
[Federal Register Volume 76, Number 129 (Wednesday, July 6, 2011)]
[Rules and Regulations]
[Pages 39646-39703]
From the Federal Register Online via the Government Printing Office [www.gpo.gov]
[FR Doc No: 2011-16118]



[[Page 39645]]

Vol. 76

Wednesday,

No. 129

July 6, 2011

Part IV





Securities and Exchange Commission





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17 CFR Part 275





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

  Federal Register / Vol. 76 , No. 129 / Wednesday, July 6, 2011 / 
Rules and Regulations  

[[Page 39646]]


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SECURITIES AND EXCHANGE COMMISSION

17 CFR Part 275

[Release No. IA-3222; File No. S7-37-10]
RIN 3235-AK81


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

AGENCY: Securities and Exchange Commission.

ACTION: Final rule.

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

DATES: Effective Date: July 21, 2011.

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

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

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

I. Background

    On July 21, 2010, President Obama signed into law the Dodd-Frank 
Act,\2\ which, among other things, repeals section 203(b)(3) of the 
Advisers Act.\3\ Section 203(b)(3) exempted any investment adviser from 
registration if the investment adviser (i) had fewer than 15 clients in 
the preceding 12 months, (ii) did not hold itself out to the public as 
an investment adviser and (iii) did not act as an investment adviser to 
a registered investment company or a company that has elected to be a 
business development company (the ``private adviser exemption'').\4\ 
Advisers specifically exempt under section 203(b) are not subject to 
reporting or recordkeeping provisions under the Advisers Act, and are 
not subject to examination by our staff.\5\
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    \2\ Dodd-Frank Wall Street Reform and Consumer Protection Act, 
Public Law 111-203, 124 Stat. 1376 (2010).
    \3\ In this Release, when we refer to the ``Advisers Act,'' we 
refer to the Advisers Act as in effect on July 21, 2011.
    \4\ 15 U.S.C. 80b-3(b)(3) as in effect before July 21, 2011.
    \5\ Under section 204(a) of the Advisers Act, the Commission has 
the authority to require an investment adviser to maintain records 
and provide reports, as well as the authority to examine such 
adviser's records, unless the adviser is ``specifically exempted'' 
from the requirement to register pursuant to section 203(b) of the 
Advisers Act. Investment advisers that are exempt from registration 
in reliance on other sections of the Advisers Act (such as sections 
203(l) or 203(m) which we discuss below) are not ``specifically 
exempted'' from the requirement to register pursuant to section 
203(b), and thus the Commission has authority under section 204(a) 
of the Advisers Act to require those advisers to maintain records 
and provide reports and has authority to examine such advisers' 
records.
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    The primary purpose of Congress in repealing section 203(b)(3) was 
to require advisers to ``private funds'' to register under the Advisers 
Act.\6\ Private funds include hedge funds, private equity funds and 
other types of pooled investment vehicles that are excluded from the 
definition of ``investment company'' under the Investment Company Act 
of 1940 \7\ (``Investment Company Act'') by reason of section 3(c)(1) 
or 3(c)(7) of such Act.\8\ Section 3(c)(1) is available to a fund that 
does not publicly offer the securities it issues \9\ and has 100 or 
fewer beneficial owners of its outstanding securities.\10\ A fund 
relying on section 3(c)(7) cannot publicly offer the securities it 
issues \11\ and generally must limit the owners of its outstanding 
securities to ``qualified purchasers.'' \12\
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    \6\ See S. Rep. No. 111-176, at 71-3 (2010) (``S. Rep. No. 111-
176''); H. Rep. No. 111-517, at 866 (2010) (``H. Rep. No. 111-
517''). H. Rep. No. 111-517 contains the conference report 
accompanying the version of H.R. 4173 that was debated in 
conference. While the Senate voted to exempt private equity fund 
advisers in addition to venture capital fund advisers from the 
requirement to register under the Advisers Act, the Dodd-Frank Act 
exempts only venture capital fund advisers. Compare Restoring 
American Financial Stability Act of 2010, S. 3217, 111th Cong. Sec.  
408 (2010) (as passed by the Senate) with The Wall Street Reform and 
Consumer Protection Act of 2009, H.R. 4173, 111th Cong. (2009) (as 
passed by the House) (``H.R. 4173'') and Dodd-Frank Act (2010), 
supra note 2.
    \7\ 15 U.S.C. 80a.
    \8\ Section 202(a)(29) of the Advisers Act defines the term 
``private fund'' as ``an issuer that would be an investment company, 
as defined in section 3 of the Investment Company Act of 1940 (15 
U.S.C. 80a-3), but for section 3(c)(1) or 3(c)(7) of that Act.''
    \9\ Interests in a private fund may be offered pursuant to an 
exemption from registration under the Securities Act of 1933 (15 
U.S.C. 77) (``Securities Act''). Notwithstanding these exemptions, 
the persons who market interests in a private fund may be subject to 
the registration requirements of section 15(a) under the Securities 
Exchange Act of 1934 (``Exchange Act'') (15 U.S.C. 78o(a)). The 
Exchange Act generally defines a ``broker'' as any person engaged in 
the business of effecting transactions in securities for the account 
of others. Section 3(a)(4)(A) of the Exchange Act (15 U.S.C. 
78c(a)(4)(A)). See also Definition of Terms in and Specific 
Exemptions for Banks, Savings Associations, and Savings Banks Under 
Sections 3(a)(4) and 3(a)(5) of the Securities Exchange Act of 1934, 
Exchange Act Release No. 44291 (May 11, 2001) [66 FR 27759 (May 18, 
2001)], at n.124 (``Solicitation is one of the most relevant factors 
in determining whether a person is effecting transactions.''); 
Political Contributions by Certain Investment Advisers, Investment 
Advisers Act Release No. 3043 (July 1, 2010) [75 FR 41018 (July 14, 
2010)], n.326 (``Pay to Play Release'').
    \10\ See section 3(c)(1) of the Investment Company Act 
(providing an exclusion from the definition of ``investment 
company'' for any ``issuer whose outstanding securities (other than 
short-term paper) are beneficially owned by not more than one 
hundred persons and which is not making and does not presently 
propose to make a public offering of its securities.'').
    \11\ See supra note 9.
    \12\ See section 3(c)(7) of the Investment Company Act 
(providing an exclusion from the definition of ``investment 
company'' for any ``issuer, the outstanding securities of which are 
owned exclusively by persons who, at the time of acquisition of such 
securities, are qualified purchasers, and which is not making and 
does not at that time propose to make a public offering of such 
securities.''). The term ``qualified purchaser'' is defined in 
section 2(a)(51) of the Investment Company Act.

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[[Page 39647]]

    Each private fund advised by an adviser has typically qualified as 
a single client for purposes of the private adviser exemption.\13\ As a 
result, investment advisers could advise up to 14 private funds, 
regardless of the total number of investors investing in the funds or 
the amount of assets of the funds, without the need to register with 
us.\14\
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    \13\ See rule 203(b)(3)-1(a)(2) as in effect before July 21, 
2011.
    \14\ See Staff Report to the United States Securities and 
Exchange Commission, Implications of the Growth of Hedge Funds, at 
21 (2003), http://www.sec.gov/news/studies/hedgefunds0903.pdf 
(discussing section 203(b)(3) of the Advisers Act as in effect 
before July 21, 2011). Concern about this lack of Commission 
oversight led us to adopt a rule in 2004 extending registration to 
hedge fund advisers. See Registration Under the Advisers Act of 
Certain Hedge Fund Advisers, Investment Advisers Act Release No. 
2333 (Dec. 2, 2004) [69 FR 72054 (Dec. 10, 2004)] (``Hedge Fund 
Adviser Registration Release''). This rule was vacated by a Federal 
court in 2006. Goldstein v. Securities and Exchange Commission, 451 
F.3d 873 (D.C. Cir. 2006) (``Goldstein'').
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    In Title IV of the Dodd-Frank Act (``Title IV''), Congress 
generally extended Advisers Act registration to advisers to hedge funds 
and many other private funds by eliminating the private adviser 
exemption.\15\ In addition to removing the broad exemption provided by 
section 203(b)(3), Congress amended the Advisers Act to create three 
more limited exemptions from registration under the Advisers Act.\16\ 
These amendments become effective on July 21, 2011.\17\ New section 
203(l) of the Advisers Act provides that an investment adviser that 
solely advises venture capital funds is exempt from registration under 
the Advisers Act (the ``venture capital exemption'') and directs the 
Commission to define ``venture capital fund'' within one year of 
enactment.\18\ New section 203(m) of the Advisers Act directs the 
Commission to provide an exemption from registration to any investment 
adviser that solely advises private funds if the adviser has assets 
under management in the United States of less than $150 million (the 
``private fund adviser exemption'').\19\ In this Release, we will refer 
to advisers that rely on the venture capital and private fund adviser 
exemptions as ``exempt reporting advisers'' because sections 203(l) and 
203(m) provide that the Commission shall require such advisers to 
maintain such records and to submit such reports ``as the Commission 
determines necessary or appropriate in the public interest or for the 
protection of investors.'' \20\
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    \15\ Section 403 of the Dodd-Frank Act amended section 203(b)(3) 
of the Advisers Act by repealing the prior private adviser exemption 
and inserting a ``foreign private adviser exemption.'' See infra 
Section II.C. Unlike our 2004 rule, which sought to apply only to 
advisers of ``hedge funds,'' the Dodd-Frank Act requires that, 
unless another exemption applies, all advisers previously eligible 
for the private adviser exemption register with us regardless of the 
type of private funds or other clients the adviser has.
    \16\ Title IV also created exemptions and exclusions in addition 
to the three discussed at length in this Release. See, e.g., 
sections 403 and 409 of the Dodd-Frank Act (exempting advisers to 
licensed small business investment companies from registration under 
the Advisers Act and excluding family offices from the definition of 
``investment adviser'' under the Advisers Act). We are adopting a 
rule defining ``family office'' in a separate release (Family 
Offices, Investment Advisers Act Release No. 3220 (June 22, 2011)).
    \17\ Section 419 of the Dodd-Frank Act (specifying the effective 
date for Title IV).
    \18\ See section 407 of the Dodd-Frank Act (exempting advisers 
solely to ``venture capital funds,'' as defined by the Commission).
    \19\ See section 408 of the Dodd-Frank Act (directing the 
Commission to exempt private fund advisers with less than $150 
million in aggregate assets under management in the United States).
    \20\ See sections 407 and 408 of the Dodd-Frank Act.
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    Section 203(b)(3) of the Advisers Act, as amended by the Dodd-Frank 
Act, provides an exemption for certain foreign private advisers (the 
``foreign private adviser exemption'').\21\ The term ``foreign private 
adviser'' is defined in new section 202(a)(30) of the Advisers Act as 
an investment adviser that has no place of business in the United 
States, has fewer than 15 clients in the United States and investors in 
the United States in private funds advised by the adviser,\22\ and less 
than $25 million in aggregate assets under management from such clients 
and investors.\23\
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    \21\ Advisers specifically exempt under section 203(b) are not 
subject to reporting or recordkeeping provisions under the Advisers 
Act, and are not subject to examination by our staff. See supra note 
5.
    \22\ Subparagraph (B) of section 202(a)(30) refers to the number 
of ``clients and investors in the United States in private funds,'' 
while subparagraph (C) refers to the assets of ``clients in the 
United States and investors in the United States in private funds'' 
(emphasis added). We interpret these provisions consistently so that 
only clients in the United States and investors in the United States 
should be included for purposes of determining eligibility for the 
exemption under subparagraph (B).
    \23\ The exemption is not available to an adviser that ``acts 
as--(I) an investment adviser to any investment company registered 
under the [Investment Company Act]; or (II) a company that has 
elected to be a business development company pursuant to section 54 
of [that Act], and has not withdrawn its election.'' Section 
202(a)(30)(D)(ii). We interpret subparagraph (II) to mean that the 
exemption is not available to an adviser that advises a business 
development company. This exemption also is not available to an 
adviser that holds itself out generally to the public in the United 
States as an investment adviser. Section 202(a)(30)(D)(i).
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    These new exemptions are not mandatory.\24\ Thus, an adviser that 
qualifies for any of the exemptions could choose to register (or remain 
registered) with the Commission, subject to section 203A of the 
Advisers Act, which generally prohibits most advisers from registering 
with the Commission if they do not have at least $100 million in assets 
under management.\25\
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    \24\ An adviser choosing to avail itself of an exemption under 
section 203(l), 203(m) or 203(b)(3), however, may be required to 
register as an adviser with one or more state securities 
authorities. See section 203A(b)(1) of the Advisers Act (exempting 
from state regulatory requirements any adviser registered with the 
Commission or that is not registered because such person is excepted 
from the definition of an investment adviser under section 
202(a)(11)). See also infra note 488 (discussing the application of 
section 222 of the Advisers Act).
    \25\ Section 203A(a)(1) of the Advisers Act generally prohibits 
an investment adviser regulated by the state in which it maintains 
its principal office and place of business from registering with the 
Commission unless it has at least $25 million of assets under 
management. Section 203A(b) preempts certain state laws regulating 
advisers that are registered with the Commission. Section 410 of the 
Dodd-Frank Act amended section 203A(a) to also prohibit generally an 
investment adviser from registering with the Commission if the 
adviser has assets under management between $25 million and $100 
million and the adviser is required to be registered with, and if 
registered, would be subject to examination by, the state security 
authority where it maintains its principal office and place of 
business. See section 203A(a)(2) of the Advisers Act. In each of 
subparagraphs (1) and (2) of section 203A(a), additional conditions 
also may apply. See Implementing Adopting Release, infra note 32, at 
section II.A.
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    On November 19, 2010, the Commission proposed three rules that 
would implement these exemptions.\26\ First, we proposed rule 203(l)-1 
to define the term ``venture capital fund'' for purposes of the venture 
capital exemption. Second, we proposed rule 203(m)-1 to implement the 
private fund adviser exemption. Third, in order to clarify the 
application of the foreign private adviser exemption, we proposed new 
rule 202(a)(30)-1 to define several terms included in the statutory 
definition of a foreign private adviser as defined in section 
202(a)(30) of the Advisers Act.\27\ On the same day, we

[[Page 39648]]

also proposed rules to implement other amendments made to the Advisers 
Act by the Dodd-Frank Act, which included reporting requirements for 
exempt reporting advisers.\28\
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    \26\ Exemptions for Advisers to Venture Capital Funds, Private 
Fund Advisers with Less than $150 Million in Assets under 
Management, and Foreign Private Advisers, Investment Advisers Act 
Release No. 3111 (Nov. 19, 2010) [75 FR 77190 (Dec. 10, 2010)] 
(``Proposing Release'').
    \27\ Proposed rule 202(a)(30)-1 included definitions for the 
following terms: (i) ``Client;'' (ii) ``investor;'' (iii) ``in the 
United States;'' (iv) ``place of business;'' and (v) ``assets under 
management.'' See discussion in section II.C of the Proposing 
Release, supra note 26. We proposed rule 202(a)(30)-1, in part, 
pursuant to section 211(a) of the Advisers Act, which Congress 
amended to explicitly provide us with the authority to define 
technical, trade, and other terms used in the Advisers Act. See 
section 406 of the Dodd-Frank Act.
    \28\ Rules Implementing Amendments to the Investment Advisers 
Act of 1940, Investment Advisers Act Release No. 3110 (Nov. 19, 
2010) [75 FR 77052 (Dec. 10, 2010)] (``Implementing Proposing 
Release'').
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    We received over 115 comment letters in response to our proposals 
to implement the new exemptions.\29\ Most of these letters were from 
venture capital advisers, other types of private fund advisers, and 
industry associations or law firms on behalf of private fund and 
foreign investment advisers.\30\ We also received several letters from 
investors and investor groups.\31\ Although commenters generally 
supported the various proposed rules, many suggested modifications 
designed to expand the breadth of the exemptions or to clarify the 
scope of one or more elements of the proposed rules. Commenters also 
sought interpretative guidance on certain aspects of the scope of each 
of the rule proposals and related issues.
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    \29\ The comment letters on the Proposing Release (File No. S7-
37-10) are available at: http://www.sec.gov/comments/s7-37-10/s73710.shtml. We also considered comments submitted in response to 
the Implementing Proposing Release that were germane to the rules 
adopted in this Release.
    \30\ See, e.g., Comment Letter of Biotechnical Industry 
Organization (Jan. 24, 2011) (``BIO Letter''); Comment Letter of 
Coalition of Private Investment Companies (Jan. 28, 2011) (``CPIC 
Letter''); Comment Letter of European Private Equity and Venture 
Capital Association (Jan. 24, 2011 (``EVCA Letter''); Comment Letter 
of O'Melveny & Myers LLP (Jan. 25, 2011) (``O'Melveny Letter''); 
Comment Letter of Norwest Venture Partners (Jan. 24, 2011) 
(``Norwest Letter'').
    \31\ See, e.g., Comment Letter of the American Federation of 
Labor and Congress of Industrial Organizations (Jan. 24, 2011) 
(``AFL-CIO Letter''); Comment Letter of Americans for Financial 
Reform (Jan. 24, 2011) (``AFR Letter''); Comment Letter of The 
California Public Employees Retirement System (Feb. 10, 2011) 
(``CalPERS Letter''). See also, e.g., Comment Letter of Adams Street 
Partners (Jan. 24, 2011); Comment Letter of Private Equity 
Investors, Inc. (Jan. 21, 2011) (``PEI Funds Letter'') (letters from 
advisers of funds that invest in other venture capital and private 
equity funds).
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II. Discussion

    Today, the Commission is adopting rules to implement the three new 
exemptions from registration under the Advisers Act. In response to 
comments, we have made several modifications to the proposals. In a 
separate companion release (the ``Implementing Adopting Release'') we 
are adopting rules to implement other amendments made to the Advisers 
Act by the Dodd-Frank Act, some of which also concern certain advisers 
that qualify for the exemptions discussed in this Release.\32\
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    \32\ Rules Implementing Amendments to the Investment Advisers 
Act of 1940, Investment Advisers Act Release No. 3221 (June 22, 
2011).
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A. Definition of Venture Capital Fund

    We are adopting new rule 203(l)-1 to define ``venture capital 
fund'' for purposes of the new exemption for investment advisers that 
advise solely venture capital funds.\33\ In summary, the rule defines a 
venture capital fund as a private fund that: (i) Holds no more than 20 
percent of the fund's capital commitments in non-qualifying investments 
(other than short-term holdings) (``qualifying investments'' generally 
consist of equity securities of ``qualifying portfolio companies'' that 
are directly acquired by the fund, which we discuss below); (ii) does 
not borrow or otherwise incur leverage, other than limited short-term 
borrowing (excluding certain guarantees of qualifying portfolio company 
obligations by the fund); (iii) does not offer its investors redemption 
or other similar liquidity rights except in extraordinary 
circumstances; (iv) represents itself as pursuing a venture capital 
strategy to its investors and prospective investors; and (v) is not 
registered under the Investment Company Act and has not elected to be 
treated as a business development company (``BDC'').\34\ Consistent 
with the proposal, rule 203(l)-1 also ``grandfathers'' any pre-existing 
fund as a venture capital fund if it satisfies certain criteria under 
the grandfathering provision.\35\ An adviser is eligible to rely on the 
venture capital exemption only if it solely advises venture capital 
funds that meet all of the elements of the definition or funds that 
have been grandfathered.
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    \33\ Rule 203(l)-1.
    \34\ Rule 203(l)-1(a).
    \35\ Rule 203(l)-1(b).
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    The proposed rule defined the term venture capital fund in 
accordance with what we believed Congress understood venture capital 
funds to be, as reflected in the legislative materials, including the 
testimony Congress received.\36\ As we discussed in the Proposing 
Release, the proposed definition of venture capital fund was designed 
to distinguish venture capital funds from other types of private funds, 
such as hedge funds and private equity funds, and to address concerns 
expressed by Congress regarding the potential for systemic risk.\37\
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    \36\ See Proposing Release, supra note 26, at n.38 and 
accompanying and following text.
    \37\ See, e.g., Proposing Release, supra note 26, discussion at 
section II.A. and text accompanying nn.43, 60, 61, 82, 99, 136.
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    We received over 70 comment letters on the proposed venture capital 
fund definition, most of which were from venture capital advisers or 
related industry groups.\38\ A number of commenters supported the 
Commission's efforts to define a venture capital fund,\39\ citing the 
``thoughtful'' approach taken and the quality of the proposed rule.\40\ 
Commenters representing investors and investor groups and others 
generally supported the rule as proposed,\41\ one of which stated that 
the proposed definition ``succeeds in clearly defining those private 
funds that will be exempt.''\42\ Some of these commenters expressed 
support for a definition that is no broader than necessary in order to 
ensure that only advisers to ``venture capital funds, and not other 
types of private funds, are able to avoid the new mandatory 
registration requirements.'' \43\
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    \38\ The National Venture Capital Association submitted a 
comment letter, dated January 13, 2011 (``NVCA Letter'') on behalf 
of its members, and 27 other commenters expressed their support for 
the comments raised in the NVCA Letter.
    \39\ See BIO Letter; Comment Letter of Charles River Ventures 
(Jan. 21, 2011) (``Charles River Letter''); NVCA Letter.
    \40\ See, e.g., Comment Letter of Abbott Capital Management, LLC 
(Jan. 24, 2011) (``Abbott Capital Letter''); Comment Letter of DLA 
Piper LLP (Jan. 24, 2011) (``DLA Piper VC Letter''); Comment Letter 
of InterWest General Partners (Jan. 21, 2011) (``InterWest 
Letter''); NVCA Letter; Comment Letter of Oak Investment Partners 
(Jan. 24, 2011) (``Oak Investment Letter''); Comment Letter of Pine 
Brook Road Advisors, LP (Jan. 24, 2011) (``Pine Brook Letter'').
    \41\ See AFR Letter; AFL-CIO Letter; EVCA Letter; Comment Letter 
of U.S. Senator Carl Levin (Jan. 25, 2011) (``Sen. Levin Letter'').
    \42\ AFL-CIO Letter.
    \43\ Sen. Levin Letter. Although they did not object to the 
approach taken by the proposed rule, several commenters cautioned us 
against defining venture capital fund more broadly than necessary to 
preclude advisers to other types of private funds from qualifying 
under the venture capital exemption. See AFR Letter; CalPERS Letter; 
Sen. Levin Letter (``a variety of advisers or funds are likely to 
try to seek refuge from the registration requirement by urging an 
overbroad interpretation of the term `venture capital fund' * * * It 
is important for the Commission to define the term narrowly to 
ensure that only venture capital funds, and not other types of 
private funds, are able to avoid the new mandatory registration 
requirement.'').
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    Generally, however, our proposal prompted vigorous debate among 
commenters on the scope of the definition. For example, a number of 
commenters wanted us to take a different approach from the proposal and 
supported two alternatives. Two commenters urged us to rely on the 
California definition of ``venture capital

[[Page 39649]]

operating company.''\44\ These commenters did not, however, address our 
concern, discussed in the Proposing Release, that the California 
definition includes many types of private equity and other private 
funds, and thus incorporation of this definition would not appear 
consistent with our understanding of the intended scope of section 
203(l).\45\ Our concern was acknowledged in a letter we received from 
the current Commissioner for the California Department of Corporations, 
stating that ``we understand the [Commission] cannot adopt verbatim the 
California definition of [venture capital fund]. Congressional 
directives require the [Commission] to exclude private equity funds, or 
any fund that pivots its investment strategy on the use of debt or 
leverage, from the definition of [venture capital fund].''\46\ For 
these reasons and the other reasons cited in the Proposing Release, we 
are not modifying the proposal to rely on the California 
definition.\47\
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    \44\ Comment Letter of Lowenstein Sandler PC (Jan. 4, 2011) 
(``Lowenstein Letter''); Comment Letter of Keith Bishop (Jan. 17, 
2011).
    \45\ See Proposing Release, supra note 26, at n.72 and 
accompanying and preceding text.
    \46\ Comment Letter of Preston DuFauchard, Commissioner for the 
California Department of Corporations (Jan. 21, 2011) (``DuFauchard 
Letter'') (further stating that ``while regulators might have an 
interesting discussion on whether private equity funds contributed 
to the recent financial crisis, in light of the Congressional 
directives such a dialogue would be academic.'').
    \47\ See Proposing Release, supra note 26, at n.72 and 
accompanying and preceding text.
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    Several other commenters favored defining a venture capital fund by 
reference to investments in ``small'' businesses or companies, although 
they disagreed on the factors that would deem a business or company to 
be ``small.''\48\ As discussed in the Proposing Release, we considered 
defining a qualifying fund as a fund that invests in small companies, 
but noted the lack of consensus for defining such a term.\49\ We also 
expressed the concern in the Proposing Release that defining a 
``small'' company in a manner that imposes a single standardized metric 
such as net income, the number of employees, or another single factor 
test could ignore the complexities of doing business in different 
industries or regions. This could have the potential result that even a 
low threshold for a size metric could inadvertently restrict venture 
capital funds from funding otherwise promising young small 
companies.\50\ For these reasons, we are not persuaded that the tests 
for a ``small'' company suggested by commenters address these concerns.
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    \48\ See Comment Letter of National Association of Small 
Business Investment Companies and Small Business Investor Alliance 
(Jan. 24, 2011) (``NASBIC/SBIA Letter'') (supported a definition of 
``small'' company by reference to the standards set forth in the 
Small Business Investment Act regulations). But cf. Lowenstein 
Letter; Comment Letter of Quaker BioVentures (Jan. 24, 2011) 
(``Quaker BioVentures Letter''); Comment Letter of Venrock (Jan. 23, 
2011) (``Venrock Letter'') (each of which supported a definition of 
small company based on the size of its public float). See also 
Comment Letter of Georg Merkl (Jan. 25, 2011) (``Merkl Letter'') 
(referring to ``young, negative EBITDA [earnings before interest, 
taxes, depreciation and amortization] companies'').
    \49\ See Proposing Release, supra note 26, at section II.A.1.a. 
and n.69 and accompanying and following text.
    \50\ See Proposing Release, supra note 26, at n.69 and 
accompanying and preceding text.
---------------------------------------------------------------------------

    Unlike the commenters who suggested these alternative approaches, 
most commenters representing venture capital advisers and related 
groups accepted the approach of the proposed rule, and many of them 
acknowledged that the proposed definition would generally encompass 
most venture capital investing activity that typically occurs.\51\ 
Several, however, also expressed the concern that a venture capital 
fund may, on occasion, deviate from its typical investing pattern with 
the result that the fund could not satisfy all of the definitional 
criteria under the proposed rule with respect to each investment all of 
the time.\52\ Others explained that an investment fund that seeks to 
satisfy the definition of a venture capital fund (a ``qualifying 
fund'') would desire flexibility to invest small amounts of fund 
capital in investments that would not meet the criteria under the 
proposed rule, such as shares of other venture capital funds,\53\ non-
convertible debt,\54\ or publicly traded securities.\55\ Both groups of 
commenters urged us to accommodate them by broadening the definition 
and modifying the proposed criteria.
---------------------------------------------------------------------------

    \51\ See, e.g., Comment Letter of the Committee on Federal 
Regulation of Securities of the American Bar Association (Jan. 31, 
2011) (``ABA Letter''); ATV Letter; BIO Letter; NVCA Letter; Comment 
Letter of Proskauer LLP (Jan. 23, 2011); Comment Letter of Union 
Square Ventures, LLC (Jan. 24, 2011) (``Union Square Letter'').
    \52\ See, e.g., Comment Letter of Advanced Technology Ventures 
(Jan. 24, 2011) (``ATV Letter''); BIO Letter; NVCA Letter; Comment 
Letter of Sevin Rosen Funds (Jan. 24, 2011) (``Sevin Rosen 
Letter''). One commenter argued that the rule ``should not bar the 
occasional, but also quite ordinary, financial activities'' of a 
venture capital fund. Charles River Letter.
    \53\ See, e.g., Comment Letter of Dechert LLP (Jan. 24, 2011) 
(``Dechert General Letter''); Comment Letter of First Round Capital 
(Jan. 24, 2011) (``First Round Letter''); Sevin Rosen Letter.
    \54\ See, e.g., Comment Letter of BioVentures Investors (Jan. 
24, 2011) (``BioVentures Letter''); Charles River Letter; Comment 
Letter of Davis Polk & Wardwell LLP (Jan. 24, 2011) (``Davis Polk 
Letter''); Merkl Letter.
    \55\ See, e.g., Comment Letter of Cardinal Partners (Jan. 24, 
2011) (``Cardinal Letter''); Davis Polk Letter; Comment Letter of 
Gunderson Dettmer Stough Villeneuve Franklin & Hachigian (Jan. 24, 
2011) (``Gunderson Dettmer Letter''); Merkl Letter.
---------------------------------------------------------------------------

    Commenters wanted advisers seeking to be eligible for the venture 
capital exemption to have greater flexibility to operate and invest in 
portfolio companies and to accommodate existing (and potentially 
evolving) business practices that may vary from what commenters 
characterized as typical venture capital fund practice.\56\ Some argued 
that a limited basket for such atypical investing activity could 
facilitate job creation and capital formation.\57\ They were also 
concerned that the multiple detailed criteria of the proposed rule 
could result in ``inadvertent'' violations of the criteria under the 
rule.\58\ Some expressed concern that a Commission rule defining a 
venture capital fund by reference to investing activity would have the 
result of reducing an adviser's investment discretion.\59\
---------------------------------------------------------------------------

    \56\ See, e.g., NVCA Letter; Comment Letter of Bessemer Venture 
Partners (Jan. 24, 2011) (``Bessemer Letter''); Oak Investment 
Letter. See also supra note 51.
    \57\ See, e.g., NVCA Letter (stating that a low level of 15% 
would ``allow innovation and job creation to flourish within the 
venture capital industry''); Sevin Rosen Letter (a 20% limit would 
be ``flexible enough not to severely impair the operations of bona 
fide [venture capital funds], a critically important resource for 
American innovation and job creation'').
    \58\ See, e.g., NVCA Letter (``Because of the consequence (i.e., 
Federal registration) of having even one inadvertent, non-qualifying 
investment, allowance for unintended or insignificant deviations, or 
differences in interpretations, is appropriate.''); Comment Letter 
of SV Life Sciences (Jan. 21, 2011) (``SV Life Sciences Letter'') 
(the ``lack of flexibility and ambiguity in certain definitions * * 
* could cause our firm or other venture firms to inadvertently hold 
non-qualifying investments''). See also ATV Letter.
    \59\ DuFauchard Letter (``Only the VC Fund advisers/managers are 
in a position to determine what best form `down-round' financing 
should take. Whether that should be new capital, project finance, a 
bridge loan, or some other form of equity or debt, is neither a 
question for the regulators nor should it be a question of strict 
regulatory control.''); ESP Letter (``There is no way a single 
regulation can determine what the appropriate level of leverage 
should be for every portfolio company.''); Merkl Letter (``The 
Commission should not regulate from whom the [portfolio company] 
securities can be acquired or how the [company's] capital can be 
used.'').
---------------------------------------------------------------------------

    We are sensitive to commenters' concerns that the definition not 
operate to foreclose investment funds from investment opportunities 
that would benefit investors but would not change the character of a 
venture capital fund.\60\ On the other hand, we are troubled that the 
cumulative effect of revising the rule to reflect all of the 
modifications supported by commenters could permit reliance on the 
exemption by advisers to other types of private funds and thus

[[Page 39650]]

expand the exemption beyond what we believe was the intent of 
Congress.\61\ A number of commenters argued that defining a venture 
capital fund by reference to multiple detailed criteria could result in 
``inadvertent'' violations of the definitional criteria by a qualifying 
fund.\62\ Another commenter acknowledged that providing de minimis 
carve-outs to the multiple criteria under the proposed rule could be 
``cumbersome,''\63\ which could lead to the result, asserted by some 
commenters, that an overly prescriptive rule could invite further 
unintentional violations of the registration provisions of the Advisers 
Act.\64\
---------------------------------------------------------------------------

    \60\ See, e.g., Oak Investment Letter; Sevin Rosen Letter.
    \61\ For example, one commenter suggested that the definition of 
venture capital fund include a fund that incurs leverage of up to 
20% of fund capital commitments without limit on duration and 
invests up to 20% of fund capital commitments in publicly traded 
securities and an additional 20% of fund capital commitments in non-
conforming investments. Charles River Letter. Under these 
guidelines, it would be possible to structure a fund that borrows up 
to 20% of the fund's ``capital commitments'' to acquire highly 
leveraged derivatives and publicly traded debt securities. If the 
fund only calls 20% of its capital, fund indebtedness would equal 
100% of fund assets, all of which would be in derivative instruments 
or publicly traded debt securities.
    \62\ See supra note 58.
    \63\ First Round Letter.
    \64\ See, e.g., generally NVCA Letter. See also Merkl Letter.
---------------------------------------------------------------------------

    To balance these competing considerations, we are adopting an 
approach suggested by several commenters that defines a venture capital 
fund to include a fund that invests a portion of its capital in 
investments that would not otherwise satisfy all of the elements of the 
rule (``non-qualifying basket'').\65\ Defining a venture capital fund 
to include funds engaged in some amount of non-qualifying investment 
activity provides advisers to venture capital funds with greater 
investment flexibility, while precluding an adviser relying on the 
exemption from altering the character of the fund's investments to such 
extent that the fund could no longer be viewed as a venture capital 
fund within the intended scope of the exemption. To the extent an 
adviser uses the basket to invest in some non-qualifying investments, 
it will have less room to invest in others, but the choice is left to 
the adviser. While the definition limits the amount of non-qualifying 
investments, it allows the adviser to choose how to allocate those 
investments. Thus, one venture capital fund may take advantage of some 
opportunities to invest in debt whereas others may seek limited 
opportunities in publicly offered securities. The definition of 
``business development company'' under the Advisers Act contains a 
similar basket for non-qualifying investments.\66\
---------------------------------------------------------------------------

    \65\ See, e.g., Abbott Capital Letter; ATV Letter; Bessemer 
Letter; BioVentures Letter; Cardinal Letter; Charles River Letter; 
Comment Letter of CompliGlobe Ltd. (Jan. 24, 2011) (``CompliGlobe 
Letter''); Davis Polk Letter; First Round Letter; NVCA Letter; 
Comment Letter of PTV Sciences (Jan. 24, 2011) (``PTV Sciences 
Letter''); Quaker BioVentures; Comment Letter of Sant[eacute] 
Ventures (Jan. 24, 2011) (``Sant[eacute] Ventures Letter''); Sevin 
Rosen Letter; SV Life Sciences; Comment Letter of U.S. Venture 
Partners (Jan. 24, 2011) (``USVP Letter''); Venrock Letter.
    \66\ Advisers Act section 202(a)(22) (defining a ``business 
development company'' as any company that meets the definition set 
forth in section 2(a)(48) of, and complies with section 55 of, the 
Investment Company Act, except that a BDC under the Advisers Act is 
defined to mean a company that invests 60% of its total assets in 
the assets specified in section 55 of the Investment Company Act).
---------------------------------------------------------------------------

    Commenters suggested non-qualifying baskets ranging from 15 to 30 
percent of a fund's capital commitments, although many of these same 
commenters wanted us to expand the other criteria of the proposed 
rule.\67\ Several commenters in favor of a non-qualifying basket 
asserted that setting the level for non-qualifying investments at a 
sufficiently low threshold would preclude advisers to other types of 
private funds from relying on the venture capital exemption while 
providing venture capital advisers the flexibility to take advantage of 
investment opportunities.\68\ These commenters properly framed the 
question before us. We did not, however, receive specific empirical 
analysis regarding the venture capital industry as a whole that would 
help us determine the appropriate size of the basket.\69\ Many of those 
supporting a 15 percent non-qualifying basket also supported expanding 
some of the other elements of the definition, and thus it is unclear 
whether a 15 percent non-qualifying basket alone would satisfy their 
needs.\70\ On the other hand, those supporting a much larger basket did 
not, in our view, adequately address our concern that an overly 
expansive definition would provide room for advisers to private equity 
funds to remain unregistered, a consequence several commenters urged us 
to avoid.\71\
---------------------------------------------------------------------------

    \67\ See, e.g., NVCA Letter (more than 25 comment letters 
expressed general support for the comments raised in the NVCA 
Letter). Two commenters expressed support for a 30% basket for non-
qualifying investments. See Comment Letter of Shearman & Sterling 
LLP (Jan. 24, 2011) (``Shearman Letter'') (citing, in support of 
this position, the BDC definition under the Investment Company Act, 
which specifies a threshold of 30% for non-qualifying activity); 
Quaker BioVentures Letter (citing, in support of this position, the 
BDC definition under the Investment Company Act and the BDC 
definition under the Advisers Act which increased the non-qualifying 
activity threshold to 40%).
    \68\ Norwest Letter; Sevin Rosen Letter (noting that a 20% limit 
is ``low enough to ensure that only true [venture capital funds] are 
able to qualify for the [venture capital] exemption.''). See also 
NVCA Letter.
    \69\ We did, however, receive much anecdotal evidence of 
particular advisers' experiences with non-qualifying investments. 
See, e.g., Cardinal Letter (``In a very limited number of cases, it 
has been necessary for us to purchase securities from current 
shareholders of the portfolio company in order for the financing to 
be completed. However, in NO case have purchases from existing 
shareholders ever exceeded 15% of the total investment by Cardinal 
in a proposed financing.''); Charles River Letter (``The vast 
majority of our investments are in the form of Convertible Preferred 
Stock. * * * However, very rarely--but more often than never--- we 
invest in the form of a straight, non-convertible Demand Note.''); 
Pine Brook Letter (``Our fund documents provide for investments 
outside of our core investing practice of up to 25% of our committed 
capital.''). But cf. Mesirow Financial Private Equity Advisors, Inc. 
(Jan. 24, 2011) (``Mesirow Letter'') (a Commission-registered 
adviser that advises funds that invest in other venture capital and 
private equity funds stated that ``[s]ince the main purpose of 
[venture capital funds] is to invest in and help build operating 
companies, we believe their participation in non-qualifying activity 
will be rare.'').
    \70\ See supra note 67.
    \71\ See supra note 43.
---------------------------------------------------------------------------

