Document ID: SEC-2010-1882-0001
Agency: sec
Document Type: Proposed Rule
Title: Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less Than $150 Million in Assets, etc.
Posted Date: 2010-12-10T05:00Z

[Federal Register Volume 75, Number 237 (Friday, December 10, 2010)]
[Proposed Rules]
[Pages 77190-77227]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2010-29957]

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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-3111; File No. S7-37-10]
RIN 3235-AK81

Exemptions for Advisers to Venture Capital Funds, Private Fund 
Advisers With Less Than $150 Million in Assets Under Management, and 
Foreign Private Advisers

AGENCY: Securities and Exchange Commission.

ACTION: Proposed rule.

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SUMMARY: The Securities and Exchange Commission (the ``Commission'') is 
proposing rules that would implement new exemptions from the 
registration requirements of the Investment Advisers Act of 1940 for 
advisers to certain privately offered investment funds that were 
enacted as part of the Dodd-Frank Wall Street Reform and Consumer 
Protection Act (the ``Dodd-Frank Act''). As required by Title IV of the 
Dodd-Frank Act--the Private Fund Investment Advisers Registration Act 
of 2010, the new rules would define ``venture capital fund'' and 
provide for an exemption for advisers with less than $150 million in 
private fund assets under management in the United States. The new 
rules would also clarify the meaning of certain terms included in a new 
exemption for foreign private advisers.

DATES: Comments should be received on or before January 24, 2011.

ADDRESSES: Comments may be submitted by any of the following methods:

Electronic Comments

     Use the Commission's Internet comment form (http://www.sec.gov/rules/proposed.shtml); or
     Send an e-mail to rule-comments@sec.gov. Please include 
File Number S7-37-10 on the subject line; or
     Use the Federal eRulemaking Portal (http://www.regulations.gov). Follow the instructions for submitting comments.

Paper Comments

     Send paper comments in triplicate to Elizabeth M. Murphy, 
Secretary, Securities and Exchange Commission, 100 F Street, NE., 
Washington, DC 20549-1090.

All submissions should refer to File Number S7-37-10. This file number 
should be included on the subject line if e-mail is used. To help us 
process and review your comments more efficiently, please use only one 
method. The Commission will post all comments on the Commission's 
Internet Web site (http://www.sec.gov/rules/proposed.shtml). Comments 
are also available for Web site viewing and printing in the 
Commission's Public Reference Room, 100 F Street, NE., Washington, DC 
20549, on official business days between the hours of 10 a.m. and 3 
p.m. All comments received will be posted without change; we do not 
edit personal identifying information from submissions. You should 
submit only information that you wish to make available publicly.

FOR FURTHER INFORMATION CONTACT: Tram N. Nguyen, Daniele Marchesani, or 
David A. Vaughan, at (202) 551-6787 or (IArules@sec.gov), Division of 
Investment Management, U.S. Securities and Exchange Commission, 100 F 
Street, NE., Washington, DC 20549-8549.

SUPPLEMENTARY INFORMATION: The Commission is requesting public comment 
on proposed rules 203(l)-1, 203(m)-1 and 202(a)(30)-1 (17 CFR 
275.203(l)-1, 275.203(m)-1 and 275.202(a)(30)-1) under the Investment 
Advisers Act of 1940 (15 U.S.C. 80b) (``Advisers Act'').\1\
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    \1\ Unless otherwise noted, all references to rules under the 
Advisers Act will be to title 17, part 275 of the Code of Federal 
Regulations (17 CFR 275).
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Table of Contents

I. Background
II. Discussion
    A. Definition of Venture Capital Fund
    1. Qualifying Portfolio Companies
    2. Management Involvement
    3. Limitation on Leverage
    4. No Redemption Rights
    5. Represents Itself as a Venture Capital Fund
    6. Is a Private Fund
    7. Other Factors
    8. Application to Non-U.S. Advisers
    9. Grandfathering Provision
    B. Exemption for Investment Advisers Solely to Private Funds 
With Less Than $150 million in Assets Under Management
    1. Advises Solely Private Funds
    2. Private Fund Assets
    3. Assets Managed in the United States
    4. United States Person
    5. Transition Rule
    C. Foreign Private Advisers
    1. Clients
    2. Private Fund Investor
    3. In the United States
    4. Place of Business
    5. Assets Under Management
    D. Subadvisory Relationships and Advisory Affiliates
III. Request for Comment
IV. Paperwork Reduction Act Analysis
V. Cost-Benefit Analysis
VI. Regulatory Flexibility Act Certification
VII. Statutory Authority
Text of Proposed Rules

I. Background

    On July 21, 2010, President Obama signed into law the Dodd-Frank 
Act,\2\ which amends various provisions of the Advisers Act and 
requires or authorizes the Commission to adopt several new rules and 
revise existing rules.\3\ Unless otherwise provided for in the Dodd-
Frank Act, the amendments become effective on July 21, 2011.\4\
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    \2\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, 124 Stat. 1376 (2010).
    \3\ In this Release, when we refer to the ``Advisers Act,'' we 
refer to the Advisers Act as in effect on July 21, 2011.
    \4\ Section 419 of the Dodd-Frank Act.
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    The amendments include the repeal of section 203(b)(3) of the 
Advisers Act, which exempts any investment adviser from registration if 
the investment adviser (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 and (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 (the ``private adviser exemption'').\5\ 
Advisers specifically exempt under section 203(b) are not subject to 
reporting or recordkeeping provisions under the Advisers Act, and are 
not subject to examination by our staff.\6\
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    \5\ 15 U.S.C. 80b-3(b)(3) as in effect before July 21, 2011.
    \6\ See section 204(a) of the Advisers Act. See also infra note 
30.
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    The primary purpose of Congress in repealing section 203(b)(3) was 
to

[[Page 77191]]

require advisers to ``private funds'' to register under the Advisers 
Act.\7\ Private funds include hedge funds, private equity funds and 
other types of pooled investment vehicles that are excluded from the 
definition of ``investment company'' under the Investment Company Act 
of 1940 \8\ (``Investment Company Act'') by reason of sections 3(c)(1) 
or 3(c)(7) of such Act.\9\ Section 3(c)(1) is available to a fund that 
does not publicly offer the securities it issues \10\ and has 100 or 
fewer beneficial owners of its outstanding securities.\11\ A fund 
relying on section 3(c)(7) cannot publicly offer the securities it 
issues \12\ and generally must limit the owners of its outstanding 
securities to ``qualified purchasers.'' \13\
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    \7\ See S. Rep. No. 111-176, at 71-3 (2010) (``S. Rep. No. 111-
176''); H. Rep. No. 111-517, at 866 (2010) (``H. Rep. No. 111-
517''). H. Rep. No. 111-517 contains the conference report 
accompanying the version of H.R. 4173 that was debated in 
conference, infra note 39.
    \8\ 15 U.S.C. 80a.
    \9\ Section 202(a)(29) of the Advisers Act defines the term 
``private fund'' as ``an issuer that would be an investment company, 
as defined in section 3 of the Investment Company Act of 1940 (15 
U.S.C. 80a-3), but for section 3(c)(1) or 3(c)(7) of that Act.''
    \10\ Interests in a private fund may be offered pursuant to an 
exemption from registration under the Securities Act of 1933 (15 
U.S.C. 77a) (``Securities Act''). Notwithstanding these exemptions, 
the persons who market interests in a private fund may be subject to 
the registration requirements of section 15(a) under the Securities 
Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 78o(a)). The 
Exchange Act generally defines a ``broker'' as any person engaged in 
the business of effecting transactions in securities for the account 
of others. Section 3(a)(4)(A) of the Exchange Act (15 U.S.C. 
78c(a)(4)(A)). See also Definition of Terms in and Specific 
Exemptions for Banks, Savings Associations, and Savings Banks Under 
Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, 
Exchange Act Release No. 44291 (May 11, 2001) [66 FR 27759 (May 18, 
2001)], at n.124 (``Solicitation is one of the most relevant factors 
in determining whether a person is effecting transactions.''); 
Political Contributions by Certain Investment Advisers, Investment 
Advisers Act Release No. 3043 (July 1, 2010) [75 FR 41018 (July 14, 
2010)], n.326 (``Pay to Play Release'').
    \11\ See section 3(c)(1) of the Investment Company Act 
(providing an exclusion from the definition of ``investment 
company'' for any ``issuer whose outstanding securities (other than 
short-term paper) are beneficially owned by not more than one 
hundred persons and which is not making and does not presently 
propose to make a public offering of its securities.'').
    \12\ See supra note 10.
    \13\ See section 3(c)(7) of the Investment Company Act 
(providing an exclusion from the definition of ``investment 
company'' for any ``issuer, the outstanding securities of which are 
owned exclusively by persons who, at the time of acquisition of such 
securities, are qualified purchasers, and which is not making and 
does not at that time propose to make a public offering of such 
securities.''). The term ``qualified purchaser'' is defined in 
section 2(a)(51) of the Investment Company Act.
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    Each of these types of private funds advised by an adviser 
typically qualifies as a single client for purposes of the private 
adviser exemption.\14\ As a result, investment advisers could form up 
to 14 private funds, regardless of the total number of investors 
investing in the funds, without the need to register with us.\15\ This 
has permitted the growth of unregistered investment advisers with large 
amounts of assets under management and significant numbers of investors 
but without the Commission oversight that registration under the 
Advisers Act provides.\16\ Concern about this lack of Commission 
oversight led us to adopt a rule in 2004 extending registration to 
hedge fund advisers,\17\ which was vacated by a federal court in 
2006.\18\ In Title IV of the Dodd-Frank Act (``Title IV''), Congress 
has now generally extended Advisers Act registration to advisers to 
hedge funds and many other private funds by eliminating the current 
private adviser exemption.\19\
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    \14\ See rule 203(b)(3)-1(a)(2).
    \15\ See Staff Report to the united states securities and 
exchange Commission, Implications of the Growth of Hedge Funds, at 
21 (2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf 
(discussing section 203(b)(3) of the Advisers Act as in effect 
before July 21, 2011).
    \16\ See generally id. (noting that the private adviser 
exemption contributed to growth in the number and size of, and 
investor participation in, hedge funds).
    \17\ See Registration Under the Advisers Act of Certain Hedge 
Fund Advisers, Investment Advisers Act Release No. 2333 (Dec. 2, 
2004) [69 FR 72054 (Dec. 10, 2004)] (``Hedge Fund Adviser 
Registration Release'').
    \18\ Goldstein v. Securities and Exchange Commission, 451 F.3d 
873 (D.C. Cir. 2006) (``Goldstein'').
    \19\ Section 403 of the Dodd-Frank Act amends existing section 
203(b)(3) of the Advisers Act by repealing the current private 
adviser exemption and inserting the foreign private adviser 
exemption. See infra Section II.C. Unlike our 2004 rule, which 
sought to apply only to advisers of ``hedge funds,'' the Dodd-Frank 
Act requires that, unless another exemption applies, all advisers 
previously eligible for the private adviser exemption register with 
us regardless of the type of private funds or other clients the 
adviser has.
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    In addition to removing the broad exemption provided by section 
203(b)(3), Congress created three exemptions from registration under 
the Advisers Act.\20\ These new exemptions apply to: (i) Advisers 
solely to venture capital funds, without regard to the number of such 
funds advised by the adviser or the size of such funds; \21\ (ii) 
advisers solely to private funds with less than $150 million in assets 
under management in the United States, without regard to the number or 
type of private funds advised; \22\ and (iii) non-U.S. advisers with 
less than $25 million in aggregate assets under management from U.S. 
clients and private fund investors and fewer than 15 such clients and 
investors.\23\
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    \20\ Title IV also created exemptions and exclusions in addition 
to the three discussed at length in this Release. See, e.g., 
sections 403 and 409 of the Dodd-Frank Act (exempting advisers to 
licensed small business investment companies from registration under 
the Advisers Act and excluding family offices from the definition of 
``investment adviser'' under the Advisers Act). We proposed a rule 
defining ``family office'' in a prior release (Family Offices, 
Investment Advisers Act Release No. 3098 (Oct. 12, 2010) [75 FR 
63753 (Oct. 18, 2010)]).
    \21\ See section 407 of the Dodd-Frank Act (exempting advisers 
solely to ``venture capital funds,'' as defined by the Commission).
    \22\ See section 408 of the Dodd-Frank Act (directing the 
Commission to exempt private fund advisers with less than $150 
million in aggregate assets under management in the United States).
    \23\ See section 402 of the Dodd-Frank Act (defining ``foreign 
private adviser'' as ``any investment adviser who--(A) Has no place 
of business in the United States; (B) has, in total, fewer than 15 
clients and investors in the United States in private funds advised 
by the investment adviser; (C) has aggregate assets under management 
attributable to clients in the United States and investors in the 
United States in private funds advised by the investment adviser of 
less than $25,000,000, or such higher amount as the Commission may, 
by rule, deem appropriate in accordance with the purposes of this 
title; and (D) neither--(i) Holds itself out generally to the public 
in the United States as an investment adviser; nor (ii) acts as--(I) 
an investment adviser to any investment company registered under the 
Investment Company Act of 1940 [15 U.S.C. 80a]; or a company that 
has elected to be a business development company pursuant to section 
54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53), and has 
not withdrawn its election.'').
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II. Discussion

    Today we are proposing three rules that would implement these 
exemptions.\24\ In a separate companion release (the ``Implementing 
Release''),\25\ we are proposing rules to implement other amendments 
made to the Advisers Act by the Dodd-Frank Act, some of which also 
concern certain advisers that qualify for the exemptions discussed in 
this Release.\26\
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    \24\ The Commission provided the public with an opportunity to 
present its views on various rulemaking and other initiatives that 
the Dodd-Frank Act required the Commission to undertake. Public 
views relating to our rulemaking in connection with the exemptions 
for certain advisers addressed in this Release are available at 
http://www.sec.gov/comments/df-title-iv/exemptions/exemptions.shtml.
    \25\ Rules Implementing Amendments to the Investment Advisers 
Act of 1940, Investment Advisers Act Release No. 3110 (Nov. 19, 
2010).
    \26\ See infra note 30 and accompanying and following text.
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    New section 203(l) of the Advisers Act provides that an investment 
adviser that solely advises venture capital funds is exempt from 
registration under the Advisers Act and directs the Commission to 
define ``venture capital fund'' within one year of enactment.\27\ We 
are proposing new rule 203(l)-1 to provide such a definition, which we 
discuss below in Section II.A of this Release.
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    \27\ See supra note 21.
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    New section 203(m) of the Advisers Act directs the Commission to 
provide

[[Page 77192]]

an exemption from registration to any investment adviser that solely 
advises private funds if the adviser has assets under management in the 
United States of less than $150 million.\28\ We are proposing such an 
exemption in a new rule 203(m)-1, which we discuss below in Section 
II.B of this Release. Proposed rule 203(m)-1 includes provisions for 
determining the amount of an adviser's private fund assets for purposes 
of the exemption and when those assets are deemed managed in the United 
States.
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    \28\ See supra note 22.
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    The new exemptions under sections 203(l) and 203(m) provide that 
the Commission shall require advisers relying on them to provide the 
Commission with reports and keep records as the Commission determines 
necessary or appropriate in the public interest or for the protection 
of investors.\29\ These new exemptions do not limit our statutory 
authority to examine the books and records of advisers relying upon 
these exemptions.\30\ For purposes of this Release we will refer to 
these advisers as ``exempt reporting advisers.'' In the Implementing 
Release, we are proposing reporting requirements for exempt reporting 
advisers.\31\
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    \29\ See supra notes 21 and 22.
    \30\ Under section 204(a) of the Advisers Act, the Commission 
has the authority to require an investment adviser to maintain 
records and provide reports, as well as the authority to examine 
such adviser's records, unless the adviser is ``specifically 
exempted'' from the requirement to register pursuant to section 
203(b) of the Advisers Act. Investment advisers that are exempt from 
registration in reliance on section 203(l) or 203(m) of the Advisers 
Act are not ``specifically exempted'' from the requirement to 
register pursuant to section 203(b), and thus the Commission has 
authority under section 204(a) of the Advisers Act to require those 
advisers to maintain records and provide reports and has authority 
to examine such advisers' records.
    \31\ See Implementing Release, supra note 25, at section II.B.
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    The third exemption, set forth in amended section 203(b)(3) of the 
Advisers Act, provides an exemption from registration for certain 
foreign private advisers. New section 202(a)(30) of the Advisers Act 
defines ``foreign private adviser'' as an investment adviser that has 
no place of business in the United States, has fewer than 15 clients in 
the United States and investors in the United States in private funds 
advised by the adviser,\32\ and less than $25 million in aggregate 
assets under management from such clients and investors.\33\ As 
discussed in Section II.C of this Release, in order to clarify the 
application of this new exemption, we are proposing a new rule 
202(a)(30)-1, which would define a number of terms included in the 
statutory definition of foreign private adviser.\34\
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    \32\ Subparagraph (B) of section 202(a)(30) refers to number of 
``clients and investors in the United States in private funds,'' 
while subparagraph (C) refers to the assets of ``clients in the 
United States and investors in the United States in private funds'' 
(emphasis added). We interpret these provisions consistently so that 
only clients in the United States and investors in the United States 
should be included for purposes of determining eligibility for the 
exemption under subparagraph (B).
    \33\ The exemption is not available to an adviser that ``acts as 
(I) an investment adviser to any investment company registered under 
the [Investment Company Act]; or (II) a company that has elected to 
be a business development company pursuant to section 54 of [that 
Act] and has not withdrawn its election.'' Section 
202(a)(30)(D)(ii). We interpret subparagraph (II) to prevent an 
adviser that advises a business development company from relying on 
the exemption.
    \34\ Proposed rule 202(a)(30)-1 would define the following 
terms: (i) ``client;'' (ii) ``investor;'' (iii) ``in the United 
States;'' (iv) ``place of business;'' and (v) ``assets under 
management.'' See discussion infra in section II.C of this Release. 
We are proposing rule 202(a)(30)-1 pursuant to section 211(a) of the 
Advisers Act, which Congress amended to explicitly provide us with 
the authority to define technical, trade, and other terms used in 
the Advisers Act. See section 406 of the Dodd-Frank Act.
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    These exemptions are not mandatory. Thus, an adviser that qualifies 
for any of the exemptions could choose to register (or remain 
registered) with the Commission, subject to section 203A of the 
Advisers Act, which generally prohibits from registering with the 
Commission most advisers that do not have at least $100 million in 
assets under management.\35\ An adviser choosing to avail itself of the 
exemptions under sections 203(l), 203(m) or 203(b)(3), however, may be 
subject to registration by one or more state securities 
authorities.\36\
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    \35\ Section 203A(a)(1) of the Advisers Act generally prohibits 
an investment adviser regulated by the state in which it maintains 
its principal office and place of business from registering with the 
Commission unless it has at least $25 million of assets under 
management, and preempts certain state laws regulating advisers that 
are registered with the Commission. Section 410 of the Dodd-Frank 
Act amended section 203A(a) to also prohibit generally from 
registering with the Commission an investment adviser that has 
assets under management between $25 million and $100 million if the 
adviser is required to be registered with, and if registered, would 
be subject to examination by, the state security authority where it 
maintains its principal office and place of business. See section 
203A(a)(2) of the Advisers Act. In each of subparagraphs (1) and (2) 
of section 203A(a), additional conditions also may apply. See 
Implementing Release, supra note 25, at section II.A.
    \36\ See section 203A(b)(1) of the Advisers Act (exempting from 
state regulatory requirements only advisers registered with the 
Commission). See also infra note 265 (discussing the application of 
section 222 of the Advisers Act).
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A. Definition of Venture Capital Fund

    We are proposing a definition of ``venture capital fund'' for 
purposes of the new exemption for investment advisers that advise 
solely venture capital funds.\37\ Proposed rule 203(l)-1 would define 
the term venture capital fund consistently with what we believe 
Congress understood venture capital funds to be, and in light of other 
provisions of the federal securities laws that seek to achieve similar 
objectives.\38\
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    \37\ See proposed rule 203(l)-1.
    \38\ See infra notes 94, 123, 125 (discussing the history of and 
regulatory framework applicable to business development companies 
under federal securities laws).
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    We understand that Congress sought to distinguish advisers to 
``venture capital funds'' from the larger category of advisers to 
``private equity funds'' for which Congress considered, but ultimately 
did not provide, an exemption.\39\ As a general matter, venture capital 
funds are long-term investors in early-stage or small companies that 
are privately held, as distinguished from other types of private equity 
funds, which may invest in businesses at various stages of development 
including mature, publicly held companies.\40\ Testimony received by 
Congress characterized venture capital funds as typically contributing 
substantial capital to early-stage companies \41\ and generally not

[[Page 77193]]

leveraged,\42\ and thus not contributing to systemic risk, a factor 
that appears significant to Congress' determination to exempt these 
advisers.\43\ In drafting the proposed rule, we have sought to 
incorporate this Congressional understanding of the nature of 
investments of a venture capital fund, and these principles guided our 
consideration of the proposed venture capital fund definition.
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    \39\ While the Senate voted to exempt private equity fund 
advisers in addition to venture capital fund advisers, the final 
Dodd-Frank Act only exempts venture capital fund advisers. Compare 
Restoring American Financial Stability Act of 2010, S. 3217, 111th 
Cong. Sec.  408 (2010) (as passed by the Senate) with Dodd-Frank 
Wall Street Reform and Consumer Protection Act of 2009, H.R. 4173, 
111th Cong. (2009) (as passed by the House) (``H.R. 4173'') and 
Dodd-Frank Act.
    \40\ See Testimony of Trevor Loy, Flywheel Ventures, before the 
Senate Banking Subcommittee on Securities, Insurance and Investment 
Hearing, July 15, 2009 (``Loy Testimony''), at 3; Testimony of James 
Chanos, Chairman, Coalition of Private Investment Companies, July 
15, 2009, at 4 (``Chanos Testimony'') (``Private investment 
companies play significant, diverse roles in the financial markets 
and in the economy as a whole. For example, venture capital funds 
are an important source of funding for start-up companies or 
turnaround ventures. Other private equity funds provide growth 
capital to established small-sized companies, while still others 
pursue `buyout' strategies by investing in underperforming companies 
and providing them with capital and/or expertise to improve 
results.''); Testimony of Mark Tresnowksi, General Counsel, Madison 
Dearborn Partners, LLC, on behalf of the Private Equity Council, 
before the Senate Banking Subcommittee on Securities, Insurance and 
Investment, July 15, 2009, at 2 (``Tresnowski Testimony'') (stating 
that private equity firms invest in broad categories of companies, 
including ``struggling and underperforming businesses'' and '' 
promising or strong companies''). See also Preqin, Private Equity 
and Alternative Asset Glossary, http://www.preqin.com/itemGlossary.aspx?pnl=UtoZ (defining venture capital as ``a type of 
private equity investment that provides capital to new or growing 
businesses. Venture funds invest in start-up firms and small 
businesses with perceived, long-term growth potential.'').
    \41\ Loy Testimony, supra note 40, at 3; Testimony of Terry 
McGuire, General Partner, Polaris Venture Partners, and Chairman, 
National Venture Capital Association, before the U.S. House of 
Representatives Committee on Financial Services, October 6, 2009, at 
3 (``McGuire Testimony'') (``Our job is to find the most promising, 
innovative ideas, entrepreneurs, and companies that have the 
potential to grow exponentially with the application of our 
expertise and venture capital investment. Often these companies are 
formed from ideas and entrepreneurs that come out of university and 
government laboratories--or even someone's garage.''). See also 
National Venture Capital Association Yearbook 2010, at 7-8 (noting 
that venture capital is a ``long-term investment'' and the ``payoff 
[to the venture capital firm] comes after the company is acquired or 
goes public'') (``NVCA Yearbook 2010''); Private Equity Growth 
Capital Council, Private Equity: Frequently Asked Questions, http://www.privateequitycouncil.org/just-the-facts/private-equity-frequently-asked-questions/ (noting that venture capital funds focus 
on ``start-up and young companies with little or no track record,'' 
whereas buyout and growth funds focus on more mature businesses).
    \42\ Loy Testimony, supra note 40, at 3. See also McGuire 
Testimony, supra note 41, at 3-4 (``most limited partnership 
agreements [of venture capital funds] * * * prohibit [the venture 
capital fund] from any type of long term borrowing. * * * Leverage 
is not part of the equation because start-ups do not typically have 
the ability to sustain debt interest payments and often do not have 
collateral that lenders desire. In fact most of our companies are 
not profitable and require our equity to fund their losses through 
their initial growth period.'').
    \43\ See S. Rep. No. 111-176, supra note 7, at 74-5 (noting that 
venture capital funds ``do not present the same risks as the large 
private funds whose advisers are required to register with the SEC 
under this title [IV]. Their activities are not interconnected with 
the global financial system, and they generally rely on equity 
funding, so that losses that may occur do not ripple throughout 
world markets but are borne by fund investors alone. Terry McGuire, 
Chairman of the National Venture Capital Association, wrote in 
congressional testimony that `venture capital did not contribute to 
the implosion that occurred in the financial system in the last 
year, nor does it pose a future systemic risk to our world financial 
markets or retail investors.'''). See also Loy Testimony, supra note 
40, at 7 (noting the factors by which the venture capital industry 
is exposed to ``entrepreneurial and technological risk not systemic 
financial risk'').
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    This is not the first time that Congress has included special 
provisions to the federal securities laws for these types of private 
funds and the advisers that advise them. In 1980, in an effort to 
promote capital raising by small businesses,\44\ Congress provided 
exemptions from various requirements in the Investment Company Act and 
Advisers Act for ``business development companies'' (or ``BDCs'').\45\ 
Congress adopted the term BDC to avoid ``semantical disagreements'' 
over what constituted a venture capital or small business company,\46\ 
but acknowledged that the purpose of the BDC provisions was to support 
``venture capital'' activity in capital formation for small 
businesses.\47\ The BDC provisions and venture capital exemption 
reflect many similar policy considerations, and thus in drafting the 
definition of ``venture capital fund,'' we have looked, in part, to 
language Congress previously used to describe these types of funds.
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    \44\ See H. Rep. No. 96-1341, at 21-22 (1980) (``1980 House 
Report'').
    \45\ See infra note 123 for a discussion of these definitions.
    \46\ See 1980 House Report, supra note 44, at 22.
    \47\ See id., at 21.
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    As described in more detail below, we propose to define a venture 
capital fund as a private fund that: (i) Invests in equity securities 
of private companies in order to provide operating and business 
expansion capital (i.e., ``qualifying portfolio companies,'' which are 
discussed below) and at least 80 percent of each company's securities 
owned by the fund were acquired directly from the qualifying portfolio 
company; (ii) directly, or through its investment advisers, offers or 
provides significant managerial assistance to, or controls, the 
qualifying portfolio company; (iii) does not borrow or otherwise incur 
leverage (other than limited short-term borrowing); (iv) does not offer 
its investors redemption or other similar liquidity rights except in 
extraordinary circumstances; (v) represents itself as a venture capital 
fund to investors; and (vi) is not registered under the Investment 
Company Act and has not elected to be treated as a BDC.\48\ We also 
propose to grandfather an existing fund as a venture capital fund if it 
satisfies certain criteria under the grandfathering provision.\49\ An 
adviser would be eligible to rely on the exemption under section 203(l) 
of the Advisers Act (the ``venture capital exemption'') only if it 
solely advised venture capital funds that met all of the elements of 
the proposed definition or if it were grandfathered.
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    \48\ Proposed rule 203(l)-1(a).
    \49\ Proposed rule 203(l)-1(b).
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1. Qualifying Portfolio Companies
    We propose to define a venture capital fund for the purposes of the 
exemption as a fund that invests in equity securities issued by 
``qualifying portfolio companies,'' which we define generally as any 
company that: (i) Is not publicly traded; (ii) does not incur leverage 
in connection with the investment by the private fund; (iii) uses the 
capital provided by the fund for operating or business expansion 
purposes rather than to buy out other investors; and (iv) is not itself 
a fund (i.e., is an operating company).\50\ In addition to equity 
securities, the venture capital fund may also hold cash (and cash 
equivalents) and U.S. Treasuries with a remaining maturity of 60 days 
or less.\51\ We understand each of the criteria to be characteristic of 
issuers of portfolio securities held by venture capital funds.\52\ 
Moreover, collectively, these criteria would operate to exclude most 
other private equity funds and hedge funds from the definition. We 
describe each element of a qualifying portfolio company below.
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    \50\ Proposed rule 203(l)-1(c)(4).
    \51\ Proposed rule 203(l)-1(a)(2).
    \52\ See infra sections II.A.1.a-II.A.1.e of this Release.
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a. Private Companies
    We propose to define a venture capital fund as a fund that invests 
in equity securities of qualifying portfolio companies and cash and 
cash equivalents and U.S. Treasuries with a remaining maturity of 60 
days or less.\53\ At the time of each investment by the venture capital 
fund, the portfolio company could not be publicly traded nor could it 
control, be controlled by, or be under common control with, a publicly 
traded company.\54\ Under the proposed definition, a venture capital 
fund could continue to hold securities of a portfolio company that 
subsequently becomes public.
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    \53\ Proposed rule 203(l)-1(a)(2).
    \54\ Proposed rule 203(l)-1(c)(4)(i); proposed rule 203(l)-
1(c)(3) (defining a ``publicly traded'' company as one that is 
subject to the reporting requirements under section 13 or 15(d) of 
the Exchange Act, or has a security listed or traded on any exchange 
or organized market operating in a foreign jurisdiction). This 
definition is similar to rule 2a51-1 under the Investment Company 
Act (defining ``public company,'' for purposes of the qualified 
purchaser standard, as ``a company that files reports pursuant to 
section 13 or 15(d) of the Securities Exchange Act of 1934'') and 
rule 12g3-2 under the Exchange Act (conditioning a foreign private 
issuer's exemption from registering securities under section 12(g) 
of the Exchange Act if, among other conditions, the ``issuer is not 
required to file or furnish reports'' pursuant to section 13(a) or 
section 15(d) of the Exchange Act). Under the proposed rule, 
securities of a publicly traded company, as defined, would include 
securities of non-U.S. companies that are listed on a non-U.S. 
market or non-U.S. exchange. Some securities that are ``pink 
sheets'' (i.e., generally over-the-counter securities that are 
quoted on an electronic quotation system operated by Pink OTC 
Markets) are not subject to the reporting requirements under 
sections 13 and 15(d) of the Exchange Act and would not be publicly 
traded for purposes of the proposed rule.
---------------------------------------------------------------------------

    Venture capital funds provide operating capital to companies in the 
early stages of their development with the goal of eventually either 
selling the company or taking it public.\55\ Unlike

[[Page 77194]]

other types of private funds, venture capital funds do not trade in the 
public markets, but may sell portfolio company securities into the 
public markets once the portfolio company has matured.\56\ As of year-
end 2009, U.S. venture capital funds managed approximately $179.4 
billion in assets.\57\ In comparison, as of year-end 2009, the U.S. 
publicly traded equity market had a market value of approximately $13.7 
trillion,\58\ whereas global hedge funds had approximately $1.4 
trillion in assets under management.\59\ As a consequence, the 
aggregate amount invested in venture capital funds is considerably 
smaller, and Congressional testimony asserted that these funds may be 
less connected with the public markets and may involve less potential 
for systemic risk.\60\ This appears to be a key consideration by 
Congress that led to the enactment of the venture capital 
exemption.\61\
---------------------------------------------------------------------------

