VENTURE CAPITAL REVIEW

Transcription

1 VENTURE CAPITAL REVIEW ISSUE 24 FALL 2009 PRODUCED BY THE NATIONAL VENTURE CAPITAL ASSOCIATION AND ERNST & YOUNG LLP

2 National Venture Capital Association (NVCA) The National Venture Capital Association (NVCA) represents more than 450 venture capital and private equity organizations. NVCA s mission is to foster the understanding of the importance of venture capital to the vitality of the US and global economies, to stimulate the flow of equity capital to emerging growth companies by representing the public policy interests of the venture capital and private equity communities at all levels of government, to maintain high professional standards, facilitate networking opportunities and to provide research data and professional development for its members. National Venture Capital Association 1655 Fort Myer Drive Phone: Suite 850 Fax: Arlington, VA Web site:

3 2 Entrepreneurship and Innovation: The Keys to Global Economic Recovery Selected highlights from an Ernst & Young whitepaper 11 What It Would Mean to Be a Registered Investment Adviser By Howard J. Beber and Michael R. Suppappola 23 The Importance of Evaluating the Cost of Capital for Early-Stage Biotechnology Ventures to Preserve Innovation By Iaian Cockburn and Josh Lerner 29 Flip Transactions Revisited Written by Daniel Zimmermann and Craig Menden 36 Donating Non-Publicly Traded Assets to Charity: Effective and Tax-Efficient Giving During Tough Economic Times By Karla D Alleva Valas, Chief Compliance Officer, Fidelity Charitable Gift Fund 41 Health Reform: Impact of What Congress Is Considering on the Employer-Based Delivery System By Scott J. Macey (Reprinted with permission from Aon Consulting) Please send comments about articles in this issue or suggestions regarding topics you would like to see covered in future issues to Jeanne Metzger, NVCA s Director of Marketing, at jmetzger@nvca.org.

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5 What It Would Mean to Be a Registered Investment Adviser By Howard J. Beber and Michael R. Suppappola KEY POINTS Proposed legislation may require private investment fund managers to register with the SEC as investment advisers under the Investment Advisers Act of Current legislative proposals in the house and senate would provide managers of venture capital funds (as defined by the SEC) with an exemption from SEC registration but there is no assurance that these proposals will ultimately pass or, if passed how the SEC will define venture capital fund. Registered investment advisers must appoint a chief compliance officer and implement a comprehensive compliance program designed to prevent violations of the Advisers Act. Registered investment advisers are subject to on-site examinations by the SEC. Introduction As the dust begins to settle from the financial events of late 2008, leaders in Washington are holding hearings in an effort to overhaul the US financial regulatory system. Legislative proposals in each chamber of Congress, along with proposals directly from the Obama administration, indicate that the regulatory framework in which many private investment fund managers operate may soon change significantly. New and comprehensive legislation may significantly affect the day-to-day operations of certain private investment fund managers. In the post-madoff world, the White House, Congress and regulators have all called for increased transparency from private investment fund managers. A potential consequence is legislation that would require private investment fund managers to register as investment advisers with the Securities Exchange Commission (SEC) under the Investment Advisers Act of 1940 (the Advisers Act ). At the time of publication legislation introduced by the House Financial Services Committee would exempt venture capital fund advisers from SEC registration, provided that such venture fund advisers comply with heightened disclosure obligations intended to provide the SEC with greater transparency regarding any high-risk activities. There is no assurance that these proposals will ultimately pass or, if passed how the SEC will define venture capital fund. Similar, the discussion draft of a bill introduced to the Senate by Senate Banking, Housing, and Urban Affairs Committee Chairman Chris Dodd would exempt venture fund advisors from SEC registration. The National Venture Capital Association (NVCA), in its significant lobbying efforts on the issue, has argued 11

6 As a result, virtually all private investment fund managers (including advisers to hedge funds, buyout funds and venture capital funds) could be required to register as investment advisers with the SEC. that the venture capital industry does not impose systemic risks to the financial system. The NVCA has asserted that SEC registration would be burdensome to both the venture capital industry and the SEC and unnecessary to prevent such systemic risks. This article provides a general overview of the Advisers Act and its regulatory requirements as they would relate to private investment fund managers registered as investment advisers, including venture capital fund advisers if not otherwise exempt from registration. Background and Recent Legislative Proposals The Advisers Act defines the term investment adviser broadly to include, any person who, for compensation, engages in the business of advising others... as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. A general partner or manager of a private investment fund, including a venture capital fund, will generally fall into this broad definition because it typically receives compensation in the form of a management fee in exchange for managing the investment activities of the fund. 1 Although a venture capital fund s carried interest is a share of the fund s cumulative net profits and not a fee for services, the Advisers Act generally treats carried interest in the same manner as a fee. As such, 1 See SCF Partners, L.P., SEC No-Action Letter (pub. avail. Dec. 16, 1991). the definition of investment adviser encompasses virtually any manager of a venture capital fund. Most venture capital fund managers avoid registration under the Advisers Act by relying on the 15-client private adviser exemption set forth in Section 203(b) (3) of the Advisers Act. The private adviser exemption generally permits investment advisers with fewer than 15 clients during the preceding twelve months to avoid registration as an investment adviser with the SEC. 2 Advisers Act Rule 203(b)(3)-1 provides that a limited partnership or other pooled investment vehicle is generally counted as a single client, notwithstanding the actual number of investors in the vehicle. 3 Recent legislative proposals contemplate significantly limiting the application of the private adviser exemption, or (in certain cases) eliminating the private adviser exemption in its entirety. 4 As a result, virtually all private investment fund managers (including advisers to hedge funds, buyout funds and venture capital funds) could potentially be required to register as investment advisers with the SEC. 5 These proposals cast a much wider regulatory net than the so-called Hedge Fund Rule promulgated by the SEC in 2005 (and later struck down by the US Court of Appeals for the District of Columbia Circuit in Goldstein v SEC). 6 Unregistered investment advisers to venture capital funds are currently subject to a limited number of rules and regulations under the Advisers Act, including 2 Investment Advisers Act of (b)(3). To avail itself of the private adviser exemption, an investment adviser must also refrain from holding itself out to the public as an investment adviser and not act as an investment adviser to any registered investment company or business development company. 3 Advisers Act Rule 203(b)(3)-1. Nevertheless, there are circumstances where one or more beneficial owners of a private investment fund could be considered separate clients of the adviser. For example, if the fund permits investors to participate in investments on a deal-by-deal basis through the use of discretionary opt-in and/or opt-out investment rights, then the SEC may consider the fund to be a device for facilitating individual investment decisions and therefore each investor may be considered a separate client of the fund manager for purposes of Section 203(b)(3). 4 See, e.g., Hedge Fund Adviser Registration Act of 2009, H.R. 711, 111th Cong. (1st Sess. 2009). 5 Certain proposals have, however, included an exemption for advisers to venture capital funds. See Private Fund Investment Advisers Registrant Act of 2009, Discussion Draft dated October 16, 2009 (111 th Cong.) (1 st Sess. 2009). Restoring America Financial Stability Act of 2009, Discussion Draft dated Nov. 10, 2009 (111th Cong.) (1st Sess. 2009) 6 See Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006). The Hedge Fund Rule generally required advisers to private investment funds to look through any private investment fund that permitted investors to withdraw or redeem its interests during the first two years of owning an interest in the fund. 12