    On balance, and after giving due consideration to the approaches 
suggested by commenters, we are adopting a limit of 20 percent of a 
qualifying fund's capital commitments for non-qualifying investments. 
We believe that a 20 percent limit will provide the flexibility sought 
by many venture capital fund commenters while appropriately limiting 
the scope of the exemption. We note that several commenters recommended 
a non-qualifying basket limit of 20 percent.\72\
---------------------------------------------------------------------------

    \72\ See, e.g., ATV Letter; Charles River Letter; Sevin Rosen 
Letter. At least one commenter stated that the minimum threshold 
limit for the non-qualifying basket should be 20%. Charles River 
Letter (``we believe anything less than 20% would be inadequate'').
---------------------------------------------------------------------------

    We considered adopting a 40 percent basket for non-qualifying 
investments by analogy to the Advisers Act definition of BDC.\73\ That 
basket was established by Congress rather than the Commission, and it 
strikes us as too large in light of our task of implementing a 
statutory provision that does not specify a basket.\74\ We find a 
better analogy in a rule we adopted in 2001 under the Investment 
Company Act. Under rule 35d-1 of that Act, commonly referred to as the 
``names rule,'' an investment company with a name suggesting that it 
invests in certain investments is limited to investing no more than 20 
percent of its assets in other types of investments (i.e.,

[[Page 39651]]

non-qualifying investments).\75\ In adopting that rule, we explained 
that ``if an investment company elects to use a name that suggests its 
investment policy, it is important that the level of required 
investments be high enough that the name will accurately reflect the 
company's investment policy.'' \76\ We noted that having a registered 
investment company hold a significant amount of investments consistent 
with its name is an important tool for investor protection,\77\ but 
setting the limit at 20 percent gives the investment company management 
flexibility.\78\ While our policy goal today in defining a ``venture 
capital fund'' is somewhat different from our goal in prescribing 
limitations on investment company names, the tensions we sought to 
reconcile are similar.\79\
---------------------------------------------------------------------------

    \73\ See supra note 66.
    \74\ A larger non-qualifying basket of 40% could have the result 
of changing the fundamental underlying nature of the investments 
held by a qualifying fund, such as for example increasing the extent 
to which non-qualifying investments may contribute to the returns of 
the fund's portfolio.
    \75\ Rule 35d-1(a)(2) under the Investment Company Act (``a 
materially deceptive and misleading name of a [registered investment 
company] includes * * * [a] name suggesting that the [registered 
investment company] focuses its investments in a particular type of 
investment or investments, or in a particular industry or group of 
industries, unless: (i) The [registered investment company] has 
adopted a policy to invest, under normal circumstances, at least 80% 
of the value of its [total assets] in the particular type of 
investments, or in investments in the particular industry or 
industries, suggested by the [registered investment company's] name 
* * *''). 17 CFR 270.35d-1(a)(2).
    \76\ Investment Company Names, Investment Company Act Release 
No. 24828 (Jan. 17, 2001) [66 FR 8509, 8511 (Feb. 1, 2001), 
correction 66 FR 14828 (Mar. 14, 2001)] (``Names Rule Adopting 
Release'').
    \77\ Names Rule Adopting Release, supra note 76, at text 
accompanying n.3 and text following n.7.
    \78\ See Names Rule Adopting Release, supra note 76, at text 
accompanying n.14. See also NVCA Letter; Sevin Rosen Letter (citing 
rule 35d-1 in support of recommending that the rule adopt a non-
qualifying basket); Quaker BioVentures Letter (citing the approach 
taken by the staff generally limiting an investment company excluded 
by reason of section 3(c)(5)(C) of the Investment Company Act to 
investing no more than 20% of its assets in non-qualifying 
investments).
    \79\ A number of commenters recommended that the rule specify a 
range for the non-qualifying basket, arguing that this approach 
would provide advisers to venture capital funds with better 
flexibility to manage their investments over time. See, e.g., DLA 
Piper VC Letter; DuFauchard Letter; Norwest Letter; Oak Investment 
Letter. As we discuss in greater detail below, the non-qualifying 
basket is determined as of the time immediately following each 
investment and hence a range is not necessary.
---------------------------------------------------------------------------

1. Qualifying Investments
    Under the rule, to meet the definition of venture capital fund, the 
fund must hold, immediately after the acquisition of any asset (other 
than qualifying investments or short-term holdings), no more than 20 
percent of the fund's capital commitments in non-qualifying investments 
(other than short-term holdings).\80\ Thus, as discussed above, a 
qualifying fund could invest without restriction up to 20 percent of 
the fund's capital commitments in non-qualifying investments and would 
still fall within the venture capital fund definition.
---------------------------------------------------------------------------

    \80\ Rule 203(l)-1(a)(2). The rule specifies that ``immediately 
after the acquisition of any asset (other than qualifying 
investments or short-term holdings)'' no more than 20% of the fund's 
aggregate capital contributions and uncalled committed capital may 
be held in assets (other than short-term holdings) that are not 
qualifying investments.'' See infra Section II.A.1.c. for a 
discussion on the operation of the 20% limit.
---------------------------------------------------------------------------

    For purposes of the rule, a ``qualifying investment,'' which we 
discuss in greater detail below, generally consists of any equity 
security issued by a qualifying portfolio company that is directly 
acquired by a qualifying fund and certain equity securities exchanged 
for the directly acquired securities.\81\
---------------------------------------------------------------------------

    \81\ See Sections II.A.1.b.
---------------------------------------------------------------------------

a. Equity Securities of Portfolio Companies
    Rule 203(l)-1 defines a venture capital fund as a private fund 
that, excluding investments in short-term holdings and non-qualifying 
investments, generally holds equity securities of qualifying portfolio 
companies.\82\
---------------------------------------------------------------------------

    \82\ Rule 203(l)-1(a)(2) (specifying the investments of a 
venture capital fund); (c)(3) (defining ``qualifying investment''); 
and (c)(6) (defining ``short-term holdings'').
---------------------------------------------------------------------------

    We proposed to define ``equity security'' by reference to the 
Exchange Act.\83\ Commenters did not generally object to our proposal 
to do so, although many urged that we expand the definition of venture 
capital fund to include investments in other types of securities.\84\ 
Commenters asserted that venture capital funds may invest in securities 
other than equity securities (including debt securities) for various 
business reasons, including to provide ``bridge'' financing to 
portfolio companies between equity financing rounds,\85\ for working 
capital needs \86\ or for tax or structuring reasons.\87\ Many of these 
commenters recommended that the rule also define a venture capital fund 
to include funds that invest in non-convertible bridge loans of a 
portfolio company,\88\ interests in other pooled investment funds 
(including other venture capital funds) \89\ and publicly offered 
securities.\90\ Commenters argued that these types of investments 
facilitate access to capital for a company's expansion,\91\ offer 
qualifying funds flexibility to structure investments in a manner that 
is most appropriate for the fund (and its investors), including for 
example to obtain favorable tax treatment, manage risks (such as 
bankruptcy protection), maintain the value of the fund's equity 
investment or satisfy the specific financing needs of a portfolio 
company,\92\ and enable a portfolio company to seek such financing from 
venture capital funds if the company is unable to obtain financing from 
traditional lending sources.\93\
---------------------------------------------------------------------------

    \83\ Proposed rule 203(l)-1(c)(2).
    \84\ Several commenters opposed any restriction on the 
definition of equity security. See, e.g., Bessemer Letter; ESP 
Letter; NVCA Letter.
    \85\ ATV Letter; NVCA Letter.
    \86\ Comment Letter of Cook Children's Health Care Foundation 
Investment Committee (Jan. 20, 2011) (``Cook Children's Letter''); 
Comment Letter of Leland Fikes Foundation, Inc. (Jan. 21, 2011) 
(``Leland Fikes Letter'').
    \87\ Bessemer Letter; Merkl Letter.
    \88\ See, e.g., Comment Letter of CounselWorks LLC (Jan. 24, 
2011); ESP Letter; Comment Letter of McGuireWoods LLP (Jan. 24, 
2011) (``McGuireWoods Letter''); NVCA Letter; Oak Investment Letter. 
See also BioVentures Letter (supported venture capital fund 
investments in non-convertible debt without a time limit); Cook 
Children's Letter; Leland Fikes Letter (each of which expressed 
general support). One commenter indicated that the proposed 
condition limiting investments in portfolio companies to equity 
securities was too narrow. See Pine Brook Letter.
    \89\ See, e.g., Cook Children's Letter; Leland Fikes Letter; PEI 
Funds Letter; Comment Letter of SVB Financial Group (Jan. 24, 2011) 
(``SVB Letter'').
    \90\ See, e.g., ATV Letter; BIO Letter (noted that investments 
by venture capital funds in ``PIPEs'' (i.e., ``private investments 
in public equity'') are ``common'').
    \91\ See, e.g., Lowenstein Letter; Comment Letter of John G. 
McDonald (Jan. 21, 2011) (``McDonald Letter''); Quaker BioVentures 
Letter; Comment Letter of Trident Capital (Jan. 24, 2011) (``Trident 
Letter'').
    \92\ See, e.g., Merkl Letter; Oak Investments Letter; Sevin 
Rosen Letter; Comment Letter of Vedanta Capital, LP (Jan. 24, 2011) 
(``Vedanta Letter'').
    \93\ NVCA Letter; Trident Letter.
---------------------------------------------------------------------------

    We recognize that a venture capital fund may, on occasion, make 
investments other than in equity securities.\94\ Under the rule, as 
discussed above, a venture capital fund may make these investments (as 
well as other types of investments that commenters may not have 
suggested) to the extent there is room in the fund's non-qualifying 
basket. Hence, we are adopting the definition of equity security as 
proposed.
---------------------------------------------------------------------------

    \94\ See, e.g., ESP Letter; Leland Fikes Letter; McGuireWoods 
Letter; NVCA Letter; Oak Investment Letter. See also supra Section 
II.A.
---------------------------------------------------------------------------

    The final rule incorporates the definition of equity security in 
section 3(a)(11) of the Exchange Act and rule 3a11-1 thereunder.\95\ 
Accordingly,

[[Page 39652]]

equity security includes common stock as well as preferred stock, 
warrants and other securities convertible into common stock in addition 
to limited partnership interests.\96\ Our definition of equity security 
is broad. The definition includes various securities in which venture 
capital funds typically invest and provides venture capital funds with 
flexibility to determine which equity securities in the portfolio 
company capital structure are appropriate for the fund. Our use of the 
definition of equity security under the Exchange Act acknowledges that 
venture capital funds typically invest in common stock and other equity 
instruments that may be convertible into equity common stock but does 
not otherwise specify the types of equity instruments that a venture 
capital fund could hold in deference to the business judgment of 
venture capital funds.
---------------------------------------------------------------------------

    \95\ Rule 203(l)-1(c)(2) (equity security ``has the same meaning 
as in section 3(a)(11) of the Securities Exchange Act of 1934 (15 
U.S.C. 78c(a)(11)) and Sec.  240.3a11-1 of this chapter.''). See 15 
U.S.C. 78c(a)(11) (defining ``equity security'' as ``any stock or 
similar security; or any security future on any such security; or 
any security convertible, with or without consideration, into such a 
security, or carrying any warrant or right to subscribe to or 
purchase such a security; or any such warrant or right; or any other 
security which the Commission shall deem to be of similar nature and 
consider necessary or appropriate, by such rules and regulations as 
it may prescribe in the public interest or for the protection of 
investors, to treat as an equity security.''); rule 3a11-1 under the 
Exchange Act (17 CFR 240.3a11-1) (defining ``equity security'' to 
include ``any stock or similar security, certificate of interest or 
participation in any profit sharing agreement, preorganization 
certificate or subscription, transferable share, voting trust 
certificate or certificate of deposit for an equity security, 
limited partnership interest, interest in a joint venture, or 
certificate of interest in a business trust; any security future on 
any such security; or any security convertible, with or without 
consideration, into such a security, or carrying any warrant or 
right to subscribe to or purchase such a security; or any such 
warrant or right; or any put, call, straddle, or other option or 
privilege of buying such a security from or selling such a security 
to another without being bound to do so.'').
    \96\ See rule 3a11-1 under the Exchange Act (17 CFR 240.3a11-1) 
(defining ``equity security'' to include any ``limited partnership 
interest'').
---------------------------------------------------------------------------

b. Capital Used for Operating and Business Purposes
    Rule 203(l)-1 defines a venture capital fund as a private fund that 
holds no more than 20 percent of the fund's capital commitments in non-
qualifying investments (other than short-term holdings). Under the 
final rule, qualifying investments are generally equity securities that 
were acquired by the fund in one of three ways that suggest that the 
fund's capital is being used to finance the operations of businesses 
rather than for trading in secondary markets. As discussed in greater 
detail below, rule 203(l)-1 defines a ``qualifying investment'' as: (i) 
Any equity security issued by a qualifying portfolio company that is 
directly acquired by the private fund from the company (``directly 
acquired equity''); (ii) any equity security issued by a qualifying 
portfolio company in exchange for directly acquired equity issued by 
the same qualifying portfolio company; and (iii) any equity security 
issued by a company of which a qualifying portfolio company is a 
majority-owned subsidiary, or a predecessor, and that is acquired by 
the fund in exchange for directly acquired equity.\97\
---------------------------------------------------------------------------

    \97\ Rule 203(l)-1(c)(3). A security received as a dividend by 
virtue of the fund's holding of a qualifying investment would also 
be a qualifying investment. See generally infra note 480.
---------------------------------------------------------------------------

    In the Proposing Release we explained that one of the features of 
venture capital funds that distinguish them from hedge funds and 
private equity funds is that they invest capital directly in portfolio 
companies for the purpose of funding the expansion and development of 
the companies' business rather than buying out existing security 
holders.\98\ Thus, we proposed that, to meet the definition, at least 
80 percent of a fund's investment in each portfolio company must be 
acquired directly from the company, in effect limiting a venture 
capital fund's ability to acquire secondary market shares to 20 percent 
of the fund's investment in each company.\99\
---------------------------------------------------------------------------

    \98\ Proposing Release, supra note 26, at text accompanying 
n.104.
    \99\ Proposed rule 203(l)-1(a)(2).
---------------------------------------------------------------------------

    A few commenters objected to any limitation on secondary market 
purchases of a qualifying portfolio company's shares,\100\ but did not 
address the critical role this condition played in differentiating 
venture capital funds from other types of private funds, such as 
leveraged buyout funds, which acquire controlling equity interests in 
operating companies through the ``buyout'' of existing security 
holders.\101\ Nor did they offer an alternative method in lieu of the 
direct acquisition criterion to distinguish venture capital funds from 
the buyout funds that are considered private equity funds. We continue 
to believe that the limit on secondary purchases is an important 
element for distinguishing advisers to venture capital funds from 
advisers to the types of private equity funds for which Congress did 
not provide an exemption.\102\ Therefore, we are not modifying the 
definition of qualifying investment to broadly include equity 
securities acquired in secondary transactions.
---------------------------------------------------------------------------

    \100\ See, e.g., ESP Letter; Merkl Letter.
    \101\ See also Proposing Release, supra note 26, at section 
II.A.1.d.
    \102\ See id., at n.112 and accompanying text.
---------------------------------------------------------------------------

    We are, however, making two changes in this provision in response 
to commenters. First, we have eliminated the 20 percent limit for 
secondary market transactions that we included in this provision in our 
proposal in favor of the broader 20 percent limit for assets that are 
not qualifying investments.\103\ Most commenters addressing the limit 
on secondary market acquisitions supported changing the threshold from 
80 percent of the fund's investment in each portfolio company to either 
50 percent in each portfolio company,\104\ or 80 percent of the fund's 
total capital commitments.\105\ These commenters argued that secondary 
acquisitions provide liquidity to founders, angel investors and 
employees/former employees or align the interests of a fund with those 
of a portfolio company.\106\
---------------------------------------------------------------------------

    \103\ Cf. proposed rule 203(l)-1(a)(2) and rule 203(l)-1(a)(2).
    \104\ See DLA Piper VC Letter; Davis Polk Letter; Sevin Rosen 
Letter (each supported lowering the direct purchase requirement from 
80% to 50% of each qualifying portfolio company's equity 
securities); Dechert General Letter (argued that the 20% allowance 
for secondary purchases should be increased to 45%, consistent with 
rules 3a-1 and 3c-5 under the Investment Company Act). See also ABA 
Letter (supported lowering the threshold from 80% to 70%); NVCA 
Letter; Mesirow Letter; Oak Investments Letter. Several commenters 
disagreed with the proposed direct acquisition criterion and 
recommended that venture capital fund investments in portfolio 
company securities through secondary transactions should not be 
subject to any limit. See, e.g., ESP Letter; Merkl Letter.
    \105\ ATV Letter; Bessemer Letter; Charles River Letter; Davis 
Polk Letter; First Round Letter; Gunderson Dettmer Letter; InterWest 
Letter; Mesirow Letter; Norwest Letter; NVCA Letter; Oak Investment 
Letter; Sevin Rosen Letter; SVB Letter; Union Square Letter; Vedanta 
Letter. See also Comment Letter of Alta Partners (Jan. 24, 2011) 
(``Alta Partners Letter''); USVP Letter.
    \106\ See, e.g., Bessemer Letter; Norwest Letter; Sevin Rosen 
Letter.
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    We believe that the limit on secondary purchases remains an 
important element for distinguishing advisers to venture capital funds 
from advisers to the types of private equity funds for which Congress 
did not provide an exemption.\107\ However, as discussed above, a 
venture capital fund may purchase shares in secondary markets to the 
extent it has room for such securities in its non-qualifying basket.
---------------------------------------------------------------------------

    \107\ See Proposing Release, supra note 26, at n.112 and 
accompanying text.
---------------------------------------------------------------------------

    Second, the final rule defines qualifying investments as including 
equity securities issued by the qualifying portfolio company that are 
received in exchange for directly acquired equities issued by the same 
qualifying portfolio company.\108\ This revision was suggested by a 
number of

[[Page 39653]]

commenters to enable a qualifying fund to participate in the 
reorganization of the capital structure of a portfolio company, which 
may require the fund, along with other existing security holders, to 
accept newly issued equity securities in exchange for previously issued 
equity securities.\109\
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    \108\ Under rule 203(l)-1(c)(3)(ii), ``qualifying investments'' 
include any equity security issued by a qualifying portfolio company 
in exchange for an equity security issued by the qualifying 
portfolio company that is directly acquired. See infra note 113.
    \109\ See, e.g., NVCA Letter. See also Sevin Rosen Letter. 
Although we understand that the securities received in an exchange 
are typically newly issued, the rule would also cover exchanges for 
outstanding securities. See also infra note 113.
---------------------------------------------------------------------------

    The rule similarly treats as a qualifying investment any equity 
security issued by another company in exchange for directly acquired 
equities of a qualifying portfolio company, provided that the 
qualifying portfolio company becomes a majority-owned subsidiary of the 
other company or is a predecessor company.\110\ This provision enables 
a qualifying fund to acquire securities in connection with the 
acquisition (or merger) of a qualifying portfolio company by another 
company,\111\ without jeopardizing the fund's ability to satisfy the 
definition of venture capital fund. A venture capital fund's 
acquisition of publicly offered securities in these circumstances may 
not present the same degree of interconnectedness with the public 
markets as secondary acquisitions through the open markets that are 
typical of other types of leveraged buyout private funds.\112\ As a 
result of the modification to the proposed rule, a venture capital fund 
could hold equity securities of a company subject to reporting under 
the Exchange Act, if such equity securities were issued to the fund in 
exchange for directly acquired equities of a qualifying portfolio 
company that became a majority-owned subsidiary of the reporting 
company.\113\
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    \110\ Under rule 203(l)-1(c)(3)(iii), ``qualifying investments'' 
include any equity security issued by a company of which a 
qualifying portfolio company is a majority-owned subsidiary (as 
defined in section 2(a)(24) of the Investment Company Act), or a 
predecessor company, and that is acquired by the private fund in 
exchange for an equity security described in paragraph (c)(3)(i) or 
(c)(3)(ii) of the rule. See infra note 113.
     A ``majority-owned subsidiary'' is defined by reference to 
section 2(a)(24) of the Investment Company Act, (15 U.S.C. 
80a2(a)(24), which defines a ``majority-owned subsidiary'' of any 
person as ``a company 50 per centum or more of the outstanding 
voting securities of which are owned by such person, or by a company 
which, within the meaning of this paragraph, is a majority-owned 
subsidiary of such person.''
    \111\ See, e.g., Davis Polk Letter; Comment Letter of 
Institutional Venture Partners (Jan. 24, 2011) (``IVP Letter''); 
Mesirow Letter; PTV Sciences Letter. A number of commenters argued 
that without this expanded definition, typical transactions enabling 
a venture capital fund to restructure its investment in a portfolio 
company, exit its investment or obtain liquidity for itself and its 
investors, as well as profits, would be precluded. See, e.g., NVCA 
Letter; PTV Sciences Letter.
    \112\ See, e.g., Davis Polk Letter. See also Mesirow Letter.
    \113\ Under the rule, a qualifying fund could separately 
purchase additional securities pursuant to a public offering (or 
recapitalization) from a company after it ceases to be a 
``qualifying portfolio company'' (because for example such company 
has become a reporting or foreign traded company), subject to the 
non-qualifying basket.
---------------------------------------------------------------------------

c. Operation of the 20 Percent Limit
    Under the rule, to meet the definition of venture capital fund, a 
qualifying fund must hold, immediately after the acquisition of any 
asset (other than qualifying investments or short-term holdings), no 
more than 20 percent of the fund's capital commitments in non-
qualifying investments (other than short-term holdings).\114\ Under 
this approach, a fund need only calculate the 20 percent limit when the 
fund acquires a non-qualifying investment (other than short-term 
holdings); after the acquisition, the fund need not dispose of a non-
qualifying investment simply because of a change in the value of that 
investment. A qualifying fund, however, could not purchase additional 
non-qualifying investments until the value of its then-existing non-
qualifying investments fell below 20 percent of the fund's committed 
capital.
---------------------------------------------------------------------------

    \114\ Rule 203(l)-1(a)(2). The calculation of the 20% limit 
operates in a fashion similar to the diversification and ``Second 
Tier Security'' tests of rule 2a-7 under the Investment Company Act. 
17 CFR 270.2a-7(a)(24). See Revisions to Rules Regulating Money 
Market Funds, Investment Company Act Release No. 18005 (Feb. 20, 
1991) [56 FR 8113, 8118 (Feb. 27, 1991)].
---------------------------------------------------------------------------

    As discussed above, most commenters supporting a basket for non-
qualifying investments recommended a limit expressed as a percentage of 
fund capital commitments.\115\ One commenter further suggested that the 
value of investments included in the non-qualifying basket be 
calculated at the time each investment is made to include only those 
non-qualifying investments that are then held by the fund (thus 
excluding liquidated assets); the commenter argued that this approach 
would give funds certainty that a qualifying investment would not 
become ``non-qualifying'' and simplify the test for compliance.\116\
---------------------------------------------------------------------------

    \115\ See supra note 67.
    \116\ Sevin Rosen Letter. See also BioVentures Letter (endorsing 
the NVCA Letter supporting a non-qualifying basket determined as a 
percentage of fund capital commitments, but also arguing in favor of 
determining the basket ``at any point in time, rather than in the 
aggregate over the life of the fund'').
---------------------------------------------------------------------------

    We are persuaded that the non-qualifying basket should be based on 
a qualifying fund's total capital commitments, and the fund's 
compliance with the 20 percent limit should be calculated at the time 
any non-qualifying investment is made, based on the non-qualifying 
investments then held in the fund's portfolio.\117\ We understand that 
using a fund's capital commitments for determining investment 
thresholds is generally consistent with existing venture capital fund 
practice,\118\ and nearly all of the commenters requesting a basket 
specified the basket as a percentage of the fund's capital 
commitments.\119\ We expect that calculating the size of the non-
qualifying basket as a percentage of a qualifying fund's capital 
commitments, which will remain relatively constant during the fund's 
term, will provide advisers with a degree of predictability when 
managing the fund's portfolio and determining how much of the basket 
remains available for new investments.
---------------------------------------------------------------------------

    \117\ Capital commitments that have been called but returned to 
investors and subject to a future call would be treated as uncalled 
capital commitments. Capital commitments that are no longer subject 
to a call by the fund would not be treated as uncalled capital 
commitments.
    \118\ See generally infra notes 240-243 (discussing the use of a 
qualifying fund's capital commitments to determine the fund's 
compliance with the leverage criterion). See also DLA Piper VC 
Letter.
    \119\ See generally supra note 67. For purposes of reporting its 
``regulatory assets under management'' on Form ADV, an adviser would 
include uncalled capital commitments of a private fund advised by 
the adviser.
---------------------------------------------------------------------------

    We acknowledge that limiting non-qualifying investments to a 
percentage of fund capital commitments could result in a qualifying 
fund that invests its initial capital call in non-qualifying 
investments; \120\ but that ability would be constrained by the 
adviser's need to reconcile that investment with the fund's required 
representation that it pursues a venture capital strategy.\121\ An 
investment adviser that manages a fund in such a manner that renders 
the representation to investors and potential investors that the fund 
pursues a venture capital strategy an untrue statement of material fact 
would violate the antifraud provisions of the Advisers Act.\122\ We 
understand that a venture capital fund is not typically required to 
call or fully draw down all of its capital commitments. However, only 
bona fide capital commitments may be included in the calculation under 
rule 203(l)-

[[Page 39654]]

1.\123\ For example, commitments made for the purpose of increasing the 
non-qualifying basket and with an understanding with investors that 
they will not be called cannot be included.\124\
---------------------------------------------------------------------------

    \120\ See AFL-CIO Letter; AFR Letter (discussing issues 
associated with specifying leverage as a percentage of fund capital 
commitments).
    \121\ See infra Section II.A.7.
    \122\ The Commission does not need to demonstrate that an 
adviser violating rule 206(4)-8 acted with scienter. See Prohibition 
of Fraud by Advisers to Certain Pooled Investment Vehicles, 
Investment Advisers Act Release No. 2628 (Aug. 3, 2007) [72 FR 44756 
(Aug. 9, 2007)] (``Pooled Vehicles Release'').
    \123\ See also Investment Adviser Performance Compensation, 
Investment Advisers Act Release No. 3198 (May 10, 2011) [76 FR 27959 
(May 13, 2011)] at n.17 (in determining whether a person holds the 
requisite amount of assets under management, an investment adviser 
may include ``assets that a client is contractually obligated to 
invest in private funds managed by the adviser. Only bona fide 
contractual commitments may be included, i.e., those that the 
adviser has a reasonable belief that the investor will be able to 
meet.'').
    \124\ Similarly, fee waivers or reductions for the purpose of 
inducing investors to increase the size of their capital commitments 
with an understanding that they will not be called (and hence enable 
the adviser to increase the size of the non-qualifying basket) would 
indicate that the commitments are not bona fide. In addition, the 
amount of capital commitments and contributions made by investors 
and the investments made by the fund are indispensable to the 
functioning of a venture capital fund, and we understand advisers to 
venture capital funds typically maintain records reflecting them. 
See generally supra note 5 (describing the Commission's authority to 
examine the records of advisers relying on the venture capital 
exemption). We note that a person claiming an exemption under the 
Federal securities laws has the burden of proving it is entitled to 
the exemption. See, e.g., SEC v. Ralston Purina Co., 346 U.S. 119, 
126 (1953); Gilligan, Will & Co. v. SEC, 267 F.2d 461, 466 (2d Cir. 
1959); Swenson v. Engelstad, 626 F.2d 421, 425 (5th Cir. 1980); SEC 
v. Wall St. Transcript Corp., 454 F. Supp. 559, 566 (S.D.N.Y. 1978) 
(stating that the defendant publisher ``must register unless it can 
be shown that it is'' entitled to rely on an exclusion from the 
definition of ``investment adviser'').
---------------------------------------------------------------------------

    Moreover, we believe that by applying the 20 percent limit as of 
the time of acquisition of each non-qualifying investment, a fund is 
able to determine prospectively how much it can invest in the non-
qualifying basket. We believe that this simpler approach to determining 
the non-qualifying basket would better limit a qualifying fund's non-
qualifying investments and ease the burden of determining compliance 
with the criterion under the rule.
    To determine compliance with the 20 percent limit, a venture 
capital fund would, immediately after the acquisition of any non-
qualifying investment, excluding any short-term holdings,\125\ 
calculate the total value of all of the fund's assets held at that 
time, excluding short-term holdings, that are invested in non-
qualifying investments, as a percentage of the fund's total capital 
commitments.\126\ For this purpose, the 20 percent test is determined 
based on the qualifying fund's non-qualifying investments after taking 
into account the acquisition of any newly acquired non-qualifying 
investment.\127\
---------------------------------------------------------------------------

    \125\ Rule 203(l)-1(c)(6) (``Short-term holdings'' means cash 
and cash equivalents as defined in Sec.  270.2a51-1(b)(7)(i), U.S. 
Treasuries with a remaining maturity of 60 days or less, and shares 
of an open-end management investment company registered under 
section 8 of the Investment Company Act of 1940 [15 U.S.C. 80a-8] 
that is regulated as a money market fund under Sec.  270.2a-7 of 
this chapter.'').
    \126\ A qualifying investment that is acquired as a result of an 
exchange of equity securities provided by rule 203(l)-1(c)(3)(ii) 
and (iii) would not result in a requirement to calculate the 20% 
limit under rule 203(l)-1(a)(2).
    \127\ Rule 203(l)-1(a)(2).
---------------------------------------------------------------------------

    To determine if a fund satisfies the 20 percent limit for non-
qualifying investments, the fund may use either historical cost or fair 
value, as long as the same method is applied to all investments of a 
qualifying fund in a consistent manner during the term of the 
fund.\128\ Under the rule, a venture capital fund could use either 
historical cost or fair value, depending, for example, on the fund's 
approach to valuing investments since the fund's inception. Under the 
final rule, a qualifying fund using historical cost need not account 
for changes in the value of its portfolio due to, for example, market 
fluctuations in the value of a non-qualifying investment or the sale or 
other disposition of a qualifying investment (including the associated 
distribution of sale proceeds to fund investors). Requiring fair value 
in this particular instance could make investment planning difficult 
because the amount of dollars allocated to the non-qualifying basket 
would vary depending on changes in the value of investments already 
made. In addition, requiring fair value could complicate compliance for 
those qualifying funds that make investments frequently, because each 
investment would result in a requirement to value the fund's assets. 
Because the rule specifies that the valuation method must be 
consistently applied, this approach is designed to prevent a qualifying 
fund, or its adviser, from alternating between valuation methodologies 
in order to circumvent the 20 percent limit.
---------------------------------------------------------------------------

    \128\ Id.
---------------------------------------------------------------------------

    Our rule's approach to the valuation method, which allows the use 
of historical cost in determining compliance with the non-qualifying 
basket limit, is similar in this respect to rules under the Employee 
Retirement Income Security Act of 1974 (``ERISA'') for funds qualifying 
as ``venture capital operating companies,'' which generally specify 
that the value of a fund's investments is determined on a cost 
basis.\129\ Many commenters cited the ERISA rule in connection with 
comments on other proposed criteria,\130\ and hence we believe 
advisers' familiarity with the ERISA rule will facilitate compliance 
with our approach to the 20 percent limit and reduce the burdens 
associated with compliance.
---------------------------------------------------------------------------

    \129\ Under U.S. Department of Labor regulations, a venture 
capital operating company (``VCOC'') is any entity that, as of the 
date of the first investment (or other relevant time), has at least 
50% of its assets (other than short-term investments pending long-
term commitment or distribution to investors), valued at cost, 
invested in venture capital investments. 29 CFR 2510.3-101(d). See 
also Proposing Release, supra note 26, at n.70.
    \130\ For example, a number of commenters urged us to adopt the 
approach under ERISA that would determine whether or not a fund has 
satisfied the managerial assistance criterion. See infra note 225.
---------------------------------------------------------------------------

2. Short-Term Holdings
    A qualifying fund may also invest in cash and cash equivalents, 
U.S. Treasuries with a remaining maturity of 60 days or less and shares 
of registered money market funds.\131\ A qualifying fund need not 
include its investments in these short-term holdings when determining 
whether it satisfies the 20 percent limit for non-qualifying 
investments.\132\
---------------------------------------------------------------------------

    \131\ Rule 203(l)-1(c)(6).
    \132\ Rule 203(l)-1(a)(2). As proposed, a venture capital fund 
would have been defined as a fund that invested solely in certain 
investments, including specified cash instruments. Proposed rule 
203(l)-1(a)(2)(ii). In the final rule, a venture capital fund is 
defined as a fund that holds no more than 20% of its committed 
capital in assets that are not qualifying investments, excluding for 
this purpose short-term holdings (which is defined to include 
specified cash instruments). Rule 203(l)-1(a)(2). The general focus 
of both the proposal and the final rule is on the types of 
investments in which a qualifying fund may invest. As a result of 
the modifications to the rule to incorporate a non-qualifying 
basket, we are excluding short-term holdings from the calculation of 
qualifying and non-qualifying investments.
---------------------------------------------------------------------------

    Most commenters that addressed the cash element of the proposal did 
not disagree with our approach to the cash element but urged us to 
expand it to include money market funds,\133\ any U.S. Treasury without 
regard to maturity,\134\ debt issued by foreign governments,\135\ 
repurchase agreements,\136\ and certain highly rated corporate 
commercial paper.\137\ Many commenters did not provide a rationale, 
other than business practice, for expanding the cash element to include 
these other types of investments or discuss whether these changes would 
also permit other types of funds to meet the definition. One commenter 
did note, however, that short-term investments are typically held 
during the period between a capital call and funding by

[[Page 39655]]

investors and invested in instruments that may provide higher returns 
than the cash items identified in the proposed rule.\138\
---------------------------------------------------------------------------

    \133\ Comment Letter of Federated Investors, Inc. (Jan. 18, 
2011); IVP Letter; Merkl Letter.
    \134\ See, e.g., Dechert General Letter; IVP Letter. See also 
Shearman Letter; SVB Letter (also argued that Treasuries pose no 
systemic risk issues).
    \135\ Dechert General Letter; Commenter Letter of European Fund 
and Asset Management Association (Jan. 24, 2011) (``EFAMA Letter''); 
Merkl Letter.
    \136\ IVP Letter; NVCA Letter.
    \137\ Sevin Rosen Letter.
    \138\ NVCA Letter.
---------------------------------------------------------------------------

    The Commission recognizes that a broader definition of short-term 
holdings could yield venture capital funds greater returns.\139\ The 
exclusion of short-term holdings from a qualifying fund's assets for 
purposes of the 20 percent test, however, recognizes that such holdings 
are not ordinarily held as part of the fund's investment portfolio but 
as a cash management tool.\140\ Advisers to venture capital funds that 
wish to invest in longer-term or higher yielding debt may make use of 
the non-qualifying basket for such investments. We are, however, 
modifying the definition to include as short-term holdings shares of 
registered money market funds that are regulated under rule 2a-7 under 
the Investment Company Act,\141\ which we understand are commonly held 
for purposes of cash management.\142\
---------------------------------------------------------------------------

    \139\ See, e.g., NVCA Letter.
    \140\ We do not view investing in short-term holdings as being a 
venture capital strategy; however, for purposes of the exemption, a 
qualifying fund could invest in short-term holdings as part of 
implementing its investment strategy. See also infra Section II.A.7.
    \141\ Rule 203(l)-1(c)(6).
    \142\ See, e.g., NVCA Letter.
---------------------------------------------------------------------------

    The rule defines short-term holdings to include ``cash and cash 
equivalents'' by reference to rule 2a51-1(b)(7)(i) under the Investment 
Company Act.\143\ We did not receive any comments on this aspect of the 
proposal and are adopting it without modification. Rule 2a51-1, 
however, is used to determine whether an owner of an investment company 
excluded by reason of section 3(c)(7) of the Investment Company Act 
meets the definition of a qualified purchaser by examining whether such 
owner holds sufficient ``investments'' (generally securities and other 
assets held for investment purposes).\144\ We are not defining a 
venture capital fund's cash holdings by reference to whether the cash 
is held ``for investment purposes'' or to the net cash surrender value 
of an insurance policy. Furthermore, since rule 2a51-1 does not 
explicitly include short-term U.S. Treasuries, which we believe would 
be an appropriate form of cash equivalent for a venture capital fund to 
hold pending investment in a portfolio company or distribution to 
investors, our rule includes short-term U.S. Treasuries with a 
remaining maturity of 60 days or less.\145\
---------------------------------------------------------------------------

    \143\ Rule 2a51-1(b)(7) under the Investment Company Act 
provides that cash and cash equivalents include foreign currencies 
``held for investment purposes'' and ``(i) [b]ank deposits, 
certificates of deposit, bankers acceptances and similar bank 
instruments held for investment purposes; and (ii) [t]he net cash 
surrender value of an insurance policy.'' 17 CFR 270.2a51-1(b)(7).
    \144\ See generally sections 2(a)(51) and 3(c)(7) of the 
Investment Company Act; 17 CFR 270.2a51-1(b) and (c).
    \145\ We have treated debt securities with maturities of 60 days 
or less differently than debt securities with longer maturities 
under our rules. In particular, we have recognized that the 
potential for fluctuation in those shorter-term securities' market 
value has decreased sufficiently that, under certain conditions, we 
allow certain open-end investment companies to value them using 
amortized cost value rather than market value. See Valuation of Debt 
Instruments by Money Market Funds and Certain Other Open-End 
Investment Companies, Investment Company Act Release No. 9786 (May 
31, 1977) [42 FR 28999 (June 7, 1977)]. We believe that the same 
consideration warrants treating U.S. Treasury securities with a 
remaining maturity of 60 days or less as more akin to cash 
equivalents than Treasuries with longer maturities for purposes of 
the definition of venture capital fund.
---------------------------------------------------------------------------

