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Overview of the Investment Company and Investment Advisers Acts

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Overview of the Investment Company and Investment Advisers Acts

Do you have an interest in working with funds and/or investment advisors? Are you vaguely familiar with certain exemptions in the Investment Company Act of 1940 and Investment Advisers Act of 1940, but are unsure of the undertakings necessary when there is not an exemption?  This course will lay the foundation for both of the 1940 Acts, and will outline the components of each, including all of the exemptions (not just Section 3(c)(1) and Section 3(c)(7)).

Transcript

Hi, my name is Gary Ross and I'm here to talk to you today about the Investment Company Act of 1940 and the Investment Advisers Act of 1940. I'd like to thank Quimbee for putting putting this program together. I've always enjoyed doing things with them. First, I'm going to give a brief introduction about these these acts. They're not the most famous securities acts, but they are they are relevant for a lot of a lot of securities attorneys. And it's good to be it's good to be familiar with these with these two acts. And I'm going to say a little bit about why that is. First, we're going to start with the Investment Company Act of 1940, which is the the longer, more encompassing one and then the investment. And then we're going to move to the Investment Advisers Act of 1940. And along with the Investment Advisers Act of 1940, is the concept of exempt reporting advisors, which we'll cover at the end. I was been a capital markets attorney for many years as a securities attorney, and when I was a capital markets attorney, I knew the Securities Act of 1933 and the Securities Exchange Act of 1934 just in and out, had dreams about it. But I really didn't know anything about 1940 act. I wasn't even it wasn't 100% certain. I'm not even sure that I knew there were two of those. So Investment Company, Act and Investment Advisers Act. A lot of times, even if you took securities regulation and law school, maybe spent half a day on both of these. So it's not something that's kind of front and center a lot. It's not really part of a lot of, you know, alerts or anything like that. So today we're going to try to kind of increase knowledge about it. And we'll just we'll just discuss both of them. There are several examples of when a securities attorney should really know about the Investment Company Act and Investment Advisers Act. One of those is when representing a company that's offering securities. And you're expected to give an opinion that the company is not an investment company. So that comes up frequently. A lot of times underwriters counsel or the investors or whatnot, they're going to want assurance that it's not a that the issuer is not an investment company. And I'll talk a little bit about why that is here in a few minutes. Also, obviously, if you're representing a mutual fund or a closed end fund, private equity or hedge fund, any kind of fun you should be familiar with with both of these. And then when representing an advisor or an investor in any of those funds, it's good to be familiar with these with these two acts. The Investment Company Act of 1940. These were both enacted on the same day. The Investment Company Act and the Investment Advisers Act. This is often called the Company Act. So I have prepared or negotiated agreements where we we had some cross border aspect and we had attorneys and they had their own company act and we had our company company act and we were kind of fighting over what what to use or define for a defined term of it. But a lot of us call it the company Act in the Great Depression. So obviously there was a lot of speculation and whatnot, which in the Great Depression and all this kind of a lot of fraud happening and had an opaque system for the most part. You didn't have all these disclosure rules like you do, like you do now. And as a result of that, Congress passed Securities Act of 1933 and Securities Exchange Act of 1934. And just during the heyday of a lot of people were marketing these fund vehicles. And there was a lot of it was these funds were opaque. It was hard to hard to really tell what was in them. And the issue that was happening was these sponsors were going around and and, you know, selling shares of the funds to investors, and then they'd amass a large amount of money and they were kind of treating it like their personal piggy bank. They didn't have a lot of equity put in it. You know, they had it put a lot of money in there. Instead, they had amassed this large, large amount of money and they were just kind of investing in speculative investments and the like, knowing that they would get part of the return if there was a return, and if there wasn't a return, it was okay because they won their money. And then and also sometimes whoever had raised the fund, if they had some bad investments on the side, they would cash out of those investments. They would transfer those personal investments in the fund and get whatever they had paid for it, even though it had lost value. So there was a lot of kind of shenanigans going around. So Congress felt, hey, we really need to address this. It just took a while for them to get to this. So 1940 acts, both of them is still kind of the same genesis as the same as 33 act and 34 act. It was really kind of the the heyday of late 1920s and then, of course, the crash in 19 1929. The company act. We also have here that it's defines responsibilities and limitations of mutual funds, unit investment trusts and closing funds. And it's not just disclosure, it's it also has some governance requirements and the like, which we'll we'll chat about. First, let's talk about what is an investment company. An investment company is a company that holds itself out as being primarily engaged or proposes to primarily engage in the business of investing, reinvesting or trading in securities. This B here is rare these days. I'll go ahead and read it, but you don't really need to commit this one to memory is engage or proposes to engage in business issuing face amount securities of installment type or has been engaged in such business and yada yada. We don't really come across that. And then but C is equally as important as A is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities and owns or proposes to acquire investment securities having a value exceeding 40% of the issuer's total assets. Now you might ask what is an investment security? I'm glad you asked that because here is investment security. So it is a broad, broad concept. It includes notes, stocks, treasury stocks, securities, bonds, debentures, really any type of indebtedness, any type of put call option, any instrument known as a security. You're in a rough spot if you're trying to argue that something is not a security. When I first started giving this, it was I would just say, yes, any kind of security, I would move on. And then we had the whole cryptocurrency thing a few years ago where people were questioning, Hey, is this a security or not this, this thing? And that's can still be relevant. But by and large, you're in kind of a rough position if you're trying to argue that something is not a security. So if you're trying to say that something is not a security, my advice to clients who want to maintain that is always, well, follow these rules anyway. Just just to be just so you're on the safe side. It does not include government securities or securities issued by employees, securities companies or securities issued by majority owned subs of the owner, which are not investment companies or are not relying on the exception from the definition of investment company under 3C1 and 3C7, which we'll talk about here in a bit. And the reason is if you have a if a company has a subsidiary that's over half owned, it's really part of the business. It's not really like an investment, not like a passive investment where you just have a small portion. It's really part of the overall business structure of it's majority owned. So the 40 this 40% test is key for the Investment Company Act. A company is going to be deemed to be an investment company. If 40% or more of its total assets, excluding excluding government securities or cash items if it consists of investment securities. And then government securities are really any security issued or guaranteed by the United States or one of its instrumentalities pursuant to authority granted by Congress. It generally is not going to include municipal bonds and the like. So there are several ways someone can run afoul of this. So it's a little bit of a trap for operating