7 the Advisers Act anti-fraud provisions 7, the duty to supervise advisory employees, and implementation and enforcement of an insider trading policy. Registered investment advisers are subject to many additional provisions under the Advisers Act, including rules relating to advertising, advisory contracts, custody of client funds and securities, personal trading activity of employees, portfolio management, regulatory reporting and recordkeeping. Moreover, carried interest received by a venture capital fund s general partner or an affiliate pursuant to the fund s limited partnership agreement may violate the Advisers Act with respect to certain investors who fail to meet specific net worth or asset thresholds. These regulatory requirements and their potential effect on venture capital funds are discussed in detail below. Registering as an Investment Adviser The authority to require investment advisers to register is bifurcated between the SEC and the states. In general, an investment adviser may register with the SEC if it has between US$25 and US$30 million of assets under management, and, unless an exemption applies, it must register with the SEC if it has greater than US$30 million of assets under management. The Advisers Act prohibits a state from requiring registration of an investment adviser that (i) is registered with the SEC or (ii) does not have a place of business in the state and has fewer than six clients that were residents of the state in the preceding 12 months. Investment personnel of SEC-registered investment advisers to venture capital funds are also generally exempt from state licensing and examination requirements. 8 The SEC registration process requires the investment adviser to file an application Form ADV with the 7 Section 206 of the Advisers Act, which applies to both registered and unregistered investment advisers, generally prohibits an investment adviser from engaging in any transaction or course of business that operates as a fraud or deceit on any current or prospective client. Rule 206(4)-8 of the Advisers Act extends this protection to private investment fund investors as well. 8 See Advisers Act Rule 203A-3(a). Most states require investment adviser representatives to be licensed and fulfill certain examination requirements. However, generally speaking, states are prohibited from requiring licensing of an SEC-registered investment adviser s representatives who are supervised persons of the adviser and (i) provide investment advice to fewer than six natural person clients or (ii) ten percent or less of whose clients are natural persons. Natural person does not include individuals who are qualified clients under the Advisers Act. Because most venture capital fund managers provide advice exclusively to nonnatural persons (i.e., the venture capital funds are considered the adviser s clients ), state licensing is typically not an issue for most venture capital fund managers. The SEC registration process requires the investment adviser to file an application Form ADV with the SEC. SEC. 9 Form ADV is divided into two parts. Form ADV Part I is filed electronically via the Investment Adviser Registration Depository (the IARD) 10 and contains information about the investment adviser and its associated persons. Part I deals primarily with basic information about the investment adviser, including its business practices, assets under management, financial industry affiliations, and ownership and control structure. Information provided in Form ADV Part I is carefully scrutinized by the SEC staff and may assist the SEC in arriving at the investment adviser s initial risk profile for purposes of SEC examinations. Form ADV Part I must be updated within 90 days of the end of each fiscal year of an adviser. 11 In addition, if certain information previously provided in Form ADV Part I responses becomes inaccurate, an interim amendment may need to be filed. 12 Form ADV Part II has traditionally been considered one of the cornerstones of a registered investment adviser s fiduciary obligation to its clients. Form ADV Part II focuses on disclosure of potential conflicts of interest and risks regarding the registered investment adviser s business practices. The information in Form ADV Part II includes a comprehensive description of the registered investment adviser s services, the advisory fees charged, how investments are analyzed, how investment recommendations are made, a description of the education and business background of certain personnel, and any participation or interest in client transactions on the part of the investment adviser. The Advisers Act also requires an investment adviser to make certain disclosures concerning its legal and 9 Prospective registrants should note that Section 207 of the Advisers Act prohibits willfully made false statements of material fact or willful omissions of material facts in connection with any application or report filed with the SEC. In addition, Section 206(2) of the Advisers Act makes it unlawful for an investment adviser to make false or misleading statements, even if the conduct is not willful, provided that it operates as a fraud or deceit upon any client or prospective client. See Advisers Act 206(2) Advisers Act Rule 204-1(a)(1). 12 Advisers Act Rule 204-1(a)(2). 13