3. Qualifying Portfolio Company
    Under the rule, qualifying investments generally consist of equity 
securities issued by a qualifying portfolio company. A ``qualifying 
portfolio company'' is defined as any company that: (i) Is not a 
reporting or foreign traded company and does not have a control 
relationship with a reporting or foreign traded company; (ii) does not 
incur leverage in connection with the investment by the private fund 
and distribute the proceeds of any such borrowing to the private fund 
in exchange for the private fund investment; and (iii) is not itself a 
fund (i.e., is an operating company).\146\ We are adopting the rule 
substantially as proposed, with modifications to the leverage criterion 
in order to address certain concerns raised by commenters. We describe 
each element of a qualifying portfolio company below. We understand 
each of the criteria to be characteristic of issuers of portfolio 
securities held by venture capital funds.\147\ Moreover, collectively, 
we believe these criteria would operate to exclude most private equity 
funds and hedge funds from the definition.
---------------------------------------------------------------------------

    \146\ Rule 203(l)-1(c)(4). In the Proposing Release, we used the 
defined term ``publicly traded'' company, but are modifying the rule 
to use the defined term ``reporting or foreign traded'' company to 
match more closely the defined term and to make clear that certain 
companies that have issued securities that are traded on a foreign 
exchange are covered by the definition. See proposed rule 203(l)-
1(c)(3) and (4).
    \147\ See Proposing Release, supra note 26, sections II.A.1.a.-
II.A.1.e.
---------------------------------------------------------------------------

a. Not a Reporting Company
    Under the rule, a qualifying portfolio company is defined as a 
company that, at the time of any investment by a qualifying fund, is 
not a ``reporting or foreign traded'' company (a ``reporting company'') 
and does not control, is not controlled by or under common control 
with, a reporting company.\148\ Under the definition, a venture capital 
fund may continue to treat as a qualifying investment any previously 
directly acquired equity security of a portfolio company that 
subsequently becomes a reporting company.\149\ Moreover, after a 
company becomes a reporting company, a qualifying fund could acquire 
the company's publicly traded (or foreign traded) securities in the 
secondary markets, subject to the availability of the fund's non-
qualifying basket.
---------------------------------------------------------------------------

    \148\ Rule 203(l)-1(c)(4)(i); rule 203(l)-1(c)(5) (defining a 
``reporting or foreign traded'' company as one that is subject to 
the reporting requirements under section 13 or 15(d) of the Exchange 
Act, or has a security listed or traded on any exchange or organized 
market operating in a foreign jurisdiction). This definition is 
similar to rule 2a51-1 under the Investment Company Act (defining 
``public company,'' for purposes of the qualified purchaser 
standard, as ``a company that files reports pursuant to section 13 
or 15(d) of the Securities Exchange Act of 1934''), and rule 12g3-2 
under the Exchange Act (conditioning a foreign private issuer's 
exemption from registering securities under section 12(g) of the 
Exchange Act if, among other conditions, the ``issuer is not 
required to file or furnish reports'' pursuant to section 13(a) or 
section 15(d) of the Exchange Act). 17 CFR 270.2a51-1; 17 CFR 
240.12g3-2. Under the rule, securities of a ``reporting or foreign 
traded company'' include securities of non-U.S. companies that are 
listed on a non-U.S. market or non-U.S. exchange. Rule 203(l)-
1(c)(5).
    \149\ Rule 203(l)-1(c)(4)(i) (defining a qualifying portfolio 
company as any company that at the time of any investment by a 
venture capital fund is not a reporting or foreign traded company).
---------------------------------------------------------------------------

    As we discussed in the Proposing Release, venture capital funds 
provide operating capital to companies in the early stages of their 
development with the goal of eventually either selling the company or 
taking it public.\150\ Unlike

[[Page 39656]]

other types of private funds, venture capital funds are characterized 
as not trading in the public markets, but may sell portfolio company 
securities into the public markets once the portfolio company has 
matured.\151\ As of year-end 2010, U.S. venture capital funds managed 
approximately $176.7 billion in assets.\152\ In comparison, as of year-
end 2010, the U.S. publicly traded equity market had a market value of 
approximately $15.4 trillion,\153\ whereas global hedge funds had 
approximately $1.7 trillion in assets under management.\154\ The 
aggregate amount invested in venture capital funds is considerably 
smaller.\155\ Congressional testimony asserted that these funds may be 
less connected with the public markets and may involve less potential 
for systemic risk.\156\ This appears to be a key consideration by 
Congress that led to the enactment of the venture capital 
exemption.\157\ As we discussed in the Proposing Release, the rule we 
proposed sought to incorporate this Congressional understanding of the 
nature of investments of a venture capital fund, and these principles 
guided our consideration of the proposed venture capital fund 
definition.\158\ The proposed rule would have required that a 
qualifying fund invest primarily in equity securities of companies that 
are not capitalized by the public markets.\159\
---------------------------------------------------------------------------

    \150\ See Testimony of James Chanos, Chairman, Coalition of 
Private Investment Companies, July 15, 2009, at 4 (``[V]enture 
capital funds are an important source of funding for start-up 
companies or turnaround ventures.''); National Venture Capital 
Association Yearbook 2010 (``NVCA Yearbook 2010''), at 7-8 (noting 
that venture capital is a ``long-term investment'' and the ``payoff 
[to the venture capital firm] comes after the company is acquired or 
goes public.''); George W. Fenn, Nellie Liang and Stephen Prowse, 
The Economics of the Private Equity Market, December 1995, 22, n.61 
and accompanying text (``Fenn et al.'') (``Private sales'' are not 
normally the most important type of exit strategy as compared to 
IPOs, yet of the 635 successful portfolio company exits by venture 
capitalists between 1991-1993 ``merger and acquisition transactions 
accounted for 191 deals and IPOs for 444 deals.'' Furthermore, 
between 1983 and 1994, of the 2,200 venture capital fund exits, 
1,104 (approximately 50%) were attributed to mergers and 
acquisitions of venture-backed firms.). See also Jack S. Levin, 
Structuring Venture Capital, Private Equity and Entrepreneurial 
Transactions, 2000 (``Levin'') at 1-2 to 1-7 (describing the various 
types of venture capital and private equity investment business but 
stating that ``the phrase `venture capital' is sometimes used 
narrowly to refer only to financing the start-up of a new 
business''); Anna T. Pinedo & James R. Tanenbaum, Exempt and Hybrid 
Securities Offerings (2009), Vol. 1 at 12-2 (discussing the role 
initial public offerings play in providing venture capital investors 
with liquidity).
    \151\ See Testimony of Trevor Loy, Flywheel Ventures, before the 
Senate Banking Subcommittee on Securities, Insurance and Investment 
Hearing, July 15, 2009 (``Loy Testimony''), at 5 (``We do not trade 
in the public markets.''). See also Testimony of Terry McGuire, 
General Partner, Polaris Venture Partners, and Chairman, National 
Venture Capital Association, before the U.S. House of 
Representatives Committee on Financial Services, October 6, 2009 
(``McGuire Testimony'') at 11 (``[V]enture capital funds do not 
typically trade in the public markets and generally limit advisory 
activities to the purchase and sale of securities of private 
operating companies in private transactions''); Levin, supra note 
150, at 1-4 (``A third distinguishing feature of venture capital/
private equity investing is that the securities purchased are 
generally privately held as opposed to publicly traded * * * a 
venture capital/private equity investment is normally made in a 
privately-held company, and in the relatively infrequent cases where 
the investment is into a publicly-held company, the [venture capital 
fund] generally holds non-public securities.'') (emphasis in 
original).
    \152\ National Venture Capital Association Yearbook 2011 (``NVCA 
Yearbook 2011'') at 9, Fig. 1.0.
    \153\ Bloomberg Terminal Database, WCAUUS  Bloomberg 
United States Exchange Market Capitalization).
    \154\ Credit Suisse, 2010 Hedge Fund Industry Review, Feb. 2011 
(``Credit Suisse Report''), at 1.
    \155\ In 2010, investors investing in newly formed funds 
committed approximately $12.3 billion to venture capital funds 
compared to approximately $85.1 billion to private equity/buyout 
funds. NVCA Yearbook 2011, supra note 152, at 20 at Fig. 2.02. In 
comparison, hedge funds raised approximately $22.6 billion from 
investors in 2010. Credit Suisse Report, supra note 154, at 1.
    \156\ See S. Rep. No. 111-176, supra note 6, at 74-5 (noting 
that venture capital funds ``do not present the same risks as the 
large private funds whose advisers are required to register with the 
SEC under this title [IV]. Their activities are not interconnected 
with the global financial system, and they generally rely on equity 
funding, so that losses that may occur do not ripple throughout 
world markets but are borne by fund investors alone. Terry McGuire, 
Chairman of the National Venture Capital Association, wrote in 
congressional testimony that `venture capital did not contribute to 
the implosion that occurred in the financial system in the last 
year, nor does it pose a future systemic risk to our world financial 
markets or retail investors.' ''). See also Loy Testimony, supra 
note 151, at 7 (noting the factors by which the venture capital 
industry is exposed to ``entrepreneurial and technological risk not 
systemic financial risk''); McGuire Testimony, supra note 151, at 6 
(noting that the ``venture capital industry's activities are not 
interwoven with U.S. financial markets''). See also Group of Thirty, 
Financial Reform: A Framework for Financial Stability, January 15, 
2009, at 9 (discussing the need for registration of managers of 
``private pools of capital that employ substantial borrowed funds'' 
yet recognizing the need to exempt venture capital from 
registration).
    \157\ See supra note 156.
    \158\ See Proposing Release, supra note 26, at n.43 and n.60 and 
following text.
    \159\ Most commenters did not express any objection to our 
proposed definition of ``publicly traded,'' although one commenter 
did disagree with the proposed definition's approach to foreign 
traded securities. This commenter argued that the proposed rule 
should be modified to ``cover securities that have been publicly 
offered to investors in a foreign jurisdiction and equity securities 
that are widely held and traded over-the-counter in a foreign 
jurisdiction.'' Merkl Letter. We decline to adopt this approach 
because the definition would require us to define what constitutes a 
``public offering'' notwithstanding the laws of foreign regulators 
and legislatures.
---------------------------------------------------------------------------

    Several commenters asserted that the definition should not exclude 
securities of reporting companies.\160\ Most, however, did not object 
to the rule's limitation on investments in non-reporting companies, but 
instead sought a more flexible definition that would include some level 
of investments in reporting companies under certain conditions. For 
example, certain commenters supported venture capital fund investments 
in reporting companies only if, at the time the company becomes a 
reporting company, the fund continued to hold at least a majority of 
its original investment made when the company was a non-reporting 
company.\161\ Some of these commenters asserted that public offerings, 
which trigger reporting requirements under the Federal securities laws, 
were viewed as an additional financing round, with pre-existing venture 
investors expected to participate.\162\ Alternatively, several 
commenters recommended that a venture capital fund could limit its 
investment in reporting companies, such as 15 or 20 percent of the 
fund's capital commitments.\163\
---------------------------------------------------------------------------

    \160\ See Bessemer Letter; IVP Letter (also suggested additional 
conditions); Merkl Letter. One commenter also suggested that the 
definition should not exclude investments in companies that may be 
deemed to be ``controlled'' by a public company (or its venture 
capital investment division). See Comment Letter of Berkeley Center 
for Law, Business and the Economy (Feb. 1, 2011) (``BCLBE Letter''). 
See also Dechert General Letter (argued that restricting the 
application of the control element may be necessary because an 
adviser to a venture capital fund could be controlled by a public 
company, and might itself be deemed to control a portfolio company 
as a result of its prior investments). Under our rule, a venture 
capital fund could invest in such companies under the non-qualifying 
basket.
    \161\ ATV Letter; BIO Letter; NVCA Letter. See also Davis Polk 
Letter; InterWest Letter; McDonald Letter; Mesirow Letter; PTV 
Sciences Letter. A number of commenters supported expanding the 
proposed definition but without additional conditions. See, e.g., 
BioVentures Letter; ESP Letter; Quaker BioVentures Letter; SV Life 
Sciences Letter.
    \162\ See, e.g., Alta Partners Letter; Gunderson Dettmer Letter; 
InterWest Letter; McDonald Letter; NVCA Letter; Quaker BioVentures 
Letter. See also Bessemer Letter; BIO Letter; Lowenstein Letter.
    \163\ Alta Partners Letter (supported limiting investments in 
public companies to 15% of fund capital commitments); Gunderson 
Dettmer Letter (supported limiting investments in public securities 
to 20% of fund capital commitments). See also Davis Polk Letter 
(supported limiting investments in public companies to 20% of fund 
capital commitments provided the fund continues to hold a majority 
of its original investment in the company when it was private); SVB 
Letter (supported investments in public securities but did not 
identify a percentage threshold).
---------------------------------------------------------------------------

    We understand that venture capital funds seek flexibility to invest 
in promising portfolio companies, including companies deemed 
sufficiently profitable to become reporting companies or companies that 
may be owned directly or indirectly by a public company. Rather than 
modify the rule to impose additional criteria for investing in 
reporting companies, however, we have adopted a limit of 20 percent for 
non-qualifying investments, which may be used to hold securities of 
reporting companies. We believe that the 20 percent limit appropriately 
balances commenters' expressed desire for greater flexibility to 
accommodate existing business practices while providing sufficient 
limits on the extent of investments that would implicate Congressional 
statements regarding the interconnectedness of venture capital funds 
with the public markets.\164\
---------------------------------------------------------------------------

    \164\ See supra Section II.A.1.b. One commenter argued that, in 
addition to funds that would satisfy the proposed definition, a 
venture capital fund should include any fund that invests at least 
75% of its capital in privately held ``domestic small business'' as 
defined in the Small Business Investment Act (the ``SBIA'') 
regulations, regardless of the equity/debt nature of the investment. 
See NASBIC/SBIA Letter. In the Proposing Release, we noted our 
concerns with adopting a definition for a ``small'' company, 
including reliance on the SBIA regulatory standards for treatment as 
a ``small'' company, which generally imposes specific tests for net 
worth, net income or number of employees for each type of company, 
depending on its geographic location and industry classification. 
See Proposing Release, supra note 26, at n.69 and accompanying and 
following text. We have considered the issues raised in the NASBIC/
SBIA Letter and continue to believe that a qualifying portfolio 
company should not be defined by reference to whether a company is 
``small'' for the reasons cited in the Proposing Release.

---------------------------------------------------------------------------

[[Page 39657]]

    Under our rule, a qualifying portfolio company is defined to 
include a company that is not a reporting company (and does not have a 
control relationship with a reporting company) at the time of each fund 
investment.\165\ However, one commenter observed that an existing 
investment in a portfolio company that ultimately becomes a successful 
venture capital investment (such as when the company issues its 
securities in a public offering or becomes a reporting company) should 
not result in the investment becoming a non-qualifying investment.\166\ 
We agree. Under the rule, such an investment would not become a non-
qualifying investment because the definition focuses on the time at 
which the venture capital fund acquires the particular equity security 
issued by a portfolio company and does not limit the definition of 
qualifying portfolio company solely to companies that are and remain 
non-reporting companies. Under this approach, an adviser could continue 
to rely on the exemption even if the venture capital fund's portfolio 
ultimately consisted entirely of securities that become securities of 
reporting companies. We believe that our approach would give advisers 
to venture capital funds sufficient flexibility to exercise their 
business judgment on the appropriate time to dispose of portfolio 
company investments--whether that occurs at a time when the company is 
or is not a reporting company.\167\ Moreover, under the Federal 
securities laws, a person, such as a venture capital fund, that is 
deemed to be an affiliate of a company may be limited in its ability to 
dispose of the company's securities.\168\ Under the final rule, a 
qualifying fund would not be in the position of having to dispose of 
securities of a qualifying portfolio company that subsequently becomes 
a reporting company.
---------------------------------------------------------------------------

    \165\ See rule 203(l)-1(c)(4)(i).
    \166\ PTV Sciences Letter (stating that following a merger or 
public offering of a qualifying portfolio company's securities, the 
shares held by the fund ``are turned into profits to our 
investors'').
    \167\ See Proposing Release, supra note 26, at n.55 and 
following text.
    \168\ See sections 2(a)(11) (defining ``underwriter'') and 5 of 
the Securities Act. See also E.H. Hawkins, SEC Staff No-Action 
Letter (June 26, 1997) (staff explained how the term ``underwriter'' 
in the Securities Act restricts resales of securities by affiliates 
of issuing companies).
---------------------------------------------------------------------------

b. Portfolio Company Leverage
    Rule 203(l)-1 defines a qualifying portfolio company for purposes 
of the exemption as one that does not borrow or issue debt obligations 
in connection with the venture capital fund's investment in the company 
and distribute to the fund the proceeds of such borrowing or issuance 
in exchange for the fund's investment.\169\ As a consequence, certain 
types of funds that use leverage or finance their investments in 
portfolio companies or the buyout of existing investors with borrowed 
money (e.g., leveraged buyout funds, which are a different subset of 
private equity funds) would not meet the rule's definition of a venture 
capital fund.\170\ As discussed in greater detail below and in the 
Proposing Release, we believe that Congress did not intend the venture 
capital fund definition to apply to these types of private equity 
funds.\171\
---------------------------------------------------------------------------

    \169\ Rule 203(l)-1(c)(4)(ii).
    \170\ Leveraged buyout funds are private equity funds that will 
``borrow significant amounts from banks to finance their deals--
increasing the debt-to-equity ratio of the acquired companies * * 
*'' U.S. Govt. Accountability Office, Private Equity: Recent Growth 
in Leveraged Buyouts Exposed Risks that Warrant Continued Attention 
(2008) (``GAO Private Equity Report''), at 1. A leverage buyout fund 
in 2005 typically financed a deal with 34% equity and 66% debt. Id. 
at 13. See also Fenn et al., supra note 150, at 23 (companies that 
have been taken private in a leveraged buyout (or ``LBO'') 
transaction generally ``spend less on research and development, 
relative to assets, and have a greater proportion of fixed assets; 
their debt-to-assets ratios are high, above 60 percent, and are two 
to four times those of venture-backed firms.'' Moreover, compared to 
venture capital backed companies, LBO-private equity backed 
companies that are taken public typically use proceeds from an IPO 
to reduce debt whereas new venture capital backed firms tend to use 
proceeds to fund growth.); Testimony of Mark Tresnowksi, General 
Counsel, Madison Dearborn Partners, LLC, on behalf of the Private 
Equity Council, before the Senate Banking Subcommittee on 
Securities, Insurance and Investment, July 15, 2009, at 2 
(indicating that portfolio companies in which private equity funds 
invest typically have 60% debt and 40% equity).
    \171\ See discussion in section II.A.1.c. and d. of the 
Proposing Release, supra note 26.
---------------------------------------------------------------------------

    We proposed to define a qualifying portfolio company as a company 
that does not borrow ``in connection'' with a venture capital fund 
investment. We also proposed to define a qualifying portfolio company 
as a company that does not participate in an indirect buyout involving 
a qualifying fund (as a corollary to our proposed limitation on venture 
capital fund acquisitions of portfolio company securities through 
secondary transactions, i.e., direct buyouts).\172\ We proposed these 
elements to distinguish between venture capital funds that provide 
capital to portfolio companies for operating and business purposes (in 
exchange for an equity investment) and leveraged buyout funds, which 
acquire controlling equity interests in operating companies through the 
``buyout'' of existing security holders or which finance such 
investments or buyouts with borrowed money.\173\ We proposed these 
elements of the qualifying portfolio company definition because of the 
focus on leverage in the Dodd-Frank Act as a potential contributor to 
systemic risk as discussed by the Senate Committee report,\174\ and the 
testimony before Congress that stressed the lack of leverage in venture 
capital investing.\175\
---------------------------------------------------------------------------

    \172\ Proposed rules 203(l)-1(a)(2)(i); (c)(4)(ii) and 
(c)(4)(iii).
    \173\ See generally Proposing Release, supra note 26, at 
sections II.A.1.c. and d.
    \174\ See S. Rep. No. 111-176, supra note 6, at 74 (``The 
Committee believes that venture capital funds, a subset of private 
investment funds specializing in long-term equity investment in 
small or start-up businesses, do not present the same risks as the 
large private funds whose advisers are required to register with the 
SEC under this title.''); id. at 75 (concluding that private equity 
funds that use limited or no leverage at the fund level engage in 
activities that do not pose risks to the wider markets through 
credit or counterparty relationships).
    \175\ See Proposing Release, supra note 26, at n.100.
---------------------------------------------------------------------------

    Some commenters argued that defining a venture capital fund as a 
fund that does not participate in buyouts was too restrictive or too 
difficult to apply.\176\ Most of the commenters who addressed the issue 
opposed a definition that excluded any buyouts of portfolio company 
securities by venture capital funds.\177\ Some commenters argued that 
because a venture capital fund could, under the proposed rule, acquire 
up to 20 percent of portfolio company securities in secondary 
transactions, indirect buyouts achieved at the portfolio company level 
should not be precluded.\178\ Some commenters stated that buyouts are 
an important means of providing liquidity to portfolio company 
founders, employees, former employees and vendors/service 
providers,\179\ while others argued that

[[Page 39658]]

buyouts occurring as a result of recapitalizations\180\ or conversions 
of permissible bridge loans \181\ should not preclude a fund from 
relying on the definition.\182\
---------------------------------------------------------------------------

    \176\ See, e.g., McGuireWoods Letter; NVCA Letter; Pine Brook 
Letter.
    \177\ One commenter sought interpretative guidance on which 
buyout transactions would be considered to be ``in connection with'' 
a venture capital fund investment. Mesirow Letter. See also 
McGuireWoods Letter; NVCA Letter (discussing some interpretative 
issues with the ``in connection with'' language).
    \178\ ATV Letter; NVCA Letter. See also ABA Letter (also 
recommending that the buyout bucket be increased to 30%); Charles 
River Letter (supported a 20% buyout limit to accommodate the 
increasing industry use of buyouts); First Round Letter (supported 
25% buyout limit for each deal and a 20% limit for all fund 
investments in order to facilitate liquidity to founders).
    \179\ See, e.g., Davis Polk Letter; ESP Letter; SVB Letter.
    \180\ Alta Partners Letter; BioVentures Letter.
    \181\ ATV Letter; NVCA Letter.
    \182\ See also Pine Brook Letter (suggesting ``careful 
drafting'' that would not preclude transactions in the normal course 
of business by defining a set of prohibited buyout transactions 
(e.g., ``leveraged dividend recapitalizations'')).
---------------------------------------------------------------------------

    We have eliminated the proposed indirect buyout criterion in the 
final rule. Because the non-qualifying basket does not exclude 
secondary market transactions (or other buyouts of existing security 
holders), it would be inconsistent to define a venture capital fund as 
a fund that does not participate in a buyout.
    We are retaining and clarifying, however, the leveraged buyout 
criterion as it relates to qualifying portfolio companies. We had 
proposed to define a qualifying portfolio company as a company that, 
among other things, does not borrow ``in connection'' with a venture 
capital fund investment. As noted above, we proposed this element to 
distinguish venture capital funds from leveraged buyout funds, and we 
continue to believe that this remains an important distinction. We 
believe that these differences (i.e., the use of buyouts and associated 
leverage) distinguish venture capital funds from buyout private equity 
funds for which Congress did not provide an exemption.\183\
---------------------------------------------------------------------------

    \183\ See supra note 174 and accompanying text.
---------------------------------------------------------------------------

    One of the distinguishing features of venture capital funds is 
that, unlike many hedge funds and private equity funds, they invest 
capital directly in portfolio companies for the purpose of funding the 
expansion and development of the company's business rather than buying 
out existing security holders, otherwise purchasing securities from 
other shareholders, or leveraging the capital investment with debt 
financing.\184\ Testimony received by Congress and our research suggest 
that venture capital funds provide capital to many types of businesses 
at different stages of development,\185\ generally with the goal of 
financing the expansion of the company \186\ and helping it progress to 
the next stage of its development through successive tranches of 
investment (i.e., ``follow-on'' investments) if the company reaches 
agreed-upon milestones.\187\
---------------------------------------------------------------------------

    \184\ See Loy Testimony, supra note 151, at 2 (``Although 
venture capital funds may occasionally borrow on a short-term basis 
immediately preceding the time when the cash installments are due, 
they do not use debt to make investments in excess of the partner's 
capital commitments or `lever up' the fund in a manner that would 
expose the fund to losses in excess of the committed capital or that 
would result in losses to counter parties requiring a rescue 
infusion from the government.''). See also infra notes 189-191; Mark 
Heesen & Jennifer C. Dowling, National Venture Capital Association, 
Venture Capital & Adviser Registration (October 2010), materials 
submitted in connection with the Commission's Government-Business 
Forum on Small Business Capital Formation (summarizing the 
differences between venture capital funds and buyout and hedge 
funds), available at http://www.sec.gov/info/smallbus/2010gbforumstatements.htm.
    \185\ See, e.g., McGuire Testimony, supra note 151, at 1; NVCA 
Yearbook 2010, supra note 150; PricewaterhouseCoopers/National 
Venture Capital Association MoneyTree Report, Q4 2009/Full-year 2009 
Report (providing data on venture capital investments in portfolio 
companies); James Schell, Private Equity Funds: Business Structure 
and Operations (2010), at Sec.  1.03[1] (``Schell''), at Sec.  
1.03[1]; Paul A. Gompers & Josh Lerner, The Venture Capital Cycle, 
at 459 (MIT Press 2004), at 178, 180 table 8.2 (displaying 
percentage of annual venture capital investments by stage of 
development and classifying ``early stage'' as seed, start-up, or 
early stage and ``late stage'' as expansion, second, third, or 
bridge financing).
    \186\ See McGuire Testimony, supra note 151, at 1; Loy 
Testimony, supra note 151, at 3 (``Once the venture fund is formed, 
our job is to find the most promising, innovative ideas, 
entrepreneurs, and companies that have the potential to grow 
exponentially with the application of our expertise and venture 
capital investment.''). See also William A. Sahlman, The Structure 
and Governance of Venture-Capital Organizations, Journal of 
Financial Economics 27 (1990), at 473, 503 (``Sahlman'') (noting 
venture capitalists typically invest more than once during the life 
of a company, with the expectation that each capital investment will 
be sufficient to take the company to the next stage of development, 
at which point the company will require additional capital to make 
further progress).
    \187\ See Sahlman, supra note 186, at 503; Loy Testimony, supra 
note 151, at 3 (``[W]e continue to invest additional capital into 
those companies that are performing well; we cease follow-on 
investments into companies that do not reach their agreed upon 
milestones.'').
---------------------------------------------------------------------------

    In contrast, private equity funds that are identified as buyout 
funds typically provide capital to an operating company in exchange for 
majority or complete ownership of the company,\188\ generally achieved 
through the buyout of existing shareholders or other security holders 
and financed with debt incurred by the portfolio company,\189\ and 
compared to venture capital funds, hold the investment for shorter 
periods of time.\190\ As a result of the use of the capital provided 
and the incurrence of this debt, following the buyout fund investment, 
the operating company may carry debt several times its equity and may 
devote significant levels of its cash flow and corporate earnings to 
repaying the debt financing, rather than investing in capital 
improvement or business operations.\191\
---------------------------------------------------------------------------

    \188\ GAO Private Equity Report, supra note 170, at 8 (``A 
private equity-sponsored LBO generally is defined as an investment 
by a private equity fund in a public or private company (or division 
of a company) for majority or complete ownership.'').
    \189\ See Annalisa Barrett et al., Prepared by the Corporate 
Library Inc., under contract for the IRRC Institute, What is the 
Impact of Private Equity Buyout Fund Ownership on IPO Companies' 
Corporate Governance?, at 7 (June 2009) (``Barrett et al.'') (``In 
general, VC firms provide funding to companies in early stages of 
their development, and the money they provide is used as working 
capital for the firm. Buyout firms, in contrast, work with mature 
companies, and the funds they provide are used to compensate the 
firm's existing owners.''); Ieke van den Burg and Poul Nyrup 
Rasmussen, Hedge Funds and Private Equity: A Critical Analysis 
(2007), at 16-17 (``van den Burg''); Sahlman, supra note 186, at 
517. See also Tax Legislation: CRS Report, Taxation of Hedge Fund 
and Private Equity Managers, Tax Law and Estate Planning Course 
Handbook Series, Practicing Law Institute (Nov. 2, 2007) at 2 
(noting that in a leveraged buyout ``private equity investors use 
the proceeds of debt issued by the target company to acquire all the 
outstanding shares of a public company, which then becomes 
private'').
    \190\ Unlike venture capital funds, which generally invest in 
portfolio companies for 10 years or more, private equity funds that 
use leveraged buyouts invest in their portfolio companies for 
shorter periods of time. See Loy Testimony, supra note 151, at 3 
(citing venture capital fund investments periods in portfolio 
companies of five to 10 years or longer); van den Burg, supra note 
189, at 19 (noting that LBO investors generally retain their 
investment in a listed company for 2 to 4 years or even less after 
the company goes public). See also Paul A. Gompers, The Rise and 
Fall of Venture Capital, Business And Economic History, vol. 23, no. 
2, Winter 1994, at 17 (stating that ``an LBO investment is 
significantly shorter than that of a comparable venture capital 
investment. Assets are sold off almost immediately to meet debt 
burden, and many companies go public again (in a reverse LBO) in a 
very short period of time.'').
    \191\ See Barrett et al., supra note 189. See also Fenn et al., 
supra note 150, at 23 (companies that have been taken private in an 
LBO transaction generally ``spend less on research and development, 
relative to assets, and have a greater proportion of fixed assets; 
their debt-to-assets ratios are high, above 60%, and are two to four 
times those of venture-backed firms.'' Moreover, compared to venture 
capital backed companies, LBO-private equity backed companies that 
are taken public typically use proceeds from an IPO to reduce debt 
whereas new venture capital backed firms tend to use proceeds to 
fund growth.).
---------------------------------------------------------------------------

    Some commenters agreed that distinguishing between venture capital 
and other private funds with reference to a portfolio company's 
leverage and indirect buyouts is important.\192\ Many commenters, 
however, urged a more narrowly drawn restriction on a portfolio 
company's ability to borrow (or issue debt) or to effect indirect 
buyouts.\193\ Some argued that the manner in which proceeds from 
indebtedness are used by a portfolio company (e.g., distributed by the 
company to the venture capital fund) better distinguishes venture 
capital funds from leveraged buyout private equity funds.\194\ 
Nevertheless, the majority of commenters who addressed this criterion 
supported a leverage criterion that would be more specific, or

[[Page 39659]]

limited, in scope,\195\ focusing on the use of proceeds derived from 
portfolio company leverage.\196\ Commenters suggested that the rule 
define leverage as leverage incurred for the purpose of buying out 
shareholders at the demand of the venture capital fund \197\ or for 
returning capital to the fund,\198\ and not, for example, define 
leverage to include indebtedness incurred to pay for a qualifying 
portfolio company's operating expenses.\199\
---------------------------------------------------------------------------

    \192\ See, e.g., AFL-CIO Letter; Sen. Levin Letter; Pine Brook 
Letter.
    \193\ See, e.g., ATV Letter; Charles River Letter; NVCA Letter; 
Oak Investment Letter; Pine Brook Letter.
    \194\ See, e.g., NVCA Letter; Pine Brook Letter; SV Life 
Sciences Letter; Vedanta Letter.
    \195\ See, e.g., ATV Letter; Charles River Letter (supports 
modifying the rule so that up to 20% of fund capital commitments may 
be invested in portfolio companies that do not adhere to the 
leverage condition provided that the venture capital fund is not the 
party providing the leverage to the company); NVCA Letter; Comment 
Letter of the Securities Regulation Committee of the Business Law 
Section of the New York State Bar Association, Apr. 1, 2011 (``NYSBA 
Letter''); SVB Letter.
    \196\ Although two commenters supported the leverage limitation 
as proposed (see AFL-CIO Letter (also supporting a specific 
prohibition on borrowing by a portfolio company to pay dividends or 
fees to the venture capital fund); Sen. Levin Letter (together with 
the equity investment requirement, the definition appropriately 
excludes leveraged buyout funds)), two other commenters opposed it, 
arguing that qualifying portfolio company leverage should not be 
restricted at all (see ESP Letter (limits on leverage would prevent 
portfolio companies from receiving lending from venture debt funds 
and state governments and lenders rather than regulators should 
determine the appropriate level of portfolio company debt); Merkl 
Letter (young negative EBITDA companies would not be able to obtain 
significant amounts of debt and hence no leverage prohibition is 
required)). See also NASBIC/SBIA Letter (portfolio companies should 
not be precluded from accessing leverage); Sevin Rosen Letter, Pine 
Brook Letter (each expressed support for a use of proceeds 
approach).
    \197\ See, e.g., Gunderson Dettmer Letter; McDonald Letter; NVCA 
Letter; SVB Letter.
    \198\ See, e.g., McDonald Letter; NVCA Letter.
    \199\ Gunderson Dettmer Letter; Pine Brook Letter; Trident 
Letter; Vedanta Letter. One commenter suggested that a use of 
proceeds test would be difficult to enforce because such a test 
would need to be extremely detailed in order to prevent 
circumvention. See Merkl Letter.
---------------------------------------------------------------------------

    Some commenters argued that the proposed ``in connection with'' 
element would be difficult to apply, arguing that the standard was too 
vague or raised too many interpretative issues.\200\ In response to our 
request for comment, many commenters sought confirmation that the 
limitation on portfolio company leverage would be triggered only in the 
instances of leverage provided to the portfolio company by the venture 
capital fund or if portfolio company borrowing were effected in 
satisfaction of a contractual obligation with the venture capital 
fund.\201\
---------------------------------------------------------------------------

    \200\ See, e.g., Merkl Letter; Sevin Rosen Letter; SVB Letter.
    \201\ See, e.g., ABA Letter; ATV Letter; Bessemer Letter; 
Mesirow Letter; NVCA Letter; SV Life Sciences Letter. See also 
Proposing Release, supra note 26, discussion at section II.A.1.c.
---------------------------------------------------------------------------

    After careful consideration of the intended purpose of the leverage 
limitation of the proposed rule and the concerns raised by commenters, 
we are modifying the qualifying portfolio company leverage criterion to 
define a qualifying portfolio company as any company that does not both 
borrow (or issue debt) in connection with a venture capital fund 
investment and distribute the proceeds of such borrowing or issuance to 
the venture capital fund in exchange for the fund's investment. In 
contrast to the proposed rule, the final rule more specifically 
delineates the types of leveraged transactions involving a qualifying 
fund (i.e., a company's distribution of proceeds received in a debt 
offering to the qualifying fund) that would result in the company being 
excluded from the definition of a qualifying portfolio company. We 
believe that these modifications more closely achieve our goal of 
distinguishing advisers to venture capital funds from other types of 
private funds for which Congress did not provide an exemption because 
it looks to the substance, not just the form, of a transaction or 
series of transactions.
    This definition of qualifying portfolio company would only exclude 
companies that borrow in connection with a venture capital fund's 
investment and distribute such borrowing proceeds to the venture 
capital fund in exchange for the investment, but would not exclude 
companies that borrow in the ordinary course of their business (e.g., 
to finance inventory or capital equipment, manage cash flows, meet 
payroll, etc.). Under the rule, a venture capital fund could provide 
financing or loans to a portfolio company, provided that the financing 
meets the definition of equity security or is made subject to the 20 
percent limit for non-qualifying investments. Although we would 
generally view any financing to a portfolio company that was provided 
by, or was a condition of a contractual obligation with, a fund or its 
adviser as part of the fund's investments in the company as being a 
type of financing that is ``in connection with'' the fund's investment, 
the definition's limitation would only apply if the proceeds of such 
financing were distributed to the venture capital fund in exchange for 
its investment. Moreover, subsequent distributions to the venture 
capital fund solely because it is an existing investor would not be 
inconsistent with this criterion. We believe that this modification to 
the rule adequately distinguishes between venture capital funds and 
leveraged buyout funds and provides a simpler and clearer approach to 
determining whether or not a qualifying portfolio company satisfies the 
definition.
c. Operating Company
    Rule 203(l)-1 defines the term qualifying portfolio company for the 
purposes of the exemption to exclude any private fund or other pooled 
investment vehicle.\202\ Under the rule, a qualifying portfolio company 
could not be another private fund, a commodity pool or other 
``investment companies.'' \203\ We are adopting this criterion because 
Congress did not express an intent to include venture capital funds of 
funds within the definition.\204\ In the Senate Report, Congress 
characterized venture capital as a subset of private equity 
``specializing in long-term equity investment in small or start-up 
businesses'' \205\ and did not refer to funds investing in other funds. 
Moreover, testimony to Congress described venture capital investments 
in operating companies rather than other private funds.\206\
---------------------------------------------------------------------------

