As described in greater detail in this Cooley alert, the HFIAA obligates directors and executive officers of FPIs to begin filing reports under Section 16(a) 90 days following the date of its enactment. As a result, effective March 18, 2026, such directors and officers will be required to file a Form 3 with the US Securities and Exchange Commission (SEC) reporting their ownership of the issuer’s equity securities.  Thereafter, these individuals will be required to file Form 4s within two business days to report changes in their ownership. Additionally, these filing obligations will equally apply to funds and other institutional investors that consider themselves to be “directors by deputization” for Section 16 purposes. 

The HFIAA’s expansion of the Section 16 reporting requirements does not extend to 10% stockholders of FPIs, unlike US domestic companies. However, investment funds whose investment professionals serve as directors of FPIs should be aware that the fund’s holdings and transactions may be required to be reported on the director’s Section 16 filings if the director is considered to “beneficially own” the fund’s securities.  Additionally, the HFIAA directs the SEC to undertake rulemaking to amend existing Section 16 rules to conform to HFIAA requirements. In the course of that rulemaking, it is possible the SEC could further extend the reach of Section 16 reporting to also include 10% stockholders of FPIs.

Importantly, by its terms, the HFIAA does not extend the short-swing profit liability provisions of Section 16(b) of the Exchange Act or the short-sale limitations of Section 16(c) of the Exchange Act to FPIs. However, it is possible that these provisions could be extended to FPIs through the SEC rulemaking required by the HFIAA.

Steps that funds and other institutional investors should take now

With the March 18, 2026, effective date roughly two months away, funds and other institutional investors whose investment professionals serve as directors of FPIs should begin to take proactive steps to comply with these requirements, including:

• Identifying any investment professionals serving as directors of FPIs in their portfolios.
• Confirming these individuals’ SEC filing credentials or applying for credentials on their behalf (note that this process can take up to two weeks or more).
• Ensuring that they understand Section 16 filing triggers and reporting obligations.
• Reviewing their compliance systems to confirm that they have appropriate controls to comply with these requirements.
• Conferring with their advisors to prepare and submit any required filings in a timely manner.

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Schedule 13G

Funds – including their general partners and, in some cases, managing principals – that hold in excess of 5% of a class of public equity generally must file a Schedule 13G to publicly report their beneficial ownership of the portfolio company’s securities. In most instances, the initial filing is due within 45 days of the end of the quarter in which the fund’s ownership first exceeds 5%, including as a result of a portfolio company’s initial public offering (IPO). Additionally, any fund that has previously filed a Schedule 13G with respect to a portfolio company must file a quarterly amendment to its Schedule 13G within 45 days of quarter-end if there have been material changes in ownership since the most recent filing – including an “exit” filing if the fund’s ownership has declined below 5% of the outstanding class of stock.

Importantly, whether a fund is permitted to file a Schedule 13G for a particular investment, or is required to file the more onerous Schedule 13D, is often an important threshold question. Schedule 13D filings require far greater information, and these filings are due on a much more accelerated schedule, as compared to Schedule 13G filings. More information regarding Schedule 13D triggering events and filing deadlines is available in this October 2023 Cooley alert.

Form 13F

Investment advisers who exercise investment discretion over “Section 13(f) securities” – generally equity securities of public companies – are required to file quarterly reports with the SEC on Form 13F within 45 days of each quarter-end. Subject to certain exceptions, if your funds collectively owned in excess of $100 million of Section 13(f) securities as of the last day of any month during the 2025 calendar year, you’re obligated to file a Form 13F for the quarter ended December 31, 2025, which filing will be due February 17, 2026. In addition, the filing obligation continues for a minimum of an additional three consecutive calendar quarters (i.e., March 31, June 30 and September 30), with these filings due within 45 days of the relevant quarter-end. It is important to note that, even if you did not exceed the $100 million threshold as of December 31, 2025, the obligation to file a Form 13F for the quarter ended December 31, 2025 remains if the threshold was exceeded as of the last day of any single month in 2025.

Form 13H

Investment advisers who have previously filed a Form 13H to register as a “large trader” are required to file an annual update to the filing within 45 days of year-end. Large traders who have completed a full calendar year without exceeding any of the Form 13H triggering thresholds – measured across all portfolio companies – may be eligible to elect “inactive” status and thereby suspend certain ongoing large trader obligations. These triggering thresholds are daily trading of at least two million shares or $20 million in share value, or calendar-month trading of at least 20 million shares or $200 million in share value, in each case aggregating purchases and sales of the securities of all portfolio companies during the relevant day or month.

In addition to the annual filing requirement, large traders have a quarterly obligation to promptly amend the Form 13H following any quarter during which any of the information in their Form 13H materially changes.

Closing thoughts

As 2026 begins, funds should start to consider whether they will need to make any of the annual and quarterly filings under Section 13. The determination of whether you have a Schedule 13G, Form 13F or Form 13H filing obligation is often complex. As part of your assessment, consider contacting your fund/securities counsel to begin a Section 13 analysis, then prepare any required filings well in advance of the February 17, 2026 deadline.

Expanded scope of protected information

The definition of “customer information” under Regulation S-P is broadened to include any record containing nonpublic personal information about a customer of a covered institution. The definition includes “personally identifiable financial information” and more broadly encompasses “any list, description, or other grouping of consumers (and publicly available information pertaining to them) that is derived using” nonpublic personal information.

Regulation S-P applies to customer information regardless of whether the customer information relates to individuals with whom the covered institution itself has a relationship, arguably requiring notification to individuals if the covered institution is processing that information on behalf of another entity.

Incident response program

Covered institutions must implement a written incident response program in order to detect, respond to and recover from security incidents impacting customer information. At a minimum, the program must include written policies or procedures that help the covered institution to:

• Assess the nature and scope of an incident to determine whether there was any unauthorized access to or use of customer information.
• Contain and control the incident.
• Notify impacted individuals of the incident.

The incident response program should be commensurate to the covered institution’s size, operations and data processing activities.

Federal breach notification standard

The amendments establish a federal breach notification standard. Under Regulation
S-P, covered institutions must provide clear and conspicuous written notice to each affected individual whose sensitive customer information was – or is reasonably likely to have been – accessed or used without authorization. Regulation S-P defines sensitive customer information broadly as any customer information “the compromise of which could create a reasonably likely risk of substantial harm or inconvenience to an individual identified with the information,” unlike other data breach regulations, which define specific data elements that are considered to trigger notification obligations.

This notice must be provided as soon as practicable, but no later than 30 days after becoming aware of the incident, except under certain limited circumstances where the US attorney general determines that the notice poses a substantial risk to national security or public safety and notifies the SEC of such determination.

The notification to individuals must include:

• A description of the incident and the types of data involved.
• Recommended steps individuals can take to protect themselves (e.g., placing fraud alerts, obtaining credit reports).
• Resources from the Federal Trade Commission on protecting oneself from identity theft.
• More than one method for the customer to contact the covered institution.

One of the most notable provisions of Regulation S-P is the requirement to notify all individuals whose sensitive customer information resides on the covered institution’s system that was subject to unauthorized access, if the covered institution cannot determine which individuals’ sensitive information was subject to unauthorized access.

Notification is not required if the sensitive information was not subject to unauthorized access or use, or if the RIA determines after conducting a reasonable investigation that the sensitive customer information has not been and is not reasonably likely to be used in a way that would result in substantial harm or inconvenience to the customer.

Service provider oversight

Incident response programs must contain written policies and procedures that address due diligence and ongoing monitoring of service providers who have access to customer information.

These policies and procedures must require the service provider to:

• Take reasonable measures to protect against unauthorized access or use of customer information.
• Notify the RIA as soon as possible, and no later than 72 hours, after becoming aware of a breach involving customer information processed by the service provider.

RIAs may contract with service providers to send customer notices on their behalf, but the RIA remains ultimately responsible for ensuring timely and compliant notification.

Data disposal requirements

Under the amendments, covered institutions must have written policies and procedures addressing data disposal and take reasonable measures to securely dispose of customer information.

Recordkeeping requirements

Covered institutions must maintain written records documenting compliance with Regulation S-P. This includes:

• Policies and procedures implementing Regulation S-P’s requirements.
• Documentation of incidents and the covered institution’s incident response.
• Records of incident forensic investigations and the covered institution’s determinations regarding notification of individuals.
• Copies of any notices sent to individuals.
• Documentation related to service provider diligence and oversight.

These records must be retained for five years, with the first two years in an easily accessible format.

Annual privacy notice exception

The amendments codify the Gramm-Leach-Bliley Act (GLBA) exception to annual privacy notices. RIAs are exempt from delivering annual privacy notices if:

• They have not changed their data privacy and disclosure practices.
• They only share nonpublic personal information with nonaffiliates under an applicable exception.

What registered fund managers should do by December 3, 2025

For “large” registered fund managers, the practical implications are clear – and urgent. By the compliance deadline, managers should be prepared to:

• Demonstrate a fit-for-purpose incident response program.
• Implement breach notification workflows that meet the 30-day timeline and content requirements.
• Map and vet service providers and require service providers to notify covered institutions of data breaches within 72 hours.
• Apply expanded data disposal safeguards.
• Update recordkeeping practices.

Need help?

If you would like assistance operationalizing these requirements across policies, vendor oversight, templates and training, please reach out to your Cooley contact to be connected with our cyber/data/privacy practitioners.

While 401(k) and other defined contribution (DC) savings plans (as opposed to defined benefit pension plans) may eventually offer participants an opportunity to invest more widely in alternative assets – i.e., assets beyond the conventional mix of publicly traded mutual funds, stocks, bonds and collective investment trusts (CITs) that now dominate the investment mix of DC plans – any such change will not result solely from the executive order and likely will take considerable time to crystallize in any broad-based form. However, the order may serve as a robust catalyst for that process. This alert focuses particularly on what alternative asset sponsors like PE and VC funds should know now.

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(For a review of the securities laws exemptions discussed in this post, please see our previous post “Securities Laws Fundamentals for Venture Capital Fund Managers.”)

DEAL Act: Modernizing the definition of qualifying investments

The DEAL Act focuses on the definition of “qualifying investment,” which is central to the VC exemption. To rely on the VC exemption, a fund manager must ensure that each fund it manages invests at least 80% of its aggregate capital commitments in qualifying investments. Qualifying investments generally refer to equity securities (including securities convertible to equity) acquired directly from qualifying portfolio companies (at a high level, these typically refer to private operating companies). Securities acquired in a secondary transaction or investments in other venture capital funds are not qualifying investments and must therefore go in the “20% nonqualifying basket.”

The DEAL Act would make two key changes:

• Broader definition of qualifying investments: The definition of qualifying investments would be revised to include securities acquired in secondary transactions and investments in other venture capital funds.
• New portfolio composition requirement: At least 51% of a fund’s aggregate capital commitments would need to be equity securities acquired directly from qualifying portfolio companies, and no more than 49% could be invested in other venture capital funds or in securities acquired in secondary transactions.

Notably, the DEAL Act would not remove or replace the 20% nonqualifying basket. So, while secondaries and fund of funds investments would not fill up the nonqualifying basket, other nonqualifying investments such as crypto, debt and public company shares would still be limited to the 20% nonqualifying basket.

ICAN Act: Expanding the pool for venture capital funds

The ICAN Act proposes targeted amendments to Section 3(c)(1) of the Investment Company Act, which exempts private funds that have no more than 100 beneficial owners. (The other exemption that private funds commonly rely on is the 3(c)(7) exemption, which requires investors to be qualified purchasers (generally, individuals with $5 million in investments or entities with $25 million in investments)). While the 3(c)(1) exemption generally does not have a dollar cap, it does provide an option for venture capital funds to exceed the 100-beneficial-owner limit – allowing up to 250 beneficial owners – if they limit aggregate commitments to $12 million. Given the relatively low cap on aggregate commitments, however, most venture capital funds do not exceed the 100-beneficial-owner limit.

The ICAN Act would raise the thresholds in Section 3(c)(1) for venture capital funds:

• Increased investor limit: The maximum number of permitted beneficial owners would be raised from 250 to 500.
• Raised asset cap: The threshold for aggregate commitments would be raised from $12 million to $50 million.

Notably, the ICAN Act would not remove or replace the 100-beneficial-owner limit, meaning that a venture capital fund would be able to continue relying on the 3(c)(1) exemption without any cap on aggregate commitments by limiting the number of beneficial owners to 100.

Next steps

The DEAL Act and ICAN Act passed the House Financial Services Committee 50 to 2, indicating strong bipartisan support. If they pass the full House and Senate and are signed into law, the US Securities and Exchange Commission (SEC) will need to revise the VC exemption within 180 days to implement the DEAL Act. The amendments to the 3(c)(1) exemption will not require immediate rulemaking, although the ICAN Act does mandate that a study be conducted five years after enactment. This study would assess the impact of the new thresholds on the geographic and socioeconomic distribution of capital, the diversity of founders, and other key metrics. Based on the findings and public feedback, the SEC may further adjust the thresholds – potentially increasing the investor cap up to 750 or reducing it to no lower than 250 and raising the asset cap up to $100 million or reducing it to no lower than $10 million.

Takeaway

Venture capital fund managers could see some exciting changes in the future, although it is worth noting that prior versions of these changes were introduced by lawmakers as early as April 2023. A newfound momentum in the US Congress could see these bills through. If so, it would lead to greater flexibility for venture capital firms in their fundraising, portfolio construction and investments in a broader range of startups.

1. HR 4429 and HR 4431, respectively ↩︎

1. Carried interest
2. Pass-through entity taxes (PTET) and SALT deductions
3. Qualified small business stock (QSBS)
4. Interest deductibility
5. Section 899 ‘revenge tax’
6. Endowment tax
7. Cuts to tax benefits for green-energy projects
8. Miscellaneous itemized deductions for US individuals
9. Downward attribution rules for controlled foreign corporations (CFCs)

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The QSBS exclusion is an increasingly popular tax benefit for founders and investors in early-stage companies. Provided that certain holding period and other requirements are satisfied, the QSBS exclusion permits stockholders to exclude taxable gain from federal income tax, subject to the caps described below. The SFC bill would enhance these benefits and relax certain restrictions, making QSBS even more attractive for early-stage investors.

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This article discusses our firm’s experience with non-notified CFIUS inquiries since the beginning of the 2020 enforcement initiative, and reports the trends, outcomes and government practices we have observed in our matters.

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Impact to fund managers

A number of rules the SEC withdrew were proposed under the Investment Advisers Act of 1940. While exempt reporting advisers would have been spared much of the additional compliance obligations, registered investment advisers, on the other hand, would have faced substantial new burdens.

• Safeguarding client assets: The SEC had proposed new requirements for registered investment advisers regarding the custody and safeguarding of client assets, including updates to requirements under the existing custody rule.
• Cybersecurity risk management: The SEC had proposed a rule that would have required registered investment advisers to adopt cybersecurity policies and procedures, report incidents and maintain related records.
• ESG disclosures: The SEC had proposed disclosure requirements for investment advisers regarding their environmental, social and governance (ESG) investment practices.
• Outsourcing by investment advisers: The SEC had proposed a rule that prohibited registered investment advisers from outsourcing certain services or functions without meeting certain requirements related to diligence, monitoring and record retention.
• Conflicts of interest and predictive data analytics: The SEC had proposed a rule aimed at addressing how investment advisers use certain technologies (such as artificial intelligence, machine learning and data algorithms) in their interactions with investors.

What happens next?

The SEC did not provide detailed reasoning for the withdrawal. Instead, the SEC stated in its notice that the agency is withdrawing the rules because it no longer intends to issue final rules with respect to these proposals. Any future regulatory action in these areas will require a fresh start and a new round of notice-and-comment process. The notice of withdrawal was published on the SEC’s website on June 12, 2025, and will become effective once it is published in the Federal Register. The notice comes one day after the SEC extended the compliance date for the amended Form PF, which Atkins has directed the SEC staff to review, citing “serious concerns whether the government’s use of this data justifies the massive burdens it imposes.”

We note that while the withdrawal affords fund managers and other market participants a degree of short-term certainty under the current SEC, it also illustrates how swiftly the agency’s regulatory agenda can shift.

1. All but one of the rules were proposed under Gensler. ↩︎

Under current law, the federal deduction for certain state, local and foreign taxes is capped at $10,000 per year for taxpayers who itemize deductions. This cap is scheduled to expire for taxable years beginning after December 31, 2025. TOBBB would permanently extend the SALT cap but increase it to $40,000 per year starting in 2025 (i.e., for taxable years beginning after December 31, 2024). For taxpayers with modified adjusted gross income of more than $500,000 per year (as defined specially for this purpose), the allowable deduction is reduced (but not below $10,000) by 30% of the excess of the taxpayer’s modified adjusted gross income over $500,000. Starting in 2026, both the revised cap and modified adjusted gross income limit would increase by 1% each year until 2033 (after which they would stay at the 2033 levels going forward).

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As discussed in this December 2023 client alert, in November 2023, the US Tax Court held that state law limited partners are not per se entitled to the limited partner exception because the limited partner exception does not apply to a partner who is limited in name only. Instead, a functional analysis must be applied to determine whether the limited partner exception applies (the Soroban holding). The case subsequently went to trial to be determined on the facts.

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A little more than two years ago, in January 2023, SEC staff issued an FAQ stating its view that displaying the gross return of one investment (e.g., a case study), or a group of investments from a private fund, is an example of extracted performance under the Marketing Rule, and that registered investment advisers (RIAs) were not permitted to show such extracted performance on a gross basis without also showing it on a net basis. Because fees and expenses are not usually deducted at the investment level, however, the 2023 FAQ resulted in RIAs having to calculate an often arbitrary net return.

In its updated FAQ, SEC staff now provides that RIAs can show gross returns at the investment level without also showing net returns (i.e., gross extracted performance only) if they meet certain criteria. Specifically:

• The gross extracted performance is accompanied by fund-level gross and net returns that comply with the Marketing Rule.
• The gross extracted performance is clearly identified as gross (e.g., by disclosing that it does not reflect the deduction of all fees and expenses and cross-referencing the fund-level gross and net returns).
• The fund-level gross and net returns are presented with at least equal prominence to – and in a manner designed to facilitate comparison with – the gross extracted performance.
• The fund-level gross and net returns are calculated over a period that includes the entire period over which the gross extracted performance is calculated.

The updated FAQ helpfully provides that, in the SEC staff’s view, the fund-level gross and net returns do not need to be on the same page as the gross extracted performance, as long as the presentation facilitates comparison between the fund-level returns and the gross extracted performance. In this regard, SEC staff notes that the fund-level gross and net returns can appear before the gross extracted performance.

In a companion FAQ, which may be less applicable to venture capital and private equity firms, SEC staff also provides its view on certain performance-like metrics and how an RIA might include them on a gross-only basis in an advertisement. The FAQ references “characteristics,” such as “yield, coupon rate, contribution to return, volatility, sector or geographic returns, attribution analyses, the Sharpe ratio, the Sortino ratio, and other similar metrics.” Importantly, SEC staff clarifies that “characteristics” would not include “total return, time-weighted return, return on investment (RoI), internal rate of return (IRR), multiple on invested capital (MOIC), or Total Value to Paid in Capital (TVPI), regardless of how such metrics are labelled.”

While stating that it was not taking a position on whether any particular characteristic or attribute should be considered performance for purposes of the Marketing Rule, SEC staff stated that it would not recommend enforcement action to the SEC under the Marketing Rule if an adviser chooses to present one or more gross characteristics of a portfolio or investment without showing corresponding net characteristic(s) if they meet certain criteria. Specifically:

• The gross characteristic is accompanied by fund-level gross and net returns that comply with Marketing Rule requirements.
• The gross characteristic is clearly identified as being calculated without the deduction of fees and expenses.
• The fund-level gross and net returns are presented with at least equal prominence to – and in a manner designed to facilitate comparison with – the gross characteristic.
• The fund-level gross and net returns are calculated over a period that includes the entire period over which the gross characteristic is calculated.

RIAs should keep in mind that other aspects of the Marketing Rule, including the general prohibitions, still apply to all performance advertising. For more on the Marketing Rule, please see Venture Capital Fund Managers’ Guide to Applying the Latest Marketing Rule Risk Alert and Last-Minute Checklist for Private Fund Managers Complying With Marketing Rule.

Background

Rule 506(c) allows private funds to engage in general solicitation and general advertising if they take reasonable steps to verify the “accredited investor” status of their investors.

What has changed

In a new no action letter (NAL), the SEC staff expressed its view that a fund could satisfy the verification requirement by taking into account a specific minimum investment or binding commitment amount if certain conditions are met. The implication of the SEC’s guidance is that the more burdensome steps to “verify” accredited investor status that had been associated with Rule 506(c) may be bypassed by simple reference to the minimum investment or commitment amount. As a result, both registered investment advisers (RIAs) and exempt reporting advisers (ERAs) may turn to Rule 506(c) more confidently, and hence discuss their fundraising more freely, including on various social media platforms, at conferences and through meetings with new prospective investors – instead of clinging to Rule 506(b) and its well-known obligation not to generally solicit or generally advertise.

Rule 506

As many managers know, sales of fund interests need to be registered under the Securities Act unless they qualify for an exemption. (See Securities Laws Fundamentals for Venture Capital Fund Managers.) Rule 506 provides two nonexclusive safe harbor exemptions for private offerings. First, Rule 506(b) exempts offerings that do not involve any general solicitation or general advertising if all purchasers are accredited investors (although up to 35 nonaccredited investors may be admitted if the issuer is willing to prepare and disclose information that goes far beyond what private funds typically share). Second, Rule 506(c) exempts offerings that involve general solicitation or general advertising, provided that the issuer takes “reasonable steps to verify” that purchasers are accredited investors. Unlike Rule 506(b), which generally allows issuers to rely on a purchaser’s self-certification of its accredited investor status, Rule 506(c) requires issuers to make an objective determination of a purchaser’s accredited status based on the applicable facts and circumstances.

Accredited investors include (among others):

• A natural person with individual income greater than $200,000 in each of the two most recent years, or joint income with that person’s spouse or spousal equivalent greater than $300,000 in each of those years, and who has a reasonable expectation of reaching the same income level in the current year.
• A natural person whose individual net worth, or joint net worth with that person’s spouse or spousal equivalent, is greater than $1 million (after accounting for certain calculations with respect to that person’s primary residence).
• An entity not formed for the purpose of acquiring the securities offered, with total assets greater than $5 million.
• A trust with total assets greater than $5 million, not formed for the specific purpose of acquiring the securities offered, whose purchase is directed by a sophisticated person.
• An entity in which all of the equity owners are accredited investors (look-through entity).

Rule 506(c) provides a nonexclusive list of verification methods, which includes reviewing IRS forms, bank statements, brokerage statements, appraisal reports issued by independent third parties, or having investors provide a written confirmation of accredited investor status from their certified accountants. While the SEC had previously stated that minimum investment amounts could be a factor in determining accredited investor status, until now, there had not been a bright-line approach that funds, especially commitment-based funds (which do not require investors to fund their investments all at once), were able to rely on for using minimum amounts as a verification method. Therefore, most fund managers had viewed the “reasonable steps to verify” requirement as an unreasonable burden, both to them and to their investors.

SEC staff’s no action letter

In the NAL, the SEC staff expressed its view that an issuer could reasonably conclude that it had taken reasonable steps to verify an investor’s accredited investor status based on a high minimum investment amount under certain conditions. Specifically, an issuer doing the following, without taking additional steps, could reasonably conclude it had taken the requisite steps under Rule 506(c):

• Obtain written representations from the purchaser that both:
  • The purchaser is an accredited investor. (Note: The NAL excludes certain categories of accredited investors that are less commonly used.)
  • The purchaser’s minimum investment amount is not financed in whole or in part by a third party for the specific purpose of making the particular investment in the issuer.
• Require a minimum investment or binding commitment amount of at least $200,000 for natural persons and $1 million for entities.
• Have no actual knowledge of facts that would indicate the purchaser’s representations are untrue.

For a look-through entity, the written representations would need to provide that:

• The look-through entity is an accredited investor in which each of its equity owners is an accredited investor. (Note: The NAL excludes certain categories of accredited investors that are less commonly used.)
• Each of the look-through entity’s equity owners has a minimum investment or binding commitment obligation to the look-through entity of at least $200,000 for natural persons and $1 million for entities.
• The minimum investment amount of the look-through entity, and of each of the look-through entity’s equity owners, is not financed in whole or in part by a third party for the specific purpose of making the particular investment in the issuer.

In addition, a look-through entity must agree to make a minimum investment or binding commitment of at least $1 million – or, if the look-through entity has fewer than five natural persons, $200,000 for each of the look-through entity’s equity owners.

The conditions in the NAL would not preclude a purchaser from financing its investment in, or binding commitment to, an issuer so long as the minimum amounts are not financed for the specific purpose of making the particular investment in the issuer. So, for instance, borrowings to fund capital calls in excess of the minimum commitment amount would not be precluded, nor would a secured credit facility that had a purpose other than funding the investment or binding commitments that predated the commencement of the offering.

Potential impact

We expect that the most likely use case of the new guidance will come from firms that are already relying on Rule 506(c) or those whose fundraising activities easily draw public attention. Rule 506(c) is still a “private offering” under Regulation D, and the verification requirement is intended to limit the offering to sophisticated investors. Going forward, we expect more funds will be less constrained on social media, and firms’ legal and compliance departments will have a less worrisome attitude toward the public statements made by their firm’s individuals – i.e., sponsors can use Rule 506(c) with more confidence, knowing the verification process is not as onerous on their investors or their back offices as once perceived, and they won’t need to self-edit their public statements as vigorously to work to fit into the no general solicitation, no general advertisement rubric of Rule 506(b). But while there may be more funds mentioned on public websites, blogs, podcasts and interviews, and at industry events, we expect the new guidance will mostly be used as a fail-safe to comply with Rule 506 and not necessarily to engage in broad marketing efforts like paid advertisements, cold calling, or posting a fund’s offering documents on social media.

We remind our RIA clients to keep the SEC’s marketing rule in mind when engaging in marketing activities. (See Venture Capital Fund Managers’ Guide to Applying the Latest Marketing Rule Risk Alert and Last-Minute Checklist for Private Fund Managers Complying With Marketing Rule.) ERAs also should be mindful of the general antifraud provisions that apply to their activities. Finally, firms conducting concurrent offerings in the US and in non-US jurisdictions may want to reach out to their Cooley contacts to discuss potential implications of engaging in these activities.

Schedule 13G

Funds – including their general partners and, in some cases, managing principals – that hold in excess of 5% of a class of public equity generally must file a Schedule 13G to publicly report their beneficial ownership of the portfolio company’s securities. In most instances, the initial filing is due within 45 days of the end of the quarter in which the fund’s ownership first exceeds 5%, including as a result of a portfolio company’s initial public offering (IPO). Additionally, any fund that has previously filed a Schedule 13G with respect to a portfolio company must file a quarterly amendment to its Schedule 13G within 45 days of quarter-end if there have been material changes in ownership since the most recent filing – including an “exit” filing if the fund’s ownership has declined below 5% of the outstanding class of stock.

As described in this December 2024 blog post, effective December 18, 2024, all Schedule 13Gs are now required to be filed with the SEC in the XML filing format.

Importantly, whether a fund is permitted to file a Schedule 13G for a particular investment, or is required to file the more onerous Schedule 13D, is often an important threshold question. Schedule 13D filings require far greater information, and these filings are due on a much more accelerated schedule, as compared to Schedule 13G filings. More information regarding Schedule 13D triggering events and filing deadlines is available in this October 2023 Cooley alert.

Form 13F

Investment advisers who exercise investment discretion over “Section 13(f) securities” – generally equity securities of public companies – are required to file quarterly reports with the SEC on Form 13F within 45 days of each quarter-end. Subject to certain exceptions, if your funds collectively owned in excess of $100 million of Section 13(f) securities as of the last day of any month during the 2024 calendar year, you’re obligated to file a Form 13F for the quarter ended December 31, 2024, which filing will be due February 14, 2025. In addition, the filing obligation continues for a minimum of an additional three consecutive calendar quarters (i.e., March 31, June 30 and September 30), with these filings due within 45 days of the relevant quarter-end. It is important to note that, even if you did not exceed the $100 million threshold as of December 31, 2024, the obligation to file a Form 13F for the quarter ended December 31, 2024 remains if the threshold was exceeded as of the last day of any single month in 2024.

Form 13H

Investment advisers who have previously filed a Form 13H to register as a “large trader” are required to file an annual update to the filing within 45 days of year-end. Large traders who have completed a full calendar year without exceeding any of the Form 13H triggering thresholds – measured across all portfolio companies – may be eligible to elect “inactive” status and thereby suspend certain ongoing large trader obligations. These triggering thresholds are daily trading of at least two million shares or $20 million in share value, or calendar-month trading of at least 20 million shares or $200 million in share value, in each case aggregating purchases and sales of the securities of all portfolio companies during the relevant day or month.

In addition to the annual filing requirement, large traders have a quarterly obligation to promptly amend the Form 13H following any quarter during which any of the information in their Form 13H materially changes.

Closing thoughts

As 2025 begins, funds should start to consider whether they will need to make any of the annual and quarterly filings under Section 13. The determination of whether you have a Schedule 13G, Form 13F or Form 13H filing obligation is often complex. As part of your assessment, consider contacting your fund/securities counsel to begin a Section 13 analysis, then prepare any required filings well in advance of the February 14, 2025 deadline. Funds with Schedule 13G filing requirements also should allow additional time to transition their filings to the new XML filing format.

Why the change?

The SEC’s move to require XML filings aims to enhance the accessibility and analysis of information disclosed by institutional investors in their beneficial ownership reports. By standardizing submissions in a structured format, the SEC hopes to streamline data processing and improve comparability of investors’ filings – while enhancing the overall transparency of the ownership information for publicly traded companies. For funds, these new requirements will necessitate a review and alteration of existing disclosure practices.

What does this mean for funds?

1. Advance planning will be important – With the pending effectiveness of the XML filing requirements, funds should prepare well in advance of their first Section 13 filing under the new requirements to ensure that they are prepared to comply. This will include reviewing their historical filing disclosures and considering necessary restructuring to facilitate compliance with the XML format.
2. Change in filing aesthetics and opportunity to reevaluate filing content – The XML format will change the “look and feel” of Section 13 beneficial ownership reports. The structured data format may enhance the clarity and usability of the information presented, but it also will require funds to adapt to a new way of organizing and reporting their beneficial ownership information. While the change will necessitate a restructuring of funds’ beneficial ownership reports, it also will provide an ideal opportunity for funds to reconsider the information that they present in these filings.
3. Potentially increased scrutiny – As Section 13 filings become more standardized, the SEC and market analysts can be expected to increase their scrutiny of disclosed information. Funds must ensure that their reports are not only compliant with the XML filing requirements, but also that the filings accurately reflect their investment positions. In recent years, the SEC has initiated numerous enforcement actions for Section 13 compliance issues, and the new XML requirements could facilitate more SEC enforcement activity.

Conclusion

While perhaps not as significant as the changes to the Schedules 13D and 13G filing deadlines that became effective earlier this year, the XML filing requirements will necessitate careful planning by funds to ensure a smooth transition. As the December 18, 2024 effective date approaches, funds should take proactive steps to prepare for this new landscape – including conferring with counsel to ensure they’re in a position to comply with the new requirements.

What is operational integration?

A fundamental principle under the Advisers Act is that an adviser cannot indirectly do something that would be unlawful for it to do directly. This means investment advisers and their affiliates cannot circumvent their registration requirements under the Advisers Act by forming separate entities if they are ultimately “operationally integrated.” As an example, an investment adviser relying on the venture capital adviser exemption (VC exemption) must not advise any client that is not a venture capital fund. A fund manager relying on the VC exemption might wonder if it can simply form a separate legal entity to manage a secondary fund, continuation vehicle, fund of funds, crypto fund or another type of fund that would not satisfy the “venture capital fund” requirements under the Advisers Act. Unsurprisingly, the concept of operational integration would not permit such a simple workaround.

As another example, an investment adviser relying on the private fund adviser exemption (PF exemption) must advise only private funds and have regulatory assets under management (i.e., gross assets under management) of less than $150 million. A fund manager relying on the PF exemption could not simply set up a new investment adviser entity every time its regulatory assets under management near $150 million to avoid registration.

While the determination of whether an adviser and its affiliates are operationally integrated depends on the facts and circumstances, the basic framework for conducting such an analysis is a five-factor test that the SEC staff established in a no-action letter to Richard Ellis. Under that framework, an adviser may be regarded as having a separate, independent existence and deemed to be functioning independently of an affiliated adviser if it:

1. Is adequately capitalized.
2. Has a buffer between its personnel and the affiliated adviser – such as a board of directors, a majority of whose members are independent of the affiliated adviser.
3. Has employees, officers and directors who, if engaged in providing advice in its day-to-day business, are not otherwise engaged in the investment advisory business of the affiliated adviser.
4. Itself makes the decisions as to what investment advice is to be communicated to – or is to be used on behalf of – its clients, and has and uses sources of investment information not limited to its affiliated adviser.
5. Keeps its investment advice confidential until communicated to its clients.