8 disciplinary history in certain situations. Any legal or disciplinary event that is material to the evaluation of an investment adviser s integrity or ability to meet its obligations is required to be disclosed to potential clients and investors. 13 Form ADV Part II may serve as the required disclosure statement furnished to each client and prospective client pursuant to Advisers Act Rule 204-3(a) (the Brochure Rule ). 14 The SEC has recently indicated that an adviser to a private investment fund (including a venture capital fund) is not required to deliver Form ADV Part II to each investor in the fund, because an investor is not a client for purposes of the Brochure Rule. Nevertheless, Advisers Act Rule 206(4)-8 generally requires an adviser to make full disclosure of all conflicts of interest and other material facts to private fund investors. Accordingly, it is customary that registered investment advisers to venture capital funds deliver Form ADV Part II to existing and prospective fund investors to help safeguard against potential disclosure-related violations of the Advisers Act antifraud provisions. Moreover, recent legislative proposals (if passed) may ultimately give the SEC authority to change the meaning of client for various Advisers Act rules in the future, including the Brochure Rule. It should be noted that filing Form ADV Part I may give rise to certain notice filing requirements with state securities authorities. A notice filing is generally required in most states where an investment adviser has six or more clients or a place of business. 15 The burden of notice filing with states is minimal, however, as filings can be made online through the IARD website. Ethics and Securities Trading of Investment Adviser Personnel The Advisers Act features a considerable number of rules and regulations governing the compliance responsibilities of a registered investment adviser. The SEC has delegated a significant amount of compliance responsibility under the Advisers Act to the registered 13 Under Advisers Act Rule 206(4)-4, criminal convictions for felonies or misdemeanors or adverse civil court judgments connected with investment-related activities will generally be regarded as material. 14 See Nathan & Lewis Securities, SEC No-Action Letter, 1990 WL (July 19, 1990). 15 Nevertheless, notice filing requirements may vary greatly from state to state. A registered investment adviser is strongly recommended to research each state in which it does business to determine whether a state notice filing may be necessary. investment adviser, which must ensure that the firm and its personnel are in compliance with the Advisers Act on an ongoing basis through the implementation of several self-policing measures. One of the most significant requirements for registered investment advisers is the mandatory designation of a chief compliance officer (CCO). 16 Under the Advisers Act, the CCO is responsible for administering and enforcing the registered investment adviser s compliance program. 17 Moreover, the CCO is the point person for monitoring the effectiveness of the firm s compliance program and for addressing instances of noncompliance by the firm or its personnel. Under the Advisers Act, the CCO must be competent and knowledgeable regarding the Advisers Act and... empowered with full responsibility and authority to develop and enforce appropriate policies and procedures for the firm. 18 Accordingly, the CCO must have a sufficient understanding of the requirements imposed by the Advisers Act, related rules and SEC interpretive guidance, and a position of sufficient seniority and authority within the firm to enforce the firm s compliance policies and procedures. In certain circumstances, the CCO may also be personally liable for a failure to reasonably supervise supervised persons of the firm. 19 Registered investment advisers may designate a third party to serve as the firm s CCO, although the SEC staff has publicly questioned the ability of a third-party CCO to operate effectively in what it describes as a rent-a-cop compliance strategy. 20 The CCO is also typically in charge of developing a compliance manual for the investment adviser s personnel, which should contain policies and procedures designed to detect and prevent violations of the Advisers Act by firm personnel. The compliance 16 Advisers Act Rule 206(4)-7(c). 17 Ibid. 18 Investment Advisers Act Rel. No (Dec. 17, 2003). 19 Chief compliance officers should be familiar with Section 203(e)(6) of the Advisers Act, which provides that a person shall not be deemed to have failed to reasonably supervise another person if: (i) the adviser had adopted procedures reasonably designed to prevent and detect violations of the federal securities laws; (ii) the adviser had a system in place for applying the procedures; and (iii) the supervising person had reasonably discharged his or her supervisory responsibilities in accordance with the procedures and had no reason to believe the supervised person was not complying with the procedures. 20 Remarks of Lori A. Richards, SEC Director, in a speech to the Investment Company Institute/Independent Directors Council Mutual Fund Compliance Program Conference, Washington D.C., June 28,

9 One of the most significant requirements for registered investment advisers is the mandatory designation of a chief compliance officer manual should be carefully tailored to address the key risk areas of the firm. Standard off-theshelf compliance manuals that do not specifically address the registered investment adviser s particular operations, risk profile and business infrastructure should be avoided, as the SEC will view a compliance manual featuring procedures that are inapplicable to the adviser s operations (or procedures that are not being followed) as a key indicator of a suspect compliance program. The Advisers Act also compels investment advisers to self-regulate potential conflicts of interest in connection with securities trading by the registered investment adviser and certain supervised persons. 21 By requiring a registered investment adviser to develop, circulate and enforce a written code of ethics, the SEC expressly places the burden of compliance with federal securities laws squarely on the shoulders of the adviser s compliance staff. The code of ethics must contain, at a minimum: 22 (1) a standard of conduct for personnel who provide investment advice to clients that requires compliance with applicable federal securities laws; (2) procedures requiring any person with access to nonpublic investment recommendations of the firm (an access person ) to periodically submit personal securities transaction reports of the access person and certain family members to the CCO or a designee for review 23 ; (3) an insider trading policy and procedures; (4) pre-clearance requirements for investments by supervised persons of the firm in private placements or initial public offerings; (5) a policy for reporting code of ethics violations to the CCO; and (6) a requirement that each supervised person of the investment adviser acknowledge receipt of the code of ethics and any amendments thereto in writing. Additionally, registered investment advisers should ensure that securities transactions by firm personnel do not disadvantage clients or otherwise raise issues of fiduciary concern. Although not mandatory under the Advisers Act, examples of policies employed by some registered investment advisers to prevent 21 Supervised person means any partner, officer, director (or other person occupying a similar status or performing similar functions), or employee of an investment adviser, or other person who provides investment advice on behalf of the investment adviser and is subject to the supervision and control of the investment adviser. Advisers Act 202(a)(25). 22 Advisers Act Rule 204A Advisers Act Rule 204A-1(a)(3). Access persons must submit detailed quarterly and annual securities transaction and holdings reports. Submission of such reports may also be accomplished through the adviser s automatic receipt of brokerage statements for all covered accounts of the access person. 15