companies because they might find themselves even if they are an operating company and not what you would think of as a company that's making investments and the like and increasing assets due to that. But for various things like if they make a sale or something like that, they could be they could run afoul of the 40% test and we'll talk about that in a little bit. The total assets are on an unconsolidated basis, so they can't consolidate to try to like get get get down below the 40%. It's unconsolidated. So you have to have to look at everything that the company has separately. Cash items are what you would think of cash coins, demand deposits, cashier checks, letters of credit and so on. So who might fail to 40% test? So I just said that it could be a trap for operating companies. And yes, if a if a operating company if in their org chart they have a lot of minority owned subsidiaries such as companies that utilize special purpose entity or joint venture structures to acquire, say, real estate or oil and gas interests, then they could wind up. Failing this 40% test, even though they're not really holding themselves out as an investment company, even though they don't think of themselves as an investment company, they're just, hey, they're, you know, getting real estate or managing real estate or whatnot or owning real estate. But just through this, through having through conducting their business in minority owned subsidiaries, they could very well fail this 40% test. Also, operating companies that have substantial working capital reserves invested in debt and equity securities. So if they don't have it just in cash in the bank and, you know, why would you do that? So you could get some minuscule, minuscule. Interest rate. You know, you'd rather have your money working for you. And so a lot of companies will put in some sort of debt or equity securities, their working capital, some kind of short term, but that might cause them to fail. The 40% test, if they have enough there and working capital. This third bullet is what I mentioned on the previous slide. If they sold one or more of their operating operating divisions and got a whole bunch of cash or it was some kind of stocks stock purchase sale and they got a bunch of securities back then, they could be over this 40% threshold. Also newly formed operating companies that have raised money but haven't yet devoted the capital to the underlying business operations. And maybe they're keeping that money somewhere in some kind of short term securities. And and lo and behold, they're on the wrong side of this 40% threshold. Now, what if you failed a 40% test? Is that the end of the world? Do you have to close up shop or whatnot? No. There are several. There are several other tests. And so we'll go to this kind of first. If a company fails the 40% test, then we'll go to rule 3A1 and see if they're eligible for the safe harbor. And under this, if they are eligible for the safe harbor, it doesn't matter if they fail to 40% test. So you have this next test. This test takes into account the nature of assets and sources of income. So no more than 40% of the value of the issuer's total assets, which is going to exclude government securities and cash items. We talked about that a few slides ago, must consist of certain investment securities and then no more. 40% of issuer's net income after taxes must derive from investment securities. So if these are not true, if the value of the issuer's total assets, if investment securities is under 45%, and also basically their income for the last four fiscal quarters combined for the last year is their income from investment securities is under 45% of the issuer's net income. Then they can take advantage of this Rule three, a one safe harbor. And for this one you can consolidate. Remember the last one I mentioned that you cannot consolidate, but for this one you can consolidate. Okay, Well, let's talk about. Okay, you failed the 40% test and then you're not eligible for the safe harbor that we discussed on the previous slide. So what happens? These are not prohibitions where, hey, if you fail the 40% test and you're not able to. Safe harbor, then you're, you know, you're prohibited from doing your business. It's not that at all. You just have certain requirements and restrictions on your business. So the next few slides I'm going to talk about, talk about the various corporate governance requirements and the like. And this one here, transactions with affiliate affiliated persons. So really, if you can't do the 40% test or take advantage of the safe harbor are not eligible for some of the exemptions that I'll talk about here in a bit. Exceptions Then you just have certain burdens that you have to live with, certain restrictions. And one of the main ones is this prohibition on doing. Doing on having transactions with affiliated persons. So Section 17 of the Company Act prohibits many principal transactions with an affiliated person and restricts those transactions in which an affiliated person is a joint or several and joint participant with the investment company. It also applies to affiliated persons of affiliated persons. So kind of that second tier affiliates and this this what this prevents is having a marketing company or some sort of affiliated. Broker or something like that. A lot of companies, especially in this day and age, you get a lot of investment platforms and the like. A lot of websites that that help people sell their their offering and they offer all this kind of myriad of services. Also, those of you who deal with real estate investment trusts know that those org charts can look kind of crazy and you get all kinds of boxes just all over the place. But if if a company has to register as an investment company or if a company is is an investment company, then the Section 17 will prevent that. So it really tamps down on what transactions can take place with affiliated persons. 15 here on conflicts of interest. So this is 15 A is mainly getting at investment advisers. So under 15 A it's unlawful for any person to to serve as an investment adviser to a fund except pursuant to a contract that's been approved by a majority of the fund's shareholders. And as for no more than two years, unless it's continuance past the two years is approved at least annually by the board of directors or by a majority vote of the shareholders. And what this is designed to do, I know it seems it seems kind of odd when you first read it, but the Congress was trying to prevent insiders from entering into one sided long term management contracts they didn't want. And, you know, when the fun starts, there's not always somebody on the other side of the table. So a lot of times when we're we're forming a fund and a lot of my practice is in fund formation, we're forming a fund and investor is not sitting there on the other side of the table saying, hey, that's not fair. You know, there's no one really sticking up for the investor. So there's nothing to prevent an advisor from saying, Hey, our investment advisor agreement, we're going to have it for 50 years and, you know, something crazy like that. So Congress is stepping in and saying, no, that kind of behavior is not going to be okay unless a majority of the shareholders are okay with it. All compensation has to be precisely described in the investment advisory agreement. So a lot of times in this era we will have really complicated formulas and the like and saying exactly how the performance fee will be calculated and any any kind of other fee that's in there and also reimbursements. Every investment advisory agreement has to provide for automatic termination upon assignment, including change of control of advisors. This is to prevent kind of shenanigans where, you know, Bob owns the investment advisory business, but then it's really just a front for Peter and Bob gets the work but, and then assigns it immediately to, to, to Peter. Whereas Peter just got out of jail for running a used car fraud. Section ten deals with fund governance, and at least 40% of the board of directors has to be independent. And this is designed to prevent insiders from controlling investment companies to the detriment of the shareholders. And so this is a this is a big piece, and this is one of the reasons this is a big, big restriction. You know, having 40% of a board that was independent, independent means not an interest, interested person. And according to company Act, an interested person includes any affiliated person of the fund and some others, such as any affiliated person of a fund's investment adviser or principal underwriter. Any family member of an affiliated person or anyone who served as legal counsel to the fund