California Proposes Registration of Real Estate Fund Managers and Advisers
The California Department of Corporations (the Department) have announced controversial plans to require the registration of certain investment managers and advisers (the Proposals). Although the Proposals are aimed primarily at California hedge fund advisers, if the Department adopts the Proposals as currently drafted, managers and advisers to real estate and private equity funds could be affected as well.
The Department invited interested parties to comment on the Proposals, the deadline for which expired on March 31, 2008. Earlier this week, a senior spokesperson at the Department stated that the Department has received a wave of letters strongly opposing the Proposals, including letters from the California Chamber of Commerce, the State Bar of California and the American Bar Association.
Background and Responses
The Department claims that the rapid growth of hedge funds, the increase in fraud related to hedge fund activities, the increased participation in hedge funds by retail investors and the need to protect such investors, all warrant state oversight of the industry. However, the Proposals, if adopted, would not be limited to regulating hedge fund advisers, but would also apply more widely to advisers to real estate and private equity funds.
More significantly, the California Chamber of Commerce claims that the Proposals would put “California out of step with all of the other major financial services industry states by imposing a burdensome and unnecessary new licensing requirement” on advisers and would put “California at a competitive disadvantage in relation to other states in attracting and retaining advisory business in the State.” Other critics have voiced concerns that the Proposals would stifle the growth of the alternative investment industry in California as new or growing advisers would avoid opening offices in the State (or even close their existing California operations).
As the Proposals rely on the physical location of an adviser’s office or the residency of funds as the basis for regulation, the Proposals could result in unnecessary and unintended consequences. As one critic of the Proposals puts it in its public comment letter: “a large adviser with headquarters in New York or London and investors around the globe could be required to register in California if it maintained a one-person office in San Francisco for servicing a few institutional investors …Consequently, the proposal does not provide its suggested investor protections to California investors but only creates a regulatory burden on those advisers that have a place of business in the State.”
On September 14, 2007, the Department announced that it was proposing to amend regulations under the California Corporate Securities Law of 1968 (the Securities Law) governing investment advisers.
Currently, unless an exemption applies, the Securities Law requires any investment adviser or manager who meets California’s definition of an “investment adviser” to register with the Department if the adviser or manager has a place of business in California or has more than five “clients” in California.
In 2002, the Department adopted an exemption from registration for advisers who:
- Do not hold themselves out to the public as investment advisers;
- Have fewer than 15 “clients”;
- Are exempt from registration as investment advisers with the Securities and Exchange Commission (SEC); and
- Either have assets under management of million or more or provide investment advice only to “venture capital companies”, as defined in the rule.
For purposes of counting the number of clients an adviser has, the definition of “client” generally covers the fund itself, rather than the individual investors in the fund. As a result, under this exemption, many large private equity and real estate fund advisers have avoided registering with the Department.
The Proposals, however, would now limit this exemption only to advisers who provide investment advice to “venture capital companies” (assuming such advisers do not hold themselves out to the public as investment advisers and are exempt from SEC registration). Therefore, unless an unregistered adviser can claim the benefit of this now narrower registration exemption, it would be required to register with the Department if it has an office in California or has more than five California clients.
Consequences of Registration
Significantly, registered advisers are required to comply with a number of onerous requirements, including making detailed filings, being subject to various disclosure and reporting requirements, and compliance with books and records, custody, and ethics procedures. Furthermore, registered advisers are subject to minimum net worth requirements and periodic inspections by the Department, and adviser’s representatives are subject to qualification requirements.
Real Estate and Private Equity Funds
Whether the Proposals will require real estate and private equity advisers to register with the Department will turn on whether the funds they advise qualify as a “venture capital company” under the exemption. In order to qualify, the fund must have at least 50% of its assets invested in “operating companies” as to which the fund has management and control rights. However, the Department has ambiguously defined “operating company” as an entity that is “primarily engaged... in the production or sale... of a product or service other than the management or investment of capital.”
If the fund has the right to play an active role in managing the “operating company” in which it has invested capital, the fund adviser may be exempt from registration. However, if the entity does not qualify as an “operating company”, the exemption will not apply. Similarly, if the fund is not a main investor (and therefore lacks management rights), or the fund is a passive investor in the entity, the fund may not qualify as a “venture capital company” under the exemption. Therefore, if the Proposals are adopted, real estate and private equity advisers will need to carefully examine their fund investments to see if the venture capital company exemption is met.
Given the lack of support for the Proposals and the current state of the California economy, it is uncertain whether the Department will go forward with the Proposals, but either way, the Department is required to make a decision by September 14, 2008 (the one-year anniversary of the original publication of the proposal). If the Proposals are adopted, unregistered real estate and private equity fund advisers doing business in California may need to weigh their options.
*Reprinted with permission from the California Real Estate Journal