10 By requiring a registered investment adviser to develop, circulate and enforce a written code of ethics, the SEC expressly places the burden of compliance with federal securities laws squarely on the shoulders of the adviser s compliance staff. fiduciary conflicts include mandatory CCO pre-clearance of all personal securities transactions or transactions in certain restricted securities (as identified by the CCO) by firm employees and family members living in the same household. Registered investment advisers to venture capital funds should also implement and enforce policies and procedures regarding the giving and receiving of gifts by firm personnel and, to the extent the adviser s funds may have government plan investors, limitations on campaign contributions by firm personnel to public officials. Registered investment advisers must review the adequacy of all compliance policies and procedures, including the effectiveness of their implementation, on at least an annual basis. 24 The annual compliance review requirement is very broad in scope, and the parameters of the review have been left purposefully vague by the SEC so that each registered investment adviser may develop compliance review and testing procedures that are suitable for the adviser s size, complexity and risk profile. 25 The annual compliance review often includes (at a minimum) an assessment of any gaps or weaknesses in the compliance program and whether existing procedures are being followed and/or are effective in preventing compliance violations. 26 To adequately assess the effectiveness of a compliance program, various forms of compliance testing should be incorporated into the annual compliance review. Transactional tests are generally conducted at the time an activity occurs (e.g., comparing an employee s pending request for pre-clearance of a personal trade against the firm s restricted securities list). Periodic compliance testing may be performed periodically to verify that an activity was performed in compliance with the firm s compliance manual (e.g., reviewing an access person s quarterly brokerage statements to ensure that the access person appropriately precleared all investments in private placements). Finally, forensic compliance testing may be employed to analyze information over time for the purpose of identifying unusual patterns, including, for example, an analysis of the comparative performance of similarly managed funds to detect favoritism, misallocation of investment opportunities, or other breaches of fiduciary responsibilities. Rules Governing Investment Advisory Contracts Advisers Act registration generally does not affect an investment adviser s ability to draft specifically-tailored investment advisory contracts. An investment advisory contract that violates any provision of the Advisers Act, however, is not enforceable by the violating party. 27 As a result, an investment adviser will need to consider restrictions on charging performance-based payments and other issues to avoid encountering potentially costly compliance problems under the Advisers Act. The economic incentive for many venture capital fund advisers (or their affiliates) is based (in part) on the carried interest they may potentially receive with respect to the net gains of the fund. Congress has expressed concern over such profit-sharing, asserting that it encourages a heads I win, tails you lose strategy for investment advisers. 28 As a result, unless an exemption applies, a registered investment adviser is prohibited from entering into a contract that provides for payments to the investment adviser on the basis of 24 Advisers Act Rule 206(4)-7(b). 25 Indeed, a compliance program cannot be static.... [it] must be able to identify, meet, and incorporate changes in business and changes in customers... Remarks of Lori A. Richards, SEC Director, in speech to Investment Adviser Compliance Best Practices Summit: Compliance Programs: Our Shared Mission, Washington D.C., February 28, See Investment Advisers Act Rel. No (Dec. 17, 2003). 27 Advisers Act 215(b). 28 See Securities and Exchange Commission, Investment Counsel, Investment Management, Investment Supervisor and Investment Advisory Services, H.R. Doc. No. 477, 76 th Cong., 2d Sess. at 30 (1939). 16