over the past two years. Now, the FCC also adopted rules a while back that said a board would have made it difficult to operate if you didn't have at least 75% of the board consisting of independent directors. But this was invalidated in the courts. Limits on leverage. So this is another key restriction and why if people can get out of being considered an investment company, they will do it limits the amount of senior securities funds may issue. What is senior security? You might ask? It's bonds, preferred shares or any arrangement that would provide any kind of preference to the instrument's holder in a bankruptcy. Generally, mutual funds can't borrow except from a bank, and they can only borrow from a bank if they have 300% asset coverage to limit leverage. So if the fund only has $3 million in assets, they can't go out and borrow $200 million and just have the fund in a sea of red. They can do the reverse. They have $200 million in assets. They could go out and borrow $3 million, but they can't do it the other way around. Mutual funds can borrow up to 5% of their assets on a temporary basis from banks, and it won't be considered senior securities later. Sec interpretations have provided wiggle room and they have done this through this definition of senior securities. For example, SEC has stated that certain types of leveraged investments won't involve issuances of senior securities if the funds segregate its segregates those liquid assets on the books of its custodian bank. One must also maintain a certain percentage of its assets and cash for any investors who might wish to sell. So they can't not offer liquidity because, hey, you know, all our money is tied up, everything is illiquid, have to have some liquidity. Daily evaluation. So this requirement of daily evaluation is why most venture are almost all venture capital funds are not going to want to be an investment company. They're not going to want to register as an investment company because there is a requirement for investment companies to have daily valuation of portfolio securities, have to determine the net asset value at the same time every day. So not just calculated each day, you can't always calculate the NAV at 8 a.m. and then one day do it at 5 p.m. because you're trying to game the price. It has to be done at the same time each day. And the reason for this is what Congress is getting at. They didn't they don't want these inflated values. So you do get that a lot in venture capital funds. So someone will make an investment while the market is hot and maybe it'll be valued at $100 million. The company and then. Since the company is private, not traded. So you don't know how much the company is worth on a day to day basis, but say, you know, that it's lost half its value. You just don't have any proof of it. The fund can still present its investment as not having lost value because there isn't any requirement like this for NAV to be calculated each day. Can't do that if you're an investment company. If you're an investment company, you have to give net asset value each day. Most funds use market value to determine a fund's nav. If you don't use market value, you have to have a darn good reason for it because it's probably going to get challenged. And then when the market value is not available, fair value has to be determined in good faith by the board, and that's definitely something that the SEC looks at. So it's a lot of responsibility for the board to come up with fair value. But most of these funds that are investment companies, they're investing in public security, so there's already market value there. There's disclosure and reporting investment companies. They have to register their shares and disclose certain information. On the next slide, I'll talk about the SEC forms that are that are filed. If it's organized under the laws of the US or a state, have to register with the SEC. There isn't any kind of exception or exemption. In the registration, no matter which of the five forms that we'll talk about you're using, you got to disclose the structure, financial condition, if it's going down the tubes or if it's, you know, going to the moon. Investment policies and objectives to investors, meaning your investment objective, hey, what exactly are you investing in? What's your goal here? Are you going to, you know, be great at. All in mining or something like that or, you know, crypto or something. What exactly are you doing with this? This fund, If you're making a public offering, have to register securities under Securities Act of 1933. So you can't you don't this doesn't trump the Securities Act. You still have to do that. But these are the five main forms I have a lot more experience with in one A and in two than than the others. The others are a little bit I won't call them edge cases, but you have to have a really specialized practice to do those. So these forms, just like a form S1 or or F1 or whatever, whatever you're used to filing, these have to be filled out and then edgaras and submitted with the the SEC and they will let you know if they have any comments. Form n1 A is used for mutual funds. Form N two is for closed end funds. So those are two kind of forms of sort of general use I would call and these others are more specific form N three separate accounts offering annuity contracts to registered as investment companies in four separate accounts, offering annuity contracts registered as units and then separate accounts offering life insurance policies registered as a unit investment trust. Restrictions for mutual fund companies. So there are several. Primarily, Congress wanted to ensure that the mutual fund was on good footing and wasn't taking too many risky bets, and they didn't want the fund going down the tubes with people's money. So there's all these requirements for them to behave prudently. Cannot purchase securities on margin. Buying on margin means borrowing money from a broker to purchase stock. Owning a joint account that trades securities affecting a short sale of any security. Probably know what a short scale short sale is. Short sale is borrowing stock from a broker. You're selling it and then you're buying it back and returning the stock to a broker. So you're basically gambling that the stock is going to go down. You borrow stock from a broker, say you borrowed at $4, then you sell it, sell it at $4, and then you buy it back. Hopefully when it's only worth $2, you buy it back. And then you've and then you've cleared $2. With short short sale, there's if the stock goes the other way, you can lose your money. And the issue with short sales is you have unlimited. There's an unlimited amount of money that you can lose because if the stock goes up, then you're kind of in a bad spot. You borrowed the stock and you got to you got to sell it back to the broker at whatever the market is. And you know what? If it's gone up to $7,000, then you're really you're really in a in a bad spot. So they don't want people short selling and also purchasing more than 3% of outstanding voting stock of another investment company. They want people to just kind of be on, you know, focused on their own, focused on their own investments. Without a shareholder majority vote, mutual fund, cannot borrow money, make loans, buy or sell real estate, or underwrite securities issued by other companies, can't change its investment objectives. So everybody has to be on the same page. We have this come up quite a bit. So someone will launch a fund and say, Hey, I'm going to do this, that or the other, and then the market for this, that and the other and a couple of years isn't so great. So and then we get the phone call, Hey, can we change our investment objective? It's okay as long as it's okay with the shareholders. So we have to have a shareholder majority vote and then and then they can do it. They can't just do it. They just can't do it on their own. Change the nature of its business and cease acting as an investment company can't do that without shareholder majority vote and then change from a diversified form to an undiversified one. Now, many of you may have seen a some sort of. Disclosure or a risk factor for companies that are funds that say we are not a diversified fund. So that's kind of common to see If you don't have that risk factor in your fund documents, you might want to think about adding it. Diversified fund, 70% of assets, 75% of assets are invested in securities. No more than 5% of assets can be in any one security for a diversified fund. And you can't have 10% of outstanding shares in any one security. So you can't own, you know, 40% of Apple or anything like that. Non diversified fund is any mutual fund that is not it's not