While larger organizations often have multiple adviser entities that can – and do – establish adequate separation to achieve operational independence, in our experience, it is much more challenging for smaller organizations to do the same. In addition to the cost and expense typically associated with having separate operations, we find that the separation of investment personnel and investment advice is not practical and is often inconsistent with commercial objectives.

The SEC’s enforcement actions

Since the Richard Ellis no-action letter was published, the SEC has brought a handful of enforcement actions involving operational integration. Two were brought in June 2014 against affiliated advisers TL Ventures and Penn Mezzanine Partners Management. One was brought in July 2017 against affiliated advisers Bradway Financial and Bradway Capital Management. The final one was brought in September 2024 against ACP Venture Capital Management Fund.

While all of these enforcement actions were settled, they nevertheless provide valuable insight into what the SEC considers – beyond the factors outlined in Richard Ellis – when determining whether separately formed adviser entities are operationally integrated. Specifically, the SEC cited the following in these enforcement actions:

1. Sharing the same office with no physical separation.
2. Sharing the same email domain and phone number.
3. Sharing the same technology systems.
4. Marketing materials that reference a “partnership” between the advisers and an ability to leverage and benefit from such relationship, including outsourcing of back-office functions.
5. Managing directors of one adviser serving on the investment committee of the other adviser and soliciting investors for funds managed by the second adviser.
6. Lack of information security policies and procedures to protect investment advisory information from disclosure to one another.
7. Employees of one adviser routinely using their email addresses associated with the other adviser in conducting business and communicating with outside parties about and on behalf of the first adviser.

In the settled actions, either one or both affiliated entities sought to rely on the VC exemption or the PF exemption. The SEC found that on an integrated basis, taking into consideration the factors above, the advisers were not eligible for the exemption they sought because they either advised a type of client not permitted under the applicable exemption, or they exceeded the regulatory assets under management permitted under the PF exemption.

Notably, the enforcement actions from 2014 and 2017 involved adviser entities that were clearly under common control and had at least one individual that owned more than 25% of each adviser entity. In the most recent enforcement action, no individual owned more than 25% of each adviser entity. The only common owner was an individual who owned 50% of adviser A and 20% of adviser B. That individual, however, served as the chief compliance officer of both adviser A and adviser B. Moreover, the other 50% owner of adviser A served as an accounting consultant to adviser B, and two individuals who each owned a 40% interest in adviser B (one of whom was the president of adviser B) co-managed certain funds of adviser A. According to the SEC’s settlement order, adviser A and adviser B also had other overlap in personnel, including other investment personnel, and no physical separation.

We note the limited overlap in the ownership of adviser A and adviser B because, in general, operational integration involves affiliated advisers, and affiliated advisers under the Advisers Act typically means there is at least one individual that owns more than 25% of each adviser. This is because affiliates are defined as being in a controlling, controlled by or under common control relationship, and control is generally presumed to exist when a person owns more than 25% of the voting interest in an entity, while control is presumed to not exist when a person owns 25% or less of the voting interest in an entity. That said, the Advisers Act defines the term “control” as the power to exercise a controlling influence over the management or policies of a company. A common owner with a 25% voting interest in each entity is not a requisite for two entities to be under common control.

Key takeaway for fund managers

For our clients and fund managers generally, the most important takeaway from the recent enforcement action is probably the reminder that the Advisers Act prohibits investment advisers from doing indirectly what they cannot do directly. Whether or not two entities have identical owners, substantial overlap in owners or limited overlap in owners, if they are operated as an integrated business without adequate policies and procedures to separate their advisory activities, then the analysis as to whether the VC exemption or the PF exemption applies would need to be conducted treating both entities as a single adviser.

We know that the decision to register as an investment adviser is not taken lightly by exempt fund managers. To this end, if you are considering setting up a new entity to navigate around the registration and exemption requirements, we recommend reaching out to your Cooley contact to discuss operational integration. The recent enforcement action could mark a renewed focus by the SEC on this topic.

As a reminder, under Sections 13(d) and 13(g), funds that beneficially own in excess of 5% of an outstanding registered class of public equity securities are required to file beneficial ownership reports on either Schedule 13G or Schedule 13D. Schedule 13G generally requires relatively limited information regarding the funds’ ownership of such securities, whereas Schedule 13D requires additional information regarding the funds’ interests and intentions with respect to the portfolio company. SEC rules also require funds to file amendments to these schedules from time to time.

Initial Schedule 13G deadlines

The rule changes going into effect on September 30, 2024, accelerate the deadlines for initial Schedule 13Gs. Under current rules, the initial Schedule 13G filing is generally due within 45 days following the end of the calendar year of the portfolio company’s initial public offering (IPO) – although different rules often apply to funds that purchase shares in the issuer’s IPO, a follow-on offering or the open market. Under the new rules, these initial Schedule 13G filings will be due within 45 days following the end of the calendar quarter, with the first of such filings due on November 14, 2024.

Schedule 13G amendment deadlines

Similarly, under current rules, most funds that report their beneficial ownership on Schedule 13Gs have historically been required to evaluate their beneficial ownership positions annually, at calendar year-end, and to amend their Schedule 13G filings within 45 days following year-end to report any changes in the information required by the filing. Under the amended rules, funds will now be required to make this evaluation on a quarterly basis following each calendar quarter. However, under the amended rules, funds will only be required to amend their Schedule 13Gs to report material changes in the information required by the filing, with such amendments due within 45 days following the end of the quarter if there has been a material change from the information in the most recent filing.

The determination of whether a change in information is “material” for this purpose will require an assessment of the particular facts. However, the rules specifically provide that no amendment will be required if the only change in the information is a change in the beneficial ownership percentage resulting solely from a change in the outstanding shares of the class of equity securities.

Additional deadline changes

Additionally, the rules going into effect on September 30, 2024, also accelerate other filing deadlines for initial and amended Schedule 13Gs:

• Acceleration of the deadline for initial Schedule 13G for funds that qualify as “passive investors” under SEC rules – from 10 calendar days to five business days following the acquisition of beneficial ownership in excess of 5% of a registered class of equity securities.
• Modification of the deadlines for passive investors to file amended Schedule 13Gs to report beneficial ownership increasing above 10% (and subsequent 5% increases or decreases in beneficial ownership) to two business days following the event, rather than the current, more subjective “prompt” requirement.
• Acceleration of the deadlines for initial Schedule 13Gs and amended Schedule 13Gs for entities that meet the definition of “qualified institutional investor” under SEC rules.

Closing thoughts

In preparation for the effectiveness of the amended rules, funds should begin reviewing their public company portfolios to evaluate whether there have been any changes in the information previously reported in their Schedule 13G filings and assess the materiality of such changes. Additionally, funds should prepare for the related increase in the compliance burden associated with the November 14, 2024 deadline.

The SEC’s beneficial ownership reporting requirements can be quite complex – including determination of whether a fund is required to file a Schedule 13D or is permitted to file a Schedule 13G, and whether and when such filings are required to be amended. Funds are encouraged to confer with counsel on their particular situations to ensure that they remain in compliance with these requirements.

As the governor of Minnesota, Walz is an “official” as defined in the rule, which means that contributions to the Harris-Walz ticket could implicate an adviser’s ability to receive compensation from investors such as Minnesota State Retirement System, Public Employees Retirement Association, Teachers Retirement Association, and other plans or funds managed by the Minnesota State Board of Investment (SBI). While the SBI website lists a number of fund managers in its private equity portfolio, the SBI historically has not been known for its venture investments. That said, given the rule’s “stickiness,” VC firms may still want to be mindful of the rule.

Below, we’ve outlined the rule’s main requirements and some compliance considerations. But first, we note the following points, which many of our clients have asked about since the announcement of Walz as Harris’ vice presidential pick:

• Contributions to the Harris campaign made prior to August 6, 2024, do not need to be returned, even if they exceed the de minimis limits discussed below.
• Because the Harris-Walz ticket cannot be bifurcated, contributions to the Harris campaign made on or after August 6, 2024, would implicate the rule even if intended to be “only for Harris and not Walz.”
• A contribution to a national committee such as the Democratic National Committee or a political action committee (PAC) would not, in and of itself, implicate the rule, but please see below regarding the rule’s prohibitions on coordinating, soliciting and otherwise circumventing the rule. (For instance, contributions to a PAC should not be earmarked for an official that would otherwise implicate the rule. To this end, we recommend obtaining a representation letter when contributing to a PAC.)

Quick primer on the Pay-to-Play Rule

The rule makes it unlawful for an adviser to receive compensation for providing advisory services to a government entity for a two-year period after the adviser or any of its “covered associates” (including senior personnel and members of the marketing or investor relations team) makes a contribution to a government entity’s “official” (including candidates and incumbents) who is or will be in a position to influence (directly or indirectly) the award of advisory business. Determining whether a particular government investor is captured often requires reviewing the governing documents and organizational structure of a government entity.

The rule generally prohibits advisers from paying third parties to solicit government entities for advisory business, unless such third parties are registered broker-dealers or registered investment advisers, which are in each case themselves subject to pay-to-play restrictions. Intended to address the concern that advisers and covered associates might try to indirectly solicit government entities and officials, the rule seeks to ensure that those who solicit through third parties still fall within the rule’s scope.

The rule also makes it unlawful for an adviser or its covered associates to coordinate or solicit either of the following:

• Contributions to an official of a government entity to which the investment adviser is seeking to provide investment advisory services.
• Payments to a political party of a state or locality where the investment adviser is providing or seeking to provide investment advisory services to a government entity.

This provision also seeks to prevent advisers and covered associates from indirectly engaging in conduct they would not be able to engage in directly.

Finally, the rule makes it unlawful for an adviser or any of its covered associates to do anything indirectly which, if done directly, would result in a violation of the rule. This catch-all provision triples down on the anti-circumvention goals of the rule. Making contributions through a family member to avoid the rule, for example, would be prohibited.

Compliance considerations

De minimis exception

The rule has a de minimis carve out pursuant to which any person who is eligible to vote for an official can contribute up to $350 to the official without running afoul of the rule. Those who are ineligible to vote for an official may contribute up to $150. Many VC firms often expect de minimis thresholds to be higher and are surprised by these limits.

Non-monetary contributions

The rule covers monetary and non-monetary contributions. Non-monetary contributions may include providing one’s home for a fundraiser or providing firm resources to support campaign activity. The rule does not prohibit covered associates from volunteering their time, provided the volunteering is not solicited by the adviser, adviser resources are not used, and it takes place during the covered associates’ personal time.

Look-back and look-forward limitations

The rule is “sticky” in that it covers contributions by persons who become covered associates – i.e., it covers contributions regardless of whether a person was a covered associate of the adviser at the time of the contribution. Unless a covered associate does not solicit investors after becoming a covered associate, in which case the look back period is six months, the two-year look-back period applies to new covered associates. Moreover, the two-year look-back period applies even where a covered associate contributes and then becomes a noncovered associate. Thus, for example, the departure of a covered associate would not lift the two-year ban on compensation if that covered associate has made a contribution to an official in excess of the de minimis limit within the prior two years.

Importantly, the rule also is “sticky” because it impacts an adviser’s ability to receive compensation from relevant government entities at any time during the two-year period following the date of contribution. Therefore, a contribution by a covered associate now could limit an adviser’s ability to accept an investment from a relevant government entity in the future, even if that government entity has not invested with the adviser at the time of the covered associate’s contribution.

Strict liability

Firms should note that the rule is a strict liability rule. In a recent enforcement settlement, the Securities and Exchange Commission (SEC) stated that the rule “does not require a quid pro quo or actual intent to influence an elected official or candidate.” In fact, the SEC has brought enforcement actions against private fund managers whose covered associates made contributions to an official of a government entity that was already invested in the adviser’s funds.

Conclusion

Fund managers and their covered associates should familiarize themselves with the rule’s restrictions and compliance requirements to prevent violating the rule. Given the costly consequences that can result from violations, a lot of firms have adopted policies that are broader than the bare minimum required under the rule. For instance, a policy might apply to all employees and not just “covered associates,” or de minimis exceptions might not apply. We encourage firms to review their policies and reach out to their Cooley contact with any questions.

Below, we address some frequently asked questions we’ve received since the ruling.

1. Which rules have been vacated?

The following rules under the Investment Advisers Act of 1940 have been vacated:

• Preferential Treatment Rule (Rule 211(h)(2)-3)
• Restricted Activities Rule (Rule 211(h)(2)-1)
• Quarterly Statement Rule (Rule 211(h)(1)-2)
• Adviser-Led Secondaries Rule (Rule 211(h)(2)-2)
• Private Fund Audit Rule (Rule 206(4)-10)

In addition, amendments to the Recordkeeping Rule (Rule 204-2) that were related to the above rules, as well as an amendment to the Compliance Rule (Rule 206(4)-7) that would have required written documentation of annual compliance reviews, have been vacated. (For a summary of these rules, refer to our Facing the SEC’s New Rules for Venture Capital and Other Private Fund Advisers blog post.)

2. Does vacatur mean the rules are dead, annulled, canceled, gone, etc.?

Sort of. A vacatur by the applicable highest court would mean those things. However, because the ruling was made by a panel of judges in the Fifth Circuit, it can be appealed for an en banc hearing by all the judges in the Fifth Circuit. Alternatively, it can be appealed to the US Supreme Court. The SEC has not announced whether it will appeal the decision. If the SEC were to appeal to the Supreme Court, the Supreme Court would still need to grant certiorari and agree to hear the case.

3. Should we view compliance with the rules as best practice?

Not necessarily. Fund managers are likely to face pressure from investors to implement some of the disclosure and reporting measures the rules would have required. But given how prescriptive the rules were, voluntary compliance with the rules would not seem to be a prerequisite for firms following a “best practice” standard in their business. For example, the Quarterly Statement Rule would have required dollar amount disclosure of every fund expense without exception for de minimis or miscellaneous items. And other aspects of the rules would have required fitting square pegs into round holes, expending resources (time and money) trying to fit under a two-sizes-fit-all approach. While it remains to be seen how the industry will ultimately trend, we note that the Institutional Limited Partners Association (ILPA), which had published reporting templates for public comment just days before the Fifth Circuit decision, announced that it is reorienting the templates and working to relaunch the comment period once it updates the scope of the templates.

All that said, firms should keep in mind that their fiduciary duty under the Investment Advisers Act has not changed. Investment advisers, whether registered or exempt, must act in their funds’ best interest, and not place their own interest ahead of the funds’ interest. This includes adequate disclosure of conflicts of interest, particularly where fees and expenses are involved. Many of the practices that the vacated rules sought to address have been the subject of SEC enforcement actions in the past, years before the rules were even proposed. The SEC’s exam staff will continue to probe – and the SEC’s enforcement staff will continue to investigate – fund managers’ practices and disclosures where conflicts of interest or fees and expenses are concerned.

4. Does this impact the requirements around showing levered and unlevered returns?

The short answer is no. The Quarterly Statement Rule would have required registered investment advisers (RIAs) to report levered and unlevered returns in their quarterly statements to investors. While this rule has been vacated, RIAs are separately subject to the Marketing Rule (Rule 206(4)-1), which has not been vacated.

The Marketing Rule requires gross performance in an advertisement to be accompanied by net performance with equal prominence. The net performance must be calculated over the same time period, using the same type of return and methodology, as the gross performance. In a marketing compliance FAQ, the SEC staff stated that it believes an adviser would not comply with this requirement if it showed a gross internal rate of return (IRR) that is calculated from the time an investment is made without reflecting fund borrowing or subscription facilities (i.e., an unlevered gross IRR) alongside a net IRR that is calculated from the time investor capital has been called to repay such borrowing (i.e., a levered net IRR). In the same FAQ, the staff stated its view that an adviser would violate the general prohibitions of the Marketing Rule if it showed only a levered net IRR without including an unlevered net IRR or disclosing the impact of subscription facilities on the net IRR shown.

Exempt reporting advisers (ERAs) are not subject to the Marketing Rule (nor would they have been subject to the Quarterly Statement Rule). RIAs, however, continue to be subject to the Marketing Rule, and the SEC staff’s FAQ described above remains applicable to their advertisements. (To learn more about the Marketing Rule, check out our previous blog posts: Venture Capital Fund Managers’ Guide to Applying the Latest Marketing Rule Risk Alert and Last-Minute Checklist for Private Fund Managers Complying With Marketing Rule.)

Pay-related proposals

There are three types of pay-related proposals covered by the new rule, as outlined below.

1. Advisory votes on executive compensation

Sometimes referred to as “say-on-pay” proposals, these allow stockholders to cast an advisory vote on the compensation paid to the company’s named executive officers. These votes generally are held annually at the company’s annual meeting of stockholders, but some companies hold them less frequently.

2. Advisory votes on frequency of executive compensation votes

Sometimes referred to as “say-on-frequency” proposals, these allow stockholders to cast an advisory vote on the frequency of say-on-pay votes. These proposals are required to be held at least once every six years and generally are held at the company’s annual meeting of stockholders.

3. Advisory votes on ‘golden parachute’ arrangements

Sometimes referred to as “say-on-parachute” proposals, these allow stockholders to cast an advisory vote on the compensation payable to a company’s named executive officers as a result of a change-in-control event (e.g., a merger or acquisition). These proposals generally only arise in connection with the vote on the change-in-control transaction.

Form N-PX disclosure requirements

Form N-PX will require Form 13F filers to disclose, on an issuer-by-issuer basis, the number of shares voted, and how they were voted on the pay-related proposal(s) submitted to stockholders (e.g., for, against or abstain or, in the case of say-on-frequency proposals, every one, two or three years). If Form 13F filers cast votes in multiple manners for a particular company (e.g., both for and against a proposal), they should report how many shares they voted in each manner. It is important to note that there is no de minimis exemption to reporting the manner of voting, meaning that Form 13F filers will be required to report all pay-related proposal votes regardless of the number of shares of the issuer’s stock they own or the fair market value of the shares. For Form 13F filers who engage in share lending, Form N-PX will require the Form 13F filer to report the number of shares they loaned out and did not recall for voting. For any Form 13F filers who have a disclosed policy of not voting proxies, and who did not in fact vote their shares during the relevant period, Form N-PX will include a designation box to indicate this fact.

Filing deadline

The new requirements go into effect on July 1, 2024, and Form 13F filers will be required to file their first reports on Form N-PX by August 31, 2024. The first report will cover all pay-related proposals presented at any stockholder meeting held between July 1, 2023, and June 30, 2024.

Only Form 13F filers who filed Form 13F during 2023 and 2024 will be required to file Form N-PX by August 31, 2024. For fund managers who have been subject to Form 13F filings only for a portion of the 2023 to 2024 time period, the SEC has provided transition guidance on the Form N-PX filing requirements, which we’ve outlined below.

Form 13F filers for 2024, but not 2023

Form 13F filers are not required to file a Form N-PX during the first calendar year in which their initial Form 13-F was required, so these fund managers will not be required to file Form N-PX until 2025.

Form 13F filers in prior years, but not during 2024

These fund managers are not required to file a Form N-PX this year, and they will not be required to file an initial Form 13F until the calendar year following their next required Form 13F filing.

Form 13F filers who cease filing Form 13F during 2024

Fund managers who currently file Form 13F but do not trigger a filing obligation for 2025 – i.e., those managers who do not advise funds owning an aggregate of $100 million of Section 13(f) securities as of the end of any calendar month of 2024 – will be required to file a “stub period” Form N-PX next year. That filing will cover all pay-related proposals presented at stockholder meetings held between July 1, 2024, and September 30, 2024, and will be due on March 1, 2025.

What to do now

Form 13F filers should begin tracking the annual meeting dates of their public portfolio companies, including determining whether pay-related proposals will be, or have been, presented. Similarly, Form 13F filers should monitor and record the manner of voting on pay-related proposals for all their public companies during the period covered by this filing requirement. Finally, Form 13F filers should begin to aggregate this information for provision to outside counsel who can assist in preparing the Form N-PX by the filing deadline.

Practical considerations

It is important that institutional investmentfund managers recognize that their voting decisions on pay-related proposals now will be made public. Executive compensation matters recently have been the focus of heavy public criticism, so, to the extent there are sensitivities to the fund managers’ voting practices on these matters, they should consider whether and how these new requirements may impact their voting decisions.

Additionally, public companies generally are very sensitive to the degree of stockholder support that they receive on say-on-pay proposals. Companies that receive less than 80% support from stockholders on their say-on-pay proposals often undertake an investor outreach program to engage with their largest stockholders to seek feedback on their executive compensation programs. Accordingly, Form 13F filers should be mindful of the possibility of receiving outreach from management of these companies – and be prepared to engage in these discussions, particularly when their ownership position is relatively large (e.g., greater than 1%).

Last week, the Division of Examinations at the Securities and Exchange Commission (SEC) published a Risk Alert titled, “Initial Observations Regarding Advisers Act Marketing Rule Compliance.” This is the division’s third Risk Alert on the Marketing Rule since RIAs have had to come into compliance with the rule in November 2022, demonstrating the division’s continued focus on advisers’ marketing practices. (See our prior blog post on Marketing Rule compliance – Last-Minute Checklist for Private Fund Managers Complying With Marketing Rule.) In the latest Risk Alert, the division shares numerous observations by its staff regarding advisers’ compliance with the Marketing Rule.

In this post, we highlight some of the staff’s observations that we believe – based on our extensive experience reviewing our clients’ marketing decks – have particular relevance to venture capital fund managers. On their face, most, if not all, of these observations seem like obvious practices to avoid. But we’ve noted below some specific practices by VC firms that may benefit from another review in light of the new Risk Alert. While ERAs are not subject to the Marketing Rule, we encourage all of our clients – ERAs included – to review the practices noted below and be mindful of what the SEC would view as misleading.

1. Personal track record and balance sheet investments

Staff observation

The staff observed “[s]tatements or presentations regarding … advisers’ performance track record with securities that were not purchased by the advisers in a similar manner in their clients’ accounts.”

Cooley take

It is not uncommon for first-time fund managers to show their personal or angel investments as part of their track record, or for corporate VC firms or family offices launching their first third-party fund to show balance sheet investments as their track record. Doing so is not per se prohibited. But such presentations of track record should be accompanied by detailed disclosures around the assumptions made and risks involved in relying on such track record. Depending on what a firm has to work with, the track record may need to be presented as “hypothetical” performance, which too is not per se prohibited but does require policies, procedures and appropriate disclosures.

2. Unfair and unbalanced statements

Staff observation

The staff observed “statements about the potential benefits connected with the advisers’ services or methods of operation that did not appear to provide fair and balanced treatment of any material risks or material limitations associated with the potential benefits.” These included “advertisements on social media that highlighted performance information without also disclosing the material risks and limitations associated with the potential benefits.”

Cooley take

Given the very nature of marketing, it is typical for firms to emphasize the positive, and “balance” is the most common issue we address when reviewing initial drafts of marketing decks. But it also is relatively easy to correct this with the addition of footnotes, qualifiers and other disclosures. For various reasons (including the prohibition on general solicitation and general advertising under the exemption relied on by most VC funds), most of our clients do not use social media to advertise. However, when firms do use social media to highlight a new accolade, achievement or the like, it can be challenging to include the appropriate risks and limitations disclosure in the same post.

3. Cherry-picking and case studies

Staff observation

The staff observed “advertisements that included only the most profitable investments or specifically excluded certain investments without providing sufficient information and context to evaluate the rationale, such as investments that were written off as a loss or were lower-performing investments.”

Cooley take

This is another common theme in initial drafts of marketing decks we review. While the power law is of course a hallmark of VC investing, highlighting only the positive “performers,” “returners” or “drivers” can violate the Marketing Rule. References to specific investments need to be fair and balanced, which can be achieved through various means, and in our experience, firms have different appetites for how they want to comply with this requirement. One common approach is to include a table of all investments in the deck and cross-reference that table when highlighting a subset of investments.

4. Network of personnel

Staff observation

The staff observed advertisements stating material facts about the advisers’ businesses that were inaccurate, including “statements that a network of personnel perform advisory services for clients when a sole individual performs such services.”

Cooley take

We often see marketing decks that highlight venture partners, operating partners and other individuals in a firm’s network who are portrayed as having a role in the investment process. Because the actual role played by any of these individuals can vary from merely being available as consultants to actively engaging in the investment process, firms should consider how they are portraying their various networks and whether the description of the role played by any individual or groups of individuals should be refined. Firms also should take care not to imply that individuals are employed by the management company when they are in fact typically treated as third-party service providers.

5. Formalized screening processes

Staff observation

The staff observed advertisements describing material facts about advisory services or products offered that were inaccurate, including “referencing formalized securities screening processes that did not exist.”

Cooley take

Most marketing decks we review include slides on the investment process executed by a firm (e.g., how deals are sourced, screened, diligenced and voted on). Firms should consider whether the process described in their decks accurately matches what they actually do in practice, and if a formal process is referenced, firms should ensure that such a process is actually formalized.

6. Images of celebrities

Staff observation

The staff observed advertisements that contained untrue or misleading claims, such as “advertising images of celebrities in marketing materials in a manner that implied the celebrities endorsed the firms when such celebrities did not endorse the firms.”

Cooley take

While it is less common to see pop culture icons in VC fund marketing decks, we do from time to time see images of well-known investment personalities, like Warren Buffett and Elon Musk. Firms should take care when using stock images or quotes attributable to famous persons that they are not implying that such persons are endorsing them when that is not, in fact, the case.

7. Unreadable fonts

Staff observation

The staff observed advertisements that could “otherwise be materially misleading, such as presenting disclosures in an unreadable font on websites or in videos.”

Cooley take

We know that footnotes and disclaimers are not necessarily appealing, and there is a commercial desire to limit the real estate these disclosures take up in marketing materials. But using miniscule fonts could be viewed as materially misleading and lead to violations of the Marketing Rule. We are fans of concise, plain English disclosures that are set forth in legible fonts and tailored to each slide of a marketing deck. Additionally, as the Risk Alert indicates, these disclosure requirements apply to marketing materials in all forms of media. So, for example, when recording a marketing video, firms should include proper disclosures that are readable and pause long enough for the audience to be able to read them.

8. Outdated market data

Staff observation

The staff observed performance presentations that contained “outdated market data information only (e.g., market data from more than five years prior)” [emphasis added], or “investment products that were no longer available to clients and included lower investment costs than were available.”

Cooley take

For established firms with long-standing track records, it is quite standard to include performance information related to their older funds. This information can certainly be relevant (for example, to indicate a firm’s length of experience). Yet, context is important, and firms should consider whether the inclusion, or the manner of presentation, of these older funds could be misleading – for example, have the funds’ strategies or terms shifted or the investment team members evolved in such a way that their exclusion or additional explanation would be warranted?

9. ‘Proper’ calculation of net returns

Staff observation

The staff observed advertisements that contained “untrue or misleading performance claims, including … using lower fees in calculations for net of fees performance returns than were offered to the intended audience, and … omitting material information regarding fees and expenses used in calculating returns.” The staff also observed advertisements that “included the performance of only realized investment information in the total net return figure and excluded unrealized investments.”

Cooley take

In our experience, virtually all firms are aware that net returns are required when gross returns are presented. Many firms, however, do not appreciate all the nuances that the Marketing Rule requires, particularly with respect to the specific areas where the SEC or its staff have provided guidance that are not apparent from the rule and differ from industry practice. For example, both the Risk Alert and the adopting release for the Marketing Rule indicate that a RIA marketing its third fund with higher management fees than its first two funds would need to calculate the net returns of the earlier funds using the higher management fee rate to be charged to the third fund – in other words, showing the actual performance of the first two funds would be misleading because those funds charged a lower management fee rate than the fund currently being marketed. This is just one example of net return calculation principles that may not be intuitive. While a comprehensive discussion of properly calculating net returns is outside the scope of this blog post, we note that this is an area where we frequently advise RIAs and ERAs differently depending on their specific facts and circumstances.

A note that may be particularly relevant to our private equity clients: Firms that use subscription lines of credit also should be aware of the FAQ published earlier this year by the staff of the SEC’s Division of Investment Management. Please reach out to us if you have questions about this evolving area.

10. Benchmark index comparisons

Staff observation

The staff observed advertisements that contained “benchmark index comparisons that did not define the index or provide sufficient context to enable an understanding of the basis for such comparison or disclose that the benchmark performance did not include reinvestment of dividends.”

Cooley take

While we find that VC firms typically don’t include benchmark comparisons in their marketing decks, we commonly see the inclusion of benchmark comparisons in other fund asset classes. When incorporating benchmark comparisons, firms should include appropriate disclaimers for the index they are using to compare their performance.

The SEC has been focusing on Marketing Rule compliance for some time. For example, earlier this month, the SEC settled charges against five RIAs for Marketing Rule violations. While we highlighted some of the more VC-relevant issues identified in the Risk Alert above, we think firms would benefit from reviewing the entirety of the alert. As always, we are here to answer any questions and guide our clients through these marketing considerations.

The three main statutory regimes to know are:

• Investment Company Act of 1940 (Company Act): This applies to the fund and governs whether the fund must register as an investment company.
• Investment Advisers Act of 1940 (Advisers Act): This applies to the management company and governs whether the management company must register as an investment adviser.
• Securities Act of 1933 (Securities Act): This applies to fundraising and governs whether the sale of fund interests must be registered as a securities offering.

As a general matter, you will want to be exempt from registration under all three statutory regimes. However, while exemptions from the Company Act and the Securities Act are existential to a VC firm, an exemption from the Advisers Act is something that’s nice to have, if not as critical.

Company Act

The Company Act is the body of law that mutual funds are subject to. Among other things, it requires registered investment companies to make public filings, appoint independent directors, and operate subject to various restrictions, such as minimum capital requirements and limitations on leverage. By their nature, VC funds are designed to operate as private funds, without being subject to the requirements of the Company Act. To be a private fund, a venture capital fund relies on Section 3(c)(1) and/or Section 3(c)(7) of the Company Act, both of which allow the fund to be excluded from being treated as an investment company for most purposes of the Company Act.

Both “3(c)(1) funds” and “3(c)(7) funds” are equally exempt from the Company Act requirements. A 3(c)(1) fund is limited to 100 beneficial owners who must be at least “accredited investors,” which in general includes individuals with investment capital of $1 million (or individuals who meet certain income requirements) and entities with investment capital of $5 million. A 3(c)(7) fund may accept up to 1,999 investors, but each must be a “qualified purchaser.” In general, to be a “qualified purchaser,” an individual must have $5 million in investment capital and an entity must have $25 million. In some cases, an entity may count as multiple investors based on the number of its underlying owners, or the qualified purchaser requirement may need to be satisfied with respect to each underlying owner of such entity (for example, if an entity is formed for the purpose of making the investment at hand or its underlying owners can make individual investment decisions). Thus, an analysis of each investor’s beneficial ownership status is crucially important from a regulatory perspective. Most first-time fund managers will likely default to a 3(c)(1) fund, as few of their investors are likely to meet the qualified purchaser standards.

It is important to note that the qualified purchaser and 100 beneficial owners limit requirements do not apply with respect to “knowledgeable employees” of a firm sponsoring a fund. This is a defined term in the Company Act, and it requires a facts and circumstances determination in some cases. The definition generally covers executive-level personnel, as well as investment personnel who have been performing investment advisory functions for at least 12 months.

Questions to ask your Cooley contact:

1. Can I have multiple 3(c)(1) funds that each have their own 100 beneficial owners limit?
2. Can I have a 3(c)(1) fund and a 3(c)(7) fund investing alongside each other?
3. Do friends and family who are not charged fees need to be qualified purchasers or count toward the 100 beneficial owners limit?

Advisers Act

The Advisers Act is the body of law that applies to anyone meeting the definition of “investment adviser” – i.e., anyone in the business of advising others with respect to securities and who receives compensation. One thing to note about the Advisers Act is that certain of the requirements apply whether or not a firm is registered as an investment adviser – something referred to as being a “registered investment adviser” or “RIA.” For instance, the general antifraud provisions of the Advisers Act apply to RIAs and unregistered investment advisers. And, all investment advisers – registered or not – owe a fiduciary duty to their funds.

Most VC fund managers rely on an exemption from registration as an RIA that’s available under Section 203(l) of the Advisers Act. This “VC exemption” allows investment advisers whose only clients are VC funds to be exempt from registration and be subject to a much lighter regulatory regime than RIAs. The key to relying on the VC exemption is the Advisers Act’s definition of “venture capital fund.” In general, most plain vanilla VC funds should meet this definition – a 3(c)(1) fund or a 3(c)(7) fund that holds itself out as pursuing a VC strategy, doesn’t incur leverage in excess of 15% of the fund’s capital commitments (with any leverage that is incurred not exceeding 120 days), doesn’t give ordinary redemption rights to investors, and mostly invests in primary issuance of equity securities (including securities convertible to equity) of private operating companies.