11 a share of capital gains upon or capital appreciation of the funds or any portion of the funds of a client. 29 There are several exemptions to the performancebased payment restriction that an investment adviser may avail itself of. The performance-based payment restriction is not applicable to (i) any client that is a non-united States resident and (ii) clients that are qualified clients 30 under the Advisers Act. Investment advisers to venture capital funds that are exempt from registering under the Investment Company Act of 1940 (the Company Act ) in reliance on the Section 3(c)(7) exemption 31 are not subject to the performance-based payment restriction, because a 3(c)(7) fund is itself deemed a qualified client for purposes of the Advisers Act. However, investment advisers to venture capital funds that are exempt from registration under Section 3(c)(1) of the Company Act will not be automatically absolved from the performance-based payment restrictions. The investment adviser is required to ensure that any investor in a 3(c)(1) fund that is directly or indirectly charged a carried interest can also represent that it is a qualified client. 32 If the 3(c)(1) fund investor cannot make the qualified client representation, the investor may not be directly or indirectly charged any carried interest through the 3(c)(1) fund. In certain circumstances, an investment adviser applying for registration with the SEC may need to restructure carried interest allocations for existing 3(c)(1) funds to the extent such funds have investors that are not qualified clients. In light of recent Congressional proposals that would give the 29 Advisers Act 205(a)(1). 30 See Advisers Act Rule 205-3(d)(1). Qualified client is defined as: (1) any natural person or company with no less than $750,000 invested with the investment adviser immediately after entering into the contract; (2) any natural person or company that the investment adviser reasonably believes has a net worth of at least $1.5 million immediately before entering into the contract; (3) any natural person or company that meets the criteria of qualified purchaser under the Company Act immediately before entering into the contract; (4) any natural person who is an executive officer, director, trustee, general partner, or person serving in similar capacity for the adviser, or is an employee of the adviser that has been involved in investment activities for at least 12 months immediately before entering into the contract. 31 See Investment Company Act of (c)(7). A 3(c)(7) fund is exempt from performance fee protections because its securities are generally only sold through private placements to qualified purchasers. The presumption is that qualified purchasers have a certain degree of experience and sophistication with respect to investing and thus do not require additional protections. 32 Note that investment advisers to 3(c)(1) funds that may have additional fund of funds investors that also rely on Section 3(c)(1) as an exemption from the Company Act may need to look-through two layers of funds to determine the underlying qualified client status of their beneficial owners. SEC authority to revise the definition of client for various purposes of the Advisers Act (including the performance-based payment restrictions), it may be advantageous for all investment advisers (both registered and unregistered) to venture capital funds to collect qualified client representations from its investors in subscription agreements. 33 In addition to the performance-based payment restrictions, registered investment advisers may not enter into an investment advisory contract that does not expressly prohibit assignment of the contract without the consent of the client. 34 Under the Advisers Act, an assignment may occur either directly through transfer of the contract or indirectly through the sale of a controlling interest of the investment adviser firm. 35 While the SEC has not explicitly addressed the issue of how a venture capital fund may consent to an assignment (or other Advisers Act conflicts requiring client consent), it has become standard practice in the industry to obtain the consent of the venture capital fund s advisory committee or another independent board acting on behalf of the venture capital fund. Portfolio Management and Investments The anti-fraud provisions of the Advisers Act impose certain fiduciary obligations on all investment advisers, whether registered or exempt from registration. 36 Accordingly, responsibilities of disclosure, loyalty and fairness and a duty of care apply to even unregistered investment advisers in connection with their portfolio management responsibilities. 37 An investment adviser s fiduciary duty of best execution requires that the adviser execute securities transactions for clients in such a manner that the client s total costs or proceeds in each transaction 33 As of the time of publication, it is not clear whether 3(c)(1) funds in existence at the time potential legislation is enacted will be grandfathered or whether existing 3(c)(1) funds will need to restructure with respect to investors that are not qualified clients. 34 Advisers Act 205(a)(2). 35 The SEC generally establishes a rebuttable presumption that control exists when any person beneficially owns, directly or indirectly, more than 25% of the outstanding voting securities of a company. 36 See, e.g., SEC v. Capital Gains Research Bureau, 375 US 18 (1963); In re Thayer Capital Partners, et al., Investment Advisers Act Rel. No (Aug. 12, 2004); In re David M. Mobley, Sr., Investment Advisers Act Rel. No (May 20, 2003); In re Peter W. Chabot, Investment Advisers Act Rel. No (July 3, 2003); In re Robert T. Littell, et al., Investment Advisers Act Rel. No (Dec. 15, 2003). 37 See Advisers Act

12 is most favorable under the circumstances. 38 The SEC has expressly disclaimed the notion that best execution obligations are fulfilled merely by seeking out the lowest commission cost. 39 Investment advisers should periodically evaluate service providers (including broker-dealers that may be used to liquidate securities) based on factors including execution quality, price, the level of service offered, reliability, and experience in liquidating distributions from venture capital funds. Although advisers to venture capital funds generally tend to have fewer best execution compliance issues relative to hedge fund advisers, it is still imperative that venture capital advisers conduct periodic best execution reviews, particularly when selecting broker-dealers to liquidate securities in the event of an initial public offering or toward the end of the fund s life. Portfolio transactions that provide the opportunity for an investment adviser to put its own interest ahead of the interests of its clients create significant conflicts under the Advisers Act. 40 In the principal transaction scenario, an investment adviser, acting as principal for itself or an affiliate, purchases securities from or sells securities to a client s account. For example, venture capital firms that warehouse portfolio investments with the investment adviser (or another entity under common control with the investment adviser) may engage in a principal transaction when the investment is eventually transferred to the venture capital fund. 38 Securites Exchange Act Rel. No (April 23, 1986); Investment Advisers Act Rel. No. 232 (Oct. 16, 1968). 39 See Securities Exchange Act Rel. No (April 23, 1986). 40 See Advisers Act 206(3). Section 206(3) of the Advisers Act prohibits a registered or unregistered investment adviser from entering into a principal transaction without written disclosure and client consent for each such transaction. 41 In other circumstances, a venture capital fund adviser may transfer a portfolio investment from one client account to another client account. While these types of cross transactions do not generally result in a principal transaction, appropriate disclosure should still be provided in Form ADV Part II and the fund s offering documents regarding the conflicts of interest presented by the adviser acting as a fiduciary to both sides of the transaction. Advertising Investment advisers whether registered or not are prohibited from engaging in false or misleading advertising pursuant to the Advisers Act anti-fraud rules. Advisers Act Rule 206(4)-1 (the Advertising Rule ), promulgated by the SEC with respect to registered investment advisers, defines advertisement broadly to include any notice, circular, letter or other written communication addressed to more than one person, or any notice or other announcement in any publication or by radio or television, that offers an investment adviser s advisory services, including any 41 Ibid. See also Gardner Russo & Gardner, SEC No-Action Letter (June 7, 2006), which states that the principal transaction consent requirements would also apply to any cross transaction between a client account and an account which the investment adviser and/or its controlling persons, in the aggregate, own more than 25%. 18