diversified. There are several exemptions from registration requirements. These two on the slide are the most popular by far. But these even if you fail the 40% test and you're not eligible for the 3A1 safe harbor, you still might be able to take advantage of some of these exemptions. Most of the company Act exemptions require issuers to satisfy any kind of criteria to satisfy criteria regarding activities or assets. And these two only focus on number and nature of the issuers US security holders. Section 3C1 and Section 3C7. A lot of security attorneys. This is all they know about the company. Section 3C1. Any issuer whose outstanding securities are beneficially owned by not more than 100 accredited investors and which is not making does not presently propose to make a public offering of its securities. Talk a I'll mention a couple of things here. One is, in practice, we're usually treating this as a 99 investor limit because the general partner is generally going to also invest in the fund. So we don't want them to max out at 100 investors because the GP still has to make an investment. So normally we're looking at at 99 here. They Congress changed the rules or the SEC changed the rules a few years ago. They added in this 250 investors for venture capital funds added that in so you can have up to 250 investors if if if the investment company is a venture capital fund of no more than 10 million and that's at any time, that's mark to market. So if it goes above that and then you'll no longer be eligible for that. So it's not that these are only relevant at the fund launch, these are relevant at all times. If you ever exceed these thresholds, the 100 or the 250, then you might have to register as an investment company. Or here on the slide, it says 100 credit investors. And then for 250 investors, it doesn't mention that. But as I said before, Investment Company Act does not get you around the Securities Act. So generally still going to be taking advantage of regulation D here. So all investors have to be accredited. Section three C7. This is used a lot in kind of big time hedge funds and the like. Any issue, the issuer, the outstanding securities, which are owned exclusively by persons who at the time that they invested, are qualified purchasers, which does not make making does not propose to make a public offering of such securities so qualified purchasers. That is like a supercharged version of a credit investor threshold. Qualified purchaser means a person with at least 5 million in investment. So not just 5 million in. Net worth. But 5 million actually in investments are a company with at least 5 million in investments owned by close family members. Some sort of trust with 5 million. An investment manager with at least 25 million under management, that person will be a qualified person or company with 25 million of investments. So this is really our kind of heavy, heavy hitters here and qualified purchasers. A lot of people will have side by side, Section three, C one and three, C seven funds. A lot of times we will launch a fund that's a Section three, C one fund. And then when they start getting to 70 or 80 investors, they say, hey, we think we're going to run out of slots, then they'll want to launch a parallel 3C1 fund and move over all the qualified purchasers into A3C7 fund, and you're allowed to do that. So we do see these parallel parallel funds, but these are far and away the most popular. Exemptions, though they're not the only ones. And here on this next slide, we'll talk about the rest of them. So Section three B1 issues primarily engaged in business other than investing in securities. People aren't just going to take your word for it that, hey, you're doing something else. So there's certain requirements for that. And case law built up. 3c5 is one that we see people trying to take advantage of, particularly for Reg A+ offerings and other things like that. It's really it's hard to do if you're not involved in real estate, if you're not involved in real estate financing and mortgages. So it's really for commercial financing and mortgage banking businesses or issuers involved in commercial real estate financing operations. So there are certain certain requirements within Section three, C five where you might be able to take it, which allow those types of businesses to take to have an exemption. From being considered an investment company. Three nine Certain oil and gas funds are exempt. Three two. Transient investment companies. If you're just kind of we've had this come up from time to time, if you're just sort of briefly an investment company, then, you know, your world doesn't have to change because you're going to be an investment company for a few hours. And then three eight certain research and development companies. And then of course we previously discussed section three, C, one, three, C seven, and also the Safe Harbor Rule 381. Business development company is just something that I wanted to to mention here. It is related to all this as a technical matter. Business development companies, they're not registered investment companies, but they elect to be subject to many of the regulations that are applicable to registered investment companies. Majority of them are public and BDC, so they operate for the purpose of making investments in certain securities and they make available the way they word it here is makes available significant managerial assistance and they're basically kind of just what the title says business development companies, they're helping develop the business. So they're in, they're getting in the weeds and the like. It's not a passive investment. One such as, you know, the majority of funds are going to be passive. There are obviously a lot of activist funds. Business development company is a little different than that. I mean, they're not trying to be against management. They're just really helping out management and helping to develop the develop the company. It's exempt from many of the constraints from the company act. I'll talk about the constraints to which they're exempt or some of the constraints. So. They don't have to provide investors with the same degree of liquidity as the other publicly traded investments that we talked about. So unlike open ended investment companies or mutual funds where investors can only sell and buy shares directly to and from the fund themselves, that's not a constraint on business development companies. Investors also don't have to meet income net worth or sophistication criteria imposed on other private equity investments. Business about companies. They also have access to permanent capital that's not subject to shareholder redemption or the requirement that capital be distributed to investors. Managers can immediately begin earning management fees after the business development company has gone public. And unlike with some other registered funds, they can charge performance fees. And business development companies also have greater flexibility than other types of registered investment companies to use leverage and engage in affiliate transactions. Then we talked about that before and I mentioned that that really is a restriction for a lot of funds. It's not relevant for business development companies. Now we'll get to the Investment Advisers Act of 1940. So lengthwise the Investment Advisers Act is not that long. So if you do practice in this area and you've never read the Investment Advisers Act from cover to cover. I won't say it's like reading a Harry Potter book, but it is something that you can get through in a short amount of time. So I do encourage anyone who works in this area to read the Investment Advisers Act cover to cover the Investment Company Act is a little bit longer. It's about 110 pages around there and it's don't really like the way it's written, whereas the Investment Advisers Act is something that you can kind of you can kind of get through that. And it was enacted the very same day as the Company Act. It's intended to monitor and regulate the activities of investment advisers, requires advisors to register with the SEC. It also defines advisor liabilities, regulates fees and commissions, and has certain anti-fraud provisions that apply to everyone, not just those who are registered, not just the investment advisors that are registered. So what is an investment advisor? So an investment advisor. Any person who for compensation, engages in the business of advising others either directly or through publications or writing as to the value of securities, or as to the advisability of investing in purchasing or selling securities, or who for compensation and as part of a regular business issues or promulgates analyzes or reports