To drill in slightly deeper, the Advisers Act definition of VC fund has several components, the most important of which is the “20% nonqualifying basket.” A VC fund must invest at least 80% of the capital commitments in qualifying investments. Conversely, no more than 20% of the capital commitments can comprise nonqualifying investments, although the 20% nonqualifying basket can be filled with any type of nonqualifying investment (e.g., crypto, debt, public company shares, investments in other funds and securities acquired in secondary transactions). The 20% calculation is done immediately after the acquisition of each nonqualifying asset, and it can be based on either cost or fair value, as long as it’s consistently applied (i.e., a manager can’t switch between using cost and fair value).

While the VC exemption is what most VC firms rely on, some smaller managers might rely on the private fund adviser exemption – the “PF exemption” – in lieu of, or in addition to, the VC exemption. The PF exemption, which is provided under Section 203(m) of the Advisers Act, is available to investment advisers whose only clients are “private funds” and whose gross assets under management total less than $150 million. A private fund is any 3(c)(1) fund or 3(c)(7) fund, even if it is not a VC fund. The trade-off between the VC exemption and the PF exemption is that the VC exemption does not have a cap on assets under management, but it does have a cap on nonqualifying investments (among other conditions), while the PF exemption has a cap on assets under management but no operational restrictions beyond that cap.

To rely on the VC exemption or the PF exemption and avoid registration as an RIA, a fund manager needs to file a Form ADV as an exempt reporting adviser (ERA). This is a public filing with the Securities and Exchange Commission (SEC), and it includes information about the management company, its affiliates, funds, executive officers, and direct and indirect owners. While filing a Form ADV is not difficult, it is important to make the filing in a timely manner – and submit annual and interim amendments as required.

As indicated above, ERAs have a fiduciary duty to their funds and are subject to certain Advisers Act requirements. In addition to general antifraud provisions, ERAs are subject to the limitations around political contributions, must adopt an insider trading policy, and must obtain investor consent to principal transactions and other similar situations involving conflicts of interest. In addition, the SEC adopted rules in 2023 around preferential treatment (colloquially known as the “side letter rule”) and certain restricted activities by private fund advisers. (For more information, see our September 2023 post about the SEC’s rules.) However, ERAs are not subject to various other requirements under the Advisers Act, including those around custody, audit, marketing, personal trading, record-keeping and quarterly statements. (For an overview of transitioning from relying on the VC exemption to becoming an RIA, refer to our August 2023 post.)

Questions to ask your Cooley contact:

1. Can I create two entities and rely on the VC exemption for one and the PF exemption for the other?
2. Can I switch between the VC exemption and the PF exemption?
3. What do I do if I don’t qualify for the VC exemption or PF exemption?
4. When do I need to file the Form ADV?

Securities Act

The Securities Act is the body of law that applies to the sale of securities, like in an initial public offering. VC and other private funds rely on an exemption that applies to private offerings. While there is a statutory exemption for transactions not involving any public offering generally, most funds rely on the safe harbor provided by Regulation D under the Securities Act. At a high level, there are two key requirements for relying on Regulation D. First, the fund cannot engage in general solicitation or general advertising. Second, the fund must only admit accredited investors. Called a “506(b) offering,” it’s what the vast majority of VC funds rely on. Technically, a fund is allowed to admit up to 35 non-accredited investors. However, doing so would require preparation and disclosure of financial and nonfinancial information that goes far beyond what private funds typically share. Therefore, private funds typically do not admit non-accredited investors.

The restriction on general solicitation or general advertising means that a firm is prohibited from publicly speaking about the fund, posting the fund’s marketing materials on its website, or reaching out to investors it doesn’t have a relationship with. As a general rule, the SEC requires the existence of a “substantive preexisting relationship” with potential investors in order to establish that there has not been general solicitation or general advertising. This is the type of relationship that allows a firm to evaluate a potential investor’s sophistication and accredited investor status. To a limited extent, a firm may rely on their existing network to be introduced to new prospective investors. But the manner, nature, and number of such introductions must be carefully tracked to avoid what can amount to general solicitation or general advertising.

Instead of choosing a 506(b) offering, a few funds choose to do a “506(c) offering,” which also is an exempt offering under Regulation D. The benefit of a 506(c) offering is that a firm may freely engage in general solicitation or general advertising – blog posts, cold emails and speaking at conferences all would be permitted. However, a crucial condition to a 506(c) offering is the requirement to take “reasonable steps to verify” that each investor in the fund is an accredited investor. While this may sound simple enough, the types of documentation that firms are expected to obtain from investors in order to satisfy the verification requirement are often considered intrusive and invasive, and the cost of the process itself can be expensive. While there are service providers that can assist with the verification requirement, and letters from a prospective investor’s accountant or lawyer verifying the investor’s accredited status would suffice, 506(c) offerings still tend to be much less common than 506(b) offerings.

Questions to ask your Cooley contact:

1. What are some ways I can fundraise in a 506(b) offering beyond my immediate network?
2. What are the do’s and don’ts to avoid general solicitation or general advertising?
3. What happens if I’ve inadvertently engaged in general solicitation or general advertising?
4. What type of documentation is requested from investors to satisfy the verification requirement for a 506(c) offering?

Other considerations

The securities laws principles we discussed above relate to US federal requirements. State requirements also will apply, although most firms will only need to make notice filings at the state level. Firms looking to fundraise outside the United States, and firms that are based outside the United States, will have different considerations – and other bodies of law may apply to them and their fundraising efforts.

Schedule 13G

Funds – including their general partners and, in some cases, managing principals – that hold in excess of 5% of a class of public equity as of December 31, 2023, generally must file a Schedule 13G within 45 days of year-end. Also, any fund that has previously filed a Schedule 13G with respect to a portfolio company must file an annual amendment to its Schedule 13G within 45 days of year-end if there have been any changes in ownership since the most recent filing – including an “exit” filing if the fund’s ownership has declined below 5%.

Form 13F

Investment advisers who exercise investment discretion over “Section 13(f) securities” –generally equity securities of public companies – are required to file quarterly reports with the SEC on Form 13F within 45 days of each quarter-end. Subject to certain exceptions, if your funds collectively owned in excess of $100 million of Section 13(f) securities as of the last day of any month during the 2023 calendar year, you’re obligated to file a Form 13F for the quarter ending December 31, 2023, within 45 days of calendar year-end. In addition, the filing obligation continues for a minimum of three consecutive calendar quarters (i.e., March 31, June 30 and September 30), with filings due within 45 days of the relevant quarter-end.

It is important to note that, even if you do not exceed the $100 million threshold as of December 31, the obligation to file a Form 13F for the quarter ending December 31 remains if the threshold was exceeded as of the last day of any single month during the calendar year.

Form 13H

Investment advisers who have previously filed a Form 13H to register as a “large trader” are required to file an annual update to the filing within 45 days of year-end. Large traders who have completed a full calendar year without exceeding any of the Form 13H triggering thresholds, measured across all portfolio companies, may be eligible to elect “inactive” status and thereby suspend certain ongoing large trader obligations. These triggering thresholds are daily trading of at least 2 million shares or $20 million in share value, or calendar month trading of at least 20 million shares or $200 million in share value, in each case aggregating purchases and sales of the securities of all portfolio companies during the relevant day or month.

In addition to the annual filing requirement, large traders have a quarterly obligation to promptly amend the Form 13H following any quarter during which any of the information in their Form 13H materially changes.

Looking ahead: Schedule 13G filing deadlines changing

As described in an October 2023 Cooley client alert, the SEC has adopted comprehensive amendments to the Schedule 13G filing requirements. Once effective, those rule changes will generally accelerate the filing deadlines for initial and amended Schedule 13Gs. Beginning September 30, 2024, funds will be required to begin assessing their Schedule 13G filing requirements on a quarterly basis, with the first of such filings due November 14, 2024. The recent rule changes do not in any way affect the filing requirements under Form 13F or Form 13H.

Closing thoughts

As the end of the calendar year approaches, funds should start to consider whether they will need to make any of the annual filings under Section 13. The determination of whether you have a Schedule 13G, Form 13F or Form 13H filing obligation is often complex. As part of your year-end wrap-up, consider contacting your fund/securities counsel to begin a Section 13 analysis, then prepare any required filings well in advance of the February 14, 2024, deadline.

Read Full Article

The new rules cover the following topics:

1. Preferential treatment granted to select investors
2. Restricted activities of private fund advisers
3. Quarterly reporting of fees and expenses, adviser compensation and performance metrics
4. Private fund audits
5. Valuation or fairness opinions for adviser-led secondary transactions 

Rules related to the first two topics will apply to both registered investment advisers (RIAs) and exempt reporting advisers (ERAs), while rules related to the last three topics will apply only to RIAs. The SEC also adopted an amendment to an existing rule that will require RIAs to document their annual compliance reviews.

This post is intended to provide a summary of the new rules that would be most pertinent to VC advisers.

A note to our clients based outside the United States: The new rules will not apply to a non-US adviser with respect to its non-US funds, even if there are US investors in those funds. For this purpose, the SEC considers a non-US adviser to be an adviser whose principal office and place of business is outside of the US. The new rules will apply to a non-US adviser with respect to its US funds.

Rules applicable to all private fund advisers (RIAs and ERAs)

1) Rule 211(h)(2)-3 – Preferential Treatment Rule

The Preferential Treatment Rule will limit advisers from directly or indirectly providing preferential treatment – whether by agreement via a side letter or otherwise – to select investors in a fund, and in certain circumstances, investors in a similar pool of assets, unless the adviser discloses such preferential treatment to all investors, and in certain circumstances, offers the same treatment to all investors. A “similar pool of assets” would be a pooled investment vehicle with substantially similar investment policies, objectives or strategies to those of the fund and would generally pick up parallel funds, feeder funds and co-investment funds. The term will likely capture vehicles outside of what VC firms would typically view as a “substantially similar pool of assets.” For example, the SEC has stated that an adviser’s healthcare-focused fund may be considered a “similar pool of assets” to the adviser’s technology-focused fund.

Preferential redemption 

The Preferential Treatment Rule will prohibit an adviser from granting an investor in a private fund, or a similar pool of assets, the ability to redeem its interest on terms that the adviser reasonably expects to have a material, negative effect on other investors in that fund or in a similar pool of assets. There is an exception if an investor is required to redeem due to applicable laws (US or non-US), or if the adviser has offered the same redemption ability to all other existing investors (e.g., offered different share classes to all investors (but the share class must not be contingent on investment size)) and will continue to offer such redemption ability to all future investors in the same private fund and any similar pool of assets.

This aspect of the Preferential Treatment Rule is likely not going to have a large impact on VC funds, given that redemptions are impractical – if not impossible – for such funds, and are not permitted by the Advisers Act definition of “venture capital fund,” except in extraordinary circumstances. That being said, the rule will apply to ad hoc redemptions, and the SEC has indicated that extraordinary circumstances may be exactly the circumstances where preferential redemption rights for certain investors are most likely to have a material, negative effect on other investors. So, to the extent that a VC firm permits a one-off redemption to an investor that is not required by applicable laws, it will need to reasonably determine – and we would recommend documenting – that the redemption would not have a material, negative effect on other investors.

Preferential transparency

The Preferential Treatment Rule will prohibit an adviser from providing information (whether through formal or informal communication, or through written, visual or oral means) regarding portfolio holdings or exposures of the private fund, or of a similar pool of assets, to any investor in the fund if the adviser reasonably expects that providing the information would have a material, negative effect on other investors in that fund or in a similar pool of assets. There is an exception to this prohibition if the adviser offers such information to all existing investors in the private fund and any similar pool of assets at the same time or substantially the same time.

Helpfully, the SEC stated in adopting the rule that it generally would not view preferential information rights provided to an investor in an illiquid fund, such as a VC fund, as having a material, negative effect on other investors. However, the SEC did not provide a blanket exception for illiquid funds, stating instead that a facts and circumstances analysis would be required. The SEC has said that advisers would not be expected to predict how investors will react to information; rather, they would need to form only a reasonable expectation based on the facts and circumstances. VC advisers might consider whether information provided to certain investors – including in connection with their representation on limited partner advisory committees (LPACs) – should be subject to contractual provisions around non-use, in addition to nondisclosure and confidentiality.

Disclosure of preferential treatment

The Preferential Treatment Rule also will require written notice of all preferential treatment to both prospective and current investors in the fund. Disclosure will need to be provided to prospective investors – prior to their admission – if the preferential treatment is related to any material economic terms (e.g., the cost of investing, liquidity rights, fee breaks and co-investment rights). Other preferential treatments (i.e., those that are not related to any material economic terms) will need to be provided to current investors in the fund as soon as reasonably practicable following the end of the fund’s fundraising period (or, in the case of a liquid fund, following the investor’s investment in the fund). While “as soon as reasonably practicable” will depend on the facts and circumstances, the SEC has said that distributing the notice within four weeks would generally be appropriate. To the extent that an adviser provides additional preferential treatment to investors after the fund closes, it will need to provide written notice of such additional treatment on an annual basis.

Disclosure of preferential terms will require specificity. For example, if an adviser provides an investor with lower fee terms in exchange for a significantly higher capital commitment than others, the adviser will need to describe the lower fee terms, including the applicable rate (or range of rates if multiple investors pay such lower fees), in order to provide sufficiently specific information as required by the rule. Providing copies of side letters with identifying information redacted (if applicable) would comply with the disclosure requirements, as would a sufficiently specific written summary of preferential terms, such as a compendium or master side letter covering all preferential terms, similar to the practice used for most favored nation (MFN) elections.

2) Rule 211(h)(2)-1 – Restricted Activities Rule

The Restricted Activities Rule will prohibit private fund advisers from engaging in the following activities, subject to either disclosure to, and/or consent from, investors. Each consent-based exception will require an adviser to seek consent from all investors in the private fund and obtain consent from at least a majority in interest of investors that are not related persons of the adviser (i.e., LPAC consent will not suffice). A fund’s governing documents may generally prescribe the manner and process by which the applicable consent is obtained. 

Regulatory, compliance and examination expenses (post-disclosure)

The Restricted Activities Rule will prohibit an adviser from charging private fund clients:

• Regulatory or compliance fees and expenses of the adviser or its related persons
• Fees and expenses associated with an examination of the adviser or its related persons by any governmental or regulatory authority

unless the adviser distributes written notice of any such fees or expenses, including the dollar amounts, to investors in the fund within 45 days after the end of the fiscal quarter in which the charge occurs.

The written notice should include a detailed accounting of each category of such fees and expenses, and each specific category should be listed as a separate line item rather than grouped into broad categories such as “compliance expenses.”  

Investigation expenses (consent)

The Restricted Activities Rule will prohibit an adviser from charging private fund clients fees and expenses associated with an investigation of the adviser or its related persons by any governmental or regulatory authority, unless the adviser seeks written consent from all investors and obtains written consent from at least a majority in interest of the investors. However, in no event will an adviser be able to charge fees or expenses related to an investigation that results – or has resulted in – a court or governmental authority imposing a sanction for a violation of the Advisers Act or Advisers Act rules. If an adviser is ultimately sanctioned, and the adviser has already charged the fund for investigation expenses (i.e., with consent from the investors), the adviser will be required to refund the fund for the fees and expenses associated with the investigation. In light of circumstances in which governmental or regulatory bodies may not formally notify an adviser that it is under investigation, whether the adviser is under investigation would be determined based on available information. To request consent, advisers will generally need to list each category of fee or expense as a separate line item, rather than grouping them into broad categories, and describe how each such fee or expense is related to the relevant investigation. 

Adviser clawbacks – reduced for taxes (post-disclosure)

The Restricted Activities Rule will prohibit an adviser from reducing the amount of any adviser clawback by actual, potential or hypothetical taxes applicable to the adviser or its related persons (or their respective owners or interest holders), unless it distributes written notice to the investors setting forth the aggregate dollar amounts of the clawback, both before and after such reduction for taxes, within 45 days after the end of the fiscal quarter in which the adviser clawback occurs. 

Non-pro rata fees and expenses (pre-disclosure)

The Restricted Activities Rule will prohibit an adviser from charging or allocating fees and expenses related to a portfolio investment (whether or not consummated) on a non-pro rata basis when multiple clients are investing in the same portfolio investment, unless:

• The non-pro rata charge or allocation is fair and equitable under the circumstances.
• Prior to charging or allocating such fees or expenses to a fund, the adviser distributes to each investor in the fund a written notice of the non-pro rata charge or allocation and a description of how it is fair and equitable under the circumstances.  

Non-pro rata allocation may be fair and equitable where, for example, an expense is related to a bespoke structuring for one fund participating in an investment, or where one fund receives a greater benefit from an expense relative to other funds participating in the investment. Stating that there may be multiple methods to determine pro rata allocations, the SEC did not define pro rata.

Borrowing (consent)

The Restricted Activities Rule will prohibit an adviser from borrowing from a private fund client, unless the adviser distributes a written description of the material terms of the borrowing (e.g., amount to be borrowed, interest rate and repayment schedule) to the investors in the fund, seeks their consent for the borrowing and obtains written consent from at least a majority in interest of the investors that are not related persons of the adviser. The restriction will not apply to borrowings from a third party on the fund’s behalf or the adviser’s borrowings from individual investors outside of the fund, such as a bank that is invested in the fund.

Helpfully, the SEC has stated that it would not interpret management fee offsets and ordinary course tax advances (i.e., arrangements structured to contemplate amounts that reduce an adviser’s future income, as opposed to amounts that will be repaid to the fund) as borrowings subject to the rule. VC firms will need to determine whether other arrangements permitted under fund documents would be considered a borrowing subject to the rule.

Rules applicable to RIAs only (not applicable to ERAs)

3) Rule 211(h)(1)-2 – Quarterly Statements Rule

The Quarterly Statements Rule will require RIAs to private funds to distribute quarterly statements to investors, reporting detailed information regarding:

• Compensation and other amounts allocated or paid by the fund and portfolio investments to the adviser and its related persons.
• Other fees and expenses paid by the fund to third parties.
• Portfolio performance.

Statements will need to be delivered within 45 days after the end of each of the first three fiscal quarters of each fiscal year, and 90 days after the end of each fiscal year. A fund of funds, which the SEC describes as a fund that invests substantially all of its assets in the equity of third-party funds, will have 75 days after the end of each of the first three fiscal quarters, and 120 days after the end of each fiscal year. The first statement of a newly formed fund will be due following the second full fiscal quarter of operating results.

The rule requires advisers to determine – with substantiation – that a fund is either a liquid fund or an illiquid fund no later than when the adviser sends the initial quarterly statement. While most VC funds will be illiquid funds, certain hybrid funds may be liquid funds, and a fund may switch from being a liquid fund to an illiquid fund, or vice versa. Determination of whether a fund is a liquid fund or an illiquid fund turns on whether the fund is required to redeem interests upon an investor’s request and whether it has limited opportunities, if any, for investors to withdraw before termination of the fund. A fund that provides semiannual redemption rights would generally be a liquid fund. The rule requires different performance metrics depending on whether a fund is a liquid fund or an illiquid fund.

Fund table

Quarterly statements will need to include, in table format, a detailed accounting of:

• All compensation, fees and other amounts allocated or paid to the adviser or any of its related persons by the private fund during the reporting period, e.g., management fees, sub-advisory fees or carried interest (adviser compensation).
• All other fees and expenses allocated to or paid by the fund during the reporting period (fund expenses).
• The amounts of any offsets or rebates carried forward during the reporting period to the subsequent quarterly period to reduce future payments or allocations to the adviser.

The adviser compensation and fund expenses will need to be presented both before and after application of any offsets, rebates or waivers. There is no exclusion for de minimis expenses, smaller expenses may not be grouped into broad categories, and no expense may be labelled as miscellaneous.

Portfolio investment table

Quarterly statements will need to include, in table format, a detailed accounting of all portfolio investment compensation allocated or paid by each covered portfolio investment during the reporting period. Portfolio investment is defined as any entity or issuer in which the private fund has invested directly or indirectly, and would capture holding companies, subsidiaries, special purpose vehicles (SPVs) and master funds, as well as underlying third-party funds. Portfolio investment compensation is defined as any compensation, fees and other amounts (e.g., origination, management, consulting, monitoring, servicing, transaction, administrative, advisory, closing, disposition, directors, trustees or similar fees or payments) allocated or paid to the adviser or any of its related persons by a portfolio investment, which is attributable to a fund’s interest in such portfolio investment. Portfolio investment compensation is not limited to circumstances in which an adviser has discretion or authority over the portfolio investment.

Performance

Quarterly statements will need to include standardized performance information. For illiquid funds, performance will need to be shown based on internal rates of return and multiples of invested capital (both gross and net) for the entire portfolio, as well as internal rates of return and multiples of invested capital (gross only) for the realized and unrealized portions of the portfolio, with the realized and unrealized performance shown separately. For partially realized investments, advisers will need to determine whether to include them in the realized or the unrealized portion. Performance figures will need to cover the period from inception of the fund through the end of the quarter covered by the quarterly statement (or, to the extent quarter-end numbers are not available at the time the adviser distributes the quarterly statement, through the most practicable date), and will need to be disclosed with and without the impact of fund-level subscription facilities. There is no exception for short-term subscription facilities. As noted above, most VC funds will be illiquid funds; but firms should keep in mind that a fund meeting the definition of a liquid fund will need to disclose a different set of metrics, based on net total returns.

In calculating performance, advisers will generally be expected to exclude the adviser’s (and any affiliates’) interests. Advisers also will need to include a statement of contributions and distributions showing all capital inflows the fund received from investors and all capital outflows distributed to investors, with the value and date of each inflow and outflow, along with the net asset value of the fund as of the end of the reporting period.

In addition to the above, quarterly statements will need to include prominent disclosure (no hyperlinks and no separate documents) regarding the manner in which all expenses, payments, allocations, rebates, waivers and offsets are calculated, as well as cross-references to the relevant sections of the fund’s organizational and offering documents that set forth the applicable calculation methodology. Additionally, quarterly statements will need to include the date as of which the performance information is current through, and prominent disclosure (no hyperlinks and no separate documents) of the criteria used and assumptions made in calculating the performance. Advisers will need to consolidate reporting for similar pools of assets to the extent doing so would provide more meaningful information to the fund’s investors and would not be misleading. Advisers also will need to use clear, concise, plain English and present information in a format that facilitates review from one quarterly statement to the next.

4) Rule 206(4)-10 – Audit Rule

The Audit Rule will require RIAs to cause each private fund they advise (directly or indirectly, including in a sub-advisory capacity) to undergo a financial statement audit that meets the requirements set forth in Advisers Act Rule 206(4)-2 (Custody Rule), and to cause the audited financial statements to be delivered in accordance with the Custody Rule. Most RIAs already rely on private fund audits to comply with the Custody Rule. However, unlike the Custody Rule, there is not an option of surprise examination to comply with the Audit Rule, and the Audit Rule will apply regardless of whether an adviser has “custody” within the meaning of the Custody Rule. In the case of a fund that an adviser does not control (e.g., a sub-advised fund), the Audit Rule will require the adviser to take all reasonable steps to cause the fund to undergo an audit and have its financial statements delivered. 

5) Rule 211(h)(2)-2 – Adviser-Led Secondaries Rule

The Adviser-Led Secondaries Rule will require RIAs conducting an adviser-led secondary transaction to:

• Obtain and distribute a fairness opinion or a valuation opinion from an independent opinion provider.
• Prepare and distribute a written summary of any material business relationships the adviser or its related persons have – or have had within the two-year period immediately prior to the issuance of the opinion – with the independent opinion provider.

An adviser-led secondary transaction would be a transaction initiated by the adviser or any of its related persons that offers private fund investors the choice between:

• Selling all or a portion of their interests in the private fund.
• Converting or exchanging them for new interests in another vehicle advised by the adviser or its related persons.

The SEC would not consider the rule to apply to cross trades where the adviser does not offer the investors the choice to sell, convert or exchange their fund interests, and rebalancing between parallel funds generally will not be captured by the adviser-led secondary transaction definition. Distribution of the opinion and the written summary will need to occur prior to the due date of the election form.

Other rules applicable to RIAs only (not applicable to ERAs)

6) Rule 206(4)-7 – Compliance Rule

The SEC amended the existing Compliance Rule, which applies to all RIAs (i.e., not just RIAs to private funds), to require RIAs to start documenting their annual compliance reviews in writing. While documentation has always been a best practice, it is not currently required by the Compliance Rule.

7) Rule 204-2 – Recordkeeping Rule

The SEC also amended the existing Recordkeeping Rule to require RIAs to retain records related to the new rules, including notices, consents, quarterly statements, audited financials, certain determinations, and fairness or valuation opinions.

Compliance dates and transition periods

The rules will become effective on November 13, 2023.

Except with respect to the Compliance Rule, however, advisers will have a transition period to come into compliance.

• Advisers with less than $1.5 billion in private fund assets will need to comply with all applicable rules by March 14, 2025. 
• Advisers with $1.5 billion or more in private fund assets will need to comply with the Restricted Activities Rule, Preferential Treatment Rule and Adviser-Led Secondaries Rule by September 14, 2024, and the Quarterly Statement Rule and Audit Rule by March 14, 2025. 
• RIAs must begin documenting their annual compliance reviews starting on November 13, 2023.

Limited grandfathering/legacy status

The Preferential Treatment Rule and the Restricted Activities Rule both contain limited grandfathering provisions that confer legacy status to certain contractual agreements governing private funds that have commenced operations as of the applicable compliance date. Importantly, the adviser must have engaged in bona fide activity directed toward operating the fund as of the compliance date in order for legacy status to apply. The SEC has said this would include issuing capital calls, holding an initial fund closing and conducting due diligence on potential fund investments – or making an investment on behalf of the fund.

Specifically, legacy status may apply to the restrictions on preferential transparency, preferential redemption, charging a private fund fees or expenses associated with an investigation of the adviser or its related persons (unless the investigation results in a sanction for a violation of the Advisers Act), and borrowing from a fund. Legacy status would apply with respect to the foregoing if both of the following are true:

• A contractual agreement was entered into in writing prior to the applicable compliance date.
• The application of the new rules would require the parties to amend such an agreement.

Agreements subject to legacy status include limited partnership agreements, operating agreements, side letters, subscription agreements, promissory notes and credit agreements.

Legacy status will not apply to the written notice requirements under the Preferential Treatment Rule and the Restricted Activities Rule.

Next steps

These are significant rules, and significant effort will be required to come into compliance with them. While some firms may have heard that there is pending litigation with respect to the new rules, and perhaps have been considering a wait-and-see approach, we encourage fund managers to start focusing on these rules sooner rather than later. An outcome on the pending litigation is not expected in the short term, and the September 14, 2024, compliance date for larger firms is less than a year away.

• If not already in progress, we encourage fund managers to become familiar with the new rules now to begin assessing which of the new requirements and restrictions will apply to them.
• Upon attaining a working grasp of the new rules, firms should review various documents and practices – such as fund governing documents, side letters, informal arrangements with investors, practices and methodologies that can be considered borrowings from a fund, bookkeeping and expense tracking procedures, and arrangements with underlying funds and portfolio investments.
• Firms also should speak with auditors, administrators, intermediaries and service providers and work on preparing mock notices, statements and consents.
• A medium-term project will be crafting policies and procedures to comply with the new requirements. Firms that work with compliance consultants will likely receive outreach regarding this step.
• Long term, firms should adopt and implement their updated policies and procedures, train employees and stakeholders, and continue to monitor and adjust their practices, paying attention to industry standards that develop and any guidance the SEC staff may provide.

We are available to discuss and guide our clients through this process. Please reach out to a Cooley team member with any questions.

• Charging fees and expenses related to regulatory investigations, proceedings, or compliance without disclosure and consent from investors.
• Charging any fees related to sanctions of the private fund adviser in connection with a breach of the Advisers Act.
• Reducing the amount of an adviser clawback by taxes without disclosure of pre-tax and post-tax clawback calculation.
• Charging fees related to a portfolio investment on a non-pro rata basis, with certain exceptions.
• Direct or indirect borrowing by the adviser from a private fund client without disclosure and consent from the investors.

Additionally, under the reforms, all private fund advisers will be prohibited from providing certain types of preferential treatment to particular investors, including:

• Rights that modify the fees paid by particular investors without disclosure to all current and prospective investors.
• Redemption rights, unless all investors are provided the opportunity to elect such redemption rights.
• Additional information rights, unless all investors are provided the opportunity to elect such information rights.

The reforms also will require private fund advisers registered with the SEC to:

• Provide investors with quarterly statements detailing information regarding private fund performance, as well as fees and expenses charged to the private fund.
• Obtain an annual audit for each private fund.
• Acquire a fairness or valuation opinion in connection with an adviser-led secondary transaction.

Further, the reforms include amendments to the compliance rule for all registered investment advisers that require the adviser to document in writing the mandated annual review of their compliance policies and procedures. The SEC expects to use these reports to facilitate its assessment of registered investment advisers’ compliance.  

The SEC has included provisions to excuse the application of certain of the new prohibitions with respect to the preferential treatment rule and the restricted activities rule from preexisting private fund governing agreements entered into prior to the applicable compliance date.    

The adopted rule is different than the proposed rule in many respects, including the elimination of proposed limitations on indemnification and portfolio fees for services not performed (e.g., accelerated monitoring fees).  

The reforms will become effective 60 days after publication in the Federal Register and provide for a transition period of 18 months after the publication date for advisers with less than $1.5 billion in private fund assets under management (AUM). Advisers with $1.5 billion or more in private fund AUM will have 18 months after the date of publication to comply with the annual audit and quarterly statement reforms, and 12 months to comply with all other reforms. Compliance with the amended Advisers Act compliance rule will be required 60 days after publication for all registered investment advisers.  

We’re performing an in-depth review of the 660-page release and will provide an update with more information soon.

A note to our non-US clients: The registration and exemption analysis is different for managers that are based outside the US. The application of the various regulatory requirements also will depend on where your funds are organized. Please contact us for more information.

Registration basics for VC firms

Under the Investment Advisers Act of 1940 (Advisers Act), an investment adviser is any person who – for compensation – engages in the business of providing advice to others regarding securities. With the exception of family offices and corporate venture capital firms (CVCs), most VC firms will meet the definition of investment adviser. Anyone who falls within the definition of investment adviser is required to register unless an exemption applies. The main exemption for VC firms is the venture capital adviser exemption, although smaller firms, especially when first starting out, also may rely on the private fund adviser exemption.

The venture capital adviser exemption exempts from registration investment advisers that only advise one or more venture capital funds. The Advisers Act defines a venture capital fund as a type of private fund that represents to investors that it pursues a venture capital strategy, provides redemption rights only in extraordinary circumstances, does not borrow more than 15% of its aggregate capital contributions and uncalled capital commitments, and holds no more than 20% of its assets in nonqualifying investments (often referred to as the 20% basket), with the remaining 80% limited to investments in qualifying portfolio companies. Cash and cash equivalents do not count toward the 20% basket. A private fund is an investment vehicle that is not offered to the general public and is limited either to 100 beneficial owners or to beneficial owners that are qualified purchasers (which includes entities with $25 million in investments and individuals with $5 million in investments).

The private fund adviser exemption exempts from registration investment advisers that solely advise private funds and have less than $150 million in gross assets under management – also known as regulatory assets under management (RAUM) – across all their funds. While subject to a cap on its RAUM, a private fund adviser is not limited to advising venture capital funds and can advise any type of private funds, including private equity, crypto, hedge and others. A VC firm can rely on one or both of these exemptions, although it will likely outgrow the private fund adviser exemption over time. At that point, unless all of its clients are private funds that meet the venture capital fund definition, the adviser will need to register with the SEC. An adviser that relies on either exemption is referred to as an exempt reporting adviser (ERA). ERAs are required to file portions of the Form ADV Part 1A with the SEC and comply with limited requirements under the Advisers Act, and they are subject to examination by the Division of Examinations. However, they are not “registered” with the SEC.

What are the benefits of registering?

The biggest benefit of registering is flexibility. Advisers that rely on the venture capital adviser exemption or the private fund adviser exemption can find themselves forgoing certain opportunities or investment structures, negotiating less favorable terms, or taking on risk and dealing with uncertainties. They have to make a choice between the expensive and time-consuming process of registering and the regulatory burden that comes with it, or limit themselves to ensuring all their funds – including any special purpose vehicles (SPVs) they manage – meet the venture capital fund definition (including with respect to the 20% basket) or stay below $150 million of RAUM.