    \55\ See Chanos Testimony, supra note 40, at 4 (``[V]enture 
capital funds are an important source of funding for start-up 
companies or turnaround ventures.''); NVCA Yearbook 2010, supra note 
41, at 7-8 (noting that venture capital is a ``long-term 
investment'' and the ``payoff [to the venture capital firm] comes 
after the company is acquired or goes public.''); George W. Fenn, 
Nellie Liang and Stephen Prowse, The Economics of the Private Equity 
Market, December 1995, 22, n.61 and accompanying text (``Fenn et 
al.'') (``Private sales'' are not normally the most important type 
of exit strategy as compared to IPOs, yet of the 635 successful 
portfolio company exits by venture capitalists between 1991-1993 
``merger and acquisition transactions accounted for 191 deals and 
IPOs for 444 deals.'' Furthermore, between 1983 and 1994, of the 
2,200 venture capital fund exits, 1,104 (approximately 50%) were 
attributed to mergers and acquisitions of venture-backed firms.). 
See also Jack S. Levin, Structuring Venture Capital, Private Equity 
and Entrepreneurial Transactions, 2000 (``Levin'') at 1-2 to 1-7 
(describing the various types of venture capital and private equity 
investment business but stating that ``the phrase `venture capital' 
is sometimes used narrowly to refer only to financing the start-up 
of a new business''); Anna T. Pinedo & James R. Tanenbaum, Exempt 
and Hybrid Securities Offerings (2009), Vol. 1 at 12-2 (``Pinedo'') 
(discussing the role initial public offerings play in providing 
venture capital investors with liquidity).
    \56\ See Loy Testimony, supra note 40, at 5 (``We do not trade 
in the public markets.''). See also McGuire Testimony, supra note 
41, at 11 (``[V]enture capital funds do not typically trade in the 
public markets and generally limit advisory activities to the 
purchase and sale of securities of private operating companies in 
private transactions''); Levin, supra note 55, at 1-4 (``A third 
distinguishing feature of venture capital/private equity investing 
is that the securities purchased are generally privately held as 
opposed to publicly traded * * * a venture capital/private equity 
investment is normally made in a privately-held company, and in the 
relatively infrequent cases where the investment is into a publicly-
held company, the [venture capital fund] generally holds non-public 
securities.'') (emphasis in original).
    \57\ NVCA Yearbook 2010, supra note 41, at 9.
    \58\ Bloomberg Terminal Database, WCAUUS (Bloomberg United 
States Exchange Market Capitalization).
    \59\ See Saijel Kishan, Hedge Funds Hold Investors ``Hostage'' 
After Decade's Best Year, Bloomberg Businessweek, Jan. 20, 2010, 
available at http://www.businessweek.com/news/2010-01-20/hedge-funds-hold-investors-hostage-after-decade-s-best-year.html.
    \60\ See supra note 43; McGuire Testimony, supra note 41, at 6 
(noting that the ``venture capital industry's activities are not 
interwoven with U.S. financial markets.''). See also Group of 
Thirty, Financial Reform: A Framework for Financial Stability, 
January 15, 2009, at 9 (discussing the need for registration of 
managers of ``private pools of capital that employ substantial 
borrowed funds'' yet recognizing the need to exempt venture capital 
from registration).
    \61\ See supra note 43.
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    We request comment on our proposed approach. We considered more 
narrow definitions, such as defining a qualifying portfolio company as 
a ``start-up company'' or ``small company.'' \62\ There appears to be 
little consensus, however, as to what a start-up company is. A company 
may be considered a ``start-up'' business depending on when it was 
formed as a legal entity,\63\ whether it employs workers or paid 
employment taxes,\64\ or whether it has generated revenues.\65\ 
Defining a portfolio company based on any one of these factors may 
inadvertently exclude too many start-up portfolio companies. For 
example, solely relying on the age of the company (e.g., first year 
since incorporation) fails to recognize that many companies may be 
incorporated for some period of time prior to initiating business 
operations or remain unincorporated for significant periods of 
time.\66\ Likewise, payment of employment taxes assumes the hiring of 
employees, despite the fact that many new business ventures are sole 
proprietorships without employees.\67\ Such a test could also have the 
unintended effect of discouraging hiring. Similarly, a bright-line 
revenue test set too low could exclude young or new businesses that 
generate significant revenues more quickly than other companies.\68\ 
This could have the unintended consequence of venture capital funds 
that seek to fall within the definition investing in less promising, 
non-revenue generating, young companies.
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    \62\ See S. Rep. No. 111-176, supra note 7, at 74 (describing 
venture capital funds as a subset of private investment companies, 
specializing in long-term equity investments in ``small or start-up 
businesses'').
    \63\ There is no generally accepted definition of a ``start-up'' 
entity although it is generally used to refer to new business 
ventures. See, e.g., U.S. Census Bureau, Business Dynamics 
Statistics, available at http://www.ces.census.gov/index.php/bds/bds_overview (which tracks information on businesses, based on the 
size and age of the business, and assigns a ``birth'' year to a 
business beginning in the year in which it reports positive 
employment of workers on the payroll); The Kauffman Foundation, 
Where Will the Jobs Come From?, November 2009, at 5 (identifying 
``start-ups'' as those firms younger than one year); Anastasia Di 
Carlo & Roger Kelly, Private Equity Market Outlook 27 (European 
Investment Fund, Working Paper 2010/005) (defining start-ups as 
companies that are ``in the process of being set up or may have been 
in business for a short time, but have not sold their product 
commercially'').
    \64\ See, e.g., The Kauffman Foundation, An Overview of the 
Kauffman Firm Survey, Results from the 2004-2008 Data, May 2010, at 
26 (``Overview of the Kauffman Firm Survey'') (discussing the 
difficulties of compiling data on new businesses; start-up 
businesses were generally identified based on several factors: the 
payment of state unemployment taxes, the payment of Federal 
Insurance Contributions Act taxes, the existence of a legal entity, 
use of an employer identification number, and use of a schedule C to 
report business income on a personal tax return).
    \65\ See, e.g., NVCA Yearbook 2010, supra note 41, at 61, 69, 
111 (not defining ``start-up'' but classifying investments in 
``start-up/seed'' companies and defining the ``seed stage'' of a 
company as ``the state of a company when it has just been 
incorporated and its founders are developing their product or 
service,'' whereas an ``early stage'' company is one that is beyond 
the ``seed stage'' but has not yet generated revenues). Cf. 
PricewaterhouseCoopers MoneyTree Report Definitions, https://www.pwcmoneytree.com/MTPublic/ns/nav.jsp?page=definitions (last 
visited Sept. 23, 2010) (defining a ``seed/start-up'' company as one 
that has a concept or product in development but not yet operational 
and usually has been in existence for less than 18 months).
    \66\ According to the Kauffman Survey, in 2004, 36.0% of all 
start-up companies were sole proprietorships; by 2008, 34.4% of all 
surviving companies were sole proprietorships. Overview of the 
Kauffman Firm Survey, supra note 64, at 8.
    \67\ See, e.g., Ying Lowrey, Startup Business Characteristics 
and Dynamics: A Data Analysis of the Kauffman Firm Survey, Aug. 
2009, at 6 (Working Paper) (based on a survey sample of businesses 
started in 2004, reporting that 59% of all start-up companies in 
2004 had zero employees; a ``start-up'' business was any business 
that met any one of the five following criteria for being a start-
up: the payment of state unemployment taxes, the payment of Federal 
Insurance Contributions Act taxes, the existence of a legal entity, 
use of an employer identification number, and use of a schedule C to 
report business income on a personal tax return).
    \68\ According to the Kauffman Survey, which conducted a 
longitudinal study of ``start-up'' businesses that began in 2004, 
46.5% of all such ``start-up'' companies in 2004 had zero revenues; 
by 2008, 30.2% of the surviving companies in the sample reported 
zero revenues. In comparison, in 2004, 15.3% of start-up companies 
reported revenues of more than $100,000 and in 2008, 36.1% of the 
surviving companies in the survey reported revenues of more than 
$100,000. Overview of the Kauffman Firm Survey, supra note 64, at 9.
---------------------------------------------------------------------------

    We also considered defining a qualifying portfolio company as a 
small company. As in the case of defining ``start-up,'' there is no 
single definition for what constitutes a ``small company.'' \69\ We are 
concerned that

[[Page 77195]]

imposing a standardized metric such as net income, the number of 
employees, or another single factor test could ignore the complexities 
of doing business in different industries or regions. As in the case of 
adopting a revenue-based test, there is the potential that even a low 
threshold for a size metric could inadvertently restrict venture 
capital funds from funding otherwise promising young small companies.
---------------------------------------------------------------------------

    \69\ Among countries that are members of the Organisation for 
Economic Co-operation and Development, ``small and medium-sized 
enterprises'' (``SMEs'') are defined as non-subsidiary, independent 
firms employing fewer than the number of employees as is set by each 
country. The definition of SME may be used to determine funding or 
other programs sponsored by member countries. Although the European 
Union generally defines SMEs as businesses with fewer than 250 
employees, the United States sets the threshold at fewer than 500 
employees. Moreover, ``small'' firms are generally defined as those 
with fewer than 50 employees, while micro-enterprises have at most 
10, or in some cases five, workers. In 2005, the European Union 
adopted additional tests for small businesses, defining small 
business (i.e., 10-49 employees) as those with no more than [euro]10 
million in annual revenue and no more than [euro]10 million in 
assets as evidenced on their annual balance sheet. See, e.g., 
Organisation for Economic Co-operation and Development, Glossary of 
Statistical Terms, http://stats.oecd.org/glossary/detail.asp?ID=3123.
     Under one regulatory framework in the United States, a business 
may be considered ``small'' depending on the specified number of 
employees or the net worth or net income of such business. Separate 
tests are specified for a business based on various factors, such as 
the size of the industry, its geographical concentration, and the 
number of market participants. See, e.g., Small Business 
Administration, SBA Size Standards Methodology (Apr. 2009) at 8, 
http://www.sba.gov/idc/groups/public/documents/sba_homepage/size_standards_methodology.pdf (noting that the Small Business 
Administration (``SBA'') decided to apply the net worth and net 
income measures to its Small Business Investment Company (``SBIC'') 
financing program because investment companies typically evaluate 
businesses using these measures when determining whether or not to 
invest). For example, under the SBIC program administered by the 
SBA, SBA loans may be made to SBICs that invest in companies that 
are ``small'' (usually defined as having a net worth of $18 million 
or less and an average after-tax net income for the prior two years 
of no more than $6 million, although there are specific tests 
depending on the industry of the company that may be based on net 
income, net worth or number of employees). The size requirement is 
codified at 13 CFR 121.301(c)(2). See SBA, Investment Program 
Summary, http://www.sba.gov/financialassistance/borrowers/vc/sbainvp/index.html.
---------------------------------------------------------------------------

    Other tests also present concerns. A test adopted by the California 
Corporations Commission and the U.S. Department of Labor requires that 
a venture capital company hold at least 50 percent of its assets in 
``operating companies,'' which are defined as companies primarily 
engaged in the production or sale of a product or services other than 
the investment of capital.\70\ Under the California exemption, a 
venture capital fund could invest in older and more mature companies 
that qualify as ``operating companies'' as well as in securities issued 
by publicly traded companies provided that the venture capital fund 
obtained management rights in such publicly traded companies.\71\ 
Hence, although the California venture capital exemption is for 
advisers to so-called ``venture capital companies,'' the rule provides 
a much broader exemption that would include many types of private 
equity and other types of private funds and thus does not appear 
consistent with our understanding of the intended scope of section 
203(l).\72\ We request comment on any of these approaches or 
alternative ones that we have not discussed.\73\
---------------------------------------------------------------------------

    \70\ Under section 260.204.9 of the California Code of 
Regulations (the ``California VC exemption''), an adviser is exempt 
from the requirement to register if it provides investment advice 
only to ``venture capital companies,'' which are generally defined 
as entities that, on at least one annual occasion (commencing with 
the first annual period following the initial capitalization), have 
at least 50% of their assets (other than short-term investments 
pending long-term commitment or distribution to investors), valued 
at cost, in ``venture capital investments.'' A venture capital 
investment is defined as an acquisition of securities in an 
operating company as to which the adviser has or obtains management 
rights. See Cal. Code Regs. tit. 10, Sec.  260.204.9(a), (b)(3), 
(b)(4) (2010). An ``operating company'' is defined to mean any 
entity ``primarily engaged, directly or through a majority owned 
subsidiary or subsidiaries, in the production or sale (including any 
research or development) of a product or service other than the 
management or investment of capital but shall not include an 
individual or sole proprietorship.'' Id. tit. 10, Sec.  
260.204.9(b)(7). ``Management rights'' is defined as the ``right, 
obtained contractually or through ownership of securities . . . to 
substantially participate in, to substantially influence the conduct 
of, or to provide (or offer to provide) significant guidance and 
counsel concerning, the management, operations or business 
objectives of the operating company in which the venture capital 
investment is made.'' Id. tit. 10, Sec.  260.204.9(b)(6). Management 
rights may be held by the adviser, the fund or an affiliated person 
of the adviser, and may be obtained either through one person or 
through two or more persons acting together. Id.
     The U.S. Department of Labor regulations (``VCOC exemption'') 
are similar to the California VC exemption. The regulations define 
``operating company'' to mean an entity that is ``primarily engaged, 
directly or through a majority owned subsidiary or subsidiaries, in 
the production or sale of a product or service other than the 
investment of capital. The term `operating company' includes an 
entity that is not described in the preceding sentence, but that is 
a `venture capital operating company' described in paragraph (d) or 
a `real estate operating company' described in paragraph (e).'' 29 
CFR 2510.3-101(c)(1). The regulations define a venture capital 
operating company (``VCOC'') as any entity that, as of the date of 
the first investment (or other relevant time), has at least 50% of 
its assets (other than short-term investments pending long-term 
commitment or distribution to investors), valued at cost, invested 
in venture capital investments. 29 CFR 2510.3-101(d). A venture 
capital investment is defined as ``an investment in an operating 
company (other than a venture capital operating company) as to which 
the investor has or obtains management rights'' that are 
``contractual rights * * * to substantially participate in, or 
substantially influence the conduct of, the management of the 
operating company.'' 29 CFR 2510.3-101(d)(3).
    \71\ See Cal. Code Reg. tit. 10, Sec.  260.204.9.
    \72\ The California VC exemption does not limit permitted 
investments to companies that are start-up or privately held 
companies, which were cited as characteristic of venture capital 
investing in testimony to Congress. See McGuire Testimony, supra 
note 41; Loy Testimony, supra note 40.
    \73\ See Letter of Keith P. Bishop (July 28, 2009) (recommending 
elements of the California VC exemption). Cf. Letter of P. James 
(August 21, 2010) (expressing the view that the provision of 
management services does not distinguish venture capital from 
private equity). We received these letters in response to our 
request for public views on rulemaking and other initiatives under 
the Dodd-Frank Act. See generally supra note 24.
---------------------------------------------------------------------------

    We also request comment on our approach to ``follow-on'' 
investments.\74\ Under our proposed rule, a qualifying portfolio 
company is defined to include a company that is not publicly traded (or 
controlled by a publicly traded company) at the time of each fund 
investment,\75\ but would not exclude a portfolio company that 
ultimately becomes a successful venture capital investment (typically 
when the company is taken ``public''). Under this approach, an adviser 
could continue to rely on the exemption even if the venture capital 
fund's portfolio ultimately consisted entirely of publicly traded 
securities, a result that could be viewed as inconsistent with section 
203(l) of the Advisers Act. We believe that our proposed approach would 
give advisers to venture capital funds sufficient flexibility to 
exercise their business judgment on the appropriate time to dispose of 
portfolio company investments--which may occur at a time when the 
company is privately held or publicly held.\76\ Moreover, under the 
federal securities laws, a person that is deemed to be an affiliate of 
a publicly traded company may be limited in its ability to dispose of 
publicly traded securities.\77\ Would our proposed approach to follow-
on investments accommodate the way venture capital funds typically 
invest? Are there circumstances in which a venture capital fund would 
provide follow-on investments in a company that has become public? 
Should the rule specifically provide that a venture capital fund 
includes a fund that invests a limited percentage of its capital in 
publicly traded securities under certain circumstances (e.g., a follow-
on investment in a company in which the fund's previous investments 
were made when the company was private)? If so, what is the appropriate 
percentage threshold (e.g., 5, 10 or 20 percent)?
---------------------------------------------------------------------------

    \74\ See, e.g., Loy Testimony, supra note 40, at 3 (discussing 
the role of follow-on investments); NVCA Yearbook 2010, supra note 
41, at 34 (statistics comparing initial investments versus follow-on 
investments made by venture capital funds at Figure 3.15).
    \75\ See proposed rule 203(l)-1(c)(4)(i).
    \76\ See supra note 55.
    \77\ See, e.g., rule 144 under the Securities Act (17 CFR 
230.144) (prohibiting the resale of certain restricted and control 
securities by ``affiliates'' unless certain conditions are met).
---------------------------------------------------------------------------

    We request comment on whether our definition should exclude any 
venture capital fund that holds any publicly traded securities or a 
specified percentage of publicly traded portfolio

[[Page 77196]]

company securities. What percentage would be appropriate? What 
percentage would give venture capital funds sufficient flexibility to 
dispose of their publicly traded securities? Would 30 or 40 percent of 
the value of a venture capital fund's assets be appropriate? \78\ 
Should the rule specify that publicly traded securities may only be 
held for a limited period of time, such as one-year, or that a venture 
capital fund's entire portfolio may not consist only of publicly traded 
securities except for a limited period of time, such as one-year or 
other period?
---------------------------------------------------------------------------

    \78\ Cf. note 94 (discussing limits applicable to BDCs).
---------------------------------------------------------------------------

b. Equity Securities, Cash and Cash Equivalents and Short-Term U.S. 
Treasuries.
    We propose to define venture capital fund for purposes of the 
exemption as a fund that invests in equity securities of qualifying 
portfolio companies, cash and cash equivalents and U.S. Treasuries with 
a remaining maturity of 60 days or less.\79\ Under our proposed 
definition, a fund would not qualify as a venture capital fund for 
purposes of the exemption if it invested in debt instruments (unless 
they met the definition of ``equity security'') of a portfolio company 
or otherwise lent money to a portfolio company, strategies that are not 
the typical form of venture capital investing.\80\ Congress received 
testimony that, unlike other types of private funds, venture capital 
funds ``invest cash in return for an equity share of the company's 
stock.'' \81\ As a consequence, venture capital funds avoid using 
financial leverage, and leverage appears to have raised systemic risk 
concerns for Congress.\82\ Should our definition of venture capital 
fund include funds that invest in debt, or certain types of debt, 
issued by qualifying portfolio companies, or make certain types of 
loans to qualifying portfolio companies? We understand that some 
venture capital funds may extend ``bridge'' financing to portfolio 
companies in anticipation of a future round of venture capital 
investment.\83\ Such financings may take the form of investment in 
instruments that are ultimately convertible into a portfolio company's 
common or preferred stock at a subsequent investment stage and thus 
would meet the definition of ``equity security.'' \84\ Should our 
definition include any fund that extends bridge financing that does not 
meet the definition of ``equity security'' on a short-term limited 
basis to a qualifying portfolio company? Should our definition be 
limited to those funds that make bridge loans to a portfolio company 
that are convertible into equity funding only in the next round of 
venture capital investing? Under our proposed definition, debt 
investments or loans with respect to qualifying portfolio companies 
that did not meet the definition of ``equity security'' could not be 
made by a fund seeking to qualify as a venture capital fund. Should we 
modify the proposed rule so that such investments and loans could be 
made subject to a limit? If so, what would be an appropriate limit 
(e.g., 5 or 10 percent) and how should the limit be determined (e.g., 
as a percentage of the fund's capital commitments)?
---------------------------------------------------------------------------

    \79\ Proposed rule 203(l)-1(a)(2).
    \80\ See Loy Testimony, supra note 40, at 2, 4; Pinedo, supra 
note 55, Vol. 1 at 12-2; Levin, supra note 55, at 1-5 (noting that 
venture capital funds focus on ``common stock or common equivalent 
securities, with any purchase of subordinated debentures and/or 
preferred stock generally designed merely to fill a hole in the 
financing or to provide [the venture capitalist] with some priority 
over management in liquidation or return of capital''). See also 
Jesse M. Fried and Mira Ganor, Agency Costs of Venture Capitalist 
Control in Startups, 81 N.Y.U. Law Journal 967, 970 (2006) (venture 
capital funds investing in U.S. start-ups ``almost always receive 
convertible preferred stock''); Fenn et al., supra note 55, at 32.
    \81\ McGuire Testimony, supra note 41, at 4; Loy Testimony, 
supra note 40, at 2.
    \82\ See infra section II.A.3 of this Release.
    \83\ See, e.g., Darian M. Ibrahim, Debt as Venture Capital, 4 U. 
Ill. L. Rev. 1169, 1173, 1206 (2010) (``VCs sometimes [provide] 
bridge loans to their portfolio companies * * * [A] bridge loan * * 
* is [essentially] about `funding to subsequent rounds of equity' 
rather than relying on the underlying start-up's ability to repay 
the loan through cash flows.''); Alan Olsen, Venture Capital 
Financing: Structure and Pricing, VirtualStreet (July 25, 2010), 
available at http://www20.csueastbay.edu/news/2010/07/alan-olsen-venture-capital.html (``Bridge financing is designed as temporary 
financing in cases where the company has obtained a commitment for 
financing at a future date, which funds will be used to retire the 
debt.''); Thomas Flynn, Venture Capital: Current Trends and Lessons 
Learned, Ventures and Intellectual Property Letter (2003), available 
at http://www.shipmangoodwin.com/publications/Detail.aspx?pub=194 
(``The bridge financing, intended to take the cash strapped company 
either to the next full round of venture investment or alternatively 
to a liquidity event or wind-up, has become a familiar fixture in 
the life cycle of a venture-backed company.'').
    \84\ Provided such financings were structured to satisfy the 
definition of equity security, we would view such transactions to 
satisfy the definition of qualifying portfolio company under 
proposed rule 203(l)-1(c)(4)(ii).
---------------------------------------------------------------------------

    We propose to use the definition of equity security in section 
3(a)(11) of the Securities Exchange Act of 1934 (``Exchange Act'') and 
rule 3a11-1 thereunder.\85\ This definition is broad, and includes 
common stock as well as preferred stock, warrants and other securities 
convertible into common stock in addition to limited partnership 
interests.\86\ This definition would include various securities in 
which venture capital funds typically invest and would provide venture 
capital funds with flexibility to determine which equity securities in 
the portfolio company capital structure are appropriate for the 
fund.\87\ We request comment on the use of this definition. Should we 
consider a more limited definition of equity security? Do venture 
capital funds typically invest in other types of equity securities that 
are not covered by the proposed definition?
---------------------------------------------------------------------------

    \85\ See 15 U.S.C. 78c(a)(11) (defining ``equity security'' as 
``any stock or similar security; or any security future on any such 
security; or any security convertible, with or without 
consideration, into such a security, or carrying any warrant or 
right to subscribe to or purchase such a security; or any such 
warrant or right; or any other security which the Commission shall 
deem to be of similar nature and consider necessary or appropriate, 
by such rules and regulations as it may prescribe in the public 
interest or for the protection of investors, to treat as an equity 
security.''); rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) 
(defining ``equity security'' to include ``any stock or similar 
security, certificate of interest or participation in any profit 
sharing agreement, preorganization certificate or subscription, 
transferable share, voting trust certificate or certificate of 
deposit for an equity security, limited partnership interest, 
interest in a joint venture, or certificate of interest in a 
business trust; any security future on any such security; or any 
security convertible, with or without consideration into such a 
security, or carrying any warrant or right to subscribe to or 
purchase such a security; or any such warrant or right; or any put, 
call, straddle, or other option or privilege of buying such a 
security from or selling such a security to another without being 
bound to do so.'').
    \86\ See rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) 
(defining ``equity security'' to include any ``limited partnership 
interest'').
    \87\ Our proposed use of the definition of equity security under 
the Exchange Act acknowledges that venture capital funds typically 
invest in common stock and other equity instruments that may be 
convertible into equity common stock. See supra note 80. Our 
proposed definition does not otherwise specify the types of equity 
instruments that a venture capital fund could hold in deference to 
the business judgment of venture capital investors.
---------------------------------------------------------------------------

    Under the proposed rule, we define a venture capital fund for 
purposes of the exemption as a fund that holds cash and cash 
equivalents or short-term U.S. Treasuries, in recognition of the manner 
in which venture capital funds operate.\88\ A venture capital fund may 
hold cash funded by its investors until the cash is allocated to an 
investment opportunity; subsequently, upon liquidation of the 
investment, the venture capital fund will receive cash as a return on 
its investment, which is then distributed to the fund's investors.\89\

[[Page 77197]]

Thus, pending receipt of all capital commitments from investors or 
pending distribution of such proceeds to investors, a venture capital 
fund could hold cash and cash equivalents and short-term U.S. 
Treasuries.\90\ We define ``cash and cash equivalents'' by reference to 
rule 2a51-1(b)(7)(i) under the Investment Company Act.\91\ Rule 2a51-1, 
however, is used to determine whether an owner of an investment company 
excluded by reason of section 3(c)(7) of the Investment Company Act 
meets the definition of a qualified purchaser by examining whether such 
owner holds sufficient ``investments'' (generally securities and other 
assets held for investment purposes).\92\ We do not propose to define a 
venture capital fund's cash holdings by reference to whether the cash 
is held ``for investment purposes'' or to the net cash surrender value 
of an insurance policy. Furthermore, since rule 2a51-1 does not 
explicitly include short-term U.S. Treasuries, which we believe would 
be an appropriate form of cash equivalent for a venture capital fund to 
hold pending investment in a portfolio company or distribution to 
investors, our rule would include short-term U.S. Treasuries with a 
remaining maturity of 60 days or less among the investments a venture 
capital fund could hold.\93\ Should we specify a shorter or longer 
period of remaining maturity for U.S. Treasuries?
---------------------------------------------------------------------------

    \88\ Proposed rule 203(l)-1(a)(2)(ii).
    \89\ ``[T]he capital supplied to a venture capital fund consists 
entirely of equity commitments provided as cash from investors in 
installments on an as-needed basis. * * * The `capital calls' for 
investments generally happen in cycles over the full life of the 
fund on an `as needed' basis as investments are identified by the 
general partners and then as further rounds of investment are made 
into the portfolio companies.'' Loy Testimony, supra note 40, at 2; 
Paul A. Gompers & Josh Lerner, The Venture Capital Cycle, at 459 
(MIT Press 2004) (``Gompers & Lerner'') (``Venture capitalists can 
liquidate their position in the company by selling shares on the 
open market and then paying those proceeds to investors in cash.'').
    \90\ Proposed rule 203(l)-1(a)(2)(ii).
    \91\ Rule 2a51-1(b)(7) under the Investment Company Act provides 
that cash and cash equivalents include foreign currencies ``held for 
investment purposes'' and ``(i) [b]ank deposits, certificates of 
deposit, bankers acceptances and similar bank instruments held for 
investment purposes; and (ii) [t]he net cash surrender value of an 
insurance policy.'' 17 CFR 270.2a51-1(b)(7).
    \92\ See generally sections 2(a)(51) and 3(c)(7) of the 
Investment Company Act; 17 CFR 270.2a51(b) and (c).
    \93\ We have treated debt securities with maturities of 60 days 
or less differently than debt securities with longer maturities 
under our rules. In particular, we have recognized that the 
potential for fluctuation in those shorter-term securities' market 
value has decreased sufficiently that, under certain conditions, we 
allow certain open-end investment companies to value them using 
amortized cost value rather than market value. See Valuation of Debt 
Instruments by Money Market Funds and Certain Other Open-End 
Investment Companies, Investment Company Act Release No. 9786 (May 
31, 1977) [42 FR 28999 (June 7, 1977)]. We believe that the same 
consideration warrants treating U.S. Treasury securities with a 
remaining maturity of 60 days or less as more akin to cash 
equivalents than Treasuries with longer maturities for purposes of 
the definition of venture capital fund.
---------------------------------------------------------------------------

    We request comment on whether the proposed rule's provision for 
cash holdings is too broad or too narrow. Should the rule only specify 
that cash be held in anticipation of investments, or in connection with 
the payment of expenses or liquidations from underlying portfolio 
companies? Are there other types of cash instruments in which venture 
capital funds typically invest and/or that should be reflected in the 
proposed rule?
    We do not propose to define venture capital fund for purposes of 
the exemption as one that invests solely in U.S. companies. In 
contrast, the BDC provisions in the Investment Company Act generally 
limit the exemption to U.S. companies and require that permitted 
investments generally be made in U.S. companies.\94\ However, as we 
discuss below, there is no indication in the legislative record that 
Congress intended the venture capital exemption would be available only 
to U.S. advisers or to advisers that invest fund assets solely in U.S. 
companies.\95\ Should our proposed definition similarly define a 
venture capital fund as a fund formed under the laws of the United 
States and/or that invests exclusively or primarily in U.S. portfolio 
companies or a sub-set of such companies (e.g., U.S. companies 
operating in non-financial sectors)? Are venture capital funds that 
invest in non-U.S. portfolio companies more or less likely to have 
financial relationships that may pose systemic risk issues, a rationale 
that was presented and appeared significant to Congress in exempting 
advisers to venture capital funds?
---------------------------------------------------------------------------

    \94\ See sections 2(a)(46) and 2(a)(48) of the Investment 
Company Act. Under section 55 of the Investment Company Act, a BDC 
is prohibited from acquiring any assets, except for permitted 
assets, unless, at the time the acquisition is made, permitted 
assets ``represent at least 70 per centum of the value of [the 
BDC's] total assets.'' Permitted assets for this purpose generally 
mean securities of an ``eligible portfolio company,'' which is 
defined in section 2(a)(46) of the Investment Company Act.
    \95\ See infra section II.A.8 of this Release.
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c. Portfolio Company Leverage
    Proposed rule 203(l)-1 would define a qualifying portfolio company 
for purposes of the exemption as one that does not borrow, issue debt 
obligations or otherwise incur leverage in connection with the venture 
capital fund's investments.\96\ As a consequence, certain types of 
funds that use leverage or finance their investments in portfolio 
companies or the buyout of existing investors with borrowed money 
(e.g., leveraged buyout funds, which are a different subset of private 
equity funds) would not meet the proposed rule's definition of a 
venture capital fund.\97\ As discussed in greater detail below, we 
believe that Congress did not intend the venture capital fund 
definition to apply to these other types of private equity funds.\98\ 
This definition of qualifying portfolio company would only exclude 
companies that borrow in connection with a venture capital fund's 
investment, but would not exclude companies that borrow in the ordinary 
course of their business (e.g., to finance inventory or capital 
equipment, manage cash flows, and meet payroll). We would generally 
view any financing or loan (unless it met the definition of equity 
security) to a portfolio company that was provided by, or was a 
condition of a contractual obligation with, a fund or its adviser as 
part of the fund's investments as being a type of financing that is 
``in connection with'' the fund's investment, although we recognize 
that other types of financings may also be ``in connection with'' a 
fund's investment. Should we provide guidance on other types of 
financing transactions as being ``in connection with'' a fund's 
investment in a qualifying portfolio company? If so, what types of 
financing transactions should such guidance address? We propose this 
element of the qualifying portfolio company definition because of the 
focus on leverage in the Dodd-Frank Act as a potential contributor to 
systemic risk as discussed by the Senate Committee report,\99\ and the 
testimony

[[Page 77198]]

before Congress that stressed the lack of leverage in venture capital 
investing.\100\ Should we use a test other than whether the loan is 
``in connection with'' the fund's investments? For example, should the 
test be whether the portfolio company currently intends to borrow at 
the time of the fund's investment? Should the test depend only on how 
the portfolio company uses the proceeds of borrowing, such as by 
excluding companies that use proceeds to buyout investors or return 
capital to a fund?
---------------------------------------------------------------------------

    \96\ Proposed rule 203(l)-1(c)(4)(ii) (setting forth this 
requirement as a condition for the portfolio company to qualify as a 
``qualifying portfolio company'').
    \97\ A leveraged buyout fund is a private equity fund that will 
``borrow significant amounts from banks to finance their deals--
increasing the debt-to-equity ratio of the acquired companies.'' 
U.S. Govt. Accountability Office, Private Equity: Recent Growth in 
Leveraged Buyouts Exposed Risks that Warrant Continued Attention 
(2008) (``GAO Private Equity Report''), at 1. A leverage buyout fund 
in 2005 typically financed a deal with 34% equity and 66% debt. Id. 
at 13. See also Fenn et al., supra note 55, at 23 (companies that 
have been taken private in an LBO transaction generally ``spend less 
on research and development, relative to assets, and have a greater 
proportion of fixed assets; their debt-to-assets ratios are high, 
above 60%, and are two to four times those of venture-backed 
firms.'' Moreover, compared to venture capital backed companies, 
LBO-private equity backed companies that are taken public typically 
use proceeds from an IPO to reduce debt whereas new venture capital 
backed firms tend to use proceeds to fund growth.); Tresnowski 
Testimony, supra note 40, at 2 (indicating that portfolio companies 
in which private equity funds invest typically have 60% debt and 40% 
equity).
    \98\ See infra discussion in section II.A.1.d of this Release.
    \99\ See S. Rep. No. 111-176, supra note 7, at 74 (``The 
Committee believes that venture capital funds, a subset of private 
investment funds specializing in long-term equity investment in 
small or start-up businesses, do not present the same risks as the 
large private funds whose advisers are required to register with the 
SEC under this title.''); id. at 75 (concluding that private funds 
that use limited or no leverage at the fund level engage in 
activities that do not pose risks to the wider markets through 
credit or counterparty relationships).
    \100\ See Loy Testimony, supra note 40, at 6 (noting that ``many 
venture capital funds significantly limit borrowing''). See also 
McGuire Testimony, supra note 41, at 7 (``Not only are our 
partnerships run without debt but our portfolio companies are 
usually run without debt as well.'').
---------------------------------------------------------------------------

    Venture capital has been described as investing in companies that 
cannot borrow from the usual lending sources.\101\ Should we define a 
qualifying portfolio company as a company that does not incur certain 
specified types of borrowing or other forms of leverage? Would such a 
definition narrow the current range of portfolio companies in which 
venture capital funds typically invest?
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    \101\ See Loy Testimony, supra note 40, at 3. See also James 
Schell, Private Equity Funds: Business Structure and Operations 
(2010), at Sec.  1.03[1] (``Schell'') (``Venture Capital Funds 
provide investment capital to business enterprises early in their 
development cycle at a time when access to conventional financing 
sources is non-existent or extremely limited.'').
---------------------------------------------------------------------------

d. Capital Used for Operating and Business Purposes
    Under proposed rule 203(l)-1, a venture capital fund is defined as 
a fund that holds equity securities of qualifying portfolio companies, 
and at least 80 percent of each company's equity securities owned by 
the venture capital fund were acquired directly from each such 
qualifying portfolio company.\102\ This element reflects the 
distinction between venture capital funds that provide capital to 
portfolio companies for operating and business purposes (in exchange 
for an equity investment) and leveraged buyout funds, which acquire 
controlling equity interests in operating companies through the ``buy 
out'' of existing security holders. Hence, in addition to the 
definitional element that a venture capital fund is one that does not 
redeem or repurchase securities from other shareholders (i.e., a 
``buyout''), a related criterion in the rule specifies that a 
qualifying portfolio company is one that does not distribute company 
assets to other security holders in connection with the venture capital 
fund's investment in the company (which could be an indirect 
buyout).\103\
---------------------------------------------------------------------------

    \102\ Proposed rule 203(l)-1(a)(2)(i).
    \103\ Proposed rule 203(l)-1(c)(4)(iii).
---------------------------------------------------------------------------

    One of the distinguishing features of venture capital funds is 
that, unlike many hedge funds and private equity funds, they invest 
capital directly in portfolio companies for the purpose of funding the 
expansion and development of the company's business rather than buying 
out existing security holders, otherwise purchasing securities from 
other shareholders, or leveraging the capital investment with debt 
financing.\104\ Testimony received by Congress and our research suggest 
that venture capital funds provide capital to many types of businesses 
at different stages of development,\105\ generally with the goal of 
financing the expansion of the company \106\ and helping it progress to 
the next stage of its development through successive tranches of 
investment (i.e., ``follow-on'' investments) if the company reaches 
agreed-upon milestones.\107\
---------------------------------------------------------------------------

    \104\ See Loy Testimony, supra note 40, at 2 (``Although venture 
capital funds may occasionally borrow on a short-term basis 
immediately preceding the time when the cash installments are due, 
they do not use debt to make investments in excess of the partner's 
capital commitments or `lever up' the fund in a manner that would 
expose the fund to losses in excess of the committed capital or that 
would result in losses to counter parties requiring a rescue 
infusion from the government.''). See also infra notes 109-111; Mark 
Heesen & Jennifer C. Dowling, National Venture Capital Association, 
Venture Capital & Adviser Registration, materials submitted in 
connection with the Commission's Government-Business Forum on Small 
Business Capital Formation (``Heesen'') (summarizing the differences 
between venture capital funds and buyout and hedge funds), available 
at http://www.sec.gov/info/smallbus/2010gbforumstatements.htm.
    \105\ See, e.g., McGuire Testimony, supra note 41, at 1; NVCA 
Yearbook 2010, supra note 41; PricewaterhouseCoopers/National 
Venture Capital Association MoneyTree Report, Q4 2009/Full-year 2009 
Report (providing data on venture capital investments in portfolio 
companies); Schell, supra note 101, at Sec.  1.03[1]; Gompers & 
Lerner, supra note 89, at 178, 180 table 8.2 (displaying percentage 
of annual venture capital investments by stage of development and 
classifying ``early stage'' as seed, start-up, or early stage and 
``late stage'' as expansion, second, third, or bridge financing).
    \106\ See McGuire Testimony, supra note 41, at 1; Loy Testimony, 
supra note 40, at 3 (``Once the venture fund is formed, our job is 
to find the most promising, innovative ideas, entrepreneurs, and 
companies that have the potential to grow exponentially with the 
application of our expertise and venture capital investment.''). See 
also William A. Sahlman, The Structure and Governance of Venture-
Capital Organizations, Journal of Financial Economics 27 (1990), at 
473, 503 (``Sahlman'') (noting venture capitalists typically invest 
more than once during the life of a company, with the expectation 
that each capital investment will be sufficient to take the company 
to the next stage of development, at which point the company will 
require additional capital to make further progress).
    \107\ See Sahlman, at 503; Loy Testimony, supra note 40, at 3 
(``[W]e continue to invest additional capital into those companies 
that are performing well; we cease follow-on investments into 
companies that do not reach their agreed upon milestones.'').
---------------------------------------------------------------------------

    In contrast, private equity funds that are identified as buyout 
funds typically provide capital to an operating company in exchange for 
majority or complete ownership of the company,\108\ generally achieved 
through the buyout of existing shareholders or other security holders 
and financed with debt incurred by the portfolio company,\109\ and 
compared to venture capital funds, hold the investment for shorter 
periods of time.\110\ As a result of the use of the capital provided 
and the incurrence of this debt, following the buyout fund investment, 
the operating company may carry debt several times its equity and may 
devote significant levels of its cash flow and corporate earnings to 
repaying the debt financing, rather than investing in capital 
improvement or business operations.\111\
---------------------------------------------------------------------------

    \108\ GAO Private Equity Report, supra note 97, at 8 (``A 
private equity-sponsored LBO generally is defined as an investment 
by a private equity fund in a public or private company (or division 
of a company) for majority or complete ownership.'').
    \109\ See Annalisa Barrett et al., Prepared by the Corporate 
Library Inc., under contract for the IRRC Institute, What is the 
Impact of Private Equity Buyout Fund Ownership on IPO Companies' 
Corporate Governance?, at 7 (June 2009) (``Barrett et al.'') (``In 
general, VC firms provide funding to companies in early stages of 
their development, and the money they provide is used as working 
capital for the firm. Buyout firms, in contrast, work with mature 
companies, and the funds they provide are used to compensate the 
firm's existing owners.''); Ieke van den Burg and Poul Nyrup 
Rasmussen, Hedge Funds and Private Equity: A Critical Analysis 
(2007), at 16-17 (``van den Burg''); Sahlman, supra note 106, at 
517. See also Tax Legislation: CRS Report, Taxation of Hedge Fund 
and Private Equity Managers, Tax Law and Estate Planning Course 
Handbook Series, Practicing Law Institute (Nov. 2, 2007) at 2 
(noting that in a leveraged buyout ``private equity investors use 
the proceeds of debt issued by the target company to acquire all the 
outstanding shares of a public company, which then becomes 
private'').
    \110\ Unlike venture capital funds, which generally invest in 
portfolio companies for 10 years or more, private equity funds that 
use leveraged buyouts invest in their portfolio companies for 
shorter periods of time. See Loy Testimony, supra note 40, at 3 
(citing venture capital fund investments periods in portfolio 
companies of five to 10 years or longer); van den Burg, at 19 
(noting that LBO investors generally retain their investment in a 
listed company for 2 to 4 years or even less after the company goes 
public). See also Paul A. Gompers, The Rise and Fall of Venture 
Capital, Business And Economic History, vol. 23, no. 2, Winter 1994, 
at 17 (``Gompers'') (stating that ``an LBO investment is 
significantly shorter than that of a comparable venture capital 
investment. Assets are sold off almost immediately to meet debt 
burden, and many companies go public again (in a reverse LBO) in a 
very short period of time'').
    \111\ See Barrett et al., supra note 109. See also Fenn et al., 
supra note 55, at 23 (when comparing venture capital backed 
companies that are taken public to LBO-private equity backed 
companies that are taken public, the common use of proceeds from an 
IPO are used by LBO-private equity backed companies to reduce debt 
whereas new firms use proceeds to fund growth).