    \202\ Rule 203(l)-1(c)(4)(iii). For this purpose, pooled 
investment vehicles include investment companies, issuers relying on 
rule 3a-7 under the Investment Company Act and commodity pools. 17 
CFR 270.3a-7.
    \203\ Under the ``holding out'' criterion (discussed in Section 
II.A.7. below), a fund that represents itself as pursuing a venture 
capital strategy to investors implies that the fund invests 
primarily in operating companies and not for example in entities 
that hold oil and gas leases.
    \204\ One commenter agreed that ``there is no indication that 
Congress intended the venture capital exemption to apply to `funds 
of funds,''' but argued that the qualifying portfolio company 
definition was ``unduly restrictive'' because it would exclude such 
funds of funds and discourage use of special purpose vehicles. ABA 
Letter.
    \205\ S. Rep. No. 111-176, supra note 6, at 74.
    \206\ See generally Loy Testimony, supra note 151, and McGuire 
Testimony, supra note 151.
---------------------------------------------------------------------------

    Moreover, without this definitional criterion, a qualifying fund 
could circumvent the intended scope of the rule by investing in other 
pooled investment vehicles that are not themselves subject to the 
definitional criteria under our rule.\207\ For example, without this 
criterion, a venture capital fund could circumvent the intent of the 
rule by incurring off-balance sheet leverage or indirectly investing in 
reporting companies in excess of the 20 percent limit for non-
qualifying

[[Page 39660]]

investments.\208\ Our exclusion is similar to the approach of other 
definitions of ``venture capital'' discussed in the Proposing Release, 
which limit investments to operating companies and thus would exclude 
investments in other private funds or securitized asset vehicles.\209\
---------------------------------------------------------------------------

    \207\ One commenter indicated that it was ``sympathetic'' to the 
Commission's concerns about the use of fund of funds structures to 
circumvent the intended purpose of the exemption, and agreed that 
such ``investments would unacceptably heighten the possibility for 
abuse.'' See NVCA Letter (suggesting that the Commission address 
this concern by applying the venture capital fund leverage limit on 
a full ``look-through'' basis to the underlying funds).
    \208\ Similarly, a qualifying fund could not, for example, 
invest in an investment management entity (e.g., a general partner 
entity) that in turn invests in another pooled vehicle, except as an 
investment under the non-qualifying basket.
    \209\ See Proposing Release, supra note 26, at nn.70-72 
(discussing the California venture capital exemption and the VCOC 
definition under ERISA, 29 CFR 2510.3-101(d)).
---------------------------------------------------------------------------

    Many commenters opposed the operating company criterion and 
recommended that the rule include fund of venture capital fund 
structures.\210\ Some commenters supported no limits on investments in 
other pooled investment vehicles,\211\ while others supported 
broadening the definition to include funds that invest in other funds 
if either (i) the underlying funds qualify as venture capital funds 
(i.e., comply with rule 203(l)-1) \212\ or (ii) investment in 
underlying funds does not exceed a specified threshold (such as a 
percentage of fund capital).\213\ Commenters argued that broadening the 
definition of qualifying portfolio company was necessary in order to 
accommodate current business practices,\214\ or was appropriate because 
funds of funds (including secondary funds) provide investors with 
liquidity or do not pose systemic risk.\215\ Other commenters advocated 
a definition that would permit investments in qualifying portfolio 
companies held through an intermediate holding company structure formed 
solely for tax, legal or regulatory reasons.\216\
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    \210\ See, e.g., NVCA Letter; Sevin Rosen Letter; Comment Letter 
of VCFA Group (Jan. 21, 2011).
    \211\ See, e.g., Cook Children's Letter; Leland Fikes Letter; 
Merkl Letter.
    \212\ See, e.g., ATV Letter, Charles River Letter, NVCA Letter, 
Sevin Rosen Letter (specifically in the context of funds of ``seed'' 
funds); SVB Letter, Vedanta Letter (85% cap for investments in rule 
203(l)-1 compliant, unleveraged funds). See also Dechert General 
Letter (suggested that funds investing solely in venture capital 
funds should be permitted or, in the alternative, investments of up 
to 20% of committed capital should be permitted in ``incubator'' 
funds).
    \213\ First Round Letter (supported investments in underlying 
funds representing no more than 10% of a fund's called capital, 
measured at the end of the fund's term); ATV Letter and Charles 
River Letter (supported investments in underlying funds representing 
no more than 20% of a fund's committed capital subject to other 
conditions); PEI Funds Letter (supports ``substantial'' investment 
in venture capital investments rather than a specific numerical 
threshold); Comment Letter of Private Equity Investors, Inc. and 
Willowbridge Partners, Inc. (Jan. 7, 2011) (``PEI/Willowbridge 
Letter'') (supported investments in other qualifying funds 
representing at least 50% of the qualifying fund's assets or 
committed capital) and Comment Letter of Venture Investment 
Associates (Jan. 24, 2011) (``VIA Letter'') (supported investments 
in underlying funds representing at least 50% of a qualifying fund's 
capital commitments).
    \214\ See, e.g., ATV Letter, Charles River Letter, Cook 
Children's Letter, Leland Fikes Letter (each of which cited the use 
of technology incubators).
    \215\ See, e.g., PEI/Willowbridge Letter and VIA Letter.
    \216\ See, e.g., ABA Letter; Davis Polk Letter; NVCA Letter.
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    For purposes of the definition of a qualifying portfolio company, 
we agree that a fund may disregard a wholly owned intermediate holding 
company formed solely for tax, legal or regulatory reasons to hold the 
fund's investment in a qualifying portfolio company. Such structures 
are used to address the particular needs of venture capital funds or 
their investors and are not intended to circumvent the rule's general 
limitation on investing in other investment vehicles.\217\
---------------------------------------------------------------------------

    \217\ See, e.g., Davis Polk Letter for a discussion of these 
considerations.
---------------------------------------------------------------------------

    We do not agree, however, that Congress viewed funds of venture 
capital funds as being consistent with the exemption, and continue to 
believe that this criterion remains an important tool to prevent 
circumvention of the intended scope of the venture capital exemption. A 
fund strategy of selecting a venture capital or other private fund in 
which to invest is different from a strategy of selecting qualifying 
portfolio companies. Nevertheless, we are persuaded that a venture 
capital fund's limited ability to invest a limited portion of its 
assets in other pooled investment vehicles would not be inconsistent 
with the intent of the rule if the fund primarily invests directly in 
qualifying portfolio companies. As a result, for purposes of the 
exemption, investments in other private funds or venture capital funds 
could be made using the non-qualifying basket.
4. Management Involvement
    We are not adopting a managerial assistance element of the rule, as 
originally proposed. We proposed that advisers seeking to rely on the 
rule have a significant level of involvement in developing a fund's 
portfolio companies.\218\ We modeled our proposed approach to 
managerial assistance in part on existing provisions under the Advisers 
Act and the Investment Company Act dealing with BDCs. These provisions 
were added over the years to ease the regulatory burden on venture 
capital and other private equity investments.\219\ Congress did not use 
the existing BDC definitions when determining the scope of the venture 
capital exemption, and the primary policy considerations that led to 
the adoption of the BDC exemptions differed from those under the Dodd-
Frank Act.\220\
---------------------------------------------------------------------------

    \218\ See Proposing Release, supra note 26, section II.A.2.
    \219\ See id., at n.123.
    \220\ See id., at section II.A.2.
---------------------------------------------------------------------------

    Commenters presented several problems with the application of the 
managerial assistance criterion and its intended scope under the 
proposed rule. Some objected to the managerial assistance criterion as 
proposed, arguing that such assistance to (or control of) a portfolio 
company is not a key or distinguishing characteristic of venture 
capital investing; \221\ that relationships between qualifying funds 
and qualifying portfolio companies may be less formal and may not 
constitute management or control of a portfolio company under the 
proposed rule; \222\ or that the discretion to determine the extent of 
involvement with a portfolio company should not affect a qualifying 
fund's ability to satisfy the definitional criterion.\223\
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    \221\ Merkl Letter; SVB Letter (managerial assistance criterion 
is unnecessary because it does not distinguish venture capital funds 
from other types of funds providing managerial assistance).
    \222\ ESP Letter.
    \223\ Sevin Rosen Letter.
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    Most commenters sought guidance on determining what activities 
would constitute managerial assistance or ``control.'' \224\ Other 
commenters specifically requested confirmation that a management rights 
letter for purposes of ``venture capital operating company'' status 
under ERISA would be sufficient.\225\ Finally, some commenters 
recommended that the rule address syndicated transactions,\226\ and 
provide that the managerial assistance criterion would be satisfied if 
one fund within the syndicate provided the requisite assistance or 
control.\227\
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    \224\ BCLBE Letter; Gunderson Dettmer Letter; McGuireWoods 
Letter; Shearman Letter. Shearman sought confirmation on whether 
control included both direct and indirect control, and BCLBE sought 
confirmation that board representation would be sufficient for 
control purposes. Other commenters, however, acknowledged that the 
``offer-only'' element of the proposed rule would provide sufficient 
flexibility for a venture capital fund to alter its relationship 
with a portfolio company over time. See, e.g., First Round Letter; 
NVCA Letter. The NVCA and one other commenter did not support 
imposing specific requirements as to what constituted managerial 
assistance. See NVCA Letter (definitive requirements are not 
appropriate); Sevin Rosen Letter (opposed requiring board seat or 
observer rights).
    \225\ ATV Letter; Charles River Letter; NVCA Letter; Oak 
Investment Letter; Sant[eacute] Ventures Letter; Sevin Rosen Letter; 
Village Ventures Letter.
    \226\ ABA Letter; ESP Letter; McGuireWoods Letter.
    \227\ ABA Letter (asserted that most deals are syndicated 
deals). See also Dechert General Letter; ESP Letter (indicating that 
in syndicated transactions, there may be varying degrees of 
managerial involvement by funds participating in the transactions; 
one fund may take an active role, with the other funds taking a more 
passive role with respect to portfolio companies).

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[[Page 39661]]

    We appreciate the difficulties of applying the managerial 
assistance criterion under the proposed definition and in particular 
the issues associated with a qualifying fund proving compliance when it 
participates in a syndicated transaction involving multiple funds. We 
are persuaded that to modify the rule to specify which activities 
constitute ``managerial assistance'' would introduce additional 
complexity and require us to insert our judgment for that of a venture 
capital fund's adviser regarding the minimum level of portfolio company 
involvement that would be appropriate for the fund, rather than 
enabling investors to select venture capital funds based in part on 
their level of involvement.\228\ We also appreciate that the offer of 
managerial assistance may not distinguish venture capital funds from 
other types of funds.
---------------------------------------------------------------------------

    \228\ For example, one commenter indicated that although it may 
seek to offer assistance to portfolio companies, not all of the 
companies have accepted. Charles River Letter. Similarly, a number 
of venture capital advisers stated that their funds may invest in a 
significant but non-controlling stake in underlying portfolio 
companies. See, e.g., ATV Letter; First Round Letter.
---------------------------------------------------------------------------

    While many venture capital fund advisers do provide managerial 
assistance, we believe that the managerial assistance criterion, as 
proposed, does not distinguish these advisers from other advisers, 
would be difficult to apply and could be unnecessarily prescriptive 
without creating benefits for investors. As a consequence of our 
modification to the proposed rule, a qualifying fund is not required to 
offer (or provide) managerial assistance to, or control any, qualifying 
portfolio company in order to satisfy the definition.
5. Limitation on Leverage
    Under rule 203(l)-1, a venture capital fund is a private fund that 
does not borrow, issue debt obligations, provide guarantees or 
otherwise incur leverage, in excess of 15 percent of the fund's capital 
contributions and uncalled committed capital, and any such borrowing, 
indebtedness, guarantee or leverage is for a non-renewable term of no 
longer than 120 calendar days.\229\ For purposes of this leverage 
criterion, any guarantee by the private fund of a qualifying portfolio 
company's obligations up to the value of the private fund's investment 
in the qualifying portfolio company is not subject to the 120 calendar 
day limit.\230\
---------------------------------------------------------------------------

    \229\ Rule 203(l)-1(a)(3).
    \230\ Id.
---------------------------------------------------------------------------

    The 15 percent threshold is determined based on the venture capital 
fund's aggregate capital commitments. In practice, this means that a 
qualifying fund could leverage an investment transaction up to 100 
percent when acquiring equity securities of a particular portfolio 
company as long as the leverage amount does not exceed 15 percent of 
the fund's total capital commitments.
    Although a minority of commenters generally supported the leverage 
criterion as proposed,\231\ many commenters sought to broaden it in 
several ways. Two commenters that generally supported the leveraged 
criterion also recommended that the criterion exclude uncalled capital 
commitments so that a qualifying fund could not incur excessive 
leverage.\232\ Although determining the leverage criterion as a 
percentage of total fund capital commitments may enable a qualifying 
fund to incur a degree of leverage that represents a disproportionate 
percentage of the fund's assets early in the life of the fund, the 
leverage criterion is also constrained by the 120 calendar day limit. 
Therefore, we do not believe it is necessary to exclude uncalled 
capital commitments from the leverage criterion.
---------------------------------------------------------------------------

    \231\ See Sen. Levin Letter; NVCA Letter. See also AFL-CIO 
Letter, AFR Letter (generally supported the leverage limit but also 
supported excluding uncalled capital commitments); Oak Investment 
Letter (generally supported the leverage limit, but did not agree 
that the 120-day limit should apply to guarantees of portfolio 
company obligations by venture capital funds).
    \232\ AFR Letter; AFL-CIO Letter.
---------------------------------------------------------------------------

    Other commenters proposed to exclude from the 15 percent leverage 
limitation capital call lines of credit (i.e., venture capital fund 
borrowings repaid with proceeds of capital calls from fund 
investors),\233\ or borrowings by a venture capital fund in order to 
meet fee and expense obligations.\234\ One commenter sought to increase 
the leverage threshold from 15 percent to 20 percent.\235\ One 
commenter, on behalf of many venture capital advisers, however, agreed 
with the proposed leverage criterion, arguing that venture capital fund 
financing would generally not exceed 15 percent of fund capital 
commitments or remain outstanding for longer than 120 days.\236\
---------------------------------------------------------------------------

    \233\ Cook Children's Letter; Leland Fikes Letter; SVB Letter. 
We would view a line of credit used to advance anticipated committed 
capital that remains available for longer than 120 days to be 
consistent with the criterion, if each drawdown is repaid within 120 
days and subsequent drawdowns relate to subsequent capital calls.
    \234\ Dechert General Letter.
    \235\ See Charles River Letter (argued that a qualifying fund 
should be able to borrow, without limit on duration, up to 20% of 
capital commitments with the consent of its investors).
    \236\ NVCA Letter. See also Merkl Letter.
---------------------------------------------------------------------------

    We decline to increase the leverage threshold for a qualifying fund 
under the rule or exclude other certain types of borrowings as 
requested by some commenters. Our rule defines a venture capital fund 
by reference to a maximum of 15 percent of borrowings based on our 
understanding that venture capital funds typically would not incur 
borrowings in excess of 10 to 15 percent of the fund's total capital 
contributions and uncalled capital commitments,\237\ which commenters 
have confirmed.\238\ We believe that imposing a maximum at the upper 
range of borrowings typically used by venture capital funds will 
accommodate existing practices of the vast majority of industry 
participants.
---------------------------------------------------------------------------

    \237\ See Loy Testimony, supra note 151, at 6 (``[M]any venture 
capital funds significantly limit borrowing such that all 
outstanding capital borrowed by the fund, together with guarantees 
of portfolio company indebtedness, does not exceed the lesser of (i) 
10-15% of total limited partner commitments to the fund and (ii) 
undrawn limited partner commitments.'').
    \238\ NVCA Letter. See also Merkl Letter; Oak Investments 
Letter.
---------------------------------------------------------------------------

    Our rule specifies that the 15 percent calculation must be 
determined based on the fund's aggregate capital contributions and 
uncalled capital commitments.\239\ Unlike most registered investment 
companies or hedge funds, venture capital funds rely on investors 
funding their capital commitments from time to time in order to acquire 
portfolio companies.\240\ A capital commitment is a contractual 
obligation to acquire an interest in, or provide the total commitment 
amount over time to, a fund, when called by the fund. Accordingly, an 
adviser to venture capital funds manages the fund in anticipation of 
all investors fully funding their commitments when due and typically 
has the right to penalize investors for failure to do so.\241\ Venture

[[Page 39662]]

capital funds are subject to investment restrictions, and, during the 
initial years of a fund, calculate fees payable to an adviser as a 
percentage of the total capital commitments of investors, regardless of 
whether or not the capital commitment is ultimately fully funded by an 
investor.\242\ Venture capital fund advisers typically report and 
market themselves to investors on the basis of aggregate capital 
commitment amounts raised for prior or existing funds.\243\ These 
factors would lead to the conclusion that, in contrast to other types 
of private funds, such as hedge funds, which trade on a more frequent 
basis, a venture capital fund would view the fund's total capital 
commitments as the primary metric for managing the fund's assets and 
for determining compliance with investment guidelines. Hence, we 
believe that calculating the leverage threshold to include uncalled 
capital commitments is appropriate, given that capital commitments are 
already used by venture capital funds themselves to measure investment 
guideline compliance.
---------------------------------------------------------------------------

    \239\ Rule 203(l)-1(a)(3).
    \240\ Schell, supra note 185, at Sec.  1.03[8] (``The typical 
Venture Capital Fund calls for Capital Contributions from time to 
time as needed for investments.''); id. at Sec.  2.05[2] (stating 
that ``[venture capital funds] begin operation with Capital 
Commitments but no meaningful assets. Over a specific period of 
time, the Capital Commitments are called by the General Partner and 
used to acquire Portfolio Investments.'').
    \241\ See Loy Testimony, supra note 151, at 5 (``[Limited 
partners] make their investment in a venture fund with the full 
knowledge that they generally cannot withdraw their money or change 
their commitment to provide funds. Essentially they agree to ``lock-
up'' their money for the life of the fund * * *''). See also 
Stephanie Breslow & Phyllis Schwartz, Private Equity Funds, 
Formation and Operation 2010 (``Breslow & Schwartz''), at Sec.  
2:5.6 (discussing the various remedies that may be imposed in the 
event an investor fails to fund its contractual capital commitment, 
including, but not limited to, ``the ability to draw additional 
capital from non-defaulting investors;'' ``the right to force a sale 
of the defaulting partner's interests at a price determined by the 
general partner;'' and ``the right to take any other action 
permitted at law or in equity'').
    \242\ See, e.g., Breslow & Schwartz, supra note 241, at Sec.  
2:5.7 (noting that a cap of 10% to 25% of remaining capital 
commitments is a common limitation for follow-on investments). See 
also Schell, supra note 185, at Sec.  1.01 (noting that capital 
contributions made by the investors are used to ``make investments * 
* * in a manner consistent with the investment strategy or 
guidelines established for the Fund.''); id. at Sec.  1.03 
(``Management fees in a Venture Capital Fund are usually an annual 
amount equal to a fixed percentage of total Capital Commitments.''); 
see also Dow Jones, Private Equity Partnership Terms and Conditions, 
2007 edition (``Dow Jones Report'') at 15.
    \243\ See, e.g., NVCA Yearbook 2010, supra note 150, at 16; John 
Jannarone, Private Equity's Cash Problem, Wall St. J., June 23, 
2010, http://online.wsj.com/article/SB10001424052748704853404575323073059041024.html#printMode.
---------------------------------------------------------------------------

    Thus, we are retaining the 15 percent leverage threshold, as 
proposed, so that a qualifying fund could only incur debt (or provide 
guarantees of portfolio company obligations) subject to this threshold. 
However, we are modifying the leverage criterion to exclude from the 
120-calendar day limit any guarantee of qualifying portfolio company 
obligations by the qualifying fund, up to the value of the fund's 
investment in the qualifying portfolio company.\244\ Commenters 
generally argued in favor of extending the period during which a 
qualifying fund's leverage could remain outstanding. Some recommended 
extending the 120-day limit with respect to leverage to 180 days with 
one 180-day renewal in the case of non-convertible bridge loans 
extended by the venture capital fund to a portfolio company.\245\ 
Others seeking to accommodate business practices and provide maximum 
flexibility for venture capital fund debt investments in portfolio 
companies recommended excluding guarantees of portfolio company debt by 
a venture capital fund from the 120-day limit.\246\ Other commenters 
argued that guarantees of portfolio company obligations would not 
result in qualifying funds incurring extensive leverage.\247\
---------------------------------------------------------------------------

    \244\ Rule 203(l)-1)(a)(3).
    \245\ See, e.g., NVCA Letter; Davis Polk Letter; Bessemer 
Letter.
    \246\ Cook Children's Letter; Leland Fikes Letter; Gunderson 
Dettmer Letter; Oak Investment Letter; SVB Letter. See also ABA 
Letter.
    \247\ See, e.g., SVB Letter.
---------------------------------------------------------------------------

    We understand that guarantees of portfolio company leverage by a 
venture capital fund are typically limited to the value of the fund's 
investment in the company (often through a pledge of the fund's 
interest in the company).\248\ Such guarantees by a qualifying fund may 
help a qualifying portfolio company obtain credit for working capital 
purposes, rather than be used by the fund to leverage its investment in 
the company.\249\ We are persuaded that such guarantees of portfolio 
company indebtedness do not present the same types of risks identified 
by Congress. Congress cited the implementation of trading strategies 
that use financial leverage by certain private funds as creating a 
potential for systemic risk.\250\ In testimony before Congress, the 
venture capital industry identified the lack of financial leverage in 
venture capital funds as a basis for exempting advisers to venture 
capital funds \251\ in contrast with other types of private funds such 
as hedge funds, which may engage in trading strategies that may 
contribute to systemic risk and affect the public securities 
markets.\252\ For this reason, our proposed rule was designed to 
address concerns that financial leverage may contribute to systemic 
risk by excluding funds that incur more than a limited amount of 
leverage from the definition of venture capital fund.\253\ We believe 
that the alternative approach to fund leverage we have adopted in the 
final rule better reflects industry practice while still addressing 
Congress' concern that the use of financial leverage may create the 
potential for systemic risk.
---------------------------------------------------------------------------

    \248\ See also NVCA Letter.
    \249\ See, e.g., Oak Investments Letter; SVB Letter.
    \250\ See Proposing Release, supra note 26, at n. 136 and 
accompanying text.
    \251\ See McGuire Testimony, supra note 151, at 7 (``Venture 
capital firms do not use long term leverage, rely on short term 
funding, or create third party or counterparty risk * * *. [F]rom 
previous testimony submitted by the buy-out industry, the typical 
capital structure of the companies acquired by a buyout fund is 
approximately 60% debt and 40% equity. In contrast, borrowing at the 
venture capital fund level, if done at all, typically is only used 
for short-term capital needs (pending drawdown of capital from its 
partners) and does not exceed 90 days. Not only are our partnerships 
run without debt but our portfolio companies are usually run without 
debt as well.''); Loy Testimony, supra note 151, at 2 (``Although 
venture capital funds may occasionally borrow on a short-term basis 
immediately preceding the time when the cash installments are due, 
they do not use debt to make investments in excess of the partner's 
capital commitments or `lever up' the fund in a manner that would 
expose the fund to losses in excess of the committed capital or that 
would result in losses to counter parties requiring a rescue 
infusion from the government.'').
    \252\ See S. Rep. No. 111-176, supra note 6, at 74-75.
    \253\ In proposing an exemption for advisers to private equity 
funds, which would have required the Commission to define the term 
``private equity fund,'' the Senate Banking Committee noted the 
difficulties in distinguishing some private equity funds from hedge 
funds and expected the Commission to exclude from the exemption 
private equity funds that raise significant potential systemic risk 
concerns. S. Rep. No. 111-176, supra note 6, at 75. See also G20 
Working Group 1, Enhancing Sound Regulation and Strengthening 
Transparency, at 7 (March 25, 2009) (noting that unregulated 
entities such as hedge funds may contribute to systemic risks 
through their trading activities).
---------------------------------------------------------------------------

6. No Redemption Rights
    We are adopting as proposed the definitional element under which a 
venture capital fund is a private fund that issues securities that do 
not provide investors redemption rights except in ``extraordinary 
circumstances'' but that entitle investors generally to receive pro 
rata distributions.\254\ Unlike hedge funds, a venture capital fund 
does not typically permit investors to redeem their interests during 
the life of the fund,\255\ but rather distributes assets generally as 
investments mature.\256\
---------------------------------------------------------------------------

    \254\ Rule 203(l)-1(a)(4).
    \255\ See Schell, supra note 185, at Sec.  1.03[7] (venture 
capital fund ``redemptions and withdrawals are rarely allowed, 
except in the case of legal compulsion''); Breslow & Schwartz, supra 
note 241, at Sec.  2:14.2 (``the right to withdraw from the fund is 
typically provided only as a last resort'').
    \256\ Loy Testimony, supra note 151, at 2-3 (``As portfolio 
company investments are sold in the later years of the [venture 
capital] fund--when the company has grown so that it can access the 
public markets through an initial public offering (an IPO) or when 
it is an attractive target to be bought-the liquidity from these 
`exits' is distributed back to the limited partners. The timing of 
these distributions is subject to the discretion of the general 
partner, and limited partners may not otherwise withdraw capital 
during the life of the venture [capital] fund.''). Id. at 5 
(Investors ``make their investment in a venture [capital] fund with 
the full knowledge that they generally cannot withdraw their money 
or change their commitment to provide funds. Essentially they agree 
to `lock-up' their money for the life of the fund, generally 10 or 
more years as I stated earlier.''). See also Dow Jones Report, supra 
note 242, at 60 (noting that an investor in a private equity or 
venture capital fund typically does not have the right to transfer 
its interest). See generally Proposing Release, supra note 26, 
section II.A.4.

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[[Page 39663]]

    Although venture capital funds typically return capital and profits 
to investors only through pro rata distributions, such funds may also 
provide extraordinary rights for an investor to withdraw from the fund 
under foreseeable but unexpected circumstances or to be excluded from 
particular investments due to regulatory or other legal 
requirements.\257\ These events may be ``foreseeable'' because they are 
circumstances that are known to occur (e.g., changes in law, corporate 
events such as mergers, etc.) but are unexpected in their timing or 
scope. Thus, withdrawal, exclusion or similar ``opt-out'' rights would 
be deemed ``extraordinary circumstances'' if they are triggered by a 
material change in the tax law after an investor invests in the fund, 
or the enactment of laws that may prohibit an investor's participation 
in the fund's investment in particular countries or industries.\258\ 
The trigger events for these rights are typically beyond the control of 
the adviser and fund investor (e.g., tax and regulatory changes).
---------------------------------------------------------------------------

    \257\ See Hedge Fund Adviser Registration Release, supra note 
14, at n.240 and accompanying text (``Many partnership agreements 
provide the investor the opportunity to redeem part or all of its 
investment, for example, in the event continuing to hold the 
investment became impractical or illegal, in the event of an owner's 
death or total disability, in the event key personnel at the fund 
adviser die, become incapacitated, or cease to be involved in the 
management of the fund for an extended period of time, in the event 
of a merger or reorganization of the fund, or in order to avoid a 
materially adverse tax or regulatory outcome. Similarly, some 
investment pools may offer redemption rights that can be exercised 
only in order to keep the pool's assets from being considered `plan 
assets' under ERISA [Employee Retirement Income Security Act of 
1974].''). See, e.g., Breslow & Schwartz, supra note 241, at Sec.  
2:14.1 (``Private equity funds generally provide for mandatory 
withdrawal of a limited partner [i.e., investor] only in the case 
where the continued participation by a limited partner in a fund 
would give rise to a regulatory or legal violation by the investor 
or the fund (or the general partner [i.e., adviser] and its 
affiliates). Even then, it is often possible to address the 
regulatory issue by excusing the investor from particular 
investments while leaving them otherwise in the fund.'').
    \258\ See, e.g., Breslow & Schwartz, supra note 241, at Sec.  
2:14.2 (``The most common reason for allowing withdrawals from 
private equity funds arises in the case of an ERISA violation where 
there is a substantial likelihood that the assets of the fund would 
be treated as `plan assets' of any ERISA partner for purposes of 
Title I of ERISA or section 4975 of the Code.''). See also Schell, 
supra note 185, at Sec.  9.04[3] (``Exclusion provisions allow the 
General Partner to exclude a Limited Partner from participation in 
any or all investments if a violation of law or another material 
adverse effect would otherwise occur.''); id. at Appendix D-31 
(attaching model limited partnership agreement providing ``The 
General Partner at any time may cancel the obligations of all 
Partners to make Capital Contributions for Portfolio Instruments if 
* * * changes in applicable law * * * make such cancellation 
necessary or advisable * * *'').
---------------------------------------------------------------------------

    Most commenters addressing the redeemability criterion did not 
oppose it, but rather sought clarification or guidance on the scope of 
its application.\259\ For example, commenters specifically requested 
confirmation that the lack of redeemability criterion would not 
preclude a qualifying fund from (i) making distributions of carried 
interest to a general partner,\260\ (ii) specifying redemption rights 
for certain categories of investors under certain circumstances \261\ 
or (iii) specifying opt-out rights for investors.\262\ Several 
commenters, however, indicated that the term ``extraordinary 
circumstances'' is sufficiently clear,\263\ suggesting that the 
proposal did not require further clarification.
---------------------------------------------------------------------------

    \259\ A number of commenters agreed with the redeemability 
criterion. See, e.g., ATV Letter; Charles River Letter; Gunderson 
Dettmer Letter. However, one commenter argued that a fund's 
redeemability is not necessarily characteristic of venture capital 
funds. Comment Letter of Cooley LLP (Jan. 21, 2011).
    \260\ See, e.g., NVCA Letter. The rule specifies that a 
qualifying fund is a private fund that ``issues securities the terms 
of which do not provide a holder with any right, except in 
extraordinary circumstances, to withdraw * * *'' If a general 
partner interest is not a ``security,'' then the redeemability 
criterion of the rule would not be implicated. Whether or not a 
general partner interest is a ``security'' depends on the particular 
facts and circumstances. See generally Williamson v. Tucker, 645 
F.2d 404 (5th Cir. 1981), cert. denied, 454 U.S. 897 (1981).
    \261\ ABA Letter (sought guidance on whether granting redemption 
rights to certain types of investors such as ERISA funds and state 
plans, in the event of certain ERISA, tax or regulatory changes 
would be considered extraordinary).
    \262\ McGuireWoods Letter.
    \263\ See Gunderson Dettmer Letter; Merkl Letter; SVB Letter.
---------------------------------------------------------------------------

    We believe that the term ``extraordinary circumstances'' is 
sufficiently clear. Whether or not specific redemption or ``opt out'' 
rights for certain categories of investors under certain circumstances 
should be treated as ``extraordinary'' will depend on the particular 
facts and circumstances.
    For these purposes, for example, a fund that permits quarterly or 
other periodic withdrawals would be considered to have granted 
investors redemption rights in the ordinary course even if those rights 
may be subject to an initial lock-up or suspension or restrictions on 
redemption. We believe, and several commenters confirmed, that the 
phrase ``extraordinary circumstances'' is sufficiently clear to 
distinguish the terms for investor liquidity of venture capital funds, 
as they operate today, from hedge funds.\264\ Congressional testimony 
cited an investor's inability to withdraw from a venture capital fund 
as a key characteristic of venture capital funds and a factor for 
reducing their potential for systemic risk.\265\ Although a fund 
prohibiting redemptions would satisfy the redeemability criterion of 
the venture capital fund definition, the rule does not specify a 
minimum period of time for an investor to remain in the fund.
---------------------------------------------------------------------------

    \264\ See, e.g., id.
    \265\ See supra notes 255-256 and accompanying text.
---------------------------------------------------------------------------

    In the Proposing Release, we expressed the general concern that a 
venture capital fund might seek to circumvent the intended scope of 
this criterion by providing investors with nominally ``extraordinary'' 
rights to redeem that effectively result in de facto redemption rights 
in the ordinary course.\266\ One commenter expressly disagreed with 
this view, asserting that in the case of transfers effected with the 
consent of a general partner, such transactions are intended to 
accommodate an investor's internal corporate restructurings, 
bankruptcies or portfolio allocations rather than to provide investors 
with liquidity from the fund.\267\ While consents to transfer do not 
raise the same level of concern as de facto redemption rights, we do 
not believe that an adviser or its related persons could, while relying 
on the venture capital exemption, create de facto periodic redemption 
or transfer rights by, for example, regularly identifying potential 
investors on behalf of fund investors seeking to transfer or redeem 
fund interests.\268\
---------------------------------------------------------------------------

    \266\ For example, in the Proposing Release, we stated that a 
private fund's governing documents might provide that investors do 
not have any right to redeem without the consent of the general 
partner. In practice, if the general partner typically permits 
investors to redeem their otherwise non-redeemable interests on a 
periodic basis, then the fund would not be considered to have issued 
securities that ``do not provide a holder with any right, except in 
extraordinary circumstances, to withdraw.'' Rule 203(l)-1(a)(4). See 
Proposing Release, supra note 26, at n.154.
    \267\ See NVCA Letter (disagreeing with statements in the 
Proposing Release regarding the de facto creation of redemption 
rights but generally agreeing with the general prohibition on 
redemptions except in extraordinary circumstances).
    \268\ Section 208(d) of the Advisers Act.
---------------------------------------------------------------------------

    We are not modifying the rule to include additional conditions for 
fund redemptions, such as specifying a minimum holding or investment 
period by investors or a maximum amount that may be redeemed at any 
time. Commenters generally did not support

[[Page 39664]]

the imposition of such conditions,\269\ and we agree that imposing such 
conditions would not appear to be necessary to achieve the purposes of 
the rule.
---------------------------------------------------------------------------

    \269\ See, e.g., SVB Letter (expressing opposition to a rule 
that would limit redemptions following a minimum investment period 
or limit redemptions to a specified maximum threshold).
---------------------------------------------------------------------------

7. Represents Itself as Pursuing a Venture Capital Strategy
    Under the rule, a qualifying fund must represent itself as pursuing 
a venture capital strategy to its investors and potential 
investors.\270\ Without this element, a fund that did not engage in 
typical venture capital activities could be treated as a venture 
capital fund simply because it met the other elements specified in our 
rule (because for example it only invests in short-term holdings, does 
not borrow, does not offer investors redemption rights, and is not a 
registered investment company).\271\ We believe that only funds that do 
not significantly differ from the common understanding of what a 
venture capital fund is,\272\ and that are actually offered to 
investors as funds that pursue a venture capital strategy, should 
qualify for the exemption. Thus, for example, an adviser to a venture 
capital fund that is otherwise relying on the exemption could not (i) 
identify the fund as a hedge fund or multi-strategy fund (i.e., venture 
capital is one of several strategies used to manage the fund) or (ii) 
include the fund in a hedge fund database or hedge fund index.
---------------------------------------------------------------------------

    \270\ Rule 203(1)-1(a)(1).
    \271\ We also note that a fund that represents to investors that 
it is one type of fund while pursuing a different type of fund 
strategy may raise concerns under rule 206(4)-8 of the Advisers Act.
    \272\ See Proposing Release, supra note 26, at n.157.
---------------------------------------------------------------------------

    As proposed, rule 203(l)-1 defined a venture capital fund as a 
private fund that ``represents itself as being a venture capital fund 
to its investors and potential investors.'' \273\ Although several 
commenters generally supported the ``holding out'' criterion as 
proposed,\274\ many sought confirmation that the use of specific self-
identifying terminology by a fund in its name (e.g., ``private equity'' 
fund, ``multi-strategy'' fund or ``growth capital'' fund) would not 
automatically disqualify the fund under the definition.\275\ Several 
commenters argued that historically, some funds have avoided referring 
to themselves as ``venture capital funds.'' \276\ One commenter argued 
that the proposed condition was too restrictive because it focuses on 
the fund's name rather than its investment strategy and suggested that 
the definition instead exclude any fund that markets itself as a hedge 
fund, multi-strategy fund, buyout fund or fund of funds.\277\
---------------------------------------------------------------------------

    \273\ Proposed Rule 203(l)-1(a)(1).
    \274\ See Gunderson Dettmer Letter; Sen. Levin Letter; Merkl 
Letter.
    \275\ See, e.g., IVP Letter; Comment Letter of MissionPoint 
Capital Partners, Jan. 24, 2011; PEI Funds Letter.
    \276\ See, e.g., NVCA Letter; Pine Brook Letter. See also IVP 
Letter; PEI Funds Letter.
    \277\ See Pine Brook Letter.
---------------------------------------------------------------------------

    We believe that the ``holding out'' criterion remains an important 
distinction between funds that are eligible to rely on the definition 
and funds that are not, because an investor's understanding of the fund 
and its investment strategy must be consistent with an adviser's 
reliance on the exemption. However, we also recognize that it is not 
necessary (nor indeed sufficient) for a qualifying fund to name itself 
as a ``venture capital fund'' in order for its adviser to rely on the 
venture capital exemption. Hence, we are modifying the proposed 
definition to refer to the way a qualifying fund describes its 
investment strategy to investors and prospective investors.
    A qualifying fund name that does not use the words ``venture 
capital'' and is not inconsistent with pursuing a venture capital 
strategy would not preclude a qualifying fund from satisfying the 
definition.\278\ Whether or not a fund represents itself as pursuing a 
venture capital strategy, however, will depend on the particular facts 
and circumstances. Statements made by a fund to its investors and 
prospective investors, not just what the fund calls itself, are 
important to an investor's understanding of the fund and its investment 
strategy.\279\ The appropriate framework for analyzing whether a 
qualifying fund has satisfied the holding out criterion depends on all 
of the statements (and omissions) made by the fund to its investors and 
prospective investors. While this includes the fund name, it is only 
part of the analysis.
---------------------------------------------------------------------------