Perhaps the most significant limitation for venture capital advisers is the cap on nonqualifying investments. In general, qualifying investments are limited to equity investments acquired directly from private operating companies. Debt securities, securities acquired in secondary transactions (including from founders and company employees), public company securities, cryptocurrencies and interests in other venture capital funds are among the common nonqualifying investments that need to fit in the 20% basket. By registering, a venture capital adviser would no longer be constrained by the 20% basket, which, in addition to freeing up capacity in its main funds for nonqualifying investments, also can prove especially impactful on the use and nature of SPVs that invest in such nonqualifying investments. Registering also would mean that the adviser could advise funds that borrow in excess of the 15% limit or permit investors to redeem outside of extraordinary circumstances.

Registration also allows increased flexibility to take on non-private fund clients, such as separately managed accounts, family offices and employee funds that are not private funds. For firms looking to explore new business lines and different asset classes, or enter into joint ventures, registration may provide much-needed latitude.

Finally, some firms may find that certain investors are more willing to commit to a fund advised by a RIA than an ERA. While registration does not impose a heightened standard of fiduciary duty (ERAs are subject to the same standard of conduct as RIAs), it does impose a host of additional rules and requirements on the adviser that are designed to protect investors and provide additional information to the SEC. For some investors, this may be a factor they consider when choosing an investment adviser firm.

What are the downsides of registering?

While registration opens up new opportunities by removing regulatory constraints and offering flexibility in its place, it also imposes significant time and money costs. One of the first impositions of registration is the requirement to appoint a chief compliance officer (CCO) and implement a compliance program tailored to the RIA’s business. These days, there are a plethora of compliance consultants who can assist with the development of a compliance program and also can conduct training sessions. There also are various compliance tools to assist with the collection, approval and oversight functions. What is important for firms to understand, however, is that the mere adoption of a compliance program will not be adequate. RIAs are expected to have a dynamic compliance program that adapts to changes in their business and organization, as well as developments in the law and market.

Becoming a RIA will mean greater scrutiny by the SEC. While ERAs are subject to examination and do get examined, RIAs are much more likely to undergo an examination. As a rule of thumb, RIAs should expect to be examined within their first year of registration and approximately once every seven years thereafter. During an examination, SEC staff will rigorously evaluate an adviser’s compliance with the myriad of legal and regulatory requirements, including many that are based on fiduciary duty principles and disclosures to investors regarding conflicts of interest. Most examinations will result in the adviser receiving a deficiency letter that lists the areas where the adviser falls short, although some can and do get referred to the Division of Enforcement.

A firm that registers will become subject to various new rules under the Advisers Act, including the code of ethics rule, custody rule, marketing rule and recordkeeping rule. Each of these rules involves pain points that a new RIA will need to cope with. For example, the code of ethics rule requires senior executives and certain other personnel to submit quarterly transaction reports and annual holdings reports for their personal securities accounts and to preclear transactions in private placements and initial public offerings. The marketing rule requires deal-level net returns to be shown with equal prominence when deal-level gross returns are shown (something firms typically do not do and find meaningless), places limitations on the ability to use a track record achieved at a prior firm, and triggers disclosure and oversight requirements when engaging a placement agent. The custody rule requires stub year audits for funds that launch at the end of the year, irrespective of costs and investors’ consent to extended audits, while the recordkeeping rule requires RIAs to manage how employees use off-channel communications like text messages, WhatsApp and other direct messaging applications. (Please note that the above is not intended to summarize these rules or their numerous challenges, which is beyond the scope of this post.)

In addition, RIAs are subject to statutory requirements under the Advisers Act, pursuant to which they may be required to obtain investor consent when there are changes to their ownership structure. The addition or removal of a person who owns more than 25% of a RIA’s voting stock can result in a deemed assignment of an advisory contract requiring consent. Moreover, for RIAs to receive performance-based compensation, their investors must be qualified clients (which may require investors to satisfy a net worth standard that is more than double what they need to satisfy for a fund managed by an ERA).

RIAs also are subject to additional reporting requirements. First, rather than completing just portions of Part 1A of the Form ADV as ERAs do, RIAs must complete the entire Part 1A, as well as Part 2A (the brochure) and Part 2B (the brochure supplement). While these additional sections require more time and attention to complete, once prepared, they are typically not as time-consuming to update and keep current. Second, RIAs must file a Form PF with the SEC, a confidential filing that collects information about the private funds they advise. Although Form PF can be heavily burdensome for large hedge fund and private equity fund managers who may need to file the form quarterly, most registered VC firms only need to make the filing annually, and their costs for the reporting are typically not significant.

In considering the overall cost of registering, firms should note that in the past couple of years, the SEC has had an unusually active rulemaking agenda. Under current Chair Gary Gensler, the SEC has proposed a long list of rules, many of which are slated to be adopted in the coming months. Although some of these rules also would apply to ERAs, RIAs would be subject to significantly more, and the cumulative burden of the new rules may be prohibitive for a smaller firm newly registering. Among other requirements, if the proposed rules are adopted, RIAs would be required to send quarterly statements to fund investors detailing various fees and expenses, obtain fairness opinions prior to closing on adviser-led secondary transactions, adopt cybersecurity policies and procedures, disclose environmental, social and governance (ESG) practices and cybersecurity incidents and risks in their Form ADV, custody all client assets – not just funds or securities – with a qualified custodian, and conduct due diligence on outsourced service providers.

In addition, both RIAs and ERAs would be subject to new rules that, if adopted, would prohibit certain activities with respect to their private funds and place limitations on side letters. Among other things, the prohibited activities rule would prohibit an adviser from charging a fund fees or expenses associated with SEC exams and any compliance expenses incurred by the adviser, including registration expenses.

Should I register?

Given the number of variables that go into deciding whether to register, it can be a complicated decision. There is no one-size-fits-all answer. With that said, prior to the current administration at the SEC, an important aspect that a firm might have considered is the amount of resources – time and money – that registration requires. While compliance with additional requirements was an important consideration, it likely was not a determinative factor. Today, however, firms might consider not just the time and money that would be required to register but also the likelihood that they would be able to comply with all the requirements applicable to a RIA, especially if the proposed rules also are adopted. Dedicating a certain level of resources is one thing; inability to operate a business under the burden of compliance is another. For an established VC firm with ample personnel exploring new opportunities, registration may provide freedom from the 20% basket and flexibility to expand its business. But for a smaller firm with limited resources, would that flexibility be crushed by new restrictions and prohibitions that its own team and compliance program might not be able to handle? The answer here is entirely situational, and we are here to guide firms through the various considerations in answering this difficult question.

Securities Act Rule 144

Rule 144 provides an exemption from SEC registration for resales of securities acquired directly from an issuer in a private offering (restricted securities) and resales of securities held by affiliates of an issuer (control securities). 

Restricted securities

Restricted securities are securities acquired in unregistered, private transactions from the issuer or an affiliate of the issuer. Examples of restricted securities include securities received in venture financings and private placements, including private investment in public equity (PIPE) transactions.

Control securities

Control securities are securities held by an affiliate of the issuer, regardless of how the shares were acquired. An affiliate is a person, such as a director or large shareholder, in a relationship of control with the issuer. Control means the power to direct the management and policies of the company, whether through the ownership of voting securities, board representation or otherwise. A fund will generally be considered to be an affiliate if it – alone or with related funds – beneficially owns more than 10% of the company’s stock, or if the fund has an associated individual serving as a director of the company.

The conditions of Rule 144 that apply to a particular sale of restricted or control securities vary depending on the circumstances and are beyond the scope of this alert. If you have questions regarding whether Rule 144 applies and about particular requirements of the rule, please reach out to your Cooley contacts.

Form 144

Among the conditions that apply to Rule 144 sales by affiliates is the requirement to file a Form 144 (notice of proposed sale) with the SEC, if aggregate sales over a three-month period involve more than 5,000 shares or greater than $50,000. Forms 144 have historically been paper filings to be deposited in the mail to the SEC on the date of first sale, and most full-service brokers have customarily prepared and submitted these Form 144 filings on behalf of their clients.

However, the SEC recently adopted rule amendments that will require all Forms 144 to be filed electronically on EDGAR beginning on April 13, 2023. 

What this means for you

Based on our conversations with many brokers, we believe that the majority of large, full-service brokers will continue to prepare and file Forms 144 for their clients after the transition to electronic filing. In order to do so, these brokers will, at a minimum, now require the EDGAR filing codes of any selling stockholder. In addition, some brokers are requiring amendments to service agreements and, for those brokers who plan to execute Forms 144 on behalf of their clients, you will likely be asked to deliver a power of attorney authorizing them to do so.

If you haven’t already been in communication with your broker(s) about this rule change, we recommend proactively reaching out to them to determine whether they intend to continue making filings on your behalf and, if so, what they will require from you. If any of them are not planning to make filings on your behalf following the rule change, you will need to plan for how you will make these filings.

Each entity and control person that will potentially sell portfolio company securities will be required to have their own separate EDGAR codes. We recommend evaluating your structure –including any affiliated entities or individuals that could receive distributions in kind – to identify potential filing persons. If any of them do not have EDGAR codes, consider applying as soon as possible. The application process is quite variable and can take between one day to two weeks, depending on the SEC’s backlog for processing applications. If you have questions concerning the identification of potential filing persons or need assistance with applying for EDGAR codes, please reach out to your Cooley contacts for assistance.

Finally, EDGAR code management practices vary considerably from fund to fund. The process of updating EDGAR codes can often result in avoidable fire drills when filings are triggered.  Given the tight filing deadlines for Forms 144, it will be more important than ever for funds to maintain a current schedule of EDGAR filing codes for their affiliated entities and individuals. Additionally, you should ensure that current filing codes are provided to your brokers and any outside counsel that may be involved in preparing or submitting these filings on your behalf. 

Action items

• Contact your brokers to confirm whether they intend to continue filing Forms 144 on your behalf and ascertain what they need from you in order to be prepared to file electronically beginning on April 13, 2023.
• Evaluate your structure to identify any entities or individuals that will need EDGAR codes and start the application process.
• Review your EDGAR code management practices and update them as needed to ensure that your brokers and outside counsel are promptly alerted to any updated codes.

Please reach out to the Cooley fund formation team if you have any questions. We are ready to assist you with this transition in any way we can. 

After five years on the Securities and Exchange Commission’s rulemaking agenda, the proposed amendments to registered investment advisers’ custody rule finally came out for public comment last week. While the proposing release includes hundreds of questions regarding the proposed amendments, the most relatable question for venture capital firms that invest in crypto assets – especially firms that have recently switched from being exempt reporting advisers (ERAs) to registered investment advisers (RIAs) – might be the one posed by Commissioner Mark Uyeda in his statement on the proposed rule: “How could an adviser seeking to comply with this rule possibly invest client funds in crypto assets after reading this release?” In fact, there are a number of statements in the proposing release that prompt particular frustration for crypto fund managers. In the words of Commissioner Hester Peirce: “These statements encourage investment advisers to back away immediately from advising their clients with respect to crypto.”

Proposed Rule 223-1 (Safeguarding Rule) would replace current Rule 206(4)-2 (Custody Rule) under the Investment Advisers Act of 1940. Unlike the Custody Rule, which applies only to funds and securities, the Safeguarding Rule would apply to all assets, including crypto assets, whether or not they are funds or securities. Moreover, the Safeguarding Rule would apply to all client assets, even those for which the RIA receives no compensation. To be clear, the Safeguarding Rule would not apply to ERAs, nor would it apply to non-US RIAs with respect to their non-US funds, although these advisers may receive questions from their investors regarding how their crypto assets are held.

Under the Safeguarding Rule, a RIA with “custody” of a private fund’s assets, which would include serving as the general partner of the fund or having discretionary authority, would need to comply with the following requirements:

1. Engage a qualified custodian (QC) to maintain possession or control of client assets.
   • “Qualified custodian” is a defined term that includes certain banks, savings associations and registered broker-dealers. A crypto custodian that does not meet the definition of QC – no matter how superior its systems and protocols and notwithstanding the lack of any alternative options – could not custody client assets.
   • To have “possession or control,” the QC must be required to participate in any change in beneficial ownership of assets, its participation must effectuate the transaction involved in the change in beneficial ownership, and its involvement must be a condition precedent to the change in beneficial ownership.
2. Enter into a written agreement with the QC that provides for all of the following provisions and reasonably believe they have been implemented:
   • The QC will promptly provide records to the SEC or an independent public accountant engaged by the RIA to perform custody audits.
   • The QC will obtain, and provide to the RIA, an annual written internal control report that includes an opinion of an independent public accountant as to whether controls have been placed in operation as of a specific date, are suitably designed and are operating effectively.
   • The parties will specify the agreed-upon level of authority of the RIA to effect transactions in the account.
3. Obtain reasonable assurances in writing from the QC that:
   • The QC will exercise due care and implement appropriate measures to safeguard client assets.
   • The QC will indemnify the client – and have insurance to adequately protect the client – against the risk of loss in the event of the QC’s own negligence, recklessness or willful misconduct.
   • The QC’s obligations to the client will not be excused by the existence of any sub-custodial, securities depository or other similar arrangements.
   • The QC will clearly identify the client’s assets as such, hold them in a custodial account and segregate all client assets from the QC’s proprietary assets and liabilities.
   • The QC will not subject client assets to any right, charge, security interest, lien or claim in favor of the QC or its creditors, except to the extent authorized in writing by the client.
4. Engage a Public Company Accounting Oversight Board-registered independent public accountant to prepare annual audited financial statements in accordance with US generally accepted accounting principles and distribute the audited financial statements to investors within 120 days of the fund’s fiscal year-end. (Like under the Custody Rule, this “audited financial statements approach” would be an alternative to engaging an independent public accountant to conduct surprise examinations, and funds of funds would have additional time to deliver the financial statements.)
5. Enter into a written agreement with the independent public accountant providing that the accountant will notify the SEC within one business day of issuing an audit that contains a modified opinion, and within four business days of resignation or termination of engagement.

For a RIA to satisfy these requirements, it would effectively need to enforce the requirements of the Safeguarding Rule on its service providers – namely, the QCs and the independent public accountants. Setting aside the challenge of compelling a QC to meet the rule’s requirements, for crypto fund managers, the primary challenge may be finding a QC in the first instance that has the capability to maintain possession or control of the different crypto assets that the RIA’s clients own. As indicated above, the custodian most qualified to custody a crypto asset may not be a QC. To be a QC, the custodian would need to be a US bank, an SEC-registered broker-dealer, a registered futures commission merchant or a state-chartered trust company. A financial institution formed under non-US laws would not be a QC unless it satisfied seven conditions specified in the Safeguarding Rule – including that it is a foreign regulated entity, it is legally required to comply with anti-money laundering provisions similar to those in the Bank Secrecy Act, and it is legally required to implement internal controls designed to ensure the exercise of due care with respect to safekeeping client assets. In addition, the SEC and the RIA engaging the foreign financial institution would need to be able to enforce judgments against it.

Like the Custody Rule, the Safeguarding Rule would include various exceptions. For example, there would be an exception for certain assets unable to be maintained with a QC. However, this exception, which would apply to privately offered securities and physical assets, is unlikely to apply to crypto assets (if at all), either because they are not securities or because they are recorded on public, permissionless blockchains (rather than on the nonpublic books of the issuer or its transfer agent).

In proposing to expand the scope of assets that would need to be held by a QC, the SEC cites an investment adviser’s fiduciary duty and how that duty “extends to the entire relationship between the adviser and client regardless of whether a specific holding in a client account meets the definition of funds or a security.” The SEC also reminds advisers that “as additional financial institutions become available to custody assets, advisers must continue to exercise their fiduciary duties to clients in connection with selection and monitoring of the qualified custodian.”

For crypto fund managers, these statements by the SEC pose a fiduciary dilemma. If in exercising the due care necessary to satisfy its fiduciary obligations a RIA determines that the custodian most qualified to safekeep a client’s crypto asset is not a QC, must the RIA use a custodian that is less qualified but is a QC? If in managing a client’s investments a RIA determines that it would be in the client’s best interest – and consistent with the client’s investment objectives – to invest in crypto assets that can only be held by custodians that are not QCs, must the RIA forego such investments on behalf of the client?

As firms become more familiar with the proposed rule, they may discover additional challenges and questions. We encourage firms to share their concerns and take advantage of the comment process. Comments on the Safeguarding Rule will be due 60 days after the proposed amendments are published in the Federal Register. Anyone interested in submitting comments directly can do so via the SEC’s online form.

According to the 2023 priorities, there has been an 80% increase in the gross assets of private funds in the past five years, with retirement plans steadily contributing to this growth. More than 5,500 registered investment advisers (RIAs), totaling over 35% of all RIAs, manage approximately 50,000 private funds with gross assets exceeding $21 trillion. Citing these facts, the 2023 priorities state that the division will continue to focus on RIAs to private funds. In particular, the division will concentrate on the following areas:

1. Conflicts of interest.
2. Calculation and allocation of fees and expenses, including the calculation of post-commitment period management fees and the impact of valuation practices at private equity funds.
3. Compliance with the Marketing Rule, including performance advertising and compensated testimonials and endorsements, such as solicitations.
4. Policies and practices regarding the use of alternative data and compliance with Advisers Act Section 204A, which requires investment advisers to establish, maintain and enforce written policies and procedures reasonably designed to prevent the misuse of material nonpublic information.
5. Compliance with Advisers Act Rule 206(4)-2, the Custody Rule, including timely delivery of audited financials and selection of permissible auditors.

The 2023 priorities state that the division will also focus on private funds with specific risk characteristics – including, among others, private funds that hold certain hard-to-value investments, such as crypto assets, and private funds involved in adviser-led restructurings, including stapled secondary transactions and continuation funds.

Venture capital firms that are exempt reporting advisers (ERAs) might wonder if the 2023 priorities’ focus on RIAs to private funds means that ERAs are not part of the SEC’s scrutiny. From our experience, it appears that the SEC is increasing its focus on private funds across the board. As noted in a previous blog post, we saw the SEC bring a number of enforcement actions against venture capital firms that are ERAs throughout last year. In addition, at the end of last year, we saw the SEC initiate a sweep against venture capital ERAs – and that sweep has continued into this year. Just over a year ago, the SEC proposed a suite of new rules that would drastically impact both RIAs and ERAs. We expect these rules to be adopted in the near future.

ERAs, of course, are not subject to certain Advisers Act rules that RIAs are subject to. For example, the Marketing Rule and the Custody Rule – both of which are identified in the 2023 priorities – apply only to RIAs. To this end, compliance and regulatory burdens on RIAs and ERAs are different. As we always remind our ERA clients, though, ERAs remain subject to their fiduciary duty. Adequate disclosure regarding conflicts of interest and proper calculation and allocation of fees and expenses are just as important for ERAs as they are for RIAs. In addition, certain other requirements under the Advisers Act, such as having adequate policies and procedures reasonably designed to prevent the misuse of material nonpublic information, as well as compliance with Advisers Act Rule 206(4)-5 (the Pay-to-Play Rule), are substantive requirements that apply to all investment advisers, including ERAs. With this in mind, we encourage ERAs and RIAs to be vigilant of the SEC’s focus on private funds.

Schedule 13G

Funds – including their general partners and, in some cases, managing principals – that hold in excess of 5% of a class of public equity as of December 31, 2022, generally must file a Schedule 13G within 45 days of year-end. Also, any fund that has previously filed a Schedule 13G with respect to a portfolio company must file an annual amendment to its Schedule 13G within 45 days of year-end if there have been any changes in ownership since the most recent filing – including an “exit” filing if the fund’s ownership has declined below 5%.

Form 13F

Investment advisers who exercise investment discretion over “Section 13(f) securities” –generally equity securities of public companies – are required to file quarterly reports with the SEC on Form 13F within 45 days of each quarter-end. Subject to certain exceptions, if your funds collectively owned in excess of $100 million of Section 13(f) securities as of the last day of any month during the 2022 calendar year, you are obligated to file a Form 13F for the quarter ending December 31, 2022, within 45 days of calendar year-end. In addition, the filing obligation continues for a minimum of three consecutive calendar quarters (i.e., March 31, June 30 and September 30), which filings will be due within 45 days of the relevant quarter-end.

It is important to note that, even if you do not exceed the $100 million threshold as of December 31, the obligation to file a Form 13F for the quarter ending December 31 remains if the threshold was exceeded as of the last day of any single month during the calendar year.

Form 13H

Investment advisers who have previously filed a Form 13H to register as a “large trader” are required to file an annual update to the filing within 45 days of year-end. Large traders who have completed a full calendar year without exceeding any of the Form 13H triggering thresholds, measured across all portfolio companies, may be eligible to elect “inactive” status and thereby suspend certain ongoing large trader obligations. These triggering thresholds are daily trading of at least two million shares or $20 million in share value, or calendar month trading of at least 20 million shares or $200 million in share value, in each case aggregating purchases and sales of the securities of all portfolio companies during the relevant day or month.

In addition to the annual filing requirement, large traders are reminded that there is a quarterly obligation to promptly amend the Form 13H following any quarter during which any of the information in the large trader’s Form 13H materially changes.

Closing thoughts

As the end of the calendar year approaches, funds should start to consider whether they will need to make any of the annual filings under Section 13. The determination of whether you have a Schedule 13G, Form 13F or Form 13H filing obligation is often complex. As part of your year-end wrap-up, consider contacting your fund/securities counsel to begin a Section 13 analysis, and then prepare any required filings well in advance of the February 14, 2023, deadline.

The SEC also proposed record-keeping requirements that would apply in connection with the new rule, as well as further diligence and monitoring requirements that would apply when RIAs engage third parties as record-keepers. If the rule is adopted, the impact of the prescribed oversight requirements would be particularly burdensome on smaller RIAs, many of whom engage compliance consultants – and would need to conduct due diligence and periodic reassessments on their engagement of those compliance consultants – in addition to conducting such diligence and reassessments on other service providers.

Scope of the proposed rule

Proposed Rule 206(4)-11 under the Investment Advisers Act of 1940 would apply to RIAs, as would the proposed amendments to Investment Advisers Act Rule 204-2, which is known as the “Books and Records Rule.” Venture capital firms and private fund advisers that are “exempt reporting advisers” (ERAs) would not be subject to the proposed requirements.

Rule 206(4)-11 would apply with respect to “covered functions,” which the SEC proposes to define as functions that:

1. Are necessary to provide advisory services in compliance with federal securities laws.
2. If not performed or performed negligently, would be reasonably likely to cause a material negative impact on the RIA’s clients or on the RIA’s ability to provide investment advisory services.

The SEC proposes to define a “service provider” to include an RIA’s affiliates if they are not otherwise subject to the RIA’s oversight as supervised persons (as defined in the Investment Advisers Act).

Due diligence and monitoring

Under proposed Rule 206(4)-11, before engaging a service provider, an RIA would need to reasonably identify and determine that a covered function is appropriate to outsource to a service provider and that the selected service provider would be appropriate to perform such covered function. Rule 206(4)-11 would require an RIA to evaluate and consider the following elements as part of its due diligence:

1. The nature and scope of the services to be performed.
2. Potential risks resulting from the service provider performing the covered function, including how to mitigate and manage such risks.
3. The service provider’s competence, capacity, and resources necessary to perform the covered function in a timely and effective manner.
4. The service provider’s subcontracting arrangements related to the covered function – and how the RIA will mitigate and manage potential risks in light of any subcontracting arrangements.
5. Coordination with the service provider for federal securities law compliance.
6. The orderly termination of the provision of the covered function by the service provider.

Once selected, the RIA would need to periodically monitor the service provider and reassess the elements above to reasonably determine that it would be appropriate to continue outsourcing the covered function to that service provider. The amount of due diligence that would be considered reasonable would depend on the nature, scope, and risk profile of a covered function and the service provider.

Record-keeping requirements

The SEC also is proposing to amend the Books and Records Rule to require an RIA to keep detailed records related to its compliance with Rule 206(4)-11. This would include maintaining a list of covered functions and the service providers to whom such functions have been outsourced, records that document the RIA’s due diligence and monitoring as required by Rule 206(4)-11, and copies of written agreements entered into with the service providers. Such records would need to be maintained in an easily accessible place throughout the period that the RIA outsources a covered function, and for a period of five years thereafter.

In addition, if an RIA relies on a third party to make and/or keep any books and records required by the Books and Records Rule, the proposed amendments would require the RIA to perform due diligence and monitoring as though the record-keeping function were a covered function and the third party were a service provider. The RIA would also need to obtain reasonable assurances that the third party will:

1. Adopt and implement internal processes and/or systems for making and/or keeping records that meet the requirements of the Books and Records Rule applicable to RIAs.
2. Make and/or keep records that meet all of the requirements of the Books and Records Rule applicable to RIAs.
3. Provide the RIAs and the SEC access to electronic records.
4. Ensure the continued availability of records if the third party’s operations or relationship with the RIA ceases.

The SEC suggests that one way to obtain reasonable assurances from a third-party record-keeper would be to enter into a written agreement that expressly includes the four standards listed above. Alternatively, an RIA may seek to ensure the requirements are satisfied through one or more letters of understanding, statements of work, or other means.

Form ADV reporting and transition period

Accompanying proposed Rule 206(4)-11 and the proposed record-keeping requirements is a proposed amendment to the Form ADV. The SEC proposes to include a new item in Part 1A that would collect census-type information about the RIA’s use of service providers.

If the SEC’s proposals are adopted, RIAs would have 10 months from the effective date to come into compliance. The new requirements would apply to any engagement of new service providers made on or after the compliance date, with ongoing monitoring requirements also applying to existing engagements of service providers. Comments on the proposal will be due 30 days after publication in the Federal Register or December 27, 2022, whichever is later and may be submitted here: https://www.sec.gov/regulatory-actions/how-to-submit-comments

A note to venture capital firms and private fund managers that are exempt reporting advisers (ERAs): The Marketing Rule applies to RIAs. Technically, it does not apply to ERAs. This means that the SEC cannot charge an ERA for violation of the Marketing Rule. However, ERAs are subject to the general antifraud provisions of the Investment Advisers Act. To this end, ERAs might consider the requirements of the Marketing Rule, especially its general principles, as a guide to what the SEC might consider misleading.

1. Advertisements

Determine which materials are advertisements. Marketing decks, firm overviews, and track record information sent to prospective investors are advertisements. Letters and reports sent to existing investors are not advertisements unless they offer new products or services, or they are sent to prospective investors.

2. Data rooms

If using a data room, take down any advertisements that have not been updated to comply with the Marketing Rule. It may be possible to take the view that historical investor communications provided to prospective investors upon request or as supplemental diligence information are not advertisements. Include clear legends on such materials, and understand that there is a risk the SEC may disagree.

3. Track record

Track record presentation should meet the “fair and balanced” standard. There are nuances to presenting a track record. If there are multiple ways to show a return, or when fees and carry differ across prior funds and current funds, it may be necessary to err on the side of using the more conservative returns and including explanatory footnotes to “paint the full picture.” If showing the returns of a subset of investments from a fund, also include the total fund level return. If including the returns of prior funds, do not cherry-pick (e.g., if including same strategy funds, include all same strategy funds).

4. Net returns

Net returns must be presented with equal prominence to gross returns. If including deal level returns, net returns may not be necessary under a plain reading of the Marketing Rule, but understand that there is a risk the SEC may disagree. If including “pro forma” deal level returns, paint the full picture with explanatory footnotes.

5. Targets and projections (hypothetical returns)

Understand that “hypothetical performance” is defined broadly as any performance not actually achieved by a fund or an account. It includes target returns, projected returns, and combined investments from multiple funds or accounts. There are specific requirements to using hypothetical performance, which generally entail:

• Adopting policies and procedures around providing hypothetical performance only to those who can understand it and to whom it is relevant.
• Disclosing the criteria and assumptions used in calculating the performance.
• Including a statement regarding the risks and limitations of using hypothetical returns to make investment decisions.

For the purposes of this last-minute checklist, consider removing hypothetical returns from advertisements and working with counsel to determine what would be required to comply with the Marketing Rule.

6. Substantiation

For any material statements of fact, confirm there is a reasonable basis for believing the statements can be substantiated upon demand by the SEC. Include sources in footnotes and retain copies. Take caution to ensure subjective statements are not presented as facts.

7. Explanatory footnotes

Include all relevant information to explain and give context to the presentation. If including a discussion of potential benefits connected with the manager’s services or methods of operation, include a discussion of material risks and material limitations associated with those benefits. Include a general disclaimer in the front and specific disclaimers in footnotes.

8. Case studies and investment examples

References to specific investments must be “fair and balanced” (i.e., no cherry-picking). Including all investments in a fund will be the simplest way to satisfy this standard (although not the only way). “Early drivers” and “key performers” are red flags for cherry-picking.

9. Ratings or rankings

If including a third-party rating or ranking, the manager must have a reasonable basis for believing (e.g., by reviewing the questionnaire, survey or description of the methodology) that any questionnaire or survey used to prepare the rating or ranking is structured to make it equally easy for a participant to provide favorable or unfavorable responses, and it is not designed or prepared to produce any predetermined result. Clearly and prominently disclose the date of the rating or ranking and the time period covered, the identity of the third party and, if applicable, that compensation has been provided in connection with obtaining or using the rating or ranking.

10. Testimonials and endorsements

Statements that describe a person’s experience with the manager or its personnel, or that refer investors to the manager’s funds, are “testimonials” if made by investors and “endorsements” if made by non-investors. Endorsements include statements by founders from prior portfolio companies and others in the manager’s network that indicate approval, support, or recommendation of the manager. For all unpaid testimonials and endorsements, use a clear and prominent disclaimer stating that the person giving the testimonial or endorsement (promoter) is either a current investor or not a current investor, as applicable, and disclose any conflicts of interests arising from the manager’s relationship with the promoter. For any paid testimonial or endorsement (“paid” can include fee discounts, indirect payments, and non-cash compensation), there are additional disclosure, oversight, and disqualification requirements. To meet these requirements by the compliance date, it may be necessary to remove the testimonial or endorsement until you can consult counsel to determine what would be required to comply with the Marketing Rule.

11. Placement agreements

Placement agents (also known as consultants, finders and introducers) for funds managed by RIAs are considered promoters under the Marketing Rule. If a promoter will be referring investors to the manager as of, or after, the compliance date, including non-US promoters referring non-US investors, and the placement agreement has not already been updated to comply with the Marketing Rule, contact counsel immediately to determine what would be required.

12. Policies and procedures

If policies and procedures have not yet been updated, work with counsel or a compliance consultant to make appropriate revisions.

With the compliance date just a few days away, setting priorities and getting the right players to focus and coordinate is crucial. The Marketing Rule is complex and complicated, and there remain a number of unanswered interpretative questions. The good news is that the industry has been working closely together over the transition period to come up with good faith approaches to complying with the rule. This checklist will help you to assess your immediate needs. Then, work with your counsel and your compliance advisers to resolve the more difficult questions.

The landscape appears to be changing under Gary Gensler’s leadership of the SEC. With five new settled enforcement actions against venture capital advisers in September alone, we are reminded that VC advisers are not outside the SEC’s ambit of scrutiny. Since March, the SEC has announced the following categories of settled enforcement actions against venture capital advisers:

1. Pay to play: These four enforcement actions involved political contributions made by employees of fund managers to certain public officials occupying positions within government entities that were already invested in the managers’ funds. 
2. Interfund loans and commingling: These two enforcement actions involved loans and cash transfers between the sponsors’ various funds that the SEC alleged were unauthorized and undisclosed. 
3. Miscalculation of management fees: These two enforcement actions involved disclosures around management fees that the SEC alleged were misleading and calculation of management fees that the SEC alleged resulted in overpayment to the managers. 

The SEC’s focus on private fund advisers has been clear for some time, as evidenced by the Division of Examinations’ Risk Alerts and Exam Priorities. Moreover, as the industry is keenly aware, the SEC proposed sweeping new rules earlier this year that would drastically impact private fund advisers, including ERAs. The enforcement actions listed above do not include the charges that the SEC has recently brought against other types of private fund advisers (just last week, 9 settlements were announced involving registered private fund advisers and alleged custody rule violations). As the SEC continues to focus on private fund advisers, it’s likely that we’ll see more venture capital advisers operating under the ERA exemption being caught by the SEC’s scrutiny.

So, what to do? This is a time to clearly understand the obligations that ERAs are bound to, adhere to them, and follow elements of your agreements (such as the determination of management fees) with extreme precision.

Do private fund managers need to comply with US sanctions regulations?

Fund managers who are subject (or likely subject) to US jurisdiction need to comply with US sanctions regulations. US sanctions against Russia and Belarus apply to US persons, which are defined to include US citizens and permanent resident aliens, persons holding special immigration status (e.g., refugees and aslyees), entities organized under US law, and any person acting within the United States. Whether a fund is subject to US jurisdiction is a complicated issue, but in general, if your fund or fund manager is legally organized in the US, if one or more of the control persons of the fund manager are US persons or located in the US, if the fund manager has an office located in the US, and/or if the fund directly or indirectly has US investors, the fund manager and fund are likely subject to US jurisdiction and should comply with US sanctions regimes.