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[[Page 77199]]

    We believe that these differences (i.e., the use of buyouts and 
associated leverage) distinguish venture capital funds from buyout 
private equity funds for which Congress did not provide an 
exemption.\112\ Under our proposed rule, an exempt adviser relying on 
section 203(1) of the Advisers Act would not be eligible for the 
exemption if it advised these types of private equity funds that in 
effect acquire a majority of the equity securities of portfolio 
companies directly from other security holders.\113\ Correspondingly, 
we also propose to define a qualifying portfolio company for purposes 
of the exemption as one that does not redeem or repurchase outstanding 
securities in connection with a venture capital fund's investment.\114\ 
Because at least 80 percent of each portfolio company's equity 
securities in which the fund invests must be acquired directly from the 
portfolio company, a venture capital fund relying on the exemption 
could purchase the remainder of the securities directly from existing 
shareholders (i.e., a ``buyout''). Under our proposed definition, 
however, a company that achieves an indirect buyout of its security 
holders, such as through the complete recapitalization or restructuring 
of the portfolio company capital structure would not be a qualifying 
portfolio company.\115\ The 80 percent test is not intended to preclude 
conversions of directly acquired securities into other equity 
securities. Similarly, we would not view a capital reorganization 
intended merely to simplify a qualifying portfolio company's capital 
structure and outstanding securities without any change in the existing 
beneficial owners' rights, priority, or economic terms as breaching the 
80 percent condition.
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    \112\ See supra notes 39, 42, 43, 99 and accompanying text.
    \113\ Proposed rule 203(l)-1(a)(2)(i).
    \114\ Proposed rule 203(l)-1(c)(4)(iii).
    \115\ For example, concurrently with the issuance of new 
securities to the venture capital fund, a portfolio company could 
redeem existing shareholders and use proceeds from the venture 
capital fund investment to pay such shareholders redemption 
proceeds. Similarly, existing shareholders may receive new 
securities that are subordinated to the securities issued to the 
venture capital fund in exchange for tendering their outstanding 
securities, partially funded with investments received from the 
venture capital fund. In each of these examples, the fund becomes a 
majority owner of the company by ``buying out'' the existing owners 
with investment capital initially provided by the fund.
---------------------------------------------------------------------------

    We propose to define a venture capital fund by reference to 
ownership of equity securities of a qualifying portfolio company, 
wherein at least 80 percent of the securities owned were acquired 
directly from the company, in order to give venture capital funds 
relying on the exemption some flexibility to acquire securities from a 
portfolio company founder or ``angel'' investor who may seek liquidity 
from his or her initial investment.\116\ We adopted this 80 percent 
threshold because we understand that many venture capital funds 
currently are managed in a manner that seeks to rely on provisions of 
the tax code providing favorable tax treatment for directly acquired 
equity securities of issuers that satisfy certain conditions.\117\ 
Thus, using this threshold in our definition may not result in 
substantial changes to either investment strategies employed, or the 
compliance programs currently used, by venture capital advisers. Is our 
assumption that venture capital funds do not generally acquire 
portfolio company securities directly from existing shareholders 
correct? Is 80 percent the appropriate threshold? Should the threshold 
be set lower? Should direct acquisitions of equity securities be 
increased to 90 percent or 100 percent in order to more effectively 
prevent advisers to funds engaged in activities that are not 
characteristic of venture capital funds from relying on the exemption?
---------------------------------------------------------------------------

    \116\ See NVCA Yearbook 2010, supra note 41, at 57 (defining 
``angel'' as ``a wealthy individual that invests in companies in 
relatively early stages of development''). See also Fenn et al., 
supra note 55, at 2 (defining angel capital as ``investments in 
small, closely held companies by wealthy individuals, many of whom 
have experience operating similar companies [and] * * * may have 
substantial ownership stakes and may be active in advising the 
company, but they generally are not as active as professional 
managers in monitoring the company and rarely exercise control.'').
    \117\ See Int. Rev. Code Sec.  1202(e)(1)(A) (26 U.S.C. 1202) 
(``IRC 1202'') (which permits partial exclusion from income tax gain 
on directly acquired equity securities of certain issuers that, 
among other things, devote at least 80% of their assets to the 
conduct of their business as specified in IRC 1202). Under our 
proposed rule, at least 80% of the portfolio company securities 
owned by a venture capital fund must be acquired directly from the 
portfolio company, which in turn cannot redeem or repurchase 
existing security holders in connection with such venture capital 
fund investment. Thus we presume that venture capital funding 
proceeds (or at least 80% of such proceeds) will be used for 
operating and business expansion purposes, which is similar to the 
requirements under IRC 1202.
---------------------------------------------------------------------------

    In contrast to leveraged buyout fund financing, venture capital 
received by a portfolio company is devoted to developing the company's 
business rather than repurchasing the securities of other shareholders 
or making payments to fund debt financing through the portfolio 
company. We request comment on this criterion. Does the definition's 
focus on a portfolio company's use of capital received from a venture 
capital fund impose any unnecessary burdens on the company's operation 
or business? Rather than define a venture capital fund by reference to 
the manner in which it acquires equity securities (or the manner in 
which qualifying portfolio companies may indirectly facilitate a 
buyout), should the proposed rule instead define the manner in which 
proceeds from a venture capital investment may be used? For example, 
should the rule specify that proceeds of borrowings or other financings 
not be used to finance the acquisition of equity securities by a 
venture capital fund or otherwise distribute company assets to equity 
owners? Would defining qualifying portfolio company in this manner 
facilitate compliance or would this approach make it easier for a 
company to achieve a ``buyout'' and thereby circumvent the intended 
scope of the exemption, given the fungibility of cash and the privately 
negotiated nature of typical venture capital transactions? We do not 
intend that a venture capital fund would not meet the proposed 
definition if it acquired equity securities from a portfolio company in 
connection with a capital reorganization intended to simplify the 
company's capital structure without changing the existing beneficial 
owners' rights, priority, or economic terms. Are there other capital 
reorganizations that would be consistent with the intent of our 
proposed rule but that would prevent a venture capital fund from 
satisfying the proposed definition?
e. Operating Companies
    Proposed rule 203(l)-1 would define the term qualifying portfolio 
company for the purposes of the exemption to exclude any private fund 
or other pooled investment vehicle.\118\ There is no indication that 
Congress intended the venture capital exemption to apply to funds of 
funds. Without this definition, a venture capital fund could circumvent 
the intended scope of the exemption by investing in other pooled 
investment vehicles that are not themselves subject to the definitional 
criteria under our proposed rule. For example, a venture capital fund 
could circumvent the intent of the proposed rule by incurring off-
balance sheet leverage or indirectly investing in companies that may be 
publicly traded. Our proposed exclusion would be similar to the 
approach of other

[[Page 77200]]

definitions of ``venture capital'' discussed above, which limit 
investments to operating companies and thus would exclude investments 
in other private funds or securitized asset vehicles.\119\ We request 
comment on this definitional element. Under the proposed definition, a 
venture capital fund would not invest in another private fund, a 
commodity pool or other ``investment companies.'' Should the proposed 
definition specifically identify other types of pooled investment 
vehicles (e.g., real estate funds or structured investment vehicles) in 
which a fund seeking to satisfy the proposed definition could not 
invest?
---------------------------------------------------------------------------

    \118\ Proposed rule 203(l)-1(c)(4)(iv). For this purpose, pooled 
investment vehicles include investment companies, investment 
companies relying on rule 3a-7 under the Investment Company Act and 
commodity pools.
    \119\ See California VC exemption, supra notes 70-72; see also 
VCOC exemption under 29 CFR 2510.3-101(d), supra note 70.
---------------------------------------------------------------------------

1. Management Involvement
    To qualify as a venture capital fund under our proposed definition, 
the fund or its investment adviser would: (i) Have an arrangement under 
which it offers to provide significant guidance and counsel concerning 
the management, operations or business objectives and policies of the 
portfolio company (and, if accepted, actually provides the guidance and 
counsel) or (ii) control the portfolio company.\120\ Because a key 
distinguishing characteristic of venture capital investing is the 
assistance beyond the mere provision of capital, we propose that 
advisers seeking to rely on the rule have a significant level of 
involvement in developing a fund's portfolio companies.\121\ Managerial 
assistance generally takes the form of active involvement in the 
business, operations or management of the portfolio company, or less 
active forms of control of the portfolio company, such as through board 
representation or similar voting rights.\122\ We also acknowledge that 
the nature of managerial assistance may evolve over time as the needs 
of qualifying portfolio companies change, and hence the proposed rule 
does not specify that managerial assistance has a fixed character.
---------------------------------------------------------------------------

    \120\ Proposed rule 203(l)-1(a)(3). Under section 202(a)(12) of 
the Advisers Act, ``control'' is defined to mean ``the power to 
exercise a controlling influence over the management or policies of 
a company, unless such power is solely the result of an official 
position with such company.''
    \121\ See McGuire Testimony, supra note 41, at 1 (``[W]e build 
companies by actively partnering with each entrepreneur and 
management team to help propel their ideas into market leading 
businesses. We do this by providing a small amount of capital and a 
large amount of operating expertise and strategic counsel over a 
long period of time. While providing capital is the first order of 
business, it is the least time consuming of all our activities. We 
also recruit and attract employees at all levels [for the portfolio 
company]. We identify and structure strategic partnerships. We raise 
additional equity to help the [portfolio] company make it to the 
next milestone. And, we're available 24/7 to support great teams, 
solve problems, identify opportunities and detect `land mines.' * * 
* We provide access to [our] expertise and network at all stages of 
a [portfolio] company's development and across all strategic areas 
of the business.''). See also Levin, supra note 55, at 1-3 (noting 
that the ``first feature distinguishing venture capital/private 
equity investing is the VC professional's active involvement in 
identifying the investment, negotiating and structuring the 
transaction, and monitoring the portfolio company after the 
investment has been made. Often, the VC professional will serve as a 
board member and/or financial advisor to the portfolio company. 
Hence, venture capital/private equity investing is significantly 
different from passive selection and retention of stock and debt 
investments by a money manager.'') (emphasis in original); Sahlman, 
supra note 106, at 508 (noting that venture capitalists typically 
play a role in the operation of the company, help to establish 
tactics and strategy, work with suppliers and customers, and often 
assume more direct control by changing management and sometimes 
taking over day-to-day operations themselves). See also Fenn et al., 
supra note 55, at 32-33 for a discussion of various control 
mechanisms available to venture capital and private equity funds, 
including preferred stock ownership, representation on the board and 
various contractual covenants.
    \122\ See generally supra note 121. See also Alan T. Frankel, et 
al., Venture Capital: Financial and Tax Considerations, The CPA 
Journal (Aug. 2003) at 1 (noting that the ``VC will also monitor the 
portfolio company after the investment has been made. Oftentimes, 
the VC will serve as a board member or financial and strategic 
advisor to the portfolio company.'').
---------------------------------------------------------------------------

    We have modeled the proposed approach to managerial assistance in 
part on existing provisions under the Advisers Act and the Investment 
Company Act dealing with BDCs, which were added over the years to ease 
the regulatory burdens on venture capital and other private equity 
investments.\123\ In 1980, when Congress first introduced BDCs into the 
Advisers Act and Investment Company Act, it acknowledged that the 
purpose of the BDC provisions was to support ``venture capital'' 
activity in capital formation for small business, and described BDCs as 
principally investing in and providing managerial assistance to small, 
growing and financially troubled businesses.\124\ Because Congress 
modeled the definition of BDC under the Advisers and Investment Company 
Acts on the capital formation activities of venture capital funds, both 
definitions under such Acts incorporate the requirement to make 
available significant managerial assistance to portfolio 
companies.\125\
---------------------------------------------------------------------------

    \123\ The term ``business development company'' was first 
introduced into the Investment Company Act and the Advisers Act in 
1980 as part of the Small Business Investment Incentive Act of 1980 
(``Small Business Act''), and was amended as part of the National 
Securities Markets Improvement Act of 1996, Public Law 104-290, 110 
Stat. 3416 (1996) (``NSMIA''). Congress introduced an alternative 
regulatory framework applicable to BDCs, which was designed to 
remove ``unnecessary disincentives'' for BDCs to provide capital to 
small businesses, while also preserving protection for investors and 
preventing fraud and abuse. See 1980 House Report, supra note 44, at 
21-22.
     In the Small Business Act, Congress modeled the definition of a 
BDC under section 202(a)(22) of the Advisers Act on the capital 
formation activities of venture capital funds. Congress recognized 
that the principal activity of a BDC is to invest in and provide 
managerial assistance to small, growing and financially troubled 
companies. See 1980 House Report, supra note 44, at 21. See also 
infra note 129 (definition of ``making available significant 
managerial assistance'' by a BDC under section 2(a)(47) of the 
Investment Company Act).
    \124\ See 1980 House Report, supra note 44, at 21.
    \125\ See section 202(a)(22) of the Advisers Act; section 
2(a)(48)(B) of the Investment Company Act. Generally, a BDC under 
the Advisers Act is any company that meets the definition of BDC 
under the Investment Company Act, except that certain requirements 
were modified for ``private'' BDCs under the Advisers Act. See also 
Prohibition of Fraud by Advisers to Certain Pooled Investment 
Vehicles; Accredited Investors in Certain Private Investment 
Vehicles, Investment Advisers Act Release No. 2576 (Dec. 27, 2006) 
[72 FR 400 (Jan. 4, 2007)] (``Accredited Natural Person Release''), 
at n.69 (discussing the difference between the term BDC under the 
Investment Company Act and the Advisers Act). In 1996, as part of 
NSMIA, Congress sought to encourage greater investment in small 
businesses by giving BDCs more flexibility, and therefore expanded 
the class of eligible portfolio companies in which BDCs could invest 
without being required to provide ``managerial assistance.'' See S. 
Rep. No. 104-293, at 13 (1996).
---------------------------------------------------------------------------

    Congress did not use the existing BDC definitions when determining 
the scope of the venture capital exemption,\126\ and the primary policy 
considerations that led to the adoption of the BDC exemptions differed 
from those under the Dodd-Frank Act. However, we believe these 
provisions are instructive because they reflect many of the same 
characteristics of venture capital and private equity fund activity 
presented in testimony before Congress in connection with the Dodd-
Frank Act.\127\ Although Congress viewed BDC activities as typical of 
``venture capital'' investing,\128\ the BDC provisions are complex. 
Hence, we are proposing a modified version of the definition of 
``making available significant managerial assistance'' in order to 
simplify the language and to reduce the potential for confusion that

[[Page 77201]]

might arise in interpreting the meaning of the term.
---------------------------------------------------------------------------

    \126\ We have looked to the BDC definition to define a venture 
capital fund before. In 2006, we proposed to impose a qualification 
standard for all investors of private investment funds, excluding 
venture capital funds, which we proposed to define by reference to 
section 202(a)(22) of the Advisers Act. See Accredited Natural 
Person Release, supra note 125 (proposing to define the term 
``accredited natural person'' as any natural person who satisfies 
the requirements in Regulation D as an accredited investor and who 
also owns investments of at least $2.5 million). We sought 
additional comment on this proposal in a subsequent release but a 
rule has not been adopted. See Revisions of Limited Offering 
Exemptions in Regulation D, Securities Act Release No. 8828 (Aug. 3, 
2007) [72 FR 45116 (Aug. 10, 2007)].
    \127\ See generally Loy Testimony, supra note 40; McGuire 
Testimony, supra note 41.
    \128\ See 1980 House Report, supra note 44, at 21-2.
---------------------------------------------------------------------------

    We request comment on the approach to managerial assistance in the 
definition of venture capital fund. As we have noted above, 
Congressional testimony asserted that a key characteristic of venture 
capital funds is the provision of managerial assistance. Is this true 
in the industry generally? We request comment on the description of 
managerial assistance in proposed rule 203(l)-1. Is this description 
easier to understand and apply than the definition in section 2(a)(47) 
of the Investment Company Act? \129\ As under the definition of BDC in 
the Advisers and Investment Company Acts, the proposed definition 
specifies the fund or its adviser need only offer assistance. Should 
the rule specify that the fund or its adviser actually provide 
assistance? If so, what if a portfolio company that initially accepts 
the offer of assistance later refuses any actual or further assistance? 
We understand that when venture capital funds invest as a group, there 
may be an understanding among the funds and the portfolio company that 
while all fund advisers may be available to provide managerial 
assistance if necessary, one adviser is generally expected to provide 
most, if not all, of the assistance to the portfolio company. Is that 
understanding correct? Under proposed rule 203(l)-1, venture capital 
funds that invest as a group would only satisfy the definition if each 
venture capital fund (or its adviser) offered (and, if accepted, 
provided) managerial assistance or exercised control.\130\ Should the 
rule specify how managerial assistance or control is to be determined 
in the case of venture capital funds that invest as a group if only one 
fund (or its adviser) provides the assistance? Should the rule specify 
the extent to which each fund (or its adviser) must offer or provide 
managerial assistance or adopt the approach of other regulatory 
definitions of ``venture capital'' funds, which impose strict numerical 
investment or ownership tests for determining whether a venture capital 
fund exercises supervision or influence over the operation or business 
of the operating company? \131\ Does the fact that the assistance need 
only be offered render the condition so readily met that the criterion 
should be removed from the rule? Should our rule provide guidance on 
what constitutes ``control'' under our proposed definition? For 
example, instructions to Form ADV provide a presumption of control if a 
person has the power to vote 25 percent or more of a corporation's 
voting securities, or a person acts as manager of a limited liability 
company.\132\ Should the proposed rule rely on similar or different 
presumptions?
---------------------------------------------------------------------------

    \129\ Section 2(a)(47) of the Investment Company Act states:
     ```Making available significant managerial assistance' by a 
business development company means--
    (A) Any arrangement whereby a business development company, 
through its directors, officers, employees, or general partners, 
offers to provide, and, if accepted, does so provide, significant 
guidance and counsel concerning the management, operations, or 
business objectives and policies of a portfolio company;
    (B) the exercise by a business development company of a 
controlling influence over the management or policies of a portfolio 
company by the business development company acting individually or 
as part of a group acting together which controls such portfolio 
company; or
    (C) with respect to a small business investment company licensed 
by the Small Business Administration to operate under the Small 
Business Investment Act of 1958, the making of loans to a portfolio 
company.
    For purposes of subparagraph (A), the requirement that a 
business development company make available significant managerial 
assistance shall be deemed to be satisfied with respect to any 
particular portfolio company where the business development company 
purchases securities of such portfolio company in conjunction with 
one or more other persons acting together, and at least one of the 
persons in the group makes available significant managerial 
assistance to such portfolio company, except that such requirement 
will not be deemed to be satisfied if the business development 
company, in all cases, makes available significant managerial 
assistance solely in the manner described in this sentence.''
    In contrast to section 2(a)(47) of the Investment Company Act, 
our proposed definitional approach to managerial assistance does not 
specifically define managerial assistance by referring to a fund's 
directors, officers, employees, or general partners or address how 
managerial assistance is determined for funds that invest as a 
group.
    \130\ According to one study, funds focusing on later-stage 
companies and middle-market buyout investing tend to invest 
alongside other funds, whereas venture capital funds focusing on 
early stage companies tend to invest individually in portfolio 
companies. See Fenn et al., supra note 55, at 31.
    \131\ See supra note 70 and accompanying text (discussing the 
California VC exemption and the VCOC exemption).
    \132\ See Amendments to Form ADV, Investment Advisers Act 
Release No. 3060 (July 28, 2010) [75 FR 49234 (Aug. 12, 2010)] 
(``Form ADV Release'').
---------------------------------------------------------------------------

    Our proposed rule provides that when a fund controls the qualifying 
portfolio company, an offer to provide managerial assistance is not 
required. As in the case of ``managerial assistance'' as defined in the 
BDC provisions, the proposed rule presumes that when a fund acquires 
control, it is likely to be exercised. Should the rule specify that in 
all cases managerial assistance includes both the offer of assistance 
as well as the exercise of control? We request comment on whether 
venture capital funds (or their advisers) typically have the personnel 
to provide significant managerial assistance to all of their portfolio 
companies or only a subset. Would the requirement to offer and 
potentially provide managerial assistance to all of a fund's portfolio 
companies result in potential demands on a fund or its adviser that 
could not be satisfied if all or a significant subset of a fund's 
portfolio companies accepted the offer? Alternatively, does the 
proposed definition provide a venture capital fund (including those 
that invest as a group) with sufficient flexibility to determine the 
scope of any managerial assistance or control it may seek to offer (or 
provide) to a portfolio company?
2. Limitation on Leverage
    Under proposed rule 203(l)-1, the definition of a venture capital 
fund for purposes of the exemption would be limited to a private fund 
that does not borrow, issue debt obligations, provide guarantees or 
otherwise incur leverage, in excess of 15 percent of the fund's capital 
contributions and uncalled committed capital, and any such borrowing, 
indebtedness, guarantee or leverage is for a non-renewable term of no 
longer than 120 calendar days.\133\ Under the proposed definition, a 
fund could borrow and still be a venture capital fund provided it did 
not borrow or otherwise use leverage in excess of the specified 
threshold.
---------------------------------------------------------------------------

    \133\ Proposed rule 203(l)-1(a)(4). Similarly, our proposed rule 
would exclude from the definition of ``qualifying portfolio 
company'' a company that borrowed in connection with the venture 
capital fund's investments in the company. Proposed rule 203(l)-
1(c)(4)(ii). See supra section II.A.1 of this Release.
---------------------------------------------------------------------------

    By specifying that loans be non-renewable, we would avoid the 
transformation of short-term debt into long-term debt without full 
repayment to the lender. Should the rule specify other borrowing or 
financing terms or conditions that would nevertheless avoid this type 
of transformation? Do venture capital funds use lines of credit 
repeatedly but pay the outstanding amounts in full before drawing down 
additional credit? Should loans of this nature be included in the 
definition? Under our proposed definition, it would be possible for a 
venture capital fund to issue commercial paper on a short-term basis to 
potential investors because the proposed definition does not specify 
which types of instruments a venture capital fund issues. Should the 
proposed rule specifically exclude commercial paper from debt issuances 
to avoid the potential that a venture capital fund could convert short-
term debt into long-term debt by continuing to roll over its commercial 
paper

[[Page 77202]]

issuances? \134\ This criterion regarding leverage at the venture 
capital fund level is in addition to the conditions relating to a 
qualifying portfolio company's debt issuances in connection with the 
venture capital fund's investment.\135\ Under this condition, a venture 
capital fund seeking to satisfy the definitional criteria could not 
avoid the borrowing element at the portfolio company level by incurring 
such leverage at the venture capital fund level.
---------------------------------------------------------------------------

    \134\ We note that because commercial paper issuers often 
refinance the repayment of maturing commercial paper with newly 
issued commercial paper, they may face roll-over risk, i.e., the 
risk that investors may not be willing to refinance maturing 
commercial paper. These risks became particularly apparent for 
issuers of asset-backed commercial paper beginning in August 2007. 
At that time, structured investment vehicles (``SIVs''), which are 
off-balance sheet funding vehicles sponsored by financial 
institutions, issued commercial paper to finance the acquisition of 
long-term assets, including residential mortgages. As a result of 
problems in the residential home mortgage market, short-term 
investors began to avoid asset-backed commercial paper tied to 
residential mortgages, regardless of whether the securities had 
substantial exposure to sub-prime mortgages. Unable to roll over 
their commercial paper, SIVs suffered severe liquidity problems and 
significant losses. See Money Market Fund Reform, Investment Company 
Act Release No. 28807 (June 30, 2009) [74 FR 32688 (July 8, 2009)] 
(``Money Market Fund Reform Release'') at nn.37-39 and preceding and 
accompanying text; Marcin Dacperczyk and Philipp Schnabl, When Safe 
Proved Risky: Commercial Paper During the Financial Crisis of 2007-
2009 (Nov. 2009).
    \135\ See proposed rule 203(l)-1(c)(4)(ii); supra section 
II.A.1.c of this Release. Because private equity funds often engage 
in leveraged buy-out transactions in which the portfolio company, 
rather than the fund, incurs debt, our proposed definition would 
exclude leveraged buy-out funds.
---------------------------------------------------------------------------

    Congress cited the implementation of trading strategies that use 
financial leverage by certain private funds as creating a potential for 
systemic risk.\136\ In testimony before Congress, the venture capital 
industry identified the lack of financial leverage in venture capital 
funds as a basis for exempting advisers to venture capital funds \137\ 
in contrast to other types of private funds such as hedge funds, which 
may engage in trading strategies that may contribute to systemic risk 
and affect the public securities markets.\138\ For this reason, our 
proposed rule is designed to address concerns that financial leverage 
may contribute to systemic risk by excluding funds that incur more than 
a limited amount of leverage from the definition of venture capital 
fund.\139\
---------------------------------------------------------------------------

    \136\ See, e.g., section 115 of the Dodd-Frank Act (enumerating 
prudential standards for addressing systemic risks, including risk-
based capital requirements, leverage limits, liquidity requirements, 
resolution plan and credit exposure report requirements, 
concentration limits, a contingent capital requirement, enhanced 
public disclosures, short-term debt limits, and overall risk 
management requirements). See also G20 Working Group 1, Enhancing 
Sound Regulation and Strengthening Transparency, at iii-iv (March 
25, 2009) (``G20 Working Group Report''), at iii (noting 
contribution to ``market turmoil'' when ``the financial system 
developed new structures and created new instruments, some with 
embedded leverage.'' Further, ``[w]hile the build-up of leverage and 
the underpricing of credit risk were recognized in advance of the 
turmoil, their extent was under-appreciated and there was no 
coordinated approach to assess the implications of these systemic 
risks * * *''); International Monetary Fund, Lessons of the Global 
Crisis for Macroeconomic Policy, February 19, 2009, at 6 (noting how 
``[l]everage * * * increases lender exposure by magnifying the 
impact of a price adjustment on borrowers' balance sheets and, thus 
on banks' losses and capital.''). See generally Department of 
Treasury, Financial Regulatory Reform, A New Foundation: Rebuilding 
Financial Supervision and Regulation, June 2009, available at http://www.financialstability.gov/docs/regs/FinalReport_web.pdf.
    \137\ See McGuire Testimony, supra note 41, at 7 (``Venture 
capital firms do not use long term leverage, rely on short term 
funding, or create third party or counterparty risk * * * [F]rom 
previous testimony submitted by the buy-out industry, the typical 
capital structure of the companies acquired by a buyout fund is 
approximately 60% debt and 40% equity. In contrast, borrowing at the 
venture capital fund level, if done at all, typically is only used 
for short-term capital needs (pending drawdown of capital from its 
partners) and does not exceed 90 days. Not only are our partnerships 
run without debt but our portfolio companies are usually run without 
debt as well.''); Loy Testimony, supra note 40, at 2 (``Although 
venture capital funds may occasionally borrow on a short-term basis 
immediately preceding the time when the cash installments are due, 
they do not use debt to make investments in excess of the partner's 
capital commitments or `lever up' the fund in a manner that would 
expose the fund to losses in excess of the committed capital or that 
would result in losses to counter parties requiring a rescue 
infusion from the government.'').
    \138\ See S. Rep. No. 111-176, supra note 7, at 74-75.
    \139\ In proposing an exemption for advisers to private equity 
funds, which would have required the Commission to define the term 
private equity fund, the Senate Banking Committee noted the 
difficulties in distinguishing some private equity funds from hedge 
funds and expected the Commission to exclude from the exemption 
private equity funds that raise significant potential systemic risk 
concerns. S. Rep. No. 111-176, supra note 7, at 75. See also G20 
Working Group Report, supra note 136, at 7 (noting that unregulated 
entities such as hedge funds may contribute to systemic risks 
through their trading activities).
---------------------------------------------------------------------------

    We also understand that venture capital funds generally do not rely 
on short-term financing,\140\ which has been identified as another 
potential systemic risk factor.\141\ Should we increase or reduce the 
15 percent threshold for short-term borrowing? If so, what is the 
appropriate threshold (e.g., 20, 10, or 5 percent)? Or should we define 
a venture capital fund as a private fund that does not borrow at all or 
otherwise incur any financial leverage? Would even the limited ability 
to engage in short-term borrowing or other forms of leverage encourage 
venture capital funds to incur other investment risks different from 
those typically associated with venture capital investing today? To the 
extent that venture capital funds use short-term leverage or borrowing, 
90 days has been cited as typical.\142\ Would a 120-day period, as 
specified in our proposed rule, create other investment risks for 
venture capital funds? Our proposed rule refers specifically to 
borrowing but also is designed to give venture capital funds the 
flexibility to issue debt (which is also a form of borrowing) for 
short-term purposes. Should the rule refer specifically to additional 
forms of borrowing not already identified? Do any or many venture 
capital funds borrow in excess of 120 days? Should the 15 percent limit 
not apply when a fund borrows in order to invest in a qualifying 
portfolio company and is repaid with capital called from the fund's 
investors? Would the 120-day limit alone achieve a similar result?
---------------------------------------------------------------------------

    \140\ See Loy Testimony, supra note 40, at 7 (``[V]enture 
capital firms do not generally rely on short-term funding. In fact, 
quite the opposite is true.''); Schell, supra note 101, at Sec.  
1.03[6] (``Venture Capital Funds rarely have the ability to borrow 
money, other than short-term loans to cover Partnership Expenses or 
to `bridge' Capital Contributions.''); Heesen, supra note 104, at 
17.
    \141\ See, e.g., Financial Crisis Inquiry Commission, 
Preliminary Staff Report, Shadow Banking and the Financial Crisis 
(May 4, 2010).
    \142\ See McGuire Testimony, supra note 41, at 7.
---------------------------------------------------------------------------

    Our proposed rule specifies that the 15 percent calculation must be 
determined based on the fund's aggregate capital contributions and 
uncalled capital commitments. Unlike most registered investment 
companies or hedge funds, venture capital funds rely on investors 
funding their capital commitments from time to time in order to acquire 
portfolio companies.\143\ A capital commitment is a contractual 
obligation to acquire an interest in, or provide the total commitment 
amount over time to, a fund, when called by the fund. Accordingly, 
advisers to venture capital funds manage the fund in anticipation of 
all investors fully funding their commitments when due and typically 
have the right to penalize investors for failure to do so.\144\ Venture

[[Page 77203]]

capital funds are subject to investment restrictions, and calculate 
fees payable to an adviser, as a percentage of the total capital 
commitments of investors, regardless of whether or not the capital 
commitment is ultimately funded by an investor.\145\ Venture capital 
fund advisers typically report and market themselves to investors on 
the basis of aggregate capital commitment amounts raised for prior or 
existing funds.\146\ These factors would lead to the conclusion that, 
in contrast to other types of private funds, such as hedge funds, which 
trade on a more frequent basis, a venture capital fund would view the 
fund's total capital commitments as the primary metric for managing the 
fund's assets and for determining compliance with investment 
guidelines. Hence, we believe that calculating the leverage threshold 
to include uncalled capital commitments is appropriate, given that 
capital commitments are already used by venture capital funds 
themselves to measure investment guideline compliance.
---------------------------------------------------------------------------

