January 24, 2012
Practice Groups:
Investment
Management
Hedge Funds and
Venture Funds
California Seeks Comments on Its Proposed
Private Fund Adviser Exemption Rule
By J. Matthew Mangan and Yusef Alexandrine
On December 21, 2011, the California Department of Corporations (“Department”) issued notice of a
proposed rulemaking action to amend Rule 260.204.9 of Title 10 of the California Code of
Regulations (“Rule 260.204.9”) to provide for an exemption from the state investment adviser
registration requirements for advisers that provide advice solely to certain private investment funds
(the “Proposed Exemption”).1 If adopted, the Proposed Exemption would exempt many Californiabased investment advisers that solely advise eligible “private funds” from registration with the
Department. The Department has requested comments on the Proposed Exemption by March 25,
2012.
I. Background
Many California-based private fund advisers rely on the current version of Rule 260.204.9 for
exemption from state registration. In its current form, Rule 260.204.9 provides an exemption for any
adviser that (i) has had fewer than 15 clients in the preceding 12 months, (ii) does not hold itself out to
the public as an investment adviser, (iii) does not act as an investment adviser to a registered
investment company or a company that has elected to be a business development company and (iv)
either has assets under management (“AUM”) of $25 million or more or provides investment advice
solely to one or more venture capital companies.2
The current Rule 260.204.9 exemption has been extended until April 17, 2012 by an emergency
regulation. In addition, the Proposed Exemption contains a provision that would further extend the
current 260.204.9 exemption until June 27, 2012.
II. California’s Proposed Private Fund Adviser Exemption Rule
The Proposed Exemption sets forth four basic requirements that an adviser would have to meet in
order to claim exemption from California’s registration requirements, and it also prescribes additional
requirements for advisers to qualifying private funds that rely on the exclusion from the definition of
an “investment company” contained in Section (3)(c)(1) of the Investment Company Act of 1940, as
amended (the “Investment Company Act”).
A. Basic Requirements
The four basic requirements for exemption under the Proposed Exemption are as follows:
 advisers must solely advise “private funds”; 3
1
California Corporations Code Section 25230 requires investment advisers to apply for and secure from the Department a
certificate authorizing the adviser to conduct business within the state, unless the adviser is eligible for an exemption.
2
3
For a description of “venture capital companies,” see Section II.C., infra.
Under Rule 260.204.9, “private funds” are generally defined as an issuer that would be an “investment company” as
defined by Section 3 of the Investment Company Act, but for the exclusions contained in Sections 3(c)(1) or 3(c)(7) of the
Investment Company Act.
 advisers may not be subject to SEC or California disqualification;4
 advisers must file each report required to be filed by an exempt reporting adviser pursuant to Rule
204-4 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) (see Section
IV below for a description of the Exempt Adviser Reporting Requirements); and
 advisers must pay the standard $125 California investment adviser registration and renewal fees
for each year in which the exemption is sought.
Notably, the Proposed Exemption does not include the $25 million in AUM minimum threshold or the
15 client limit contained in the current version of Rule 260.204.9.
B. Special Requirements for Advisers to 3(c)(1) Funds
The Proposed Exemption sets forth additional requirements for advisers to qualifying private funds
that rely on the exclusion from the definition of an “investment company” contained in Section
(3)(c)(1) of the Investment Company Act (“3(c)(1) Funds”) that are not venture capital companies.5
Advisers to these 3(c)(1) Funds would be exempt from registration with the Department only if they
adhered to the following requirements and restrictions:
 each investor in each 3(c)(1) Fund would be required to meet the “accredited investor”6 standard at
the time an investor purchases interests in a Fund;
 advisers would only be permitted to charge performance fees7 to 3(c)(1) Fund investors that meet
the higher “qualified client” standard;8
 advisers would be required to obtain, on an annual basis, audited financial statements for each
3(c)(1) Fund that is not a venture capital company;
 advisers would be required to annually distribute audited financial statements to investors in each
3(c)(1) Fund that is not a venture capital company; and
 at the time of purchase, advisers would be required to make the following written disclosures to
investors in each 3(c)(1) Fund that is not a venture capital company (“3(c)(1) Disclosures”):
o all services to be provided to the investor;
4
SEC “disqualification” is described in Rule 262 of Regulation A under the Securities Act of 1933, as amended (the “1933
Act”). California disqualification is described in Sections 25232 (a) through (h) of the California Corporations Code.
5
For a description of a “venture capital company,” see Section II.C., infra.
6
The term “accredited investor” is defined in Rule 501 of Regulation D under the 1933 Act. The accredited investor
standard looks to an individual’s financial means to determine whether such person meets a minimum threshold. For
natural persons, individual net worth, or joint net worth with a person’s spouse, must exceed $1,000,000, excluding the
value of the primary residence of such person or persons. A natural person will also be deemed an accredited investor if
such person had an individual income in excess of $200,000 in each of the two most recent years or joint income with that
person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same
income level in the current year.
7
The term “performance fee” refers to compensation to an investment adviser on the basis of a share of capital gains
upon or capital appreciation of the funds, or any portion of the funds, of a client. Performance fees are generally
calculated as a percentage of investment profits (the increase in the fund's net asset value), often both realized and
unrealized. Notably, the Proposed Exemption would permit advisers to charge a performance fee to certain institutional
investors that do not meet the “qualified client” threshold.
