On January 14, 2014, the Texas State Securities Board (“the Board”) adopted §139.23, a new registration exemption for investment advisers to private funds. A related amendment to §109.6, concerning investment adviser registration exemption for investment advice to financial institutions and certain institutional investors, was concurrently adopted. Both new §139.23 and the amendment to §109.6 became effective on March 31, 2014.

This Q&A format is designed to address the exemption provided by §139.23 and its interplay with amended §109.6. This discussion cannot address every possible scenario, so readers should consult the Texas Securities Act and Board Rules for additional information. These FAQs are not intended as legal advice. Readers are encouraged to consult an attorney.

The Rules and Regulations of the Board are located at 7 Texas Administrative Code §§101 to 139 and are accessible from this web site. References to Sections refer to Sections of the Texas Securities Act (“the Act”), Tex. Rev. Civ. Stat. Ann., arts. 581-1 to 581-45.

References to the Investment Company Act of 1940 refer to Title 15 of the United States Code, Chapter 2D, §§80a-1 to 80a-64. References to SEC Rules refer to the regulations promulgated by the United States Securities and Exchange Commission (“SEC”) located in Title 17 of the Code of Federal Regulations ("CFR") Chapter II, Part 275. Also available is a currently updated, but unofficial edition of the Electronic Code of Federal Regulations or e-CFR.

How was §109.6 amended?

The exemption was made unavailable to private fund advisers as that term is defined in new §139.23, the exclusion from the exemption in subsection (c) for advisers to “private funds” was removed, and a grandfathering provision for certain investment advisers currently relying on the §109.6 exemption was added as new subsection (e).

What is a “private fund” for purposes of §109.6?

New §139.23 defines “private fund” as an issuer that would be an investment company as defined in the Investment Company Act of 1940, §3, but for an exclusion from the definition of an investment company in §3(c)(1) or §3(c)(7) of that Act, 15 U.S.C. §80a. A private fund adviser may not rely on the amended §109.6 exemption unless covered by the grandfathering provision in new subsection (e).

Under what circumstances may an investment adviser continue to use §109.6?

The grandfathering provision in new subsection (e) allows an investment adviser to a private fund to continue to qualify for the exemption if all of the following circumstances apply:

  1. the private fund existed prior to March 31, 2014;
  2. the investment adviser qualified for the exemption in subsection (b) as modified by subsection (c) as both subsections of this section existed prior to March 31, 2014; and
  3. as of March 31, 2014, the private fund ceases to accept new beneficial owners.

Who will not be considered "new beneficial owners" for purposes of the grandfathering provision in §109.6(e)?

Certain transfers will not be considered a change in beneficial ownership. For example, the following will not be considered “new beneficial owners”:

  1. donees of gifts, where the donor is a natural person. In these cases, the donee must be either (a) a natural person (family member) of the donor, (b) an entity composed only of such family members, i.e., trusts, etc., or (c) an IRC 501(c)(3) charitable organization;
  2. a successor who received the interest due to an involuntary transfer (examples would be legal separation, divorce, death, devise, bankruptcy, or receivership); or
  3. a "knowledgeable employee" of the issuer or adviser who replaces a departing knowledgeable employee.

What is the definition of a “knowledgeable employee“?

On February 6, 2014, the SEC issued a no-action letter (Managed Funds Ass'n) which expanded the scope of who may qualify as a "knowledgeable employee." While maintaining that the knowledgeable employee analysis is always a factual determination made on a case-by-case basis, the letter described individuals in certain factual scenarios performing particular functions and duties and confirmed that they can be considered knowledgeable (as employees who participate in the investment activities of a private fund) if they regularly perform such functions or duties and have been doing so for at least 12 months.

Are there any filing requirements for §109.6?

No, the exemption remains self-executing if the investment adviser can rely on the rule, as amended.

Who qualifies for the new exemption from registration provided by §139.23?

A "private fund adviser," which is defined in subsection (a)(1) as an investment adviser who provides advice either solely to one or more private funds or solely to one or more private funds and certain other clients pursuant to another exemption from investment adviser registration provided under the Act or Board rules.

Subsection (e) of §139.23 extends the exemption to an investment adviser's representatives if they do not engage in outside activities.