    \143\ Schell, supra note 101, at Sec.  1.03[8] (``The typical 
Venture Capital Fund calls for Capital Contributions from time to 
time as needed for investments.''); id. at Sec.  2.05[2] (stating 
that ``[venture capital funds] begin operation with Capital 
Commitments but no meaningful assets. Over a specific period of 
time, the Capital Commitments are called by the General Partner and 
used to acquire Portfolio Investments.'').
    \144\ See Loy Testimony, supra note 40, at 5 (``[Limited 
partners] make their investment in a venture fund with the full 
knowledge that they generally cannot withdraw their money or change 
their commitment to provide funds. Essentially they agree to ``lock-
up'' their money for the life of the fund.''). See also Stephanie 
Breslow & Phyllis Schwartz, Private Equity Funds, Formation and 
Operation 2010 (``Breslow & Schwartz''), at Sec.  2:5.6 (discussing 
the various remedies that may be imposed in the event an investor 
fails to fund its contractual capital commitment, including, but not 
limited to, ``the ability to draw additional capital from non-
defaulting investors;'' ``the right to force a sale of the 
defaulting partner's interests at a price determined by the general 
partner;'' and ``the right to take any other action permitted at law 
or in equity'').
    \145\ See, e.g., Breslow & Schwartz, supra note 144, at Sec.  
2:5.7 (noting that a cap of 10% to 25% of remaining capital 
commitments is a common limitation on follow-on investments). See 
also Schell, supra note 101, at Sec.  1.01 (noting that capital 
contributions made by the investors are used to ``make investments * 
* * in a manner consistent with the investment strategy or 
guidelines established for the Fund.''); id. at Sec.  1.03 
(``Management fees in a Venture Capital Fund are usually an annual 
amount equal to a fixed percentage of total Capital Commitments.''); 
see also Dow Jones, Private Equity Partnership Terms and Conditions, 
2007 edition (``Dow Jones Report'') at 15.
    \146\ See, e.g., NVCA Yearbook 2010, supra note 41, at 16; John 
Jannarone, Private Equity's Cash Problem, Wall St. J., June 23, 
2010, http://online.wsj.com/article/SB10001424052748704853404575323073059041024.html#printMode.
---------------------------------------------------------------------------

    The proposed 15 percent threshold would be determined based on the 
venture capital fund's aggregate capital commitments. In practice, this 
means that a venture capital fund relying on the exemption could 
leverage an investment transaction up to 100 percent when acquiring 
equity securities of a particular portfolio company as long as the 
investment amount does not exceed 15 percent of the fund's total 
capital commitments, albeit on a short-term basis that did not exceed 
120 days. Should the 15 percent calculation be determined with respect 
to the total investment amount for each portfolio company? Would this 
standard be easier to apply?
    Our proposed rule defines a venture capital fund by reference to a 
maximum of 15 percent of borrowings based on our understanding that 
venture capital funds typically would not incur borrowings in excess of 
10 to 15 percent of the fund's total capital contributions and uncalled 
capital commitments.\147\ We believe that imposing a maximum at the 
upper range of borrowings typically used by venture capitals may 
accommodate existing practices of the vast majority of industry 
participants.
---------------------------------------------------------------------------

    \147\ See Loy Testimony, supra note 40, at 6 (``[M]any venture 
capital funds significantly limit borrowing such that all 
outstanding capital borrowed by the fund, together with guarantees 
of portfolio company indebtedness, does not exceed the lesser of (i) 
10-15% of total limited partner commitments to the fund and (ii) 
undrawn limited partner commitments.'').
---------------------------------------------------------------------------

3. No Redemption Rights
    Proposed rule 203(l)-1 would define a venture capital fund as a 
fund that issues securities that do not provide investors redemption 
rights except in ``extraordinary circumstances'' but that do entitle 
investors generally to receive pro rata distributions.\148\ Unlike 
hedge funds, venture capital funds do not typically permit investors to 
redeem their interests during the life of the fund,\149\ but rather 
distribute assets generally as investments mature.\150\ Although 
venture capital funds typically return capital and profits to investors 
only through pro rata distributions, such funds may also provide 
extraordinary rights for an investor to withdraw from the fund under 
foreseeable but unexpected circumstances or rights to be excluded from 
particular investments due to regulatory or other legal 
requirements.\151\ These events may be ``foreseeable'' because they are 
circumstances that are known to occur (e.g., changes in law, corporate 
events such as mergers) but are unexpected in their timing or scope. 
Thus, withdrawal or exclusion rights might be triggered by a change in 
the tax law after an investor invests in the fund, or the enactment of 
laws that may prohibit an investor's participation in the fund's 
investment in particular countries or industries.\152\ The trigger 
events for these rights are typically beyond the control of the adviser 
and fund investor (e.g., tax and regulatory changes).
---------------------------------------------------------------------------

    \148\ Proposed rule 203(l)-1(a)(5) (limiting venture capital 
funds to funds that ``[o]nly issue[] securities the terms of which 
do not provide a holder with any right, except in extraordinary 
circumstances, to withdraw, redeem or require the repurchase of such 
securities but may entitle holders to receive distributions made to 
all holders pro rata'').
    \149\ See Schell, supra note 101, at Sec.  1.03[7] (venture 
capital fund ``redemptions and withdrawals are rarely allowed, 
except in the case of legal compulsion''); Breslow & Schwartz, supra 
note 144, at Sec.  2:14.2 (``the right to withdraw from the fund is 
typically provided only as a last resort'').
    \150\ Loy Testimony, supra note 40, at 2-3 (``As portfolio 
company investments are sold in the later years of the [venture 
capital] fund--when the company has grown so that it can access the 
public markets through an initial public offering (an IPO) or when 
it is an attractive target to be bought--the liquidity from these 
`exits' is distributed back to the limited partners. The timing of 
these distributions is subject to the discretion of the general 
partner, and limited partners may not otherwise withdraw capital 
during the life of the venture [capital] fund.''). Id. at 5 
(Investors ``make their investment in a venture [capital] fund with 
the full knowledge that they generally cannot withdraw their money 
or change their commitment to provide funds. Essentially they agree 
to `lock-up' their money for the life of the fund, generally 10 or 
more years as I stated earlier.''). See also Dow Jones Report, supra 
note 145, at 60 (noting that an investor in a private equity or 
venture capital fund typically does not have the right to transfer 
its interest).
    \151\ See Hedge Fund Adviser Registration Release, supra note 
17, at n.240 and accompanying text (``Many partnership agreements 
provide the investor the opportunity to redeem part or all of its 
investment, for example, in the event continuing to hold the 
investment became impractical or illegal, in the event of an owner's 
death or total disability, in the event key personnel at the fund 
adviser die, become incapacitated, or cease to be involved in the 
management of the fund for an extended period of time, in the event 
of a merger or reorganization of the fund, or in order to avoid a 
materially adverse tax or regulatory outcome. Similarly, some 
investment pools may offer redemption rights that can be exercised 
only in order to keep the pool's assets from being considered `plan 
assets' under ERISA [Employee Retirement Income Security Act of 
1974].''). See, e.g., Breslow & Schwartz, supra note 144, at Sec.  
2:14.1 (``Private equity funds generally provide for mandatory 
withdrawal of a limited partner [i.e., investor] only in the case 
where the continued participation by a limited partner in a fund 
would give rise to a regulatory or legal violation by the investor 
or the fund (or the general partner [i.e., adviser] and its 
affiliates). Even then, it is often possible to address the 
regulatory issue by excusing the investor from particular 
investments while leaving them otherwise in the fund.'').
    \152\ See, e.g., Breslow & Schwartz, supra note 144, at Sec.  
2:14.2 (``The most common reason for allowing withdrawals from 
private equity funds arises in the case of an ERISA violation where 
there is a substantial likelihood that the assets of the fund would 
be treated as `plan assets' of any ERISA partner for purposes of 
Title I of ERISA or section 4975 of the Code.''). See also Schell, 
supra note 101, at Sec.  9.04[3] (``Exclusion provisions allow the 
General Partner to exclude a Limited Partner from participation in 
any or all investments if a violation of law or another material 
adverse effect would otherwise occur.''); id. at Appendix D-31 
(attaching model limited partnership agreement providing ``The 
General Partner at any time may cancel the obligations of all 
Partners to make Capital Contributions for Portfolio Instruments if 
* * * changes in applicable law * * * make such cancellation 
necessary or advisable. * * * '').
---------------------------------------------------------------------------

    For these purposes, for example, a fund that permits quarterly or 
other periodic withdrawals would be considered to have granted 
investors redemption rights in the ordinary course even if those rights 
may be subject to an initial lock-up or suspension or restrictions on 
redemption. Is the phrase ``extraordinary circumstances'' sufficiently 
clear to distinguish the investor liquidity terms of venture capital 
funds, as they operate today,

[[Page 77204]]

from hedge funds? Congressional testimony cited an investor's inability 
to withdraw from a venture capital fund as a key characteristic of 
venture capital funds and a factor for reducing their potential for 
systemic risk.\153\ Although a fund prohibiting redemptions would be a 
venture capital fund for purposes of the exemption, the rule does not 
specify a minimum period of time for an investor to remain in the fund. 
Should the rule define when withdrawals by investors would be 
``extraordinary?'' Should the rule specify minimum investment periods 
for investors? Could venture capital funds provide investors with 
``extraordinary'' rights to redeem that could effectively result in 
redemption rights in the ordinary course? \154\ Should we address this 
potential for circumvention of the definition by establishing a maximum 
amount that may be redeemed during any period of time (e.g., 10 percent 
of an investor's total capital commitments)? Would such a limit 
constrain investors in a way so as to prevent them from complying with 
other legal or regulatory requirements?
---------------------------------------------------------------------------

    \153\ See supra notes 149-150 and accompanying text.
    \154\ For example, a private fund's governing documents may 
provide that investors do not have any right to redeem without the 
consent of the general partner. In practice, if the general partner 
typically permits investors to redeem or transfer their otherwise 
non-redeemable, non-transferable interests on a periodic basis, then 
the fund would not be considered to have issued securities that ``do 
not provide a holder with any right, except in extraordinary 
circumstances, to withdraw.''
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4. Represents Itself as a Venture Capital Fund
    Proposed rule 203(l)-1 would limit the definition of venture 
capital fund for the purposes of the exemption to a private fund that 
represents itself as being a venture capital fund to its investors and 
potential investors.\155\ A private fund could satisfy this 
definitional element by, for example, describing its investment 
strategy as venture capital investing or as a fund that is managed in 
compliance with the elements of our proposed rule. Without this 
element, a fund that did not engage in typical venture capital 
activities could be treated as a venture capital fund simply because it 
met the other elements specified in our proposed rule (because for 
example it only invests in short term Treasuries, controls portfolio 
companies, does not borrow, does not offer investors redemption rights, 
and is not a registered investment company).\156\ We believe that only 
funds that do not significantly differ from the common understanding of 
what a venture capital fund is,\157\ and that are actually offered to 
investors as venture capital funds, should qualify for the exemption. 
Thus, an adviser to a venture capital fund that is otherwise relying on 
the exemption could not identify the fund as a hedge fund or multi-
strategy fund (i.e., venture capital is one of several strategies used 
to manage the fund) or include the fund in a hedge fund database or 
hedge fund index.
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    \155\ Proposed rule 203(l)-1(a)(1).
    \156\ We also note that a fund that represents to investors that 
it is one type of fund while pursuing a different type of fund 
strategy may raise concerns under rule 206(4)-8 of the Advisers Act.
    \157\ See Gompers, supra note 110, at 6-7.
---------------------------------------------------------------------------

    We request comment on a venture capital fund's representations 
regarding itself as a criterion under the proposed definition. Is our 
criterion inconsistent with current practice? Does the proposed 
criterion regarding venture capital fund representations adequately 
address our concern that advisers should not be eligible for the 
exemption if they advise funds that otherwise meet the definitional 
criteria in the rule but engage in activities that do not constitute 
venture capital investing?
5. Is a Private Fund
    We propose to define a venture capital fund for the purposes of the 
exemption as a private fund, which is defined in the Advisers Act,\158\ 
and exclude from the proposed definition funds that are registered 
investment companies (e.g., mutual funds) or have elected to be 
regulated as BDCs.\159\ There is no indication that Congress intended 
this exemption to apply to advisers to these publicly available 
funds,\160\ referring to venture capital funds as a ``subset of private 
investment funds.'' \161\ We request comment on this requirement and 
whether it appropriately reflects the expectation of Congress.
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    \158\ See section 202(a)(29) of the Advisers Act.
    \159\ Proposed rule 203(l)-1(a)(6).
    \160\ Legislative history does not indicate that Congress 
addressed this matter, nor does testimony before Congress suggest 
that this was contemplated. See, e.g., McGuire Testimony, supra note 
41, at 3 (noting that venture capital funds are not directly 
accessible by individual investors); Loy Testimony, supra note 40, 
at 2 (``Generally * * * capital for the venture fund is provided by 
qualified institutional investors such as pension funds, 
universities and endowments, private foundations, and to a lesser 
extent, high net worth individuals.''). See generally supra note 158 
(definition of ``private fund'').
    \161\ See S. Rep. No. 111-176, supra note 7, at 74 (describing 
venture capital funds as a subset of ``private investment funds'').
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6. Other Factors
    We request comment on whether the proposed rule should include 
other elements that were described in testimony as characteristic of 
venture capital funds or that distinguish venture capital funds from 
other types of private equity or private funds.\162\ For example, 
testimony presented to Congress indicated that venture capital funds 
typically have capital contributions from their advisers, generally up 
to five percent of the fund's total capital commitments.\163\ Congress 
also received testimony that venture capital funds are generally not 
open to retail investors,\164\ have long investment periods, generally 
of at least ten years,\165\ and contribute to the U.S. economy by 
creating jobs, fostering competition and facilitating innovation.\166\
---------------------------------------------------------------------------

    \162\ See, e.g., Heesen, supra note 104 (generally describing 
characteristics that distinguish venture capital funds from hedge 
funds and buyout funds).
    \163\ See Loy Testimony, supra note 40, at 2 (``[g]enerally, 95 
to 99 percent of capital for the venture fund is provided by * * * 
investors * * * and we supply the rest of the capital for the fund 
from our own personal assets''); McGuire Testimony, supra note 41, 
at 3. Industry data confirm that such investments are typical in the 
venture capital industry. See, e.g., Dow Jones Report, supra note 
145, at 23-24 (showing that, in a survey of 110 North American 
general partners, at least 83% contributed at least 1% of venture 
capital fund capital). We note that certain investors perceive an 
investment in the fund as aligning the interest of investors and 
advisers. See Institutional Limited Partners Association Private 
Equity Principles, September 9, 2009, at 3 (recommending that the 
``general partner should have a substantial equity interest in the 
fund to maintain a strong alignment of interest with the limited 
partners, and a high percentage of the amount should be in cash as 
opposed to being contributed through the waiver of the management 
fee.''); Mercer Investment Consulting, Inc., Key Terms and 
Conditions for Private Equity Investing, 1996 at 13 (``Many limited 
partners view the 1% standard as an inadequate sharing of risk * * * 
.'').
    \164\ See McGuire Testimony, supra note 41, at 3 (``Venture 
capital funds are not sold directly to retail investors like mutual 
funds.''); Loy Testimony, supra note 40, at 2 (``Generally, 95 to 99 
percent of capital for the venture fund is provided by qualified 
institutional investors such as pension funds, universities and 
endowments, private foundations, and to a lesser extent, high net 
worth individuals.'').
    \165\ See Loy Testimony, supra note 40, at 2; McGuire Testimony, 
supra note 41, at 3.
    \166\ See Loy Testimony, supra note 40, at 4; McGuire Testimony, 
supra note 41, at 5.
---------------------------------------------------------------------------

    Are any of these characteristics appropriate to include as elements 
in the definition? If so, which elements should be included and what 
would be appropriate thresholds for application? Do venture capital 
advisers typically invest in the funds they manage? Should we modify 
the proposed rule to include as a condition that advisers relying on 
the exemption under section 203(l) would invest in the venture capital 
fund at a specified minimum threshold? If so, what is an appropriate 
investment threshold--less than one percent, one percent, three 
percent, five percent, or somewhere in between? Should the proposed 
rule be modified to

[[Page 77205]]

specify that venture capital funds have a minimum term, for example, of 
10 years? Should the proposed rule be modified to specify that a 
venture capital fund is one that does not have retail investors? If so, 
how should ``retail investor'' be defined? Should ``retail investor'' 
exclude persons who are not ``qualified clients'' for purposes of the 
Advisers Act?\167\
---------------------------------------------------------------------------

    \167\ Rule 205-3 generally defines a qualified client as any 
person who has at least $750,000 under management with an adviser 
immediately after entering into the contract or who has a net worth 
of more than $1,500,000 at the time the contract is entered into.
---------------------------------------------------------------------------

7. Application to Non-U.S. Advisers
    Neither the statutory text of section 203(l) nor the legislative 
reports gives an indication of whether Congress intended the exemption 
to be available to advisers that operate principally outside of the 
United States but that invest in U.S. companies or solicit U.S. 
investors.\168\ Testimony before Congress presented by members of the 
U.S. venture capital industry discussed the industry's role primarily 
in the U.S. economy including its lack of interconnection with the U.S. 
financial markets and ``interdependence'' with the world financial 
system.\169\ Nevertheless, we expect that venture capital funds with 
advisers operating principally outside of the United States may seek to 
access the U.S. capital markets by investing in U.S. companies or 
soliciting U.S. investors; investors in the United States may also have 
an interest in venture capital opportunities outside of the United 
States. We request comment on whether the proposed rule should specify 
that an adviser with its principal office and place of business outside 
of the United States (a ``non-U.S. adviser'') is eligible to rely on 
the exemption even if it advises funds that do not meet our proposed 
definition of venture capital fund.
---------------------------------------------------------------------------

    \168\ See section 203(l) of the Advisers Act; H. Rep. No. 111-
517, supra note 7, at 867; S. Rep. No. 111-176, supra note 7, at 74-
75.
    \169\ See Loy Testimony, supra note 40, at 4-5; McGuire 
Testimony, supra note 41, at 5-6.
---------------------------------------------------------------------------

    A non-U.S. adviser currently may rely on the private adviser 
exemption, if it meets the conditions of current section 203(b)(3) of 
the Advisers Act, including advising no more than 14 clients.\170\ We 
have permitted such an adviser to count only clients that are residents 
of the United States,\171\ and for this purpose permitted the adviser 
to treat a private fund incorporated outside of the United States as a 
non-resident of the United States, even if some or all of the investors 
in the private fund are residents of the United States.\172\ A non-U.S. 
adviser may rely on the venture capital exemption if all of its 
clients, whether U.S. or non-U.S., are venture capital funds. In 
effecting the new venture capital exemption, should we specifically 
provide that a non-U.S. adviser may avail itself of the exemption even 
if it advises clients other than venture capital funds, provided such 
clients are non-United States persons, under the definition we propose 
for purposes of the other exemptions discussed below? \173\ If we take 
this approach, should the non-U.S. adviser be able to rely on the 
venture capital exemption if it advises these other clients from within 
the United States?
---------------------------------------------------------------------------

    \170\ See supra note 5 and accompanying text.
    \171\ See rule 203(b)(3)-1(b)(5).
    \172\ See rule 203(b)(3)-1(a)(2). See also ABA Subcommittee on 
Private Investment Companies, SEC Staff No-Action Letter (Aug. 10, 
2006) (``ABA Letter''). In the ABA Letter, Commission staff 
expressed the view that the substantive provisions of the Advisers 
Act do not apply to offshore advisers with respect to such advisers' 
dealings with offshore funds and other offshore clients to the 
extent described in prior staff no-action letters and the Hedge Fund 
Adviser Registration Release, supra note 17. The staff took the 
position, however, that an offshore adviser registered with the 
Commission under the Advisers Act must comply with the Advisers Act 
and the Commission's rules thereunder with respect to any U.S. 
clients (and any prospective U.S. clients) it may have.
    \173\ See proposed rule 203(m)-1(e)(8); proposed rule 
202(a)(30)-1(c)(2)(i).
---------------------------------------------------------------------------

    If a non-U.S. adviser must advise solely venture capital funds 
(even those advisers that principally operate outside of the United 
States) our proposed definition may have the result of subjecting non-
U.S. advisers to United States regulatory oversight because they advise 
funds offered only outside the United States. Under our proposed rule, 
only a private fund as defined under section 202(a)(29) may be a 
venture capital fund.\174\ A non-U.S. fund that uses U.S. 
jurisdictional means in the offering of the securities it issues and 
relies on sections 3(c)(1) or 3(c)(7) would be a private fund.\175\ A 
non-U.S. fund that does not make such a U.S. offering would not be a 
private fund and therefore could not qualify as a venture capital fund, 
even if operated as a venture capital fund in a manner that would 
otherwise meet the criteria under our proposed definition. If we adopt 
the approach we are proposing today, should we allow an adviser to 
treat such a non-U.S. fund as a private fund and, to the extent that 
the fund meets all of the other conditions of our proposed definition, 
as a venture capital fund for purposes of the exemption? If so, under 
what conditions? For example, should a non-U.S. fund be a private fund 
under the proposed rule if the non-U.S. fund would be deemed a private 
fund upon conducting a private offering in the United States in 
reliance on sections 3(c)(1) or 3(c)(7)?
---------------------------------------------------------------------------

    \174\ See proposed rule 203(l)-1(a).
    \175\ An issuer that is organized under the laws of the United 
States or of a state is a private fund if it is excluded from the 
definition of an investment company for most purposes under the 
Investment Company Act pursuant to sections 3(c)(1) or 3(c)(7). 
Section 7(d) of the Investment Company Act prohibits a non-U.S. fund 
from using U.S. jurisdictional means to make a public offering, 
absent an order permitting registration. A non-U.S. fund may conduct 
a private U.S. offering without violating section 7(d) only if the 
fund complies with either section 3(c)(1) or 3(c)(7) with respect to 
its U.S. investors (or some other available exemption or exclusion). 
Consistent with this view, a non-U.S. fund is a private fund if it 
makes use of U.S. jurisdictional means to, directly or indirectly, 
offer or sell any security of which it is the issuer and relies on 
either section 3(c)(1) or 3(c)(7). See Hedge Fund Adviser 
Registration Release, supra note 17, at n.226; Offer and Sale of 
Securities to Canadian Tax-Deferred Retirement Savings Accounts, 
Securities Act Release No. 7656 (Mar. 19, 1999) [64 FR 14648 (Mar. 
26, 1999)], at nn.10, 20, 23; Statement of the Commission Regarding 
Use of Internet Web Sites to Offer Securities, Solicit Securities 
Transactions or Advertise Investment Services Offshore, Securities 
Act Release No. 7516 (Mar. 23, 1998) [63 FR 14806 (Mar. 27, 1998)], 
at n.41. See also Dechert LLP, SEC Staff No-Action Letter (Aug. 24, 
2009) at n.8; Goodwin, Procter & Hoar LLP, SEC Staff No-Action 
Letter (Feb. 28, 1997) (``Goodwin Procter Letter''); Touche Remnant 
& Co., SEC Staff No-Action Letter (Aug. 27, 1984).
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8. Grandfathering Provision
    We propose to include in the definition of ``venture capital fund'' 
any private fund that: (i) Represented to investors and potential 
investors at the time the fund offered its securities that it is a 
venture capital fund; (ii) has sold securities to one or more investors 
prior to December 31, 2010; and (iii) does not sell any securities to, 
including accepting any additional capital commitments from, any person 
after July 21, 2011 (the ``grandfathering provision'').\176\ The 
grandfathering provision thus would include any fund that has accepted 
capital commitments by the specified dates even if none of the 
commitments has been called.\177\ As a result, any investment adviser 
that solely advises private funds that meet the definitions in either 
proposed rule 203(l)-1(a) or (b) would be exempt from registration.
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    \176\ Proposed rule 203(l)-1(b).
    \177\ See also Electronic Filing and Revision of Form D, 
Securities Act Release No. 8891(Feb. 6, 2008) [73 FR 10592 (Feb. 27, 
2008)], at section VIII, Form D, General Instructions--When to File 
(noting that a Form D is required to be filed within 15 days of the 
first sale of securities which would include ``the date on which the 
first investor is irrevocably contractually committed to invest''), 
n.159 (``a mandatory capital commitment call would not constitute a 
new offering, but would be made under the original offering'').
---------------------------------------------------------------------------

    We believe that most funds previously sold as venture capital funds 
likely would satisfy all or most of the conditions in the proposed 
rule.

[[Page 77206]]

Nevertheless, we recognize that investment advisers currently seeking 
to sponsor new funds before the adoption of the final version of 
proposed rule 203(l)-1 will continue to face uncertainty regarding the 
precise terms of the definition and hence uncertainty regarding their 
eligibility for the new exemption. Thus, our proposed rule presumes 
that a fund that has commenced its offering (i.e., has initially sold 
securities by December 2010) and that also concludes its offering by 
the effective date of Title IV of the Dodd-Frank Act (i.e., July 21, 
2011) is unlikely to have been structured to circumvent the intended 
scope of the exemption. Moreover, requiring existing venture capital 
funds to modify their investment conditions or characteristics, 
liquidate portfolio company holdings or alter the rights of investors 
in the funds in order to satisfy the proposed definition of a venture 
capital fund would likely be impossible in many cases and yield 
unintended consequences for the funds and their investors.
    Thus, we propose that an investment adviser may treat any existing 
private fund as a venture capital fund for purposes of section 203(l) 
of the Advisers Act if the fund meets the elements of the 
grandfathering provision. The current private adviser exemption does 
not require an adviser to identify or characterize itself as any type 
of adviser (or impose limits on advising any type of funds). 
Accordingly, we believe that advisers have not had an incentive to mis-
characterize existing venture capital funds that have already been 
marketed to investors. As we note above, a fund that ``represents'' 
itself to investors as a venture capital fund is typically one that 
discloses it pursues a venture capital investing strategy and 
identifies itself as such. We do not expect funds identifying 
themselves as ``private equity'' or ``hedge'' would be able to rely on 
this exemption.
    We request comment on this grandfathering provision. Should we 
include other conditions in addition to the fund representing itself as 
a venture capital fund? For example, should a fund seeking to be 
grandfathered also provide that its investors do not have any 
redemption rights except in extraordinary circumstances,\178\ not incur 
leverage except on a short-term basis,\179\ limit the securities that 
it acquires from portfolio companies to equity securities,\180\ or 
provide significant managerial assistance to the portfolio companies in 
which the fund invests? \181\ Should the grandfathering provision be 
modified to exclude other types of funds, such as funds of venture 
capital funds or publicly available venture capital funds? \182\ We 
understand that venture capital funds may be in the planning and 
initial offering stage for a considerable period of time.\183\ Should 
funds that have their first sale of securities within a period of time 
such as 180 days after the final rule is adopted be able to rely on the 
proposed grandfathering provision? Does our grandfathering provision 
unnecessarily encourage the formation of new funds before December 31, 
2010, and therefore should the grandfathering provision only apply to 
funds in existence on the date of this proposal or some other time 
before December 31, 2010? Would the dates specified in the 
grandfathering provision significantly shorten the fundraising periods 
for venture capital funds? Should we specify a date later than December 
31, 2010 or earlier than July 21, 2011? Do venture capital fund 
advisers need more time or flexibility to determine eligibility for the 
grandfathering provision? Alternatively, would exempt advisers consider 
registering with the Commission in order to retain flexibility to raise 
capital for new venture capital funds without regard to the 
grandfathering provision?
---------------------------------------------------------------------------

    \178\ See proposed rule 203(l)-1(a)(5); supra discussion in 
section II.A.4 of this Release.
    \179\ See proposed rule 203(l)-1(a)(4); supra discussion in 
section II.A.3 of this Release.
    \180\ See proposed rule 203(l)-1(a)(1); supra discussion in 
section II.A.1.b of this Release.
    \181\ See proposed rule 203(l)-1(a)(3); supra discussion in 
section II.A.2 of this Release.
    \182\ See supra discussion in sections II.A.1.e and II.A.6 of 
this Release.
    \183\ See Breslow & Schwartz, supra note 144, at Sec.  2:4.1 
(private equity fundraising may take six to 12 months following the 
initial closing, depending upon whether the adviser has an existing 
investor base or a successful performance record).
---------------------------------------------------------------------------

B. Exemption for Investment Advisers Solely to Private Funds With Less 
Than $150 Million in Assets Under Management

    Section 203(m) of the Advisers Act directs the Commission to exempt 
from registration any investment adviser solely to private funds that 
has less than $150 million in assets under management in the United 
States.\184\ We are proposing a new rule 203(m)-1 that would provide 
the exemption and address several interpretive questions raised by 
section 203(m). We will refer to this exemption as the ``private fund 
adviser exemption.''
---------------------------------------------------------------------------

    \184\ Section 408 of the Dodd-Frank Act, which is codified in 
section 203(m) of the Advisers Act. See supra note 22.
---------------------------------------------------------------------------

1. Advises Solely Private Funds
    Proposed rule 203(m)-1 would, like section 203(m) of the Advisers 
Act, limit an adviser relying on the exemption to advising ``private 
funds'' as that term is defined in that Act.\185\ An adviser that 
acquires a different type of client would have to register under the 
Advisers Act unless another exemption is available. An adviser could 
advise an unlimited number of private funds, provided the aggregate 
value of the adviser's private fund assets is less than $150 million.
---------------------------------------------------------------------------

    \185\ See proposed rule 203(m)-1(a) and (b). A ``private fund'' 
includes a private fund that invests in other private funds.
---------------------------------------------------------------------------

    In the case of an adviser with a principal office and place of 
business outside of the United States (a ``non-U.S. adviser''), we 
propose to provide the exemption as long as all of the adviser's 
clients that are United States persons are qualifying private 
funds.\186\ As a consequence, a non-U.S. adviser could enter the U.S. 
market and take advantage of the exemption without regard to the type 
or number of its non-U.S. clients. Under this approach, a non-U.S. 
adviser would not lose the private fund adviser exemption as a result 
of its business activities outside the United States. Recognizing that 
non-U.S. activities of non-U.S. advisers are less likely to implicate 
U.S. regulatory interests and in consideration of general principles of 
international comity, our rules have taken a similar approach by 
permitting a non-U.S. adviser to count only clients that are U.S. 
persons when determining whether it has 14 or fewer clients, and is 
thus eligible for the private adviser exemption.\187\
---------------------------------------------------------------------------

    \186\ Proposed rule 203(m)-1(b)(1).
    \187\ Rule 203(b)(3)-1(b)(5) (``If you have your principal 
office and place of business outside the United States, you are not 
required to count clients that are not United States residents, but 
if your principal office and place of business is in the United 
States, you must count all clients.''). See infra note 207.
---------------------------------------------------------------------------

    We request comment on our proposed application of the statute to 
non-U.S. advisers. Should we, alternatively, interpret section 203(m) 
as denying the private fund adviser exemption to a non-U.S. adviser 
that has other types of clients outside of the United States? This 
interpretation would have the effect of treating non-U.S. and U.S. 
advisers equally with respect to the types of clients they may have, 
but could also have the result of requiring many non-U.S. advisers to 
register because of the scope and nature of their non-U.S. advisory 
business, an outcome which the ``assets under management in the United 
States'' limitation in section 203(m) suggests was not a consideration 
relevant to the scope of the exemption.