13 communications intended to induce existing clients to continue or renew advisory services. 42 The Advisers Act advertising rules are extremely complicated as they relate to the advertising practices of venture capital firms. An investment adviser is prohibited from employing client testimonials when advertising itself or its services. 43 The Advisers Act also prohibits advisers from cherry picking past specific portfolio recommendations which were or would have been profitable to any person for purposes of advertising unless the adviser also discloses a list of all recommendations made by the adviser in the immediately preceding one-year period. 44 This restriction can create issues for investment advisers that wish to highlight the performance of a limited number of portfolio recommendations in pitchbooks and other offering materials. Advertising of performance information is also highly restricted by the Advertising Rule and related SEC interpretive guidance. Actual or model performance information may be advertised so long as the information (i) is presented on a net-of-fee basis (including the deduction of management fees, fund expenses and carried interest) and (ii) includes a number of disclosures. 45 Investment advisers may, however, include gross performance numbers so long as both the gross and net performance numbers are presented in an equally prominent manner. Moreover, an investment adviser may make one-onone presentations that include gross performance information to certain wealthy investors in limited circumstances provided that the adviser makes specific disclosures in writing to such investors. 46 In addition, registered investment advisers to venture capital funds may encounter issues when advertising 42 See Advisers Act Rule 206(4)-1(b). 43 See Advisers Act Rule 206(4)-1(a)(1). 44 Advisers Act Rule 206(4)-1(a)(2). Disclosures include: (i) State the name of each such security recommended, the date and nature of each such recommendation (e.g., whether to buy, sell or hold), the market price at that time, the price at which the recommendation was to be acted upon, and the market price of each such security as of the most recent practicable date, and (ii) contain the following cautionary legend on the first page thereof in print or type as large as the largest print or type used in the body or text thereof: it should not be assumed that recommendations made in the future will be profitable or will equal the performance of the securities in this list. See also Starr and Kuehl, Inc., SEC No-Action Letter, 1976 WL 9116 (Apr. 17, 1976). 45 See Clover Capital Mgt., Inc., SEC No-Action Letter, 1986 WL (avail. Oct. 28, 1986). 46 See Investment Company Institute, SEC No-Action Letter, 1987 WL (Aug. 24, 1987). As a result, unless an exemption applies, a registered investment adviser is prohibited from entering into a contract that provides for payments to the 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. the performance of an account or fund managed by a current employee of the adviser while the employee was at a different advisory firm. In general, performance of accounts managed at a prior employer may only be used by the investment adviser if (i) no other person played a significant role in achieving the performance; (ii) the account or fund managed at the prior advisory firm is sufficiently similar to the account or fund offered by the present advisory firm such that the comparison is meaningful and relevant; and (iii) the investment adviser has adequate records from the prior employer to support the cited prior performance. 47 The Advertising Rule is particularly relevant for venture capital fund advisers during a fund s fundraising period. In addition to complying with the private placement rules of the Company Act and the Securities Act of 1933 (the Securities Act ), the venture capital fund adviser will have to be sure its marketing materials (including its private offering memorandum) are in compliance with the Advertising Rule. Custody of Client Assets Registered investment advisers to venture capital funds must comply with rules safeguarding against improper use of client assets. A registered investment adviser is deemed to have custody of client funds and/or securities where the adviser holds client funds or securities or has any authority to obtain possession 47 See Great Lakes Advisers, Inc., SEC No-Action Letter, (pub. avail. Apr. 3, 1992). 19

14 The anti-fraud provisions of the Advisers Act impose certain fiduciary obligations on all investment advisers, whether registered or exempt from registration. of them. By virtue of its position as the general partner (or an affiliate of the general partner) to a venture capital fund, a registered investment adviser to a venture capital fund generally has authority to dispose of funds and securities in the venture capital fund s account and therefore will be deemed to have custody of client assets. Advisers Act Rule 206(4)-2 (the Custody Rule ) requires investment advisers with custody of their clients assets to: (i) arrange for a qualified custodian to maintain such assets; (ii) notify investors of the custodial arrangement with the qualified custodian; and (iii) have a reasonable belief that the qualified custodian is sending quarterly account statements to investors setting forth the funds and securities held in the account along with account transactions for the quarter. 48 If the registered investment adviser (rather than the qualified custodian) sends the account statements itself, it must undergo an annual surprise examination by an independent accountant. A registered investment adviser to a venture capital fund can typically avail itself of two helpful exemptions to the Custody Rule. First, a registered investment adviser with custody need not comply with the account statement delivery rule (or surprise annual examination requirement) with respect to any venture capital fund that is audited annually in accordance with GAAP and where the audited financial statements are sent to the investors of the fund within 120 days of its fiscal year-end (or 180 days for funds of funds) (the Annual Audit Exemption ). Second, securities that are (i) acquired in a non-public offering; (ii) only recorded on the books of the issuer (i.e., uncertificated); and (iii) only transferable with the consent of the issuer 48 See Advisers Act Rule 206(4)-2(a). or holders of the outstanding securities of the issuer are exempt for all purposes of the Custody Rule if the venture capital fund adviser is properly relying on the Annual Audit Exemption. Accordingly, these types of uncertificated securities would not need to be kept with a qualified custodian. Nevertheless, the SEC is currently taking comments on a proposed rule that would amend the Custody Rule to, among other things, (i) require all registered investment advisers (including advisers to venture capital funds) to comply with the annual surprise examination requirement and (ii) eliminate the exemption for privately placed uncertificated securities. If the new custody proposal is passed in its current form, it would have a significant impact on registered investment advisers to venture capital funds. Recordkeeping Advisers Act Rule (the Recordkeeping Rule ) sets forth the books and records that a registered investment adviser is required to maintain. The list of records to be kept under the Recordkeeping Rule is exhaustive and voluminous. 49 The CCO and at least one member of the professional staff of a registered investment adviser should be fully familiar with the contents of the Recordkeeping Rule and with all operating procedures for complying with the Recordkeeping Rule. Any and all of the required books and records are subject to inspection by the SEC at any time, without notice. All of these records must generally be kept in an easily accessible place for a period of not less than five years from the end of the fiscal year during which the last entry was made on a particular record. 50 For the first two years after the end of the last fiscal year an entry was made, such records 49 See Advisers Act Rule The list of required records falls into nine general categories: 1) adviser formation, governance, and ownership documents; 2) accounting records; 3) client relationship records, such as advisory contracts, powers of attorney or investment recommendations; 4) marketing and performance information; 5) solicitor records, such as agreements with or payments made to solicitors; 6) the adviser s code of ethics along with personal and proprietary trading information; 7) portfolio management and trading records; 8) custody records, such as a journal or ledger tracking purchases, sales, receipts, and deliveries of securities; 9) proxy vote-related records, including a copy of each proxy statement the adviser receives regarding client securities, as well as a record of votes cast by the adviser on behalf of clients. 50 There are, however, a few exceptions to the five-year rule. For example, documentation that supports performance advertising numbers must be kept for a period of not less than five years from the end of the fiscal year in which the advertisement was last published or otherwise disseminated. Advisers Act Rule 204-2(e)(1). In addition, corporate records must be retained until three years after termination of the investment adviser. Advisers Act Rule 204-2(e)(2). 20

