on Financial Markets3 suggesting that additional regulatory oversight of hedge funds and their advisers is unnecessary.

Interested parties may request a public hearing on the Proposed Amendment by submitting a written request no later than November 11, 2007, and may submit written comments on the proposal until November 26, 2007.

Background and Brief History

In pertinent part, Section 25009 of the CSL defines an "investment adviser" as "any person who, for compensation, engages in the business of advising others... as to the advisability of investing in, purchasing or selling securities..." Section 25230 of the CSL requires investment advisers to register with the Department unless they are exempt. CSL Section 25202, adopted in 1997, provides that an adviser is not subject to registration if the adviser does not have a place of business in California and had no more than five California clients during the preceding 12-month period. An adviser who failed to meet both conditions would be required to register with the Department unless the adviser was registered with the SEC under IAA Section 203(b).4

In 2002, the Department adopted Rule 260.204.9, which exempts any investment adviser from the registration requirements of Section 25230 if the adviser:

does not hold itself out generally to the public as an investment adviser;

has fewer than 15 clients;

is exempt from SEC registration by virtue of IAA Section 203(b)(3); and

either:

(i) has assets under management of at least $25,000,000; or

(ii) provides investment advice to venture capital companies only.

The Department's Statement of Reasons supporting the original adoption of Rule 260.204.9 made it clear that the intended beneficiaries were advisers to venture capital companies.5 However, the use of the disjunctive "or" in subsection (4) allowed other advisers to be exempted from registration if they met conditions (1) through (3) and had assets under management of $25,000,000 or more. Satisfying conditions (1) and (3) is usually easy for hedge fund and private equity managers. Subsection (2) also is generally not a problem since CSL Section 25202(b) borrows the federal definition of "client" used in IAA Section 222(d) and IAA Rule 203(b)(3)-1, which counts the fund itself, rather than the individual investors in the fund, as the "client" for purposes of IAA Section 203(b)(3).6 As a result, hedge fund and private equity managers could avoid registering with the Department if their funds were large enough.

Nor, at that...