If I am a private fund adviser eligible to file as an exempt reporting adviser ("ERA") with the SEC, what filing is required to claim the exemption in §139.23?

An investment adviser eligible to file as an ERA with the SEC must indicate this status by completing Item 2.B of Form ADV, Part 1A, and check the box for Texas on Item 2.C of Form ADV, Part 1A, electronically through the IARD system. This will alert the Board that the investment adviser will be notice filing in Texas per the exemption in §139.23.

If the investment adviser is not (or ceases to be) eligible to file as an ERA with the SEC, must the investment adviser still make the filing for Texas by checking Item 2.C of the Form ADV, Part 1A?

Yes. Private fund advisers with less than $25 million in assets under management will be able to electronically file their Form ADV as exempt reporting advisers in Texas without filing as such with the SEC.

If an investment adviser registers with the SEC by completing Item 2.A of the Form ADV, Part 1A, can it rely on §139.23?

No, an investment adviser already registered, or seeking registration with the SEC will need to make a notice filing in Texas pursuant to §116.1(b)(2)(A) and pay the filing fees for the investment adviser and its investment adviser representatives called for in §116.1(b)(2)(c).

The same is true for an investment adviser who would be eligible for ERA status but who has chosen to register with the SEC.

Are there bad actor disqualifications that prevent a private fund adviser from relying on §139.23?

Yes. Neither a private fund adviser, nor its advisory affiliates as that term is defined in Part 1A of the Form ADV, may rely on the exemption if they are subject to any of the disqualifications in subsection (b)(2). Such disqualifications include, but are not limited to, certain criminal convictions and administrative enforcement orders finding fraud or deceit in connection with the purchase or sale of a security or the rendering of investment advice.

However, subsection (b)(3) automatically waives the disqualifications if the party is licensed or registered to conduct securities or investment advisory business in the state which created the disqualification. It also provides for waiver of the disqualification at the discretion of the Securities Commissioner upon a showing of good cause.

Are there additional requirements in new §139.23?

Yes, subsection (c) imposes additional restrictions on advisers to 3(c)(1) funds. If the 3(c)(1) fund is not a private equity, real estate, or venture capital fund (as those terms are defined in subsection (a)(4)-(6)), the private fund adviser must also comply with the following requirements:

  1. the private fund adviser may advise only those 3(c)(1) funds whose outstanding securities (other than short-term paper) are beneficially owned entirely by persons who would each meet the definition of a qualified client in SEC Rule 205-3 when the securities are purchased from the issuer;
  2. if a qualified client is an entity organized to acquire an interest in the 3(c)(1) fund, all of the beneficial owners of the entity must also be qualified clients (what is known as a “look-through provision”); and
  3. the private fund adviser must, with respect to all the funds it advises, comply with §116.17, relating to custody  of funds or securities of clients by registered investment advisers, as if the private fund adviser was registered.  For more information on the custody rule, see the July 2013 issue of the Texas Regulatory ReviewInsight for Advisers and Brokers.

Is a “qualified client” the same as an accredited investor?

No, “qualified client" is a higher standard than that of accredited investor. It is defined in SEC Rule 205-3, 17 CFR §275.205-3.

Does an investment adviser relying on this exemption need to comply with any other provisions of the Act in conducting its investment advisory business?

Yes, certain civil liability provisions located in Sections 33 and 33-1 of the Act and the penal provisions located in Section 29, including the anti-fraud provisions of Section 29.C, apply even though the investment adviser is operating under an exemption from registration. Violations of Section 29 of the Act are felonies and carry substantial penalties.

The offering of securities is separate from the exemption afforded in §139.23; therefore, "securities", as that term is defined in Section 4.A of the Act, offered and sold by a private fund must be registered pursuant to Section 7 of the Act or qualify for a securities exemption pursuant to Section 5 of the Act.

Are private fund advisers subject to unannounced inspections?

No, but upon written request, an investment adviser relying on the exemption in §139.23 must make available to the Commissioner, or to the Commissioner's authorized representative, all records subject to the custody or control of the investment adviser related to any private fund to which the investment adviser provides investment advice. Failure to comply with such a request will result in the loss of the exemption.

Is there a filing fee for claiming the exemption in §139.23?

No, there is no filing fee.