On Jan. 14, 2014, the Texas State Securities Board approved amendments to its investment adviser registration rules.¹ These amendments take effect on March 31, 2014 and require currently exempt Texas-based private fund managers, including most private equity and venture capital funds, to confirm their exemption from Texas investment adviser registration and possibly either register with the Texas Securities Commissioner or file a short-form ADV. The amendments also provide a new exemption that will be available for most Texas-based hedge fund managers with less than $150 million in assets under management.
The amendments follow proposals issued by the Texas State Securities Board in October 2013, and reflect significant input from a subcommittee chaired by Gardere Partner George Lee. That subcommittee – a subcommittee of the Securities Law Committee of the Texas State Bar's Business Law Section – spent considerable time and energy under Mr. Lee's leadership to negotiate the amendments over a two-year period with the Texas State Securities Board.
The amendments are designed to offer clarity to private fund managers by providing Texas registration exemptions modeled after the federal exemptions.
In 2011, the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act") ended the "15 client exemption" that most private fund managers relied on and created new exemptions from registration under the Investment Advisers Act of 1940 (the "Advisers Act") for, among others, investment advisers to (1) "private funds" with less than $150 million in assets under management and (2) "venture capital funds" of any size.
As a result of the Dodd-Frank Act, private fund advisers with assets under management of at least $25 million who are exempt from registration under state law and either of these two federal exemptions must file a short-form ADV with the Securities and Exchange Commission (the "SEC") – known as an exempt reporting adviser report (an "ERA Report"). The new Texas amendments generally apply to these so-called "exempt reporting advisers," as well as to smaller advisers to private funds who currently do not file an ERA Report, by requiring them to file an ERA Report with the Texas Securities Commissioner, assuming the exemption is available.
Investment advisers to Texas-based private equity funds and venture capital funds generally have relied on Section 109.6 as an exemption from registration in Texas. That rule provides a registration exemption for investment advisers to certain institutional clients with a net worth of at least $5 million. The exemption is not available, however, for investment advisers providing investment advice to "private funds." Before the amendments, the definition of a "private fund" was limited to those funds having natural person investors with withdrawal rights during the first two years of their investment. A consequence of the existing Section 109.6 is that many Texas-based hedge funds have registered with the SEC or the Texas Securities Commissioner, while many venture capital and private equity funds have not registered.
As amended, Section 109.6 will continue in effect; however, the exemption will no longer be available to "private fund advisers," including advisers to private equity funds and venture capital funds, which must seek exemption under another section – such as new Section 139.23 – or qualify for grandfather status under Section 109.6.
A new sub-item (e) to Section 109.6 will grandfather certain investment advisers to private funds as long as:
Regarding the latter requirement, the Texas State Securities Board will permit certain transfers of interests, such as gifts to family and charitable organizations, involuntary transfers in connection with a bankruptcy or divorce, and transfers related to replacing certain knowledgeable employees, without affecting an adviser's grandfather status.
Private fund advisers grandfathered under Section 109.6(e) will not have to file an ERA Report with the Texas Securities Commissioner, which (as further discussed below) is required by the new amendments.
Section 139.23 creates a new registration exemption in Texas for "private fund advisers" not otherwise grandfathered under Section 109.6(e). A "private fund adviser" is an investment adviser providing advice solely to one or more "private funds," or to one or more "private funds" and other clients (who are not private funds) under another available exemption. Under the new rule, a "private fund" is a fund exempt from the Investment Company Act of 1940 under Section 3(c)(1) of that Act (a fund with 100 or less investors) or Section 3(c)(7) of that Act (a fund with only qualified purchasers pursuant to a private offering), and generally includes hedge funds, private equity funds, venture capital funds, and certain real estate, and oil and gas funds, among others.