15 must be kept in an appropriate office of the registered investment adviser. Books and records may be kept in electronic format, provided that an investment adviser undertakes procedures to preserve and safeguard the records from loss and ensures that any reproduction of an original record is faithful to such original record when retrieved. 51 Advisers Act Rule 204-2(g) requires that registered investment advisers arrange and index electronic books and records in a way that permits easy location, access, and retrieval of any particular record. The SEC, however, has generally been silent on what its expectations are with respect to reasonable procedures for archiving electronic books and records. SEC examiners now routinely request prompt production of all correspondence sent or received by certain principals of a registered investment adviser in an easily searchable format. As a result of the uncertainty regarding SEC expectations for retaining in compliance with Advisers Act electronic retention requirements (as well as the administrative burden inherent in reviewing individual s prior to deletion), many registered investment advisers choose to archive all correspondence for a period of five years. Moreover, it has become increasingly common for registered investment advisers to hire third party electronic document service providers to assist with archiving all correspondence of the advisory firm and promptly responding to SEC requests for production of s during an examination. SEC Examinations Advisers Act Section 204 gives the SEC authority to conduct periodic... examinations from time to time. 52 The SEC s Office of Compliance Inspections and Examinations (OCIE) carries out routine inspections of registered investment advisers. The frequency with which a registered investment adviser is examined is highly dependent on the adviser s risk profile, with high-risk registered investment advisers potentially subject to a routine inspection every two to four years. The SEC may also conduct for cause examinations or risk-targeted sweeps from time to time. 51 See Advisers Act Rule 204-2(g)(3). 52 See Advisers Act 204. OCIE prepares for routine inspections by familiarizing itself with the registered investment adviser s prior examination results (if any), website, Form ADV, compliance history and any complaints by clients or investors. It will then send the registered investment adviser a list of books and records to be made available to the SEC upon its arrival. The SEC will also typically request production of s from key personnel for a certain period of time (e.g., six months) in an electronically searchable format. While the SEC has traditionally provided one to two week s advance notice to most registered investment advisers, advance notice is not required. An investment adviser should take note that information provided to the SEC without a request for confidentiality may be available to the public via the Freedom of Information Act. On-site examinations generally consist of meetings with senior management, the CCO and other risk management professionals regarding the topic of risk management and compliance. The SEC will test the internal controls in specific areas of the investment adviser s business that are high risk, as determined by its review of the investment adviser s policies and procedures, code of ethics, books and records, interviews with personnel and other material facts. The examination process itself may last anywhere from a few days to a few months. After the examination is complete, OCIE staff will evaluate its findings, prepare a report and present it as well as any recommendation for corrective action to SEC supervisors. OCIE will inform the registered investment adviser of its results via either a self-explanatory no findings letter, a deficiency letter, or a referral to the SEC s Division of Enforcement. If the registered investment adviser receives a deficiency letter (which will be the result of approximately 90% of SEC examinations), it will generally have thirty days to address and resolve the deficiencies contained in the letter. A referral to the Division of Enforcement (which will be the result of approximately 4% of SEC examinations) will result in a more formal investigation that may include the subpoena of certain individuals and compulsion of certain evidence. 21