[[Page 77207]]

Under such an approach, moreover, the exemption would be unavailable to 
a non-U.S. adviser unless all of the non-U.S. funds it manages are 
offered to investors in the United States (and therefore meet the 
definition of ``private fund'').\188\ If we adopt this alternative 
approach, should the exemption apply to a non-U.S. adviser even if not 
all of the non-U.S. funds it manages are offered in the United States?
---------------------------------------------------------------------------

    \188\ See supra note 174-175 and accompanying paragraph.
---------------------------------------------------------------------------

2. Private Fund Assets
    Under proposed rule 203(m)-1, an adviser would have to aggregate 
the value of all assets of private funds it manages in the United 
States to determine if the adviser remains below the $150 million 
threshold.\189\ Proposed rule 203(m)-1 would require advisers to 
calculate the value of private fund assets by reference to Form ADV, 
under which we propose to provide a uniform method of calculating 
assets under management for regulatory purposes under the Advisers 
Act.\190\ In the case of a sub-adviser, it would have to count only 
that portion of the private fund assets for which it has 
responsibility.\191\
---------------------------------------------------------------------------

    \189\ Proposed rule 203(m)-1(c).
    \190\ See proposed rules 203(m)-1(a)(2); 203(m)-1(b)(2); 203(m)-
1(e)(1) (defining ``assets under management'' to mean ``regulatory 
assets under management'' in proposed item 5.F of Form ADV, Part 
1A); 203(m)-1(e)(4) (defining ``private fund assets'' to mean the 
assets under management attributable to a qualifying private fund). 
This uniform method of calculation would be used to determine 
whether an adviser qualifies to register with the Commission rather 
than the states, as well as to determine eligibility for the private 
fund adviser exemption and the foreign private adviser exemption 
discussed in this Release. Under the proposed Form ADV instructions, 
advisers would include in their ``regulatory assets under 
management'' any proprietary assets, assets managed without 
receiving compensation, and assets of non-U.S. clients, all of which 
an adviser may currently exclude, as well as, in the case of private 
funds, uncalled capital commitments. Moreover, the adviser could not 
deduct liabilities, such as accrued fees and expenses or the amount 
of any borrowing. See Implementing Release, supra note 25, at 
section II.A.3 (discussing the rationale underlying the proposed new 
instructions for calculating assets under management under Form 
ADV).
    \191\ See proposed Form ADV: Instructions for Part 1A, instr. 
5.b(2).
---------------------------------------------------------------------------

    In addition to assets appearing on a private fund's balance sheet, 
advisers would include any uncalled capital commitments, which are 
contractual obligations of an investor to acquire an interest in, or 
provide the total commitment amount over time to, a private fund, when 
called by the fund.\192\ Advisers to private funds that use capital 
commitments seek investments early in the life of the fund in 
anticipation of all investors fully paying in these capital commitments 
during the life of the fund, and fees payable to the adviser are 
calculated as a percentage of total capital commitments.\193\ Many of 
these types of private funds are managed following investment 
guidelines and restrictions that are determined as a percentage of 
overall capital commitments, rather than as a percentage of current net 
asset value.\194\ We request comment on whether the method for 
calculating the relevant assets under management should deviate from 
the method in the proposed amendments to Form ADV instructions by, for 
example, excluding proprietary assets, assets managed without 
compensation, or uncalled capital commitments.
---------------------------------------------------------------------------

    \192\ See proposed Form ADV: Instructions for Part 1A, instr. 
5.b(1).
    \193\ See supra notes 143-145.
    \194\ Id.
---------------------------------------------------------------------------

    Under proposed rule 203(m)-1, each adviser would have to determine 
the amount of its private fund assets quarterly, based on the fair 
value of the assets at the end of the quarter.\195\ We propose that 
advisers use the fair value of private fund assets in order to ensure 
that, for purposes of this exemption, advisers value private fund 
assets on a meaningful and consistent basis. Use of the cost basis 
(i.e., the value at which the assets were originally acquired), for 
example, could under certain circumstances understate significantly the 
value of appreciated assets, and thus result in advisers availing 
themselves of the exemption. Use of the fair valuation method by all 
advisers, moreover, would result in more consistent asset calculations 
and reporting across the industry and, therefore, in a more coherent 
application of the Advisers Act's regulatory requirements and of our 
staff's risk assessment program.
---------------------------------------------------------------------------

    \195\ See proposed rule 203(m)-1(c); supra note 190; proposed 
Form ADV: Instructions for Part 1A, instr. 5.b(4). As discussed in 
the Implementing Release, we are proposing to require advisers to 
value private fund assets using fair value when calculating their 
assets under management for several purposes under the Advisers Act. 
See Implementing Release, supra note 25, at section II.A.3. A fund's 
governing documents may provide for a specific process for 
calculating fair value (e.g., that the general partner, rather than 
the board of directors, determines the fair value of the fund's 
assets). An adviser would be able to rely on such a process also for 
purposes of calculating its assets under management.
---------------------------------------------------------------------------

    We understand that many, but not all, private funds value assets 
based on their fair value in accordance with U.S. generally accepted 
accounting principles (``GAAP'') or other international accounting 
standards.\196\ Some private funds do not use fair value methodologies, 
which may be more difficult to apply when the fund holds illiquid or 
other types of assets that are not traded on organized markets.\197\ 
Would the proposed approach result in advisers valuing their private 
fund assets in a generally uniform manner and in comparability of the 
valuations? We are not proposing to require advisers to determine fair 
value in accordance with GAAP. Should we adopt such a requirement? If 
not, should we specify that advisers may only determine the fair value 
of private fund assets in accordance with a body of accounting 
principles used in preparing financial statements? We understand that 
GAAP does not require some funds to fair value certain investments. 
Should we provide for an exception from the proposed fair valuation 
requirement with respect to any of those investments?
---------------------------------------------------------------------------

    \196\ See, e.g., Comment Letter of National Venture Capital 
Association (July 28, 2009), at 2 (the ``vast majority of venture 
capital funds provide their LPs [i.e., investors] quarterly and 
audited annual financial reports. These reports are prepared under 
generally accepted accounting principles, or GAAP, and audited under 
the standards established for all investment companies, including 
the largest mutual fund complexes.''); Comment Letter of Managed 
Funds Association (July 28, 2009), at 3 (a ``substantial proportion 
of hedge fund managers, whether or not they are registered with the 
Commission, provide independently audited financial statements of 
the [hedge] fund to investors.''). These comment letters were 
submitted in connection with the Commission's proposed amendments to 
the custody rule, Custody of Funds or Securities of Clients by 
Investment Advisers, Investment Advisers Act Release No. 2876 (May 
20, 2009) [74 FR 25354 (May 27, 2009)], and are available on the 
Commission's Internet Web site at http://www.sec.gov/comments/s7-09-09/s70909.shtml.
    \197\ Those assets include, for example, ``distressed debt'' 
(such as securities of companies or government entities that are 
either already in default, under bankruptcy protection, or in 
distress and heading toward such a condition) or certain types of 
emerging market securities that are not readily marketable. See 
Gerald T. Lins et al., Hedge Funds and Other Private Funds: Reg and 
Comp Sec.  5:22 (2009) (``At any given time, some portion of a hedge 
fund's portfolio holdings may be illiquid and/or difficult to value. 
This is particularly the case for certain types of hedge funds, such 
as those focusing on distressed securities, activist investing, 
etc.'').
---------------------------------------------------------------------------

    Should we adopt a different approach altogether and allow advisers 
to use a method other than fair value? Are there other methods that 
would not understate the value of fund assets? Should the rule permit 
advisers to rely exclusively on the method set forth in a fund's 
governing documents, or the method used to report the value of assets 
to investors or to calculate fees (or other compensation) for 
investment advisory services? What method should apply if a fund uses 
different methods for different purposes? Should we modify the proposed 
rule to require that the valuation be derived from audited financial 
statements or subject to review

[[Page 77208]]

by auditors or another independent third party?
    As discussed above, we are proposing that funds value assets no 
less frequently than quarterly, although such values are not subject to 
quarterly reporting to us.\198\ As a consequence, short-term market 
value fluctuations would not affect the availability of the exemption 
between the ends of calendar quarters. We request comment on our 
proposed quarterly calculation. Should compliance with the $150 million 
threshold be determined more or less frequently than quarterly? For 
purposes of reporting on proposed amendments on Form ADV, registered 
investment advisers (and exempt reporting advisers) would be required 
to report their regulatory assets under management annually.\199\ 
Should the availability of the exemption under proposed rule 203(m)-1 
be conditioned on annual valuation rather than quarterly valuation?
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    \198\ The proposed frequency of the calculation is consistent 
with section 2(a)(41)(A) of the Investment Company Act, which 
specifies the valuation of the assets of an issuer for purposes of 
determining whether it meets the definition of investment company 
under section 3 of that Act.
    \199\ See proposed rules 204-1(a) and 204-4(a) and proposed 
General Instruction 3 to Form ADV. See Implementing Release, supra 
note 25, at section II.B.3. See also Form ADV Release, supra note 
132, at 15 (``Advisers must update the amount of their assets under 
management annually (as part of their annual updating amendment) and 
make interim amendments only for material changes in assets under 
management when they are filing an `other than annual amendment' for 
a separate reason.'').
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3. Assets Managed in the United States
    Under proposed rule 203(m)-1, all of the private fund assets of an 
adviser with a principal office and place of business in the United 
States would be considered to be ``assets under management in the 
United States,'' even if the adviser has offices outside of the United 
States.\200\ A non-U.S. adviser, however, would need only count private 
fund assets it manages from a place of business in the United States 
toward the $150 million asset limit under the exemption.\201\
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    \200\ Proposed rule 203(m)-1(a). The proposed rule also would 
define the United States to have the same meaning as in rule 902(l) 
of Regulation S under the Securities Act, which is ``the United 
States of America, its territories and possessions, any State of the 
United States, and the District of Columbia.'' Proposed rule 203(m)-
1(e)(7).
    \201\ Proposed rule 203(m)-1(b). Any assets managed from a U.S. 
place of business for clients other than private funds would make 
the exemption unavailable. We understand that others have supported 
a jurisdictional approach to regulation, which focuses on the 
primary market in which an adviser conducts its business. See, e.g., 
G20 Working Group Report, supra note 136, at 16; Testimony of W. 
Todd Groome, Chairman, The Alternative Investment Management 
Association, before the House Subcommittee on Capital Markets, 
Insurance and Government Sponsored Enterprises, May 7, 2009, at 3. 
These commenters propose an approach that looks to the location 
where the primary business is conducted, which is similar to our 
territorial approach.
---------------------------------------------------------------------------

    Rule 203(m)-1 would deem all of the assets managed by an adviser to 
be managed ``in the United States'' if the adviser's ``principal office 
and place of business'' is in the United States. We would look to an 
adviser's principal office and place of business as the location where 
the adviser controls, or has ultimate responsibility for, the 
management of private fund assets, and therefore as the place where all 
the advisers' assets are managed, although day-to-day management of 
certain assets may also take place at another location. This approach 
is similar to the way we have identified the location of the adviser 
for regulatory purposes under our current rules,\202\ which define an 
adviser's principal office and place of business as the location where 
it ``directs, controls and coordinates'' its global advisory 
activities, regardless of the location where some of the advisory 
activities might occur.\203\ For most advisers, this approach would 
avoid difficult attribution determinations that would be required if 
assets are managed by teams located in multiple jurisdictions, or if 
portfolio managers located in one jurisdiction rely heavily on research 
or other advisory services performed by employees located in another 
jurisdiction.
---------------------------------------------------------------------------

    \202\ See rule 203A-3(c); rule 222-1. Both rules define 
``principal place of business'' of an investment adviser as the 
executive office of the investment adviser from which the officers, 
partners or managers of the investment adviser direct, control and 
coordinate the activities of the investment adviser.
    \203\ See proposed rule 203(m)-1(e)(3) (defining ``principal 
office and place of business'' as the adviser's executive office 
from which the officers, partners, or managers of the adviser 
direct, control, and coordinate the adviser's activities); proposed 
rule 203(m)-1(e)(2) (defining ``place of business,'' by reference to 
proposed rule 222-1(a), as (i) an office where the investment 
adviser regularly provides investment advisory services, solicits, 
meets with, or otherwise communicates with clients, and (ii) any 
other location that it holds out to the general public as a place 
where those activities take place).
---------------------------------------------------------------------------

    We considered but decided not to propose an approach that would 
presume that a non-U.S. adviser to private funds offered in the United 
States would have no assets managed from a location in the United 
States if its principal office and place of business is not ``in the 
United States.''\204\ Such an interpretation of the statute would treat 
U.S. advisers the same as non-U.S. advisers, but would seem to ignore 
the fact that day-to-day management of some assets of the private fund 
does in fact take place ``in the United States,'' even though that 
management is ultimately controlled from outside of the United States. 
Moreover, it would permit an adviser engaging in substantial advisory 
activities in the United States to escape our regulatory oversight 
merely because the adviser's principal office and place of business is 
outside the United States. This consequence seems at odds not only with 
section 203(m), but also with the ``foreign private adviser'' exemption 
discussed below in which Congress specifically set forth circumstances 
under which a non-U.S. adviser may be exempt provided it does not have 
any place of business in the United States, among other 
conditions.\205\
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    \204\ Under our proposed rule, assets under management for 
purposes of the exemption are those assets for which the adviser 
provides ``continuous and regular supervisory or management 
services.'' See proposed rule 203(m)-1(e)(1); proposed Form ADV: 
Instructions for Part 1A, instr. 5.b(3). For a non-U.S. adviser, the 
assets for which the adviser provides such services from a place of 
business in the United States would count towards the $150 million 
asset threshold under the exemption. See proposed rule 203(m)-
1(b)(2). See also supra note 203 for the definition of ``place of 
business'' under proposed rule 203(m)-1(e)(2).
    \205\ See section II.C of this Release.
---------------------------------------------------------------------------

    We request comment on our proposed approach, which is similar to 
the way we have administered the current private adviser exemption in 
section 203(b)(3) of the Advisers Act with respect to non-U.S. 
advisers. Under that exemption (as discussed above), an adviser with a 
principal office and place of business outside of the United States 
need only count clients that are residents of the United States towards 
the 14 client limit.\206\ As with other Commission rules that adopt a 
territorial approach, the private adviser exemption is available to a 
non-U.S. adviser (regardless of its non-U.S. advisory activities) in 
recognition of the fact that non-U.S. activities of non-U.S. advisers 
are less likely to implicate U.S. regulatory interests and in 
consideration of general principles of international comity.\207\ This 
approach to the exemption is designed to encourage the participation of 
non-U.S. advisers in the

[[Page 77209]]

U.S. market by applying the U.S. securities laws in a manner that does 
not impose U.S. regulatory and operational requirements on an adviser's 
non-U.S. advisory business.\208\
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    \206\ Rule 203(b)(3)-1(b)(5) (adviser with principal office and 
place of business outside of the United States not required to count 
clients that are not United States residents, but adviser with 
principal office and place of business is in the United States must 
count all clients). Our staff has taken the position that under the 
existing private adviser exemption, a non-U.S. adviser need not 
count its non-U.S. clients, including an offshore fund, even if 
there are U.S. investors in the fund. See ABA Letter, supra note 
172, at 2 and discussion infra section II.C.1 of this Release.
    \207\ See, e.g., Regulation S (adopting a territorial approach 
to offers and sales of securities); rule 15a-6 under the Exchange 
Act (17 CFR 240.15a-6) (providing an exemption from U.S. 
registration for non-U.S. broker-dealers who limit their activities 
and satisfy certain conditions).
    \208\ See generally Division of Investment Management, SEC, 
Protecting Investors: A Half Century of Investment Company 
Regulation, May 1992, at 223-227 (recognizing that non-U.S. advisers 
that registered with the Commission were arguably subject to all of 
the substantive provisions of the Advisers Act with respect to their 
U.S. and non-U.S. clients, which could result in inconsistent 
regulatory requirements or practices imposed by the regulations of 
their local jurisdiction and the U.S. securities laws; in response, 
advisers could form separate and independent subsidiaries but this 
could result in U.S. clients having access to a limited number of 
advisory personnel and reduced access by the U.S. subsidiary to 
information or research by non-U.S. affiliates).
---------------------------------------------------------------------------

    Should we adopt a different approach that more broadly applies the 
availability of the private fund adviser exemption to U.S. advisers? We 
could treat U.S. and non-U.S. advisers alike, in which case a U.S. 
adviser could exclude assets it manages through non-U.S. offices. Under 
the proposed rule, would some or most advisers with non-U.S. branch 
offices re-organize those offices as subsidiaries in order to avoid 
attributing assets managed to the non-U.S. office? We understand that 
U.S. advisers that manage private fund assets in a non-U.S. country 
typically do so through one or more separate subsidiaries organized in 
such non-U.S. jurisdictions.\209\ If so, the proposed rule may have a 
limited effect on multi-national advisory firms, which for tax or 
business reasons keep their non-U.S. advisory activities separate from 
their U.S. advisory activities. Is this understanding correct? Such 
U.S. advisers would not generally have to count the assets managed by 
the non-U.S. affiliates under the proposed rule.\210\ Should our rule 
determine ``private fund assets'' on an aggregated basis if, for 
example, U.S. and non-U.S. affiliates share advisory duties for a 
private fund, or if one affiliate provides subadvisory services to 
another affiliate?
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    \209\ See, e.g., James D. Rosener, Legal Considerations for 
Establishing Operations in the United States, Pepper Hamilton LLP, 
June 25, 2002, http://www.pepperlaw.com/publications_article.aspx?ArticleKey=186 (creating separate subsidiaries offers 
benefits, including the ability to offset profits from one 
subsidiary against losses in another); see also Edward F. Greene, et 
al., U.S. Regulation of the International Securities and Derivatives 
Markets, Sec.  11.02[2].
    \210\ See infra note 270.
---------------------------------------------------------------------------

    Alternatively, should we interpret ``assets under management in the 
United States'' by reference to the source of the assets (i.e., U.S. 
private fund investors)? Under this approach, a non-U.S. adviser would 
count the assets of private funds attributable to U.S. investors 
towards the $150 million threshold, regardless of the location where it 
manages the private funds. We note that this approach could have the 
result that fewer non-U.S. advisers would be eligible for the exemption 
if there are significant assets of U.S. investors in those funds that 
the advisers manage from a non-U.S. location. This approach could also 
mean that a U.S. adviser managing assets from, for example, an office 
in New York City, could manage substantially in excess of $150 million 
in assets of one or more private funds as long as the investors in 
those funds were not U.S persons.
    Do commenters view either of these alternatives, separately or in 
combination with our proposed approach, as more closely reflecting the 
intent of Congress in using the term ``assets under management in the 
United States'' and our regulatory interests? Would either alternative 
approach be easier for advisers to comply with than the one we are 
proposing to adopt? Would it be easier for investors to understand the 
rationale for why an adviser is eligible for the exemption under the 
proposed approach or either of the alternative approaches?
4. United States Person
    Under proposed rule 203(m)-1(b), a non-U.S. adviser could not rely 
on the exemption if it advised any client that is a United States 
person other than a private fund.\211\ We propose to define a ``United 
States person'' generally by incorporating the definition of a ``U.S. 
person'' in our Regulation S.\212\ Regulation S looks generally to the 
residence of an individual to determine whether the individual is a 
United States person,\213\ and also addresses the circumstances under 
which a legal person, such as a trust, partnership or a corporation, is 
a United States person.\214\ Regulation S generally treats legal 
partnerships and corporations as Unites States persons if they are 
organized or incorporated in the United States, and trusts by reference 
to the residence of the trustee.\215\ It treats discretionary accounts 
generally as United States persons if the fiduciary is a resident of 
the United States.\216\
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    \211\ Proposed rule 203(m)-1(b)(1).
    \212\ Proposed rule 203(m)-1(e)(8).
    \213\ 17 CFR 230.902(k)(1)(i).
    \214\ See, e.g., 17 CFR 230.902(k)(1) and (2).
    \215\ 17 CFR 230.902(k)(1)(ii) and (iv).
    \216\ 17 CFR 230.902(k)(1)(vii).
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    We are proposing to incorporate Regulation S because it would 
provide a well-developed body of law that would, in our view, 
appropriately address many of the questions that will arise under rule 
203(m)-1. Moreover, managers to private funds and their counsel must 
today be familiar with the definition of ``U.S. person'' under 
Regulation S in order to comply with other provisions of the federal 
securities laws.\217\ We ask comment on the proposed use of the 
Regulation S definition of U.S. person. Should we use a different 
definition of United States person? We have previously suggested that 
advisers may rely on an alternative to Regulation S for certain types 
of clients.\218\ Would that approach be less prone to abuse or 
circumvention or provide greater clarity?
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    \217\ For instance, our staff has generally taken the 
interpretive position that an investor that is not a U.S. person 
under Regulation S is not a U.S. person when determining whether a 
non-U.S. private fund meets the counting or qualification 
requirements that apply to U.S. beneficial owners or owners of a 
private fund under sections 3(c)(1) or 3(c)(7) of the Investment 
Company Act. We understand that many U.S. and non-U.S. advisers 
currently follow our staff's guidance and rely on this definition 
when determining whether a pooled investment vehicle qualifies as a 
private fund. See Goodwin Procter Letter, supra note 175; ABA 
Letter, supra note 172. Advisers apply the Regulation S definition 
of ``U.S. person'' also for other purposes. See infra note 259.
    \218\ In connection with adopting rule 203(b)(3)-2 under the 
Advisers Act, we previously noted that commenters had suggested that 
we incorporate the definition of U.S. person from Regulation S. 
Pending our reconsideration of the use of the Regulation S 
definition, we indicated at the time that we would not object if 
advisers identified U.S. persons by looking: ``(i) In the case of 
individuals to their residence, (ii) in the case of corporations and 
other business entities to their principal office and place of 
business, (iii) in the case of personal trusts and estates to the 
rules set out in Regulation S, and (iv) in the case of discretionary 
or non-discretionary accounts managed by another investment adviser 
to the location of the person for whose benefit the account is 
held.'' See Hedge Fund Adviser Registration Release, supra note 17, 
at n.201. We reconsidered the use of Regulation S and concluded it 
is appropriate as modified in our proposed rule.
---------------------------------------------------------------------------

    Proposed rule 203(m)-1 contains a special rule for discretionary 
accounts maintained outside of the United States for the benefit of 
United States persons.\219\ Under the proposed rule, an adviser must 
treat a discretionary or other fiduciary account as a United States 
person if the account is held for the benefit of a United States person 
by a non-U.S. fiduciary who is a related person of the adviser. An 
adviser could not rely on the exemption if it established discretionary 
accounts for the benefit of U.S. clients with an offshore affiliate 
that would then delegate the actual management of the account back to 
the adviser.\220\ We request comment on this special rule. Does our 
proposed rule adequately

[[Page 77210]]

address the concern that an adviser could avoid the limitation of the 
exemption through non-U.S. discretionary accounts?
---------------------------------------------------------------------------

    \219\ Proposed rule 203(m)-1(e)(8).
    \220\ Under Regulation S, a discretionary account maintained by 
a non-U.S. fiduciary (such as an investment adviser) is not a ``U.S. 
person'' even if the account is owned by a U.S. person. See rule 
902(k)(1)(vii); rule 902(k)(2)(i).
---------------------------------------------------------------------------

5. Transition Rule
    We propose to include in proposed rule 203(m)-1 a provision giving 
an adviser one calendar quarter (three months) to register with the 
Commission after becoming ineligible to rely on the exemption due to an 
increase in the value of its private fund assets.\221\ Because 
qualification for the exemption depends on remaining below the $150 
million threshold on a quarterly basis, an adviser could exceed the 
limit based on market fluctuations without any new investments from 
existing or new investors. This three month period would enable the 
adviser to take steps to register and otherwise come into compliance 
with the requirements of the Advisers Act applicable to registered 
investment advisers, including the adoption and implementation of 
compliance policies and procedures.\222\ It would be available only to 
an adviser that has complied with all applicable Commission reporting 
requirements.\223\ We are not required to provide the safe harbor, and 
we do not believe it would be appropriate for an adviser to rely on it 
if the adviser has failed to comply with its reporting requirements. We 
request comment on this transition period. Is the calendar quarter 
period sufficient? Should the transition period be longer, such as two 
calendar quarters, or shorter, such as 30 days? If the adviser 
determines to expand its advisory business to manage assets other than 
private funds (e.g., separate accounts), should the transition period 
also be available? Should a transition period be available at all?
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    \221\ Proposed rule 203(m)-1(d). In effect, an adviser would 
register by the end of the calendar quarter following the quarter-
end date at which private fund assets equaled or exceeded $150 
million. If, however, on the succeeding calendar quarter end date, 
private fund assets have declined below $150 million, then 
registration would not be required.
    \222\ See rule 206(4)-7.
    \223\ See proposed rule 203(m)-1(d); see also, e.g., proposed 
rule 204-4 under the Advisers Act (discussed in the Implementing 
Release, supra note 25, at section II.B).
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C. Foreign Private Advisers

    Section 403 of the Dodd-Frank Act replaces the current private 
adviser exemption from registration under the Advisers Act with a new 
exemption for a ``foreign private adviser,'' as defined in new section 
202(a)(30).\224\ The new exemption is codified as amended section 
203(b)(3).
---------------------------------------------------------------------------

    \224\ Section 402 of the Dodd-Frank Act (providing a definition 
of ``foreign private adviser,'' to be codified at section 202(a)(30) 
of the Advisers Act). See supra note 23 and accompanying text.
---------------------------------------------------------------------------

    Under section 202(a)(30), a foreign private adviser is any 
investment adviser that: (i) Has no place of business in the United 
States; (ii) has, in total, fewer than 15 clients in the United States 
and investors in the United States in private funds advised by the 
investment adviser; (iii) has aggregate assets under management 
attributable to clients in the United States and investors in the 
United States in private funds advised by the investment adviser of 
less than $25 million; \225\ and (iv) does not hold itself out 
generally to the public in the United States as an investment 
adviser.\226\ Section 202(a)(30) provides the Commission with authority 
to increase the $25 million threshold ``in accordance with the purposes 
of this title.'' \227\
---------------------------------------------------------------------------

    \225\ Subparagraph (B) of section 202(a)(30) refers to the 
number of ``clients and investors in the United States in private 
funds,'' while subparagraph (C) refers to assets of ``clients in the 
United States and investors in the United States in private funds'' 
(emphasis added). We interpret these provisions consistently so that 
only clients in the United States and investors in the United States 
should be counted for purposes of subparagraph (B).
    \226\ In addition, the exemption is not available to an adviser 
that ``acts as (I) an investment adviser to any investment company 
registered under the [Investment Company Act]; or (II) a company 
that has elected to be a business development company pursuant to 
section 54 of [that Act] and has not withdrawn its election.'' 
Section 202(a)(30)(D)(ii). We interpret subparagraph (II) to prevent 
an adviser that advises a business development company from relying 
on the exemption.
    \227\ Section 202(a)(30)(C).
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    We are proposing a new rule, 202(a)(30)-1, which would define 
certain terms in section 202(a)(30) for use by advisers seeking to 
avail themselves of the foreign private adviser exemption. Because 
eligibility for the new foreign private adviser exemption, like the 
current private adviser exemption, is determined, in part, by the 
number of clients an adviser has, we propose to include in rule 
202(a)(30)-1 the safe harbor rules and many of the client counting 
rules that appear in rule 203(b)(3)-1, as currently in effect.\228\ In 
addition, we propose to define other terms used in the definition of 
``foreign private adviser'' in section 202(a)(30), including: (i) 
``investor;'' (ii) ''in the United States;'' (iii) ``place of 
business;'' and (iv) ``assets under management.'' \229\
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    \228\ Rule 203(b)(3)-1, as currently in effect, provides a safe 
harbor for determining who may be deemed a single client for 
purposes of the private adviser exemption. We would not, however, 
carry over from rule 203(b)(3)-1 a provision that distinguishes 
between advisers whose principal places of business are inside or 
outside of the United States. Under the definition of ``foreign 
private adviser,'' an adviser may not have any place of business in 
the United States. See section 402 of the Dodd-Frank Act (defining 
``foreign private adviser''); rule 203(b)(3)-1(b)(5). We would also 
not include rule 203(b)(3)-1(b)(7), which specifies that a client 
who is an owner of a private fund is a resident where the client 
resides at the time of the client's investment in the fund. The 
provision was vacated by Goldstein. See supra note 18. As discussed 
below, we are proposing to include another, similar, provision in 
rule 202(a)(30)-1, which would apply to both clients and investors 
for purposes of the foreign private adviser exemption. See infra 
note 257 and accompanying text.
    \229\ Proposed rule 202(a)(30)-1(c).
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1. Clients
    For purposes of the definition of ``foreign private adviser,'' 
proposed rule 202(a)(30)-1 would include the safe harbor for counting 
clients currently in rule 203(b)(3)-1, as modified to account for its 
use in the foreign private adviser context and to eliminate a provision 
allowing advisers not to count those clients from which they receive no 
compensation. We note, however, that the foreign private adviser 
exemption provides a much more limited exemption in this regard than 
our current rule 203(b)(3)-1 because section 202(a)(30) requires an 
adviser to also count the number of ``investors'' of an issuer that is 
a ``private fund'' (a term that is defined in section 202(a)(29)) 
managed by the adviser.\230\
---------------------------------------------------------------------------

    \230\ See supra note 9.
---------------------------------------------------------------------------

    Specifically, proposed rule 202(a)(30)-1, like current rule 
203(b)(3)-1, would allow an adviser to treat as a single client a 
natural person and: (i) That person's minor children (whether or not 
they share the natural person's principal residence); (ii) any 
relative, spouse, or relative of the spouse of the natural person who 
has the same principal residence; (iii) all accounts of which the 
natural person and/or the person's minor child or relative, spouse, or 
relative of the spouse who has the same principal residence are the 
only primary beneficiaries; and (iv) all trusts of which the natural 
person and/or the person's minor child or relative, spouse, or relative 
of the spouse who has the same principal residence are the only primary 
beneficiaries.\231\ Proposed rule 202(a)(30)-1 would also retain other 
provisions of rule 203(b)(3)-1 that permit an adviser to treat as a 
single ``client'' (i) a corporation, general partnership, limited 
partnership, limited liability company, trust, or other legal 
organization to which the adviser provides investment advice based on 
the organization's investment objectives, and (ii) two or more legal 
organizations

[[Page 77211]]

that have identical shareholders, partners, limited partners, members, 
or beneficiaries.\232\
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    \231\ Proposed rule 202(a)(30)-1(a)(1). If a client relationship 
involving multiple persons does not fall within the rule, the 
question of whether the relationship may appropriately be treated as 
a single ``client'' must be determined on the basis of the facts and 
circumstances involved.
    \232\ Proposed rule 202(a)(30)-1(a)(2). In addition, proposed 
rule 202(a)(30)-1(b)(1) through (3) would retain the following 
related ``special rules'': (1) An adviser must count a shareholder, 
partner, limited partner, member, or beneficiary (each, an 
``owner'') of a corporation, general partnership, limited 
partnership, limited liability company, trust, or other legal 
organization, as a client if the adviser provides investment 
advisory services to the owner separate and apart from the legal 
organization; (2) an adviser is not required to count an owner as a 
client solely because the adviser, on behalf of the legal 
organization, offers, promotes, or sells interests in the legal 
organization to the owner, or reports periodically to the owners as 
a group solely with respect to the performance of or plans for the 
legal organization's assets or similar matters; and (3) any general 
partner, managing member or other person acting as an investment 
adviser to a limited partnership or limited liability company must 
treat the partnership or limited liability company as a client.
---------------------------------------------------------------------------

    We would not include the ``special rule'' providing advisers with 
the option of not counting as a client any person for whom the adviser 
provides investment advisory services without compensation.\233\ As 
noted above, we propose to require advisers to include the assets of 
such clients in their ``regulatory assets under management,'' \234\ and 
we propose the same approach with respect to counting clients.\235\
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    \233\ See rule 203(b)(3)-1(b)(4).
    \234\ In the Implementing Release, we are proposing to adopt a 
uniform method for calculating assets under management for purposes 
of registration pursuant to which an adviser would count assets that 
are managed without compensation. In this Release, we propose to 
apply the proposed method of calculation to the foreign private 
adviser exemption and the private fund adviser exemption. See infra 
section II.C.5 of this Release; Implementing Release, supra note 25, 
at section II.A.3.
    \235\ As discussed in the Implementing Release, our proposed 
changes to the method of calculating assets under management would 
remove the option of excluding certain assets from an adviser's 
calculation in order to avoid registration with the Commission and 
regulatory requirements associated with registration. See 
Implementing Release, supra note 25, nn.44-50 and accompanying and 
following text. Allowing an adviser not to count as clients persons 
in the United States that do not compensate the adviser would 
similarly allow certain advisers to avoid registration through 
reliance on the foreign private adviser exemption despite the fact 
that the adviser provides advisory services to such persons.
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    Finally, we propose to add a provision that would avoid double-
counting private funds and their investors by advisers.\236\ This 
provision would specify that an adviser need not count a private fund 
as a client if the adviser counted any investor, as defined in the 
rule, in that private fund as an investor in that private fund for 
purposes of determining the availability of the exemption.\237\
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    \236\ See proposed rule 202(a)(30)-1(b)(4).
    \237\ See proposed rule 202(a)(30)-1(b)(4); 202(a)(30)-1(c)(1). 
See also infra section II.C.2 of this Release (discussing the 
definition of investor).
---------------------------------------------------------------------------

    We are proposing to include the current rule 203(b)(3)-1 safe 
harbor for counting clients in proposed rule 202(a)(30)-1 because we 
believe that application of this provision (as we propose to modify it) 
will operate to effect the purposes of the foreign private adviser 
exemption. Congress replaced the private adviser exemption with the 
foreign private adviser exemption, both of which require advisers to 
count clients. As Congress was aware of rule 203(b)(3)-1's counting 
guidelines when it incorporated a limitation on the number of 
``clients'' in the definition of ``foreign private adviser,'' we 
believe it would be consistent with Congress's amendment to preserve 
generally the method for counting clients, together with the 
requirement to count clients.
    We request comment generally on our approach to counting 
``clients'' in proposed rule 202(a)(30)-1 and on each of the specific 
proposed provisions. Is it appropriate to derive the definition of 
``client'' in proposed rule 202(a)(30)-1 from rule 203(b)(3)-1's 
definition? Are there alternative approaches we should consider 
instead? Is including the ``special rules'' in proposed rule 202(a) 
(30)-1 appropriate? Are there any that are not appropriate in this 
context and should not be included in the proposed rule? In particular, 
should we have maintained the special rule allowing an adviser not to 
count as a client any person for whom the adviser provides investment 
advisory services without compensation, even though such person may be 
treated as a client for other purposes (e.g., reporting on Form ADV)? 
Should we modify the proposed rule that allows an adviser not to count 
a private fund as a client if it counts any investor in that private 
fund by also providing that an adviser may avoid counting as a client 
any person it counts as an investor? Finally, are there any further 
modifications to the definition that we should make?
2. Private Fund Investor
    Section 202(a)(30) provides that a ``foreign private adviser'' 
eligible for the new registration exemption cannot have more than 14 
clients ``or investors in the United States in private funds'' advised 
by the adviser. We propose to define ``investor'' in a private fund in 
rule 202(a)(30)-1 as any person who would be included in determining 
the number of beneficial owners of the outstanding securities of a 
private fund under section 3(c)(1) of the Investment Company Act, or 
whether the outstanding securities of a private fund are owned 
exclusively by qualified purchasers under section 3(c)(7) of that 
Act.\238\ In order to avoid double-counting, an adviser would be able 
to treat as a single investor any person who is an investor in two or 
more private funds advised by the investment adviser.\239\
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    \238\ See proposed rule 202(a)(30)-1(c)(1); supra notes 8-13 and 
accompanying text. Under the proposed rule, knowledgeable employees 
with respect to the private fund (and certain persons related to 
them) and beneficial owners of short-term paper issued by the 
private fund would also count as investors. See infra note 246 and 
accompanying text.
    \239\ See proposed rule 202(a)(30)-1(c)(1), at note to paragraph 
(c)(1).
---------------------------------------------------------------------------

    The term ``investor'' is not currently defined under the Advisers 
Act or the rules under the Advisers Act. Defining the term as proposed 
would ensure consistent application of the statutory provision and 
prevent, for example, non-U.S. advisers from circumventing the 
limitations in section 203(b)(3) by using nominee accounts that would 
aggregate investors into a single nominal investor for purposes of the 
counting requirement of section 202(a)(30). Under section 203(b)(3), an 
adviser relying on the foreign private adviser exemption may only have 
advisory relationships with private funds with a limited number of U.S. 
investors. Advisers should not be able to avoid this limitation by 
setting up intermediate accounts through which investors may access a 
private fund and not be counted for purposes of the exemption.
    Defining investors by reference to sections 3(c)(1) and 3(c)(7) of 
the Investment Company Act may best achieve these purposes. Funds and 
their advisers must determine who is a beneficial owner for purposes of 
section 3(c)(1) or whether an owner is a qualified purchaser for 
purposes of section 3(c)(7).\240\ Typically, a prospective investor in 
a private fund must complete a subscription agreement that includes 
representations or confirmations that it is qualified to invest in the 
fund and whether it is a U.S. person. This information is designed to 
allow the adviser (on behalf of the fund) to make the above 
determination. Therefore, an adviser seeking to rely on the foreign 
private adviser exemption will have ready access to this information.
---------------------------------------------------------------------------

    \240\ See supra notes 11 and 13.
---------------------------------------------------------------------------

    More important, defining the term ``investor'' by reference to 
sections 3(c)(1) and 3(c)(7) appears to appropriately limit the ability 
of a non-U.S. adviser to avoid application of the registration 
provisions of the Advisers Act. For example, under the proposed rule, 
holders of both equity and debt securities would be counted as

[[Page 77212]]

investors.\241\ Advisers, moreover, would have to ``look though'' 
nominee and similar arrangements to the underlying holders of private 
fund-issued securities to determine whether they have fewer than 15 
clients and private fund investors in the United States.\242\
---------------------------------------------------------------------------