concerning securities. So whether or not a person is considered to be an investment advisor really depends on three criteria the type of advice offered. So if someone just walks up to me on the street and says plastics, that person is not going to be considered an investment. Like somebody walks up and says, Hey, and invest in Ohio Plastic Company. You know, 34, something like that. You know, by their latest preferred stock or something like that, then, hey, that person might actually be an investment advisor. The second criteria is the method of compensation. So whether it's performance based or something else has has a role in whether someone's an advisor. And also the third criteria, whether or not a significant portion of the advisor's income come from giving investment advice. If the person who walked up to me on the street and said Ohio Plastic Company if they are a. A ballerina, then their problem and most of their income is from being a ballerina. Then they're probably not going to be considered an investment advisor. Also just kind of related to the last point when we talked about as part of a regular business, there's also the consideration of whether the person leads others to believe whether the is an he or she is an investment advisor. Like through advertisement, somebody just started a business and they advertised, Hey, I'm an investment advisor. Then they can't say, Hey, I'm not an investment advisor because it's not part of my regular business. Well, if you're holding yourself out as it, then it is part of your regular business. Investment advisors that don't include certain people. So it doesn't include doesn't include banks. It doesn't include lawyers. So if I give my tip, hey, I represent such and such company and you know, they're doing really good, then I wouldn't be considered an investment advisor. Not sure I want to do that, but if I did, I wouldn't be considered an investment advisor. Brokers or dealers. This is one where people get tripped up a lot. Brokers and dealers. If the performance of the advisory services is solely incidental to the conduct of their business brokers and dealers. So if someone's a broker and you're just they're someone that I would call up if I wanted to invest in Ohio Plastic company and. And the person said, Oh yeah, that's a good investment. You know, they wouldn't be considered an investment advisor then if they're just taking my order and just commenting like that and I'm not giving them any kind of special comp or anything for those that services, publishers of newspapers, magazines and the like. So the folks on fast money on CNBC, you know, they're not going to be considered investment advisors. You can't sue them if they say something bad unless they're getting compensated and they're not not saying it. And then persons and firms whose advice, analysis or reports are related only to securities, really only to government securities, then they're okay. If somebody says, hey, buy treasuries, then that's not going to be considered an investment advisor. Now also mention how investment advisor works in the fund space. The. In the fun space. The fun is considered the client. So the fun is really just a pool of capital that can be poked around and directed, but the pool is just sitting there. It's not really doing anything. And so the advisor is the one telling the GP or sometimes the GP is the actual advisor. So the advisor is the one poking in and saying, Hey, hey, fun, hey, pool of capital you need to invest in, yada yada yada. So when people start first to enter the fun world, they think that the advisor is being used in a weird way, and it kind of is. But the idea is that the fun is just this pool of capital that's just going to sit there without somebody advising it. So anytime you have a fun, you're probably going to have an advisor also. The way that they word this registration requirement is like a lot of federal things. It's mentions the mail and interstate commerce. So you can't be an investment adviser and make use of mails or interstate commerce unless you're registered with the SEC or exempt from registration. The Investment Advisers Act. Prohibited transactions. So if our other requirements, if you're a registered investment advisor, then you're going to be termed an RA. Ra fiduciaries as fiduciaries. They have to refrain from certain prohibited transactions, such as assigning the investment contract to another firm without firm's consent. You can't can't sign up with Bob, and Bob gives your contract to Steve which just got out of prison. Ra can't use it. Best advisory contracts with language that attempt to limit or avoid civil liability for mistakes made in managing clients money. So you can't kind of surprise the client when you've done something nefarious and lost all their money and say, Hey, but our agreement said, you know, I'm not liable no matter what I do, even if I do this nefarious stuff. So you can't can't do that. A lot of this is about protection. So like a lot that Congress does in the securities space, it's all about investor protection and making sure investors have good, good information on the information front that next one they have. Ra have to make full disclosure of fees, investment strategies and business practices. It can't be opaque. There have to say exactly what they're doing. They have to treat clients impartially and can't favor one client over another. And then it's really more burdensome requirements than for broker dealers, which is somewhat surprising because the process for being a licensed broker is, in my mind, a little bit harder than the process for being an RA. Other things that I'll mention a lot of times at the state level and SEC levels, a lot of times you can only take carried interest. Carried interest being your performance fee. When you take carried interest from qualified clients, qualified clients is a little bit more than having to be an accredited investor. So there's the accredited accredited investor threshold and then the qualified purchaser threshold and qualified client is somewhere in between. It has certain net worth requirements. I think it's 2.3. It changed. It used to be 2.1 for a while. I think it's 2.3 now. Net worth. Also, there's certain marketing restrictions on registered investment advisors. What they can, what they can advertise. And and then there's also certain custodial requirements that apply to RIAs. So who has to register with the investment adviser? Who has to register? So all persons who are receiving compensation for serving as an investment advisor has to registered with with the SEC. It was revised with Dodd-Frank in 2010. So now it used to be a lot more open than than now. Now there's these these tiers here. So if the. Advisor if the advisor combining all the funds and SPVs and the like that they that they manage or advise over. If combining all of that, if the AUM is over $100 million and the advisor has to register with the SEC as a requirement to register with the SEC, if it's between 25 million or 100 million, they have to either register with the SEC or the state. Right now, if the AUM is between 25 and 100 million, you're going to have to register with the SEC. Unless you're in New York. In New York. Oh, you know what? I misstated that. I'm sorry. If you're between 25 and 100 million in New York, you'll have to register with the SEC. If you're anywhere else, you're still going to be. Under the purview of the state. So I apologize for misspeaking again. If your AUM is over 25 million and you're in New York, then you have to register with the SEC. If you're in any other state, then you are still under the state. State Securities Department. The state is going to be a primary regulator of advisors with AUM under 25 million. We call that small advisor exemption. With Dodd Frank. It created this mid sized investment advisor category. There's also a buffer. So the buffers are at 30 million and 110. So if you're with the state, state of Pennsylvania or whatnot and you get to 25,000,000 in 1 cent, it's not like everything you got to stop everything you're doing and withdraw from the state and then do it. Or I guess that would only be relevant in New York. I keep messing that up. Say you're in New York and you got AUM of 25 million. If you have one additional cent since stock price goes up or something like that and it's 25,000,000 in 1 cent, you don't have to drop everything and withdraw your New York application and then apply again at the SEC level, you get a buffer. You really only have to change once you're at 30 million. The buffer isn't forever and ever. It's a short period of time, but there is a little bit of a buffer there. And then on the higher threshold, the buffer