16 SEC Enforcement and Limited Private Rights of Action In addition to performing inspections, the SEC has investigative authority pursuant to Advisers Act Section 209(b). Investigations are conducted by the Division of Enforcement, which may subpoena both witnesses and evidence as part of its investigative authority. One key area of enforcement is situations in which the investment adviser and its managers fail to supervise persons under their supervision. 53 A registered investment adviser with policies and procedures designed to prevent a supervised person from violating securities laws and which has reasonable cause to believe such procedures are being complied with is generally protected from a failure to supervise claim. 54 The SEC only has the power to levy civil penalties under the Advisers Act. The Office of the US Attorney handles criminal prosecutions. Clients may also bring limited actions against an investment adviser under certain circumstances. In Transamerica Mortgage Advisers, Inc. v. Lewis, 55 the US Supreme Court held that clients may sue their investment adviser under the Advisers Act to void an investment advisory contract and collect restitution. Restitution against an investment adviser generally 53 In the Matter of Applied Financial Group, Inc., and Dennis Holcombe, Advisers Act Rel. No. 2436, 2005 WL (Sept. 30, 2005). 54 See Advisers Act 203(e)(6)(A) and (B). 55 Transamerica Mortgage Advisers, Inc. v. Lewis, 444 US 11 (1979). equates to a return of fees paid to the investment adviser (including for this purpose, carried interest) minus any value conferred by the investment adviser (i.e., appreciation of assets). An investment adviser may still be named as a defendant in a private action alleging fraud under Rule 10b-5 of the Securities Exchange Act of 1934 or under other state and/or federal securities laws. Conclusion The intent of this article is to explore the most significant aspects of registration as an investment adviser under the Advisers Act. Nevertheless, the topics discussed herein by no means constitute an exhaustive list of Advisers Act issues. Indeed, other areas of Advisers Act concern include privacy and safeguarding of client information, valuation, investment allocation issues, proxy voting, anti-money laundering, disaster recovery, business continuity planning and solicitation arrangements. While it is not yet clear whether the recent legislative proposals will be passed, whether such legislation will exempt venture capital funds, or, if passed, how the SEC would define venture capital funds, investment advisers to venture capital funds should be aware of the potential costs and burdens that could be imposed on them in connection with Advisers Act registration. About the Authors Howard J. Beber is a partner in the Corporate Department of Proskauer Rose LLP and a member of the firm s Private Investment Funds Group. Howard s practice focuses on representing venture capital and private equity funds and institutional investors on a broad range of issues including fund formations, secondary transactions and portfolio investments. He is actively involved in all stages of fund formation and fund sponsor representation, counseling on terms and marketing strategy, drafting partnership and general partner documents, negotiating with investors, providing advice on internal general partner and management company issues and legal and regulatory compliance. Howard also routinely represents some of the most active institutional and fund of funds investors when investing in venture capital, buyout and other private investment funds. Michael R. Suppappola is an associate in the Corporate Department of Proskauer Rose LLP and a member of the firm s Private Investment Funds Group. Mike s practice focuses on the representation of venture capital and private equity funds, funds of funds and investment advisers. He counsels US and non-us sponsors on all aspects of the fund formation and capital raising process, as well as day-to-day operational issues and secondary transactions. In addition, Mike provides ongoing advice to fund managers and other investment advisers on legal and regulatory compliance with federal and state securities laws (with a focus on the Investment Advisers Act of 1940) and he represents institutional investors with respect to investments in US. and non-us. private investment funds. The authors would like to thank Stephen Meli, an associate in the Corporate Department of Proskauer Rose LLP and member of the Private Investment Funds Group, for his valuable contributions to this article. 22

17 Ernst & Young is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 144,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential. For more information, please visit Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. Ernst & Young Global Limited, a UK company limited by guarantee, does not provide services to clients. About Ernst & Young s Strategic Growth Markets Network Ernst & Young s worldwide Strategic Growth Markets Network is dedicated to serving the changing needs of rapid-growth companies. For more than 30 years, we ve helped many of the world s most dynamic and ambitious companies grow into market leaders. Whether working with international mid-cap companies or early-stage venture-backed businesses, our professionals draw upon their extensive experience, insight and global resources to help your business achieve its potential. It s how Ernst & Young makes a difference. Proskauer is an international law firm with over 750 lawyers serving clients around the world in all areas of practice important to businesses and individuals. Our lawyers are established leaders in the venture capital and private equity sectors and practice in strategic business centers that allow us to represent fund sponsors and institutional investors worldwide in a range of activities including fund formation, internal governance and succession planning, investment transactions, acquisitions or sales of interests on the secondary market, liquidity events, distributions, tax planning, regulatory compliance, portfolio company dispositions, management buyouts and leveraged recapitalizations, risk management, and compensation and estate planning for partners. Headquartered in New York since 1875, the firm has offices in Boca Raton, Boston, Chicago, Hong Kong, London, Los Angeles, New Orleans, Newark, Paris, Sao Paulo and Washington D.C. Sonnenschein s Venture Technology Group has been ranked in the Top 10 nationally by Dow Jones Private Equity Analyst. In addition, the team has been recognized by Chambers USA as one of the premier national venture capital practices. Cutting-edge emerging growth and Fortune 500 technology and life sciences companies moving at breakneck speed in competitive markets require nimble, fast-paced counsel at the convergence of finance, strategy, policy and law. For high potential entrepreneurs, our recently expanded Sprout Incubation/Acceleration Initiative has been a growth catalyst for more than 100 successful startups from Silicon Valley to Boston and New York and around the globe. Our success is driven by a multidisciplinary team comprised of more than 200 attorneys and other professionals specializing in venture capital, recovery act and legislative strate gies, incubation services, M&A and strategic advisory, IP and patent litigation, fund services, licensing and IT transactions, capital markets/ipos, corporate governance, and outsourcing/asia. Sonnenschein s Venture Technology Group leverages its deep expertise in IT, life sciences and medical devices, digital media, clean technology, telecommunications and data privacy, along with a global network of venture capital and investment banking firms. The practice is headed globally by Victor H. Boyajian. The Fidelity Charitable Gift Fund ( Gift Fund ) is an independent public charity with a donor advised fund program. Various Fidelity companies provide investment management and administrative services to the Gift Fund. The Charitable Gift Fund logo is a service mark of the Trustees of the Fidelity Investments Charitable Gift Fund. Fidelity and Fidelity Investments are registered service marks of FMR LLC, used by the Gift Fund under license. ADP TotalSource, the Professional Employer Organization (PEO) of ADP, Inc., provides small and midsize venture-backed businesses with innovative solutions to managing the complexities, costs and administrative burdens of human resources management. ADP TotalSource s integrated suite of services incorporates both traditional and Web-based products, which collectively span the entire employee life cycle, from recruitment to termination. Major components of the suite of services include human resources administration, employee recruiting and selection assistance, professional development training, regulatory and compliance management, safety and risk management, payroll and tax administration and reporting, retirement plan services, workers compensation and benefits administration, and access to a leading edge HRMS and robust employee benefit packages that might otherwise be unavailable to a smaller employer EYG No. XXXXXX

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