    \241\ Sections 3(c)(1) and 3(c)(7) of the Investment Company Act 
refer to beneficial owners and owners, respectively, of 
``securities'' (which is broadly defined in section 2(a)(36) of that 
Act to include debt and equity).
    \242\ Proposed rule 202(a)(30)-1(c)(1). See generally sections 
3(c)(1) and 3(c)(7) of the Investment Company Act.
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    Under the proposed rule, an adviser would determine the number of 
investors in a private fund based on facts and circumstances and in 
light of the applicable prohibition not to do indirectly, or through or 
by any other person, what is unlawful to do directly.\243\ In the 
following circumstances, for example, an adviser relying on the 
exemption would have to count as an investor a person who is not the 
nominal owner of a private fund's securities. First, the adviser to a 
master fund in a master-feeder arrangement would have to treat as 
investors the holders of the securities of any feeder fund formed or 
operated for the purpose of investing in the master fund rather than 
the feeder funds, which act as conduits.\244\ Second, an adviser would 
need to count as an investor any holder of an instrument, such as a 
total return swap, that effectively transfers the risk of investing in 
the private fund from the record owner of the private fund's 
securities. The record owner of private fund securities could enter 
into a total return swap transaction to transfer to a third party any 
profits or losses that the record owner could incur as a result of its 
investment in the private fund. Thus, even though the record owner 
would remain the nominal owner of private fund securities, the 
associated risks of an investment in the securities would have been 
transferred to the third party who has made the determination to invest 
in the private fund indirectly through the record owner. In such a 
case, the third party would be counted as a beneficial owner under 
section 3(c)(1), or be required to be a qualified purchaser under 
section 3(c)(7).\245\ Accordingly, the third party would be counted as 
an investor in the private fund for purposes of the foreign private 
adviser exemption.
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    \243\ See section 208(d) of the Advisers Act.
    \244\ A ``master-feeder fund'' is an arrangement in which one or 
more funds with identical investment objectives (``feeder funds'') 
invest all of their assets in a single fund (``master fund'') with 
the same investment objective and strategies. We have taken the same 
approach within our rules that expressly require a private fund to 
``look-through'' any investor that is formed for the specific 
purpose of investing in a private fund. See rule 2a51-3(a) under the 
Investment Company Act (17 CFR 270.2a51-3(a)) (a company is not a 
qualified purchaser if it is ``formed for the specific purpose of 
acquiring the securities'' of an investment company that is relying 
on section 3(c)(7) of the Investment Company Act, unless each of the 
company's beneficial owners is also a qualified purchaser). See also 
Privately Offered Investment Companies, Investment Company Act 
Release No. 22597 (Apr. 3, 1997) [62 FR 17512 (Apr. 9, 1997)] 
(``NSMIA Release'') (explaining that rule 2a51-3(a) would limit the 
possibility that ``a company will be able to do indirectly what it 
is prohibited from doing directly [by organizing] * * * a `qualified 
purchaser' entity for the purpose of making an investment in a 
particular Section 3(c)(7) Fund available to investors that 
themselves did not meet the definition of `qualified purchaser.' 
'').
    \245\ As noted above, we have recognized that in certain 
circumstances it is appropriate to ``look through'' an investor 
(i.e., attribute ownership of a private fund to another person who 
is the ultimate owner). See, e.g., NSMIA Release, supra note 244 
(``The Commission understands that there are other forms of holding 
investments that may raise interpretative issues concerning whether 
a Prospective Qualified Purchaser `owns' an investment. For 
instance, when an entity that holds investments is the `alter ego' 
of a Prospective Qualified Purchaser (as in the case of an entity 
that is wholly owned by a Prospective Qualified Purchaser who makes 
all the decisions with respect to such investments), it would be 
appropriate to attribute the investments held by such entity to the 
Prospective Qualified Purchaser.'').
---------------------------------------------------------------------------

    We are also proposing to treat as investors beneficial owners (i) 
who are ``knowledgeable employees'' with respect to the private fund, 
and certain other persons related to such employees (we refer to these, 
collectively, as ``knowledgeable employees''); \246\ and (ii) of 
``short-term paper'' \247\ issued by the private fund,\248\ even though 
these persons are not counted as beneficial owners for purposes of 
section 3(c)(1), and knowledgeable employees are not required to be 
qualified purchasers under section 3(c)(7).\249\ We are proposing to 
count knowledgeable employees as investors under the same approach we 
take with our proposal that advisers count in their calculation of 
assets under management assets they manage without being compensated, 
which often include assets of knowledgeable employees.\250\ Under our 
proposed rule, holders of short-term paper, like other debt holders, 
would also be counted as investors because a private fund's losses 
directly affect these holders' interest in the fund just as they affect 
the interest of other debt holders in the fund.\251\
---------------------------------------------------------------------------

    \246\ See proposed rule 202(a)(30)-1(c)(1)(A) (referencing rule 
3c-5 under the Investment Company Act (17 CFR 270.3c-5(b)), which 
excludes from the determinations under sections 3(c)(1) and 3(c)(7) 
of that Act any securities beneficially owned by knowledgeable 
employees of a private fund; a company owned exclusively by 
knowledgeable employees; and any person who acquires securities 
originally acquired by a knowledgeable employee through certain 
transfers of interests, such as a gift or a bequest).
    \247\ See proposed rule 202(a)(30)-1(c)(1)(B) (referencing the 
definition of ``short-term paper'' contained in section 2(a)(38) of 
the Investment Company Act, which defines ``short-term paper'' to 
mean ``any note, draft, bill of exchange, or banker's acceptance 
payable on demand or having a maturity at the time of issuance of 
not exceeding nine months, exclusive of days of grace, or any 
renewal thereof payable on demand or having a maturity likewise 
limited; and such other classes of securities, of a commercial 
rather than an investment character, as the Commission may designate 
by rules and regulations.'')
    \248\ See proposed rule 202(a)(30)-1(c)(1).
    \249\ See section 3(c)(1) of the Investment Company Act; rule 
3c-5(b) under the Investment Company Act.
    \250\ See supra note 190. As discussed above, our proposed 
changes to the method of calculating assets under management would 
preclude some advisers from excluding certain assets from their 
calculation in order to avoid registration with the Commission and 
regulatory requirements associated with registration. Allowing an 
adviser not to count as investors persons that do not compensate the 
adviser, such as knowledgeable employees, would similarly allow 
certain advisers to avoid registration by relying on the foreign 
private adviser exemption.
    \251\ Various types of investment vehicles make significant use 
of short-term paper for financing purposes so holders of this type 
of security are, in practice, exposed to the investment results of 
the security's issuer. See Money Market Fund Reform Release, supra 
note 134, at nn. 37-39 and preceding and accompanying text 
(discussing how money market funds were exposed to substantial 
losses during 2007 as a result of exposure to debt securities issued 
by structured investment vehicles).
---------------------------------------------------------------------------

    We request comment on our definition of ``investor.'' Does the term 
require further definition? Does our definition of ``investor'' 
appropriately reflect Congress's intent in providing an exemption for 
foreign private advisers? Under our proposal, advisers would not be 
able to consolidate investors for counting purposes in the same manner 
they would be able to consolidate clients under certain circumstances. 
Should we consider extending to investors the ``special rules'' for 
counting clients under proposed rule 202(a)(30)-1? Would this lead to 
either under-counting or over-counting of investors? Is it appropriate 
to count as a single investor a person that invests in two or more 
private funds advised by the adviser? Is it appropriate to treat as 
investors beneficial owners who are ``knowledgeable employees'' with 
respect to the private fund, and of short-term paper issued by the 
fund?
3. In the United States
    Section 202(a)(30)'s definition of ``foreign private adviser'' 
employs the term ``in the United States'' in several contexts 
including: (i) Limiting the number of--and assets under management 
attributable to--an adviser's ``clients'' ``in the United States'' and 
``investors'' ``in the United States'' in private funds advised by the 
adviser; (ii) exempting only those advisers without

[[Page 77213]]

a place of business ``in the United States''; and (iii) exempting only 
those advisers that do not hold themselves out to the public ``in the 
United States'' as an investment adviser.\252\ We are proposing to 
define ``in the United States'' to provide clarification of the term 
for all of the above purposes as well as provide specific instruction 
as to the relevant time for making the related determination.
---------------------------------------------------------------------------

    \252\ See section 402 of the Dodd-Frank Act.
---------------------------------------------------------------------------

    Proposed rule 202(a)(30)-1 defines ``in the United States'' 
generally by incorporating the definition of a ``U.S. person'' and 
``United States'' under Regulation S.\253\ In particular, we would 
define ``in the United States'' in proposed rule 202(a)(30)-1(c)(2) to 
mean: (i) With respect to any place of business located in the ``United 
States,'' as that term is defined in Regulation S; \254\ (ii) with 
respect to any client or private fund investor in the United States, 
any person that is a ``U.S. person'' as defined in Regulation S,\255\ 
except that any discretionary account or similar account that is held 
for the benefit of a person ``in the United States'' by a non-U.S. 
dealer or other professional fiduciary is deemed ``in the United 
States'' if the dealer or professional fiduciary is a related person of 
the investment adviser relying on the exemption; and (iii) with respect 
to the public in the ``United States,'' as that term is defined in 
Regulation S.\256\ In addition, we are proposing to add a note to 
paragraph (c)(2)(i) specifying that for purposes of that definition, a 
person that is ``in the United States'' may be treated as not being 
``in the United States'' if such person was not ``in the United 
States'' at the time of becoming a client or, in the case of an 
investor in a private fund, at the time the investor acquires the 
securities issued by the fund.\257\ We believe that without this note 
this rule might be burdensome because an adviser would have to monitor 
the location of clients and investors on an ongoing basis, and might 
have to choose between registering with us or terminating the 
relationship with any client that moved to the United States, or 
redeeming the interest in the private fund of any investor that moved 
to the United States.
---------------------------------------------------------------------------

    \253\ Proposed rule 202(a)(30)-1(c)(2). As discussed above, we 
are also proposing to reference Regulation S's definition of a 
``U.S. person'' for purposes of the definition of ``United States 
person'' in rule 203(m)-1. See sections II.B.3 and II.B.4 of this 
Release (discussing proposed rules 203(m)-1(e)(7) through (8)).
    \254\ See 17 CFR 230.902(l).
    \255\ See 17 CFR 230.902(k).
    \256\ See 17 CFR 230.902(l).
    \257\ Proposed rule 202(a)(30)-1, at note to paragraph (c)(2)(i) 
(``A person that is in the United States may be treated as not being 
in the United States if such person was not in the United States at 
the time of becoming a client or, in the case of an investor in a 
private fund, at the time the investor acquires the securities 
issued by the fund.'').
---------------------------------------------------------------------------

    We believe that the use of Regulation S is appropriate for purposes 
of the foreign private adviser exemption because Regulation S provides 
more specific rules when applied to various types of legal 
structures.\258\ Advisers, moreover, already apply the Regulation S 
definition of U.S. person with respect to both clients and investors 
for other purposes and therefore are familiar with the definition.\259\ 
The proposed references to Regulation S with respect to a place of 
business ``in the United States'' and the public in the ``United 
States'' would also allow us to maintain consistency across our rules.
---------------------------------------------------------------------------

    \258\ See supra notes 214-216 and accompanying text. See also 
Letter of Paul, Hastings, Janofsky & Walker LLP (Oct. 29, 2010) 
(``Paul Hastings Letter'') (addressing the foreign private adviser 
exemption in response to our request for public views, and 
recommending that we rely on a modified Regulation S definition of 
``U.S. person'' for purposes of defining ``in the United States'' 
with respect to clients and investors). See generally supra note 24.
    \259\ Many non-U.S. advisers identify whether a client is a 
``U.S. person'' under Regulation S in order to determine whether 
such client may invest in certain private funds and certain private 
placement offerings exempt from registration under the Securities 
Act. With respect to ``investors,'' our staff has generally taken 
the interpretive position that an investor that does not meet that 
definition is not a U.S. person when determining whether a non-U.S. 
private fund meets the section 3(c)(1) and 3(c)(7) counting or 
qualification requirements. See supra note 217. Many non-U.S. 
advisers, moreover, currently determine whether a private fund 
investor is a ``U.S. person'' under Regulation S for purposes of the 
safe harbor for offshore offers and sales.
---------------------------------------------------------------------------

    Similar to our approach in proposed rule 203(m)-1(e)(8),\260\ we 
treat as persons ``in the United States'' for purposes of the foreign 
private adviser, certain persons that would not be considered ``U.S. 
persons'' under Regulation S. We are proposing to treat as a U.S. 
person discretionary accounts owned by a U.S. person and managed by a 
non-U.S. affiliate of the adviser in order to discourage non-U.S. 
advisers from creating such discretionary accounts with the goal of 
circumventing the exemption's limitation with respect to persons in the 
United States.\261\
---------------------------------------------------------------------------

    \260\ See supra discussion in section II.B.4 of this Release 
regarding the definition of United States persons and the treatment 
of discretionary accounts.
    \261\ See supra notes 219-220 and accompanying paragraph.
---------------------------------------------------------------------------

    We request comment on the definition of ``in the United States'' in 
proposed rule 202(a)(30)-1(c)(2). Is our definition appropriate as it 
relates to a ``place of business?'' Is it appropriate as it relates to 
``clients'' and ``investors in a private fund?'' Is it appropriate as 
it relates to the ``public?'' Is it necessary to define ``in the United 
States'' for purposes of the definition of ``foreign private adviser'' 
in new section 202(a)(30)? Is our understanding of non-U.S. advisers' 
application of the Regulation S definition correct? Since private funds 
already rely on the Regulation S definition of U.S. person to determine 
which investors must qualify to invest in the fund, would adopting a 
different definition increase regulatory burdens associated with 
determining eligibility for the proposed exemption? \262\ Are there 
alternatives that would better reflect the intent of Congress in 
creating a new category of ``foreign private advisers'' and providing 
them with an exemption from registration? Is our proposed note 
regarding the relevant time for determining whether a person is ``in 
the United States'' appropriate? If not, how should we modify it?
---------------------------------------------------------------------------

    \262\ See supra note 217 and accompanying and following text.
---------------------------------------------------------------------------

4. Place of Business
    Proposed rule 203(a)(30)-1, by reference to proposed rule 222-
1,\263\ defines ``place of business'' to mean any office where the 
investment adviser regularly provides advisory services, solicits, 
meets with, or otherwise communicates with clients, and any location 
held out to the public as a place where the adviser conducts any such 
activities.\264\ We believe this definition appropriately identifies a 
location where an adviser is doing business for purposes of section 
202(a)(30) of the Advisers Act and thus provides a basis for an adviser 
to determine whether it can rely on the exemption in section 203(b)(3) 
of the Advisers Act for foreign private advisers. Because both the 
Commission and the state securities authorities use this definition to 
identify an unregistered foreign adviser's place of business for 
purposes of determining regulatory jurisdiction,\265\ it appears to be 
logical as well as efficient to use the rule 222-1(a) definition of 
``place of

[[Page 77214]]

business'' for purposes of the foreign private adviser exemption.
---------------------------------------------------------------------------

    \263\ Rule 222-1(a) (defining ``place of business'' of an 
investment adviser as: ``(1) An office at which the investment 
adviser regularly provides investment advisory services, solicits, 
meets with, or otherwise communicates with clients; and (2) Any 
other location that is held out to the general public as a location 
at which the investment adviser provides investment advisory 
services, solicits, meets with, or otherwise communicates with 
clients.'').
    \264\ Proposed rule 202(a)(30)-1(c)(3).
    \265\ Under section 222(d) of the Advisers Act, a state may not 
require an adviser to register if the adviser does not have a 
``place of business'' within, and has fewer than six clients 
resident in, the state.
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    We request comment on our definition of ``place of business'' as it 
relates to the definition of ``foreign private adviser.'' Is this 
definition of ``place of business'' appropriate in this context? Do 
commenters recommend any alternative definitions?
5. Assets Under Management
    For purposes of rule 202(a)(30)-1 we propose to define ``assets 
under management'' by reference to the calculation of ``regulatory 
assets under management'' for Item 5 of Form ADV.\266\ As discussed 
above, in Item 5 of Form ADV we are proposing to implement a uniform 
method of calculating assets under management that can be used for 
several purposes under the Advisers Act, including the foreign private 
adviser exemption.\267\ Because the foreign private adviser exemption 
is also based on assets under management, we believe that all advisers 
should use the same method for calculating assets under management to 
determine if they are required to register or may be eligible for the 
exemption. We believe that uniformity in the method for calculating 
assets under management would result in more consistent asset 
calculations and reporting across the industry and, therefore, in a 
more coherent application of the Advisers Act's regulatory requirements 
and of our staff's risk assessment program.\268\
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    \266\ See proposed rule 202(a)(30)-1(c)(4); instructions to Item 
5.F of Form ADV, Part 1A. As discussed above, we are proposing to 
take the same approach under proposed rule 203(m)-1. See supra 
section II.B.2 of this Release.
    \267\ See supra note 190 and accompanying text.
    \268\ Id. See also Letter of Shearman and Sterling LLP (Nov. 3, 
2010) (``Shearman & Sterling Letter'') (in response to our request 
for public views, arguing that ``[w]hile each [exemption related 
asset threshold established by the Dodd-Frank Act] serves a 
different purpose, it appears to us that any steps that might be 
taken in the way of harmonization will facilitate both compliance 
with the requirements by the industry and their administration by 
the Commission and its Staff,'' and suggesting that as an example, 
we raise the assets under management threshold under the foreign 
private adviser exemption to $150 million in line with the assets 
threshold under the private fund adviser exemption). See generally 
supra note 24.
---------------------------------------------------------------------------

    We request comment on our definition of ``assets under management'' 
as it relates to the definition of ``foreign private adviser.'' Is this 
definition of ``assets under management'' appropriate in this context? 
Are there any special considerations relevant to foreign private 
advisers? Do commenters recommend any alternative definitions? Should 
assets under management be calculated at a particular point of time? 
Should we, as proposed, require foreign private advisers to calculate 
assets under management consistent with the proposed ``regulatory 
assets under management'' calculation for Form ADV? Or should we 
require a different calculation? For example, should foreign private 
advisers be permitted to exclude proprietary assets or assets they 
manage without compensation?

D. Subadvisory Relationships and Advisory Affiliates

    We generally interpret advisers as including subadvisers,\269\ and 
therefore believe it is appropriate to permit subadvisers to rely on 
each of the new exemptions, provided that subadvisers satisfy all terms 
and conditions of the applicable proposed rules. We are aware that in 
many subadvisory relationships a subadviser has contractual privity 
with a private fund's primary adviser rather than the private fund 
itself. Although both the private fund and the fund's primary adviser 
may be viewed as clients of the subadviser, we would consider a 
subadviser eligible to rely on section 203(m) if the subadviser's 
services to the primary adviser relate solely to private funds and the 
other conditions of the exemptions are met. Similarly, a subadviser may 
be eligible to rely on section 203(l) if the subadviser's services to 
the primary adviser relate solely to venture capital funds and the 
other conditions of the rule are met.
---------------------------------------------------------------------------

    \269\ See, e.g., Pay to Play Release, supra note 10, at n.391-94 
and accompanying and following text; Hedge Fund Adviser Registration 
Release, supra note 17, at n.243.
---------------------------------------------------------------------------

    We anticipate that an adviser with advisory affiliates will 
encounter interpretative issues as to whether it may rely on any of the 
exemptions discussed in this Release without taking into account the 
activities of its affiliates. The adviser, for example, might have 
advisory affiliates that are registered or that provide advisory 
services that are inconsistent with an exemption on which the adviser 
may seek to rely.\270\ We request comment on whether any proposed rule 
should provide that an adviser must take into account the activities of 
its advisory affiliates when determining eligibility for an exemption. 
For example, should the rule specify that the exemption is not 
available to an affiliate of a registered investment adviser? \271\
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    \270\ Generally, a separately formed advisory entity that 
operates independently of an affiliate may be eligible for an 
exemption if it meets all of the criteria set forth in the relevant 
rule. However, the existence of separate legal entities may not by 
itself be sufficient to avoid integration of the affiliated 
entities. The determination of whether the advisory businesses of 
two separately formed affiliates may be required to be integrated is 
based on the facts and circumstances. Our staff has taken this 
position in Richard Ellis, Inc., SEC Staff No-Action Letter (Sept. 
17, 1981) (discussing the staff's views of factors relevant to the 
determination of whether a separately formed advisory entity 
operates independently of an affiliate).
    \271\ We have received a number of letters requesting 
interpretative guidance on whether and to what extent certain prior 
staff positions would apply to the new exemptions provided by the 
Dodd-Frank Act. See, e.g., Letter of Katten Muchin Rosenman LLP 
(Sept. 14, 2010); Letter of TA Jones (Sept. 25, 2010); Letter of 
Ropes & Gray LLP (Nov. 1, 2010) in response to our solicitation for 
public views. See generally supra note 24. We acknowledge that such 
determinations will depend on the particular facts and circumstances 
of non-U.S. advisers. Advisers should consider whether they may 
avail themselves of either the foreign private adviser exemption or 
the private fund adviser exemption as proposed in this Release, and 
are encouraged to submit comment letters addressing with 
particularity and specificity interpretative issues that may not be 
addressed in our proposed rules.
---------------------------------------------------------------------------

III. Request for Comment

    The Commission requests comment on the proposed rules in this 
Release. We also request suggestions for additional changes to existing 
rules, and comments on other matters that might have an effect on the 
proposals contained in this Release. Commenters are requested to 
provide empirical data to support their views.

IV. Paperwork Reduction Act Analysis

    The proposed rules do not contain a ``collection of information'' 
requirement within the meaning of the Paperwork Reduction Act of 
1995.\272\ Accordingly, the Paperwork Reduction Act is not applicable.
---------------------------------------------------------------------------

    \272\ 44 U.S.C. 3501.
---------------------------------------------------------------------------

V. Cost-Benefit Analysis

    The Commission is sensitive to the costs and benefits imposed by 
its rules. We have identified certain costs and benefits of the 
proposed rules, and we request comment on all aspects of this cost-
benefit analysis, including identification and assessment of any costs 
and benefits not discussed in this analysis. We seek comment and data 
on the value of the benefits identified. We also welcome comments on 
the accuracy of the cost estimates in this analysis, and request that 
commenters provide data that may be relevant to these cost estimates. 
In addition, we seek estimates and views regarding these benefits and 
costs for advisers solely to venture capital funds, private fund 
advisers with less than $150 million in aggregate assets under 
management and foreign private advisers as well as any other costs or 
benefits that may result from the adoption of the proposed rules. Where 
possible, we request commenters

[[Page 77215]]

provide empirical data to support any positions advanced.
    As discussed above, we are proposing rules 203(l)-1, 203(m)-1 and 
202(a)(30)-1 to implement certain provisions of the Dodd-Frank Act. As 
a result of the Dodd-Frank Act's repeal of the private adviser 
exemption, some advisers that previously were eligible to rely on that 
exemption will be required to register under the Advisers Act unless 
these advisers are eligible for a new exemption. Thus, the benefits and 
costs associated with registration are attributable to the Dodd-Frank 
Act. The Commission has discretion, however, to adopt rules to define 
the terms used in the Advisers Act, and we undertake below to discuss 
the benefits and costs of the defined terms that we are proposing.

A. Definition of Venture Capital Fund

    Our proposed rule is designed to: (i) implement the directive from 
Congress to define the term venture capital fund in a manner that 
reflects Congress' understanding of what venture capital funds are, and 
as distinguished from other private equity funds and hedge funds; and 
(ii) facilitate the transition to the new exemption. Our proposal would 
define the term venture capital fund consistently with what we believe 
Congress understood venture capital funds to be, and in light of other 
provisions of the federal securities laws that seek to achieve similar 
objectives.\273\
---------------------------------------------------------------------------

    \273\ See supra notes 38-43 and accompanying and following text.
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    Using these characteristics as our model, we propose to define a 
venture capital fund as a private fund that: (i) Invests in equity 
securities of private companies in order to provide operating and 
business expansion capital (i.e., ``qualifying portfolio companies'') 
and at least 80 percent of each company's equity securities owned by 
the fund were acquired directly from the qualifying portfolio company; 
(ii) directly, or through its investment advisers, offers or provides 
significant managerial assistance to, or controls, the qualifying 
portfolio company; (iii) does not borrow or otherwise incur leverage 
(other than limited short-term borrowing); (iv) does not offer its 
investors redemption or other similar liquidity rights except in 
extraordinary circumstances; (v) represents itself as a venture capital 
fund to investors; and (vi) is not registered under the Investment 
Company Act and has not elected to be treated as a BDC.\274\
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    \274\ Proposed rule 203(l)-1(a).
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    We propose to define a ``qualifying portfolio company'' as any 
company that: (i) Is not publicly traded; (ii) does not incur leverage 
in connection with the investment by the private fund; (iii) uses the 
capital provided by the fund for operating or business expansion 
purposes rather than to buy out other investors; and (iv) is not itself 
a fund (i.e., is an operating company).\275\
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    \275\ Proposed rule 203(l)-1(c)(4).
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    We also propose to grandfather existing funds by including in the 
definition of ``venture capital fund'' any private fund that: (i) 
Represented to investors and potential investors at the time the fund 
offered its securities that it is a venture capital fund; (ii) prior to 
December 31, 2010, has sold securities to one or more investors that 
are not related persons of any investment adviser of the venture 
capital fund; and (iii) does not sell any securities to, including 
accepting any additional capital commitments from, any person after 
July 21, 2011 (the ``grandfathering provision'').\276\ An adviser 
seeking to rely on the exemption under section 203(l) of the Advisers 
Act would be eligible for the venture capital exemption only if it 
exclusively advised venture capital funds that met all of the elements 
of the proposed definition or grandfathering provision.
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    \276\ Proposed rule 203(l)-1(b).
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1. Benefits
    Based on the testimony presented to Congress and our research, we 
believe that venture capital funds today would meet most, if not all, 
of the elements of our proposed definition of venture capital fund. Our 
proposed definition includes one specific element, however, that may 
not be characteristic of some existing venture capital funds. The 
proposed rule defines a venture capital fund as one that does not issue 
debt or provide guarantees except on a short-term basis (and 
correspondingly defines a qualifying portfolio company as one that does 
not borrow or otherwise incur leverage in connection with the venture 
capital fund investment). We propose this element of the qualifying 
portfolio company definition because of the focus on leverage in the 
Dodd-Frank Act as a potential contributor to systemic risk as discussed 
by the Senate Committee report,\277\ and the testimony before Congress 
that stressed the lack of leverage in venture capital investing.\278\ 
Our research suggests that on occasion, however, some venture capital 
funds may provide financing on a short-term basis to portfolio 
companies as a ``bridge'' between funding rounds.\279\ It is possible 
that certain types of bridge financing currently used by venture 
capital funds may not satisfy the definition of equity security under 
our proposed rule.
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    \277\ See supra note 99. See also S. Rep. No. 111-176, supra 
note 7, at 73-74 (stating that advisers of venture capital funds are 
not required to register with the SEC because they do not present 
the same risks as advisers to other private funds that are required 
to register, and specifying that the Commission shall require 
advisers of private funds to report systemic risk data including, 
among other things, information on the ``use of leverage, 
counterparty credit risk exposure, trading and investment 
positions''). See also supra notes 136-137 and accompanying text.
    \278\ See supra note 100.
    \279\ See, e.g., supra note 83 and accompanying text.
---------------------------------------------------------------------------

    Although the limitation on acquiring debt securities from portfolio 
companies may not be characteristic of some existing venture capital 
funds, the failure of existing venture capital funds to meet the 
proposed definition would not preclude advisers to those funds from 
relying on the exemption in section 203(l) of the Advisers Act under 
our proposed rule. An adviser of existing venture capital funds could 
avail itself of the exemption under the proposed grandfathering 
provision provided that each fund (i) Has represented to investors that 
it is a venture capital fund, (ii) has initially sold interests by 
December 31, 2010, and (iii) does not sell any additional interests 
after July 21, 2011.\280\ We expect that all advisers to existing 
venture capital funds that currently rely on the private adviser 
exemption would be exempt from registration in reliance on the proposed 
grandfathering provision. As a result of this provision, we expect that 
advisers to existing venture capital funds that do not meet our 
proposed definition would benefit because those advisers could continue 
to manage existing funds without having to (i) Weigh the relative costs 
and benefits of registration and modification of fund operations to 
conform existing funds with our proposed definition and (ii) incur the 
costs associated with registration with the Commission or modification 
of existing funds. Advisers to venture capital funds that are in 
formation that would be able to launch by December 31, 2010 and meet 
the July 21, 2011 deadline for sales of all securities also would 
benefit from the grandfathering provision because they would not have 
to incur these costs.
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    \280\ Proposed rule 203(l)-1(b).
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    Going forward, we recognize that some advisers to existing venture 
capital funds that seek to rely on the exemption in section 203(l) of 
the Advisers Act might have to structure new funds

[[Page 77216]]

differently to meet the proposed limitation on qualified portfolio 
company leverage. To the extent that advisers choose not to change how 
they structure or manage new funds they launch, those advisers would 
have to register with the Commission,\281\ which offers many benefits 
to the investing public and facilitates our mandate to protect 
investors. Registered investment advisers are subject to periodic 
examinations by our staff and are also subject to our rules including 
rules on recordkeeping, custody of client funds and compliance 
programs. We believe that in general Congress considered registration 
to be beneficial to investors because of, among other things, the added 
protections offered by registration. Accordingly, Congress limited the 
section 203(l) exemption to advisers to venture capital funds. As noted 
above, we proposed certain elements in the portfolio company definition 
because of the focus on leverage in the Dodd-Frank Act as a potential 
contributor to systemic risk as discussed by the Senate Committee 
report,\282\ and the testimony before Congress that stressed the lack 
of leverage in venture capital investing.\283\ We expect that 
distinguishing between venture capital funds and other private funds 
that pursue investment strategies involving financial leverage that 
Congress highlighted for concern would benefit financial regulators 
mandated by the Dodd-Frank Act (such as the Financial Stability 
Oversight Council) with monitoring and assessing potential systemic 
risks. Because advisers that manage funds with these characteristics 
would be required to register, we expect that financial regulators 
could more easily obtain information and data regarding these financial 
market participants, which should benefit those regulators to the 
extent it helps to reduce the overall cost of systemic risk monitoring 
and assessment.\284\
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    \281\ See infra text following note 294; notes 299-303 and 
accompanying text for a discussion of potential costs for advisers 
that would have to choose between registering or restructuring 
venture capital funds formed in the future.
    \282\ See supra note 99.
    \283\ See supra note 100.
    \284\ See S. Rep. No. 111-176, supra note 7, at 39 (explaining 
the requirement that private funds disclose information regarding 
their investment positions and strategies, including information on 
fund size, use of leverage, counterparty credit risk exposure, 
trading and investment positions and any other information that the 
Commission in consultation with the Financial Stability Oversight 
Council determines is necessary and appropriate to protect investors 
or assess systemic risk).
---------------------------------------------------------------------------

    In addition to the benefits discussed above, we expect that 
investment advisers that seek to rely on the exemption would benefit 
from the flexibility in the proposed definition of venture capital fund 
than a more rigid or narrow definition, which should allow them more 
easily to structure and operate funds that meet the definition. This 
flexibility should facilitate compliance with the proposed rule and 
transition to the new exemption. For example, we propose to define 
equity securities broadly to cover many types of equity securities in 
which venture capital funds typically invest, rather than limit the 
definition solely to common stock.\285\ To meet the proposed 
definition, at least 80 percent (not 100 percent) of the equity 
securities of a portfolio company in which a venture capital fund 
invests must be acquired directly from the issuing portfolio company 
(including securities that have been converted into equity securities), 
but there is no limit as to how the remaining 20 percent could be 
acquired.\286\ Furthermore, under the proposed definition, the venture 
capital fund may offer or provide managerial assistance to or 
alternatively control the qualified portfolio company directly, or may 
do so through its advisers. As noted above, we have modeled this 
element of the definition in part on existing provisions under the 
Advisers Act and Investment Company Act dealing with BDCs.\287\ Our 
proposed definition also is designed to be a simplified version of the 
definition of ``making available significant managerial assistance'' 
under the BDC provisions, which we expect would reduce confusion and 
facilitate understanding of the proposed rule.\288\ This approach would 
preserve flexibility for venture capital funds that invest as a group 
to determine which members of the group are best qualified, or best 
able, to control the portfolio company or alternatively to offer (and/
or provide) managerial assistance to the portfolio company.
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    \285\ See supra notes 85-87 and accompanying text.
    \286\ See supra section II.A.1.d of this Release.
    \287\ See supra notes 123-128 and accompanying text.
    \288\ See supra note 128 and accompanying and following text. 
For example, unlike the BDC provision, the proposed definition does 
not specifically define managerial assistance by referring to a 
fund's directors, officers, employees or general partners. In 
addition, like the BDC provision, the proposed definition would 
require the venture capital fund to control the qualifying portfolio 
company (if it does not offer or provide significant managerial 
assistance), but without reference to exercising a controlling 
influence because the ability to exercise a controlling influence is 
inherent in the control relationship. See section 202(a)(12) of the 
Advisers Act (defining control to mean the power to exercise a 
controlling influence over the management or policies of a company 
unless such power is solely the result of an official position with 
such company). See supra note 129 for the definition of ``making 
available significant managerial assistance'' by a BDC.
---------------------------------------------------------------------------

    Our proposed definition of qualifying portfolio company is 
similarly broad because the definition does not restrict qualifying 
companies to ``small or start-up'' companies. As we have noted above, 
we believe that such definitions would be too restrictive and provide 
venture capital fund advisers with too little flexibility and limited 
options with respect to potential portfolio company investments.\289\ 
In addition, we propose to define a ``qualifying portfolio company'' as 
a company that does not borrow from, or issue debt in connection with 
the investment from, venture capital funds. Thus, a qualifying 
portfolio company could borrow for working capital or other operating 
needs from other lenders, such as banks, without jeopardizing the 
venture capital fund adviser's eligibility for the exemption. These 
proposed broad definitions and criteria should benefit advisers that 
intend to rely on the exemption because they give the adviser 
flexibility to structure transactions and investments in underlying 
portfolio companies in a manner that meets their business objectives 
without unduly creating systemic or other risks of the kind that 
Congress suggested should require registration of the fund's adviser. 
For commenters recommending more narrow elements for our definition, we 
request comment on the costs to advisers of having to change their 
business practices to comply with such narrower elements.
---------------------------------------------------------------------------

    \289\ See supra discussion in section II.A.1.a of this Release.
---------------------------------------------------------------------------

    We believe that the grandfathering provision would promote 
efficiency because it will allow advisers to existing venture capital 
funds to continue to rely on the exemption without having to 
restructure funds that may not meet the proposed definition. It also 
would allow advisers to funds that are currently in formation and can 
meet the requirements of the grandfathering provision to rely on the 
exemption without the potential costs of having to renegotiate with 
potential investors and restructure those funds within the limited 
period before the rule must be adopted. Advisers that seek to form new 
funds should have sufficient time and notice to structure those funds 
to meet the proposed definition should they seek to rely on the 
exemption in section 203(l) of the Advisers Act.
    Finally, we believe that our proposed definition would include an 
additional benefit for investors and regulators. Section 203(l) of the 
Advisers Act provides an exemption specifically for

[[Page 77217]]

advisers that ``solely'' advise venture capital funds. Currently none 
of our rules requires that an adviser exempt from registration specify 
the basis for the exemption. We are proposing, however, to require 
exempt reporting advisers to identify the exemption(s) on which they 
are relying.\290\ Requiring that venture capital funds represent 
themselves as such to investors should allow the Commission and the 
investing public (particularly potential investors in venture capital 
funds) to determine, and confirm, an adviser's rationale for remaining 
unregistered with the Commission. This element is designed to deter 
advisers to private funds other than venture capital funds from 
claiming to rely on an exemption from registration for which they are 
not eligible.
---------------------------------------------------------------------------