is at 110 million. There are exemptions, just like with the Investment Company Act and just like with securities law in general, there's these registration requirements and then there's these exemptions. So Section 203, B one is not one that we think about a lot should probably think about this a little bit more, but it's the interstate exemption. So if the investment advisor, all the clients are in the same state as the advisors principal business Office, and that doesn't provide advice or issues reports about securities listed on any national securities exchange. So if everything is just really, really local, if someone is in Philadelphia and they're just there, their office in Philadelphia and all their clients are in Philadelphia and they're really just advising on local businesses and no, no, none of the companies are listed. Then they could use 2 or 3 B one 203, B two investment advisor that only advises insurance companies. So there's other regulations that would apply to that person. Foreign private advisor is one that we come across a lot in our practice. So it's an investment advisor has no place of business in the US. Fewer than 15 clients and investors in the US. And for this, normally in this space we consider the fund a client. But for this one foreign private advisor, we're counting both clients and investors. So if they have a if the advisor is, let's say Mauritius or somewhere like that and there's 20 US investors in the fund, then they would have an investment advisor issue and they would have to register as investment advisor or find a fund an exemption for. So for this one, we are counting individual investors and we count the individual investors. You know, we're not counting the fund also. So it's not like you count the 20 investors. And then also, hey, one more of them with the fund, you don't do that. You don't really count the fund. You count the investors in there. And also has less than 25 million of aggregate assets under management attributable to US investors. So it's so it's either one. So you could have 16 clients who have all invested $1 and you would no longer be eligible for an private advisor. Or you could have one client who has invested 30 million and you would no longer be eligible. And also neither holds itself out generally to the public in the US as an investment advisor or advisors, mutual funds or business development companies. Supervised person. So and RA has to have a code of ethics with the standards of business conduct for any supervised persons, and it has to address their personal securities trading. So supervised persons would be people who, instead of having instead of being a registered investment advisor on their own, they're supervised by a registered investment advisor. So this is fairly common. Sometimes that person is has a close affiliation with that. Ra Sometimes it's really just kind of for a higher RA, for a higher In those instances, of course the RA is getting paid to supervise the person and like it says here, they have code of ethics that's relevant. Supervised person will be any partner, officer, director or employee of an advisor or other person who who provides investment advice on behalf of the investment advisor and subject to their supervision and control of the investment advisor. And then part of this being supervised. In control by the investment advisers having this code of ethics with certain standards of conduct. When I first started teaching this course, we just had part one and part two. But Congress added this part three not too long ago, So part one requires information about the investment advisers, business ownership clients, employees, business practice affiliations, and and any disciplinary events. So part one is really a quantitative disclosure. So organize, check the box, fill in the blank format. Not a lot of open ended questions. It's really just you saying who's the ownership of the entity, Where are you located, what kind of conflicts might you have? But what kind of conflicts is really just an check the box. It wants to know if you're like some realtor who, hey, on the side, you're pushing, pushing investment in a fund or you're a real estate clients and the like. It also has certain registration information, such as. The funds and SPVs that you do advise whether they have filled out form DS and then certain information about that. But it's really a check. The box disclosure doesn't take too long to fill out. You still should have an attorney do it. It's still good for an attorney to do it, but it's really a what I would consider a quantitative disclosure. Part two is more of a qualitative disclosure. So it is a narrative brochure as opposed to, as it says here, supposed to be written clearly and concisely. Some people don't follow that. And it has a lot of information That's where you're talking about who is in charge of this advisor. So who are the principals of the advisor? What's their bio? What fees are they charging? What's their philosophy? Have they ever gotten any kind of trouble? With any kind of disciplinary organization, what conflicts do they have? So it's really more of your. Qualitative disclosures. So a lot of times the brochure meaning where 15, 25 pages, sometimes even more. And then and there was a feeling that some brochures were just kind of too long. And, you know, people's attention span is not always that great. So and then now part three of the four is required. It is a client relationship summary that basically contains a lot of what is in part two but in a very concise format. So just small places for descriptions of services, for client relationships. And then a lot of this stuff in part two fees costs, conflicts of interest, legal and disciplinary history, where to get additional information. But it's just in a short form. It's only a couple pages, I believe. And so it's really someone can start out with part three just to really get a feel for what's going on. What the Advisor Rays have to deliver a form ADV to potential clients prior to any kind of investment contract or when entering that and submit the form 80 adv through i a r d i a r d is the investment Adviser Registration depository so website. If you google it, it'll pop right up or pd. I should mention that the brochure supplement not required to be updated annually, but you can have things in there that are that are false. The primary purpose of the form ADV. So make sure investors have detailed information about the the RES and any investment advisor representatives before entering into the advisory relationship. Are set to update the brochure within 90 days after their fiscal year, so each year have to update the brochure. It's a big process. If you have a lot of clients like we do and then also have to provide prompt updates in case there's any inaccuracies. If a principal left or anything like that or any kind of major change have to update. Your other disclosure requirements. Every ra that has any kind of custody discretionary authority over a client funds or securities. Some do you have separately managed accounts or something like that unless it goes promptly to clients and prospective clients, any financial conditions that are reasonably likely to impair the ability of the adviser to meet contractual commitments to clients. So going through any kind of trouble, we're just going through any kind of trouble that is going to affect the advisor's business. You have to tell person that you can't be one day away from bankruptcy and not not mentioning it to a new client and also have to disclose promptly to clients any kind of legal or disciplinary event that's material to an evaluation of integrity or ability to meet commitments to clients. If you got caught even with doing something that's not securities related at all, but you're about to go to jail for 20 years, then you got to go out and tell clients. Full and fair disclosure of all material facts is an affirmative duty that Arias owe to the clients. And if you're wondering what rule all this comes from, it's rule 264 four. Anti-fraud requirements. These apply to everyone. So not not to talk about exempt reporter advisor next. So these apply to everyone. Section 206 prevents misstatements or misleading omissions of material facts and also other fraudulent acts or practices in connection with conduct of an investment advisory business. It's not always clear whether an RA owes a fiduciary duty to clients. Should mention 206 does apply equally to prospective and current investment advisor clients. The not always clear whether owes a fiduciary duty. One example of whether when it's not always clear are a of an advisory firm holds a license to sell insurance when it stops giving investment