8
Rule 205-3 under the Advisers Act defines a “qualified client” as (i) a client with at least $1,000,000 under the
management of the adviser immediately after entering into the advisory contract, or (ii) a client that the adviser reasonably
believes (a) has a net worth (in the case of a natural person, together with assets owned jointly by his or her spouse) of
more than $2,000,000 at the time the advisory contract is entered into or (b) is a “qualified purchaser,” as defined in
Section 2(a)(51)(A) of the Investment Company Act.
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o all duties the adviser owes to the investor; and
o any other material information regarding the investor’s rights or responsibilities.
C. Advisers to Venture Capital Companies
Under the Proposed Exemption, advisers solely to one or more venture capital companies would be
exempt from registration with the Department if they were to meet the four basic requirements for
exemption (described above in Section II.A.). Under Rule 260.204.9, “venture capital company”
generally means an entity in which at least 50% of its assets (other than certain short-term
investments) are interests in an operating company as to which the investment adviser, the entity
advised by the investment adviser, or an affiliated person of either has management rights.9
III. Grandfathering Provision for 3(c)(1) Fund Advisers
The Proposed Exemption provides a grandfathering provision for certain advisers to one or more
3(c)(1) Funds that are not venture capital companies. The exemption provides that if such 3(c)(1)
Funds contain investors who do not meet the “accredited investor”10 standard they would nonetheless
be eligible for exemption from registration with the Department if the following conditions were
satisfied:
 the 3(c)(1) Funds in question must have existed prior to the effective date of Rule 260.204.9 (the
“Effective Date”);11
 as of the Rule’s Effective Date, these 3(c)(1) Funds must cease to accept new investors who are not
“accredited investors”;
 the adviser must make the 3(c)(1) Disclosures (described above in Section II.B.) to all investors in
each such 3(c)(1) Fund; and
 the adviser must distribute audited financial statements annually to all investors in each such
3(c)(1) Fund.
IV. Exempt Adviser Reporting Requirements
The Proposed Exemption would require exempt advisers to file all reports that advisers who are
exempt from federal registration must file with the SEC pursuant to Rule 204-4. Rule 204-4 requires
exempt advisers to complete and periodically update the relevant items required on the Form ADV
Part 1A, including the following items: Item 1 (identifying information), Item 2.B. (SEC reporting by
exempt advisers), Item 3 (form of organization), Item 6 (other business activities), Item 7 (financial
industry affiliation and private fund reporting), Item 10 (control persons), Item 11 (disciplinary
9
This definition of “venture capital company” is contained in both the current version of Rule 260.204.9 and the Proposed
Exemption. Notably, venture capital company assets are to be valued at cost. In addition to interests in operating
companies, the 50% of assets threshold may also take into account “derivative investments,” which are securities
acquired in the ordinary course of business in exchange for an existing venture capital investment either (1) upon the
exercise or conversion of the existing venture capital investment or (2) in connection with a public offering of securities or
the merger or reorganization of the operating company to which the existing venture capital investment relates.
10
For a description of the “accredited investor” standard, see footnote 6, supra.
11
The term “effective date,” as used here, refers to the future date when the Department will adopt some version of the
amendments to Rule 260.204.9 that it has proposed in the Proposed Exemption.
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history), as well as those sections of Schedules A, B, C and D that correspond to the items listed
above.12 Exempt advisers would not be required to complete a Form ADV Part 2A or 2B.
V. Investment Adviser Representatives
The Proposed Exemption would exempt from registration any person employed by or associated with
an investment adviser that is exempt under Rule 260.204.9.
VI. Transition to State Registration
The Proposed Exemption provides that advisers who become ineligible for the Rule 260.204.9
exemption would be required to register with the Department within ninety (90) days from the date
upon which an adviser ceases to be eligible for the exemption.
VII. The Proposed Exemption Is More Permissive than the
Proposed Model NASAA Rule Applicable to Private Fund
Advisers
On December 16, 2011, the North American Securities Administrators Association (“NASAA”), a
voluntary association of state, provincial and territorial securities administrators, adopted a model rule
on private fund adviser registration and exemption. Although the Proposed Exemption substantially
tracks the NASAA model rule, the rules differ in two important respects. First, the NASAA model
rule contains a requirement that all investors in each 3(c)(1) Fund under advisement must meet the
definition of “qualified client” at the time interests in the Fund are purchased, which is different from
the lower “accredited investor” standard used in the Proposed Exemption. Second, the NASAA
model rule has adopted the definition of “venture capital fund” used by the SEC, which differs from
the “venture capital company” definition contained in the Proposed Exemption.13
VIII. Request for Comments
Comments may be submitted electronically, by mail or by fax. Persons who submit comments
electronically should send comments to regulations@corp.ca.gov, together with the following
identifier: PRO 02/11. Persons who submit comments by mail should send their comments to the
following address: California Department of Corporations, Office of Legislation and Policy,
Attention: Karen Fong (PRO 02/11), 1515 K. St., Suite 200, Sacramento, CA 95814. Persons wishing
to submit comments by fax may do so at (916) 322-5875.
The written comment period for the draft Proposed Exemption ends on March 25, 2012. After
consideration of comments to the Proposed Exemption, the Department will issue a final rule.
12
The SEC requires certain categories of advisers who are exempt from registration under the Advisers Act, including
advisers to private funds, to provide it with the information listed above in notice filings. For a detailed discussion of the
SEC’s notice filing requirements, click here.
13
The SEC has defined “venture capital fund” in Rule 203(l)-1 under the Advisers Act. For a complete description of the
SEC’s definition, click here.
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Authors:
J. Matthew Mangan
Yusef Alexandrine
matt.mangan@klgates.com
+1. 415.249.1046
yusef.alexandrine@klgates.com
+1. 415.249.1044
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