    \278\ Similarly, misleadingly including the words ``venture 
capital'' in the name of a fund pursuing a different strategy would 
not satisfy the definition.
    \279\ One commenter requested confirmation and examples of what 
constituted appropriate representations to investors given that 
``many'' venture capital funds do not use private placement 
memoranda or other offering materials during fundraising. See 
Gunderson Dettmer Letter (expressed the view that the following 
would be sufficient: (i) Checking the ``venture capital'' box on 
Form D or (ii) stating on the adviser's Web site that all of the 
funds advised by the adviser are venture capital funds). As we noted 
above, whether or not a venture capital fund satisfies the ``holding 
out'' criterion will depend on the particular facts and 
circumstances surrounding all of the statements and omissions made 
by the fund in light of the circumstances under which they were 
made. Moreover, a venture capital fund that seeks to rely on the 
safe harbor for non-public offerings under rule 506 of Regulation D 
is subject to all of the conditions of such rule, including the 
prohibition on general solicitation and general advertising 
applicable to statements attributable to the fund on a publicly 
available Web site. See 17 CFR 230.502(c).
---------------------------------------------------------------------------

    This approach is similar to our general approach to antifraud 
provisions under the Federal securities laws, including Advisers Act 
rule 206(4)-8 regarding pooled investment vehicles.\280\ The general 
antifraud rule under rule 206(4)-8 looks to the private fund's 
statements and omissions in light of the circumstances under which such 
statements or omissions are made.\281\ Similarly, the holding out 
criterion under our venture capital fund definition looks to all of the 
relevant statements made by the qualifying fund regarding its 
investment strategy.
---------------------------------------------------------------------------

    \280\ 17 CFR 275.206(4)-8.
    \281\ See Pooled Vehicles Release, supra note 122, at n.27 (``A 
fact is material if there is a substantial likelihood that a 
reasonable investor in making an investment decision would consider 
it as having significantly altered the total mix of information 
available,'' citing Basic, Inc. v. Levinson, 485 U.S. 224, 231-32 
(1988)).
---------------------------------------------------------------------------

8. Is a Private Fund
    We define a venture capital fund for purposes of the exemption as a 
private fund, which is defined in the Advisers Act, and exclude from 
the definition funds that are registered investment companies (e.g., 
mutual funds) or have elected to be regulated as BDCs.\282\ We are 
adopting this provision as proposed.
---------------------------------------------------------------------------

    \282\ Rule 203(l)-1(a) and (a)(5). See also discussion infra 
note 319.
---------------------------------------------------------------------------

    There is no indication that Congress intended the venture capital 
exemption to apply to advisers to these publicly available funds,\283\ 
referring to venture capital funds as a ``subset of private investment 
funds.'' \284\ The comment letters that addressed this proposed 
criterion generally supported it.\285\
---------------------------------------------------------------------------

    \283\ Legislative history does not indicate that Congress 
addressed this matter, nor does testimony before Congress suggest 
that this was contemplated. See, e.g., McGuire Testimony, supra note 
151, at 3 (noting that venture capital funds are not directly 
accessible by individual investors); Loy Testimony, supra note 151, 
at 2 (``Generally * * * capital for the venture fund is provided by 
qualified institutional investors such as pension funds, 
universities and endowments, private foundations, and to a lesser 
extent, high net worth individuals.''). See generally section 
202(a)(29) of the Advisers Act (definition of ``private fund'').
    \284\ See S. Rep. No. 111-176, supra note 6, at 74 (describing 
venture capital funds as a subset of ``private investment funds'').
    \285\ Gunderson Dettmer Letter; Merkl Letter; NYSBA Letter; Sen. 
Levin Letter.
---------------------------------------------------------------------------

9. Application to Non-U.S. Advisers
    The final rule does not define a venture capital fund as a fund 
advised by a U.S. adviser (i.e., an adviser with a principal office and 
place of business

[[Page 39665]]

the United States). Thus, a non-U.S. adviser, as well as a U.S. 
adviser, may rely on the venture capital exemption provided that such 
adviser solely advises venture capital funds that satisfy all of the 
elements of the rule or satisfy the grandfathering provision (discussed 
in greater detail below). A non-U.S. adviser may rely on the venture 
capital exemption if all of its clients, whether U.S. or non-U.S., are 
venture capital funds.
    Neither the statutory text of section 203(l) nor the legislative 
reports provide an indication of whether Congress intended the 
exemption to be available to advisers that operate principally outside 
of the United States but that invest in U.S. companies or solicit U.S. 
investors.\286\ Testimony before Congress presented by members of the 
U.S. venture capital industry discussed the industry's role primarily 
in the U.S. economy including its lack of interconnection with the U.S. 
financial markets and ``interdependence'' with the world financial 
system.\287\ Nevertheless, we expect that venture capital funds with 
advisers operating principally outside of the United States may seek to 
access the U.S. capital markets by investing in U.S. companies or 
soliciting U.S. investors; investors in the United States may also have 
an interest in venture capital opportunities outside of the United 
States.
---------------------------------------------------------------------------

    \286\ See section 203(l) of the Advisers Act; H. Rep. No. 111-
517, supra note 6, at 867; S. Rep. No. 111-176, supra note 6, at 74-
75.
    \287\ See Loy Testimony, supra note 151, at 4-5; McGuire 
Testimony, supra note 151, at 5-6.
---------------------------------------------------------------------------

    Commenters generally did not support defining venture capital fund 
or qualifying portfolio company by reference to the jurisdiction of 
formation of the fund or portfolio company.\288\ Several commenters, 
however, supported modifying the rule to apply the venture capital 
exemption in the same manner as the proposed private fund adviser 
exemption, with the result that a non-U.S. adviser could disregard its 
non-U.S. activities when assessing eligibility for the venture capital 
exemption.\289\ Under this approach, only U.S.-domiciled private funds 
would be required to satisfy our definition of a venture capital fund 
in order for the adviser to rely on the venture capital exemption.\290\ 
One commenter suggested that the same policy rationale underlying the 
private fund adviser exemption justified this approach to the venture 
capital exemption.\291\ Two other commenters supported this approach 
arguing that non-U.S. funds may operate in a manner that does not 
resemble venture capital fund investing in the United States or by U.S. 
venture capital fund advisers.\292\
---------------------------------------------------------------------------

    \288\ See, e.g., Bessemer Letter; EVCA Letter; McDonald Letter; 
Merkl Letter; NVCA Letter; SV Life Sciences Letter.
    \289\ See McGuireWoods Letter; Shearman Letter. See also EFAMA 
Letter (also noting that as a practical matter, the rule should 
account for non-U.S. specific practices so that non-U.S. advisers 
could rely on the exemption); Gunderson Dettmer Letter (exemption 
should be available to non-U.S. advisers even if non-U.S. funds do 
not satisfy definitional elements); Dechert General Letter (non-U.S. 
advisers that manage funds that are not venture capital funds 
outside of the U.S. should be able to rely on rule 203(l) for funds 
that are managed in the U.S. or that are marketed to U.S. 
investors).
    \290\ See EFAMA Letter (certain conditions of the proposed rule, 
such as the limitation on cash investments to U.S. Treasuries, are 
inconsistent with practices outside the United States). We believe 
that these concerns are adequately addressed by the non-qualifying 
basket.
    \291\ See Shearman Letter.
    \292\ See EFAMA Letter; McGuireWoods Letter.
---------------------------------------------------------------------------

    We do not agree that the private fund adviser exemption is the 
appropriate framework for the venture capital exemption in the case of 
non-U.S. advisers. Section 203(l) provides an exemption for an 
investment adviser based on the strategy of the funds that the adviser 
manages (i.e., venture capital funds). This exemption thus specifies 
the activities in which an adviser's clients may engage, and does not 
refer to activities in the United States.\293\ By contrast, section 
203(m) is based upon the location where the advisory activity is 
conducted. Accordingly, we do not believe it would be appropriate for 
an adviser relying on section 203(l) to disregard its non-U.S. 
activities. Moreover, a non-U.S. adviser could circumvent the intended 
scope of the exemption by merely sponsoring and advising solely non-
U.S. domiciled funds that are not venture capital funds.
---------------------------------------------------------------------------

    \293\ See also infra note 322 and accompanying and following 
text.
---------------------------------------------------------------------------

    Under our rule, only a private fund may qualify as a venture 
capital fund. As we noted in the Proposing Release, a non-U.S. fund 
that uses U.S. jurisdictional means in the offering of the securities 
it issues and that relies on section 3(c)(1) or 3(c)(7) of the 
Investment Company Act would be a private fund.\294\ A non-U.S. fund 
that does not use U.S. jurisdictional means to conduct an offering 
would not be a private fund and therefore could not qualify as a 
venture capital fund, even if it operated as a venture capital fund in 
a manner that would otherwise meet the criteria under our 
definition.\295\ As a result, under the proposed rule, if a non-U.S. 
fund did not qualify as a venture capital fund, then the fund's adviser 
would not be able to rely on the exemption.\296\
---------------------------------------------------------------------------

    \294\ An issuer that is organized under the laws of the United 
States or of a state is a private fund if it is excluded from the 
definition of an investment company for most purposes under the 
Investment Company Act pursuant to section 3(c)(1) or 3(c)(7). 
Section 7(d) of the Investment Company Act prohibits a non-U.S. fund 
from using U.S. jurisdictional means to make a public offering, 
absent an order permitting registration. A non-U.S. fund may conduct 
a private U.S. offering in the United States without violating 
section 7(d) only if the fund complies with either section 3(c)(1) 
or 3(c)(7) with respect to its U.S. investors (or some other 
available exemption or exclusion). Consistent with this view, a non-
U.S. fund is a private fund if it makes use of U.S. jurisdictional 
means to, directly or indirectly, offer or sell any security of 
which it is the issuer and relies on either section 3(c)(1) or 
3(c)(7). See Hedge Fund Adviser Registration Release, supra note 14, 
at n.226; Offer and Sale of Securities to Canadian Tax-Deferred 
Retirement Savings Accounts, Securities Act Release No. 7656 (Mar. 
19, 1999) [64 FR 14648 (Mar. 26, 1999)] (``Canadian Tax-Deferred 
Retirement Savings Accounts Release''), at nn.10, 20, 23; Statement 
of the Commission Regarding Use of Internet Web Sites to Offer 
Securities, Solicit Securities Transactions or Advertise Investment 
Services Offshore, Securities Act Release No. 7516 (Mar. 23, 1998) 
[63 FR 14806 (Mar. 27, 1998)], at n.41. See also Dechert LLP, SEC 
Staff No-Action Letter (Aug. 24, 2009) at n.8; Goodwin, Procter & 
Hoar LLP, SEC Staff No-Action Letter (Feb. 28, 1997) (``Goodwin 
Procter No-Action Letter''); Touche Remnant & Co., SEC Staff No-
Action Letter (Aug. 27, 1984) (``Touche Remnant No-Action Letter''); 
Proposing Release, supra note 26, at n.175 and accompanying text.
    \295\ See Proposing Release, supra note 26, at nn.175 and 188 
and accompanying text.
    \296\ Under the Advisers Act, an adviser relying on the venture 
capital exemption must ``solely'' advise venture capital funds and 
under our rule all of the funds advised by the adviser must be 
private funds.
---------------------------------------------------------------------------

    In light of this result, we asked in the Proposing Release whether 
we should adopt a broader interpretation of the term ``private fund.'' 
\297\ In response, commenters supported making the venture capital 
exemption available to non-U.S. advisers even if they advise venture 
capital funds that are not offered through the use of U.S. 
jurisdictional means.\298\ We agree. Accordingly, as adopted, rule 
203(l)-1 contains a note indicating that an adviser may treat as a 
``private fund''--and thus a venture capital fund, if it meets the 
rule's other criteria--any non-U.S. fund that is not offered through 
the use of U.S. jurisdictional means but that would be a private fund 
if the issuer were to conduct a private offering in the United 
States.\299\ Moreover, a non-U.S. fund that is treated as a private 
fund under these circumstances by an adviser relying on the venture 
capital

[[Page 39666]]

exemption would also be treated as a private fund under the Advisers 
Act for all purposes. This element is designed to ensure that an 
adviser relying on the venture capital exemption by operation of the 
note is subject to the same Advisers Act requirements as other advisers 
relying on the venture capital exemption without use of the note.
---------------------------------------------------------------------------

    \297\ See Proposing Release, supra note 26, at section II.A.8 
(``[S]hould a non-U.S. fund be a private fund under the proposed 
rule if the non-U.S. fund would be deemed a private fund upon 
conducting a private offering in the United States in reliance on 
sections 3(c)(1) or 3(c)(7)?'').
    \298\ See, e.g., Dechert General Letter; EFAMA Letter; Gunderson 
Dettmer Letter; McGuireWoods Letter; Shearman Letter.
    \299\ As discussed below, this issue also is relevant to the 
exemption provided by rule 203(m)-1. See also infra note 319.
---------------------------------------------------------------------------

10. Grandfathering Provision
    Under the rule, the definition of ``venture capital fund'' includes 
any private fund that: (i) Represented to investors and potential 
investors at the time the fund offered its securities that it pursues a 
venture capital strategy; (ii) has sold securities to one or more 
investors prior to December 31, 2010; and (iii) does not sell any 
securities to, including accepting any capital commitments from, any 
person after July 21, 2011 (the ``grandfathering provision'').\300\ A 
grandfathered fund would thus include any fund that has accepted all 
capital commitments by July 21, 2011 (including capital commitments 
from existing and new investors) even if none of the capital 
commitments has been called by such date.\301\ The calling of capital 
after July 21, 2011 would be consistent with the grandfathering 
provision, as long as the investor became obligated by July 21, 2011 to 
make a future capital contribution. As a result, any investment adviser 
that solely advises private funds that meet the definition in either 
rule 203(l)-1(a) or (b) would be exempt from registration.
---------------------------------------------------------------------------

    \300\ Rule 203(l)-1(b).
    \301\ See also Electronic Filing and Revision of Form D, 
Securities Act Release No. 8891(Feb. 6, 2008) [73 FR 10592 (Feb. 27, 
2008)], at section VIII, Form D, General Instructions--When to File 
(noting that a Form D is required to be filed within 15 days of the 
first sale of securities which would include ``the date on which the 
first investor is irrevocably contractually committed to invest''), 
n.159 (``a mandatory capital commitment call would not constitute a 
new offering, but would be made under the original offering'').
---------------------------------------------------------------------------

    Although several commenters expressed support for the proposed 
rule,\302\ two commenters indicated that the proposed grandfathering 
provision was too restrictive because of the holding out 
criterion.\303\ In contrast, the North American Securities 
Administrators Association, Inc. expressed its view that the proposed 
grandfathering provision was too expansive and urged that the rule 
impose additional substantive requirements similar to those included 
among the definitional elements in rule 203(l)-1(a).\304\
---------------------------------------------------------------------------

    \302\ Comment Letter of AustinVentures (Jan. 21, 2011) (``AV 
Letter''); Norwest Letter; NYSBA Letter. See also NVCA Letter.
    \303\ DLA Piper VC Letter; Pine Brook Letter.
    \304\ Comment Letter of North American Securities Administrators 
Association, Inc., Feb. 10, 2011 (``NASAA Letter'').
---------------------------------------------------------------------------

    As in the case of the holding out criterion discussed above, this 
element of the grandfathering provision elicited the most comments. 
Generally, commenters either (i) did not support a grandfathering 
provision that defined a venture capital fund as a fund that identified 
itself (or called itself) ``venture capital,'' \305\ or (ii) sought 
clarification or an expansive interpretation of the holding out element 
so that existing funds would not be excluded from the definition merely 
because they have identified themselves as ``growth capital,'' ``multi-
strategy'' or ``private equity,'' \306\ which commenters asserted is 
typical of some older funds. No commenter addressed the dates proposed 
in the grandfathering provision.\307\
---------------------------------------------------------------------------

    \305\ Davis Polk Letter; DLA Piper VC Letter; Pine Brook Letter.
    \306\ Davis Polk Letter; Gunderson Dettmer Letter; IVP Letter; 
Norwest Letter; NVCA Letter.
    \307\ The NVCA specifically stated that other than clarification 
on the names that venture capital funds may use to identify 
themselves, no ``further changes to the grandfathering proposal are 
necessary or appropriate and [we] do not believe that this 
criterion, as it exists for new funds, presents problems to the 
industry.'' See NVCA Letter.
---------------------------------------------------------------------------

    As discussed above, we believe that the ``holding out'' requirement 
is an important prophylactic tool to prevent circumvention of the 
intended scope of the venture capital exemption. Thus, we are adopting 
the grandfathering provision as proposed, with the modifications to the 
holding out criterion discussed above.\308\ As noted above in the 
definition of a venture capital fund generally, the holding out 
criterion in the grandfathering provision has also been changed to 
refer to the strategy pursued by the private fund. A fund that seeks to 
qualify under our rule should examine all of the statements and 
representations made to investors and prospective investors to 
determine whether the fund has satisfied the ``holding out'' criterion 
as it is incorporated into the grandfathering provision.\309\
---------------------------------------------------------------------------

    \308\ See supra discussion at Section II.A.7.
    \309\ Id.
---------------------------------------------------------------------------

    Thus, under the rule, an investment adviser may treat any existing 
private fund as a venture capital fund for purposes of section 203(l) 
of the Advisers Act if the fund meets the elements of the 
grandfathering provision. The current private adviser exemption does 
not require an adviser to identify or characterize itself as any type 
of adviser (or impose limits on advising any type of fund). 
Accordingly, we believe that advisers have not had an incentive to mis-
characterize the investment strategies pursued by existing venture 
capital funds that have already been marketed to investors. As we note 
above, a fund that ``represents'' itself to investors as pursuing a 
venture capital strategy is typically one that discloses it pursues a 
venture capital strategy and identifies itself as such.\310\ We do not 
expect existing funds identifying themselves as pursuing a ``private 
equity'' or ``hedge'' fund strategy would be able to rely on this 
element of the grandfathering provision.
---------------------------------------------------------------------------

    \310\ See id.
---------------------------------------------------------------------------

    We believe that most funds previously sold as venture capital funds 
likely would satisfy all or most of the conditions in the 
grandfathering provision. Nevertheless, we recognize that investment 
advisers that sponsored new funds before the adoption of rule 203(l)-1 
faced uncertainty regarding the precise terms of the definition and 
hence uncertainty regarding their eligibility for the new exemption. 
Thus, as proposed, the grandfathering provision specifies that a 
qualifying fund must have commenced its offering (i.e., initially sold 
securities) by December 2010 and must have concluded its offering by 
the effective date of Title IV (i.e., July 21, 2011). This provision is 
designed to prevent circumvention of the intended scope of the 
exemption. Moreover, requiring existing venture capital funds to modify 
their investment conditions or characteristics, liquidate portfolio 
company holdings or alter the rights of investors in the funds in order 
to satisfy the definition of a venture capital fund would likely be 
impossible in many cases and yield unintended consequences for the 
funds and their investors.\311\
---------------------------------------------------------------------------

    \311\ One commenter agreed that it may be difficult for a 
qualifying fund seeking to rely on the grandfathering provision to 
change fund terms and liquidate its positions to the possible 
detriment of the fund and its investors. AV Letter.
---------------------------------------------------------------------------

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

    Section 203(m) of the Advisers Act directs the Commission to exempt 
from registration under the Advisers Act any investment adviser solely 
to private funds that has less than $150 million in assets under 
management in the United States.\312\ Rule 203(m)-1, which we are

[[Page 39667]]

adopting today, provides the exemption and, in addition, addresses 
several interpretive questions raised by section 203(m). As noted 
above, we refer to this exemption as the ``private fund adviser 
exemption.''
---------------------------------------------------------------------------

    \312\ Section 408 of the Dodd-Frank Act, which is codified in 
section 203(m) of the Advisers Act. See supra note 19.
---------------------------------------------------------------------------

1. Advises Solely Private Funds
    Rule 203(m)-1, like section 203(m), limits an adviser relying on 
the exemption to those advising ``private funds'' as that term is 
defined in the Advisers Act.\313\ An adviser that has one or more 
clients that are not private funds is not eligible for the exemption 
and must register under the Advisers Act unless another exemption is 
available. An adviser may advise an unlimited number of private funds, 
provided the aggregate value of the assets of the private funds is less 
than $150 million.\314\
---------------------------------------------------------------------------

    \313\ See rule 203(m)-1(a) and (b). Section 202(a)(29) of the 
Advisers Act defines the term ``private fund'' as ``an issuer that 
would be an investment company, as defined in section 3 of the 
Investment Company Act of 1940 (15 U.S.C. 80a-3), but for section 
3(c)(1) or 3(c)(7) of that Act.'' A ``private fund'' includes a 
private fund that invests in other private funds. See also supra 
note 294; Proposing Release, supra note 26, at n.175 and 
accompanying text.
    \314\ We note, however, that depending on the facts and 
circumstances, we may view two or more separately formed advisory 
entities that each has less than $150 million in private fund assets 
under management as a single adviser for purposes of assessing the 
availability of exemptions from registration. See infra note 506. 
See also section 208(d), which prohibits a person from doing, 
indirectly or through or by another person, any act or thing which 
it would be unlawful for such person to do directly.
---------------------------------------------------------------------------

    In the case of an adviser with a principal office and place of 
business outside of the United States (a ``non-U.S. adviser''), the 
exemption is available as long as all of the adviser's clients that are 
United States persons are qualifying private funds.\315\ As a 
consequence, a non-U.S. adviser may enter the U.S. market and take 
advantage of the exemption without regard to the type or number of its 
non-U.S. clients or the amount of assets it manages outside of the 
United States. Under the rule, a non-U.S. adviser would not lose the 
private fund adviser exemption as a result of the size or nature of its 
advisory or other business activities outside of the United States. The 
rule reflects our long-held view that non-U.S. activities of non-U.S. 
advisers are less likely to implicate U.S. regulatory interests and 
that this territorial approach is in keeping with general principles of 
international comity.\316\ Commenters supported the proposed rule's 
treatment of non-U.S. advisers.\317\
---------------------------------------------------------------------------

    \315\ Rule 203(m)-1(b)(1). As discussed below, we also are 
adding a note to rule 203(m)-1 that clarifies that a client will not 
be considered a United States person if the client was not a United 
States person at the time of becoming a client. See infra note 403.
    \316\ These considerations have, for example, been incorporated 
in our rules permitting a non-U.S. adviser relying on the private 
adviser exemption to count only clients that are U.S. persons when 
determining whether it has 14 or fewer clients. Rule 203(b)(3)-
1(b)(5) (``If you have your principal office and place of business 
outside the United States, you are not required to count clients 
that are not United States residents, but if your principal office 
and place of business is in the United States, you must count all 
clients.''). See infra note 392. The Dodd-Frank Act repeals the 
private adviser exemption as of July 21, 2011, and we are rescinding 
rule 203(b)(3)-1 in the Implementing Adopting Release. See 
Implementing Adopting Release, supra note 32, at section II.D.2.a.
    \317\ See, e.g., ABA Letter; Comment Letter of Debevoise & 
Plimpton LLP (Jan. 24, 2011) (``Debevoise Letter''); Comment Letter 
of Dechert LLP (on behalf of Foreign Adviser) (Jan. 24, 2011) 
(``Dechert Foreign Adviser Letter''); Gunderson Dettmer Letter; 
Merkl Letter; Comment Letter of Katten Muchin Rosenman LLP (on 
behalf of Certain Non-U.S. Advisers) (Jan. 24, 2011) (``Katten 
Foreign Advisers Letter''); Comment Letter of MAp Airports Limited 
(Jan. 24, 2011) (``MAp Airports Letter''); Comment Letter of 
Wellington Financial LP (Jan. 24, 2011) (``Wellington Letter'').
---------------------------------------------------------------------------

    Some commenters urged that the rule should also permit U.S. 
advisers relying on the exemption to advise other types of 
clients.\318\ Section 203(m) directs us to provide an exemption to 
advisers that act solely as advisers to private funds.\319\ Our 
treatment of non-U.S. advisers with respect to their non-U.S. clients, 
as we note above, establishes certain appropriate limits on the 
extraterritorial application of the Advisers Act.\320\ In contrast, 
permitting U.S. advisers with additional types of clients to rely on 
the exemption would appear to directly conflict with section 203(m), 
and we therefore are not revising the rule as the commenters proposed.
---------------------------------------------------------------------------

    \318\ See, e.g., Letter of Sadis & Goldberg (Jan. 11, 2011) 
(submitted in connection with the Implementing Proposing Release, 
avail. at http://www.sec.gov/comments/s7-36-10/s73610.shtml) 
(``Sadis & Goldberg Implementing Release Letter'') (exemption should 
be available to advisers who, in addition to advising private funds, 
also have five or fewer clients that are separately managed 
accounts); Comment Letter of Seward & Kissel LLP (Jan. 31, 2011) 
(``Seward Letter'') (advisers should be permitted to rely on 
multiple exemptions and advisers relying on the private fund adviser 
exemption should be permitted to engage in ``some activities that do 
not involve advising clients and have no effect on assets under 
management,'' such as providing research to institutional 
investors).
    \319\ One commenter argued that a U.S. adviser should be 
permitted to treat as a private fund for purposes of rule 203(m)-1 a 
non-U.S. fund that has not made an offering to U.S. persons. See 
Comment Letter of Fox Horan & Camerini LLP (Dec. 22, 2010). See also 
supra notes 294 and 313. We agree.
    \320\ In contrast to the foreign private adviser exemption 
discussed in Section II.C, a non-U.S. adviser relying on the private 
fund adviser exemption may have a U.S. place of business, but a non-
U.S. adviser need not have a U.S. place of business to rely on the 
private fund adviser exemption.
---------------------------------------------------------------------------

    Some commenters suggested that the rule permit advisers to combine 
other exemptions with rule 203(m)-1 so that, for example, an adviser 
could advise venture capital funds with assets under management in 
excess of $150 million in addition to other types of private funds with 
less than $150 million in assets under management.\321\ We believe that 
the commenters' proposed interpretation runs contrary to the language 
of section 203(m), which limits advisers relying on the exemption to 
advising solely private funds with assets under management in the 
United States of less than $150 million or solely venture capital funds 
in the case of section 203(l).\322\
---------------------------------------------------------------------------

    \321\ NASBIC/SBIA Letter; Seward Letter.
    \322\ The same analysis also would apply to non-U.S. advisers, 
which may not for example combine the private fund adviser exemption 
and the foreign private adviser exemption (e.g., a non-U.S. adviser 
could not advise private funds that are United States persons with 
assets in excess of $25 million in reliance on the private fund 
adviser exemption and also advise other clients in the United States 
that are not private funds in reliance on the foreign private 
adviser exemption). We also note that depending on the facts and 
circumstances, we may view two or more separately formed advisory 
entities, each of which purports to rely on a separate exemption 
from registration, as a single adviser for purposes of assessing the 
availability of exemptions from registration. See infra note 506. 
See also section 208(d), which prohibits a person from doing, 
indirectly or through or by another person, any act or thing which 
it would be unlawful for such person to do directly.
---------------------------------------------------------------------------

    A few commenters also asked us to address whether a fund with a 
single investor could be a ``private fund'' for purposes of the 
exemption.\323\ Whether a single-investor fund could be a private fund 
for purposes of the exemption depends on the facts and circumstances. 
We are concerned that an adviser simply could convert client accounts 
to single-investor funds in order to avoid registering under the 
Advisers Act. These ``funds'' would be tantamount to separately managed 
accounts. Section 208(d) of the Advisers Act anticipates these and 
other artifices and thus prohibits a person from doing, indirectly or 
through or by another person, any act or thing which it would be 
unlawful for such person to do directly.\324\ We recognize, however, 
that

[[Page 39668]]

there are circumstances in which it may be appropriate for an adviser 
to treat a single-investor fund as a private fund for purposes of rule 
203(m)-1.\325\
---------------------------------------------------------------------------

    \323\ See ABA Letter (single-investor funds formed at the 
request of institutional investors should be considered private 
funds if they are managed in a manner similar to the adviser's 
related multi-investor private funds, have audited financial 
statements, and are treated as private funds for purposes of the 
custody rule); Comment Letter of Alternative Investment Management 
Association (Jan. 24, 2011) (``AIMA Letter'') (sought guidance 
concerning single-investor funds and managed accounts structured as 
funds); Commenter Letter of Managed Funds Association (Jan. 24, 
2011) (``MFA Letter'') (asserted that single-investor funds are 
``private funds'').
    \324\ We would view a structure with no purpose other than 
circumvention of the Advisers Act as inconsistent with section 
208(d). See, e.g., Custody of Funds or Securities of Clients by 
Investment Advisers, Investment Advisers Act Release No. 2968 (Dec. 
30, 2009) [75 FR 1456 (Jan. 11, 2010)] at n.132 (the use of a 
special purpose vehicle in certain circumstances could constitute a 
violation of section 208(d) of the Advisers Act). Thus, for example, 
an adviser would not be eligible for the exemption if it advises 
what is nominally a ``private fund'' but that in fact operates as a 
means for providing individualized investment advice directly to the 
investors in the ``private fund.'' In this case, the investors would 
also be clients of the adviser. Cf. Advisers Act rule 202(a)(30)-
1(b)(1) (an adviser ``must count an owner [of a legal organization] 
as a client if [it] provide[s] investment advisory services to the 
owner separate and apart from the investment advisory services [it] 
provide[s] to the legal organization'').
    \325\ For example, a fund that seeks to raise capital from 
multiple investors but has only a single, initial investor for a 
period of time could be a private fund, as could a fund in which all 
but one of the investors have redeemed their interests.
---------------------------------------------------------------------------

    One commenter argued that advisers should be permitted to treat as 
a private fund for purposes of rule 203(m)-1 a fund that also qualifies 
for another exclusion from the definition of ``investment company'' in 
the Investment Company Act in addition to section 3(c)(1) or 3(c)(7), 
such as section 3(c)(5)(C), which excludes certain real estate 
funds.\326\ These funds would not be private funds, because a ``private 
fund'' is a fund that would be an investment company as defined in 
section 3 of the Investment Company Act but for section 3(c)(1) or 
3(c)(7) of that Act.\327\
---------------------------------------------------------------------------

    \326\ Dechert General Letter. See also Comment Letter of Baker 
McKenzie LLP (Jan. 26, 2011) (submitted in connection with the 
Implementing Proposing Release, avail. at http://www.sec.gov/comments/s7-36-10/s73610.shtml) (recommended that the Commission 
revise the calculation of assets under management on Form ADV to 
exclude assets in certain funds relying on section 3(c)(5)(C) of the 
Investment Company Act); Comment Letter of DLA Piper LLP (US) 
(submitted by John H. Heuberger and Hal M. Brown) (similarly sought 
to exempt advisers to certain funds relying on section 3(c)(5)(C)).
    \327\ Section 202(a)(29) of the Advisers Act (defining the term 
``private fund'').
---------------------------------------------------------------------------

    The commenter argued, and we agree, that an adviser should 
nonetheless be permitted to advise such a fund and still rely on the 
exemption. Otherwise, for example, an adviser to a section 3(c)(1) or 
3(c)(7) fund would lose the exemption if the fund also qualified for 
another exclusion, even though the adviser may be unaware of the fund 
so qualifying and the fund does not purport to rely on the other 
exclusion. We do not believe that Congress intended that an adviser 
would lose the exemption in these circumstances. Accordingly, the 
definition of a ``qualifying private fund'' in rule 203(m)-1 permits an 
adviser to treat as a private fund for purposes of the exemption a fund 
that qualifies for an exclusion from the definition of investment 
company as defined in section 3 of the Investment Company Act in 
addition to the exclusions provided by section 3(c)(1) or 3(c)(7).\328\
---------------------------------------------------------------------------

    \328\ Rule 203(m)-1(d)(5). This provision may also apply to non-
U.S. funds that seek to comply with section 7(d) of the Investment 
Company Act and exclusions in addition to those provided by section 
3(c)(1) or 3(c)(7) of that Act.
---------------------------------------------------------------------------

    An adviser relying on this provision must treat the fund as a 
private fund under the Advisers Act and the rules thereunder for all 
purposes.\329\ This is to ensure that an adviser relying on the 
exemption as a result of our modification of the definition of a 
``qualifying private fund'' is subject to the same Advisers Act 
requirements as other advisers relying on the exemption. Therefore, an 
adviser to a fund that also qualifies for another exclusion in addition 
to section 3(c)(1) or 3(c)(7) may treat the fund as a private fund and 
rely on rule 203(m)-1 if the adviser meets the rule's other conditions, 
provided that the adviser treats the fund as a private fund under the 
Advisers Act and the rules thereunder for all purposes including, for 
example, reporting on Form ADV, which requires advisers to report 
certain information about the private funds they manage.\330\
---------------------------------------------------------------------------

    \329\ Rule 203(m)-1(d)(5).
    \330\ See Item 7.B of Form ADV, Part 1A.
---------------------------------------------------------------------------

2. Private Fund Assets
a. Method of Calculation
    Under rule 203(m)-1, an adviser must aggregate the value of all 
assets of private funds it manages to determine if the adviser is below 
the $150 million threshold.\331\ Rule 203(m)-1 requires advisers to 
calculate the value of private fund assets pursuant to instructions in 
Form ADV, which provide a uniform method of calculating assets under 
management for regulatory purposes under the Advisers Act.\332\
---------------------------------------------------------------------------

    \331\ Rule 203(m)-1(d)(4).
    \332\ See rules 203(m)-1(a)(2); 203(m)-1(b)(2); 203(m)-1(d)(1) 
(defining ``assets under management'' to mean ``regulatory assets 
under management'' in item 5.F of Form ADV, Part 1A); 203(m)-1(d)(4) 
(defining ``private fund assets'' to mean the ``assets under 
management'' attributable to a ``qualifying private fund''). In the 
case of a subadviser, an adviser must count only that portion of the 
private fund assets for which it has responsibility. See Form ADV: 
Instructions for Part 1A, instr. 5.b.(2) (explaining that, if an 
adviser provides continuous and regular supervisory or management 
services for only a portion of a securities portfolio, it should 
include only that portion of the securities portfolio for which it 
provides such services, and that an adviser should exclude, for 
example, the portion of an account under management by another 
person).
---------------------------------------------------------------------------

    In the Implementing Adopting Release, we are revising the 
instructions to Form ADV to provide a uniform method to calculate 
assets under management for regulatory purposes, including determining 
eligibility for Commission, rather than state, registration; reporting 
assets under management for regulatory purposes on Form ADV; and 
determining eligibility for two of the new exemptions from registration 
under the Advisers Act discussed in this Release.\333\ Under the 
revised Form ADV instructions, as relevant here, advisers must include 
in their calculations proprietary assets and assets managed without 
compensation as well as uncalled capital commitments.\334\ In addition, 
an adviser must determine the amount of its private fund assets based 
on the market value of those assets, or the fair value of those assets 
where market value is unavailable,\335\ and must calculate the assets 
on a gross basis, i.e., without deducting liabilities, such as accrued 
fees and expenses or the amount of any borrowing.\336\
---------------------------------------------------------------------------

    \333\ See Implementing Adopting Release, supra note 32, 
discussion at section II.A.3 (discussing the rationale underlying 
the new instructions for calculating assets under management for 
regulatory purposes).
    \334\ See Form ADV: Instructions for Part 1A, instr. 5.b.(1), 
(4). Advisers also must include in their ``regulatory assets under 
management'' assets of non-U.S. clients. See Implementing Adopting 
Release, supra note 32, at n.76 (explaining that a domestic adviser 
dealing exclusively with non-U.S. clients must register with the 
Commission if it uses any U.S. jurisdictional means in connection 
with its advisory business unless the adviser qualifies for an 
exemption from registration or is prohibited from registering with 
the Commission). See also infra note 415.
    \335\ This valuation requirement is described in terms similar 
to the definition of ``value'' in the Investment Company Act, which 
looks to market value when quotations are readily available and, if 
not, then to fair value. See Investment Company Act section 
2(a)(41). See also Implementing Adopting Release, supra note 32, at 
n.91 and accompanying text. Other standards also may be expressed as 
requiring that a determination of fair value be based on market 
quotations where they are readily available. Id.
    \336\ See Form ADV: Instructions for Part 1A, instr. 5.b.(2), 
(4). See also Implementing Adopting Release, supra note 32, 
discussion at section II.A.3.
---------------------------------------------------------------------------

    Use of this uniform method will, we believe, result in more 
consistent asset calculations and reporting across the industry and, 
therefore, in a more coherent application of the Advisers Act's 
regulatory requirements and assessment of risk.\337\ In addition, the 
uniform method of calculation is designed to ensure that, to the extent 
possible, advisers with similar amounts of assets under management will 
be treated similarly for regulatory purposes, including their ability 
to rely

[[Page 39669]]

on the private fund adviser exemption and the foreign private adviser 
exemption, both of which refer to an adviser's assets under 
management.\338\
---------------------------------------------------------------------------

    \337\ See Proposing Release, supra note 26, discussion at 
section II.B.2. See also Implementing Adopting Release, supra note 
32, discussion at section II.A.3.
    \338\ See Proposing Release, supra note 26, discussion at 
section V.B.1 (explaining that, because the instructions to Form ADV 
previously permitted advisers to exclude certain types of managed 
assets, ``it is not possible to conclude that two advisers reporting 
the same amount of assets under management are necessarily 
comparable because either adviser may elect to exclude all or some 
portion of certain specified assets that it manages'').
---------------------------------------------------------------------------

    Many commenters expressed general support for a uniform method of 
calculating assets under management in order to maintain consistency 
for registration and risk assessment purposes.\339\ The proposals to 
use fair value of private fund assets and to include uncalled capital 
commitments in private fund assets also received support.\340\ As 
discussed below, however, a number of commenters disagreed with or 
sought changes to one or more of the elements of the proposed method of 
calculating assets under management for regulatory purposes set forth 
in Form ADV.\341\ None of the commenters, however, suggested 
alternative approaches that could accommodate the specific changes they 
sought and achieve our goals of consistent asset calculations and 
reporting discussed above, and we are not aware of such an alternative 
approach.
---------------------------------------------------------------------------