The private fund adviser exemption under Section 139.23 has two primary requirements:
First, the private fund adviser must file with the Texas Securities Commissioner, through the Investment Adviser Registration Depository ("IARD"), the same short-form ADV that an "exempt reporting adviser" must file with the SEC pursuant to Rule 204-4 under the Advisers Act.²
Second, the private fund adviser and its advisory affiliates cannot be subject to certain "bad boy" disqualifications, such as conviction within the past five years of a felony or a misdemeanor involving securities, investment advice, embezzlement, or similar crimes and other acts.
The new Section 139.23 exemption, however, imposes two additional requirements on private fund advisers who advise certain private funds (primarily those funds that provide investors with redemption rights, which would include many hedge funds).³ To qualify for the exemption, (1) the beneficial owners of these funds must be "qualified clients" under Rule 205-3 under the Advisers Act as of the time those clients purchase equity in the fund and (2) the private fund adviser must comply with certain rules governing the "custody" of client funds.
SEC-registered private fund advisers will not be eligible for the exemption under Section 139.23 and, therefore, must notice-file a copy of their fully-completed SEC form ADV in Texas. This is done electronically through the IARD system.
Texas-based private fund managers who currently are exempt under Section 109.6 should confirm immediately whether grandfather status under Section 109.6(e) is available to them as of March 31, 2014. If grandfather status is available, no further action is required, although the manager will need to avoid the prohibited beneficial ownership changes and otherwise comply with the rule's restrictions going forward.
If grandfather status is unavailable, those private fund managers should confirm that the Section 139.23 exemption can be met and prepare to file an ERA Report with the Texas Securities Commissioner within 60 days of March 31, 2014. This ERA Report will be new to many smaller private fund managers (primarily privately equity, venture capital, real estate, and oil and gas managers with less than $25 million in assets under management).
For private funds formed after March 31, 2014, managers will need to confirm the availability of the Section 139.23 exemption, and if exempt under that rule, will need to file an ERA Report with the Texas Securities Commissioner within 60 days of March 31, 2014.
As a result of the amendments, many Texas-based advisers (primarily hedge fund managers) that are currently registered with the state or the SEC now may be able to withdraw their registration. Advisers to hedge funds with assets under management of less than $150 million likely will be eligible for the Section 139.23 exemption (assuming no "bad boy" disqualifications), and if so, consequently may withdraw their registration in Texas and/or with the SEC. Assuming these advisers meet the Section 139.23 exemption, these advisers may:
Private fund advisers exempt under Section 139.23 should beware that certain provisions of the Texas Securities Act and the federal Advisers Act (and other applicable federal law), such as antifraud prohibitions, will continue to apply to them. Private fund advisers exempt under Section 139.23 must still comply with requests from the Texas Securities Commissioner for written records relating to the investment adviser's services to the private fund, but will not be subject to surprise or regular examination.
To aid in navigating the amendments, a matrix summarizing the registration requirements is attached below.
If you have any questions regarding this alert, please contact Gardere Investment Fund Partners George T. Lee III (firstname.lastname@example.org or 214.999.4904) and Evan D. Stone (email@example.com or 214.999.4906).
The regulations governing investment advisers and funds are complex and require extensive factual analysis. Consequently, readers are cautioned not to rely on this alert in lieu of consulting with experienced counsel. This alert is presented with the understanding that it does not constitute legal advice.
¹ The amendments amend Section 109.6, and create Section 139.23, of Title 7, Part 7 of the Texas Administrative Code. References to Section 109.6 and Section 139.23 in this alert are to sections of Title 7, Part 7 of the Texas Administrative Code.
² Pursuant to Form ADV, these so-called "ERA Reports" require applicable advisers to compete only Items 1, 2, 3, 6, 7, 10, and 11 of Part IA of Form ADV, as well as the corresponding schedules.
³ The funds subject to these additional requirements are those that (1) are exempt from the Company Act under Section 3(c)(1) of that Act and (2) are not private equity funds, real estate funds, or venture capital funds (as those terms are defined in Question 10 of the Instructions for Part 1A of Form ADV).