    \290\ See Implementing Release, supra note 25, at n.130 and 
accompanying text.
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    We request comment on the potential benefits we have identified 
above. Are there benefits of the proposed definition that we have not 
identified?
2. Costs
    Costs for advisers to existing venture capital funds. As discussed 
above, we do not expect that the proposed rule would result in any 
significant costs for unregistered advisers to venture capital funds 
currently in existence and operating. We estimate that currently there 
are 800 advisers to venture capital funds.\291\ We expect that all 
these advisers, which we assume currently are not registered in 
reliance on the private adviser exemption, would continue to be exempt 
after the repeal of that exemption on July 21, 2011 in reliance on the 
proposed grandfathering provision.\292\ We anticipate that such 
advisers to grandfathered funds would incur minimal costs, at most, to 
confirm that existing venture capital funds managed by the adviser meet 
the conditions of the grandfathering provision. We estimate that these 
costs would be no more than $800 to hire outside counsel to assist in 
this determination.\293\
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    \291\ See NVCA Yearbook 2010, supra note 41, at figure 1.04 
(providing number of ``active'' venture capital advisers who have 
raised a venture capital partnership within the past eight years).
    \292\ We estimate that these advisers (and any other adviser 
that seeks to remain unregistered in reliance on the exemption under 
section 203(l) of the Advisers Act) would incur, on average, $2,041 
per year to complete and update related reports on Form ADV, 
including Schedule D information relating to private funds. See 
Implementing Release, supra note 25, at section IV.B.2. This 
estimate includes internal costs to the adviser of $1,764 to prepare 
and submit an initial report on Form ADV and $277 to prepare and 
submit annual amendments to the report. These estimates are based on 
the following calculations: $1,764 = ($3,528,000 aggregate costs / 
2,000 advisers); $277 = ($554,400 aggregate costs / 2,000 advisers). 
Id., at nn.337, 339 and accompanying text. We estimate that one 
exempt reporting adviser would file Form ADV-H per year at a cost of 
$204 per filing. Id., at n.344 and accompanying text. We further 
estimate that three exempt reporting advisers would file Form ADV-NR 
per year at a cost of $57 per filing. Id., at nn.347, 349 and 
accompanying text. We anticipate that filing fees for exempt 
reporting advisers would be the same as those for registered 
investment advisers. See infra note 300. These reporting costs are 
attributable to the Dodd-Frank Act, which directs the Commission to 
require advisers to venture capital funds to provide such annual and 
other reports as we determine necessary or in the public interest or 
for the protection of investors. See section 203(l) of the Advisers 
Act.
    \293\ We expect that a venture capital adviser would need no 
more than 2 hours of legal advice to learn the differences between 
its current business practices and the conditions for reliance on 
the proposed grandfathering provision. We estimate that this advice 
would cost $400 per hour per firm based on our understanding of the 
rates typically charged by outside consulting or law firms.
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    We recognize, however, that advisers to funds that are currently in 
the process of being formed and negotiated with investors may incur 
costs to determine whether they qualify for the grandfathering 
provision. For example, these advisers may need to assess the impact on 
the fund of selling interests to initial third party investors by 
December 31, 2010 and selling interests to all investors no later than 
July 21, 2011. We do not expect that the cost of evaluating the 
grandfathering provision would be significant, however, because we 
believe that most funds in formation represent themselves as being 
venture capital funds or funds that pursue a venture capital investing 
strategy to their potential investors and the typical fundraising 
period for a venture capital fund is approximately 12 months.\294\ 
Thus, we do not anticipate that venture capital fund advisers would 
have to alter typical business practice to structure or raise capital 
for venture capital funds being formed. Nevertheless, we recognize that 
after the final rule goes into effect, exempt advisers of such funds in 
formation may forgo the opportunity to accept investments from 
investors that may seek to invest after July 21, 2011 in order to 
comply with the grandfathering provision.
---------------------------------------------------------------------------

    \294\ See Breslow & Schwartz, supra note 144, at 2-22 (``Once 
the first closing [of a private equity fund] has occurred, 
subsequent closings are typically held over a defined period of time 
[the marketing period] of approximately six to twelve months.''). 
See also Dow Jones Report, supra note 145, at 22.
---------------------------------------------------------------------------

    We request comment on the potential costs of this aspect of our 
proposed rule. Are there advisers to existing venture capital funds or 
venture capital funds in formation that would not be covered by the 
grandfathering provision? We request commenters to quantify the number 
of these advisers and provide us with specific examples of why such 
advisers would not be able to rely on the grandfathering provision.
    Costs for new advisers and advisers to new venture capital funds. 
We expect that existing advisers that seek to form new venture capital 
funds and investment advisory firms that seek to enter the venture 
capital industry would incur one-time ``learning costs'' to determine 
how to structure new funds they may manage to meet the elements of our 
proposed definition. We estimate that on average, there are 24 new 
advisers to venture capital funds each year.\295\ We expect that the 
one-time learning costs would be no more than between $2,800 and $4,800 
on average for an adviser if it hires an outside consulting or law firm 
to assist in determining how the elements of our proposed definition 
may affect intended business practices.\296\ Thus, we estimate the 
aggregate cost to existing advisers of determining how the proposed 
definition would affect funds they plan to launch would be from $67,200 
to $115,200.\297\ We request comment on whether these estimates 
accurately reflect the fees an adviser would be likely to pay to 
consulting and law firms it hires. As they launch new funds and 
negotiate with potential investors, these advisers would have to 
determine whether it is more cost effective to register or to structure 
the venture capital funds they manage to meet the proposed definition. 
Such considerations of legal or other requirements, however, comprise a 
typical business and operating expense of conducting new business. New 
advisers that enter into the business of managing venture capital funds 
also would incur such ordinary costs of doing business in a regulated 
industry.\298\
---------------------------------------------------------------------------

    \295\ This is the average annual increase in the number of 
venture capital advisers between 1980 and 2009. See NVCA Yearbook 
2010, supra note 41, at figure 1.04.
    \296\ We expect that a venture capital adviser would need 
between 7 and 12 hours of consulting or legal advice to learn the 
differences between its current business practices and the proposed 
definition, depending on the experience of the firm and its 
familiarity with the elements of the proposed rule. We estimate that 
this advice would cost $400 per hour per firm based on our 
understanding of the rates typically charged by outside consulting 
or law firms.
    \297\ This estimate is based on the following calculations: 
$2,800 x 24 = $67,200; 24 x $4,800 = $115,200.
    \298\ For estimates of the costs of registration for those 
advisers that would choose to register, see infra notes 299-304.
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    We believe that existing advisers to venture capital funds meet 
most, if not all, of the elements of the proposed

[[Page 77218]]

definition because it is modeled on current business practices of 
venture capital funds. We thus do not anticipate that many venture 
capital fund advisers would have to change significantly the structure 
of new funds they launch. Under our proposed definition, an adviser 
would not be able to rely on the exemption if a venture capital fund 
invested in securities that were not equity securities issued by 
qualifying portfolio companies. Although we believe this practice is 
not common in the industry, this element of our proposed rule may 
result in some venture capital funds incurring costs to structure and 
acquire equity investments that possess terms and protections typically 
found in debt instruments. To the extent that venture capital funds 
might not be able to structure equity investments in this way, and 
portfolio companies would have to forgo debt issuance, the proposal 
could have an adverse effect on capital formation.
    We also recognize that some existing venture capital funds may have 
characteristics that differ from the elements of the proposed 
definition other than the limitation on investments in debt securities 
issued by portfolio companies. To the extent that investment advisers 
seek to form new venture capital funds with these characteristics, 
those advisers would have to choose whether to structure new venture 
capital funds to conform to the proposed definition, forgo forming new 
funds, or register with the Commission. In any case, each investment 
adviser would assess the costs associated with registering with the 
Commission relative to the costs of remaining unregistered (and hence 
structuring funds to meet our proposed definition in order to be 
eligible for the exemption). We expect that this assessment would take 
into account many factors, including the size, scope and nature of its 
business and investor base. Such factors will vary from adviser to 
adviser, but each adviser would determine whether registration, 
relative to other choices, is the most cost-effective or strategic 
business option for itself.
    To the extent that advisers choose to structure new venture capital 
funds to conform to the proposed definition, or choose not to form new 
funds in order to avoid registration, these choices could result in 
fewer investment choices for investors, less competition and less 
capital formation. To the extent that advisers choose to register in 
order to structure new venture capital funds without regard to the 
proposed definitional elements or in order to expand their business 
(e.g., pursue additional investment strategies beyond venture capital 
investing or expand the potential investor base to include investors 
that are required to invest with registered advisers), these choices 
may result in greater investment choices for investors, greater 
competition and greater capital formation.
    Investment advisers to new venture capital funds that would not 
meet the proposed definition would have to register and incur the costs 
associated with registration (assuming the adviser could not rely on 
the private fund adviser exemption). We estimate that the internal cost 
to register with the Commission would be $11,526 on average for a 
private fund adviser,\299\ excluding the initial filing fees and annual 
filing fees to the Investment Adviser Registration Depository 
(``IARD'') system operator.\300\ These registration costs include the 
costs attributable to completing and periodically amending Form ADV, 
preparing brochure supplements, and delivering codes of ethics to 
clients.\301\ In addition to the internal costs described above, we 
estimate that for an adviser choosing to use outside legal services to 
complete its brochure, such costs would be $3,000 to $5,000.\302\
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    \299\ This estimate is based upon the following calculations: 
$11,526 = ($7,699,860 aggregate costs to complete Form ADV / 750 
advisers) + ($1,197,000 aggregate costs to complete private fund 
reporting requirements / 950 advisers). See Implementing Release, 
supra note 25, at nn.355-361. This also assumes that an adviser's 
registration process would be conducted by a senior compliance 
examiner and a compliance manager at an estimated cost of $210 and 
$294 per hour, respectively. See Implementing Release, supra note 
25, at nn.354 and accompanying text.
    \300\ The initial filing fee and annual filing fee for advisers 
with $25 million to $100 million of assets under management is $150 
and for advisers with $100 million or more of assets under 
management is $200. See Electronic Filing for Investment Advisers on 
IARD: IARD Filing Fees, available at http://www.sec.gov/divisions/investment/iard/iardfee.shtml.
    \301\ Part 1 of Form ADV requires advisers to answer basic 
identifying information about their business, their affiliates and 
their owners, information that is readily available to advisers, and 
thus should not result in significant costs to complete. Registered 
advisers must also complete Part 2 of Form ADV and file it 
electronically with us. Part 2 requires disclosure of certain 
conflicts of interest and could be prepared based on information 
already contained in materials provided to investors, which could 
reduce the costs of compliance even further.
    \302\ See Implementing Release, supra note 25, at n.363, 421 
(noting the cost estimate for compliance consulting services related 
to initial preparation of the amended Form ADV ranges from $3,000 
for smaller advisers to $5,000 for medium-sized advisers).
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    New registrants would also face costs to bring their business 
operations into compliance with the Advisers Act and the rules 
thereunder. These costs would vary depending on the size, scope and 
nature of the adviser's business, but in any case would be an ordinary 
business and operating expense of entering into any business that is 
regulated. We estimate that the one-time costs to new registrants to 
establish a compliance infrastructure would range from $10,000 to 
$45,000, while ongoing annual costs of compliance and examination would 
range from $10,000 to $50,000.\303\
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    \303\ We expect that most advisers that might choose to register 
have already built compliance infrastructures as a matter of good 
business practice. Nevertheless, we expect advisers will incur costs 
for outside legal counsel to evaluate their compliance procedures 
initially and on an ongoing basis. We estimate that the costs to 
advisers to establish the required compliance infrastructure will 
be, on average, $20,000 in professional fees and $25,000 in internal 
costs including staff time. These estimates were prepared in 
consultation with attorneys who, as part of their private practice, 
have counseled private fund advisers establishing their 
registrations with the Commission. We have included a range because 
we believe there are a number of unregistered private funds whose 
compliance operations are already substantially in compliance with 
the Advisers Act and that would therefore experience only minimal 
incremental ongoing costs as a result of registration. In connection 
with previous estimates we have made regarding compliance costs for 
registered advisers, we received comments from small advisers 
estimating that their annual compliance costs would be $25,000 and 
could be as high as $50,000. See, e.g., Comment Letter of Joseph L. 
Vidich (Aug. 7, 2004). Cf. Comment Letter of Venkat Swarna (Sept. 
14, 2004) (estimating costs of $20,000 to $25,000). These comment 
letters were submitted in connection with Hedge Fund Adviser 
Registration Release, supra note 17, and are available on the 
Commission's Internet Web site at http://www.sec.gov/rules/proposed/s73004.shtml.
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    We do not believe that the proposed definition of venture capital 
fund is likely to affect whether advisers to venture capital funds 
would choose to launch new funds or whether persons would choose to 
enter into the business of advising venture capital funds because, as 
noted above, we believe the proposed definition reflects the way most 
venture capital funds currently operate. For this reason, we expect 
that the proposed definition is not likely to significantly affect the 
way in which investment advisers to these funds do business and thus 
compete. For the same reason, we do not believe that our proposed rule 
is likely to have a significant effect on overall capital formation.
    We request comment on the costs we have discussed above. Are there 
costs of the proposed definition that we have not identified? How many 
advisers to venture capital funds are likely to choose to register or 
structure new venture capital funds differently from their existing 
funds in order to meet the proposed definition? How costly would it be 
for advisers to structure new venture capital funds to conform to the 
proposed definition in order to qualify

[[Page 77219]]

for an exemption from registration? Would advisers choose not to launch 
new funds or not enter the venture capital industry in order to avoid 
the costs associated with structuring venture capital funds to conform 
to the definition or registration? \304\
---------------------------------------------------------------------------

    \304\ Commission staff estimates that the one-time costs of 
registration for a venture capital fund adviser with $150 million in 
assets under management in the United States (i.e., an adviser that 
would not qualify for the exemption under section 203(m) of the 
Advisers Act), would be approximately 0.01% of assets, and annual 
costs of compliance and examination would range from 0.007% to 0.03% 
of assets under management. These figures are based on the following 
calculations: ($11,526 (registration costs) + $3,000 (lower estimate 
of external costs to prepare brochure)) / $150,000,000 = 0.000097; 
($11,526 (registration costs) + $5,000 (higher estimate of external 
costs to prepare brochure)) / $150,000,000 = 0.0001); $10,000 (lower 
estimate of ongoing costs) / $150,000,000 = 0.000067; $50,000 
(higher estimate of ongoing costs) / $150,000,000 = 0.000333).
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B. Exemption for Investment Advisers Solely to Private Funds With Less 
Than $150 Million in Assets Under Management

    As discussed in Section II.B., proposed rule 203(m)-1 would exempt 
any investment adviser solely to private funds that has less than $150 
million in assets under management in the United States. Our proposed 
rule is designed to implement the private fund adviser exemption, as 
directed by Congress, in section 203(m) of the Advisers Act and 
includes provisions for determining the amount of an adviser's private 
fund assets for purposes of the exemption and when those assets are 
deemed managed in the United States.\305\
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    \305\ See supra sections II.B.2-3 of this Release.
---------------------------------------------------------------------------

1. Benefits
    As discussed above and in the Implementing Release, we are 
proposing a uniform method of calculating assets under management in 
the instructions to Form ADV, which would be used to determine whether 
an adviser qualifies to register with the Commission rather than the 
states, and to determine eligibility for the private fund adviser 
exemption under section 203(m) of the Advisers Act and the foreign 
private adviser exemption under section 203(b)(3) of the Advisers 
Act.\306\ We anticipate that this uniform approach would benefit 
regulators (both state and federal) as well as advisers, because only a 
single determination of assets under management would be required for 
purposes of registration and exemption from federal registration.
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    \306\ See supra note 190 and accompanying text; Implementing 
Release, supra note 25, at nn.58-59 and accompanying text. Thus, 
under proposed rule 203(m)-1, to determine its assets under 
management for purposes of the proposed private fund adviser 
exemption, an adviser would calculate its ``regulatory assets under 
management'' attributable to private funds according to the 
instructions to Form ADV. Proposed rule 203(m)-1(a)(2), (b)(2) 
(conditioning the exemption on an adviser managing private fund 
assets of less than $150 million); proposed rule 203(m)-1(e)(1) 
(defining ``assets under management'' for purposes of the proposed 
rule's exemption); proposed rule 203(m)-1(e)(4) (defining ``private 
fund assets'' as the investment adviser's assets under management 
attributable to a qualifying private fund).
---------------------------------------------------------------------------

    The instructions to Form ADV currently permit, but do not require, 
advisers to exclude certain types of managed assets.\307\ As a result, 
it is not possible to conclude that two advisers reporting the same 
amount of assets under management are necessarily comparable because 
either adviser may elect to exclude all or some portion of certain 
specified assets that it manages. By specifying that assets under 
management must be calculated according to the instructions to Form 
ADV, our proposed approach should benefit advisers by increasing 
administrative efficiencies because advisers would have to calculate 
assets under management only once for multiple purposes.\308\ We expect 
this would minimize costs relating to software modifications, 
recordkeeping, and training required to determine assets under 
management for regulatory purposes. We also anticipate that the 
consistent calculation and reporting of assets under management would 
benefit investors and regulators because it would provide enhanced 
transparency and comparability of data, and allow investors and 
regulators to analyze on a more cost effective basis whether any 
particular adviser may be required to register with the Commission or 
is eligible for an exemption.
---------------------------------------------------------------------------

    \307\ See proposed Form ADV: Instructions to Part 1A, instr. 
5.b(1).
    \308\ See Shearman & Sterling Letter, supra note 268.
---------------------------------------------------------------------------

    We anticipate that the valuation of private fund assets under 
proposed rule 203(m)-1 would benefit private fund advisers that seek to 
rely on the exemption.\309\ Under proposed rule 203(m)-1, each adviser 
would determine the amount of its private fund assets based on the fair 
value of the assets at the end of each quarter. We propose that 
advisers use fair value of private fund assets in order to ensure that, 
for purposes of this exemption, advisers value private fund assets on a 
meaningful and consistent basis. We understand that many, but not all, 
advisers to private funds value assets based on their fair value in 
accordance with GAAP or other international accounting standards.\310\ 
We acknowledge that some advisers to private funds may not use fair 
value methodologies, which may be more difficult to apply when the fund 
holds illiquid or other types of assets that are not traded on 
organized markets.
---------------------------------------------------------------------------

    \309\ See proposed rule 203(m)-1(c); Implementing Release, supra 
note 25, proposed Form ADV: Instructions to Part 1A, instr. 5.b(4).
    \310\ See supra note 196.
---------------------------------------------------------------------------

    Proposed rule 203(m)-1(c) specifies that an adviser relying on the 
exemption would determine the amount of its private fund assets 
quarterly, which we believe would benefit advisers. We understand that 
a quarterly calculation of assets under management is consistent with 
business practice--many types of private funds calculate fees payable 
to advisers and other service providers on at least a quarterly 
basis.\311\ The quarterly calculation also would allow advisers that 
rely on the exemption to maintain the exemption despite short-term 
market value fluctuations that might result in the loss of the 
exemption if, for example, the rule required daily valuation. We expect 
that quarterly valuation would also benefit these advisers by allowing 
them to avoid the cost of more frequent valuations, including costs 
(such as third party quotes) associated with valuing illiquid assets, 
which may be particularly difficult to value more often because of the 
lack of frequency with which such assets are traded.
---------------------------------------------------------------------------

    \311\ See supra section II.B.2 of this Release; see, e.g., 
Breslow & Schwartz, supra note 144, at Sec.  2.8.2[C].
---------------------------------------------------------------------------

    Under proposed rule 203(m)-1(a), all of the private fund assets of 
an adviser with a principal office and place of business in the United 
States would be considered to be ``assets under management in the 
United States,'' even if the adviser has offices outside of the United 
States.\312\ A non-U.S. adviser would need only count private fund 
assets it manages from a place of business in the U.S. toward the $150 
million limit under the exemption. As discussed below, we believe that 
this interpretation of ``assets under management in the United States'' 
would offer greater flexibility to advisers and reduce many costs 
associated with compliance. These costs could include difficult 
attribution determinations that would be required if assets are managed 
by teams located in multiple jurisdictions or if portfolio managers 
located in one jurisdiction rely heavily on research or other

[[Page 77220]]

advisory services performed by employees located in another 
jurisdiction.
---------------------------------------------------------------------------

    \312\ As discussed above, the proposed rule looks to an 
adviser's principal office and place of business as the location 
where it directs, controls and coordinates its global advisory 
activities. Proposed rule 203(m)-1(e)(3). See supra notes 202-203 
and accompanying text.
---------------------------------------------------------------------------

    To the extent that this interpretation may increase the number of 
advisers subject to registration under the Advisers Act, we anticipate 
that our proposal also would benefit investors by providing more 
information about those advisers (e.g., information that would become 
available through Form ADV, Part I). We further anticipate that this 
would enhance investor protection by increasing the number of advisers 
registering pursuant to the Advisers Act and by improving the 
Commission's ability to exercise its investor protection and 
enforcement mandates over those newly registered advisers. As discussed 
above, registration offers benefits to the investing public, including 
periodic examination of the adviser and compliance with rules requiring 
recordkeeping, custody of client funds and compliance programs.\313\
---------------------------------------------------------------------------

    \313\ See supra text following note 281 and preceding and 
accompanying text.
---------------------------------------------------------------------------

    Under proposed rule 203(m)-1(b), a non-U.S. adviser with no U.S. 
place of business could avail itself of the exemption under section 
203(m) even if it advised non-U.S. clients that are not private funds, 
provided that it did not advise any U.S. clients other than private 
funds.\314\ We anticipate that the proposed approach to the exemption 
under section 203(m) of the Advisers Act, which would look primarily to 
the principal office and place of business of an adviser to determine 
eligibility for the exemption, would increase the number of non-U.S. 
advisers that may be eligible for the exemption. As with other 
Commission rules that adopt a territorial approach, the private fund 
adviser exemption would be available to a non-U.S. adviser (regardless 
of its non-U.S. advisory activities) in recognition that non-U.S. 
activities of non-U.S. advisers are less likely to implicate U.S. 
regulatory interests and in consideration of general principles of 
international comity. This approach to the exemption is designed to 
encourage the participation of non-U.S. advisers in the U.S. market by 
applying the U.S. securities laws in a manner that does not impose U.S. 
regulatory and operational requirements on an adviser's non-U.S. 
advisory business.\315\ We anticipate that our proposed interpretation 
of the availability of the private fund adviser exemption for non-U.S. 
advisers may benefit those advisers by facilitating their continued 
participation in the U.S. market with limited disruption to their non-
U.S. advisory business practices.\316\ This approach also might benefit 
U.S. investors and facilitate competition in the market for advisory 
services to the extent that it would maintain or increase U.S. 
investors' access to potential advisers. Furthermore, because non-U.S. 
advisers that elect to avail themselves of the exemption would be 
subject to certain reporting requirements,\317\ our proposed approach 
would increase the availability of information publicly available to 
U.S. investors who invest in the private funds advised by such exempt 
but reporting non-U.S. advisers.
---------------------------------------------------------------------------

    \314\ By contrast, a U.S. adviser could ``solely advise private 
funds'' as specified in the statute. Compare proposed rule 203(m)-
1(a)(1) with proposed rule 203(m)-1(b)(1).
    \315\ See supra note 208 and accompanying text.
    \316\ See supra section II.B.3 of this Release.
    \317\ See Implementing Release, supra note 25, at section II.B.
---------------------------------------------------------------------------

    We request comment on the potential benefits we have identified 
above. Are there benefits of the proposed rule that we have not 
identified?
2. Costs
    As noted above, under proposed rule 203(m)-1, we would look to an 
adviser's principal office and place of business as the location where 
the adviser directs, controls or has responsibility for, the management 
of private fund assets and therefore as the place where all the 
adviser's assets are managed. Thus, a U.S. adviser would include all 
its private fund assets under management in determining whether it 
exceeds the $150 million limit under the exemption. We also look to 
where day-to-day management of private fund assets may occur for 
purposes of a non-U.S. adviser, whose principal office and place of 
business is outside the United States.\318\ A non-U.S. adviser 
therefore would count only the private fund assets it manages from a 
place of business in the United States in determining the availability 
of the exemption. This approach is similar to the way we have defined 
the location of the adviser for regulatory purposes under our current 
rules,\319\ and thus we believe it is the way in which most advisers 
would interpret the exemption without our proposed rule.\320\ We 
anticipate that our proposed approach would promote efficiency because 
advisers are familiar with it, and we do not anticipate that U.S. 
investment advisers to private funds would likely change their business 
models, the location of their private funds, or the location where they 
manage assets as a result of the proposed rule. We anticipate, however 
that non-U.S. advisers may incur minimal costs to determine whether 
they have assets under management in the U.S. We estimate that these 
costs would be no greater than $6,940 to hire U.S. counsel and perform 
an internal review to assist in this determination, in particular to 
assess whether a non-U.S. affiliate manages a discretionary account for 
the benefit of a United States person under the proposed rule.\321\
---------------------------------------------------------------------------

    \318\ See supra paragraph accompanying note 205.
    \319\ See supra note 202 and accompanying text.
    \320\ We do not believe that the statutory text refers to where 
the assets themselves may be located or traded or the location of 
the account where the assets are held. In today's market, using the 
location of assets would raise numerous questions of where a 
security with no physical existence is ``located.'' Although 
physical stock certificates were once sent to investors as proof of 
ownership, stock certificates are now centrally held by securities 
depositories, which perform electronic ``book-entry'' changes in 
their records to document ownership of securities. This arrangement 
reduces transmittal costs and increases efficiencies for securities 
settlements. See generally Bank for International Settlements, The 
Depository Trust Company: Response to the Disclosure Framework for 
Securities Settlement Systems (2002), http://www.bis.org/publ/cpss20r3.pdf. An account also has no physical location even if the 
prime broker, custodian or other service that holds assets on behalf 
of the customer does. Each of these approaches would be confusing 
and extremely difficult to apply on a consistent basis.
    \321\ We expect that a non-U.S. adviser would need no more than 
10 hours of external legal advice (at $400 per hour) and 10 hours of 
internal review by a senior compliance officer (at $294 per hour) to 
evaluate whether the adviser would qualify for the exemption under 
section 203(l).
---------------------------------------------------------------------------

    As noted above, because our rule is designed to encourage the 
participation of non-U.S. advisers in the U.S. market, we anticipate 
that it would have minimal regulatory and operational burdens on 
foreign advisers and their U.S. clients. Non-U.S advisers would be able 
to rely on proposed rule 203(m)-1 if they manage U.S. private funds 
with more than $150 million in assets from a non-U.S. location as long 
as the private fund assets managed from a U.S. place of business are 
less than $150 million. This could affect competition with U.S. 
advisers, which must register when they have $150 million in private 
fund assets under management regardless of where the assets are 
managed.
    To avail themselves of proposed rule 203(m)-1, some advisers might 
choose to move their principal office and place of business outside the 
United States and manage private funds from that location. This might 
result in costs to U.S. investors in private funds that are managed by 
these advisers because they would not have the investor protection and 
other benefits that result from an adviser's registration under the 
Advisers Act. We do not expect that many advisers would be likely to 
relocate for

[[Page 77221]]

purposes of avoiding registration, however, because we understand that 
the primary reasons for advisers to locate in a particular jurisdiction 
involve tax and other business considerations. We also note that if an 
adviser did relocate, it would incur the costs of regulation under the 
laws of most of the foreign jurisdictions in which it may be likely to 
relocate. We do not believe, in any case, that the adviser would 
relocate if relocation would result in a material decrease in the 
amount of assets managed because that loss would likely not justify the 
benefits of avoiding registration, and thus we do not believe our 
proposed rule would have an adverse effect on capital formation.
    Our proposed rule incorporates the valuation methodology in the 
instructions to Form ADV. More specifically, proposed instruction 
5.b(4) to Form ADV would require advisers to use fair value of private 
fund assets for determining regulatory assets under management. We 
acknowledge that there may be some private fund advisers that may not 
use fair value methodologies.\322\ The costs incurred by these advisers 
to use fair valuation methodology would vary based on factors such as 
the nature of the asset, the number of positions that do not have a 
market value, and whether the adviser has the ability to value such 
assets internally or would rely on a third party for valuation 
services.\323\ Nevertheless, we do not believe that the requirement to 
use fair value methodologies would result in significant costs for 
these advisers. We understand that private fund advisers, including 
those that may not use fair value methodologies for reporting purposes, 
perform administrative services, including valuing assets, internally 
as a matter of business practice.\324\ Commission staff estimates that 
such an adviser would incur $1,224 in internal costs to conform its 
internal valuations to a fair value standard.\325\ In the event a fund 
does not have an internal capability for valuing specific illiquid 
assets, we expect that it could obtain pricing or valuation services 
from an outside administrator or other service provider. In the event a 
fund does not have an internal capability for valuing specific illiquid 
assets, we expect that it could obtain pricing or valuation services 
from an outside administrator or other service provider. Staff 
estimates that the cost of such a service would range from $1,000 to 
$120,000 annually, which could be borne by several funds that invest in 
similar assets or have similar investment strategies.\326\ We request 
comment on these estimates. Do advisers that do not use fair value 
methodologies for reporting purposes have the ability to fair value 
private fund assets internally? If not, what would be the costs to 
retain a third party valuation service? Are there certain types of 
advisers (e.g., advisers to real estate private funds) that would 
experience special difficulties in performing fair value analyses? If 
so, why?
---------------------------------------------------------------------------

    \322\ See supra note 310 and accompanying and following text.
    \323\ See supra note 197.
    \324\ For example, a hedge fund adviser may value fund assets 
for purposes of allowing new investments in the fund or redemptions 
by existing investors, which may be permitted on a regular basis 
after an initial lock-up period. An adviser to private equity funds 
may obtain valuation of portfolio companies in which the fund 
invests in connection with financing obtained by those companies. 
Advisers to private funds also may value portfolio companies each 
time the fund makes (or considers making) a follow-on investment in 
the company. Private fund advisers could use these valuations as a 
basis for complying with the fair valuation requirement we propose 
with respect to private fund assets.
    \325\ This estimate is based upon the following calculation: 8 
hours x $153/hour = $1,224. The hourly wage is based on data for a 
fund senior accountant from SIFMA's Management and Earnings in the 
Securities Industry 2009, modified by Commission staff to account 
for an 1,800-hour work-year and multiplied by 5.35 to account for 
bonuses, firm size, employee benefits and overhead.
    \326\ These estimates are based on conversations with valuation 
service providers. We understand that the cost of valuation for 
illiquid fixed income securities generally ranges from $1.00 to 
$5.00 per security, depending on the difficulty of valuation, and is 
performed for clients on weekly or monthly basis. We understand that 
appraisals of privately placed equity securities may cost from 
$3,000 to $5,000 with updates to such values at much lower prices. 
For purposes of this cost benefit analysis, we are estimating the 
range of costs for (i) a private fund that holds 50 fixed income 
securities at a cost of $5.00 to price and (ii) a private fund that 
holds privately placed securities of 15 issuers that each cost 
$5,000 to value initially and $1,000 thereafter. We believe that 
costs for funds that hold both fixed-income and privately placed 
equity securities would fall within the maximum of our estimated 
range. We note that funds that have significant positions in 
illiquid securities are likely to have the in-house capacity to 
value those securities or already subscribe to a third party service 
to value them. We note that many private funds are likely to have 
many fewer fixed income illiquid securities in their portfolios, 
some or all of which may cost less than $5.00 per security to value. 
Finally, we note that obtaining valuation services for a small 
number of fixed income positions on an annual basis may result in a 
higher cost for each security or require a subscription to the 
valuation service for those that do not already purchase such 
services. The staff's estimate is based on the following 
calculations: (50 x $5.00 x 4 = $1,000; (15 x $5,000) + (15 x $1,000 
x 3) = $120,000).
---------------------------------------------------------------------------

    Our earlier discussion of the proposed rule also seeks comment on 
an alternative interpretation of ``assets under management in the 
United States,'' which would reference the source of the assets (i.e., 
U.S. private fund investors).\327\ Under this approach, a non-U.S. 
adviser would count the assets of private funds attributable to U.S. 
investors towards the $150 million threshold, regardless of the 
location where it manages private funds, and a U.S. adviser would 
exclude assets that are not attributable to U.S. investors. As a 
result, under this alternative more U.S. advisers might be able to rely 
on rule 203(m)-1 than under our proposed approach. To the extent that 
non-U.S. advisers have U.S. investors in funds that they manage from a 
non-U.S. location, fewer non-U.S. advisers would be eligible for the 
exemption under this approach than under our proposal. Thus, this 
alternative could increase costs for those non-U.S. advisers who would 
have to register but reduce costs for those U.S. advisers who would not 
have to register. We seek comment on the number of U.S. advisers that 
would be able to avail themselves of the private fund adviser exemption 
under this alternative approach, but would not be able to rely on 
proposed rule 203(m)-1.
---------------------------------------------------------------------------

    \327\ See supra paragraph following note 210.
---------------------------------------------------------------------------

    This alternative approach could discourage U.S. advisers that may 
want to avoid registration from managing U.S. investor assets, which 
could affect competition for the management of those assets. We believe 
this is unlikely however, because to the extent the adviser would 
manage fewer assets we do not believe the loss of managed assets would 
justify the savings from avoiding registration.
    Under either the proposed approach or the alternative, each adviser 
may incur costs to evaluate whether it would be able to avail itself of 
the exemption. We estimate that each adviser may incur between $800 to 
$4,800 in legal advice to learn whether it may rely on the 
exemption.\328\ Each adviser that registers would incur registration 
costs, which we estimate would be $11,526.\329\ They also would incur 
estimated initial compliance costs ranging from $10,000 to $45,000 and 
ongoing annual compliance costs from $10,000 to $50,000.\330\ 
Nevertheless, to the extent there would be an increase in registered 
advisers, as we have noted above, there

[[Page 77222]]

are benefits to registration for both investors and the 
Commission.\331\
---------------------------------------------------------------------------

    \328\ We expect that a private fund adviser would obtain between 
2 and 12 hours of external legal advice (at a cost of $400 per hour) 
to determine whether it would be eligible for the private fund 
adviser exemption.
    \329\ This range is attributable to the amount of assets under 
management, which affects the magnitude of filing fees associated 
with registration, and whether the adviser chooses to retain outside 
legal services to prepare its brochure. See supra notes 300-302 and 
accompanying text.
    \330\ See supra note 303 and accompanying text.
    \331\ See supra text following note 281.
---------------------------------------------------------------------------

    We seek comment on our analysis of the costs associated with the 
approach we have proposed and the costs of the alternative on which we 
seek comment. Are there costs of the proposed rule or the alternative 
approach that we have not identified?

