Hedge Fund Managers Exempt from Registration in California

As a general proposition, managers who are located in California must register as an investment adviser if they are providing investment advice for compensation.  There are exemptions from the registration requirement which we have detailed previously.  Because of the changes in the statutes and regulations at the Federal level, the states are changing their laws with respect to adviser registration.  Some states, such as California (see post), have adopted interim orders for certain advisers to address gaps in the Federal and state laws until state laws or appropriate regulations can be adopted.  California is proposing to adopt laws which would exempt many hedge fund managers from registration with the California Securities Regulation Division.

The proposed regulations if adopted would likely go into effect sometime in the first half of 2012.  The California Department of Corporations has requested comments on the proposal which may be submitted by February 20, 2012.  We have summarized the proposed exemption below and for more information, please see the following releases:

• Proposed Amendment to Section 260.204.9
• CA Notice of Proposed Private Fund Exemption
• CA Statement re: Private Fund Exemption

California Private Adviser Exemption Overview

If the proposed rule is approved, a manager would be exempt from registration as an investment adviser with the state of California if the manager meets the following requirements:

• manager provides advice only to one or more “qualifying private funds” (includes Section 3(c)(1) funds and Section 3(c)(7) funds)
• manager may not have not violated securities laws;
• manager must file periodic reports with the Department of Corporations (an abbreviated version of the Form ADV);
• manager must pay the existing investment adviser registration and renewal fees ($125); and
• manager must comply with additional safeguards when advising funds organized under Section 3(c)(1) (other than venture capital companies). This includes:
• only accredited investors may invest in the private fund;
• the firm shall provided certain written disclosures about the services it provides, its duties, and other material information;
• the firm shall obtain an annual audit of each fund and deliver them to each investor; and
• performance fees can only be charged to qualified clients.

Firms may register with the SEC once they reach $100M in AUM. Therefore, the firm may rely on the California private adviser exemption and then, absent an exemption from SEC registration, register with the SEC at that point. Section 203(m) of the Adviser’s Act of 1940 (as amended by Dodd-Frank) provides such an exemption from such registration if the firm only manages private funds and has less than $150M AUM (the firm would be an exempt reporting adviser and would have to file the abbreviated Form ADV with the SEC).

Funds with Non-Accredited Investors

The proposed rule does have a grandfathering provision that will make the California private adviser exemption available to a firm that currently manages any Section 3(c)(1) fund that has non-accredited investors if the following requirements are met:

• the fund existed prior to the effective date of the California private adviser exemption;
• as of the effective date of the Private Adviser Exemption, the fund no longer accepts accredited investors;
• the firm provides certain written disclosures about the services it provides, its duties, and other material information; and
• as of the effective date of the Private Adviser Exemption, the firm delivers audited financials to the investors.

Currently, the proposed rule does not have an anticipated effective date. If approved, managers of funds with non-accredited investors may still qualify for the Private Adviser Exemption.

Conclusion

The California private adviser exemption will change the entire registration regime in California. Firms that solely manage qualifying funds and meet the requirements discussed above will not have to register with the DOC and those that are currently registered may withdraw their registration. So, hedge fund managers in California with under $100M in AUM generally will not be registered with any regulatory agency. Do keep in mind that if a manager manages even a single separate account, in addition to the qualifying funds, it will not be eligible for the private adviser exemption.

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Cole-Frieman & Mallon LLP provides investment adviser registration and compliance services to hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.