What do I need to do with respect to the potential that limited partners are directly subject to Russian or Belarusian sanctions?

We recommend undertaking the following three-step process to assess your direct exposure to Russian or Belarusian sanctions issues:

1. Check your records to ensure that none of your limited partners are located in the Crimea, Donetsk or Luhansk areas of Ukraine.
2. Check your records to ensure that no Russian or Belarusian governmental entities, including sovereign wealth or other state-sponsored entities, are limited partners directly.
3. Check your limited partner list against the Office of Foreign Assets Control (OFAC) list of Specially Designated Nationals and Blocked Persons to ensure no persons or entities match your directly subscribed limited partners.

If you identify the potential existence of any of the above types of limited partners, contact your legal counsel immediately for assistance – and refrain from accepting capital contributions from or making distributions to such investors until your legal counsel has discussed the situation with you.

What about the potential that sanctioned parties indirectly hold interests in my direct limited partners?

You are obligated to ensure that none of your direct limited partners are in turn more than 50% owned, directly or indirectly, by persons or entities on the US sanctions lists. Generally, clients we work with will often first determine their comfort level with respect to the potential for indirect issues (i.e., “look-through issues”) with their limited partner base. On one end of the spectrum, a fund that is comprised of all individuals known to be US persons has no look-through issue. On the other end of the spectrum, a large fund raised globally that has numerous institutional limited partners may have a material risk of look-through issues.

Where a fund is concerned about look-through issues, the next step is usually to examine the fund’s subscription materials. In some cases, those materials may contain representations made by entity limited partners at the time of subscription to the effect that none of their capital is attributable to sanctioned parties, together with representations to update the fund manager of any future changes. If you are in this situation, you might determine either to rest on these representations or to disseminate a reminder to your applicable limited partners of their attendant obligations. If the fund’s subscription materials do not rise to the above level or if there are additional concerns, the fund manager may wish to obtain current, proactive representations from applicable limited partners to have more certainty that there are not indirect issues with the fund’s limited partner base. The fund’s counsel should assist to develop the appropriate questionnaire depending on the exact circumstances.

Do I really need to worry about any of this? What are the potential consequences of failing to comply?

The potential consequences are serious. Violations are enforced on a “strict liability” basis – meaning if you have sanctioned persons or entities in your limited partner base (directly or indirectly with reference to the above 50% standard) you are in violation – there is no “intent” element. Further, failure to timely identify sanctions issues may lead to a continuing series of violations. OFAC, for its part, treats violations as a serious threat to national security and foreign relations. As a result, offenders face very significant monetary fines. In addition, criminal penalties, including prison time, can be pursued for willful (i.e., knowing and intentional) violations.

What about my portfolio companies?

Where a portfolio company is not a controlled entity (as typical for most venture capital fund managers), in general there is not a legal requirement to ensure compliance, as such legal requirement falls to the portfolio company and its management. However, as portfolio companies can experience significant monetary fines for transacting with sanctioned parties, and as reputational issues may accrue even to such companies’ investors, it is prudent to ensure that each of your portfolio companies is taking steps to ensure sanctions compliance. In addition, you may have agreed in a side letter with one or more of your limited partners to monitor compliance of your portfolio companies. If you are aware of potential sanctions violations by a portfolio company, or if you make control investments, contact the fund’s legal counsel immediately for further assistance.

For the full list of topics and complete presentation, please see below:

GGV Capital VIII will support entrepreneurs across all stages of growth; GGV Capital VIII Plus enables GGV to extend its investment in portfolio companies that are part of Fund VIII that have demonstrated ability to scale and have become category leaders; GGV Discovery III is dedicated to global entrepreneurs at the earliest stage of development; and GGV Capital VIII Entrepreneurs Fund will continue to the firm’s tradition of extending and building the GGV entrepreneur family network globally.

The closing of the funds coincides with one subsequent closing of GGV Capital RMB Fund II, with total committed capital of approximately $525 million. This increases the firm’s total capital under management to approximately $9.2 billion across 17 funds.

“It’s been another productive, highly efficient experience working with Jordan and his team at Cooley once again to raise our biggest funds in history in less than three months,” said Jenny Lee, managing partner at GGV. “We are excited as this capital will allow GGV to continue to invest in entrepreneurs around the world across all stages of growth.”

GGV Capital has been a Cooley client since its founding in 2000. Cooley has advised GGV on the closing of all its USD-denominated funds and 80+ of its financing transactions across the US, China, Southeast Asia and India. GGV Capital invests in seed-to-growth stage companies across three sectors: social/internet, enterprise tech and smart tech. Over the past two decades, GGV has backed more than 400 companies around the world. In the past 15 months, 11 GGV portfolio companies have completed public listings, including Affirm, Agora, Airbnb, BigCommerce, DraftKings, eHang, Kingsoft WPS, Poshmark, Opendoor Technologies, Wish and Xpeng.

About Cooley LLP

Clients partner with Cooley on transformative deals, complex IP and regulatory matters, and high-stakes litigation, where innovation meets the law.

Cooley has 1,100+ lawyers across 16 offices in the United States, Asia and Europe.

View the full discussion below:

We are providing updates on our original post here to reflect the issuance of a final rule by the U.S. Treasury Department which will become effective on October 15, 2020.  Between November 2018 (when the first regulations implementing FIRRMA came into effect) and October 15, 2020 (when the Final Rule becomes effective), mandatory CFIUS filings were assessed with reference to an industry test, which asked whether the U.S. business receiving an investment or being acquired utilizes its technology in, or designs its critical technology for use in, certain industries listed in the CFIUS regulations (e.g., biotechnology, battery manufacturing, semiconductor manufacturing, and so forth).

The final rule disposes of that industry criterion and replaces it with a new test that asks whether a U.S. regulatory authorization (e.g., an export license) would be required to release the U.S. business’s products or technology to its foreign investor or acquirer pursuant to any of the four main U.S. export control regimes administered by the Departments of State, Commerce, Energy and the Nuclear Regulatory Commission. More specifically, the final rule requires transacting parties to determine whether a regulatory authorization would be required for the “export, reexport, transfer (in-country) or retransfer” of the critical technology of the U.S. company to the specific foreign investor or acquirer and certain other foreign persons or entities in that foreign investor’s or acquirer’s upstream ownership chain.

Unlike the comparatively simple (though somewhat ambiguous) industry test, which focuses on the business activities of the U.S. company, the far more complex regulatory authorization test focuses on the export control classification of a U.S. business’s products and technologies, as well as the principal place of business (for entities) or nationality (for individuals) of each of the foreign parties involved, including certain entities in the foreign parties’ ownership chains.

Practically speaking, the final rule will add complexity to assessments of mandatory CFIUS filing requirements – particularly with respect to the requisite export control/regulatory authorization analysis, and determinations of whether an investor is a “foreign investor,” and if so, such investor’s specific nationality.

Under the CFIUS regulations in effect prior to October 15, 2020, the absence of a mandatory filing requirement often could be ascertained relatively easily (e.g., by determining that the U.S. business in question does not operate in one of 27 sensitive industries listed in the CFIUS regulations). Under the final rule, mandatory filing determinations require more comprehensive diligence of both the U.S. business and the foreign investor(s) or acquirer.  The U.S. business may need to assess not only the products that it sells, but also the technologies related to the development, production or use of those products, as well as any technologies that are developed and tested for the U.S. business’s internal use only.  Foreign investors and acquirers may need to determine their own nationality and the nationalities of all foreign persons and entities in their upstream ownership chains.

Venture funds investing in U.S. companies that may be implicated will require more complex and detailed legal guidance after October 15, 2020 than previously.  Care should be taken to add as a “checklist item”, early in the investment process, an analysis of the potential target company for CFIUS purposes.

Previous Blog Post (January 2, 2020)

Contributors

Jordan Silber

Unregistered “finders” have long been a fixture in the venture capital community, and a source of considerable regulatory uncertainty.  Based on SEC guidance dating back to the early 1990’s, a so-called “finder’s exemption” was thought to exist whereby a person could perform the limited function of introducing investors to an issuer, such as a venture capital firm raising a new fund, for compensation without registering with the SEC as a broker.  However, the SEC never formally endorsed a “finder’s exemption.”

Indeed, based on its broad interpretation of the term “broker,” the SEC has in some cases over the years denied regulatory relief to finders and even brought enforcement action against finders and the issuers that hired them.

As market practices and the SEC’s approach to finders have diverged, fund managers that want to use unregistered “finders”  have faced a difficult choice: accept the regulatory risk, insist that the “finder” associate herself with a licensed broker-dealer or simply forego the chance for increased investor introductions.  IA particular regulatory risk faced by fund issuers was resulting doubt regarding the use of Regulation D as a 1933 Act exemption for their offerings.

In response to demands from the industry over many years for additional clarity in this space, the SEC has now proposed a formal exemption from broker registration requirements for finders that meet certain conditions.  If the exemption is approved as proposed, it will provide much needed regulatory certainty for fund managers and a clear framework for how finders should be engaged.

Scope of the Proposed Exemption

The proposed exemption would permit payment of transaction-based compensation by fund managers (i.e., a percentage of sourced investors who subscribe to the fund, for example) to finders, provided the following conditions are met:

• The finder is a natural person, and not a legal entity or fundraising platform;
• The fund using the finder does not file reports with the SEC under the Exchange Act and is relying on an exemption from the Securities Act (such as Regulation D) to conduct a primary offering;
• The finder does not engage in general solicitation;
• All potential investors solicited and introduced by the finder are “accredited investors”;
• The issuer and finder enter into a written agreement that describes the finder’s services and compensation;
• The finder is not associated with a broker-dealer; and
• The finder is not subject to a statutory disqualification.

These conditions align well with primary offerings of private funds that rely on the 3(c)(1) or 3(c)(7) exemptions from registration under the Investment Company Act of 1940, and are offered under Rule 506(b) of Regulation D.  We suspect that our fund clients’ typical relationships with finders will generally be able to be conducted in a manner consistent with these conditions.

Tier I and Tier II Finders

The proposed exemption covers two categories of finders:

• Tier I finders would be permitted to provide contact information of potential investors in connection with a single capital raising transaction by the fund in a 12 month period, but would not be permitted to have any contact with a potential investor about the fund. This exemption essentially permits a finder to sell her rolodex to an issuer in exchange for success fees.

• Tier II finders would be permitted to engage in more direct solicitation activity, including identifying and screening potential investors; distributing offering materials to the prospective investors; discussing the offering with the prospective investors (but not advising as to the valuation or advisability of investing); and arranging or participating in meetings with the prospective investors and the issuer.

Because of their greater involvement in solicitation activities, Tier II finders would be required to provide a solicitation disclosure to each prospective investor prior to or at the time of the solicitation, and obtain a written acknowledgment of receipt of that disclosure from each prospect who invests in the fund. This process closely tracks the requirements that registered investment advisers are required to follow when hiring solicitors under the “Cash Solicitation Rule”, and we expect that finders and the fund managers that hire them will be able to leverage existing industry standard forms of agreements and disclosures to meet these requirements.

What Happens Next?

The proposed exemption will soon be published in the Federal Register, which will start a 30-day comment period. The SEC staff will then gather and review the comments, and determine whether any changes to the proposal should be made. During that process and until the exemption is ultimately finalized, we unfortunately remain in the murky grey area of uncertain regulatory risk. In addition, while some may view this proposal as an expression of the SEC’s views on the regulatory treatment of finders, we note that this proposal is not yet effective and caution is still warranted when dealing with unregistered finders.

Contributors

Kenneth Juster

The HSR Act requires parties to transactions that meet specified thresholds and do not fall within an exemption to report them to the antitrust agencies and observe a waiting period before consummating reported transactions. The HSR Act allows the agencies to investigate whether such proposed acquisitions are likely to lessen competition and to challenge them under antitrust law before they are consummated.

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Changes for Individual Investors

1.  Professional Certifications, Designations or Credentials

Traditionally, the sole avenue by which an individual investor could meet the accredited investor definition was through that investor’s relative wealth or income.[i]  However, through the Adopting Amendment, the SEC will now also look to the professional certifications, designations and/or credentials of an individual issued from an approved educational institution as evidence of one’s requisite financial sophistication and ability to assess the related risks of a securities offering to meet the accredited investor definition, regardless of an individual’s level of wealth or income.  The SEC has stated that, for now, the only recognized individuals eligible for accredited investor status under this new category are those individuals in good standing holding a Series 7, Series 65 and/or Series 82 license.  Notwithstanding this, the SEC has the ongoing authority to adjust and add to those professional certifications, designations and credentials they deem sufficient to confer accredited investor status on an individual, and thus, it is likely further types of credentialed and licensed professionals will be added in time by the SEC to the list of those individuals permitted to be treated as accredited investors under this new professional certification category.  For now, the movement away from a wealth and income-based analysis in this category is a good first step by the SEC to open the private offering markets to potential additional individuals.  However, it is still very early days with this new and expansive category to fully comprehend yet the potential implications for funds and their investors, especially with respect to the more complex fund private offerings such as those conducted under Rule 506(c) of Regulation D (i.e., general solicitation offerings) which require a much greater degree of independent verification of each investor’s accredited investor status.  Further, it remains to be seen whether this new professional certification method of qualifying for accredited investor status will be materially additive to the overall number of potential accredited investors eligible to participate in fund and other private offerings, given that many of such individuals may, by the very nature of their qualifications and profession, already meet the wealth or income requirements in the first instance.

2.  Knowledgeable Employees

As applicable solely to investments by individuals in private funds, the Adopting Amendment adds a new category of accredited investor for individuals who qualify as “knowledgeable employees” of the fund sponsor as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940, as amended (the “ICA”). Pursuant to the ICA, an individual that is a knowledgeable employee is allowed to invest in private funds sponsored by the fund manager employing such individual without affecting the fund’s ability to qualify for the exclusions from the definition of “investment company” under Section 3(c)(1) or Section 3(c)(7) of the ICA. Individuals meeting this category are deemed to possess the requisite information and financial sophistication regarding the particular fund offering due to their intimate involvement with the firm sponsoring such fund and its investment portfolio.  Individuals qualifying as knowledgeable employees include (a) executive officers, directors, trustees, general partners, advisory board members or persons serving in a similar capacity of a fund exempt from the ICA under Section 3(c)(1) or 3(c)(7), or affiliated persons of the fund who oversee the fund’s investments and (b) employees or affiliated persons of the fund (other than employees performing solely clerical, secretarial or administrative functions) who, in connection with the employees’ regular functions or duties, have participated in the investment activities of such private fund (or other private funds) for at least 12 months.  Thus, the key take away here is that, while the underlying analysis is a fact specific one, it is likely that only mid to senior level personnel with heavy involvement in and responsibility for the investment activities of the firm will be eligible for accredited investor treatment under this new category.

3.  Spousal Equivalent

The Adopting Amendment broadened the scope of the existing income and net worth tests applicable to individuals by not only permitting the income and/or net worth of a spouse of the individual to be considered when determining the individual’s status as an accredited investor[ii] but also the income and/or net worth of that individual’s “spousal equivalent” (in lieu of the individual’s spouse).  A spousal equivalent is generally considered to be a cohabitant occupying a relationship with the individual equivalent to that of a spouse without the requirement for a formal official recognition of such status (e.g., a domestic partnership or civil union).  While this specific change will not likely result in a material influx of new qualifying investors, it does reflect the SEC’s broader thinking about social norms and family constitution and tying those relationships to greater market access.

Changes for Entity Investors

1.  Regulatory Profile or Form of Certain Entities

• A new category of accredited investor has been added for those investors that are investment advisers registered under Investment Advisers Act of 1940, as amended (the “Advisers Act”), exempt reporting advisers under the Advisers Act and/or investment advisers registered under applicable state laws, regardless of whether such entities meet the $5M total asset threshold for entities generally under the accredited investor definition.

• Limited liability companies that have not been formed for the purpose of making the investment in a fund and that have total assets in excess of $5M will qualify as an accredited investor.  This change is more of a codification for how practitioners traditionally dealt with LLCs under the existing accredited investor definition than a material change to the fabric of the definition itself.

2.  General Catch-all Entity Category

A new category of accredited investor has been added for those entity investors that are not otherwise specified in the accredited investor definition and not formed for the specific purpose of acquiring the securities offered that owns more than $5M in “investments.”[iii]  It is important to highlight that this new category looks specifically to “investments” and not “assets” held by the entity, which is a change in construct from most of the primary financial determinations applicable to entities under the accredited investor definition.  Thus, not only does this new category not look to entity construction and constitution for purposes of meeting the accredited investor definition, it also veers away from the traditional asset-based mindset of analyzing whether an entity should or shouldn’t be considered an accredited investor.  This new more amorphous bucket will include entities such as Native American tribes, governmental bodies, foreign entities and other entities whose structure and nature do not fit within the other identified categories in the accredited investor definition.

3.  Family Offices and Family Office Clients

The Adopting Amendment has added a new category for those entities that (a) can meet the definition of “family office” pursuant to rules issued under the Advisers Act, (b) have at least $5M in assets under management, (c) were not formed for the purpose of making the investment in the fund and (d) are managed by an individual who has such knowledge and experience in financial and business matters that the family office is deemed capable of evaluating the merits and risks of the prospective investment.  Further, in the event that the family office can meet the above criteria, any “family client” of the family office (as defined by the rules issued under the Advisers Act) shall also be deemed to meet the definition of accredited investor regardless of whether such family client can meet any other parts of the definition of accredited investor.  Most family office structures can and do meet the existing rubric of the accredited investor definition, thus, the import of these new rules be mainly for non-traditional family office structures and/or family clients that may not themselves be eligible for accredited investor status.

Adopting Amendment Timing

While the Adopting Amendment was announced by the SEC on August 26, 2020, it will not become effective until 60 days after its publication in the Federal Register.

Parting Thoughts

Many funds and those investing in them are heralding the changes promulgated by the Adopting Amendment as an encouraging sign that the SEC is desirous of expanding market access to a greater number of investors.  Such parties view changes such as providing non-wealth based categories of measurement for accredited investor status, expanded categories and natures of entities that can qualify for accredited investor treatment and revisions to the accredited investor rules to take into account evolving social norms and ideals as necessary steps in the right direction. 

The above notwithstanding, given that the Adopting Amendment did not make any inflation-based adjustments to the existing financial thresholds applicable throughout the accredited investor definition, many (if not most) individuals that can meet the new and/or expanded categories will likely already have satisfied the language and requirements under the existing accredited investor rules.  Thus, it remains foggy at best as to the actual number of additional investors that will be eligible for accredited investor status, and thus, access to private fund and other securities offerings.  While we hope that these new changes effectuated by the Adopting Amendment do, in fact, live up to the promise and intentions pursuant to which they were enacted, only time will tell just how much of a true impact they will have given the above.

Regardless of the ultimate direction these additions and changes to the accredited investor rules take us, we do know that their effective date is fast approaching us.  To get prepared, your fund subscription agreements, transferee investor questionnaires and other recordkeeping efforts related to oversight of your investors’ accredited investor status should be made ready for the changed rules, especially for any funds or other vehicles you are managing that will have a closing after the effective date of the Adopting Amendment.  We encourage you to call your fund counsel soon and consult with them on the best plan for getting your documents and operations in order related to these issues moving forward.

[i] For instance, an individual could only be considered an accredited investor if such individual either had (a) an income in excess of $200,000 in each of the two most recent years or joint income with that individual’s spouse in excess of $300,000 in each of those years and had a reasonable expectation of reaching the same income level in the current year or (b) a net worth, or joint net worth with that individual’s spouse, in excess of $1,000,000.

[ii] See Footnote 1 for clarification on income and net worth thresholds for individuals.

[iii] “Investments” are defined by reference to Rule 2a51-1(b) under the ICA, which is used to determine an investor’s status as a “qualified purchaser” under such rules.

On June 25, 2020, various U.S. agencies and the Federal Reserve Board issued a new final rule to revise the 2014 rules, adopting several new exclusions, most notably an exclusion for “qualifying venture capital funds.”[1]

The venture capital exclusion being enacted now in 2020 is intended to support capital formation, job creation and economic growth to small businesses and start-ups, and to help ensure that banking entities can indirectly facilitate this activity (through investments in venture funds) to the same degree that banking entities can do so directly.[2]  Promoting these investment and development activities for the U.S. economy is a worthy goal, and the Volcker Rule had the unfortunate consequence of curtailing such activities.  Given that the Volcker Rule was designed in general to reduce systemic risk to the financial system, of which from our vantage point we see relatively little such risk arising from investing in venture capital funds, we view this is as a somewhat overdue acknowledgement and course correction of the overbroad nature of the 2014 rule as pertaining to these sorts of investments.

Under the Final Rule, a banking entity is permitted to invest in “qualifying venture capital funds,” in general defined as any fund that meets the “exempt reporting adviser” definition of a “venture capital fund”.  This likely creates an additional incentive for venture capital sponsors to stay inside that exemptive definition (for example a venture fund that does secondaries and is considering increasing the proportion of secondaries investments over 20% of fund capital would stand to fall outside this definition, and would have to query if changing strategy is worth it as against being able to attract banks as investors in their fund).

If a bank invests in a venture capital fund, the bank’s investment in, and relationship with, the fund must comply with certain rules regarding material conflicts of interest, high-risk investments, safety/soundness and financial stability.  Finally, while less common, if a bank wants to establish and act as sponsor of a venture capital fund, or be an investment adviser to such a fund, additional rules and disclosure requirements apply.

[1] A copy of the Final Rule is available at https://www.fdic.gov/news/board/2020/2020-06-25-notice-dis-a-fr.pdf, and becomes effective on October 1, 2020.

[2] Final Rule, pg. 11.

This might include a regional base of capital (for example, a manager limiting fund raising to high net worth family offices in Southeast Asia might select Singapore); a place of investment focus (for example, a fund that is investing all or most of its capital in India may be bound to set up shop in Mauritius or Singapore for tax treaty reasons); a type of investment structure (funds that deal in royalty income streams may locate in Luxembourg); or so forth. 

In the end, though, a desire to attract global, institutional capital will most often lead to a choice of Delaware versus Cayman.  Prominent institutional investors, almost no matter where located globally, are quite likely to be familiar with (and probably already invested in funds in) both locations.  So, there is usually little to no serious headwind created by a determination to set up in one place or the other, absent some chance of commercial perception issues as discussed below.

With all this in mind, what to do?  A careful analysis should consider all of the commercial, cost, regulatory and tax issues.  Let us take those in turn.

Commercial Issues

While it is hard to generalize for every possible situation, there is a very high chance in our experience that your reputable, institutional investors globally could, if they wanted, subscribe to your fund whether it is Delaware or Cayman based.  There are not likely to be “deal breakers” in terms of the potential for laws, rules or regulation to actually prohibit it, either from the standpoint of the domicile of the investor or from the standpoint of Delaware or Cayman welcoming your selected investors to subscribe.  The word “reputable” above is, though, key to this: investors from blacklist countries or investors from non-blacklist countries that show up on terrorist watch lists or anti-money laundering lists won’t be welcome no matter which location you choose.

However, just because it might be technically feasible from a laws, rules and regulations standpoint, it is not always the case that investors will universally be happy about your choice, and some thought should be given to this.   These degrees of willingness to invest in place X or Y, not being driven by actual laws, rules or regulations, are most often driven by perception, so to speak.

What we mean by that is, some non U.S. investors may think Delaware risks putting them too close to a regulatory system that seems onerous and intrusive to them, and they generally don’t like to make investments in Delaware, accordingly.

Likewise, another investor might attribute a bit of “tax haven” mentality around a choice of Cayman, and prefer not to invest there despite it being legally possible.  We have encountered large corporate investors, German ones in particular, that have internal policies against investing in Cayman funds based solely on the potential for the appearance, in their view, of impropriety.  This has not been particularly helped by the recent “blacklist” situation though that will be resolved quickly and has only marginally impacted this view.  The irony of the perception about Cayman is that ultimately, the AML/KYC vetting and so forth in Cayman is quite stronger at present than what is legally required in Delaware.

But back to the headline: commercially, it is usually the case that a deal could get done in either Delaware or Cayman, as the tax analysis and at some point simply manager preference ultimately dictate.  Really sticky investors the capital of which is needed could ultimately be accommodated through parallel funds or feeders, though it rarely comes to that in our experience.  So we would say, be mindful of perception issues but let regulatory, cost and, particularly, the tax analysis drive the situation.

Administrative and Cost Issues

Forming a fund in the Cayman Islands is usually more expensive.  A good benchmark is to add about 10% of total project costs for a fund formation undertaking if it will be Cayman domiciled compared to Delaware.  There is also a more detailed time and procedure aspect to Cayman funds.  This includes the need for levels of AML/KYC that are above the effort required in Delaware (though still much more user friendly than say Singapore, Mauritius, Hong Kong or most anywhere in the EEA), the requirement to maintain ownership registers, some requirements for greater levels of corporate formalities, and so forth.

Where there are good reasons otherwise to form a venture fund in the Cayman Islands these issues should not be determinative, but it is an aspect worth noting particularly for smaller or first-time funds on limited organizational budgets and/or with modest back office capabilities.

Regulatory Issues

In some cases, regulatory issues may warrant some consideration.  This typically arises where a fund is making certain investments in regulated sectors.  An exemplar case could be a media fund investing in FCC regulated businesses, or similar, often in the U.S. but sometimes outside of the U.S.

Of current particular focus are funds that may invest in U.S. critical technology companies, and thus fall under the watchful eye of CFIUS and the relatively new FIRRMA regulations.  In years past, a group of U.S. venture capitalists taking down global capital and investing globally might have chosen Cayman based on tax reasons (see below).  But today, a potential to do one or more U.S. critical technology deals may warrant stronger consideration of Delaware as a domicile (though the recently issued PPB guidance mitigates this concern in some cases).

The punch line is: if you are going to invest in regulated industries, you should have a more detailed discussion with counsel about structuring and choice of domicile than might otherwise be the case.  Still though, since most venture funds do not make myriad regulated investments, the thinking usually moves quite quickly to the tax analysis.  And that is the basis on which most ultimate decisions about domicile are in fact made.

Tax Issues

When thinking about tax, the conversation then usually covers some or all of the following eight issues, all of which have to be carefully considered together with counsel to determine the extent to which they may be applicable in your own situation.

Issues of Highest Importance

Requirement for Fund to File a U.S. Tax Return

Every partnership formed under the law of a U.S. state, like Delaware, except those that have no income, deductions, or credits for federal income tax purposes, is required to file a U.S. tax return using IRS Form 1065 each year.  As a part of that tax return filing a Schedule K-1 is issued to each and every person or entity that was a partner in the partnership at any point in the year.  In contrast, a partnership formed under non-U.S. law, like the Cayman Islands, is not required to file a U.S. return if that entity does not have “effectively connected income” (think of that as U.S. situs business income) or “U.S. source” gross income.

While not getting too deep in the weeds, there is a difference of opinion among tax practitioners whether a Cayman partnership with U.S. limited partners generates U.S. source income when it sells shares in a portfolio company.  The capital gain allocable to the U.S. limited partners is clearly U.S. source income (with some exceptions we will not discuss) as to the U.S. limited partners but opinions differ as to whether that sourcing at the partner level also applies at the partnership level.  Some Cayman funds file and some do not in this context. For those that do file there is a rule that says Schedule K-1 need only be issued to U.S. taxpayer partners.  Some fund managers are sensitive to issuing U.S. tax forms to non-U.S. taxpayer partners and this latter rule is helpful in that regard.

Withholding Documentation the Fund Must Provide to Third Parties

A Delaware limited partnership is a U.S. entity for withholding purposes and need only provide a properly filled out form W-9 to third parties (e.g. banks, brokers, paying agents, etc.).  A Cayman entity, in contrast, is a pass-through entity for withholding purposes.  Such an entity is supposed to provide a Form W-8IMY to third parties like those listed above.  This W-8IMY is supposed to include the withholding forms (e.g. W-9, W-8BEN, W-8BEN-E, etc.) of the partners in that partnership along with a “withholding statement” disclosing each partner’s share of income.

The difference in disclosure required in this context should not be minimized.  Think of the not uncommon situation where a venture fund makes a small investment in another fund, perhaps for access to deal flow or to assist in launching a new manager.  Let’s assume this fund being invested in is a U.S. filer.  If the investing fund is a Delaware entity, then the subscription process will involve solely providing the form W-9.  If the investing fund is a Cayman entity, then the withholding documentation provided will disclose the identity of all limited partners in the fund, information potentially thought of as sensitive business information.  We have seen some Cayman funds refuse to provide this “second layer of information”, but our advice would be to do so only after understanding the risk that the withholding form provided may be viewed as invalid.

Treaty Benefits

Historically many countries (Brazil, Spain and Portugal, for example, among others) have applied a “blacklist” approach to foreign investment in their country, applying higher tax rates to investors from countries viewed as tax havens.  Not surprisingly, the Cayman Islands is often on the blacklist for these countries, subjecting investment gains to higher taxes than would apply if a Delaware entity had invested.  As mentioned above, recently the European Union added the Cayman Islands to its list of non-cooperative jurisdictions (referred to as the EU’s tax haven blacklist).  Though expected to be temporary, this listing has caused consternation especially with some institutional European investors when considering whether to invest in a Cayman Islands fund.  At least at present, this poses an issue for certain investors.

Issues of Lesser Importance

Requirement for the Fund to be a Withholding Agent

As a general rule, a Delaware limited partnership will act as a withholding agent with respect to U.S. source withholdable income (such as interest and dividends) and a Cayman limited partnership will not.  As with most of tax there are exceptions to this general rule, but the general rule does inform most situations arising in practice.  Some fund managers (where the fund expects to have U.S. source withholdable income) are unhappy at the prospect of performing any withholding obligation and on this dimension will prefer a Cayman entity.  As a practical matter, venture capital funds do not earn much in the way of income subject to withholding, so this consideration is not often determinative.

Impact on U.S. Taxation of non-U.S. Limited Partners

The good news here is that the choice of Delaware or Cayman will have no impact on the requirement of a non-U.S. limited partner to file a US tax return.  While a Delaware fund would involve issuing the non-U.S. limited partner a Schedule K-1, the receipt of that piece of paper does not determine tax filing requirements.  The determining factor for tax filing status for the non-U.S. limited partners is the sort of income earned by the fund.  “Effectively connected income” earned by the fund, whether formed as a Delaware or Cayman entity, will trigger a U.S. tax filing requirement for non-U.S. limited partners.  Most venture capital funds with non-U.S. limited partners will have covenants against earning this sort of income.

Issues Involving Passive Foreign Investment Companies (PFICs)

PFICs are a complicated area and this post will not go into any detail regarding these rules – except to say that many non-U.S. formed early stage venture capital funded companies are PFICs for U.S. tax purposes.  In order to avoid adverse tax consequences attendant to owning a PFIC, an election (called the “qualified electing fund” or “QEF election”) must be made.  A Delaware fund, as a U.S. entity, makes the QEF election.  A Cayman fund, as a non-U.S. entity, cannot make the QEF election and, instead, the U.S. partners in the Cayman fund make the election.  So, the difference here is who has the burden of filing the U.S. tax form (Form 8621) to make the QEF election.  As a practical matter, whether by the terms of the limited partnership agreement, a side letter, or business practice, the fund manager will need to make the determination of PFIC status for its non-U.S. portfolio companies (in some financings we will see Investors Rights Agreements containing a requirement that the portfolio company make the determination).  As a result, the Delaware versus Cayman choice then impacts solely whether the fund or the investor makes the QEF election filing.

Issues Involving Controlled Foreign Corporations (CFCs)

The PFIC rules mentioned above and the CFC rules addressed in this paragraph fall into a category of the U.S. tax laws termed “anti-deferral” rules.  Specifically, these anti-deferral rules are designed to prevent U.S. taxpayers from “parking” income or assets offshore and delaying the U.S. taxation on that income. The PFIC rules accomplish anti-deferral by either taxing sales of PFICs as ordinary income (along with a punitive interest charge) or by virtue of the QEF election, which is an agreement to treat the PFIC as a “modified pass-through” entity for U.S. tax purposes.  The CFC rules achieve this anti-deferral by requiring some larger shareholders in non-U.S. companies controlled by U.S. shareholders to include in their income, on an annual basis, their pro rata share of certain types of income earned by the CFC, even if the CFC has not paid a dividend of those earnings.  This “deemed dividend” each year is taxed as ordinary income.