advice and only sells insurance to clients. Say that it couldn't take the pressure of being buying and selling insurance a little bit easier, besides only to sell insurance to clients. It's no longer owes those people a fiduciary duty, even though it did at one time. There's no scienter requirement. So you don't have to deliberately be defrauding someone and plus a negligent misrepresentations and conduct negligent, deceptive. There used to be a hedge fund rule in 2004. Sec passed a hedge fund rule which tried to expand the scope of the Investment Advisers Act, try to do it by broadening client and effectively. The SEC tried to shift the definition from the fund up to the investors in the fund. Remember I said before that in this space client is actually the fund. So they tried to shift that to uh, to the actual investors, but it was overturned by this Goldstein versus SEC. And the what the court said is kind of interesting. They held that an investor in a private fund may benefit from the advisors advice or of course may suffer for it, but he does not receive the advice directly. The adviser does not tell the investor how to spend his money. The investor made that decision when he invested in the fund. Books and records raise must maintain and preserve specified books and records and make them available to any SEC examiners. And the books and records. They don't have to necessarily be in a cabinet somewhere taking up a lot of space so they can be an electronic version. The actual rule mentions microfilm and probably mentions microfiche too. Of course, I haven't seen that in a while, but the idea is that it can be maintained electronically. Exempt reporting advisers. So in the fund space, particularly if you spend a lot of time with private funds like I do, then you'll probably deal with exempt reporting advisers, more so than registered investment advisers. So let's spend some time on exempt reporting advisers. Exempt reporting advisers. So I'd like to emphasize to clients that it does mean exempt reporting advisors. So you do have to actually do something. There's a reporting requirement have to file a form ADV, which I'll talk about, but it's not an exemption where, oh, I'm exempt, I don't have to do anything. I can just go on my merry way. It's not like that. You're exempt from being a registered investment advisor. You're not exempt from like, having to do anything. You still have to pay fees, still have to report public information on form ADV. So there's still some things let's talk about. These are the SEC exemptions. They're the most popular ones. So the private funds advisor exemption and the venture capital advisor exemption. Private funds Exemption. Exemption from registration for any investment advisor that acts solely as an advisor to private funds and has assets under management of less than 150 million. And this one. So it's really these private funds can be doing anything so long as they're not public. So there's no restriction on what's in these private funds they can be investing in anything could could acquire the securities in any way. Whereas with this next one, venture capital fund exemption. The exemption from registration is if the advisor solely advises venture capital funds, irrespective of such funds, number or size. And let me go back to this real quick. And for the venture capital fund advisor exemption, I should emphasize. So every single fund that an advisor. Advisors has to be a venture capital fund. How this how a venture capital fund is defined. It's a private fund that has no more than 20% of the fund's capital commitments in a non qualifying investments other than short term holdings. What is qualifying investments? Qualifying investment is basically a directly acquired equity security. It's so it's not going to include secondaries or anything like that. Uh, it just has to be something direct investment into a company, and then they get stock back. So it just has to be a direct investment. We mainly the issue is usually with secondary. So when people want to do some kind of secondary secondary offering, want to have their fund, invest in that, that's really when we start looking at, oh, what's this going to affect your venture capital advisor exemption? And one issue is when people have an SPV that's devoted to a secondary offering that's relatively common for an advisor to have an SPV focused on the secondary offering, A CFO of a company wants to sell a bunch of a bunch of the person's shares so someone will form an SPV to purchase those shares. But and then that SPV would fail this test because that SPV 100% of that SPV. Capital 100% of that, that the SPVs assets are going to be in Non-qualifying investments because it wasn't a directly acquired equities. It was acquired instead from the from the CFO. So that would fail it. So really one thing to really keep in mind on this venture capital, on this venture capital rule is that every single fund or SPV, every vehicle that an advisor that advising has to meet this test of having at least 80% of the fund be consist of qualifying investments. So that's one thing to keep in mind. A lot of people think, Oh, I can just consolidate everything and then, you know, yeah, I've got a few SPVs that have these secondaries, but hey, altogether I've got. You know, altogether I've got 200 million, 200 million assets under management and only 5 million in secondaries out of that 200. So, hey, I'm home free. But it's not the case if you got the 5 million in secondaries and one SPV, because that SPV is going to be not going to be considered venture capital fund and then you're not going to be eligible for this because you advise at least one fund that is not in venture capital fund. Then we would look at the private fund advisor exemption that we just mentioned. But if someone is over 150, then they're not eligible for that. Um, and then there's certain other things with venture capital fund that you can see here. We're usually focused on the 20% test. And there's also you have to represent yourself as pursuing a venture capital strategy and also not be registered in an investment company act and not be a business development company. Certain compliance responsibilities for exempt reporting advisors. Any investment advisor has to complete its era filing its form ADV filing that we talked about before within 60 days of claiming the exemption, eras have to file that that form ADV within within 90 days of the firm's fiscal year at the end of the firm's fiscal year. They have to update the form ADV. Normally when we're doing that, we're adding whatever special purpose vehicles or funds the person the advisor has launched within the last year areas, they only have to submit certain items, schedules and form ATV Part one. A Remember I talked about Part one is really that quantitative disclosure. It's a lot of check boxes to check and the like areas with a non US resident general partner or managing agent have separately submit that form ADV and R and states also can require notice filings and fees for Era. So it's common that we're checking a lot of boxes there. The era is has a presence in a lot of different states. Last slide here. Exempt report advisor. It still has certain reporting obligations, has to have written policies and procedures reasonably designed to prevent misuse of material nonpublic information. Normally when we're doing an era, we're giving them two things the code of ethics, like we talked about before, code of ethics and some kind of written information security policy to handle this one. The second bullet is relevant for code of ethics. There are compliance requirements. Applying to all advisors regardless of whether Era or RA regarding pay to play provisions. So you can't bribe some state official in order to get the state's pension fund work era. They don't have to have a compliance manual though. If they do, they do have to follow them. Sec can inspect IRAs, books or records. Sec is always saying they're going to ramp up their inspection of IRAs, but usually for most IRAs, such inspection is typically triggered by some kind of independent indication of wrongdoing. So. Sec. More and more, they're inspecting Era people and they keep saying they're going to have a cycle where they're going to inspect every era over the course of 3 to 5 years. But really, in in my experience, it's usually there has to be some independent allegation or indication of wrongdoing. And with that, that is all for our overview. Investment Company Act and Investment Advisor Acts. Thank you so much for joining us today. I hope that it was helpful in some way and thank Quimbee once again. Always enjoy their programs. Look forward to seeing you all again.