    \339\ See, e.g., AFL-CIO Letter (``We support the SEC's proposal 
to require funds to use a uniform standard to calculate their assets 
under management and agree that it is important that the calculation 
account for asset appreciation.''); AFR Letter (``AFR supports the 
SEC's proposal to require funds to use a uniform standard to 
calculate their assets under management, and to account for asset 
appreciation in those calculations''); AIMA Letter (``We agree that 
a clear and unified approach for calculation of AUM is necessary and 
we believe that using as a standard the assets for which an adviser 
has `responsibility' is appropriate.''); Dechert General Letter 
(commented on particular aspects of the proposed uniform method but 
stated ``[w]e generally agree with the Commission's initiative in 
creating a single uniform method of calculating an adviser's assets 
under management (`AUM') for purposes of determining an adviser's 
registration status (`Regulatory AUM')''). See also Implementing 
Adopting Release, supra note 32, at n.68 and accompanying text.
    \340\ See ABA Letter (supported use of fair value); AIMA Letter 
(supported including uncalled capital commitments, provided that the 
adviser has full contractual rights to call that capital and would 
be given responsibility for management of those assets).
    \341\ See also Implementing Adopting Release, supra note 32, 
discussion at section II.A.3.
---------------------------------------------------------------------------

    For example, some commenters sought to exclude from the calculation 
proprietary assets and assets managed without compensation because such 
a requirement would be inconsistent with the statutory definition of 
``investment adviser.'' \342\ Although a person is not an ``investment 
adviser'' for purposes of the Advisers Act unless it receives 
compensation for providing advice to others, once a person meets that 
definition (by receiving compensation from any client to which it 
provides advice), the person is an adviser, and the Advisers Act 
applies to the relationship between the adviser and any of its clients 
(whether or not the adviser receives compensation from them).\343\ Both 
the private fund adviser exemption and the foreign private adviser 
exemption are conditioned upon an adviser not exceeding specified 
amounts of ``assets under management.'' \344\ Neither statutory 
exemption limits the types of assets that should be included in this 
term, and we do not believe that such limits would be appropriate.\345\ 
In our view, the source of the assets managed should not affect the 
availability of the exemptions.
---------------------------------------------------------------------------

    \342\ See, e.g., Dechert General Letter; Seward Letter. See also 
ABA Letter; AIMA Letter (suggested a 12-month exclusion for seed 
capital consistent with the Volcker rule); Dechert Foreign Adviser 
Letter; EFAMA Letter; Katten Foreign Advisers Letter; MFA Letter. 
Under section 202(a)(11) of the Advisers Act, the definition of 
``investment adviser'' includes, among others, ``any person who, for 
compensation, engages in the business of advising others * * * as to 
the value of securities or as to the advisability of investing in, 
purchasing, or selling securities * * *.'' One commenter argued that 
including proprietary assets would deter non-U.S. advisers that 
manage large amounts of proprietary assets from establishing U.S. 
operations. Katten Foreign Advisers Letter. Such an adviser, 
however, would not be ineligible for the private fund adviser 
exemption merely because it established U.S. operations. As 
discussed below, a non-U.S. adviser may rely on the private fund 
adviser exemption while also having one or more U.S. places of 
business, provided it complies with the exemption's conditions. See 
infra Section II.B.3.
    \343\ See Implementing Adopting Release, supra note 32, at n.74 
and accompanying text. Several commenters also asserted that 
including proprietary assets as proposed would in effect require a 
wholly owned control affiliate to register as an investment adviser. 
See, e.g., Comment Letter of American Insurance Association (Jan. 
24, 2011) (``AIA Letter''); Comment Letter of Katten Muchin Rosenman 
LLP (on behalf of APG Asset Management US Inc.) (Jan. 21, 2011); 
Comment Letter of Katten Muchin Rosenman LLP (Jan. 24, 2011) (on 
behalf of Certain Non-U.S. Insurance Companies) (``Katten Foreign 
Insurance Letter''). Whether a control affiliate is deemed to be an 
``investment adviser'' under the Advisers Act because, among other 
things, it ``engages in the business of advising others'' will 
depend on the particular facts and circumstances. The calculation of 
regulatory assets under management, including the mandatory or 
optional inclusion of specified assets in that calculation, is 
applicable after the entity is determined to be an investment 
adviser.
    \344\ See sections 203(m) and 202(a)(30) of the Advisers Act.
    \345\ See also Implementing Adopting Release, supra note 32, at 
n.75 and accompanying text (explaining that ``the management of 
`proprietary' assets or assets for which the adviser may not be 
compensated, when combined with other client assets, may suggest 
that the adviser's activities are of national concern or have 
implications regarding the reporting for the assessment of systemic 
risk'').
---------------------------------------------------------------------------

    We also do not expect that advisers' principals (or other 
employees) generally will cease to invest alongside the advisers' 
clients as a result of the inclusion of proprietary assets, as some 
commenters suggested.\346\ If private fund investors value their 
advisers' co-investments as suggested by these commenters, we expect 
that the investors will demand them and their advisers will structure 
their businesses accordingly.\347\
---------------------------------------------------------------------------

    \346\ See, e.g., ABA Letter; Katten Foreign Advisers Letter; 
Seward Letter.
    \347\ Moreover, we note that an adviser seeking to rely on rule 
203(m)-1 may have only private fund clients and must include the 
assets of all of its private fund clients when determining if it 
remains under the rule's $150 million threshold.
---------------------------------------------------------------------------

    Other commenters objected to calculating regulatory assets under 
management on the basis of gross, rather than net, assets.\348\ They 
argued, among other things, that gross asset measurements would be 
confusing,\349\ complex,\350\ and inconsistent with industry 
practice.\351\ However, nothing in the current instructions suggests 
that liabilities should be deducted from the calculation of an 
adviser's assets under management. Indeed, since 1997, the instructions 
have stated that an adviser should not deduct securities purchased on 
margin when calculating its assets

[[Page 39670]]

under management.\352\ Whether a client has borrowed to purchase a 
portion of the assets managed does not seem to us a relevant 
consideration in determining the amount an adviser has to manage, the 
scope of the adviser's business, or the availability of the 
exemptions.\353\
---------------------------------------------------------------------------

    \348\ ABA Letter; Dechert General Letter; Merkl Letter; MFA 
Letter; Seward Letter; Shearman Letter.
    \349\ Dechert General Letter. See also Implementing Adopting 
Release, supra note 32, at n.80 and accompanying text.
    \350\ MFA Letter.
    \351\ See, e.g., Merkl Letter; Shearman Letter. One commenter 
asserted that the ``inclusion of borrowed assets may create an 
incentive for an adviser to reduce client borrowings to qualify for 
an exemption from registration even though reducing leverage may not 
be in the best interest of its clients,'' and that it ``could 
encourage advisers to use methods other than borrowing to obtain 
financial leverage for their clients (e.g., through swaps or other 
derivative products, which could be disadvantageous to clients due 
to the counterparty risks and increased costs that they entail).'' 
Seward Letter. See also Gunderson Dettmer Letter. We note that 
advisers, as fiduciaries, may not subordinate clients' interests to 
their own such as by altering their investing behavior in a way that 
is not in the client's best interest in an attempt to remain under 
the exemption's $150 million threshold. Another commenter argued 
that a gross assets calculation would make calculations of 
regulatory assets under management more volatile. See Dechert 
General Letter. As discussed in more detail below, we are permitting 
advisers relying on rule 203(m)-1 to calculate their private fund 
assets annually, rather than quarterly as proposed, and are 
extending the period during which certain advisers may file their 
registration applications if their private fund assets exceed the 
exemption's $150 million threshold. See infra Section II.B.2.b. We 
believe these measures will substantially mitigate or eliminate any 
volatility that may be caused by using a gross assets measurement, 
as well as potential volatility in currency exchange rates 
identified by some commenters. See CompliGlobe Letter; EVCA Letter; 
O'Melveny Letter.
    \352\ See Form ADV: Instructions for Part 1A, instr. 5.b.(2), as 
in effect before it was amended by the Implementing Adopting Release 
(``Do not deduct securities purchased on margin.''). Instruction 
5.b.(2), as amended in the Implementing Adopting Release, provides 
``Do not deduct any outstanding indebtedness or other accrued but 
unpaid liabilities.'' See Implementing Adopting Release, supra note 
32, discussion at section II.A.3.
    \353\ See id.
---------------------------------------------------------------------------

    Moreover, we are concerned that the use of net assets could permit 
advisers to highly leveraged funds to avoid registration under the 
Advisers Act even though the activities of such advisers may be 
significant and the funds they advise may be appropriate for systemic 
risk reporting.\354\ One commenter argued, in contrast, that it would 
be ``extremely unlikely that a net asset limit of $150,000,000 in 
private funds could be leveraged into total investments that would pose 
any systemic risk.'' \355\ But a comprehensive view of systemic risk 
requires information about certain funds that may not present systemic 
risk concerns when viewed in isolation, but nonetheless are relevant to 
an assessment of systemic risk across the economy. Moreover, because 
private funds are not subject to the leverage restrictions in section 
18 of the Investment Company Act, a private fund with less than $150 
million in net assets could hold assets far in excess of that amount as 
a result of its extensive use of leverage. In addition, under a net 
assets test such a fund would be treated similarly for regulatory 
purposes as a fundamentally different fund, such as one that did not 
make extensive use of leverage and had $140 million in net assets.
---------------------------------------------------------------------------

    \354\ See id., at n.82 and preceding and accompanying text.
    \355\ ABA Letter.
---------------------------------------------------------------------------

    The use of gross assets also need not cause any investor confusion, 
as some commenters suggested.\356\ Although an adviser will be required 
to use gross (rather than net) assets for purposes of determining 
whether it is eligible for the private fund adviser or the foreign 
private adviser exemptions (among other purposes), we would not 
preclude an adviser from holding itself out to its clients as managing 
a net amount of assets as may be its custom.\357\
---------------------------------------------------------------------------

    \356\ See, e.g., Dechert General Letter. See also Implementing 
Adopting Release, supra note 32, at n.80 and accompanying text.
    \357\ In addition, in response to commenters seeking 
clarification of the application of the gross assets calculation to 
mutual funds, short positions and leverage, we expect that advisers 
will continue to calculate their gross assets as they do today, even 
if they currently only calculate gross assets as an intermediate 
step to compute their net assets. See Implementing Adopting Release, 
supra note 32, at n.83. In the case of pooled investment vehicles 
with a balance sheet, for instance, an adviser could include in the 
calculation the total assets of the entity as reported on the 
balance sheet. Id.
---------------------------------------------------------------------------

    One commenter opposed the requirement that advisers include in the 
calculation of private fund assets uncalled capital commitments, 
asserting that the uncalled capital remains under the management of the 
fund investor.\358\ As we noted in the Proposing Release, in the early 
years of a private fund's life, its adviser typically earns fees based 
on the total amount of capital commitments, which we presume reflects 
compensation for efforts expended on behalf of the fund in preparation 
for the investments.\359\
---------------------------------------------------------------------------

    \358\ See Merkl Letter.
    \359\ Proposing Release, supra note 26, discussion at section 
II.B.2. See also Implementing Adopting Release, supra note 32, at 
n.90 and accompanying text.
---------------------------------------------------------------------------

    A number of commenters objected to the requirement to determine 
private fund assets based on fair value, generally arguing that the 
requirement would cause those advisers that did not use fair value 
methods to incur additional costs, especially if the private funds' 
assets that they manage are illiquid and therefore difficult to fair 
value.\360\ We noted in the Proposing Release that we understood that 
many private funds already value assets in accordance with U.S. 
generally accepted accounting principles (``GAAP'') or other 
international accounting standards that require the use of fair value, 
citing letters we had received in connection with other rulemaking 
initiatives.\361\ We are sensitive to the costs this new requirement 
will impose. We believe, however, that this approach is warranted in 
light of the unique regulatory purposes of the calculation under the 
Advisers Act. We estimated these costs in the Proposing Release \362\ 
and we have taken several steps to mitigate them.\363\
---------------------------------------------------------------------------

    \360\ See, e.g., Gunderson Dettmer Letter; Merkl Letter; 
O'Melveny Letter; Seward Letter; Wellington Letter.
    \361\ See Proposing Release, supra note 26, at n.196 and 
accompanying text.
    \362\ See id., at n.326 and accompanying text.
    \363\ We recognize that although these steps will provide 
advisers greater flexibility in calculating the value of their 
private fund assets, they also will result in valuations that are 
not as comparable as they could be if we specified a fair value 
standard (e.g., as specified in GAAP).
---------------------------------------------------------------------------

    While many advisers will calculate fair value in accordance with 
GAAP or another international accounting standard,\364\ other advisers 
acting consistently and in good faith may utilize another fair 
valuation standard.\365\ While these other standards may not provide 
the quality of information in financial reporting (for example, of 
private fund returns), we expect these calculations will provide 
sufficient consistency for the purposes that regulatory assets under 
management serve in our rules, including rule 203(m)-1.\366\
---------------------------------------------------------------------------

    \364\ Several commenters asked that we not require advisers to 
fair value private fund assets in accordance with GAAP for purposes 
of calculating regulatory assets under management because many 
funds, particularly offshore ones, do not use GAAP and such a 
requirement would be unduly burdensome. See, e.g., EFAMA Letter; 
Katten Foreign Advisers Letter. We did not propose such a 
requirement, nor are we adopting one. See Implementing Adopting 
Release, supra note 32, at n.98.
    \365\ See id., at n.99 and accompanying text. Consistent with 
this good faith requirement, we would expect that an adviser that 
calculates fair value in accordance with GAAP or another basis of 
accounting for financial reporting purposes will also use that same 
basis for purposes of determining the fair value of its regulatory 
assets under management. Id.
    \366\ See id., at n.100 and accompanying text. In addition, the 
fair valuation process need not be the result of a particular 
mandated procedure and the procedure need not involve the use of a 
third-party pricing service, appraiser or similar outside expert. An 
adviser could rely on the procedure for calculating fair value that 
is specified in a private fund's governing documents. The fund's 
governing documents may provide, for example, that the fund's 
general partner determines the fair value of the fund's assets. 
Advisers are not, however, required to fair value real estate assets 
only in those limited circumstances where real estate assets are not 
required to be fair valued for financial reporting purposes under 
accounting principles that otherwise require fair value for assets 
of private funds. For example, in those cases, an adviser may 
instead value the real estate assets as the private fund does for 
financial reporting purposes. We note that the Financial Accounting 
Standards Board (``FASB'') has a current project related to 
investment property entities that may require real estate assets 
subject to that accounting standard to be measured by the adviser at 
fair value. See FASB Project on Investment Properties. We also note 
that certain international accounting standards currently permit, 
but do not require, fair valuation of certain real estate assets. 
See International Accounting Standard 40, Investment Property. To 
the extent that an adviser follows GAAP or another accounting 
standard that requires or in the future requires real estate assets 
to be fair valued, this limited exception to the use of fair value 
measurement for real estate assets would not be available.
---------------------------------------------------------------------------

    Commenters also suggested alternative approaches to valuation, 
including the use of local accounting principles; \367\ the methodology 
used to report to the private fund's investors; \368\ the methodologies 
described in a client's governing documents or offering materials; 
\369\ historical cost; \370\ and aggregate capital raised by a private

[[Page 39671]]

fund.\371\ Use of these approaches would limit our ability to compare 
data from different advisers and thus would be inconsistent with our 
goal of achieving more consistent asset calculations and reporting 
across the industry, as discussed above, and also could result in 
advisers managing comparable amounts of assets under management being 
subject to different registration requirements. Moreover, these 
alternative approaches could permit advisers to circumvent the Advisers 
Act's registration requirements. Permitting the use of any valuation 
standard set forth in the governing documents of the private fund other 
than fair value could effectively yield to the adviser the choice of 
the most favorable standard for determining its registration obligation 
as well as the application of other regulatory requirements.
---------------------------------------------------------------------------

    \367\ Dechert Foreign Adviser Letter; EFAMA Letter.
    \368\ Merkl Letter; Wellington Letter.
    \369\ AIMA Letter; MFA Letter; Seward Letter.
    \370\ O'Melveny Letter.
    \371\ Gunderson Dettmer Letter.
---------------------------------------------------------------------------

    For these reasons and as we proposed, rule 203(m)-1 requires 
advisers to calculate the value of private fund assets pursuant to the 
instructions in Form ADV.
b. Frequency of Calculation and Transition Period
    An adviser relying on the exemption provided by rule 203(m)-1 must 
annually calculate the amount of the private fund assets it manages and 
report the amount in its annual updating amendments to its Form 
ADV.\372\ If an adviser reports in its annual updating amendment that 
it has $150 million or more of private fund assets under management, 
the adviser is no longer eligible for the private fund adviser 
exemption.\373\ Advisers thus may be required to register under the 
Advisers Act as a result of increases in their private fund assets that 
occur from year to year, but changes in the amount of an adviser's 
private fund assets between annual updating amendments will not affect 
the availability of the exemption.
---------------------------------------------------------------------------

    \372\ An adviser relying on rule 203(m)-1 must file an annual 
updating amendment to its Form ADV within 90 days after the end of 
its fiscal year, and must calculate its private fund assets in the 
manner described in the instructions to Form ADV within 90 days 
prior to the date it makes the filing. See rule 203(m)-1(c); rule 
204-4(a); General Instruction 4 to Form ADV; Form ADV: Instructions 
for Part 1A, instr. 5.b. The adviser must report its private fund 
assets on Section 2.B of Schedule D to Form ADV. Advisers also must 
report their private fund assets when they file their initial 
reports as exempt reporting advisers. See Implementing Adopting 
Release, supra note 32, discussion at section II.B.
    \373\ Under Item 2.B of Part 1A of Form ADV, an adviser relying 
on rule 203(m)-1 must complete Section 2.B of Schedule D, which 
requires the adviser to provide the amount of the ``private fund 
assets'' it manages. A note to Section 2.B of Schedule D provides 
that ``private fund assets'' has the same meaning as under rule 
203(m)-1, and that non-U.S. advisers should only include private 
fund assets that they manage at a place of business in the United 
States. See also infra notes 377-378 and accompanying text.
---------------------------------------------------------------------------

    We proposed to require advisers relying on the exemption to 
calculate their private fund assets each quarter to determine if they 
remain eligible for the exemption. Commenters persuaded us, however, 
that requiring advisers to calculate their private fund assets annually 
in connection with their annual updating amendments to Form ADV would 
be more appropriate because it would likely result in the same advisers 
becoming registered each year while reducing the costs and burdens 
associated with quarterly calculations.\374\ In addition, annual 
calculations provide a range of dates on which an adviser may calculate 
its private fund assets, addressing concerns raised by commenters about 
shorter-term fluctuations in assets under management.\375\ The rule as 
adopted also is consistent with the timeframes for valuing assets under 
management and registering with the Commission applicable to state-
registered advisers switching from state to Commission 
registration.\376\
---------------------------------------------------------------------------

    \374\ A number of commenters argued, among other things, that 
calculating private fund assets quarterly would: (i) Impose 
unnecessary costs and burdens on advisers, some of whom might not 
otherwise perform quarterly valuations; and (ii) inappropriately 
permit shorter-term fluctuations in assets under management to 
require advisers to register. See ABA Letter; AIMA Letter; Dechert 
Foreign Adviser Letter; Dechert General Letter; EFAMA Letter; Katten 
Foreign Advisers Letter; Merkl Letter; NASBIC/SBIA Letter; Seward 
Letter.
    \375\ As discussed above, an adviser relying on rule 203(m)-1 
must calculate its private fund assets in the manner described in 
the instructions to Form ADV within 90 days prior to the date it 
files its annual updating amendment to its Form ADV.
    \376\ See General Instruction 4 to Form ADV; Form ADV: 
Instructions for Part 1A, instr. 5.b.; rule 203A-1(b). See also ABA 
Letter (``We believe an annual measurement would be most 
appropriate, especially since advisers exempt from registration 
because they do not meet the $100,000,000 asset threshold will 
calculate their assets for this purpose annually, and an annual test 
for both purposes has a compelling consistency.'').
---------------------------------------------------------------------------

    As noted above, if an adviser reports in its annual updating 
amendment that it has $150 million or more of private fund assets under 
management, the adviser is no longer eligible for the exemption and 
must register under the Advisers Act unless it qualifies for another 
exemption. An adviser that has complied with all Commission reporting 
requirements applicable to an exempt reporting adviser as such, 
however, may apply for registration with the Commission up to 90 days 
after filing the annual updating amendment, and may continue to act as 
a private fund adviser, consistent with the requirements of rule 
203(m)-1, during this transition period.\377\ This 90-day transition 
period is not available to advisers that have failed to comply with all 
Commission reporting requirements applicable to an exempt reporting 
adviser as such or that have accepted a client that is not a private 
fund.\378\ These advisers therefore should plan to register before 
becoming ineligible for the exemption.
---------------------------------------------------------------------------

    \377\ General Instruction 15 to Form ADV. See also Implementing 
Adopting Release, supra note 32, discussion at section II.B.5. We 
removed what was proposed rule 203(m)-1(d), which contained the 
proposed transition period, and renumbered the final rule 
accordingly. The transition period as adopted is described in 
General Instruction 15 to Form ADV. Rule 203(m)-1(c) refers advisers 
to this instruction. This transition period is available to an 
adviser that has complied with ``all [Commission] reporting 
requirements applicable to an exempt reporting adviser as such,'' 
rather than ``all applicable Commission reporting requirements,'' as 
proposed. This condition reflects the importance of the Advisers Act 
reporting requirements applicable to advisers relying on the private 
fund adviser exemption.
    \378\ General Instruction 15 to Form ADV. See also Implementing 
Adopting Release, supra note 32, discussion at section II.B.5. An 
adviser would lose the exemption immediately upon accepting a client 
that is not a private fund. Accordingly, for the adviser to comply 
with the Advisers Act, the adviser's Commission registration must be 
approved before the adviser accepts a client that is not a private 
fund. Moreover, even an adviser to whom the transition period is 
available could not, consistent with the Advisers Act, accept a 
client that is not a private fund until the Commission approves its 
registration. These same limitations apply to non-U.S. advisers with 
respect to their clients that are United States persons.
---------------------------------------------------------------------------

    Commenters who addressed the issue generally supported the proposed 
transition period, but requested that we extend the transition period 
beyond one calendar quarter as proposed or otherwise make it more 
broadly available.\379\ Requiring annual calculations extends the 
transition period, as commenters recommended, and is consistent with 
the amount of time provided to state-registered advisers switching to 
Commission registration. Advisers to whom the transition period is 
available will have up to 180 days after the end of their fiscal years 
to register.\380\
---------------------------------------------------------------------------

    \379\ ABA Letter; AIMA Letter; CompliGlobe Letter; Gunderson 
Dettmer Letter; Katten Foreign Advisers Letter; Sadis & Goldberg 
Implementing Release Letter; Seward Letter; Shearman Letter.
    \380\ An adviser must file its annual Form ADV updating 
amendment within 90 days after the end of its fiscal year and, if 
the transition period is available, may apply for registration up to 
90 days after filing the amendment. See also supra note 378.
---------------------------------------------------------------------------

    One commenter argued that the transition period should be available 
to all advisers relying on rule 203(m)-1, including those that had not 
complied with their reporting requirements.\381\ The transition period 
is a safe harbor that provides advisers flexibility in

[[Page 39672]]

complying with rule 203(m)-1, and we continue to believe that it would 
be inappropriate to extend this benefit to advisers that have not met 
their reporting requirements.\382\
---------------------------------------------------------------------------

    \381\ Shearman Letter.
    \382\ See Proposing Release, supra note 26, discussion at n.223 
and accompanying text.
---------------------------------------------------------------------------

3. Assets Managed in the United States
    Under rule 203(m)-1, all of the private fund assets of an adviser 
with a principal office and place of business in the United States are 
considered to be ``assets under management in the United States,'' even 
if the adviser has offices outside of the United States.\383\ A non-
U.S. adviser, however, need only count private fund assets it manages 
at a place of business in the United States toward the $150 million 
asset limit under the exemption.\384\
---------------------------------------------------------------------------

    \383\ Rule 203(m)-1(a). The rule defines the ``United States'' 
to have the same meaning as in rule 902(l) of Regulation S under the 
Securities Act, which is ``the United States of America, its 
territories and possessions, any State of the United States, and the 
District of Columbia.'' Rule 203(m)-1(d)(7); 17 CFR 230.902(l).
    \384\ Rule 203(m)-1(b). Any assets managed at a U.S. place of 
business for clients other than private funds would make the 
exemption unavailable. See also supra note 378. We revised this 
provision to refer to assets managed ``at'' a place of business in 
the United States, rather than ``from'' a place of business in the 
United States as proposed. The revised language is intended to 
reflect more clearly the rule's territorial focus on the location at 
which the asset management takes place.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the rule deems all of the 
assets managed by an adviser to be managed ``in the United States'' if 
the adviser's ``principal office and place of business'' is in the 
United States. This is the location where the adviser controls, or has 
ultimate responsibility for, the management of private fund assets, and 
therefore is the place where all the adviser's assets are managed, 
although day-to-day management of certain assets may also take place at 
another location.\385\ For most advisers, this approach will avoid 
difficult attribution determinations that would be required if assets 
are managed by teams located in multiple jurisdictions, or if portfolio 
managers located in one jurisdiction rely heavily on research or other 
advisory services performed by employees located in another 
jurisdiction.
---------------------------------------------------------------------------

    \385\ This approach is similar to the way we have identified the 
location of the adviser for regulatory purposes under our current 
rules, which define an adviser's principal office and place of 
business as the location where it ``directs, controls and 
coordinates'' its advisory activities, regardless of the location 
where some of the advisory activities might occur. See rule 203A-
3(c); rule 222-1.
---------------------------------------------------------------------------

    Most commenters who addressed the issue supported our proposal to 
treat ``assets under management in the United States'' for non-U.S. 
advisers as those assets managed at a U.S. place of business.\386\ One 
commenter did, however, urge us to presume that a non-U.S. adviser's 
assets are managed from its principal office and place of business to 
avoid the inherent difficulties in determining the location from which 
any particular assets of a private fund are managed if an adviser 
operates in multiple jurisdictions.\387\ As we stated in the Proposing 
Release, this commenter's approach ignores situations in which day-to-
day management of some assets of the private fund does in fact take 
place ``in the United States.'' \388\ It also would permit an adviser 
engaging in substantial advisory activities in the United States to 
escape our regulatory oversight merely because the adviser's principal 
office and place of business is outside of the United States. This 
consequence is at odds not only with section 203(m), but also with the 
foreign private adviser exemption discussed below in which Congress 
specifically set forth circumstances under which a non-U.S. adviser may 
be exempt provided it does not have any place of business in the United 
States, among other conditions.\389\
---------------------------------------------------------------------------

    \386\ ABA Letter; Comment Letter of Association Fran[ccedil]aise 
de la Gestion financi[egrave]re (Jan. 24, 2011) (``AFG Letter'') 
(sought clarification that assets managed from non-U.S. offices are 
exempted); AIMA Letter; Comment Letter of Avoca Capital Holdings 
(Dec. 21, 2010) (``Avoca Letter''); Debevoise Letter; Dechert 
Foreign Adviser Letter; EFAMA Letter; Gunderson Dettmer Letter; 
Katten Foreign Advisers Letter; MAp Airports Letter; Merkl Letter; 
Comment Letter of Non-U.S. Adviser (Jan. 24, 2011) (``Non-U.S. 
Adviser Letter''). Cf. Sen. Levin Letter (advisers managing assets 
in the United States of funds incorporated outside of the United 
States ``are exactly the type of investment advisers to which the 
Dodd-Frank Act's registration requirements are intended to apply'').
    \387\ Katten Foreign Advisers Letter.
    \388\ See Proposing Release, supra note 26, at nn.204-205 and 
accompanying text.
    \389\ See infra Section II.C.
---------------------------------------------------------------------------

    In addition, some commenters supported an alternative approach 
under which we would interpret ``assets under management in the United 
States'' by reference to the source of the assets (i.e., U.S. private 
fund investors).\390\ One of the commenters argued that our 
interpretation would disadvantage U.S.-based advisers by permitting 
non-U.S. advisers to accept substantial amounts of money from U.S. 
investors without having to comply with certain U.S. regulatory 
requirements, and cause U.S. advisers to move offshore or close U.S. 
offices to avoid regulation.\391\
---------------------------------------------------------------------------

    \390\ Comment Letter of Portfolio Manager (Jan. 24, 2011) 
(``Portfolio Manager Letter''); Merkl Letter (suggested that it 
``may be useful'' to look both to assets managed from a U.S. place 
of business and assets contributed by U.S. private fund investors to 
address both investor protection and systemic risk concerns).
    \391\ Portfolio Manager Letter. See also Comment Letter of 
Tuttle (Nov. 30, 2010) (submitted in connection with the 
Implementing Adopting Release, avail. at http://www.sec.gov/comments/s7-35-10/s73510.shtml) (``Tuttle Implementing Release 
Letter'') (argued that businesses may move offshore if they become 
too highly regulated in the United States).
---------------------------------------------------------------------------

    As we explained in the Proposing Release, we believe that our 
interpretation recognizes that non-U.S. activities of non-U.S. advisers 
are less likely to implicate U.S. regulatory interests and is in 
keeping with general principles of international comity.\392\ The rule 
also is designed to encourage the participation of non-U.S. advisers in 
the U.S. market by applying the U.S. securities laws in a manner that 
does not impose U.S. regulatory and operational requirements on a non-
U.S. adviser's non-U.S. advisory business.\393\ Non-U.S. advisers 
relying on rule 203(m)-1 will remain subject to the Advisers Act's 
antifraud provisions and will become subject to the requirements 
applicable to exempt reporting advisers.
---------------------------------------------------------------------------

    \392\ See Proposing Release, supra note 26, at n.207 
(identifying Regulation S and Exchange Act rule 15a-6 as examples of 
Commission rules that adopt a territorial approach).
    \393\ See generally Division of Investment Management, SEC, 
Protecting Investors: A Half Century of Investment Company 
Regulation, May 1992 (``1992 Staff Report''), at 223-227 
(recognizing that non-U.S. advisers that registered with the 
Commission were arguably subject to all of the substantive 
provisions of the Advisers Act with respect to their U.S. and non-
U.S. clients, which could result in inconsistent regulatory 
requirements or practices imposed by the regulations of their local 
jurisdiction and the U.S. securities laws; in response, advisers 
could form separate and independent subsidiaries but this could 
result in U.S. clients having access to a limited number of advisory 
personnel and reduced access by the U.S. subsidiary to information 
or research by non-U.S. affiliates).
---------------------------------------------------------------------------

    One commenter proposed an additional interpretation under which we 
would determine the ``assets under management in the United States'' 
for U.S. advisers only by reference to the amount of assets invested, 
or ``in play,'' in the United States.\394\ We decline to adopt this 
approach because it would be difficult for advisers to ascertain and 
monitor which assets are invested in the United States, and this 
approach thus could be confusing and difficult to apply on a consistent 
basis. For example, an adviser might invest in the American Depositary 
Receipts of a company incorporated in Bermuda that: (i) Engages in 
mining operations in Canada, the principal trading market for its 
common stock; and (ii) derives the majority of its revenues from 
exports to the United States. It is not clear whether

[[Page 39673]]

these investments should be considered ``in play'' in the United 
States.
---------------------------------------------------------------------------

    \394\ Comment Letter of Richard Dougherty (Dec. 14, 2010) 
(``Dougherty Letter'').
---------------------------------------------------------------------------

    Another commenter urged us to exclude assets managed by a U.S. 
adviser at its non-U.S. offices.\395\ This, the commenter argued, would 
allow more U.S. advisers to rely on the exemption and allow us to focus 
our resources on larger advisers more likely to pose systemic risk. But 
the management of assets at these non-U.S. offices could have investor 
protection implications in the United States, such as by creating 
conflicts of interest for an adviser between assets managed abroad and 
those managed in the United States.
---------------------------------------------------------------------------

    \395\ Comment Letter of T.A. McKay & Co., Inc. (Nov. 23, 2010).
---------------------------------------------------------------------------

    In addition, we sought comment as to whether, under the approach we 
are adopting today, some or most U.S. advisers with non-U.S. branch 
offices would re-organize those offices as subsidiaries in order to 
avoid attributing assets managed to the non-U.S. office.\396\ No 
commenter suggested this would occur. We continue to believe that rule 
203(m)-1 will have only a limited effect on multi-national advisory 
firms, which for tax or business reasons keep their non-U.S. advisory 
activities organizationally separate from their U.S. advisory 
activities. For these reasons, and our substantial interest in 
regulating all of the activities of U.S. advisers, we decline to revise 
rule 203(m)-1 as this commenter suggested.
---------------------------------------------------------------------------

    \396\ See Proposing Release, supra note 26, at discussion 
following n.208.
---------------------------------------------------------------------------

    Several commenters asked that we clarify whether certain U.S. 
activities or arrangements would result in an adviser having a ``place 
of business'' in the United States.\397\ Commenters also sought 
guidance as to whether limited-purpose U.S. offices of non-U.S. 
advisers would be considered U.S. places of business (e.g., offices 
conducting research or due diligence).\398\
---------------------------------------------------------------------------

    \397\ See, e.g., EFAMA Letter.
    \398\ AIMA Letter; Dechert General Letter; EFAMA Letter. See 
also ABA Letter; Vedanta Letter.
---------------------------------------------------------------------------

    Under rule 203(m)-1, if a non-U.S. adviser relying on the exemption 
has a place of business in the United States, all of the clients whose 
assets the adviser manages at that place of business must be private 
funds and the assets managed at that place of business must have a 
total value of less than $150 million. Rule 203(m)-1 defines a ``place 
of business'' by reference to rule 222-1(a) as any office where the 
adviser ``regularly provides advisory services, solicits, meets with, 
or otherwise communicates with clients,'' and ``any other location that 
is held out to the general public as a location at which the investment 
adviser provides investment advisory services, solicits, meets with, or 
otherwise communicates with clients.''
    Whether a non-U.S. adviser has a place of business in the United 
States depends on the facts and circumstances, as discussed below in 
connection with the foreign private adviser exemption.\399\ For 
purposes of rule 203(m)-1, however, the analysis frequently will turn 
not on whether a non-U.S. adviser has a U.S. place of business, but on 
whether the adviser manages assets, or has ``assets under management,'' 
at such a U.S. place of business. Under the Advisers Act, ``assets 
under management'' are the securities portfolios for which an adviser 
provides ``continuous and regular supervisory or management services.'' 
\400\ This is an inherently factual determination. We would not, 
however, view providing research or conducting due diligence to be 
``continuous and regular supervisory or management services'' at a U.S. 
place of business if a person outside of the United States makes 
independent investment decisions and implements those decisions.\401\
---------------------------------------------------------------------------

    \399\ See infra Section II.C.4.
    \400\ Section 203A(a)(2) of the Advisers Act. The instructions 
to Item 5 of Form ADV provide guidance on the circumstances under 
which an adviser would be providing ``continuous and regular 
supervisory or management services with respect to an account.'' 
Form ADV: Instructions for Part 1A, instr. 5.b. The calculation of 
an adviser's assets under management at a U.S. place of business 
turns on whether the adviser is providing those services with 
respect to a particular account or accounts at a U.S. place of 
business.
    \401\ See Form ADV: Instructions for Part 1A, instr. 5.b(3)(b) 
(an adviser provides continuous and regular supervisory or 
management services with respect to an account if it has ``ongoing 
responsibility to select or make recommendations, based upon the 
needs of the client, as to specific securities or other investments 
the account may purchase or sell and, if such recommendations are 
accepted by the client, [it is] responsible for arranging or 
effecting the purchase or sale''). These research or due diligence 
services, while not ``continuous and regular supervisory or 
management services,'' may be investment advisory services that, if 
performed at a U.S. location, would cause the adviser to have a 
place of business in the United States. See infra note 493 and 
accompanying text.
---------------------------------------------------------------------------

4. United States Person
    Under rule 203(m)-1(b), a non-U.S. adviser may not rely on the 
exemption if it has any client that is a United States person other 
than a private fund.\402\ Rule 203(m)-1 defines a ``United States 
person'' generally by incorporating the definition of a ``U.S. person'' 
in Regulation S under the Securities Act.\403\ Regulation S looks 
generally to the residence of an individual to determine whether the 
individual is a United States person,\404\ and also addresses the 
circumstances under which a legal person, such as a trust, partnership 
or a corporation, is a United States person.\405\ Regulation S 
generally treats legal partnerships and corporations as United States 
persons if they are organized or incorporated in the United States, and 
analyzes trusts by reference to the residence of the trustee.\406\ It 
treats discretionary accounts generally as United States persons if the 
fiduciary is a resident of the United States.\407\ Commenters generally 
supported defining ``United States person'' by reference to Regulation 
S because, among other reasons, the definition is well developed and 
understood by advisers.\408\
---------------------------------------------------------------------------

    \402\ In response to commenters seeking clarity on this point, 
we note that a non-U.S. adviser need not have one or more private 
fund clients that are United States persons in order to rely on the 
exemption.
    \403\ Rule 203(m)-1(d)(8). We are adding a note to rule 203(m)-1 
that clarifies that a client will not be considered a United States 
person if the client was not a United States person at the time of 
becoming a client of the adviser. This will permit a non-U.S. 
adviser to continue to rely on rule 203(m)-1 if a non-U.S. client 
that is not a private fund, such as a natural person client residing 
abroad, relocates to the United States or otherwise becomes a United 
States person. As one commenter recognized, this also will establish 
similar treatment in these circumstances for non-U.S. advisers 
relying on rule 203(m)-1 or the foreign private adviser exemption, 
which contains an analogous note. See EFAMA Letter. See also Comment 
Letter of Investment Funds Institute of Canada (Jan. 24, 2011) 
(``IFIC Letter''). The note applicable to the foreign private 
adviser exemption generally describes the time when an adviser must 
determine if a person is ``in the United States'' for purposes of 
that exemption. See infra Section II.C.3.
    \404\ 17 CFR 230.902(k)(1)(i).
    \405\ See, e.g., 17 CFR 230.902(k)(1) and (2).
    \406\ 17 CFR 230.902(k)(1)(ii) and (iv).
    \407\ 17 CFR 230.902(k)(1)(vii).
    \408\ AIMA Letter; CompliGlobe Letter; Debevoise Letter; Dechert 
General Letter; Gunderson Dettmer Letter; Katten Foreign Advisers 
Letter; O'Melveny Letter. As we explained in the Proposing Release, 
advisers to private funds and their counsel must today be familiar 
with the definition of ``U.S. person'' under Regulation S in order 
to comply with other provisions of the Federal securities laws. See 
Proposing Release, supra note 26, at n.217 and accompanying text.
---------------------------------------------------------------------------

    Rule 203(m)-1 also contains a special rule that requires an adviser 
relying on the exemption to treat a discretionary or other fiduciary 
account as a United States person if the account is held for the 
benefit of a United States person by a non-U.S. fiduciary who is a 
related person of the adviser.\409\ One

[[Page 39674]]

commenter expressed concern that the special rule is unnecessary while 
another who supported the special rule as proposed noted that the 
special rule should be ``narrowly drawn'' to avoid frustrating 
legitimate subadvisory relationships between non-U.S. advisers and 
their U.S. adviser affiliates.\410\ We believe that the special rule is 
narrowly drawn and necessary to prevent advisers from purporting to 
rely on the exemption and establishing discretionary accounts for the 
benefit of U.S. clients with an offshore affiliate that would then 
delegate the actual management of the account back to the adviser.\411\
---------------------------------------------------------------------------

    \409\ Rule 203(m)-1(d)(8) provides that a ``United States person 
means any person that is a `U.S. person' as defined in [Regulation 
S], except that any discretionary account or similar account that is 
held for the benefit of a United States person by a dealer or other 
professional fiduciary is a United States person if the dealer or 
professional fiduciary is a related person of the investment adviser 
relying on [rule 203(m)-1] and is not organized, incorporated, or 
(if an individual) resident in the United States.'' In contrast, 
under Regulation S, a discretionary account maintained by a non-U.S. 
fiduciary (such as an investment adviser) is not a ``U.S. person'' 
even if the account is owned by a U.S. person. See 17 CFR 
230.902(k)(1)(vii); 17 CFR 230.902(k)(2)(i).
    \410\ Katten Foreign Advisers Letter; AIMA Letter (noting that 
the special rule should be narrowly drawn but also stating that 
``[w]e understand the rationale for the special rule proposed by the 
Commission for discretionary accounts maintained outside the US for 
the benefit of US persons and we believe that that is an appropriate 
safeguard against avoidance of the registration requirement'').
    \411\ See Proposing Release, supra note 26, discussion at 
section II.B.4.
---------------------------------------------------------------------------

    Another commenter suggested the rule apply a different approach 
with respect to business entities than that under Regulation S, which 
as noted above generally treats legal partnerships and corporations as 
U.S. persons if they are organized or incorporated in the United 
States.\412\ The commenter suggested that advisers should instead look 
to a business entity's principal office and place of business in 
certain instances because an entity organized under U.S. law should not 
necessarily be treated as a United States person if it was formed by a 
non-United States person to pursue the entity's investment 
objectives.\413\
---------------------------------------------------------------------------

    \412\ Debevoise Letter (noted that, for example, ``a private 
fund, or an entity that is organized as part of a private fund, may 
be organized under Delaware law to meet certain regulatory and tax 
objectives, but the fund's principal office and place of business in 
fact may be outside the U.S.'').
    \413\ The commenter asserted that this approach ``would not be 
inconsistent with Regulation S itself, which treats a partnership or 
corporation organized under the laws of a foreign jurisdiction as a 
U.S. person if it was `[f]ormed by a U.S. person principally for the 
purpose of investing in securities not registered under the 
[Securities] Act, unless it is organized or incorporated, and owned, 
by accredited investors * * * who are not natural persons, estates 
or trusts.''' See also Comment Letter of Fulbright & Jaworski L.L.P. 
(on behalf of a German asset manager) (Jun. 15, 2011) (``Fulbright 
Letter'').
---------------------------------------------------------------------------

    We decline to adopt this suggestion because we believe it is most 
appropriate to incorporate the definition of ``U.S. person'' in 
Regulation S with as few modifications as possible. As noted above, 
Regulation S provides a well-developed body of law with which advisers 
to private funds and their counsel must today be familiar in order to 
comply with other provisions of the Federal securities laws. 
Incorporating this definition in rule 203(m)-1, therefore, makes rule 
203(m)-1 easier to apply and fosters consistency across the Federal 
securities laws. Deviations from the definition used in Regulation S, 
including an entirely different approach to defining a ``United States 
person,'' would detract from these benefits. Moreover, a test that 
looks to a business entity's principal office and place of business, as 
suggested by the commenter, would be difficult for advisers to apply. 
It frequently is unclear where an investment fund maintains its 
``principal office and place of business'' because investment funds 
typically have no physical presence or employees other than those of 
their advisers.