CFC planning is a key difference between Delaware and Cayman funds.  A Delaware fund is a U.S. person for CFC determination purposes, thus if a Delaware fund owns 10% or more of the vote or value of the foreign portfolio company, it will be counted as a “U.S. shareholder” for purposes of determining whether U.S. shareholders as a group own more than 50% of the foreign corporation, triggering CFC status.

A Cayman entity is not a U.S. person and the determination of U.S. shareholder status would occur at the partner level.  As a result, unless the Cayman fund holds a large position in the portfolio company and a U.S. limited partner holds a large portion of the fund, it is unlikely that a Cayman based investor will contribute towards a foreign portfolio company being a CFC.

Historically, many firms with Delaware main funds have formed Cayman alternative vehicles to invest in non-U.S. portfolio companies for just this purpose (if not entirely shifted domicile to Cayman to avoid the need to do so).

The efficacy and necessity of this planning has changed given recent changes in U.S. tax law.  At a high level, the 2017 Tax Cuts and Jobs Act changed some hyper-technical “attribution of ownership” rules that now cause many more non-U.S. entities to be CFCs.  Fortunately, the U.S. Treasury has issued some proposed and final rules in this area, which, at their heart, seek to remove this “Cayman versus Delaware” distinction when determining who actually is affected by CFC status.  These new rules (from last summer) retain the Cayman versus Delaware distinction in determining which entities are CFCs but they seek to remove the distinction between Cayman and Delaware when determining who is taxed on certain types of income earned by the CFC.   CFCs may deserve a longer discussion, but, for purposes of this post, the take-away point is that the Cayman versus Delaware distinction previously applicable is less impactful.

FATCA and AEOI Issues

The venture capital community has been living with FATCA for the past 10 years now, so we will not delve into details here.  One obvious point to make, though, is that a Delaware entity is not foreign and therefore is not a foreign financial institution (FFI) required to register with the IRS and perform FATCA due diligence and reporting on its investors.  A Delaware fund’s sole interaction with FATCA is as a withholding agent when required.  A Cayman fund is an FFI and is required to obtain a Global Intermediary Identification Number (GIIN), register with the Cayman Islands Tax Information Authority and perform annual reporting to that body.  There are also similar Cayman requirements as to non-U.S. jurisdictions (AEOI).  Thus, the FATCA/AEOI compliance costs for a Cayman fund generally will be higher than those incurred by a Delaware fund.

Conclusion

As can be gleaned from the above, the choice of jurisdiction for a venture capital fund depends on a number of factors. The above discussion is limited to certain matters that most frequently come into play when sitting down to make this determination.  The importance and weighting of each factor will differ manager-to-manager.  After considering the above, and mapping out the attributes of your proposed fund, a careful structuring discussion with counsel is warranted as a first step in your fund raising effort.

As we enter the month of May, federal, state and local governments are signaling that restrictions may be loosened soon, such that certain businesses may be able to resume operations at their workplaces in coming weeks or months. While the details will differ based on how each location eases its restrictions, we recommend that employers start planning ahead now as to what a return to the office might look like. 

On April 17, we published an article highlighting a number of general issues for all employers to consider as they draft their return to office plans. This blog expands on some of the items covered in such article and highlights specific considerations for U.S-based venture capital firms.

1. When we are allowed to return to the office, how do we decide who returns?

This decision will first be impacted by how applicable restrictions are lifted. Firms should review all relevant federal, state and local orders to determine the parameters of who will be allowed to return. Some orders, for example, are only letting businesses reopen at 25 or 50% of their prior capacity. Higher-risk individuals, as identified by the CDC or other sources, may be ordered to continue to shelter in place to protect their health.

Once you have determined who you are legally permitted to allow back into the workplace, make a list of the employees who will be asked to return. Which of the firm’s critical functions cannot be successfully performed from home? Which teams need to come into the office at least occasionally to complete their tasks efficiently? 

Also consider the communication, sequencing and structure of the return. Will you have all employees return at once or allow them to return slowly in phases? Will you require employees to return or ask them to? Should the managing partners and other teams be divided into subgroups that come into the office on differing days or weeks, so that if one individual is infected the potential exposure to the entire team can be contained? 

2. What if an employee voices concern about returning to the office and asks to work from home?

If an employee is hesitant to come in, we suggest allowing them to continue working from home to the extent they can do so productively. The federal government’s guidelines on “Opening Up America Again” suggest that for the first 2 of 3 phases of returning to work, employers encourage and use telework options as much as they can while maintaining productivity. We anticipate any state or local orders will advise similarly.  

We anticipate that firms will be able to accommodate a request to work from home for most investment professionals, back office employees and administrative assistants. Especially if those employees have demonstrated during the shelter in place that they can be trusted to get their work done, we suggest allowing them to continue to work from home until they feel comfortable returning to the office.

However, some tasks must be performed in the office. For example, a firm may insist that a receptionist return to the office to perform his or her duties. For other job positions, management may determine that in-person meetings will be required for certain purposes. Management may determine that productivity is better during in-office  performance, for various reasons, and set minimum expectations for attendance. Firms may set these requirements, and employees generally cannot refuse a reasonable expectation and continue working on their own terms.

However, in responding to an employee’s refusal to come into the office, consider the following laws:

• Disability Discrimination Laws. Certain qualified disabled employees may request a reasonable accommodation, under the Americans with Disabilities Act (ADA) and, in the case of California based firms the California Fair Employment and Housing Act (FEHA) (consider other similar laws in your state if not California), to permit them to continue performing essential functions of their position remotely, in order to avoid a significant risk of substantial harm to the employee.  Employers have a duty to provide reasonable accommodations, absent undue hardship, and must engage in an interactive process with the employee to determine what accommodations may be possible. Employers may require medical substantiation of the impairment and risk of harm.  Ultimately, after the interactive process, the employer decides what, if any, reasonable accommodation will be attempted.  Refusing a request for an accommodation, or failing to conduct the interactive process, could lead to liability. A firm may begin the interactive process before employees are asked to return to the office. The federal Equal Employment Opportunity Commission (EEOC) has suggested use of an Attendance Survey in advance of returning to work, which may prompt employees to make accommodation requests in advance.  Firms should seek legal advice before using such a survey. Employees cannot be asked to disclose previously unknown impairments.
• The Occupational Safety and Health Act. Under the federal Occupational Safety and Health Act, and certain state analogs, employees have a right to refuse work assignments if they can show that the firm did not meet its duty to provide a safe and healthy workplace. This issue could arise with any employee returning to the workplace.  Some employees may resist returning to the office simply on the basis of age (per CDC recommendations for those age 65 or more), even without an impairment requiring the duty to accommodate a qualified disabled employee. The employee would have to show all of the following: (i) the employee genuinely believes an imminent danger exists in the workplace; (ii) a reasonable person would agree that there is a real danger of death or serious injury; (iii) the employee asked the firm to eliminate the danger and the employer failed to do so; and (iv) the circumstances are such that the issue cannot be corrected through regular enforcement channels.  Note that if the firm follows CDC and local health guidelines, and enforces the firm’s social distancing protocol when employees are together in the workplace, employees may not be able to show an imminent danger, or that the firm failed to meet its duty to provide a safe and healthy workplace.  Any California employer should update and apply its Injury and Illness Prevention Program, in order to show that obligations for workplace inspections, employee training and communication, and hazard investigation and abatement are being met under current health and safety requirements.  Non-California employers should consider any similar state laws.
• The National Labor Relations Act. If individual contributor employees refuse to come in, and communicate with other employees about it, or ask for their support, they might have a claim that any adverse action taken against them is retaliation for engaging in protected concerted activity under the federal National Labor Relations Act. In that case the firm should continue dealing with each individual request on its own merits, and treat the employees identically to similarly situated employees.   

Even if none of the above laws are implicated, if an employee is refusing to come in and has no reasonable or protected basis for doing so, the employer may consider such refusal insubordination.  While under ordinary circumstances, at-will employees may find themselves summarily terminated for flatly refusing a reasonable work assignment, these are not ordinary times. During the initial return to the office phases, employers may consider less drastic measures, simply for employee relations and firm culture purposes.  Instead of termination, the firm may be able to negotiate a part-time work from home arrangement with prorated pay, until the concerns in question subside, or put the employee on an unpaid personal leave. The employee should be ineligible for unemployment if the firm has clearly offered full-time employment but the employee refuses without good cause. In this case “good cause” is determined by the state’s unemployment insurance agency.  Again, if the firm is following all of the CDC and County Health Department directives, and enforces the firm’s social distancing protocol when employees are together in the workplace, the employee may not be able to show good cause for refusing the work.

3. What if an employee cannot work, either in the office or remotely?  When do we have to let the employee take a leave of absence?

Employees may be unable to return to the office or work remotely due to personal circumstances involving themselves or a family member, and having nothing to do with a risk or fear of entering the workplace due to COVID-19.  Such reasons can include the employee’s illness or that of a family member, or caretaking obligations related to dependents. 

Almost every venture firm is already familiar with paid sick leave laws enacted in the last few years, entitling employees to take paid time off for specified illness and safety reasons.  However, because of typically small workforces, many venture firms have been insulated from having to learn and apply the intricacies of the Family and Medical Leave Act (FMLA) and state analogs.  That insulation is gone for the rest of 2020.

Congress has enacted a temporary expansion of FMLA to reach all small and mid-size employers, for paid child care leave purposes related to COVID-19.  A companion expansion requires paid sick and dependent care leave for certain purposes related to COVID-19. The Families First Coronavirus Response Act (FFCRA)  allows employees to take up to an additional 2 weeks of paid sick leave if the employee is unable to work or telework for certain COVID-19 related reasons and up to an additional 10 weeks of paid family care leave if the employee is unable to work or telework because their child’s school or daycare is closed. See our prior alerts on the FFCRA here and here.

Upon an employee’s request to stop work, or reduce working time, the firm should consider why the employee is unable to work or needs to reduce working time, and assess whether that entitles them to take a limited leave of absence, whether paid or unpaid. Make sure to examine all applicable federal, state and local sick leave laws, including the FFCRA, as well as the firm’s own leave policies, to confirm what type of leave or leaves an employee may be entitled to take.

4. As we start work on a return to the office plan do we have to consider privacy laws, particularly if we plan to ask employees or visitors to disclose any medical or travel history?

The Americans with Disabilities Act (ADA) and state privacy laws impose privacy protections that will apply to certain inquiries involving COVID-19. 

The EEOC has some helpful guidance regarding the ADA and COVID-19 here.  We focus on that guidance below, although certain state laws may impose additional restrictions.

Firms may generally ask employees about COVID-19 symptoms. Initially the EEOC listed symptoms such as fever, chills, cough, shortness of breath, or sore throat. Current EEOC guidance advises: “As public health authorities and doctors learn more about COVID-19, they may expand the list of associated symptoms. Employers should rely on the CDC, other public health authorities, and reputable medical sources for guidance on emerging symptoms associated with the disease. These sources may guide employers when choosing questions to ask employees to determine whether they would pose a direct threat to health in the workplace. For example, additional symptoms beyond fever or cough may include new loss of smell or taste as well as gastrointestinal problems, such as nausea, diarrhea, and vomiting.”

The EEOC also states that, given the current pandemic, employers may take employee temperatures and may also administer COVID-19 tests as they become available. However, firms must maintain the confidentiality of any medical information obtained. Such information should be stored separately from the employee’s personnel file, with other confidential medical records such as doctor’s notes, and leave requests. If a firm chooses to administer a COVID-19 test, it should ensure the test is accurate and reliable and should consult FDA and CDC guidance in making that determination.

Employees may be instructed not to return to the office if they have COVID-19 or are under observation pending a diagnosis. Those employees will clearly be entitled to sick leave under the FFCRA and other sick leave laws, and also likely under any firm sick leave policy. Such employees can be asked to provide a fitness for duty release once they are released to return to work.

Screening office visitors is not covered by the EEOC, but must be considered in order to protect employees and provide a safe workplace. As a practical matter, visitors invited to the office could be sent a symptom questionnaire in advance, to avoid having to confront them at the front desk with a personal questionnaire. Providing a temperature check at the front desk may also be considered, and certainly should be conducted if employees are required to undergo temperature checks.

Closing Thoughts

As venture capital firms plan for an eventual return to office, they will need to take a number of issues into consideration. Our discussion above is by no means exhaustive and does not, for example, cover the considerable changes firms will have to make to their physical facilities to implement social distancing. Consult our April 17 article for these and other considerations.  Local county health officers have published guidance on these and related issues.

Most crucially, the extent to which firms can return employees to the office, and the manner by which firms can do so, will be dictated by federal, state and local orders that are issued in the coming weeks and months. These orders may be difficult to interpret or reconcile with each order.  Consider working with counsel to prepare a draft plan now and revise the firm’s plan in compliance with those orders once they are released.

As much of the world shelters in place, nearly every client conversation we have with our venture capital fund clients comes around to some version of the questions “what are you seeing” and “will all of this impact our fund raising plans”.  We acknowledge the lack of clarity, at present, regarding the eventual duration and depth of the global health pandemic, and the associated impact on financial markets.  Nonetheless, as we are now several months into these events, we thought it timely to provide our observations, initial in nature as they may be, regarding the present market for venture capital fund raising.

As background, our commentary here is based on interactions with hundreds of venture capital firms, all differently positioned.  The punch line of the situation is that the impact of COVID-19 on fund raising will inevitably interrelate with a manager’s particular attributes: investment area of focus, geography, size, performance, LP base, investment team composition and location, amount of dry powder and proximity to natural fund raising time, and cash position of portfolio companies, among others.  In addition, further developments in coming weeks and months in regard to macroeconomic conditions are also likely to factor into fund raising outcomes, particularly in respect of the potential association of the public markets’ performance with ability and desire of institutions to commit to private investments (the “denominator effect”).  The snapshot from our seat at the table looks something like this:

Timing of Fund Raising

As the pandemic unfolded, managers were in various stages of fund raising: some were in market already, some were soon to be, some had plans to go out later in 2020 and others had no such near term plans at all.  Those that were already in market and on their way to their targets were best positioned to proceed and, with rare exception and not surprisingly, those deals have had the desired outcome for the sponsor.

As to funds being offered by established sponsors that were about to launch as the pandemic unfolded, in general we have seen more of them continue unabated, perhaps with slight adjustments to timing or target capital amounts.  We are heartened to have seen some major closings including a billion dollar plus “one and done” a few weeks into U.S. shelter in place orders, and we are likewise enthusiastic about the near-term 2020 pipeline.  We are not hearing from essentially any prominent managers in important investment sectors that they are making major changes to near-term 2020 fund raising plans, though in select cases minor changes might include small modifications to timing or the holding of an additional closing to accommodate latecomers with logistical delays due to the pandemic.

Where established funds were scheduled to launch later in 2020, a demand for a closer look at unfunded reserves and the adequacy of current capital for continued operations may arise, and managers are often being asked by LPs to be transparent and to disclose a thesis as to why additional capital is needed in the planned time frame.  These managers may need to focus on explaining how they are working with portfolio companies to manage cash flow (thus indirectly reducing pressure on fund raising until a later time).  Where there is a chance to push fund raising out in time to where there might be more clarity, not only regarding the course of the pandemic but also on valuations, that has been the preferred choice of some managers; however in at least a few cases managers are electing to accelerate fund raising based on cash needs or in some cases a view that it is better to go out before there might be even more uncertainty in financial markets.  Interestingly, we note that some projects have also sprung to life on theses that are tied directly to an intent to capitalize on market dislocations (e.g., overcorrections) or with conviction based on anticipated lower valuations in future rounds of outstanding private companies.  This is a new trend in our experience likely tied to “lessons learned” following the previous global financial crisis.

While the sample is more scattered, we sense hesitancy and are discussing various types of changes in plans among pure “emerging” managers who were in process or planning initial funds in the history of their franchises.  We’ve had a number of related discussions tapping into our prior experiences in down markets and how emerging managers successfully or unsuccessfully navigated those choppy waters to meet their fund raising goals and LP base construction.  At a minimum, some of the family offices or high net worth individuals that might have been the target audiences for emerging manager deals are reassessing their programs, and “go slow” orders do seem to be cropping up in some instances.  On the other hand, we have already successfully closed first time funds during shelter in places times, including funds that were oversubscribed and engaged in cutbacks.  So while the situation for emerging managers is not a “nuclear winter” by any means, in some cases there is evidence of more caution on behalf of investors and the need on the part of managers to proceed thoughtfully.

Market Segment and Past Performance

Drilling in slightly deeper, for funds about to be in market as the pandemic was declared, the investment area of focus, construction and dynamics of the management team as well as performance (as always) have seemed most pertinent to the outcome.  The pandemic for now has arguably created “winners and losers” at the portfolio level; those managers focused on areas such as ed-tech, health care, remote enterprise, online entertainment, semiconductors, online communications and other similarly related sectors have in our recent experience mostly been encouraged by investors to go ahead with fund raising especially where there is any potential for a delay to leave the firm with inadequate dry powder for any period of time.

On the other end of the spectrum, managers focusing or overweight in consumer discretionary, retail, travel, hospitality, offline entertainment and the like have faced resistance in some cases, particularly where there is any perception that additional capital would be used to support distressed companies.  Notably, more venture managers are technology and life sciences focused, as compared to retail and consumer, and inasmuch, the industry may prove somewhat resilient to current macroeconomic events.

The LPs’ Point of View

Our observation from an LP standpoint has been that, in general, investors are continuing to go ahead with their process for deals that were significantly advanced (for example, where on-site due diligence had already been completed).  Many of them appear to have taken note, looking back to 2008 and the aftermath of the financial crisis, of the value of having dry powder to make investments as purchase price multiples level off and then drop during times of crisis.  Savvy firms we work with are highlighting this.  For example, a prominent Silicon Valley venture manager recently highlighted at their annual meeting, held online, that they continued to invest at an ordinary if not heightened pace through the 2001 and 2008 down cycles and investors were very much better off for it.

Regarding deals scheduled to go out later in 2020, it remains to be seen if on-site due diligence will be successfully replaced by remote due diligence, to the extent global travel does not resume in the near term, and if not, how that impacts fund raising.  With that said, as we witness fund managers pivot fairly successfully to remote operations, as well as to remote investor relations (i.e., web-based annual and LPAC meetings, etc.), it seems promising that a mere lack of travel will not itself have a materially detrimental impact on fund raising later this year, especially for those firms that have been nimble enough to efficiently and effectively migrate their flow of work to remote.  One key for LPs will likely be whether they have already “been in business” with the particular fund sponsor in prior funds, or at least have had an in person visit with the team prior to the current lockdown on in person meetings, providing additional headwind for emerging managers as well as a potential headwind for established managers looking to increase their LP roster.

Another trend to point out is that the industry, pre-pandemic, has been responding to a landscape where private companies stay private and require support longer, as borne out by the formation and use of a myriad of SPVs and top-up funds to capture late stage investments in portfolio winners.  We have not seen that currently abate, and if anything, some managers that may have done one-off SPVs in the past (especially where their focus is on in-demand market sectors), or may have simply let later stage opportunities go to others, may take this as a chance to launch a growth fund product.  Accordingly, there is the potential for a convergence of views and motivations: LPs understand the impact of the 2008 downturn on valuations and want access to these opportunities; and GPs have access to allocations in these sorts of deals and want to capitalize on that.  Multiple products we are working on that are either in market now or coming to market soon will offer top-up fund vehicles to capture this perceived opportunity, and in general we think the trend of strategically raised SPVs and top-up funds is very likely to continue, if not expand.

A further observation relates to the “denominator effect”.  During the global financial crisis, many LPs significantly curtailed their investments in private funds as they became overweight as public markets fell.  Commitments were cancelled and relationships were pruned.  Our perception was that in many cases this was quite formulaic and rigid.  While we have seen a small handful of institutions back out of recent deals specifically citing being overweight in privates, we are encouraged and hopeful that the rigidity of the position held in 2008 may have shifted.  It would seem that taking into account post-2008 IRRs in the space, this is savvy.  Many LPs have indicated to managers we work with that they now have greater, in some cases much greater, ability based on internal policy to break target limits where there is public market stress, so as to be positioned to capitalize on the potential for favorable private valuations moving ahead.  We think this is healthy, and are glad to hear it.  This evolving area deserves continued focus.

Finally, we have been watching developments as they relate to geography.  Of the hundreds of venture firms we represent, somewhere around 15% of them are Asia-based.  These firms and especially mainland China firms are a cycle ahead of U.S. firms, in the sense that their shelter in place orders came sooner, and have for now been lifted.  We watch with interest the trend lines as these firms get back to business, at least for the time being.  The initial observations are promising, in the sense that the return to work flows, and the resumption of investing if not fund raising, seem to us for now like a “V shaped bottom”.  This area deserves continued monitoring and we intend to watch Asia venture capital fund trends for potential signals about the U.S. market.

Advice to Managers

Our general advice to venture capital fund managers who are thinking about fund raising plans for 2020 or beyond is to assess your own unique situation, and talk to your investors.  We have found that sometimes managers have assumed LPs would desire a fund raising freeze only to discover through analysis and discussion that, in fact, LPs wanted the manager to push ahead, if not also accelerate and/or create extra opportunities for later-stage deals.  This is clearly not what every manager will discover on thoughtful diligence with their LPs, however it is important now more than ever to spend time having these detailed and honest conversations with LPs and formulating strategies around what is learned from them.

We are aware of a small number of prominent managers that are in frank conversation with their well-known investors, and highly institutional limited partners in certain of these cases have agreed to particular timing with respect to current or future fund raising plans, including delays in planned fund raising, made feasible by ready dry powder in existing funds.  The wisdom of this type of collaboration is plain: doing the right thing for your investors nearly always makes sense in the long run, and we imagine that such managers will be well served by this collaboration when they do return to market.

The extended filing deadline for Form ADV remains the same as under the prior order (May 14, 2020), however, the conditions have been simplified such that:

• Fund managers are no longer required to provide a description of the reasons why meeting the regular deadline is infeasible.
• Fund managers are no longer required to provide an estimate of when the filing is expected to be made.

Under the new order, to be eligible for Form ADV and brochure delivery extension, ERAs and RIAs need only meet the following conditions:

1. Fund managers must be unable to meet the original deadline due to circumstances related to current or potential effects of COVID-19.
2. Fund managers must promptly provide the SEC with a notice to the effect that they are relying on the SEC extension, in an email to IARDLive@sec.gov.
3. Fund managers must also post the same notice on their website (or provide such notice directly to investors and clients if no website is available).

The exemption period for RIAs filing of Form PF has also been extended.   The March 13th order covers such filings due by April 30, 2020; while the March 25th order covers such filings due by June 30, 2020.

To be eligible for the extension for Form PF filings, RIAs are now required to meet the following conditions:

1. Fund managers must be unable to timely file Form PF due to circumstances related to current or potential effects of COVID-19.
2. Fund managers must promptly provide the SEC with a notice to the effect that they are relying on the SEC extension, in an email to FormPF@sec.gov.

Additional details may be found at:  https://www.sec.gov/rules/other/2020/ia-5469.pdf.

RIAs’ brochure delivery and updating deadlines have also been extended, as have RIAs’ Form PF filings that would otherwise be due during the exemption period (March 13 – April 30, 2020).

New Deadlines.  Since the relief applies to multiple filing deadlines, the SEC states the extension as: “as soon as practicable, but to no later than 45 days after the original due date….” 

For annual Form ADV amendments otherwise due on March 30, 2020, this extension is until no later than May 14, 2020. 

Conditions.  To be eligible for the Form ADV and brochure delivery the extension, ERAs and RIAs must meet the following conditions:

1. You must be unable to meet the applicable deadline due to circumstances related to current or potential effects of COVID-19.
2. You must promptly provide the SEC an email notice that you are relying on the SEC extension, along with a brief description of the reasons you could not meet the regular deadline and an estimate of when you expect to comply. The email address is IARDLive@sec.gov. 
3. You most also post on your website the information required in the email to the SEC. Advisers without a website must provide notice directly to fund investors and any other clients.

To be eligible for the extension for Form PF filings, RIAs must meet the following conditions: 

1. You must be unable to timely file Form PF due to circumstances related to current or potential effects of COVID-19.
2. You must promptly provide the SEC notice that you are relying on the SEC extension, along with a brief description of the reasons why you could not file Form PF on a timely basis and an estimate of when you will make the filing.  The email address is FormPF@sec.gov. 

Additional details may be found at:  https://www.sec.gov/rules/other/2020/ia-5463.pdf.

The Cayman Islands published the Private Funds Law 2020 on February 7, 2020 and further amended it on July 7, 2020.  Most importantly, the Law requires certain Cayman Islands private funds to register with the Cayman Islands Monetary Authority (“CIMA”).  This requirement covers most closed-ended funds formed in Cayman Islands, including typical venture capital and private equity funds (though certain exceptions exist for single-LP funds, holding vehicles, and a few other less common situations).  Failure to register can result in penalties including a fine of approximately US$122,000.

For existing Cayman funds that will have first called capital by such date, the deadline to complete registration is August 7, 2020.  Any funds formed or first calling capital thereafter are required to file a registration application within 21 days of initial closing, and to complete the entire registration process prior to making an initial capital call for investment purposes.

Details of the registration process remain to be released by CIMA.  We anticipate that in practice legal counsel will assist fund managers to register their Cayman funds where needed as part of the ordinary fund formation routine.  Once registered, an annual fee will apply (though not in 2020).  The amount of the fee remains to be specified, but as a point of reference open-ended funds (i.e., mutual funds, hedge funds, etc.), who have been required to file for some time now, pay about US$4,500 per year.

There are some other requirements of the Law to take note of.  Implicated funds must:

• Prepare annual audited financial statements and have local Cayman auditors “sign off” on those (this requirement has existed for some time for open-ended funds; the ordinary working practice is that the long standing offshore auditors, PwC or whoever, will get their local counterparts to sign off on what they prepare, usually in a transparent manner to the fund manager in an efforts sense, and often with no additional cost); and
• Submit to CIMA the signed-off financial statements and a summary of fund information in the format prescribed by CIMA within 6 months of financial year-end.

We will update this blog post with more details when known.

Some of the most significant changes effected by FIRRMA will not take immediate effect, and may not be implemented for up to 18 months.  When FIRRMA’s changes come into effect, however, CFUIS’s expanded jurisdiction will be broad enough to reach foreign funds as well as U.S-based funds with foreign limited partners.

CFIUS Overview

CFIUS is an inter-agency U.S. government committee chaired by the Department of the Treasury tasked with reviewing acquisitions of and investments in U.S. businesses by non-U.S. persons and entities to determine whether such transactions will have a detrimental impact on U.S. national security.  Where CFIUS determines that a transaction within its jurisdiction raises security concerns, it can require the parties to mitigate those security risks (e.g., by requiring the U.S. business to divest sensitive assets, or requiring the foreign investor to relinquish board representation on the U.S. business).  In extreme cases, CFIUS can recommend that the President block or suspend a transaction, or even unwind a transaction post-closing.

Historically, CFIUS has focused its reviews on “traditional” national security concerns, such as foreign investments in U.S. defense contractors and acquisitions of companies that deal in technologies controlled under U.S. export laws.  In recent years, the government has grown increasingly concerned that CFIUS lacks the authority and resources necessary to address evolving national security risks, including efforts by foreign actors to access foundational and emerging technologies (e.g., artificial intelligence, virtual reality, autonomous vehicles) and sensitive information (e.g., personal and health data of U.S. citizens).

Congress drafted FIRRMA to limit access to important U.S. technologies and sensitive information through foreign investment, without unduly deterring the flow of foreign investment into the United States.  Whether FIRRMA and its implementing regulations will strike an appropriate balance between those dual goals remains to be seen.

Broadening CFIUS Jurisdiction to Include “Other Investments”

Prior to FIRRMA’s enactment, CFIUS’s jurisdiction was limited to transactions that could result in a foreign person gaining “control” of certain U.S. businesses.  FIRRMA broadens the scope of CFIUS’s jurisdiction to include “other investments” that do not require a foreign person gaining control of a U.S. business.

Only Applies to Certain U.S. Businesses

FIRRMA establishes the fundamental rule that to be an “other investment” the investment must be in a U.S. business that:

 (1) owns, operates, manufactures, supplies, or services critical infrastructure;

 (2) produces, designs, tests, manufactures, fabricates, or develops one or more critical technologies; or

 (3) maintains or collects sensitive personal data of United States citizens that may be exploited in a manner that threatens national security.

The terms “critical infrastructure” and “critical technologies” will be further defined in forthcoming CFIUS regulations that may not come into effect for up to 18 months.  FIRRMA’s definition of “critical technologies” includes categories of technology that already are subject to U.S. export control laws, as well as an as-yet-undetermined list of “emerging and foundational technologies.”  While the list of emerging and foundational technologies will be developed pursuant to a new U.S. government inter-agency process and with input from CFIUS, “critical technologies” likely will include capabilities associated with artificial intelligence, quantum computing, virtual and augmented reality, autonomous vehicles, encryption, and nanoscale technologies, all of which have been the focus of recent attention by CFIUS.  The definition of “critical technologies” may also include emerging financial services (i.e., “fintech”) sectors, including cryptocurrency and blockchain technology, especially where the business interconnects with sensitive personal data of U.S. persons.

Direct or Indirect Investment by Foreign Person That “Affords” Certain Covered Rights

To be an “other investment,” the investment must be a direct or indirect investment by a foreign person.  Therefore, a fund manager must assess whether the subject fund itself is a foreign person and whether such fund has any foreign person investors.

Under current CFIUS regulations, a “foreign person” means any “foreign national,” “foreign government,” “foreign entity,” or any entity controlled by any foreign person or group of foreign persons that are related or act in concert.  A “foreign entity” is an entity that is organized under non-U.S. law and has its principal place of business outside the U.S., or its equity securities are primarily traded on one or more foreign exchanges.  Notably, however, the term “foreign entity” does not include an entity that, notwithstanding the satisfaction of the criteria above, can establish that a majority of its equity interest is ultimately owned by U.S. nationals.

A fund will be controlled by a foreign person if the fund’s general partner (“GP”) itself is a foreign person or if the GP is controlled by a foreign person.  Additionally, a fund can also be deemed controlled by a foreign person if an LP or group of LPs controls the fund.  A determination of “control” will hinge on whether there is power to decide important matters, which may include investment decisions, management of portfolio companies, dismissal or compensation of the GP, dissolution of the fund or operating budgets.

In order to fall within CFIUS jurisdiction, the direct or indirect investment by a foreign person must also afford such foreign person any one of the following:

 (1) access to material non-public technical information of the business;

 (2) membership or observer seat on board of directors or similar body; or

 (3) any involvement (other than through the voting of shares) in substantive decision making regarding the use, development, acquisition, safekeeping or release of sensitive personal data of U.S citizens maintained or collected by the U.S business, the use, development, acquisition or release of critical technologies, or the management, operation, manufacture or supply of critical infrastructure.

“Material nonpublic technical information” is defined under FIRRMA as information that is not available in the public domain and that “provides knowledge, know-how, or understanding . . . of the design, location, or operation of critical infrastructure” or “is necessary to design, fabricate, develop, test, produce, or manufacture critical technologies, including processes, techniques, or methods.”  In other words, it is information that would provide a foreign person access to the kinds of critical infrastructure and critical technologies that Congress intended FIRRMA to protect.  Significantly, however, material nonpublic technical information does not include “financial information regarding the performance” of a U.S. business, so basic financial data that a fund would ordinarily receive regarding a portfolio company and potentially report to its LP investors should be excluded from that definition.

General fund strategy documents or descriptions of U.S. business portfolio companies also probably would not qualify as material nonpublic technical information, unless those documents or descriptions would provide a foreign LP insight into critical infrastructure or critical technologies that would not be available to the general public.  Going forward, funds wishing to remain firmly outside of CFIUS’s review jurisdiction should carefully consider the types of information distributed to LPs to ensure that technical information about the U.S. business is omitted from those distributions whenever possible.

Pending further guidance, questions exist regarding what “affords” means in the context access, membership or involvement in the enumerated matters, especially how this construction will be applied to indirect investment by foreign person LPs.  For example, “affords” may not be limited strictly to contractual rights, but may take into account other facts and circumstances.  For example, it may include information access certain investors obtain in due diligence or influence certain strategic investors of a fund may have in connection with rights to meet with portfolio company management.

Clarification Regarding LPAC Membership

FIRRMA includes a specific clarification regarding a foreign LP’s membership on a fund’s limited partner advisory committee (“LPAC”) or similar body.  Specifically, a fund’s investment in a covered U.S. business is not an “other transaction” solely by reason of having a foreign LP who sits on LPAC or has the right to appoint LPAC representatives, so long as (a) the foreign LP does not control the fund (i.e., no power to approve, disapprove or control investment decisions or GP decisions with respect to portfolio companies or to unilaterally dismiss, select or determine the compensation of, the GP), (b) the GP is not a foreign person and is the exclusive manager of the fund, (c) the LPAC has limited powers (i.e., no power to approve, disapprove or control investment decisions (except waivers of conflicts, allocation limits, or similar activity) or GP decisions with respect to portfolio companies), (d) the foreign LP has no access to material nonpublic technical information through LPAC, and (e) the foreign LP is not otherwise afforded covered rights.