Presenter(s)

GR
Gary Ross
Managing Partner
Ross Law Group PLLC

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                                                                                                  Pending
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                                                                                                  January 16, 2026 at 11:59PM HST

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                                                                                                  Approved
                                                                                                  Credits
                                                                                                    Available until
                                                                                                    Status
                                                                                                    Pending
                                                                                                    Credits
                                                                                                      Available until
                                                                                                      Status
                                                                                                      Pending
                                                                                                      Credits
                                                                                                        Available until
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                                                                                                        Pending
                                                                                                        Credits
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                                                                                                          Pending
                                                                                                          Credits
                                                                                                          • 1.05 general
                                                                                                          Available until

                                                                                                          August 21, 2024 at 11:59PM HST

                                                                                                          Status
                                                                                                          Approved
                                                                                                          Credits
                                                                                                          • 1.0 general
                                                                                                          Available until

                                                                                                          August 31, 2024 at 11:59PM HST

                                                                                                          Status
                                                                                                          Approved
                                                                                                          Credits
                                                                                                            Available until
                                                                                                            Status
                                                                                                            Pending
                                                                                                            Credits
                                                                                                            • 1.0 general
                                                                                                            Available until

                                                                                                            August 15, 2025 at 11:59PM HST

                                                                                                            Status
                                                                                                            Approved
                                                                                                            Credits
                                                                                                              Available until
                                                                                                              Status
                                                                                                              Not Eligible
                                                                                                              Credits
                                                                                                              • 1.0 general
                                                                                                              Available until

                                                                                                              August 15, 2025 at 11:59PM HST

                                                                                                              Status
                                                                                                              Available
                                                                                                              Credits
                                                                                                                Available until
                                                                                                                Status
                                                                                                                Pending
                                                                                                                Credits
                                                                                                                  Available until
                                                                                                                  Status
                                                                                                                  Not Eligible
                                                                                                                  Credits
                                                                                                                    Available until
                                                                                                                    Status
                                                                                                                    Not Eligible
                                                                                                                    Credits
                                                                                                                      Available until
                                                                                                                      Status
                                                                                                                      Pending

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