C. Foreign Private Advisers

    Section 403 of the Dodd-Frank Act replaces the current private 
adviser exemption from registration under the Advisers Act with a new 
exemption for a ``foreign private adviser,'' as defined in new section 
202(a)(30).\414\ The new exemption is codified as amended section 
203(b)(3).
---------------------------------------------------------------------------

    \414\ Section 402 of the Dodd-Frank Act (providing a definition 
of ``foreign private adviser,'' to be codified at section 202(a)(30) 
of the Advisers Act). See supra notes 22 and 23 and accompanying 
text.
---------------------------------------------------------------------------

    Under section 202(a)(30), a foreign private adviser is any 
investment adviser that: (i) Has no place of business in the United 
States; (ii) has, in total, fewer than 15 clients in the United States 
and investors in the United States in private funds advised by the 
investment adviser; \415\ (iii) has aggregate assets under management 
attributable to clients in the United States and investors in the 
United States in private funds advised by the investment adviser of 
less than $25 million; \416\ and (iv) does not hold itself out 
generally to the public in the United States as an investment 
adviser.\417\ Section 202(a)(30) authorizes the Commission to increase 
the $25 million threshold ``in accordance with the purposes of this 
title.'' \418\
---------------------------------------------------------------------------

    \415\ One commenter suggested that a non-U.S. adviser with no 
place of business in the United States would not be subject to the 
Advisers Act unless the adviser has at least one direct U.S. client. 
See Katten Foreign Advisers Letter. See also ABA Letter. We note 
that section 203(a) of the Advisers Act provides that an adviser may 
not, unless registered, make use of any means or instrumentality of 
interstate commerce in connection with its business as an investment 
adviser. Hence, whether a non-U.S. adviser with no place of business 
in the United States and no U.S. clients would be subject to 
registration depends on whether there is sufficient use of U.S. 
jurisdictional means. See also supra note 334.
    \416\ Subparagraph (B) of section 202(a)(30) refers to the 
number of ``clients and investors in the United States in private 
funds,'' while subparagraph (C) refers to assets of ``clients in the 
United States and investors in the United States in private funds'' 
(emphasis added). As noted in the Proposing Release, we interpret 
these provisions consistently so that only clients in the United 
States and investors in the United States would be counted for 
purposes of subparagraph (B). See Proposing Release, supra note 26, 
at n.225.
    \417\ In addition, the exemption is not available to an adviser 
that ``acts as (I) an investment adviser to any investment company 
registered under the [Investment Company Act]; or (II) a company 
that has elected to be a business development company pursuant to 
section 54 of [that Act], and has not withdrawn its election.'' 
Section 202(a)(30)(D)(ii). As noted in the Proposing Release, we 
interpret subparagraph (II) to prohibit an adviser that advises a 
business development company from relying on the exemption. See 
Proposing Release, supra note 26, at n.226.
    \418\ Section 202(a)(30)(C).
---------------------------------------------------------------------------

    Today we are adopting, substantially as proposed, new rule 
202(a)(30)-1, which defines certain terms in section 202(a)(30) for use 
by advisers seeking to avail themselves of the foreign private adviser 
exemption, including: (i) ``investor;'' (ii) ``in the United States;'' 
(iii) ``place of business;'' and (iv) ``assets under management.'' 
\419\ We are also including in rule 202(a)(30)-1 the safe harbor and 
many of the client counting rules that appeared in rule 203(b)(3)-1.
---------------------------------------------------------------------------

    \419\ Rule 202(a)(30)-1(c).
---------------------------------------------------------------------------

1. Clients
    Rule 202(a)(30)-1 includes a safe harbor for advisers to count 
clients for purposes of the definition of ``foreign private adviser'' 
that is similar to the safe harbor that has been included in rule 
203(b)(3)-1.\420\ The commenter that generally addressed this aspect of 
our proposed rule agreed with our approach,\421\ which was designed to 
apply a well-developed body of law to

[[Page 39675]]

give effect to a statutory provision with a similar purpose.
---------------------------------------------------------------------------

    \420\ Rule 203(b)(3)-1, which we are rescinding with the 
Implementing Adopting Release, provided a safe harbor for 
determining who may be deemed a single client for purposes of the 
private adviser exemption. We are not, however, carrying over from 
rule 203(b)(3)-1 a provision that distinguishes between advisers 
whose principal places of business are inside or outside of the 
United States. See rule 203(b)(3)-1(b)(5). Under the definition of 
``foreign private adviser,'' an adviser relying on the exemption may 
not have any place of business in the United States. See section 402 
of the Dodd-Frank Act (defining ``foreign private adviser''). We are 
also not including rule 203(b)(3)-1(b)(7), which specifies that a 
client who is an owner of a private fund is a resident where the 
client resides at the time of the client's investment in the fund. 
The provision was vacated by a Federal court in Goldstein, supra 
note 14. As discussed below, we are including a provision in rule 
202(a)(30)-1 that addresses when an adviser must determine if a 
client or investor is ``in the United States'' for purposes of the 
exemption. See infra note 476 and accompanying text.
    \421\ See Katten Foreign Advisers Letter.
---------------------------------------------------------------------------

    New rule 202(a)(30)-1 allows an adviser to treat as a single client 
a natural person and: (i) That person's minor children (whether or not 
they share the natural person's principal residence); (ii) any 
relative, spouse, spousal equivalent, or relative of the spouse or of 
the spousal equivalent of the natural person who has the same principal 
residence; \422\ (iii) all accounts of which the natural person and/or 
the person's minor child or relative, spouse, spousal equivalent, or 
relative of the spouse or of the spousal equivalent who has the same 
principal residence are the only primary beneficiaries; and (iv) all 
trusts of which the natural person and/or the person's minor child or 
relative, spouse, spousal equivalent, or relative of the spouse or of 
the spousal equivalent who has the same principal residence are the 
only primary beneficiaries.\423\ Rule 202(a)(30)-1 also permits an 
adviser to treat as a single ``client'' (i) a corporation, general 
partnership, limited partnership, limited liability company, trust, or 
other legal organization to which the adviser provides investment 
advice based on the legal organization's investment objectives, and 
(ii) two or more legal organizations that have identical shareholders, 
partners, limited partners, members, or beneficiaries.\424\
---------------------------------------------------------------------------

    \422\ As suggested by a commenter, we incorporated in rule 
202(a)(30)-1(a)(1) the concept of a ``spousal equivalent,'' which we 
define by reference to rule 202(a)(11)(G)-1(d)(9) as ``a cohabitant 
occupying a relationship generally equivalent to that of a spouse.'' 
See ABA Letter.
    \423\ Rule 202(a)(30)-1(a)(1). If a client relationship 
involving multiple persons does not fall within the rule, whether 
the relationship may appropriately be treated as a single ``client'' 
depends on the facts and circumstances.
    \424\ Rule 202(a)(30)-1(a)(2). In addition, rule 202(a)(30)-
1(b)(1) through (3) contain the following related ``special rules:'' 
(1) An adviser must count a shareholder, partner, limited partner, 
member, or beneficiary (each, an ``owner'') of a corporation, 
general partnership, limited partnership, limited liability company, 
trust, or other legal organization, as a client if the adviser 
provides investment advisory services to the owner separate and 
apart from the investment advisory services provided to the legal 
organization; (2) an adviser is not required to count an owner as a 
client solely because the adviser, on behalf of the legal 
organization, offers, promotes, or sells interests in the legal 
organization to the owner, or reports periodically to the owners as 
a group solely with respect to the performance of or plans for the 
legal organization's assets or similar matters; and (3) any general 
partner, managing member or other person acting as an investment 
adviser to a limited partnership or limited liability company must 
count the partnership or limited liability company as a client.
---------------------------------------------------------------------------

    As proposed, we are omitting the ``special rule'' providing 
advisers with the option of not counting as a client any person for 
whom the adviser provides investment advisory services without 
compensation.\425\ Some commenters argued that an adviser should not 
have to count such persons, who may be employees and principals of the 
firm and their family members.\426\ But as we explained in the 
Proposing Release, allowing an adviser not to count as clients persons 
in the United States who do not compensate the adviser would allow 
certain advisers to avoid registration through reliance on the foreign 
private adviser exemption despite the fact that, as those commenters 
acknowledge, the adviser provides advisory services to those 
persons.\427\
---------------------------------------------------------------------------

    \425\ See rule 203(b)(3)-1(b)(4).
    \426\ See Dechert General Letter (``In many instances, advisers 
manage the assets of employees and principals of the firm and their 
family members, and use such services as a legitimate compensation 
arrangement to retain talented employees.''); Katten Foreign 
Advisers Letter (``Such persons are likely to be in a special 
relationship with the adviser that allows them to benefit from the 
advisers' investment advice without having to pay.''). See also ABA 
Letter.
    \427\ Cf. Form ADV: Glossary (stating that for purposes of Form 
ADV, the term ``client'' ``includes clients from which [an adviser] 
receives no compensation * * *.''). We also are adopting in the 
Implementing Adopting Release a uniform method for calculating 
assets under management for regulatory purposes, including 
availability of the foreign private adviser exemption, that requires 
advisers to include in that calculation assets they manage without 
compensation. See Implementing Adopting Release, supra note 32, 
discussion at section II.A.3. Requiring foreign private advisers to 
treat as clients persons from whom they receive no compensation is 
consistent with the use of this new uniform method of calculating 
assets under management for regulatory purposes.
---------------------------------------------------------------------------

    The new rule includes two provisions that clarify that advisers 
need not double-count private funds and their investors under certain 
circumstances.\428\ One provision, as proposed, specifies that an 
adviser need not count a private fund as a client if the adviser 
counted any investor, as defined in the rule, in that private fund as 
an investor in that private fund for purposes of determining the 
availability of the exemption.\429\ The other provision, recommended by 
commenters,\430\ clarifies that an adviser is not required to count a 
person as an investor if the adviser counts such person as a client of 
the adviser.\431\ Thus, a client who is also an investor in a private 
fund advised by the adviser would only be counted once.
---------------------------------------------------------------------------

    \428\ See rule 202(a)(30)-1(b)(4)-(5).
    \429\ See rule 202(a)(30)-1(b)(4); 202(a)(30)-1(c)(2). See also 
infra Section II.C.2 (discussing the definition of investor). This 
provision is applicable only for purposes of determining whether an 
adviser has fewer than 15 clients in the United States and investors 
in the United States in private funds it advises under section 
202(a)(30)(B) of the foreign private adviser exemption. It does not 
apply to the determination of the assets under management relevant 
for purposes of that exemption under section 202(a)(30)(C). As a 
result, an adviser must include the assets of a private fund that is 
a client in the United States even if the adviser may exclude the 
private fund when determining whether the adviser has fewer than 15 
clients or investors in the United States. See also infra note 499.
    \430\ See ABA Letter; Katten Foreign Advisers Letter.
    \431\ See rule 202(a)(30)-1(b)(5).
---------------------------------------------------------------------------

2. Private Fund Investor
    Section 202(a)(30) provides that a ``foreign private adviser'' 
eligible for the new registration exemption cannot have more than 14 
clients ``or investors in the United States in private funds'' advised 
by the adviser. Rule 202(a)(30)-1 defines an ``investor'' in a private 
fund as any person who would be included in determining the number of 
beneficial owners of the outstanding securities of a private fund under 
section 3(c)(1) of the Investment Company Act, or whether the 
outstanding securities of a private fund are owned exclusively by 
qualified purchasers under section 3(c)(7) of that Act.\432\ In 
addition, a beneficial owner of short-term paper issued by the private 
fund also is an ``investor,'' notwithstanding that holders of short-
term paper need not be counted for purposes of section 3(c)(1).\433\ 
Finally, in order to avoid double-counting, the rule clarifies that an 
adviser may treat as a single investor any person who is an investor in 
two or more private funds advised by the investment adviser.\434\ We 
are adopting rule 202(a)(30)-1 substantially as proposed. In a 
modification to the proposal, however, we are not including 
knowledgeable employees in the definition of ``investor.'' \435\
---------------------------------------------------------------------------

    \432\ See rule 202(a)(30)-1(c)(2)(i); supra notes 10 and 12 and 
accompanying text. We note that the definition of ``investor'' in 
rule 202(a)(30)-1 is for purposes of the foreign private adviser 
exemption and does not limit the scope of that term for purposes of 
rule 206(4)-8.
    \433\ See rule 202(a)(30)-1(c)(2)(ii).
    \434\ See rule 202(a)(30)-1(c)(2), at note to paragraph (c)(2).
    \435\ See rule 202(a)(30)-1(c)(2). See also infra notes 448-452 
and accompanying text.
---------------------------------------------------------------------------

    The term ``investor'' is not currently defined under the Advisers 
Act or the rules under the Advisers Act. We are adopting the new 
definition to provide for consistent application of the statutory 
provision and to prevent non-U.S. advisers from circumventing the 
limitations in section 203(b)(3). As discussed in the Proposing 
Release, we believe that defining the term ``investor'' by reference to 
sections 3(c)(1) and 3(c)(7) of the Investment Company Act will best 
achieve these purposes.
    Commenters who addressed the issue agreed with our decision to 
define investor for purposes of this rule by reference to the well-
developed understanding of ownership under

[[Page 39676]]

sections 3(c)(1) and 3(c)(7).\436\ Funds and their advisers must 
determine who is a beneficial owner for purposes of section 3(c)(1) or 
whether an owner is a qualified purchaser for purposes of section 
3(c)(7).\437\ More importantly, defining the term ``investor'' by 
reference to sections 3(c)(1) and 3(c)(7) places appropriate limits on 
the ability of a non-U.S. adviser to avoid application of the 
registration provisions of the Advisers Act by setting up intermediate 
accounts through which investors may access a private fund and not be 
counted for purposes of the exemption. Advisers must ``look through'' 
nominee and similar arrangements to the underlying holders of private 
fund-issued securities to determine whether they have fewer than 15 
clients and private fund investors in the United States.\438\ Holders 
of both equity and debt securities must be counted as investors.\439\
---------------------------------------------------------------------------

    \436\ See ABA Letter; Dechert General Letter; Katten Foreign 
Advisers Letter.
    \437\ See supra notes 10 and 12 and accompanying text. In the 
Proposing Release, we noted that typically a prospective investor in 
a private fund must complete a subscription agreement that includes 
representations or confirmations that it is qualified to invest in 
the fund and whether it is a U.S. person. This information is 
designed to allow the adviser (on behalf of the fund) to make the 
above determination. Therefore, an adviser seeking to rely on the 
foreign private adviser exemption will have ready access to this 
information.
    \438\ Rule 202(a)(30)-1(c)(2). See generally sections 3(c)(1) 
and 3(c)(7) of the Investment Company Act.
    \439\ Sections 3(c)(1) and 3(c)(7) of the Investment Company Act 
refer to beneficial owners and owners, respectively, of 
``securities'' (which is broadly defined in section 2(a)(36) of that 
Act to include debt and equity).
---------------------------------------------------------------------------

    Under the new rule, an adviser will determine the number of 
investors in a private fund based on the facts and circumstances and in 
light of the applicable prohibition not to do indirectly, or through or 
by any other person, what is unlawful to do directly.\440\ Depending 
upon the facts and circumstances, persons other than the nominal holder 
of a security issued by a private fund may be counted as the beneficial 
owner under section 3(c)(1), or be required to be a qualified purchaser 
under section 3(c)(7).\441\ An adviser relying on the exemption would 
have to count such a person as an investor.
---------------------------------------------------------------------------

    \440\ See section 208(d) of the Advisers Act; section 48(a) of 
the Investment Company Act.
    \441\ As noted above, we have recognized that in certain 
circumstances it is appropriate to ``look through'' an investor 
(i.e., attribute ownership of a private fund to another person who 
is the ultimate owner). See, e.g., Privately Offered Investment 
Companies, Investment Company Act Release No. 22597 (Apr. 3, 1997) 
[62 FR 17512 (Apr. 9, 1997)] (``NSMIA Release'') (``The Commission 
understands that there are other forms of holding investments that 
may raise interpretative issues concerning whether a Prospective 
Qualified Purchaser `owns' an investment. For instance, when an 
entity that holds investments is the `alter ego' of a Prospective 
Qualified Purchaser (as in the case of an entity that is wholly 
owned by a Prospective Qualified Purchaser who makes all the 
decisions with respect to such investments), it would be appropriate 
to attribute the investments held by such entity to the Prospective 
Qualified Purchaser.'').
---------------------------------------------------------------------------

    For example, the adviser to a master fund in a master-feeder 
arrangement would have to treat as investors the holders of the 
securities of any feeder fund formed or operated for the purpose of 
investing in the master fund rather than the feeder funds, which act as 
conduits.\442\ In addition, an adviser would need to count as an 
investor an owner of a total return swap on the private fund because 
that arrangement effectively provides the risks and rewards of 
investing in the private fund to the swap owner.\443\ Whether an owner 
of another type of instrument referencing a private fund would be 
counted as the beneficial owner under section 3(c)(1), or be required 
to be a qualified purchaser under section 3(c)(7), would depend on the 
facts and circumstances.
---------------------------------------------------------------------------

    \442\ A ``master-feeder fund'' is an arrangement in which one or 
more funds with the same or consistent investment objectives 
(``feeder funds'') invest all or substantially all of their assets 
in a single fund (``master fund'') with the same or consistent 
investment objective and strategies. We have taken the same approach 
within our rules that require a private fund to ``look through'' any 
investor that is formed or operated for the specific purpose of 
investing in a private fund. See rule 2a51-3(a) under the Investment 
Company Act (17 CFR 270.2a51-3(a)) (a company is not a qualified 
purchaser if it is ``formed for the specific purpose of acquiring 
the securities'' of an investment company that is relying on section 
3(c)(7) of the Investment Company Act, unless each of the company's 
beneficial owners is also a qualified purchaser). See also NSMIA 
Release, supra note 441 (explaining that rule 2a51-3(a) would limit 
the possibility that ``a company will be able to do indirectly what 
it is prohibited from doing directly [by organizing] * * * a 
`qualified purchaser' entity for the purpose of making an investment 
in a particular Section 3(c)(7) Fund available to investors that 
themselves did not meet the definition of `qualified purchaser' '').
    \443\ One commenter argued that the swap counterparty is not 
required to hedge its exposure by investing the full notional amount 
in the private fund. See Dechert General Letter. We do not find this 
distinction persuasive in situations in which the adviser knows or 
should know of the existence of the swap. See infra discussion 
accompanying and following note 447.
---------------------------------------------------------------------------

    Several commenters generally disagreed that advisers should be 
required to ``look through'' total return swaps or similar instruments 
or master-feeder arrangements in at least certain circumstances, 
arguing among other things that these instruments or arrangements serve 
legitimate business purposes.\444\ As we explain above, however, the 
requirement to count as investors persons other than the nominal holder 
of a security issued by a private fund is derived from provisions in 
both the Advisers Act and the Investment Company Act prohibiting a 
person from doing indirectly, or through or by any other person, what 
is unlawful to do directly, and from sections 3(c)(1) and 3(c)(7).\445\
---------------------------------------------------------------------------

    \444\ See, e.g., ABA Letter; Dechert General Letter; EFAMA 
Letter.
    \445\ See supra notes 440-443 and accompanying text.
---------------------------------------------------------------------------

    Some commenters also argued that ``looking through'' a total return 
swap or similar instrument would be impractical or unduly burdensome in 
certain circumstances, including situations in which the adviser did 
not participate in the swap's creation or know of its existence.\446\ 
An issuer relying on section 3(c)(7) may treat as a qualified purchaser 
any person whom the issuer reasonably believes is a qualified 
purchaser, and the definition of investor that we are adopting today 
provides that an adviser counts as investors those persons who must be 
qualified purchasers under section 3(c)(7). Therefore, an adviser may 
treat as an investor a person the adviser reasonably believes is the 
actual investor.\447\ Similarly, if an adviser reasonably believes that 
an investor is not ``in the United States,'' the adviser may treat the 
investor as not being ``in the United States.''
---------------------------------------------------------------------------

    \446\ See, e.g., Dechert General Letter; EFAMA Letter.
    \447\ Rule 202(a)(30)-1(c)(2) defines the term ``investor'' 
generally to include persons that must be counted for purposes of 
section 3(c)(1) of the Investment Company Act or qualified 
purchasers for purposes of section 3(c)(7) of that Act. See supra 
notes 432-443 and accompanying text. Advisers to private funds 
relying on section 3(c)(7) may under Investment Company Act rule 
2a51-1(h) treat as qualified purchasers those persons they 
reasonably believe are qualified purchasers. Persons who must be 
qualified purchasers for purposes of section 3(c)(7) generally would 
be the same as those who must be counted for purposes of section 
3(c)(1). Accordingly, advisers may, for purposes of determining 
their investors in the United States under rule 202(a)(30)-1, treat 
as an investor a person the adviser reasonably believes is the 
actual investor.
---------------------------------------------------------------------------

    The final rule, unlike the proposal, does not treat as investors 
beneficial owners who are ``knowledgeable employees'' with respect to 
the private fund, and certain other persons related to such employees 
(we refer to them, collectively, as ``knowledgeable employees'').\448\ 
In formulating our

[[Page 39677]]

proposal to include knowledgeable employees in the definition of 
investor, we were concerned that excluding knowledgeable employees from 
the definition of investor would allow certain advisers to avoid 
registration by relying on the foreign private adviser exemption.\449\ 
A number of commenters opposed our proposal.\450\ In particular, they 
argued that the proposed approach was inconsistent with Congressional 
and prior Commission determinations that such employees do not need the 
protections of the Investment Company Act.\451\
---------------------------------------------------------------------------

    \448\ See proposed rule 202(a)(30)-1(c)(1)(i) (referencing rule 
3c-5 under the Investment Company Act (17 CFR 270.3c-5(b)), which 
excludes from the determinations under sections 3(c)(1) and 3(c)(7) 
of that Act any securities beneficially owned by knowledgeable 
employees of a private fund; a company owned exclusively by 
knowledgeable employees; and any person who acquires securities 
originally acquired by a knowledgeable employee through certain 
transfers of interests, such as a gift or a bequest).
    \449\ See Proposing Release, supra note 26, at n.250 and 
accompanying text.
    \450\ See Dechert General Letter; Katten Foreign Advisers 
Letter; Seward Letter; Shearman Letter.
    \451\ See, e.g., Dechert General Letter (``[The] Commission 
promulgated the knowledgeable employee safe-harbors for sections 
3(c)(1) and 3(c)(7) in response to the Congressional mandate in the 
National Securities Markets Improvement Act of 1996 to allow certain 
informed insiders to invest in a private fund without causing the 
fund to lose its exception under the 1940 Act.''); Shearman Letter 
(the proposed approach is ``contrary to a long history of 
recognizing that knowledgeable employees should be treated 
differently than other investors and that their privileged status 
with their organizations in terms of influence and access to 
information reasonably limits the public's interest in their 
protection'').
---------------------------------------------------------------------------

    Upon further consideration, we have determined that the same policy 
considerations that justify disregarding knowledgeable employees for 
purposes of other provisions provide a valid basis for excluding them 
from the definition of ``investor'' under the foreign private adviser 
exemption.\452\ Treating knowledgeable employees in the same manner for 
purposes of the definition of investor and sections 3(c)(1) and 3(c)(7) 
will also simplify compliance with regulatory requirements imposed by 
both the Advisers Act and the Investment Company Act.
---------------------------------------------------------------------------

    \452\ See Advisers Act rule 205-3(d)(1)(iii) (specifying that 
knowledgeable employees are included among the types of clients to 
whom the adviser may charge performance fees); Advisers Act rule 
202(a)(11)(G)-1 (permitting a family office excluded from the 
definition of investment adviser under the Advisers Act to provide 
investment advice to its knowledgeable employees). These provisions 
reflect a policy determination that knowledgeable employees are 
likely to be in a position or have a level of knowledge and 
experience in financial matters sufficient to be able to evaluate 
the risks and take steps to protect themselves.
---------------------------------------------------------------------------

    The new rule requires advisers to treat as investors beneficial 
owners of ``short-term paper'' \453\ issued by the private fund.\454\ 
These persons are not counted as beneficial owners for purposes of 
section 3(c)(1) but must be qualified purchasers under section 
3(c)(7).\455\ Some commenters opposed this approach, arguing that 
holders of short-term paper do not make an investment decision but 
rather are creditors making a credit risk evaluation.\456\ We disagree. 
The acquisition of those instruments involves an investment decision, 
although the considerations involved in that decision might differ from 
the considerations involved in a decision to make an equity investment.
---------------------------------------------------------------------------

    \453\ See rule 202(a)(30)-1(c)(2)(ii) (referencing the 
definition of ``short-term paper'' contained in section 2(a)(38) of 
the Investment Company Act, which defines ``short-term paper'' to 
mean ``any note, draft, bill of exchange, or banker's acceptance 
payable on demand or having a maturity at the time of issuance of 
not exceeding nine months, exclusive of days of grace, or any 
renewal thereof payable on demand or having a maturity likewise 
limited; and such other classes of securities, of a commercial 
rather than an investment character, as the Commission may designate 
by rules and regulations'').
    \454\ See rule 202(a)(30)-1(c)(2)(ii).
    \455\ See sections 3(c)(1) and 3(c)(7) of the Investment Company 
Act.
    \456\ See ABA Letter (``[H]olders of short-term securities do 
not view themselves as making an investment decision in connection 
with their extension of credit, but rather assess the risk of 
holding a private fund's short-term paper based on credit risk.''); 
Shearman Letter (``[A] lender to a fund, while it makes a `credit 
analysis,' does not deploy capital based on the perceived skill of 
the fund manager and so is not an investor by any traditional 
measure.'').
---------------------------------------------------------------------------

    One commenter asserted that treating holders of short-term paper as 
investors could result in a U.S. commercial lender to a fund being 
treated as an investor, leading non-U.S. advisers to avoid U.S. 
lenders.\457\ Unless the extension of credit by a fund's broker-dealer 
or custodian bank results in the issuance of a security by the fund to 
its creditor, the creditor would not be considered an investor for 
purposes of the foreign private adviser exemption.\458\
---------------------------------------------------------------------------

    \457\ See Shearman Letter.
    \458\ See Reves v. Ernst & Young, 494 U.S. 56 (1990).
---------------------------------------------------------------------------

    As we stated in the Proposing Release, there appears to be no valid 
reason to treat as investors all debt holders except holders of short-
term paper.\459\ Certain issuers continually roll over short-term paper 
and effectively use it as a permanent source of capital, further 
supporting our view that there appears to be no reason to treat holders 
of short-term paper differently than other longer-term debt holders for 
purposes of the exemption.\460\ Moreover, a private fund's losses 
directly affect the interests of holders of short-term paper in the 
fund just as they affect the interests of other debt holders in the 
fund.\461\ In contrast to the treatment of knowledgeable employees, 
holders of short-term paper must be qualified purchasers under section 
3(c)(7), the more recent of the two exclusions under the Investment 
Company Act on which private funds rely.\462\ Thus, we are requiring 
advisers to count as investors all debt holders, including holders of 
short-term paper.
---------------------------------------------------------------------------

    \459\ See Proposing Release, supra note 26, at n. 251 and 
accompanying text. One commenter agreed that we should not treat 
short- and longer-term debt holders differently for purposes of the 
exemption. See ABA Letter (asking that we exclude all holders of 
conventional debt from the definition of investor).
    \460\ As we noted in the Proposing Release, because commercial 
paper issuers often refinance the repayment of maturing commercial 
paper with newly issued commercial paper, they may face roll-over 
risk, i.e., the risk that investors may not be willing to refinance 
maturing commercial paper. See Proposing Release, supra note 26, at 
n. 134. These risks became particularly apparent for issuers of 
asset-backed commercial paper beginning in August 2007. At that 
time, structured investment vehicles (``SIVs''), which are off-
balance sheet funding vehicles sponsored by financial institutions, 
issued commercial paper to finance the acquisition of long-term 
assets, including residential mortgages. As a result of problems in 
the residential home mortgage market, short-term investors began to 
avoid asset-backed commercial paper tied to residential mortgages, 
regardless of whether the securities had substantial exposure to 
sub-prime mortgages. Unable to roll over their commercial paper, 
SIVs suffered severe liquidity problems and significant losses. See 
Money Market Fund Reform, Investment Company Act Release No. 28807 
(June 30, 2009) [74 FR 32688 (July 8, 2009)] (``Money Market Fund 
Reform Release'') at nn. 37-39 and preceding and accompanying text; 
Marcin Kacperczyk And Philipp Schnabl, When Safe Proved Risky: 
Commercial Paper During the Financial Crisis Of 2007-2009 (Nov. 
2009).
    \461\ As discussed in the Proposing Release, various types of 
investment vehicles make significant use of short-term paper for 
financing purposes so holders of this type of security are, in 
practice, exposed to the investment results of the security's 
issuer. See Proposing Release, supra note 26, at n. 251. See also 
Money Market Fund Reform Release, supra note 460, at nn. 37-39 and 
preceding and accompanying text (discussing how money market funds 
were exposed to substantial losses during 2007 as a result of 
exposure to debt securities issued by structured investment 
vehicles).
    \462\ Congress added section 3(c)(7) to the Investment Company 
in 1996 as part of the National Securities Markets Improvement Act 
of 1996. Section 3(c)(1) was included in the Investment Company Act 
when it was enacted in 1940.
---------------------------------------------------------------------------

    Some commenters expressed concern that the look-through requirement 
contained in the statutory definition of a ``foreign private adviser'' 
could impose significant burdens on advisers to non-U.S. funds, 
including non-U.S. retail funds publicly offered outside of the United 
States.\463\ Two of these commenters stated, for example, that in their 
view a non-U.S. fund could be considered a private fund as a result of 
independent actions of U.S. investors, such as if a non-U.S. 
shareholder of a non-U.S. fund moves to the United States and purchases 
additional shares.\464\ If these funds were ``private

[[Page 39678]]

funds,'' their advisers would, if seeking to rely on the foreign 
private adviser exemption, be required to determine the number of 
private fund investors in the United States and the assets under 
management attributable to them.
---------------------------------------------------------------------------

    \463\ See AFG Letter; Dechert Foreign Adviser Letter; EFAMA 
Letter; Shearman Letter.
    \464\ Dechert Foreign Adviser Letter; EFAMA Letter. See also 
Comment Letter of Association Fran[ccedil]aise de la Gestion 
financi[egrave]re (Jun. 14, 2011) (recommended that ``investment 
funds that already are strictly regulated and supervised by European 
Union regulators should be excluded from the scope of Title IV of 
the Dodd Frank Act and should not be considered as `private funds''' 
because, among other reasons, the commenter's management company 
members ``very often'' do not know the identities of their funds' 
investors, and ``therefore should not [] be held responsible if, 
unbeknownst to them, US persons decide to invest in their funds'').
---------------------------------------------------------------------------

    As we explain above, if an adviser reasonably believes that an 
investor is not ``in the United States,'' the adviser may treat the 
investor as not being ``in the United States.'' Moreover, we understand 
that non-U.S. private funds currently count or qualify their U.S. 
investors in order to avoid regulation under the Investment Company 
Act.\465\ A non-U.S. adviser would need to count the same U.S. 
investors (except for holders of short-term paper with respect to a 
fund relying on section 3(c)(1)) in order to rely on the foreign 
private adviser exemption. In this respect, therefore, the look-through 
requirement of the foreign private adviser exemption will generally not 
impose any new burden on advisers to non-U.S. funds.
---------------------------------------------------------------------------

    \465\ This practice is consistent with positions our staff has 
taken in which the staff has stated it would not recommend 
enforcement action in certain circumstances. See, e.g., Goodwin 
Procter No-Action Letter, supra note 294; Touche Remnant No-Action 
Letter, supra note 294. See also sections 7(d), 3(c)(1), and 3(c)(7) 
of the Investment Company Act. See also, e.g., Canadian Tax-Deferred 
Retirement Savings Accounts Release, supra note 294, at n. 23 (``The 
Commission and its staff have interpreted section 7(d) to generally 
prohibit a foreign fund from making a U.S. private offering if that 
offering would cause the securities of the fund to be beneficially 
owned by more than 100 U.S. residents.'').
---------------------------------------------------------------------------

3. In the United States
    Section 202(a)(30)'s definition of ``foreign private adviser'' 
employs the term ``in the United States'' in several contexts, 
including: (i) Limiting the number of--and assets under management 
attributable to--an adviser's ``clients'' ``in the United States'' and 
``investors in the United States'' in private funds advised by the 
adviser; (ii) exempting only those advisers without a place of business 
``in the United States;'' and (iii) exempting only those advisers that 
do not hold themselves out to the public ``in the United States'' as an 
investment adviser.\466\ Today, we are defining the term ``in the 
United States'' to clarify the term for all of the above purposes as 
well as to provide specific instructions as to the relevant time for 
making the related determination.
---------------------------------------------------------------------------