It is important to note that the clarification for LPAC participation is not a broad exemption for investment funds, but instead narrowly states that LPAC status of a foreign LP does not by itself cause a fund’s investment to fall within the “other investment” category so long as the conditions described above are met.  Additionally, the provision does not address the situation where the fund itself is a foreign person.

Introducing Mandatory Declarations

Another key innovation introduced by FIRRMA is the concept of a “mandatory declaration” for certain transactions, including “other investments” in which a foreign government will directly or indirectly acquire an as-yet-undefined threshold interest in a U.S. business.  While CFIUS has historically permitted voluntary notice of transactions, under FIRRMA parties to a transaction will be required to file mandatory declarations with CFIUS in advance of closing for investments in which a foreign investor directly or indirectly acquires a “substantial interest” in a U.S. business, and a foreign government has a “substantial interest” in the foreign investor.  Although the term “substantial interest” will be defined in forthcoming regulations, FIRRMA provides that a “substantial interest” will not include an interest that is less than a 10 percent voting interest or an interest arising from an investment that meets the requirements for exclusion from the definition of “other investment” under the LPAC rule.  Notably, the 10 percent voting interest threshold for “substantial interest” will apply both to the foreign government interest in the foreign investor, and to the foreign investor’s interest in the U.S. business.  In other words, the mandatory declaration requirement would not be triggered in cases where a foreign government controls less than 10 percent of the voting interest in a foreign investor, even if the foreign investor will acquire a greater than 10 percent voting interest in a U.S. business.

An exception to the requirement for mandatory declarations is also available for investments by investment funds if the GP of the fund is not a foreign person and is the exclusive manager of the fund, and if any foreign person serves on the LPAC of the fund, the foreign LP does not control the fund and the LPAC has limited powers.

Finally, FIRRMA gives CFIUS discretion to require a mandatory declaration for any “other investment” transaction involving foreign access to “critical technologies,” another term that has yet to be defined.  Because FIRRMA leaves this and other important terms to be defined pursuant to future regulatory action, FIRRMA’s provisions calling for mandatory declarations will not come into immediate effect.

Considerations for Fund Managers Going Forward

Although FIRRMA’s full impact on venture capital and private equity funds will depend in significant part on the substance of the forthcoming CFIUS regulations that will implement FIRRMA’s changes, funds that anticipate making investments in U.S. technology companies should consider how their organization and participation by non-U.S. LPs in future investments will implicate CFIUS jurisdiction.  For example, funds can take steps now to ensure that (i) they are controlled by a GP that will not qualify as a “foreign person” for CFIUS purposes, (ii) any non-U.S. LPs will not have access to information about portfolio companies that would provide insight into critical infrastructure or critical technologies that is not available to the general public (including limiting access to such information in the diligence process and in connection with the granting of strategic rights), and (iii) non-U.S. LPs are not granted rights that could be construed as “controlling” the fund.

Additionally, funds with investors backed by foreign governments will want to pay close attention to the mandatory declaration requirements as the relevant regulations are implemented.

Some of the most significant changes effected by FIRRMA will not take immediate effect, and may not be implemented for up to 18 months. When FIRRMA’s changes come into effect, however, CFUIS’s expanded jurisdiction will be broad enough to reach foreign funds as well as US-based funds with foreign limited partners.

CFIUS overview

CFIUS is an inter-agency US government committee chaired by the Department of the Treasury tasked with reviewing acquisitions of and investments in US businesses by non-US persons and entities to determine whether such transactions will have a detrimental impact on US national security. Where CFIUS determines that a transaction within its jurisdiction raises security concerns, it can require the parties to mitigate those security risks (e.g., by requiring the US business to divest sensitive assets, or requiring the foreign investor to relinquish board representation on the US business). In extreme cases, CFIUS can recommend that the President block or suspend a transaction, or even unwind a transaction post-closing.

Historically, CFIUS has focused its reviews on “traditional” national security concerns, such as foreign investments in US defense contractors and acquisitions of companies that deal in technologies controlled under US export laws. In recent years, the government has grown increasingly concerned that CFIUS lacks the authority and resources necessary to address evolving national security risks, including efforts by foreign actors to access foundational and emerging technologies (e.g., artificial intelligence, virtual reality, autonomous vehicles) and sensitive information (e.g., personal and health data of US citizens).

Congress drafted FIRRMA to limit access to important US technologies and sensitive information through foreign investment, without unduly deterring the flow of foreign investment into the United States. Whether FIRRMA and its implementing regulations will strike an appropriate balance between those dual goals remains to be seen.

Broadening CFIUS jurisdiction to include “other investments”

Prior to FIRRMA’s enactment, CFIUS’s jurisdiction was limited to transactions that could result in a foreign person gaining “control” of certain US businesses. FIRRMA broadens the scope of CFIUS’s jurisdiction to include “other investments” that do notrequire a foreign person gaining control of a US business.

Only applies to certain US businesses

FIRRMA establishes the fundamental rule that to be an “other investment” the investment must be in a US business that:

1. owns, operates, manufactures, supplies, or services critical infrastructure;
2. produces, designs, tests, manufactures, fabricates, or develops one or more critical technologies; or
3. maintains or collects sensitive personal data of United States citizens that may be exploited in a manner that threatens national security.

The terms “critical infrastructure” and “critical technologies” will be further defined in forthcoming CFIUS regulations that may not come into effect for up to 18 months. FIRRMA’s definition of “critical technologies” includes categories of technology that already are subject to US export control laws, as well as an as-yet-undetermined list of “emerging and foundational technologies.” While the list of emerging and foundational technologies will be developed pursuant to a new US government inter-agency process and with input from CFIUS, “critical technologies” likely will include capabilities associated with artificial intelligence, quantum computing, virtual and augmented reality, autonomous vehicles, encryption, and nanoscale technologies, all of which have been the focus of recent attention by CFIUS. The definition of “critical technologies” may also include emerging financial services (i.e., “fintech”) sectors, including cryptocurrency and blockchain technology, especially where the business interconnects with sensitive personal data of US persons.

Direct or indirect investment by foreign person that “affords” certain covered rights

To be an “other investment,” the investment must be a direct or indirect investment by a foreign person. Therefore, a fund manager must assess whether the subject fund itself is a foreign person and whether such fund has any foreign person investors.

Under current CFIUS regulations, a “foreign person” means any “foreign national,” “foreign government,” “foreign entity,” or any entity controlled by any foreign person or group of foreign persons that are related or act in concert. A “foreign entity” is an entity that is organized under non-US law and has its principal place of business outside the US, or its equity securities are primarily traded on one or more foreign exchanges. Notably, however, the term “foreign entity” does not include an entity that, notwithstanding the satisfaction of the criteria above, can establish that a majority of its equity interest is ultimately owned by US nationals.

A fund will be controlled by a foreign person if the fund’s general partner (“GP”) itself is a foreign person or if the GP is controlled by a foreign person. Additionally, a fund can also be deemed controlled by a foreign person if an LP or group of LPs controls the fund. A determination of “control” will hinge on whether there is power to decide important matters, which may include investment decisions, management of portfolio companies, dismissal or compensation of the GP, dissolution of the fund or operating budgets.

In order to fall within CFIUS jurisdiction, the direct or indirect investment by a foreign person must also afford such foreign person any one of the following:

1. access to material non-public technical information of the business;
2. membership or observer seat on board of directors or similar body; or
3. any involvement (other than through the voting of shares) in substantive decision making regarding the use, development, acquisition, safekeeping or release of sensitive personal data of US citizens maintained or collected by the US business, the use, development, acquisition or release of critical technologies, or the management, operation, manufacture or supply of critical infrastructure.

“Material nonpublic technical information” is defined under FIRRMA as information that is not available in the public domain and that “provides knowledge, know-how, or understanding … of the design, location, or operation of critical infrastructure” or “is necessary to design, fabricate, develop, test, produce, or manufacture critical technologies, including processes, techniques, or methods.” In other words, it is information that would provide a foreign person access to the kinds of critical infrastructure and critical technologies that Congress intended FIRRMA to protect. Significantly, however, material nonpublic technical information does not include “financial information regarding the performance” of a US business, so basic financial data that a fund would ordinarily receive regarding a portfolio company and potentially report to its LP investors should be excluded from that definition.

General fund strategy documents or descriptions of US business portfolio companies also probably would not qualify as material nonpublic technical information, unless those documents or descriptions would provide a foreign LP insight into critical infrastructure or critical technologies that would not be available to the general public. Going forward, funds wishing to remain firmly outside of CFIUS’s review jurisdiction should carefully consider the types of information distributed to LPs to ensure that technical information about the US business is omitted from those distributions whenever possible.

Pending further guidance, questions exist regarding what “affords” means in the context access, membership or involvement in the enumerated matters, especially how this construction will be applied to indirect investment by foreign person LPs. For example, “affords” may not be limited strictly to contractual rights, but may take into account other facts and circumstances. For example, it may include information access certain investors obtain in due diligence or influence certain strategic investors of a fund may have in connection with rights to meet with portfolio company management.

Clarification regarding LPAC membership

FIRRMA includes a specific clarification regarding a foreign LP’s membership on a fund’s limited partner advisory committee (“LPAC”) or similar body. Specifically, a fund’s investment in a covered US business is not an “other transaction” solely by reason of having a foreign LP who sits on LPAC or has the right to appoint LPAC representatives, so long as (a) the foreign LP does not control the fund (i.e., no power to approve, disapprove or control investment decisions or GP decisions with respect to portfolio companies or to unilaterally dismiss, select or determine the compensation of, the GP), (b) the GP is not a foreign person and is the exclusive manager of the fund, (c) the LPAC has limited powers (i.e., no power to approve, disapprove or control investment decisions (except waivers of conflicts, allocation limits, or similar activity) or GP decisions with respect to portfolio companies), (d) the foreign LP has no access to material nonpublic technical information through LPAC, and (e) the foreign LP is not otherwise afforded covered rights.

It is important to note that the clarification for LPAC participation is not a broad exemption for investment funds, but instead narrowly states that LPAC status of a foreign LP does not by itself cause a fund’s investment to fall within the “other investment” category so long as the conditions described above are met. Additionally, the provision does not address the situation where the fund itself is a foreign person.

Introducing mandatory declarations

Another key innovation introduced by FIRRMA is the concept of a “mandatory declaration” for certain transactions, including “other investments” in which a foreign government will directly or indirectly acquire an as-yet-undefined threshold interest in a US business. While CFIUS has historically permitted voluntary notice of transactions, under FIRRMA parties to a transaction will be required to file mandatory declarations with CFIUS in advance of closing for investments in which a foreign investor directly or indirectly acquires a “substantial interest” in a US business, and a foreign government has a “substantial interest” in the foreign investor. Although the term “substantial interest” will be defined in forthcoming regulations, FIRRMA provides that a “substantial interest” will not include an interest that is less than a 10 percent voting interest or an interest arising from an investment that meets the requirements for exclusion from the definition of “other investment” under the LPAC rule. Notably, the 10 percent voting interest threshold for “substantial interest” will apply both to the foreign government interest in the foreign investor, and to the foreign investor’s interest in the US business. In other words, the mandatory declaration requirement would not be triggered in cases where a foreign government controls less than 10 percent of the voting interest in a foreign investor, even if the foreign investor will acquire a greater than 10 percent voting interest in a US business.

An exception to the requirement for mandatory declarations is also available for investments by investment funds if the GP of the fund is not a foreign person and is the exclusive manager of the fund, and if any foreign person serves on the LPAC of the fund, the foreign LP does not control the fund and the LPAC has limited powers.

Finally, FIRRMA gives CFIUS discretion to require a mandatory declaration for any“other investment” transaction involving foreign access to “critical technologies,” another term that has yet to be defined. Because FIRRMA leaves this and other important terms to be defined pursuant to future regulatory action, FIRRMA’s provisions calling for mandatory declarations will not come into immediate effect.

Considerations for fund managers going forward

Although FIRRMA’s full impact on venture capital and private equity funds will depend in significant part on the substance of the forthcoming CFIUS regulations that will implement FIRRMA’s changes, funds that anticipate making investments in US technology companies should consider how their organization and participation by non-US LPs in future investments will implicate CFIUS jurisdiction. For example, funds can take steps now to ensure that (i) they are controlled by a GP that will not qualify as a “foreign person” for CFIUS purposes, (ii) any non-US LPs will not have access to information about portfolio companies that would provide insight into critical infrastructure or critical technologies that is not available to the general public (including limiting access to such information in the diligence process and in connection with the granting of strategic rights), and (iii) non-US LPs are not granted rights that could be construed as “controlling” the fund.

Additionally, funds with investors backed by foreign governments will want to pay close attention to the mandatory declaration requirements as the relevant regulations are implemented.

Sounds safe, right? Not so fast. There are multiple issues to consider, and our first and foremost piece of advice for managers we work with is: don’t sign that letter.

The first issue is one of how broadly the manager’s sensitive information will be broadcast, and related, who will be the eventual buyer. The agent is ordinarily, though not always, paid in a percentage of sales fashion; and the seller of course receives the purchase price. So usually, to generalize, those parties don’t care all that much about the quality of the buyer – their sole incentive is to get the highest possible price.

The fund manager’s considerations are usually adverse to the goals of agent and seller. On the issue of how broadly the manager’s information is shared, most managers we work with tend to want to keep a tight lid on things – they would prefer their sensitive information go to a very limited pool of qualified buyers they would tend to accept as substituted LPs, and not be sent out broadly in a “spray and pray” type approach by the agent – which unfortunately we do see more often than you might imagine.

Perhaps more importantly, good managers work hard to optimize their LP base over time, favoring long-term participants who understand VC and can be a helpful asset to the fund, from the standpoint of providing knowledgeable LPAC members, to understanding the manager’s amendment and consent proposals, to helping the brand to maintain its allure over time for example both by the caliber of its name but also by reducing investor turnover in the fund. Since most VC partnership agreements cause the original investor to acknowledge that their interest in the fund is highly restricted as to transferability, and accordingly, give the fund manager broad discretion to consent (or not) to any transfer proposal, the fund manager has considerable leverage in the face of these sorts of letters from agents. In light of all of the above, most managers we work with will not agree to “sign the letter” and let the agent just run with the process.

So what to do in this situation? We recommend the following as the “gold standard” in terms of approaching a structured secondary sale run by an agent: the agent should enter into an agreement with the fund manager to which the underlying limited partner acknowledges and agrees, pursuant to which the agent commits to keeping any and all fund information confidential (this step establishes a direct contractual obligation of the agent to the fund manager, as opposed to needing to rely on the underlying partnership agreement and whatever it might say the limited partner’s responsibility is for the actions of their advisors). This “master agreement” with the agent will contain an exhibit which is the agreed upon form of NDA that a prospective buyer will need to enter into. The agent becomes required to present a list of proposed buyers to the fund manager, and the fund manager may then elect to approve one or more parties on that list. Once approved, the agent is free to go off and get the prospective buyer to enter into the agreed NDA, deliver a copy of the same to the fund manager, and then (and only then) disseminate the fund manager’s confidential information in initiation of the diligence process.

This procedure solves for the key considerations noted above that a typical fund manager is concerned about. First, it eliminates the chance for a “spray and pray” including to parties the fund manager would not accept anyway (competitors or others adverse, investors of dubious credit quality, investors that might invoke regulatory concerns, and so forth.). Second, it provides a chance for the fund manager to cull the list of prospective buyers to its preference. Will it take as a buyer secondary funds that don’t have primary programs to invest in the manager’s next fund? Difficult sovereigns or public pensions where the manager has tried hard to avoid those investors in its own fund raising? Third, it gives the manager robust contractual protection to dissuade the misuse of the confidential information – both in how it creates a direct obligation on the part of the agent, but importantly, also by enforcing the use of an agreed and acceptable buyer’s NDA.

As to that buyer’s NDA, there is often a question of whose form will be used. The agent will have a reasonable concern that if every manager insists on its own form of NDA, there is a very unwieldy process at hand (a prospective buyer of the “slate” of interests prior to starting diligence may have to sign numerous NDAs, which can be costly and impracticable). In the spirit of cooperation, many managers we work with will try pretty hard to go forward with the agent’s proposed NDA. However, there are boundaries, and in some cases, an agent (or underlying limited partner) presents an NDA that is so grossly unfair to the fund manager that pushback is necessary. A couple of good examples: a UK based limited partner in a Delaware domiciled Silicon Valley VC fund presents an NDA governed by UK law with dispute resolution in London; or an NDA that does not firmly establish the express third party beneficiary status of the fund manager to enforce its terms.

So, when you get that innocent looking letter – please think hard before just signing it. There are many important considerations to evaluate and you should focus on these issues before letting the agent and seller run freely with your sensitive information.

Let’s examine the case of a US or Asia based manager that doesn’t have an office, legal registration or any personnel in the EU – a category which fits a vast supermajority of clients we work with. If you don’t fit this category (i.e. if you have a Paris office or two staff in Belgium), this article doesn’t apply to you – your EU connectivity places you squarely inside of the scope of GDPR and you should get further, detailed professional advice. But returning to the former category, we note that, looking directly to the language of the law itself, there are three ways that a firm might be jurisdictionally “captured” by GDPR. Two can be stricken right away on our assumed facts: first, firms that are located in an EU member state (which should be read broadly to include offices, personnel or legal registrations); and second, firms that while not being technically located in an EU member state are located “in a place where Member State law applies by virtue of public international law”; the example given is operating inside a consular mission in a country outside the EU. Those which are the subject of this article should have easily passed through these first two gates.

Which brings us to the third way GDPR may apply to a firm. The law states that: “This regulation applies to the processing of personal data of data subjects who are in the Union by a controller or processor not established in the Union, where the processing activities are related to either (a) the offering of goods or services, irrespective of whether a payment of the data subject is required, to such data subjects in the Union; or (b) the monitoring of their behavior (NTD: “their” being data subjects in the Union) as far as their behavior takes place within the Union.”

The key language above, highlighted, is “data subjects in the Union”. This plainly refers to individuals in the EU, and not entities (the GDPR concerns protection of the data rights of individual human beings, called “data subjects” in its parlance, and doesn’t extend protections to entities). So arises, essentially, a B2B versus B2C distinction. If a venture capital manager in say Silicon Valley or Beijing is marketing to high net worth individual investors inside the EU, which some but not many managers we work with do, GDPR will apply under this third jurisdictional test. However, mostly, fund managers outside the EU we work with, if marketing at all into the EU, are marketing only to entities – think that French fund of funds, and so forth. If this “B2B” marketing covers the extent of the venture firm’s activity with respect to the EU, it appears plain on the language of the law that GDPR simply does not apply. To be very clear, this would, in our view, cover even a situation where an individual associated with that French fund of funds inks his name, phone number and email address into a subscription agreement as a contact party, and so forth. Since the venture firm is outside the scope of GDPR, the law doesn’t apply even in respect of that limited capture of the individual’s information in the entity’s subscription agreement.

While analysis has been made that probably the venture manager on Sand Hill Road with a few bits of EU data is not the intended subject of GDPR, it appears there is a better position legally than just hoping for non-enforcement. This jurisdictional analysis should be the first stop in determining potential obligations under GDPR. With that said, at a broader level, GDPR is about transparency and security of data processing, and avoiding data breaches or at least as a fallback having plans to respond to such breaches quickly and efficiently. We have been working with clients recently, in no small part because of the directionality of GDPR and attendant media coverage and client relations inquiries, to update policies to a sensible, modern standard.

Is your venture capital fund name a trademark?

The term “trademark” generally includes any word, name or symbol that a person or company uses to identify and distinguish its goods or services from those of others, and to indicate the source of goods or services, even if that source is unknown. The name of your venture capital firm will generally be a trademark.

What makes a name a strong candidate for a trademark?

A word or name will generally fall in one of five categories along a spectrum from weak to strong: generic, descriptive, suggestive, arbitrary and fanciful.

• A generic term is the common or class name. A generic name says “what you are,” but it does not differentiate “who you are” in the context of your business. In the context of venture capital funds, terms like “Investment Fund” would be generic terms that can never be trademarks.
• A descriptive term may describe a quality, characteristic, function, feature, purpose, or use of your business or its services. At the time it is initially used in the marketplace, a descriptive term cannot be protected as a trademark. However, over time a descriptive term can acquire what is called a “secondary meaning” and thereafter can become a trademark that indicates a single source of services. Usually this takes several years of substantially exclusive use of the term. This category of marks includes names comprised of a geographic location term (such as “California” or “Silicon Valley”) plus a generic term (such as “Ventures” or “Fund”). So for example a fund manager’s use of “Silicon Valley Ventures” fits this category. It won’t be initially protected, but it might gain “secondary meaning” with the passage of time and, later, gain the ability to become protected as such.
• A suggestive term does not immediately convey something about you and your services, but it requires imagination, thought or perception to reach a conclusion as to the nature of your business and your services. Suggestive terms are on the “inherently distinctive” side of the spectrum, which means that they can be protected as trademarks from the outset, without the need to acquire distinctiveness or “secondary meaning.” This category of marks would include names like “Future Fund”.
• An arbitrary or fanciful term is generally the strongest candidate for a trademark. An arbitrary term is an existing word that has meaning in general but no meaning in the context of the services or goods then proposed for trademark, while a fanciful term is a coined word with no prior meaning. Like suggestive terms, these can be protected as trademarks from the outset.

Depending on context, a single term can fit in various places along the spectrum. For example, “espresso” would be a generic term for a beverage. “Espresso” would be descriptive for a venture capital fund that focuses on coffee companies. “Espresso” may be suggestive for a venture capital fund that focuses on opportunities in Italy. Finally, “Espresso” may be arbitrary for a venture capital fund name that was picked only because the founders like espresso, where there is no relationship between the fund and espresso.

Is the name available for me to use?

If you have picked a generic name for a fund, it is probably available under trademark law for you to use, but you would not be able to gain exclusive rights in the common term. If you have picked a more distinctive name (descriptive, suggestive, arbitrary, or fanciful), a clearance search can help you assess whether the term is available. While you can do some preliminary searching on your own with an Internet search engine and using the United States Patent and Trademark Office (“USPTO”) website available at http://tmsearch.uspto.gov/, it is a good idea to work with an experienced trademark attorney to conduct the search and interpret the results.

In the U.S., a comprehensive trademark clearance search would investigate not only the USPTO records for similar marks used with related goods/services, but would also investigate the state trademark registries, business name directories, Internet search engines, and potentially other sources as well. It is important to consider unregistered uses in the marketplace, because trademarks rights in the U.S. can begin to accrue when a trademark is first used, even if the trademark is not registered. In trademark infringement cases, courts will look for which party has priority in trademark rights and then apply the subjective “likelihood of confusion” test. A similar “likelihood of confusion” test is applied by the USPTO in determining whether to grant a trademark registration and assessing whether two trademarks are conflicting. Keeping this “likelihood of confusion” test in mind, an experienced trademark attorney would look for confusingly similar marks (not just identical marks), as well as goods/services that are related such that the relevant public might expect them to emanate from the same source as your services (even though those goods/services may not specifically entail a venture capital fund).

Should I try to register the name as a trademark?

Registering a name as a trademark is not compulsory, but registration comes with many benefits. A federal trademark registration is evidence of your nationwide and exclusive right to use the name as a trademark in the context of your services. A registration may block later-filed applications to register confusingly similar trademarks. A registration allows you to use the ® symbol, and it may deter others from adopting similar names. The registration will generally have a priority date (seniority date) set by the application filing date, so there is a benefit to starting the process early. A federal trademark registration can be very helpful in your ability to stop others from using and registering similar names as trademarks, and it may be helpful in your defense against claims of infringement and related demands that you change your name.

What entity will own the trademark?

Because a trademark indicates a particular source of goods or services, a single entity will generally own and control all related trademarks. For example, your venture capital firm may own all of the trademarks associated with the venture capital firm name and all of the names of venture capital funds that the firm operates, even though those funds are distinct legal entities. But there are alternative ways to structure trademark ownership, in particular where there is a “unity of control” among various legal entities. There are additional legal considerations to take into account when deciding which entity will be the owner of trademarks and which entity will use a name under a trademark license from the owner, so it is best to discuss these aspects of trademark strategy with experienced legal counsel.

I’ve registered my name as a trademark, now what?

Obtaining a registration for a trademark does not mean that trademarks are “checked off” the list never to be considered again. At a minimum, there will be maintenance and renewal filings required in order to keep your registration alive. In the U.S., a filing is due between the 5th and 6th anniversary of registration, and again between the 9th and 10th anniversary of registration, and every 10 years thereafter. These maintenance filings generally require payment of a fee and submission of proof that the trademark is still in use in commerce by the owner for the specified services. It is also a good practice to subscribe to a “watching service” to be alerted to third party trademark filings for the same or similar trademarks, because, if you permit others to use and register similar trademarks, you may make it more difficult to enforce your trademark rights in the future, or even lose your trademark rights altogether. Finally, if there are licensees that use the trademark with permission from the owner, there is a duty of the owner to exercise ongoing “quality control” over the use of the mark by the licensee.

What about international expansion?

Trademark rights are territorial in nature. Generally, the trademark clearance and registration process in other countries is analogous to the process in the U.S., but there are some significant differences in local trademark laws. Notably, unlike in the U.S. where trademark rights are generally recognized on a “first-to-use” basis, many other countries have a “first-to-file” system. An experienced trademark lawyer can help you coordinate an international strategy in the event your fund has international activity.

Conclusion

Even though fund names may not warrant the same level of investment in trademark clearance and protection as “consumer-facing” trademarks, fund names still raise some important trademark considerations. If it would be disruptive to be forced to change the name of your fund, or to be limited in the manner in which you can expand use of your fund name, or to have to tolerate coexistence with others using confusingly similar names for their own related goods or services, then you should consider proactively working with experienced trademark counsel to navigate these issues.

In short, it is generally not practicable or possible for a typical venture capital fund manager to manage and operate an ERISA “plan assets” fund. Luckily, the path to avoiding holding ERISA plan assets is generally pretty clear and potentially self-executing for many venture capital funds. There are two primary ways venture capital funds generally avoid holding “plan assets”: (1) by ensuring that less than 25% of the fund’s commitments are held by “benefit plan investors”(the so called “25% test,” see below for how this is calculated) or (2) by operating as a “venture capital operating company” (VCOC, for short, also described below).

For purposes of the 25% test, three primary categories of prospective LPs will be “benefit plan investors” included in the numerator: (1) private U.S. pension funds (i.e., IBM’s retirement fund for its U.S. employees), (2) LPs investing through IRAs and other similar personal retirement vehicles, and (3) funds of funds which themselves have over 25% of their assets held by “benefit plan investors.” Amounts invested by LPs in categories (1) and (2) will count 100% towards the 25% test, whereas amounts invested by LPs in category (3) will only be counted on a look-through basis. For example, assume a venture capital fund has $100 million in aggregate capital commitments, IBM’s U.S. retirement fund subscribes for $10 million and a fund of funds which itself is 30% ERISA capital subscribes for $5 million. In this event, the aggregate investment by benefit plan investors will equal the full amount of IBM’s U.S. retirement fund’s $10 million commitment plus 30% of the fund of fund’s $5 million capital commitment ($1.5 million), or $11.5 million. Participation in this $100 million fund by benefit plan investors will be 11.5%, and the fund will satisfy the 25% test. Note that if the aforementioned fund of funds itself had 20% ERISA capital, it would not identify as or be treated as a benefit plan investor subject to ERISA and would not be counted at toward the 25% test at all. It is also important to note that for purposes of this 25% test, capital committed by the fund’s sponsor or its affiliates will be disregarded (from the numerator and denominator), unless such commitment is made by an affiliated benefit plan investor (such as the sponsor’s retirement plan). Finally, while this is not ordinary for most VC funds, if there are different classes of interests, this 25% test will be applied on a class by class basis and the fund will be deemed to hold plan assets if any one class of equity interest of the fund exceeds this 25% limit.

There are two types of non-ERISA investors that, while not actually counted towards the 25% test may still cause ERISA-related concern for fund managers: first, non-U.S. pension plans (i.e., Siemens retirement fund for its German employees) and second, U.S. governmental or public pension plans (i.e., CalPERS for California public employees). While not technically included in the 25% test, these investors may however, seek similar protections and covenants as ERISA investors that are so included.

In our experience, a majority of funds will be able to meet the 25% test and avoid holding plan assets in this manner. However, if your fund exceeds this 25% limit, then you will need to structure your fund in order to qualify and operate as a VCOC. You may also want to qualify as a VCOC if benefit plan investor commitments are close to the 25% limit, if you desire to preserve flexibility to accept additional ERISA commitments in subsequent closings and/or accommodate transfers to U.S. pension plans later in your fund’s life, or if you are contractually obligated to do so pursuant to an agreement with an ERISA investor.

In order to qualify as a VCOC, on each measurement date, more than 50% of the fund’s assets, valued at cost, must be invested in “operating companies” and the fund must hold “management rights” with respect to such operating companies, and actually exercise such management rights in the ordinary course of business. This 50% of assets test is measured initially on the date of the fund’s first long term investment and then annually during a fixed 90-day period, typically commencing on each anniversary of the first investment. If the fund does not qualify as a VCOC on such first investment date, the fund cannot later obtain VCOC status.

For VCOC purposes, an “operating company” is an entity that is engaged in the production or sale of a product or service, other than investment of capital – a requirement should easily be satisfied by most fund portfolio company investments. To have “management rights” the fund must have a direct contractual right to participate in or substantially influence the company’s management. A typical way to satisfy this requirement is secure the right to appoint a member of the company’s board of directors. however, it is also possible to satisfy this requirement holding lesser management rights, such as a board observer right, consultation, inspection and informational rights, rights to talk to management, etc. These lesser rights are sometimes encapsulated in a “management rights letter” and many fund managers as a matter of practice ask to obtain such a letter in the course of every investment (whether or not they intend to comply as a VCOC). Fund sponsors may in fact find that the board seat or lesser management rights are an attractive thing to gain and dovetail with their investment strategy and can leverage their fund’s ERISA compliance obligations to ask for such item(s). Obtaining a NVCA-type management rights letter has become standard operating procedure for venture investments.

Some ERISA investors may ask for a legal opinion from fund counsel to the effect that the fund qualifies as a VCOC as of the fund’s first investment, and the ERISA investor will not be required to fund their capital commitment until this opinion is delivered. In order to support a legal opinion, you will want the strongest suite of management rights possible for your first portfolio company investment, which under DOL guidance involves the right of the fund to appoint at least one member of the company’s board of directors.

As noted above, many venture capital funds will easily satisfy the 25% test or be able to qualify as a VCOC in the ordinary course of the fund’s business and should therefore be able to avoid holding “plan assets.” However, it is important to be aware of your LP base and invest in an approach and plan for ERISA compliance at the outset. Managing ERISA compliance upfront can be straightforward and painless, but, if caught off guard, retroactive compliance or correction can be arduous if possible at all.

In order to navigate these potentially choppy waters, a firm should prepare well in advance for – or at least educate itself as to – the various issues and considerations than can arise in such a situation. This education and preparation process should begin at the inception of the firm, with thoughtful consideration of the terms of the governing agreements of the management company and first general partner (GP) entity, which will become a critical base of support for the firm’s long term health. The analysis should not stop there, however, as a firm should re-visit these issues throughout its life based on the particular circumstances it faces and experiences it may have. The approach here must be dynamic and flexible, as if you simply analyzed and drafted a form of these agreements 20 years ago and continue to simply “clone” them over time, you may be missing out on capturing more recent market practices which can serve to better protect the organization in the face of MD departures. Our most mindful clients regularly engage with us to strive to have the most company favorable terms in their documents, with a view of organizational health and stability.

While each MD departure situation has its own unique attributes, when counseling clients in these circumstances we generally cover the same basic list of issues and considerations as a starting point for helping our clients find the best way forward. Most often, the resolution of these issues between the firm and the departing MD is encapsulated in some form of separation and transition agreement that is drafted by us, as fund counsel, in conjunction with our employment lawyers to assist with the employment-related considerations. What goes into such an agreement and what are those core issues that a firm can expect to deal with an manage around when an MD departs? Let’s tackle them in turn.

What do existing governing agreements provide?