C. Foreign Private Adviser Exemption

    Section 403 of the Dodd-Frank Act replaces the current private 
adviser exemption from registration under the Advisers Act with a new 
exemption for a ``foreign private adviser,'' as defined in new section 
202(a)(30) of the Advisers Act.\332\ We are proposing new rule 
202(a)(30)-1, which would define certain terms in section 202(a)(30) 
for use by advisers seeking to avail themselves of the foreign private 
adviser exemption.\333\ Because eligibility for the new foreign private 
adviser exemption, like the current private adviser exemption, is 
determined, in part, by the number of clients an adviser has, we 
propose to include in rule 202(a)(30)-1 the safe harbor and many of the 
client counting rules that appear in rule 203(b)(3)-1, as currently in 
effect.\334\ In addition, we propose to define other terms used in the 
definition of ``foreign private adviser'' under section 202(a)(30) 
including: (i) ``Investor;'' (ii) ``in the United States;'' (iii) 
``place of business;'' and (iv) ``assets under management.'' \335\
---------------------------------------------------------------------------

    \332\ See supra note 224 and accompanying text. The new 
exemption is codified as amended section 203(b)(3).
    \333\ See supra section II.C of this Release.
    \334\ See supra section II.C.1 of this Release. Rule 203(b)(3)-
1, as currently in effect, provides a safe harbor for determining 
who may be deemed a single client for purposes of the private 
adviser exemption. We would not, however, carry over rules 
203(b)(3)-1(b)(4), (5), or (7). See supra notes 228 and 233 and 
accompanying text.
    \335\ Proposed rule 202(a)(30)-1(c). See supra section II.C.2-4 
of this Release.
---------------------------------------------------------------------------

    Proposed rule 202(a)(30)-1 clarifies several provisions used in the 
statutory definition of ``foreign private adviser.'' First, the 
proposed rule would include the safe harbor for counting clients 
currently in rule 203(b)(3)-1, as modified to account for its use in 
the foreign private adviser context. Under the safe harbor, an adviser 
would count certain natural persons as a single client under certain 
circumstances.\336\ Proposed rule 202(a)(30)-1 would also retain 
another provision of rule 203(b)(3)-1 that permits an adviser to treat 
as a single ``client'' an entity that receives investment advice based 
on the entity's investment objectives and two or more entities that 
have identical owners.\337\ As mentioned above, we would not include 
the ``special rule'' that allows advisers not to count as a client any 
person for whom the adviser provides investment advisory services 
without compensation.\338\ Finally, we propose to add a provision that 
would permit advisers to avoid double-counting private funds and their 
investors.\339\
---------------------------------------------------------------------------

    \336\ Proposed rule 202(a)(30)-1(a)(1).
    \337\ Proposed rule 202(a)(30)-1(a)(2)(i)-(ii). In addition, 
proposed rule 202(a)(30)-1(b)(1) through (3) would retain the 
following related ``special rules'': (1) An adviser must count a 
shareholder, partner, limited partner, member, or beneficiary (each, 
an ``owner'') of a corporation, general partnership, limited 
partnership, limited liability company, trust, or other legal 
organization, as a client if the adviser provides investment 
advisory services to the owner separate and apart from the legal 
organization; (2) an adviser is not required to count an owner as a 
client solely because the adviser, on behalf of the legal 
organization, offers, promotes, or sells interests in the legal 
organization to the owner, or reports periodically to the owners as 
a group solely with respect to the performance of or plans for the 
legal organization's assets or similar matters; and (3) any general 
partner, managing member or other person acting as an investment 
adviser to a limited partnership or limited liability company must 
treat the partnership or limited liability company as a client.
    \338\ See rule 203(b)(3)-1(b)(4); supra notes 233-235 and 
accompanying text.
    \339\ See proposed rule 202(a)(30)-1(b)(4) (specifying that an 
adviser would not be required to count a private fund as a client if 
it counted any investor, as defined in the proposed rule, in that 
private fund as an investor in the United States in that private 
fund).
---------------------------------------------------------------------------

    Second, section 202(a)(30) provides that a ``foreign private 
adviser'' eligible for the new registration exemption cannot have more 
than 14 clients ``or investors.'' We propose to define ``investor'' in 
a private fund in rule 202(a)(30)-1 as any person that would be 
included in determining the number of beneficial owners of the 
outstanding securities of a private fund under section 3(c)(1) of the 
Investment Company Act, or whether the outstanding securities of a 
private fund are owned exclusively by qualified purchasers under 
section 3(c)(7) of that Act.\340\ We are also proposing to treat as 
investors beneficial owners (i) who are ``knowledgeable employees'' 
with respect to the private fund; \341\ and (ii) of ``short-term 
paper'' \342\ issued by the private fund, even though these persons are 
not counted as beneficial owners for purposes of section 3(c)(1), and 
knowledgeable employees are not required to be qualified purchasers 
under section 3(c)(7).\343\
---------------------------------------------------------------------------

    \340\ See proposed rule 202(a)(30)-1(c)(1); supra section II.C.2 
of this Release. In order to avoid double-counting, we would allow 
an adviser to treat as a single investor any person that is an 
investor in two or more private funds advised by the investment 
adviser. See proposed rule 202(a)(30)-1(c)(1), at note to paragraph 
(c)(1).
    \341\ See proposed rule 202(a)(30)-1(c)(1)(A); supra note 246 
and accompanying text.
    \342\ See proposed rule 202(a)(30)-1(c)(1)(B); supra notes 247-
248 and accompanying text.
    \343\ See rule 3c-5(b) under the Investment Company Act; section 
3(c)(1) of the Investment Company Act. See also supra note 249 and 
accompanying text.
---------------------------------------------------------------------------

    Third, proposed rule 202(a)(30)-1 defines ``in the United States'' 
generally by incorporating the definition of a ``U.S. person'' and 
``United States'' under Regulation S.\344\ In particular, we would 
define ``in the United States'' in proposed rule 202(a)(30)-1 to mean: 
(i) With respect to any place of business located in the ``United 
States,'' as that term is defined in Regulation S; \345\ (ii) with 
respect to any client or private fund investor in the United States, 
any person that is a ``U.S. person'' as defined in Regulation S,\346\ 
except that under the proposed rule, any discretionary account or 
similar account that is held for the benefit of a person ``in the 
United States'' by a non-U.S. dealer or other professional fiduciary is 
a person ``in the United States'' if the dealer or professional 
fiduciary is a related person of the investment adviser relying on the 
exemption; and (iii) with respect to the public in the ``United 
States,'' as that term is defined in Regulation S.\347\ Fourth, 
proposed rule 202(a)(30)-1 defines ``place of business'' to have the 
same meaning as in Advisers Act rule 222-1(a).\348\ Finally, for 
purposes of rule 202(a)(30)-1 we propose to define ``assets under 
management'' by reference to ``regulatory assets under management'' as 
determined under Item 5 of Form ADV.\349\
---------------------------------------------------------------------------

    \344\ Proposed rule 202(a)(30)-1(c)(2). See supra notes 253-261 
and accompanying paragraphs.
    \345\ See 17 CFR 230.902(l).
    \346\ See 17 CFR 230.902(k). We would allow foreign advisers to 
determine whether a client or investor is ``in the United States'' 
by reference to the time the person became a client or an investor. 
See proposed rule 202(a)(30)-1's note to paragraph (c)(2)(i).
    \347\ See 17 CFR 230.902(l).
    \348\ See proposed rule 202(a)(30)-1(c)(3); proposed rule 222-
1(a) (defining ``place of business'' of an investment adviser as: 
``(i) An office at which the investment adviser regularly provides 
investment advisory services, solicits, meets with, or otherwise 
communicates with clients; and (ii) Any other location that is held 
out to the general public as a location at which the investment 
adviser provides investment advisory services, solicit, meets with, 
or otherwise communicates with clients.''). See supra section II.C.4 
of this Release.
    \349\ See proposed rule 202(a)(30)-1(c)(4); proposed Form ADV: 
Instructions to Part 1A, instr. 5.b(4). See also supra section 
II.C.5 of this Release.
---------------------------------------------------------------------------

1. Benefits
    We are proposing to define certain terms included in the statutory 
definition of ``foreign private adviser'' in order to clarify the 
meaning of these terms and reduce the potential administrative and 
regulatory burdens for advisers that seek to rely on the

[[Page 77223]]

foreign private adviser exemption. As discussed above, our proposed 
rule references definitions set forth in other Commission rules under 
the Advisers Act, the Investment Company Act and the Securities Act, 
all of which are likely to be familiar to foreign advisers active in 
the U.S. capital markets. We anticipate that by defining these terms, 
we would benefit foreign advisers by providing clarity with respect to 
the proposed terms that advisers would otherwise be required to 
interpret (and which they would likely interpret with reference to the 
rules we reference).\350\ The proposal would provide consistency among 
these other rules and the new exemption. This would limit foreign 
advisers' need to undertake additional analysis with respect to these 
terms for purposes of determining the availability of the foreign 
private adviser exemption.\351\ We believe that the consistency and 
clarity that would result from the proposed rule would promote 
efficiency for foreign advisers and the Commission.
---------------------------------------------------------------------------

    \350\ See Paul Hastings Letter, supra note 258 (in response to 
our request for public views, urging us to provide guidance on the 
interpretation of the terms of the statutory definition of ``foreign 
private adviser''). See generally supra note 24.
    \351\ This is true for all of the proposed definitions except 
for ``assets under management.'' An adviser that relies on the 
foreign private adviser exemption would need to calculate its assets 
under management according to the proposed instructions to Item 5 of 
Form ADV only for purposes of the availability of the exemption. As 
discussed, above, proposed rule 202(a)(30)-1 includes a reference to 
Item 5 of Form ADV in order to ensure consistency in the calculation 
of assets under management for various purposes under the Advisers 
Act. See supra note 266 and accompanying text.
---------------------------------------------------------------------------

    For example, for purposes of determining eligibility for the 
foreign private adviser exemption, advisers would count clients 
substantially in the same manner they count clients under the current 
private adviser exemption.\352\ In identifying ``investors,'' advisers 
could rely on the determination made to assess whether the private fund 
meets the counting or qualification requirements under sections 3(c)(1) 
and 3(c)(7) of the Investment Company Act.\353\ In determining whether 
a client, an investor, or a place of business is ``in the United 
States,'' or whether it holds itself out as an investment adviser to 
the public ``in the United States,'' an adviser would apply the same 
analysis it would otherwise apply under Regulation S.\354\ In 
identifying whether it has a place of business in the United States, an 
adviser would use the definition of ``place of business'' under section 
222 of the Advisers Act, which is used to determine whether a state may 
assert regulatory jurisdiction over the adviser.\355\
---------------------------------------------------------------------------

    \352\ See supra section II.C.1 of this Release.
    \353\ See supra paragraph accompanying note 240.
    \354\ See supra notes 258-259 and accompanying paragraph.
    \355\ See supra section II.C.3 of this Release. Under section 
222 of the Advisers Act a state may not require an adviser to 
register if the adviser does not have a ``place of business'' 
within, and has fewer than 6 client residents of, the state.
---------------------------------------------------------------------------

    As noted above, the proposed definitions of ``investor'' and 
``United States'' under our proposed rule would rely on existing 
definitions, with slight modifications.\356\ Our proposed rule also 
would incorporate the current safe harbor in rule 203(b)(3)-1 for 
counting clients, except that it would no longer allow an adviser to 
disregard clients for whom the adviser provides services without 
compensation.\357\ We propose these modifications in order to preclude 
some advisers from excluding certain assets or clients from their 
calculation so as to avoid registration with the Commission and the 
regulatory requirements associated with registration.\358\ We believe 
that without a definition of these terms, advisers would likely rely on 
the same definitions we propose to cross reference in rule 202(a)(30)-
1, but without the proposed modifications. Our proposal, therefore, 
would likely have the practical effect of narrowing the scope of the 
exemption, and thus would result in more advisers registering.
---------------------------------------------------------------------------

    \356\ See supra notes 238, 246-251, 253-257 and accompanying 
text.
    \357\ See supra notes 336-339 and accompanying text.
    \358\ See supra notes 246-251, 253-257 and accompanying text. 
See also infra notes 362-363 and accompanying text for an estimate 
of the costs associated with registration.
---------------------------------------------------------------------------

    We believe that any increase in registration as compared to the 
number of foreign advisers that might register if we did not propose 
rule 202(a)(30)-1 would benefit investors. Investors whose assets are, 
directly or indirectly, managed by the foreign advisers that would be 
required to register would benefit from the increased protection 
afforded by federal registration of the adviser and application to the 
adviser of all of the requirements of the Advisers Act. As noted above, 
registration offers benefits to the investing public, including 
periodic examination of the adviser and compliance with rules requiring 
recordkeeping, custody of client funds and compliance programs.\359\
---------------------------------------------------------------------------

    \359\ See supra text accompanying and following note 281.
---------------------------------------------------------------------------

    We request comment on the potential benefits we have identified 
above. Are there benefits of the proposed rule that we have not 
identified?
2. Costs
    We do not believe that the proposed definitions would result in 
significant costs for foreign advisers. We anticipate that each foreign 
adviser that seeks to avail itself of the foreign private adviser 
exemption may incur costs to determine whether it is eligible for the 
exemption. We expect that these advisers would consult with outside 
U.S. counsel and perform an internal review of the extent to which an 
advisory affiliate manages discretionary accounts owned by a U.S. 
person that would be counted toward the limitation on clients and 
investors in the United States. We estimate these costs would be 
$6,940.\360\
---------------------------------------------------------------------------

    \360\ This estimate is based on consultation with outside 
counsel (at a cost of $400 per hour) of 10 hours and an internal 
review of discretionary accounts owned by U.S. persons performed by 
a senior compliance officer (at a cost of $294 per hour) of 10 
hours. The calculation is as follows: (10 hours x $400) + (10 hours 
x $294) = $6,940.
---------------------------------------------------------------------------

    Without the proposed rule, we expect that most advisers would 
interpret the new statutory provision by reference to the same rules we 
propose to cross reference in rule 202(a)(30)-1. Without our proposal, 
some advisers would likely incur additional costs because they would 
seek guidance in interpreting the terms used in the statutory 
exemption. By defining the statutory terms in a rule, we believe that 
we can provide certainty for foreign advisers and limit the time, 
compliance costs and legal expenses foreign advisers might incur in 
seeking an interpretation, all of which costs could inhibit capital 
formation or reduce efficiency. We expect that advisers also would be 
less likely to seek additional assistance from us because they could 
rely on relevant guidance we have previously provided with respect to 
the definitions we propose to cross reference. We also believe that 
foreign advisers' ability to rely on the definitions that we have 
referenced in the proposed rule and the guidance provided with respect 
to the referenced rules may reduce Commission resources that would be 
otherwise applied to administering the private foreign adviser 
exemption, which resources could be allocated to other matters.
    We anticipate that our proposed instruction allowing foreign 
advisers to determine whether a client or investor is ``in the United 
States'' by reference to the time the person became a client or an 
investor, would also reduce advisers' costs.\361\ Advisers would make 
the determination only once and would not be required to monitor 
changes in the

[[Page 77224]]

status of each client and private fund investor. Moreover, if a client 
or an investor moved to the United States, under our approach the 
adviser would not be forced to choose among registering with us, 
terminating the relationship with the client, or forcing the investor 
out of the the private fund.
---------------------------------------------------------------------------

    \361\ See proposed rule 202(a)(30)-1, at note to paragraph 
(c)(2)(i); supra notes 267-268 and accompanying text.
---------------------------------------------------------------------------

    The proposed modifications may result in some costs for foreign 
advisers who might change their business practices in order to rely on 
the exemption. Some foreign advisers may have to choose to limit the 
scope of their contacts with the United States in order to rely on the 
statutory exemption for foreign private advisers or to register with 
us. As noted above, we have estimated the costs of registration to be 
$11,526.\362\ In addition, registered advisers would incur initial 
costs to establish a compliance infrastructure, which we estimate would 
range from $10,000 to $45,000 and ongoing annual costs of compliance 
and examination, which we estimate would range from $10,000 to 
$50,000.\363\ In either case, foreign advisers would assess the costs 
of registering with the Commission relative to relying on the 
exemption. This assessment, however, would take into account many 
factors, which would vary from one adviser to another, to determine 
whether registration, relative to other options, is the most cost-
effective business option for the adviser to pursue. If a foreign 
adviser limited its activities within the United States in order to 
rely on the exemption, the modifications might have the effect of 
reducing competition in the market for advisory services. Were the 
foreign adviser to register, competition among registered advisers 
would increase. Furthermore, to the extent that the modifications 
included in the definition of ``investor'' (in particular the one 
concerning knowledgeable employees) would limit a foreign adviser's 
ability to attract certain private fund investors, those modifications 
may have an adverse effect on capital formation.
---------------------------------------------------------------------------

    \362\ See supra note 299 and accompanying text.
    \363\ See supra note 303 and accompanying text.
---------------------------------------------------------------------------

    By referencing the method of calculating assets under management 
under Form ADV, certain foreign private advisers would use the 
valuation method provided in the instructions to Form ADV to verify 
compliance with the $25 million asset threshold included in the foreign 
private adviser exemption.\364\ More specifically, proposed instruction 
5.b(4) to Form ADV would require advisers to use fair value of private 
fund assets for determining regulatory assets under management. Some 
foreign advisers to private funds may value assets based on their fair 
value in accordance with GAAP or other international accounting 
standards, while other advisers to private funds may not use fair value 
methodologies.\365\ As discussed above, the costs associated with fair 
valuation would vary based on factors such as the nature of the asset, 
the number of positions that do not have a market value, and whether 
the adviser has the ability to value such assets internally or would 
rely on a third party for valuation services.\366\ Nevertheless, we do 
not believe that the requirement to use fair value methodologies would 
result in significant costs for these advisers to these funds.\367\ 
Commission staff estimates that such advisers would each incur $1,224 
in internal costs to conform its internal valuations to a fair value 
standard.\368\ In the event a fund does not have an internal capability 
for valuing illiquid assets, we expect that it could obtain pricing or 
valuation services from an outside administrator or other service 
provider. Staff estimates that the annual cost of such a service would 
range from $1,000 to $120,000 annually which could be borne by several 
funds that invest in similar assets or have similar investment 
strategies.\369\ We request comment on these estimates. Do foreign 
advisers that do not use fair value methodologies for reporting 
purposes have the ability to fair value private fund assets internally? 
If not, what would be the costs to retain a third party valuation 
service? Are there certain types of foreign advisers (e.g., advisers to 
real estate private funds) that would experience special difficulties 
in performing fair value analyses? If so, why?
---------------------------------------------------------------------------

    \364\ See supra section II.C.5 of this Release.
    \365\ See supra note 310 and accompanying and following text.
    \366\ See supra notes 322-325 and accompanying paragraph.
    \367\ See supra note 324 and accompanying text.
    \368\ See supra note 325.
    \369\ See supra note 326 and accompanying text.
---------------------------------------------------------------------------

    We request comment on the potential costs we have identified above. 
Are there costs of the proposed rule that we have not identified?

D. Request for Comment

    The Commission requests comments on all aspects of the cost-benefit 
analysis, including the accuracy of the potential costs and benefits 
identified and assessed in this Release, as well as any other costs or 
benefits that may result from the proposals. We encourage commenters to 
identify, discuss, analyze, and supply relevant data regarding these or 
additional costs and benefits. For purposes of the Small Business 
Regulatory Enforcement Fairness Act of 1996,\370\ the Commission also 
requests information regarding the potential annual effect of the 
proposals on the U.S. economy. Commenters are requested to provide 
empirical data to support their views.
---------------------------------------------------------------------------

    \370\ Public Law 104-121, Title II, 110 Stat. 857 (1996) 
(codified in various sections of 5 U.S.C., 15 U.S.C. and as a note 
to 5 U.S.C. 601).
---------------------------------------------------------------------------

VI. Regulatory Flexibility Act Certification

    Pursuant to section 605(b) of the Regulatory Flexibility Act,\371\ 
the Commission hereby certifies that proposed rules 203(l)-1 and 
203(m)-1 under the Advisers Act would not, if adopted, have a 
significant economic impact on a substantial number of small entities. 
Under Commission rules, for the purposes of the Advisers Act and the 
Regulatory Flexibility Act, an investment adviser generally is a small 
entity if it: (i) Has assets under management having a total value of 
less than $25 million; (ii) did not have total assets of $5 million or 
more on the last day of its most recent fiscal year; and (iii) does not 
control, is not controlled by, and is not under common control with 
another investment adviser that has assets under management of $25 
million or more, or any person (other than a natural person) that had 
$5 million or more on the last day of its most recent fiscal year 
(``small adviser'').\372\
---------------------------------------------------------------------------

    \371\ 5 U.S.C. 605(b).
    \372\ Rule 0-7(a) (17 CFR 275.0-7(a)).
---------------------------------------------------------------------------

    Investment advisers solely to venture capital funds and advisers 
solely to private funds in each case with assets under management of 
less than $25 million would remain generally ineligible for 
registration with the Commission under section 203A of the Advisers 
Act.\373\ We expect that any small adviser solely to existing venture 
capital funds that would not be ineligible to register with the 
Commission would be able to avail itself of the exemption from 
registration under the grandfathering provision. If an adviser solely 
to a new venture capital fund could not avail itself of the exemption 
because, for example, the fund it advises did not meet the proposed 
definition of ``venture capital fund,'' we anticipate that the adviser 
could avail itself of the exemption in section 203(m) of the Advisers 
Act as

[[Page 77225]]

implemented by proposed rule 203(m)-1. Similarly, we expect that any 
small adviser solely to private funds would be able to rely on the 
exemption in section 203(m) of the Advisers Act as implemented by 
proposed rule 203(m)-1. We further believe that these advisers would be 
able to avail themselves of the exemption for private fund advisers 
regardless of whether our implementing rules required them to calculate 
assets under management as proposed approach or under the alternative 
method on which we request comment.\374\
---------------------------------------------------------------------------

    \373\ Section 203A of the Advisers Act (prohibiting an 
investment adviser that is regulated or required to be regulated as 
an investment adviser in the State in which it maintains its 
principal office and place of business from registering with the 
Commission unless the adviser has $25 million or more in assets 
under management or is an adviser to a registered investment 
company).
    \374\ See supra section II.B.2 of this Release.
---------------------------------------------------------------------------

    Thus, we believe that small advisers solely to venture capital 
funds and small advisers to other private funds would generally be 
ineligible to register with the Commission. Those small advisers that 
may not be ineligible to register with the Commission, we believe, 
would be able to rely on the venture fund exemption under section 
203(l) of the Advisers Act or the private fund adviser exemption under 
section 203(m) of that Act as implemented by our proposed rules. For 
these reasons, we are certifying that proposed rules 203(l)-1 and 
203(m)-1 under the Advisers Act would not, if adopted, have a 
significant economic impact on a substantial number of small entities.
    The Commission requests written comments regarding this 
certification. The Commission requests that commenters describe the 
nature of any impact on small businesses and provide empirical data to 
support the extent of the impact.

VII. Statutory Authority

    The Commission is proposing rule 202(a)(30)-1 under the authority 
set forth in sections 403 and 406 of the Dodd-Frank Act, to be codified 
at sections 203(b) and 211(a) of the Advisers Act, respectively (15 
U.S.C. 80b-3(b), 80b-11(a)). The Commission is proposing rule 203(l)-1 
under the authority set forth in sections 406 and 407 of the Dodd-Frank 
Act, to be codified at sections 211(a) and 203(l) of the Advisers Act, 
respectively (15 U.S.C. 80b-11(a), 80b-3(l)). The Commission is 
proposing rule 203(m)-1 under the authority set forth in sections 406 
and 408 of the Dodd-Frank Act, to be codified at sections 211(a) and 
203(m) of the Advisers Act, respectively (15 U.S.C. 80b-11(a), 80b-
3(m)).

List of Subjects in 17 CFR Part 275

    Reporting and recordkeeping requirements; Securities.

Text of Proposed Rules

    For reasons set out in the preamble, the Commission proposes to 
amend Title 17, Chapter II of the Code of Federal Regulations as 
follows:

PART 275--RULES AND REGULATIONS, INVESTMENT ADVISERS ACT OF 1940

    1 . The general authority citation for Part 275 is revised to read 
as follows:

    Authority:  15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-6(4), 80b-6(a), and 80b-11, unless 
otherwise noted.
* * * * *
    2. Section 275.202(a)(30)-1 is added to read as follows:

Sec.  275.202(a)(30)-1  Foreign private advisers.

    (a) Client. You may deem the following to be a single client for 
purposes of section 202(a)(30) of the Act (15 U.S.C. 80b-2(a)(30)):
    (1) A natural person, and:
    (i) Any minor child of the natural person;
    (ii) Any relative, spouse, or relative of the spouse of the natural 
person who has the same principal residence;
    (iii) All accounts of which the natural person and/or the persons 
referred to in this paragraph (a)(1) are the only primary 
beneficiaries; and
    (iv) All trusts of which the natural person and/or the persons 
referred to in this paragraph (a)(1) are the only primary 
beneficiaries;
    (2)(i) A corporation, general partnership, limited partnership, 
limited liability company, trust (other than a trust referred to in 
paragraph (a)(1)(iv) of this section), or other legal organization (any 
of which are referred to hereinafter as a ``legal organization'') to 
which you provide investment advice based on its investment objectives 
rather than the individual investment objectives of its shareholders, 
partners, limited partners, members, or beneficiaries (any of which are 
referred to hereinafter as an ``owner''); and
    (ii) Two or more legal organizations referred to in paragraph 
(a)(2)(i) of this section that have identical owners.
    (b) Special rules regarding clients. For purposes of this section:
    (1) You must count an owner as a client if you provide investment 
advisory services to the owner separate and apart from the investment 
advisory services you provide to the legal organization, provided, 
however, that the determination that an owner is a client will not 
affect the applicability of this section with regard to any other 
owner;
    (2) You are not required to count an owner as a client solely 
because you, on behalf of the legal organization, offer, promote, or 
sell interests in the legal organization to the owner, or report 
periodically to the owners as a group solely with respect to the 
performance of or plans for the legal organization's assets or similar 
matters;
    (3) A limited partnership or limited liability company is a client 
of any general partner, managing member or other person acting as 
investment adviser to the partnership or limited liability company; and
    (4) You are not required to count a private fund as a client if you 
count any investor, as that term is defined in paragraph (c)(1) of this 
section, in that private fund as an investor in the United States in 
that private fund.

    Note to paragraphs (a) and (b):  These paragraphs are a safe 
harbor and are not intended to specify the exclusive method for 
determining who may be deemed a single client for purposes of 
section 202(a)(30) of the Act (15 U.S.C. 80b-2(a)(30)).

    (c) Definitions. For purposes of section 202(a)(30) of the Act (15 
U.S.C. 80b-2(a)(30)),
    (1) Investor means any person that would be included in determining 
the number of beneficial owners of the outstanding securities of a 
private fund under section 3(c)(1) of the Investment Company Act of 
1940 (15 U.S.C. 80a-3(c)(1)), or whether the outstanding securities of 
a private fund are owned exclusively by qualified purchasers under 
section 3(c)(7) of that Act (15 U.S.C. 80a-3(c)(7)), except that any of 
the following persons is also an investor:
    (i) Any beneficial owner of the private fund that pursuant to Sec.  
270.3c-5 of this title would not be included in the above 
determinations under section 3(c)(1) and 3(c)(7) of the Investment 
Company Act of 1940 (15 U.S.C. 80a-3(c)(1), (7)); and
    (ii) Any beneficial owner of any outstanding short-term paper, as 
defined in section 2(a)(38) of the Investment Company Act of 1940 (15 
U.S.C. 80a-2(a)(38)), issued by the private fund.

    Note to paragraph (c)(1): You may treat as a single investor any 
person that is an investor in two or more private funds you advise.

    (2) In the United States means with respect to:
    (i) Any client or investor, any person that is a ``U.S. person'' as 
defined in Sec.  230.902(k) of this title, except that any 
discretionary account or similar account that is held for the benefit 
of a person in the United States by a dealer or other

[[Page 77226]]

professional fiduciary is in the United States if the dealer or 
professional fiduciary is a related person of the investment adviser 
relying on this section and is not organized, incorporated, or (if an 
individual) resident in the United States.

    Note to paragraph (c)(2)(i): A person that is in the United 
States may be treated as not being in the United States if such 
person was not in the United States at the time of becoming a client 
or, in the case of an investor in a private fund, at the time the 
investor acquires the securities issued by the fund.

    (ii) Any place of business, in the United States, as that term is 
defined in Sec.  230.902(l) of this chapter; and
    (iii) The public, in the United States, as that term is defined in 
Sec.  230.902(l) of this chapter.
    (3) Place of business has the same meaning as in Sec.  275.222-
1(a).
    (4) Assets under management means the regulatory assets under 
management as determined under Item 5.F of Form ADV (Sec.  279.1 of 
this chapter).
    (d) Holding out. If you are relying on this section, you shall not 
be deemed to be holding yourself out generally to the public in the 
United States as an investment adviser, within the meaning of section 
202(a)(30) of the Act (15 U.S.C. 80b-2(a)(30)), solely because you 
participate in a non-public offering in the United States of securities 
issued by a private fund under the Securities Act of 1933 (15 U.S.C. 
77a).
    3. Section 275.203(l)-1 is added to read as follows:

Sec.  275.203(l)-1  Venture capital fund defined.

    (a) Venture capital fund defined. For purposes of section 203(l) of 
the Act (15 U.S.C. 80b-3(l)), a venture capital fund is any private 
fund that:
    (1) Represents to investors and potential investors that it is a 
venture capital fund;
    (2) Owns solely:
    (i) Equity securities issued by one or more qualifying portfolio 
companies, and at least 80 percent of the equity securities of each 
qualifying portfolio company owned by the fund was acquired directly 
from the qualifying portfolio company; and
    (ii) Cash and cash equivalents, as defined in Sec.  270.2a51-
1(b)(7)(i), and U.S. Treasuries with a remaining maturity of 60 days or 
less;
    (3) With respect to each qualifying portfolio company, either 
directly or indirectly through each investment adviser not registered 
under the Act in reliance on section 203(l) thereof:
    (i) Has an arrangement whereby the fund or the investment adviser 
offers to provide, and if accepted, does so provide, significant 
guidance and counsel concerning the management, operations or business 
objectives and policies of the qualifying portfolio company; or
    (ii) Controls the qualifying portfolio company;
    (4) Does not borrow, issue debt obligations, provide guarantees or 
otherwise incur leverage, in excess of 15 percent of the private fund's 
aggregate capital contributions and uncalled committed capital, and any 
such borrowing, indebtedness, guarantee or leverage is for a non-
renewable term of no longer than 120 calendar days;
    (5) Only issues securities the terms of which do not provide a 
holder with any right, except in extraordinary circumstances, to 
withdraw, redeem or require the repurchase of such securities but may 
entitle holders to receive distributions made to all holders pro rata; 
and
    (6) Is not registered under section 8 of the Investment Company Act 
of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a 
business development company pursuant to section 54 of that Act (15 
U.S.C. 80a-53).
    (b) Certain pre-existing venture capital funds. For purposes of 
section 203(l) of the Act (15 U.S.C. 80b-3(l)) and in addition to any 
venture capital fund as set forth in paragraph (a) of this section, a 
venture capital fund also includes any private fund that:
    (1) Has represented to investors and potential investors at the 
time of the offering of the private fund's securities that it is a 
venture capital fund;
    (2) Prior to December 31, 2010, has sold securities to one or more 
investors that are not related persons, as defined in Sec.  275.204-
2(d)(7), of any investment adviser of the private fund; and
    (3) Does not sell any securities to (including accepting any 
committed capital from) any person after July 21, 2011.
    (c) Definitions. For purposes of this section:
    (1) Committed capital means any commitment pursuant to which a 
person is obligated to acquire an interest in, or make capital 
contributions to, the private fund.
    (2) Equity securities has the same meaning as in section 3(a)(11) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(11)) and Sec.  
240.3a11-1 of this chapter.
    (3) Publicly traded means, with respect to a company, being subject 
to the reporting requirements under section 13 or 15(d) of the 
Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)), or having a 
security listed or traded on any exchange or organized market operating 
in a foreign jurisdiction.
    (4) Qualifying portfolio company means any company that:
    (i) At the time of any investment by the private fund, is not 
publicly traded and does not control, is not controlled by or under 
common control with another company, directly or indirectly, that is 
publicly traded;
    (ii) Does not borrow or issue debt obligations, directly or 
indirectly, in connection with the private fund's investment in such 
company;
    (iii) Does not redeem, exchange or repurchase any securities of the 
company, or distribute to pre-existing security holders cash or other 
company assets, directly or indirectly, in connection with the private 
fund's investment in such company; and
    (iv) Is not an investment company, a private fund, an issuer that 
would be an investment company but for the exemption provided by Sec.  
270.3a-7, or a commodity pool.
    4. Section 275.203(m)-1 is added to read as follows:

Sec.  275.203(m)-1  Private fund adviser exemption.

    (a) United States investment advisers. For purposes of section 
203(m) of the Act (15 U.S.C. 80b-3(m)), an investment adviser with its 
principal office and place of business in the United States is exempt 
from the requirement to register under section 203 of the Act if the 
investment adviser:
    (1) Acts solely as an investment adviser to one or more qualifying 
private funds; and
    (2) Manages private fund assets of less than $150 million.
    (b) Non-United States investment advisers. For purposes of section 
203(m) of the Act (15 U.S.C. 80b-3(m)), an investment adviser with its 
principal office and place of business outside of the United States is 
exempt from the requirement to register under section 203 of the Act 
if:
    (1) The investment adviser has no client that is a United States 
person except for one or more qualifying private funds; and
    (2) All assets managed by the investment adviser from a place of 
business in the United States are solely attributable to private fund 
assets, the total value of which is less than $150 million.
    (c) Calculations. For purposes of this section, private fund assets 
are calculated as the total value of such assets as of the end of each 
calendar quarter.
    (d) Transition rule. With respect to the calendar quarter period 
immediately

[[Page 77227]]

following the calendar quarter end date that the investment adviser 
ceases to be exempt from registration under section 203(m) of the Act 
(15 U.S.C. 80b-3(m)) due to having $150 million or more in private fund 
assets, the Commission will not assert a violation of the requirement 
to register under section 203 of the Act (15 U.S.C. 80b-3) by an 
investment adviser that was previously exempt in reliance on section 
203(m) of the Act; provided that such investment adviser has complied 
with all applicable Commission reporting requirements.
    (e) Definitions. For purposes of this section,
    (1) Assets under management means the regulatory assets under 
management as determined under Item 5.F of Form ADV (Sec.  279.1 of 
this chapter).
    (2) Place of business has the same meaning as in Sec.  275.222-
1(a).
    (3) Principal office and place of business of an investment adviser 
means the executive office of the investment adviser from which the 
officers, partners, or managers of the investment adviser direct, 
control, and coordinate the activities of the investment adviser.
    (4) Private fund assets means the investment adviser's assets under 
management attributable to a qualifying private fund.
    (5) Qualifying private fund means any private fund that is not 
registered under section 8 of the Investment Company Act of 1940 (15 
U.S.C 80a-8) and has not elected to be treated as a business 
development company pursuant to section 54 of that Act (15 U.S.C. 80a-
53).
    (6) Related person has the meaning set forth in Sec.  275.204-
2(d)(7).
    (7) United States has the meaning set forth in Sec.  230.902(l) of 
this chapter.
    (8) United States person means any person that is a ``U.S. person'' 
as defined in Sec.  230.902(k) of this chapter, except that any 
discretionary account or similar account that is held for the benefit 
of a United States person by a dealer or other professional fiduciary 
is a United States person if the dealer or professional fiduciary is a 
related person of the investment adviser relying on this section and is 
not organized, incorporated, or (if an individual) resident in the 
United States.

    By the Commission.

    Dated: November 19, 2010.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2010-29957 Filed 12-9-10; 8:45 am]
BILLING CODE P