The starting place for analysis in the face of an MD departure is to look at the “upper tier” organizational documents referenced above. As stated, these set up the basic set of ground rules for the departure. These agreements may differentiate treatment of a departing MD based on whether the MD is departing voluntarily or involuntarily, and in the latter scenario whether such departure is “for cause” or “not for cause.” The governing agreement for management company entity, if drafted with a company viewpoint in mind, is likely to have a “buy back” provision where the management company can repurchase a departing MD’s interest therein for some price (e.g, the relative capital account balance of the departing MD as of the departure date), though in some cases there may be more complex pre-negotiated severance terms in the agreement that have to be considered and complied with.

For GP entities, the underlying agreements very likely will have: (1) a set of vesting rules in place that apply to the departing MD’s carried interest therein; (2) rules about the MD’s capital commitment to the GP entity on a going forward basis, which may call for full contribution or may scale back the commitment to allow others to take up the corresponding investment; and (3) many other smaller rules, for example regarding potential future dilution for admission of additional members, ongoing obligations, etc. Importantly, some agreements that are very company favorable may have complete buyout provisions at the GP level (including of all vested components, like vested carry) to permit the GP entity to “entirely rid itself” of a difficult departee, such as one that leaves amidst a lawsuit or goes to work at a competitor. In the case of both management company and GP entities, the departing MD also almost invariably loses his or her future right to vote and any other management authority with respect to matters related to these entities.

Timing of departure

While most often not an agreement driven issue, from an organizational perspective the timing of when an MD departs can be crucially important and should be carefully planned in advance, if possible. For instance, the timing of when an MD departs can potentially disrupt fund raising, raise securities laws issues (e.g., if the departure occurs soon after a fund has closed and the firm knew of the departure before the closing happened), implicate key person clauses in underlying fund partnership agreements (see more on this below), give rise to potential tax implications to a departing MD and the firm, and so forth.

In addition, if the departing MD is going to stay on as a consultant or serve in a lesser role than the historical one, thought needs to be given to the time periods for this type of multi-step transition and what it may mean for other issues, such as vesting.

Circumstances do sometimes mitigate that someone be immediately removed from employment with the firm (e.g., the departing GP has died, committed a crime or engaged in other salacious behavior), and in these cases timing is a triage matter as opposed to part of a dutifully considered transition plan. In any event, as you can see, the timing of when an MD departs can in certain circumstances be almost as important as the terms negotiated around such departure.

Compensation and equity interests

Depending on the circumstances and negotiated terms, the departing MD may receive severance payments or some form of transition period compensation if his or her level of engagement with the firm is scheduled to sunset over a negotiated time. As mentioned above, in a minority of cases the management company governing agreement may have pre-negotiated severance terms that must be complied with as well. A benefit of a firm paying additional compensation (i.e., compensation the departing MD is not already entitled to) is the firm’s ability to demand a release of claims in connection with the granting of such additional compensation. In addition to the separation agreement setting forth any residual equity and similar interests that the departing MD will obtain in the relevant upper tier entities (as mentioned above), it will also cover treatment of any parallel or side fund interests retained by the departing MD.

Messaging of departure

One of the most fundamentally important items to fully set forth with any departing MD is how, when and to whom either the firm or its personnel on the one hand and the departing MD on the other will communicate with the outside world regarding the MD’s departure. Most often, a full set of negotiated talking points are mutually drafted and a communications plan is put in place fully setting forth the details applicable to all parties about what they can and can’t say, to whom and when. The separation agreement will also often have a specific requirement for this communications plan and attach the talking points as an exhibit so all sides are on the same page regarding proper communications regarding the MD’s departure. This kind of concerted effort ultimately benefits everyone and provides a good playbook to follow.

Track record

The firm owns its track record but departing MDs will often seek to negotiate under what circumstances they will be allowed to use certain data for their future activities, particularly data surrounding the deals they have led or been involved in. Often the management company and GP entity governing agreements, if drafted properly, will have provision regarding ownership of track record and permit a departing MD to disclose a limited set of information in the future (and under what circumstances such disclosures may be made; for example, perhaps with advance consent as to form of disclosure by the fund manager). In absence of any such provisions, the negotiations on this issue can get a bit more muddied and contentious, but firms should be aware that this will likely be one of the key points up for negotiation in relation to an MD departure.

Releases

One of the most impactful legal provisions that a firm should be obtaining from a departing MD is a full release of claims against the firm, its personnel and affiliates. This is even more true in a contentious departure. Often the departing MD will ask for this to be a mutual release, which may or may not cause the firm heartburn depending on the circumstances surrounding the departure. The release question is a big one and should be fully considered with the input of counsel given the potential ramifications involved.

Key person test

Any potential or actual departure of an MD should cause the firm to look carefully at all applicable key person provisions in their fund partnership agreements. Triggering a key person provision can lead to whole host of consequences for the fund manager, from automatic suspension of a fund’s investment period to potential rights of the LPs to vote to terminate the fund (and other possibilities in between). Accordingly, as the timing of the departure is considered, the effect on the key person provisions should be considered and planned for carefully as well, to the extent feasible.

Other negotiated topics

Other considerations and issues that are often dealt with by firms facing a GP departure, typically housed in the separation agreement, are as follows:

• Continuation of health, dental and vision benefits
• Continuation of 401(k) and other similar retirement benefits
• Expense reimbursement
• Return of company property
• Continued use of office & secretarial support
• Confidentiality
• Future cooperation
• Non-disparagement
• Non-solicitation (of employees and investors)
• Arbitration

Final thoughts and takeaways

Having counseled over the years on hundreds, if not thousands, of MD departures, a fundamentally important observation we have about firms that have successfully navigated their way through these circumstances is that those firms that were well prepared in advance on the issues noted above were the ones that ultimately had the more satisfactory outcomes. While often times an MD departure will wind up in a big negotiation where there will be give and take on all sides, the successful firms know in advance where they have leverage (e.g., through the provisions in the management company and GP entity governing agreements, which hopefully are well set up with a company favorable view) and where they don’t (e.g., they may need a departing MD to stay on board for a certain amount of time and/or continue to fulfill certain duties). They also know how best to counterbalance those considerations and be amenable to going “off script” to achieve a good outcome. As the saying goes, one who fails to prepare has ultimately prepared to fail and we’ve seen that time and again in these MD departure scenarios.

One last note in relation to planning and MD departures is a word to the wise regarding generational planning at the upper tier level. Too many firms have either unartfully implemented or wholly ignored any plans regarding how best to introduce the next generation of great MDs within their own ranks. We have found that one of the most opportune times for firms to be thinking about potential promotion or managerial additions is often when an existing MD is leaving the firm. Economics may then already be shifting, voting concentration is being adjusted and team dynamics are changing. Accordingly, these are often the best of times to execute on generational planning matters, which our best managed clients are continually focused on.

Here is a quick rundown of why these issues matter:

Advisers Act Exemption. Most of our VC fund clients rely on an exemption under the Investment Advisers Act – known helpfully as the “venture capital fund exemption” – that essentially requires that at least 80% of capital be invested in primary transactions in qualifying portfolio company issuers. Hence, an important principle to staying inbounds in regard to this exemption is not to rely upon a warehousing solution that requires sale by some interim holder that would result in the transfer to the fund, once formed, to be a “secondary” transaction, as that would not count on the “good side” of the 80% rule. Recognizing that warehousing investments is an important tool for venture capital funds, the SEC in its December 2013 guidance stated that a warehoused investment would be deemed an investment directly acquired from the issuer if (i) the warehoused investment is initially acquired by the adviser (or a person wholly owned and controlled by the adviser) directly from a qualifying portfolio company solely for the purpose of acquiring the investment for a prospective venture capital fund that is actively fundraising; and (ii) the terms of the warehoused investment are fully disclosed to each investor in the venture capital fund prior to each investor committing to invest in the fund.

Secondly, there are also limitations on long term borrowing as part of these rules. The borrowing limit is 120 days, so even if your bank (or a third party) are willing to lend to facilitate the warehousing (perhaps by forming the fund early and borrowing to close the transaction), one has to be sure to repay the borrowing in time and this can sometimes be problematic if the fund formation transaction unexpectedly is delayed.

VCOC Status. If you will have limited partners in your fund that are subject to ERISA, you may need to establish and maintain Venture Capital Operating Company status. The first long term investment by a fund is a mandatory measurement point in the VCOC analysis. So whatever warehousing path you choose, you can’t forget to secure necessary management rights (e.g., a management rights letter) in the investment. A secondary sale to the fund as part of the warehousing process is not a problem per se, so long as the appropriate management rights are established directly with the fund (not just the interim warehousing entity).

Source of Capital. While “finding the money” to close the transaction is obviously more of a business point than a legal one, we would point out that the instinct to borrow the capital should be thoughtfully managed, as in addition to the 120 day limit mentioned above in regard to the VC Fund Exemption, you must also be mindful not to create a circumstance where a tax exempt LP in the fund would have “unrelated business taxable income” upon the disposition of the warehoused securities. So if the plan would be to form the fund with a strawman LP and to borrow the capital needed for the deal, UBTI is an issue that you must keep in mind – if the securities purchased are sold within one year of repayment of the borrowing, UBTI will be incurred by the fund and your tax exempt investor will be cross with the sponsor as it will likely have to pay corporate tax on such income. Finding an anchor (or simply friendly) LP willing to close on a fast track and fund a capital call on an expedited basis takes out the issues associated with borrowing – simple, but effective. We have also seen borrowing from the general partner or the management company used in various ways, but our take away was that such solutions were often administratively messy and potentially more expensive to execute with confidence.

Transfer Mechanics. Lots of warehousing solutions have some entity or person other than the new fund act as the purchaser of the shares, with intention to transfer the securities when the fund has its initial closing. In addition to the other issues that may present (above), don’t forget to account for the fact that such transfer will need to be processed by the portfolio company. Hot deals that you had to fight to get access to are not always situations where it is ideal to go back to the issuer asking for a small favor. And VC funds also need be mindful of ROFRs or other similar limitations on transfer that might lurk in the portfolio company securities purchase documents. Solutions that involve forming the fund entity “early” as discussed above are superior in this area, as title to shares need not transfer as the fund admits the full body of long term LP investors.

LP Agreement Compliance. Whatever solution is pursued, we recommend that the LPA clearly outline the terms of the warehouse investment program, including a schedule of warehouse investments, transfer price for the investments (usually at cost plus transaction fees), and timing for making the transfers (usually recommend within 60-90 days following the final closing to provide some flexibility).

Next, we recommend that when using an affiliate to warehouse the securities, you should avoid a contribution in-kind of the warehoused securities, but rather process the ultimate transfer to the fund as a purchase at cost. Some GPs will ask if they can just contribute the warehoused securities in-kind but this can complicate the fund’s accounting, cause issues if transferring at FMV (rather than cost) and is not expressly provided under the SEC guidance for warehousing (SEC guidance speaks to the transfer of the warehoused interests rather than contributions).

Finally, if the fund wishing to acquire the securities in question has a prior fund, careful thought should be given to investment allocation principles set forth in the LPAs. The agreements of both the prior fund and the current fund may speak to the obligation of the sponsor to present opportunities, and the warehouse transaction might violate such principles of one fund or the other, particularly if the prior fund is not quite finished making new first time investments or if the sponsor has in mind to split the investment between two generations of funds.

Quite often, we hear the following thought: “Placement agents are expensive, and so if I can raise my fund without one, I’ll be better off.” If one has to make a very broad generalization this typically is the first thought on this question that most managers have, but it suffers from some flaws in our experience, mainly because it fails to consider some cases where managers might, in fact, truly benefit from using a placement agent. To point out a few shortcomings, consider the following situations, all of which we have seen on occasion: (1) a fund manager that misjudges the level of interest in its product; (2) a fund manager that might, in fact, get to the hard cap on its fund size, but not with the best long-term group of investors likely to support later vintages of their funds and supply the best credibility or advice to the manager; and (3) a fund manager that might, in fact, get to the hard cap on its fund size, but only by way of soft demand, a lengthy fund raising period, and the attendant lack of good terms and dilution of time to do things outside of fund raising that accompanies that situation.

So, a holistic analysis of the many factors that face your organization is in our experience a healthy starting point. How am I positioned now? Do I need to change that positioning? What skills do I really have internally? How much time can I really spare for fund raising? Are there any challenges my firm might have, now or in the near future? Taking introductory meetings with placement agents (pitch book in hand, hopefully) is one of the best ways to actually examine and get feedback about issues like this from a professional outfit knee deep in these issues with their clients every day. Further, having these meetings, regardless of whether you decide to engage the particular agent, is a very valuable exercise in terms of testing your underlying pitch and thesis for the fund and getting tremendous feedback from the placement agents regarding the same. Come prepared to these meetings not just to run your pitch, but to ask specific questions about the advice the agent would give, and the strategies they would recommend for use, to address any specific factors about your fund raising situation that you have been able to identify – whether from the list above or otherwise.

Beyond our own experience, in writing this post, I thought it would be meaningful to gather feedback on the issue of placement agent use from some of the veterans we see working regularly in the venture capital fund raising space. (Side note: do make sure before going down the road with a prospective placement agent that they are a registered broker-dealer, in good standing.) The first question posed to them was to explain what they saw as the biggest benefit of using a placement agent. Mac Hofeditz of GCA Advisors noted that while successful businesses mostly have a marketing and sales team in house, most fund managers do not. Hofeditz honed in on the ability of the agent to act as an outsource replacement by turning to an agent to provide counseling in respect of things like “understanding current market conditions, gaining accurate insights into current LP appetite, recent program changes, understanding investor perceptions of a firm/product, and importantly understanding how to best execute a fundraise specific to a fund manager’s set of circumstances (such as LP composition, current performance, team changes, etc.).”

Robin Tyrangiel of Eaton Partners agreed and went a step further in describing the possible help the agent can provide. Tyrangiel explained that “the best placement agents act as true partners to the fund manager. They will work with the fund manager behind the scenes to refine the positioning, messaging and differentiation which goes beyond just brushing up the materials. Sophisticated placement agents act as an extension of a manager’s investor relations team, helping design best practice processes internally, handling deep due diligence questions, and assisting with economic and legal term negotiations. Together these services enable a much more successful and efficient outcome for fund managers.”

I also talked to Paul Denning of Denning and Company, who mentioned that using a placement agent “saves time, allowing the GP to focus more on investing.” He added, “the agent will be marketing the fund to pre-qualified prospects, weeding out those uninterested or unable to perform, which is critical for efficiency and time saving; the road trips will be more efficient and robust as the agent will prepare the GP to be eminently qualified to go on the road, because the pre-marketing and the presentation will be refined before doing so.” Denning mentioned another interesting aspect, noting that historically “the placement agent will be able to garner feedback and handle objections because the LPs will be much more candid about their concerns” than if the only option is to speak directly to the GP.

Another question posed to this group was whether there were, in fact, specific situations where a fund manager might most benefit from using a placement agent. Hofeditz mentioned that “many fund managers mistakenly presume you only use a fund raising advisor for a challenging process. No placement agent can fix a broken product. Unless a firm has a dedicated investor relations function, few fund managers have an accurate and timely insight into current market conditions and investor appetite for its specific product. There are probably 10% of firms who don’t require any fundraising assistance solely because of superior returns. All others actually would benefit from outside expertise – at the right price.”

Tyrangiel mentioned three specific situations that fit well in his experience for using an agent: first, “where a manager is raising their first fund and doesn’t have an existing LP base”; second “where a manager is looking to diversify their LP base by geography or type of LP”; and third, “when firms are going through change – which may be the addition of a new strategy, or succession where the founding partners are handing the reigns to the next generation”. Denning reiterated the importance of leveraging the agent’s expertise where tailoring or expanding the LP base.

A final question was to describe pitfalls that fund managers should avoid during fund raising, from a placement agent’s view. Tyrangiel noted that problems can arise when “established institutions where [current personnel] may not have been directly involved or responsible for fundraising often have an expectation for a fundraise to be quick. They believe that LPs they may know through their network or have reached out to themselves will all commit to their fund because they are giving them positive signals or are willing to meet with them whenever they are in town. Further, oftentimes newer GPs overestimate the differentiation of their own strategy or deal flow and spend too little time requesting input or feedback on how to position and differentiate themselves.” He also noted that “many GPs try to meet as many LPs as possible and get tired out from that type of fundraise, instead of a more targeted raise focused on the most relevant LPs for their type of fund and strategy.”

Denning had three pieces of advice here: first, avoid “going out early and unprepared, [thus] muddying the waters with LPs; then getting resistance and hiring a placement agent – making the task much more difficult”; second, watch out for “using a relatively unknown agent, or an agent that doesn’t understand and respect the GP’s mission for the fund, which is probably worse than not using an agent and going out alone”; and finally, “believing all of those existing LPs are ‘in’ for the next fund, only to find out later they meant the final close” (or as we would add from Cooley’s experience, finding out that they are not in at all).

A couple of different issues were raised by Hofeditz. He noted that fund managers should watch out for a lack of self- awareness, saying specifically that many managers don’t “fully understand the investment landscape from all dimensions – market conditions, firm product/market fit, and investor demand.” He also cited poor relationship management as a common downfall of venture firms as well as “confusing activity for achievement,” for example, “executing an ad-hoc fundraising strategy led by just ‘making calls’ to current and/or prospective investors based upon no other insights other than ‘I heard they invest in funds.’”

I’d have to agree with just about every bit of advice I heard from our placement agent friends. The complexity and variety of their responses speaks to the underlying complexity of figuring out one’s place in the fund raising ecosystem, and crafting a strategy to get from point A to point B in the most efficient, timely manner, keeping cost in mind, and of course, actually getting to point B.

We help our clients a lot with fund raising strategy from our bench as fund lawyers, and we’re always happy to talk about it with our clients. We have seen many of them act on our advice without a placement agent and end up with a sensible mix of long term partners. In other cases, though, factors exist that certainly warrant considering, sometimes strongly, using an agent to achieve the best result. You should give that thought at your next fund raising, and all the ones to follow.

In summary, the article notes that some hedge fund and real estate fund managers are rushing to set up Delaware LLCs to hold their carried interests. These Delaware LLCs would elect to be taxed as “S corporations”; the theory being that the new carried interest legislation does specifically say that the new law does not apply to carried interests held by “corporations” (and therefore the three year holding period would not be required to be met).

While it is technically true that the law mentions “corporations” broadly without distinguishing between “C” corporations (which pay corporate income tax at the entity level at 21% with a second shareholder level tax on dividends) and “S” corporations (which generally pass through their income to their owners so that there is only the shareholder level tax), this idea has been floating around out there since the new law was passed. We have been very skeptical that this would end up being a viable loophole. We have expected that either Congress would pass a “technical correction” which would fix this obvious workaround, or that Treasury and the IRS would issue regulations to do the same thing. The whole situation is an unfortunate byproduct to the legislation being passed with such haste (prior versions of proposals to change the tax treatment of carried interest were much more carefully and thoughtfully drafted).

Well, it turns out that someone in President Trump’s Cabinet is an avid reader of Bloomberg News. In the afternoon after the Bloomberg article was passed, Treasury Secretary Steven Mnuchin announced that indeed this S corporation “dodge” would be shut down and that this gambit would not be available to taxpayers to get around the law. Secretary Mnuchin said:

“We do believe that taxpayers will not be able to get that loophole. We will have that resolved.” He promised the Senate Finance Committee on February 14th that the government would act within two weeks to shut down this potential workaround.

Apparently the Trump Administration is all out of valentines for the private funds industry. Stay tuned to your Cooley team for further developments in the implementation of the new rules on carried interest.

A couple distinctions are important to start with. First, as noted above, this post is tailored to ERAs. RIAs have more robust requirements and need to address additional policy considerations. Second, it’s highly important to make the distinction between, in the first place, policies that are driven due to the nature of the ERA’s involvement in the investment fund business, and in the second place, requirements for employment-related policies. That latter category is broad, and is not the subject of this post. Nevertheless, care should be taken to maintain awareness of the latter. While there are federal law considerations on the employment side (think ADEA and COBRA), mostly the need in this area arises under state law, and thus what is required varies considerably from place to place. In California, for example, employers with 5 or more employees need to have a written anti-harassment policy. A fund manager with employees, like any other business, should take care to consult with legal professionals to ensure compliance with these matters. At Cooley, we have employment lawyers trained specifically to address the special needs to venture capital and other fund managers. So let’s be clear – this post only focuses on half of the consideration you need to make.

With these distinctions in mind, we get back to the question at hand. As related to the fund business, in our view, ERAs need have in place only two written policies as a mandatory legal matter (though as we will address momentarily, even if not strictly required, as a matter of good business, it may be beneficial to have additional voluntary policies set in place). The first requirement is to have an insider trading policy, which is mandated by the SEC for all managers, including ERAs. The scope of the insider trading policy is not defined by statute. The goal however should be to help the firm (and its personnel) avoid violations of applicable law. This policy is inward facing to the firm only and often part of a broader overall policy suite, discussed further below. The second is to establish and promulgate a privacy policy consistent with the Gramm-Leach-Bliley Act. This is a statutory requirement enforced by the FTC. The scope of the policy is spelled out in the GLB Act and related guidance. The privacy policy is outward facing, meaning it is something you communicate with certain investors. It is often found in relevant subscription agreements. (On the topic of privacy, make certain to keep abreast of the GDPR in Europe, discussed in another recent post).

In answering the question of what policies are legally mandated for an ERA venture capital fund manager, that’s the extent of it as we see it (a note for the record: there is a little practitioner disagreement over the legal requirement for a couple of policies we call out below as optional, such as an information security policy; we’ll set this aside for this discussion). Despite the lack of a broad legal requirement, very few venture capital managers we work with stop there. Usually, they inquire about and find value in setting in place a variety of additional policies in what we would frame generally as an “optional policy suite.” The best practice if doing so, for various legal reasons, is to do so in writing and have everyone in the organization sign the policy, and then re-sign it annually.

What might be in such an optional policy suite? There are three underlying categories that drive these options policies in our experience. I’ll call them out, and mention a few examples of each.

First, certain voluntary policies may serve to support compliance with various laws, rules and regulations. Examples would be policies about complying with the Foreign Corrupt Practices Act (FCPA), anti-money laundering and “pay to play” laws. All of these represent legal areas in which an ERA fund manager (or, at least, one subject to U.S. jurisdiction) must ensure compliance, though, a policy per se is not required. Yet, fund managers often find it additive to set out in writing for staff a specific policy which spells out the applicable laws, the procedures to be followed and the “never do this” elements applicable. In other words, while one might not legally be required to have an FCPA policy, if all personnel are in fact required to follow that law, and if the consequences to the organization of not doing so are severe, why not call this out to those personnel by way of a policy that increases their awareness of the issues, and thus may serve to decrease the chance for violating the law?

Second, certain voluntary policies may be promulgated to satisfy investor demands. Examples would be policies about socially responsible investing, as well as anti-harassment policies (which as noted above, may be legally required in some states under local employment laws). In this area, there have been a lot of investor questions and requests during due diligence of late. It can be the case that media attention to a certain subject matter (lately, think anti-harassment) causes a flurry of questions by investors about what funds are doing about the applicable issue. Many venture capital managers we work with find it very helpful to be able to point to a policy on these sorts of issues, as opposed to the alternative which is to say, “we don’t have a policy” and perhaps start to explain that having one isn’t legally mandated in the first place. Policies in this area often represent things that fund managers stand fully behind, anyway, and as such may not be things that cause any heartburn to adopt formally. For example, a social investment policy that lays out formally the fund manager’s opposition to forced child labor may reflect no real change in behavior that would have been supported even without the policy in place.

Third, certain policies may serve to assist the fund manager with compliance with fund level covenants or to protect the organization generally. Examples would be policies about trading in fund opportunities or in actual portfolio companies (both of which are frequently regulated in fund agreements), non-disparagement, or proprietary information (these latter two generally protecting the organization from improper behavior).

While the actual policies vary case-by-case given a variety of factors, the take-away here is that most ERA regulated venture capital managers we work with go far above and beyond the level of legal requirement in this area. The general recommendation we have is to discuss a policy suite with us and let us guide you through the considerations needed to come to a determination about enacting some slate of voluntary policies. Most fund managers we work with that do so seem to be better positioned to adhere to law, respond to due diligence from investors and in general create a culture of compliance.

The PPM is a disclosure document regarding the private offering of securities (namely, limited partnership or limited liability company interests) by fund managers and is meant to provide investors with a wide array of information about the fund, the fund manager and its organization to allow those investors to make an informed decision about investing in the fund. At the same time, through those same disclosures, the PPM provides the fund manager a degree of protection against later claims by the fund’s investors and others regarding misstatements and/or omissions of information by the fund managers during the fundraising period. In addition to these benefits, from a marketing perspective, producing a PPM provides a fund manager with a perfect opportunity to fully and thoughtfully tell the business story as to why this fund offering is unique, high quality and offers prospective investors the opportunity for positive investment returns. Moreover, some investors, particularly institutional investors, might in some cases require the production of a PPM before they will either take a meeting with a fund manager or move further down their investment process with that fund manager. In those investors’ view, a PPM “professionalizes” the marketing of the fund and the story behind it in a way that just an executive summary and/or slide deck can’t. Funds working with placement agents may be encouraged, sometimes strongly, by the agent to produce a PPM in order to improve the “best of breed” appearance of the fundraising effort. Finally, it is often the case that for those firms that have historically drafted and used a PPM in their prior fundraising efforts, investor expectations are such that the PPM will be expected to be produced as a matter of precedent and it would look too unusual and require too much explanation not to draft the PPM again (though of late, a number of very reputable firms raising sometimes very large funds have proceeded without a PPM, in the interest of time or otherwise, so the ice may be melting on this point).

On the flip side, some fund managers are looking to streamline the fundraising process as much as possible. Because preparing a PPM is not a legal requirement or condition, strictly, of having a legally compliant private offering of fund interests, a number of fund managers choose not to produce one, instead relying on other marketing materials and their meetings with investors to convey the information they wish to disclose to them. The PPM drafting process does take considerable time on the part of the fund manager, who is really the only party that has the ability to draft the business case. They are passionate about it, and understand it fully. It’s not a component that can be very successfully outsourced, though there are some marketing providers who provide ghost writing type services or sometimes even more robust services involving conceptualizing and framing the overall business presentation. The PPM also requires the review of fund counsel to fully and properly set forth the legal considerations and risk factors involved with the fund offering and vet through the business story for any potential legal missteps by clients in their wording. In addition, the PPM will require updating of information constantly over a long fundraising period (e.g., portfolio performance information, changes in fund terms, possible legal or tax changes during that time, etc.), and thus, more time required to be spent on the PPM by the fund manager beyond just the initial drafting. By making the decision to not draft a PPM, a fund manager can save a lot of time and money, but at what cost?

We have seen fund managers of all shapes and sizes make all types of decisions on this issue based on the factors noted above and sometimes others. Some feel that producing a high quality PPM and its attendant benefits of greater risk minimization, an additional opportunity to fully tell the business story behind the firm and the fund and the potential for greater receptivity by institutional investors outweigh the time and cost saved by not drafting one. A competing view that we see quite often, particularly of late given the busy enviornment and haste of many offerings, is that drafting the PPM is a time consuming, costly and unnecessary extra step for the fund manager in an already tough fundraising environment. In some cases, the envisioned LP base may be viewed as not really interested or in possession of sufficient time to process such a long document – i.e., perhaps they prefer a slide deck in some cases.

The right decision for a firm depends entirely on their respective approach to these issues, taking into careful account the size and nature of fund, the LP base, and so forth. No matter the approach, many issues are involved in making this decision and having an experienced fund counsel like Cooley can greatly help you scope out the various considerations to be thinking about regarding this decision.

These are good questions, in an emerging and unsettled area mostly without clear “black and white” legal guidance. The lines of inquiry and attendant responses can be categorized depending on the nature of the activity being asked about. The easiest question to answer relates to investments in virtual currency or blockchain servicing companies, where there is no actual trading of virtual currencies by the fund and the securities being acquired are of the traditional nature (i.e., not token based). While this sector is certainly subject to risk of wild valuation swings, especially given the new and unsettled nature of cryptocurrencies themselves, making this sort of investment would not seem to be especially problematic legally as long as the general mandate of the fund in question would support it. If that was not the case, say in the case of a fund held out as a health care fund now dabbling in these sorts of investments, you’d have the typical misrepresentation concerns, but those concerns wouldn’t be related to the nature of the chosen investments, but only to the fact that they were outside the promised hunting license of the underlying fund.

That leaves the two more difficult questions I am getting: can the fund invest by way of token offerings, and can the fund invest directly in cryptocurrency. These questions bring up a myriad of issues to consider, with the analysis in some cases being similar as between token investments and direct cryptocurrency investments, and in some cases distinct. A few of the more important issues to think about follow.

First, does the LPA permit this and/or would it be inconsistent with the way the fund was marketed? Most LPAs I work with are very broad in defining the types of investments venture funds can make, but those definitions, while broad, usually revolve around some view that the fund will be acquiring “securities”. That is often lowercase, and may or may not be best read to correlate to, say, the SEC’s view of what constitutes securities (though, that would seem to be at least instructive in the analysis as to issues in the United States). A typical clause might say the fund can trade in “securities of every kind and nature and rights and options with respect thereto, including stock, notes, bonds, debentures, partnership interests, interests in limited liability companies and evidence of indebtedness”.

If tokens and/or cryptocurrencies are securities, this would seem to be well covered by that language. But this issue is somewhat unsettled right now, at least as related to the strict legal definition. So, I have seen managers starting new funds endeavor to be more specific, and for existing funds, managers have to debate whether they should seek an amendment to clarify the investment mandate. A typical addition to the above might expand the definition of permissible investments to include “investments in cryptocurrencies, decentralized application tokens and protocol tokens, blockchain-based assets and other cryptofinance and digital assets, or instruments for the purchase of such, whether issued in a private or public transaction”. Outside of the contracts, from a marketing standpoint, query whether these investments would in any way be inconsistent with the described offering, and going forward if these investments are contemplated, the term sheets and other offering descriptions that may go into say a PPM should be fulsome in describing the potential activity. Common general risk factors (for example addressing the potential for total loss of principal) may be satisfactory for near-term limited token or cryptocurrency investing activity, but going forward consider well tailored, specific risk factors to this sort of undertaking.

Second, the question of legality arises. China, South Korea and Switzerland have already expressly outlawed token offerings and in some cases, activities related to cryptocurrencies like exchanges and mining operations. Other countries seem actively more amenable to these new concepts, and in yet other countries, particularly the United States, the verdict is still mostly out. Care should be taken to limit activities to places where, at least as of the time of investment, the consummation of the token or cryptocurrency acquisition is lawful (with an attendant plan to react quickly in some manner if there is any change in law, being prepared even for nullification of prior transactions).

Next in line to consider are related legal and tax issues, and there are several of them. For starters, most venture capital funds rely on the “venture capital exemption” from investment adviser registration which allows for only 20% of capital to be in non-qualifying investments. Token investments are very likely to fail, and direct cryptocurrency investments certainly do fail, the test to be qualifying investments, and all of the above should best be thought of as non-qualifying, added with other non-qualifying investments, and a determination made as to adherence to the 20% rule, with recognition that exceeding this will trigger a registration requirement if the fund in question is inside the SEC’s jurisdiction. Funds subject to similar regimes in other localities should consider local laws (in particular Cayman Islands based funds, even where subject to SEC oversight, should be mindful of CIMA registration requirements which might be triggered in certain cases).

The list of related legal and tax issues grows longer when considering direct cryptocurrency investing. Much of this is unsettled, but care should be taken to analyze whether this might be commodity trading and thus subject the manager or fund to CFTC oversight; whether there can be negative UBTI and/or ECI implications arising because of regular trading in cryptocurrencies which could lead to a finding of being engaged in a trade or business of doing so; and where applicable to a particular fund, VCOC/ERISA issues (inasmuch as “management rights” are certainly not able to be exercised in respect of cryptocurrencies).

Third and finally, I have been counseling my clients to be extremely mindful of client relations. This is all a risky area where today’s roses may be tomorrow’s ashes. I urge managers I work with to be extremely mindful of this and not just to assume that investors will be thrilled for the fund to be “on the cutting edge” of these sorts of undertakings. With token sales, I worry about reputational issues if investments are made and later invalidated by authorities or courts. With direct cryptocurrency investments, the situation seems worse to me. The theory behind public securities limits in venture funds comes to mind. Investors typically are not thrilled about open market purchases, at least not speculatively where there is no particular inside expertise (i.e., a venture fund investing in IBM is going to be disfavored – why would LPs pay fee and carry on this investment, which they could make themselves – but holding public securities, or even purchasing more, where the fund backed the company in its private days and has a well formulated understanding of the market and the company’s position in it may be viewed as fine). It occurs to me that direct cryptocurrency investing feels much more like pure speculation than some area where the fund can propose that its expertise benefits the LPs so that they get a “better deal” than if they invested directly. I’m urging my clients to be mindful and transparent with investors regarding these issues, so that if things do go sideways, they aren’t out on a limb. Or at least a long one.