    \466\ See section 402 of the Dodd-Frank Act.
---------------------------------------------------------------------------

    New rule 202(a)(30)-1 defines ``in the United States,'' as 
proposed, generally by incorporating the definition of a ``U.S. 
person'' and ``United States'' under Regulation S.\467\ In particular, 
we are defining ``in the United States'' to mean: (i) With respect to 
any place of business, any such place that is located in the ``United 
States,'' as defined in Regulation S;)\468\ (ii) with respect to any 
client or private fund investor in the United States, any person who is 
a ``U.S. person'' as defined in Regulation S,\469\ except that any 
discretionary account or similar account that is held for the benefit 
of a person ``in the United States'' by a non-U.S. dealer or other 
professional fiduciary is deemed ``in the United States'' if the dealer 
or professional fiduciary is a related person of the investment adviser 
relying on the exemption; and (iii) with respect to the public, in the 
``United States,'' as defined in Regulation S.\470\
---------------------------------------------------------------------------

    \467\ Rule 202(a)(30)-1(c)(3). As discussed above, we are also 
referencing Regulation S's definition of a ``U.S. person'' for 
purposes of the definition of ``United States person'' in rule 
203(m)-1. See supra Section II.B.4.
    \468\ See 17 CFR 230.902(l).
    \469\ See 17 CFR 230.902(k).
    \470\ See 17 CFR 230.902(l).
---------------------------------------------------------------------------

    We believe that the use of Regulation S is appropriate for purposes 
of the foreign private adviser exemption because Regulation S provides 
more specific rules when applied to various types of legal 
structures.\471\ Advisers, moreover, already apply the Regulation S 
definition of U.S. person with respect to both clients and investors 
for other purposes and therefore are familiar with the definition.\472\ 
The references to Regulation S with respect to a place of business ``in 
the United States'' and the public in the ``United States'' also allows 
us to maintain consistency across our rules. Two commenters 
specifically supported our approach.\473\
---------------------------------------------------------------------------

    \471\ See supra notes 404-407 and accompanying text.
    \472\ As we noted in the Proposing Release, many non-U.S. 
advisers identify whether a client is a ``U.S. person'' under 
Regulation S in order to determine whether the client may invest in 
certain private funds and certain private placement offerings exempt 
from registration under the Securities Act. See Proposing Release, 
supra note 26, at n. 259. With respect to ``investors,'' our staff 
has generally taken the interpretive position that an investor that 
does not meet that definition is not a U.S. person when determining 
whether a non-U.S. private fund meets the section 3(c)(1) and 
3(c)(7) counting or qualification requirements. See id., at n. 217. 
Many non-U.S. advisers, moreover, currently determine whether a 
private fund investor is a ``U.S. person'' under Regulation S for 
purposes of the safe harbor for offshore offers and sales.
    \473\ Dechert Foreign Adviser Letter; Dechert General Letter. 
Commenters generally addressed our proposal to rely on Regulation S 
to identify U.S. persons within the context of the private fund 
adviser exemption. See supra Section II.B.4.
---------------------------------------------------------------------------

    Similar to our approach in new rule 203(m)-1(d)(8) and as we 
proposed,\474\ we are treating as persons ``in the United States'' for 
purposes of the foreign private adviser exemption certain persons that 
would not be considered ``U.S. persons'' under Regulation S. For 
example, we are treating as ``in the United States'' any discretionary 
account owned by a U.S. person and managed by a non-U.S. affiliate of 
the adviser in order to discourage non-U.S. advisers from creating such 
discretionary accounts with the goal of circumventing the exemption's 
limitation with respect to advising assets of persons in the United 
States.\475\
---------------------------------------------------------------------------

    \474\ See supra Section II.B.4 (discussing the definition of 
United States persons and the treatment of discretionary accounts).
    \475\ Rule 202(a)(30)-1(c)(3)(i). See supra note 409.
---------------------------------------------------------------------------

    We also are including the note to paragraph (c)(3)(i) specifying 
that for purposes of that definition, a person who is ``in the United 
States'' may be treated as not being ``in the United States'' if the 
person was not ``in the United States'' at the time of becoming a 
client or, in the case of an investor in a private fund, each time the 
investor acquires securities issued by the fund.\476\ As we explained 
in the Proposing Release, the note is designed to reduce the burden of 
having to monitor the location of clients and investors on an ongoing 
basis, and to avoid placing an adviser in a position whereby it might 
have to choose between registering with the Commission or terminating 
the relationship with any client that moved to the United States, or 
redeeming the interest in the private fund of any investor that moved 
to the United States.\477\
---------------------------------------------------------------------------

    \476\ Rule 202(a)(30)-1, at note to paragraph (c)(3)(i) (``A 
person who is in the United States may be treated as not being in 
the United States if such person was not in the United States at the 
time of becoming a client or, in the case of an investor in a 
private fund, each time the investor acquires securities issued by 
the fund.''). We revised the note to provide that it applies ``each 
time'' the investor acquires securities issued by the fund. Cf. 
proposed rule 202(a)(30)-1, at note to paragraph (c)(2)(i). This 
change to the note as proposed more clearly reflects the note's 
intended operation.
    \477\ See Proposing Release, supra note 26, at n.257 and 
accompanying and following text.
---------------------------------------------------------------------------

    Several commenters supported the inclusion of the note.\478\ Some 
commenters, however, advocated expanding the note to treat a private

[[Page 39679]]

fund investor in the same way as a client so that additional 
investments in a fund made after moving to the United States would not 
cause the investor to become a U.S. person.\479\ They argued that, as 
discussed above, advisers to non-U.S. funds should not be required to 
``look through'' these funds to ensure that their investors who 
purchased shares while outside of the United States did not 
subsequently relocate to the United States and purchase additional 
shares.
---------------------------------------------------------------------------

    \478\ See, e.g., Dechert General Letter (``The note provides 
helpful relief at a time when advisory clients often move across 
international borders while keeping an existing relationship with a 
financial institution.''). See also ABA Letter; Dechert Foreign 
Adviser Letter.
    \479\ See Dechert Foreign Adviser Letter; Dechert General 
Letter; EFAMA Letter.
---------------------------------------------------------------------------

    As we explain above, if an adviser reasonably believes that an 
investor is not ``in the United States,'' the adviser may treat the 
investor as not being ``in the United States.'' In addition, we 
understand that, based on no-action positions taken by our staff, non-
U.S. funds do not consider for purposes of section 3(c)(1) beneficial 
owners who were not U.S. persons at the time they invested in the fund, 
but do consider those beneficial owners if they make additional 
purchases in the same fund after relocating to the United States.\480\ 
The note is consistent with the funds' current practices, and thus 
generally should not impose any new burdens on non-U.S. funds. The note 
also is consistent with section 3(c)(7), which requires an investor to 
be a qualified purchaser at the time the investor acquires the 
securities.
---------------------------------------------------------------------------

    \480\ See Investment Funds Institute of Canada, SEC Staff No-
Action Letter (Mar. 4, 1996) (staff also stated its belief that, to 
the extent that a dividend reinvestment plan of a non-U.S. fund is 
consistent with the requirements of Securities Act Release No. 929 
(July 29, 1936), such a plan would not involve an offer for purposes 
of Section 7(d) of the Investment Company Act). See also Goodwin 
Procter No-Action Letter, supra note 294; Touche Remnant No-Action 
Letter, supra note 294.
---------------------------------------------------------------------------

    The Investment Funds Institute of Canada (IFIC) and the Investment 
Industry Association of Canada (IIAC) urged that, for purposes of the 
look-through provision, the Commission allow non-U.S. advisers not to 
count persons (and their assets) who invest in a foreign private fund 
through certain Canadian retirement accounts (``Participants'') after 
having moved to the United States.\481\ The commenters noted that this 
treatment would be consistent with rule 7d-2 under the Investment 
Company Act and certain related rules.\482\ We agree. A non-U.S. fund 
sold to Participants would be deemed a private fund if it conducted a 
private offering in the United States,\483\ but we have previously 
stated that Participants need not be counted toward the 100-investor 
limit for purposes of section 3(c)(1).\484\ As a result, and based on 
the same policy considerations embodied in rule 7d-2, we believe that a 
non-U.S. adviser should not be required to treat Participants as 
investors in the United States under rule 202(a)(30)-1 with respect to 
investments they make after moving to the United States if the fund is 
in compliance with rule 7d-2.\485\
---------------------------------------------------------------------------

    \481\ See IFIC Letter; Comment Letter of Investment Industry 
Association of Canada (Jan. 18, 2011) (``IIAC Letter'').
    \482\ We adopted rule 7d-2, along with rule 237 under the 
Securities Act, in order to allow Participants who move to the 
United States to continue to manage their Canadian retirement 
accounts. See Offer and Sale of Securities to Canadian Tax-Deferred 
Retirement Savings Accounts, Securities Act Release No. 7860 (June 
7, 2000) [65 FR 37672 (June 15, 2000)]. U.S. registration 
requirements were affecting those Participants' ability to purchase 
or exchange securities for such accounts. Rule 7d-2 generally allows 
non-U.S. funds to treat as a private offering certain offerings to 
Participants who are in the United States.
    \483\ See supra notes 294 and 313.
    \484\ See Canadian Tax-Deferred Retirement Savings Accounts 
Release, supra note 294, at n.23.
    \485\ This interpretation only applies with respect to 
Participants' investments in Eligible Securities issued by a 
Qualified Company, as these terms are defined in rule 7d-2.
---------------------------------------------------------------------------

4. Place of Business
    New rule 202(a)(30)-1, by reference to rule 222-1,\486\ defines 
``place of business'' to mean any office where the investment adviser 
regularly provides advisory services, solicits, meets with, or 
otherwise communicates with clients, and any location held out to the 
public as a place where the adviser conducts any such activities.\487\ 
We are adopting this provision as proposed because we believe the 
definition appropriately identifies a location where an adviser is 
doing business for purposes of section 202(a)(30) of the Advisers Act 
and thus provides a basis for an adviser to determine whether it can 
rely on the exemption in section 203(b)(3) of the Advisers Act for 
foreign private advisers. As discussed in the Proposing Release, 
because both the Commission and the state securities authorities use 
this definition to identify an unregistered foreign adviser's place of 
business for purposes of determining regulatory jurisdiction,\488\ we 
believe it is logical as well as efficient to use the rule 222-1(a) 
definition of ``place of business'' for purposes of the foreign private 
adviser exemption. The two commenters that considered the proposed 
definition of ``place of business'' by reference to rule 222-1 agreed 
with this analysis.\489\
---------------------------------------------------------------------------

    \486\ Rule 222-1(a) (defining ``place of business'' of an 
investment adviser as: ``(1) An office at which the investment 
adviser regularly provides investment advisory services, solicits, 
meets with, or otherwise communicates with clients; and (2) Any 
other location that is held out to the general public as a location 
at which the investment adviser provides investment advisory 
services, solicits, meets with, or otherwise communicates with 
clients.'').
    \487\ Rule 202(a)(30)-1(c)(4).
    \488\ See Proposing Release, supra note 26, at n.265 (explaining 
that, under section 222(d) of the Advisers Act, a state may not 
require an adviser to register if the adviser does not have a 
``place of business'' within, and has fewer than six clients 
resident in, the state).
    \489\ See ABA Letter (``[W]e believe that the definition of 
place of business set forth in Rule 222-1 is appropriate * * *''); 
AIMA Letter (``We consider the definition of `place of business' by 
reference to Rule 222-1 of the Advisers Act both logical and 
appropriate.'').
---------------------------------------------------------------------------

    Some commenters asked us to clarify that a ``place of business'' 
would not include an office in the United States where a non-U.S. 
adviser solely conducts research, communicates with non-U.S. clients, 
or performs administrative services and back-office books and 
recordkeeping activities.\490\ Under rule 202(a)(30)-1, as under rule 
203(m)-1, an adviser must determine whether it has a place of business, 
as defined in rule 222-1, in the United States in light of the relevant 
facts and circumstances.\491\ For example, any office from which an 
adviser regularly communicates with its clients, whether U.S. or non-
U.S., would be a place of business.\492\ In addition, an office or 
other location where an adviser regularly conducts research would be a 
place of business because research is intrinsic to the provision of 
investment advisory services.\493\ A place of business would not, 
however, include an office where an adviser solely performs 
administrative services and back-office activities if they are not 
activities intrinsic to providing investment advisory services and do 
not involve communicating with clients.
---------------------------------------------------------------------------

    \490\ See, e.g., ABA Letter; AIMA Letter.
    \491\ As discussed above, investment advisers will also apply 
this provision for purposes of the private fund adviser exemption. 
See supra Section II.B.3.
    \492\ Rule 222-1 does not distinguish between U.S. and non-U.S. 
clients.
    \493\ That would include, for example, research conducted in 
order to produce non-public information relevant to the investments 
of, or the investment recommendations for, any of the adviser's 
clients.
---------------------------------------------------------------------------

    A number of commenters sought guidance as to whether the activities 
of U.S. affiliates of non-U.S. advisers would be deemed to constitute 
places of business in the United States of the non-U.S. advisers.\494\ 
There is no presumption that a non-U.S. adviser has a place of business 
in the United States solely because it is affiliated with a U.S. 
adviser.\495\ A non-U.S. adviser might be deemed to have a place of 
business in

[[Page 39680]]

the United States, however, if the non-U.S. adviser's personnel 
regularly conduct activities at an affiliate's place of business in the 
United States.\496\
---------------------------------------------------------------------------

    \494\ See, e.g., Debevoise Letter; Dechert Foreign Adviser 
Letter; EFAMA Letter.
    \495\ See infra note 506.
    \496\ We have provided guidance as to whether certain activities 
would result in an investment adviser representative having a place 
of business as defined in rule 203A-3(b), which we believe also is 
applicable to an adviser's determination as to whether it has a U.S. 
place of business under rule 222-1 (and therefore under rule 203(m)-
1 or rule 203(a)(30)-1). We have explained that the definition in 
rule 203A-3(b) ``encompasses permanent and temporary offices as well 
as other locations at which an adviser representative may provide 
advisory services, such as a hotel or auditorium.'' Rules 
Implementing Amendments to the Investment Advisers Act of 1940, 
Investment Advisers Act Release No. 1633 (May 15, 1997) [62 FR 28112 
(May 22, 1997)]. We further explained that whether a temporary 
office or location is a place of business ``will turn on whether the 
adviser representative has let it generally be known that he or she 
will conduct advisory business at the location, rather than on the 
frequency with which the adviser representative conducts advisory 
business there.'' Id. See also infra Section II.D.
---------------------------------------------------------------------------

5. Assets Under Management
    For purposes of rule 202(a)(30)-1 we are defining ``assets under 
management,'' as proposed, by reference to the calculation of 
``regulatory assets under management'' for Item 5 of Form ADV.\497\ As 
discussed above, in Item 5 of Form ADV we are implementing a uniform 
method of calculating assets under management that can be used for 
several purposes under the Advisers Act, including the foreign private 
adviser exemption and the private fund adviser exemption.\498\ Because 
the foreign private adviser exemption is also based on assets under 
management, we believe that all advisers should use the same method for 
calculating assets under management to determine if they are required 
to register or may be eligible for the exemption.\499\
---------------------------------------------------------------------------

    \497\ See rule 202(a)(30)-1(c)(1); instructions to Item 5.F of 
Form ADV, Part 1A. As discussed above, we are taking the same 
approach under rule 203(m)-1. See supra Section II.B.2.a.
    \498\ See supra Section II.B.2.a; Implementing Adopting Release, 
supra note 32, discussion at section II.A.3.
    \499\ According to the statutory definition of ``foreign private 
adviser,'' a non-U.S. adviser calculating the assets relevant for 
purposes of the foreign private adviser exemption would only include 
those assets under management (i.e., regulatory assets under 
management) that are ``attributable to clients in the United States 
and investors in the United States in private funds advised by the 
investment adviser.'' See supra notes 416 and 429 and accompanying 
text and note 417.
---------------------------------------------------------------------------

    We believe that uniformity in the method for calculating assets 
under management will result in more consistent asset calculations and 
reporting across the industry and, therefore, in a more coherent 
application of the Advisers Act's regulatory requirements and 
assessment of risk.\500\ One commenter specifically agreed that the 
uniform method should be applied for purposes of the foreign private 
adviser exemption.\501\ Most commenters addressed the components of the 
new method of calculation in reference to the calculation of 
``regulatory assets under management'' under Form ADV, or with respect 
to the calculation of private fund assets for purposes of the private 
fund adviser exemption.\502\ We address these comments in the 
Implementing Adopting Release and in Section II.B.2.\503\
---------------------------------------------------------------------------

    \500\ See supra Section II.B.2.a; Implementing Adopting Release, 
supra note 32, discussion at section II.A.3.
    \501\ See Seward Letter.
    \502\ See supra Section II.B.2.a; Implementing Adopting Release, 
supra note 32, discussion at section II.A.3. A few commenters raised 
the same arguments in favor of revising the method of calculation 
also with respect to the calculation under the foreign private 
adviser exemption. See, e.g., ABA Letter; EFAMA Letter; Katten 
Foreign Advisers Letter (arguing that the method should exclude 
proprietary and knowledgeable employee assets, and assets for which 
the adviser receives no compensation).
    \503\ See Implementing Adopting Release, supra note 32, 
discussion at section II.A.3. In addition, several commenters 
requested that we exercise our authority to increase the $25 million 
asset threshold applicable to the foreign private adviser exemption. 
See, e.g., ABA Letter ($100 million); AFG Letter ($150 million); 
AIMA Letter (at least $100 million); Comment Letter of 
Autorit[eacute] des March[eacute]s Financiers (Jan. 18, 2011) ($150 
million); EVCA Letter ($100 or $150 million); DLA Piper VC Letter 
($250 million); Fulbright Letter ($500 million). We acknowledged in 
the Proposing Release that Section 204 of the Advisers Act provides 
us with the authority to raise the threshold, but we did not propose 
to do so. Therefore, we have not considered raising the threshold in 
connection with this rulemaking, but we will evaluate whether doing 
so may be appropriate in the future, consistent with a comment we 
received. See ABA Letter (asked that we ``monitor this issue * * * 
undertake dialogue with foreign regulators with respect to their 
supervisory regimes over investment advisers, and * * * consider 
proposing an increase in the exemption amount in the near future'').
---------------------------------------------------------------------------

D. Subadvisory Relationships and Advisory Affiliates

    We generally interpret advisers as including subadvisers,\504\ and 
therefore believe it is appropriate to permit subadvisers to rely on 
each of the new exemptions, provided that subadvisers satisfy all terms 
and conditions of the applicable rule.
---------------------------------------------------------------------------

    \504\ See, e.g., Pay to Play Release, supra note 9, at nn.391-94 
and accompanying and following text; Hedge Fund Adviser Registration 
Release, supra note 14, at n.243.
---------------------------------------------------------------------------

    We are aware that in many subadvisory relationships a subadviser 
has contractual privity with a private fund's primary adviser rather 
than the private fund itself. Although both the private fund and the 
fund's primary adviser may be viewed as clients of the subadviser, we 
would consider a subadviser eligible to rely on rule 203(m)-1 if the 
subadviser's services to the primary adviser relate solely to private 
funds and the other conditions of the rule are met. Similarly, a 
subadviser may be eligible to rely on section 203(l) if the 
subadviser's services to the primary adviser relate solely to venture 
capital funds and the other conditions of the rule are met.
    We anticipated that an adviser with advisory affiliates could 
encounter interpretative issues as to whether it may rely on any of the 
exemptions discussed in this Release without taking into account the 
activities of its affiliates. The adviser, for example, might have 
advisory affiliates that are registered or that provide advisory 
services that the adviser itself could not provide while relying on an 
exemption. In the Proposing Release, we requested comment on whether 
any proposed rule should provide that an adviser must take into account 
the activities of its advisory affiliates when determining eligibility 
for an exemption, by having the rule, for example, specify that the 
exemption is not available to an affiliate of a registered investment 
adviser.
    Commenters that responded to our request for comment generally 
supported treating each advisory entity separately without regard to 
the activities of, or relationships with, its affiliates.\505\ This 
approach, however, would for example permit an adviser managing $200 
million in private fund assets simply to reorganize as two separate 
advisers, each of which could purport to rely on the private fund 
adviser exemption. Such a result would in our view be inconsistent with 
the intent of Congress in establishing the exemption's $150 million 
threshold and would violate section 208(d) of the Advisers Act, which 
prohibits any person from doing indirectly or through or by any other 
person any act or thing which would be unlawful for such person to do 
directly. Accordingly, we would treat as a single adviser two or more 
affiliated advisers that are separately organized but operationally 
integrated, which could result in a requirement for one or both 
advisers to register.\506\ Some commenters

[[Page 39681]]

acknowledged this, but urged that, in the case of a non-U.S. advisory 
affiliate, the Commission affirm the staff's positions developed in the 
Unibanco line of no-action letters (``Unibanco letters'').\507\ In the 
Unibanco letters,\508\ the staff provided assurances that it would not 
recommend enforcement action, subject to certain conditions, against a 
non-U.S. unregistered adviser that is affiliated with a Commission-
registered adviser, despite sharing personnel and resources.\509\
---------------------------------------------------------------------------

    \505\ See, e.g., AFG Letter (in determining exemption 
thresholds, each entity's assets should be determined separately; 
does not support combining different entities with different 
business activities); Debevoise Letter (in the context of rule 
203(m)-1).
    \506\ Generally, a separately formed advisory entity that 
operates independently of an affiliate may be eligible for an 
exemption if it meets all of the criteria set forth in the relevant 
rule. However, the existence of separate legal entities may not by 
itself be sufficient to avoid integration of the affiliated 
entities. The determination of whether the advisory businesses of 
two separately formed affiliates may be required to be integrated is 
based on the facts and circumstances. Our staff has taken this 
position in Richard Ellis, Inc., SEC Staff No-Action Letter (Sept. 
17, 1981) (discussing the staff's views of factors relevant to the 
determination of whether a separately formed advisory entity 
operates independently of an affiliate). See also discussion infra 
following note 515.
    \507\ See, e.g., AIMA Letter, Commenter Letter of Bank of 
Montreal, Royal Bank of Canada and The Toronto-Dominion Bank (Jan. 
24, 2011) (``Canadian Banks Letter''); CompliGlobe Letter; Debevoise 
Letter; Dechert General Letter (also supported extending the 
Unibanco letters to U.S. advisers); Dechert Foreign Adviser Letter; 
EFAMA Letter; Katten Foreign Advisers Letter; McGuireWoods Letter; 
MFA Letter; Comment Letter of MFS Investment Management (Jan. 24, 
2011) (``MFS Letter''); Comment Letter of Ropes & Gray LLP (Jan. 24, 
2011).
    \508\ See, e.g., ABA Subcommittee on Private Investment 
Entities, SEC Staff No-Action Letter (Dec. 8, 2005) (``ABA No-Action 
Letter''); Royal Bank of Canada, SEC Staff No-Action Letter (Jun. 3, 
1998); ABN AMRO Bank, N.V., SEC Staff No-Action Letter (Jul. 7, 
1997); Murray Johnstone Holdings Limited, SEC Staff No-Action Letter 
(Oct. 7, 1994); Kleinwort Benson Investment Management Limited, SEC 
Staff No-Action Letter (Dec. 15, 1993); Mercury Asset Management 
plc, SEC Staff No-Action Letter (Apr. 16, 1993); and Uniao de Bancos 
de Brasileiros S.A., SEC Staff No-Action Letter (Jul. 28, 1992) 
(``Unibanco No-Action Letter''). See also 1992 Staff Report, supra 
note 393, at Section III.D.
    \509\ Generally, the staff has provided assurances that it will 
not recommend enforcement action in situations in which the 
unregistered non-U.S. adviser, often termed a ``participating 
affiliate'' in these letters, and its registered affiliate are 
separately organized; the registered affiliate is staffed with 
personnel (located in the U.S. or abroad) who are capable of 
providing investment advice; all personnel of the participating 
affiliate involved in U.S. advisory activities are deemed 
``associated persons'' of the registered affiliate; and the 
Commission has adequate access to trading and other records of the 
participating affiliate and to its personnel to the extent necessary 
to enable it to identify conduct that may harm U.S. clients or 
markets. See supra note 508; Hedge Fund Adviser Registration 
Release, supra note 14, at n.211 and accompanying text.
---------------------------------------------------------------------------

    The Unibanco letters grew out of recommendations in a 1992 staff 
study, and sought to limit the extraterritorial application of the 
Advisers Act while also protecting U.S. investors and markets.\510\ In 
these letters, the staff provided assurances that it would not 
recommend enforcement action of the substantive provisions of the 
Advisers Act with respect to a non-U.S. adviser's relationships with 
its non-U.S. clients.\511\ In addition, and as relevant here, the staff 
agreed not to recommend enforcement action if a non-U.S. advisory 
affiliate of a registered adviser, often termed a ``participating 
affiliate,'' shares personnel with, and provides certain services 
through, the registered adviser affiliate, without such affiliate 
registering under the Advisers Act.\512\ Many commenters asserted that 
affirming these positions would accommodate established business 
practices of global advisory firms without reducing the Commission's 
ability to protect U.S. markets and investors, because the Commission 
would continue to have access to records and personnel of unregistered 
non-U.S. advisory entities that are involved in the U.S. advisory 
business of an affiliated and registered adviser.\513\
---------------------------------------------------------------------------

    \510\ See 1992 Staff Report, supra note 393, at section III.D. 
In enacting the private fund adviser exemption and the foreign 
private adviser exemption, both of which focus on an adviser's 
activities in, or contacts with, the United States, Congress has 
addressed issues similar to those described in the 1992 Staff 
Report. See section 408 of the Dodd-Frank Act (directing the 
Commission to exempt private fund advisers with less than ``$150 
million in assets under management in the United States'') (emphasis 
added); sections 402 and 403 of the Dodd-Frank Act (exempting from 
registration foreign private advisers with no place of business in 
the United States that have a limited number of clients in the 
United States and investors in the United States in private funds 
and a limited amount of assets attributable to these clients and 
investors, among other conditions).
    \511\ See supra note 508. See also infra note 515.
    \512\ See supra note 508.
    \513\ See, e.g., Canadian Banks Letter; CompliGlobe Letter; MFA 
Letter; MFS Letter.
---------------------------------------------------------------------------

    A number of commenters asserted that the staff positions in the 
Unibanco letters are consistent with our approach to the territorial 
application of the Advisers Act with respect to non-U.S. advisers.\514\ 
As we stated in 2004, we do not apply most of the substantive 
provisions of the Advisers Act to the non-U.S. clients of a non-U.S. 
adviser registered with the Commission.\515\ However, the Unibanco 
letters were developed by the staff in the context of the private 
adviser exemption,\516\ which Congress repealed. Nothing in the rules 
we are today adopting in this Release is intended to withdraw any prior 
statement of the Commission or the views of the staff as expressed in 
the Unibanco letters. We expect that the staff will provide guidance, 
as appropriate, based on facts that may be presented to the staff 
regarding the application of the Unibanco letters in the context of the 
new foreign private adviser exemption and the private fund adviser 
exemption.
---------------------------------------------------------------------------

    \514\ See, e.g., Canadian Banks Letter; MFA Letter. See also 
supra notes 510 and 316 and accompanying text.
    \515\ See Hedge Fund Adviser Registration Release, supra note 
14, at nn.211 and 216-222 and accompanying text (noting that this 
policy was first set forth in the Unibanco No-Action Letter). 
Although the rules contained in the Hedge Fund Adviser Registration 
Release were vacated by a Federal court in Goldstein, supra note 14, 
the court's decision did not address our statement in that release 
that we do not apply most of the substantive provisions of the 
Advisers Act to the non-U.S. clients of a non-U.S. adviser 
registered with the Commission. In addition, our staff expressed 
this view in a 2006 no-action letter issued in response to a request 
for the staff's views on matters affecting investment advisers to 
certain private funds that arose as a result of the Goldstein 
decision. See ABA Subcommittee on Private Investment Companies, SEC 
Staff No-Action Letter (Aug. 10, 2006) (Commission staff expressed 
the view that the substantive provisions of the Advisers Act do not 
apply to offshore advisers with respect to such advisers' dealings 
with offshore funds and other offshore clients to the extent 
described in prior staff no-action letters and the Hedge Fund 
Adviser Registration Release, supra note 14. The staff noted, 
however, that an offshore adviser registered with the Commission 
under the Advisers Act must comply with the Advisers Act and the 
Commission's rules thereunder with respect to any U.S. clients (and 
any prospective U.S. clients) it may have.).
    \516\ Our staff has provided assurances that it would not 
recommend enforcement action when no participating affiliate has any 
U.S. clients other than clients of the registered affiliate, 
consistent with the private adviser exemption, which was conditioned 
on the number of a non-U.S. adviser's U.S. clients. See supra notes 
508-509; Hedge Fund Adviser Registration Release, supra note 14, at 
n.211 and accompanying text. Under the Unibanco letters, 
participating affiliates only share personnel with, and provide 
certain services through, their registered adviser affiliates. See 
supra notes 508-509.
---------------------------------------------------------------------------

III. Certain Administrative Law Matters

    The effective date for rules 203(l)-1, 203(m)-1 and 202(a)(30)-1 is 
July 21, 2011. The Administrative Procedure Act generally requires that 
an agency publish a final rule in the Federal Register not less than 30 
days before its effective date.\517\ This requirement does not apply, 
however, if the rule is a substantive rule which grants or recognizes 
an exemption or relieves a restriction or is an interpretative 
rule.\518\
---------------------------------------------------------------------------

    \517\ See 5 U.S.C. 553(d).
    \518\ The statute also provides an exception if the agency finds 
good cause to make the rule effective less than 30 days after its 
date of publication in the Federal Register. Id.
---------------------------------------------------------------------------

    As discussed above, effective July 21, 2011, the Dodd-Frank Act 
amends the Advisers Act to eliminate the private adviser exemption in 
pre-existing section 203(b)(3), which will require advisers relying on 
that exemption to register with the Commission as of July 21, 2011 
unless another exemption is available.\519\ Also effective July 21, 
2011, are the Dodd-Frank Act amendments to the Advisers Act that are 
described immediately below.
---------------------------------------------------------------------------

    \519\ See sections 403 of the Dodd-Frank Act; sections 203(b)(3) 
of the Advisers Act; Section I supra.
---------------------------------------------------------------------------

    Sections 203(l) and 203(b)(3) of the Advisers Act provide 
exemptions from

[[Page 39682]]

registration for advisers to venture capital funds and foreign private 
advisers, respectively. Rule 203(l)-1 defines venture capital fund, and 
rule 202(a)(30)-1 defines several terms in the definition of ``foreign 
private adviser'' in section 202(a)(30).\520\ Thus, these interpretive 
rules implement the new venture capital and foreign private adviser 
exemptions added to the Advisers Act by the Dodd-Frank Act.
---------------------------------------------------------------------------

    \520\ As discussed above, the Dodd-Frank Act amended the 
Advisers Act to define ``foreign private adviser'' in section 
202(a)(30).
---------------------------------------------------------------------------

    Section 203(m) of the Advisers Act, as amended by the Dodd-Frank 
Act, directs the Commission to provide an exemption for advisers solely 
to private funds with assets under management in the United States of 
less than $150 million. Rule 203(m)-1, which implements section 203(m), 
grants an exemption and relieves a restriction and in part has 
interpretive aspects. Accordingly, we are making the rules effective on 
July 21, 2011.

IV. Paperwork Reduction Analysis

    The rules do not contain a ``collection of information'' 
requirement within the meaning of the Paperwork Reduction Act of 
1995.\521\ Accordingly, the Paperwork Reduction Act is not applicable.
---------------------------------------------------------------------------

    \521\ 44 U.S.C. 3501.
---------------------------------------------------------------------------

V. Cost-Benefit Analysis

    As discussed above, we are adopting rules 203(l)-1, 203(m)-1 and 
202(a)(30)-1 to implement certain provisions of the Dodd-Frank Act. As 
a result of the Dodd-Frank Act's repeal of the private adviser 
exemption, some advisers that previously were eligible to rely on that 
exemption will be required to register under the Advisers Act unless 
they are eligible for a new exemption. Thus, the benefits and costs 
associated with registration for advisers that are not eligible for an 
exemption are attributable to the Dodd-Frank Act.\522\ Moreover, the 
Dodd-Frank Act provides that, unlike an adviser that is specifically 
exempt pursuant to section 203(b), an adviser relying on an exemption 
provided by section 203(l) of the Advisers Act or rule 203(m)-1 
thereunder may be subject to reporting and recordkeeping 
requirements.\523\ Hence, the benefits and costs associated with being 
an exempt reporting adviser, relative to being an adviser that is 
registered or specifically exempted by reason of section 203(b), are 
attributable to the Dodd-Frank Act. The Commission has discretion, 
however, to adopt rules to define the terms used in the Advisers Act, 
and we undertake below to discuss the benefits and costs of the rules 
that we are adopting to implement the exemptions discussed in this 
Release.\524\
---------------------------------------------------------------------------

    \522\ As we discuss above, although most venture capital 
advisers agreed with our proposed approach to the definition of 
venture capital fund, a number of commenters disagreed with our 
approach to the proposed definition, and argued that it should be 
expanded to include investments in small companies (regardless of 
whether they satisfy our definition of qualifying portfolio company) 
and investments in other private funds. See, e.g., NASBIC/SBIA 
Letter; PEI Funds/Willowbridge Letter; VIA Letter. We do not believe 
that these more expansive positions are consistent with the intended 
scope of the venture capital exemption as expressed by Congress. See 
supra note 204 and accompanying text. Thus, we believe that the 
costs of registration for advisers to funds that would not satisfy 
the definition because they hold such investments are attributable 
to the Dodd-Frank Act.
    \523\ See supra note 5.
    \524\ The benefits and costs of the reporting requirements 
applicable to advisers relying on the venture capital exemption and 
the private fund adviser exemption are discussed in greater detail 
in the Implementing Adopting Release, supra note 32, discussion at 
sections V.A.2 and V.B.2.
---------------------------------------------------------------------------

    We are sensitive to the costs and benefits imposed by our rules, 
and understand that there will be costs and benefits associated with 
complying with the rules we are adopting today. We recognize that 
certain aspects of these rules may place burdens on advisers that seek 
to qualify for the various exemptions discussed in this Release. We 
believe that these rules, as modified from the proposals, offer 
flexibility and clarity for advisers seeking to qualify for the 
exemptions. We have designed the rules to balance these concerns with 
respect to potential costs and burdens with what we understand was 
intended by Congress.
    In the Proposing Release, we identified possible costs and benefits 
of the proposed rules and requested comment on the analysis, including 
identification and assessment of any costs and benefits not discussed 
in the analysis. We requested that commenters provide analysis and 
empirical data to support their views on the costs and benefits 
associated with the proposals. In addition, we requested confirmation 
of our understanding of how advisers that may seek to rely on the 
exemptions operate and manage private funds and how the proposals may 
affect them and their businesses.

A. Definition of Venture Capital Fund

    We define a venture capital fund as a private fund that: (i) Holds 
no more than 20 percent of the fund's capital commitments in non-
qualifying investments (other than short-term holdings) (``qualifying 
investments'' generally consist of equity securities of ``qualifying 
portfolio companies'' and are discussed below); (ii) does not borrow or 
otherwise incur leverage, other than limited short-term borrowing 
(excluding certain guarantees of qualifying portfolio company 
obligations by the fund); (iii) does not offer its investors redemption 
or other similar liquidity rights except in extraordinary 
circumstances; (iv) represents itself as pursuing a venture capital 
strategy to investors; and (v) is not registered under the Investment 
Company Act and has not elected to be treated as a BDC.\525\
---------------------------------------------------------------------------

    \525\ Rule 203(l)-1(a).
---------------------------------------------------------------------------

    We define ``qualifying investments'' as: (i) Directly acquired 
equities; (ii) equity securities issued by a qualifying portfolio 
company in exchange for directly acquired equities issued by the same 
qualifying portfolio company; and (iii) equity securities issued by a 
company of which a qualifying portfolio company is a majority-owned 
subsidiary, or a predecessor, and is received in exchange for directly 
acquired equities of the qualifying portfolio company (or securities 
exchanged for such directly acquired equities).\526\ We define a 
``qualifying portfolio company'' as any company that: (i) Is not a 
reporting company and does not have a control relationship with a 
reporting company; (ii) does not borrow or issue debt obligations in 
connection with the investment by the private fund and distribute 
proceeds of the borrowing or issuance to the private fund in exchange 
for the private fund investment; and (iii) is not itself a fund (i.e., 
is an operating company).\527\
---------------------------------------------------------------------------

    \526\ Rule 203(l)-1(c)(3).
    \527\ Rule 203(l)-1(c)(4). See also text accompanying note 148.
---------------------------------------------------------------------------

    The final rule also grandfathers existing funds by including in the 
definition of ``venture capital fund'' any private fund that: (i) 
Represented to investors and potential investors at the time the fund 
offered its securities that it pursues a venture capital strategy; (ii) 
prior to December 31, 2010, has sold securities to one or more 
investors that are not related persons of any investment adviser of the 
venture capital fund; and (iii) does not sell any securities to, 
including accepting any additional capital commitments from, any person 
after July 21, 2011 (the ``grandfathering provision'').\528\ An adviser 
seeking to rely on the exemption under section 203(l) of the Advisers 
Act would be eligible for the venture capital exemption only if it 
exclusively advised venture capital funds that satisfy all of the 
elements of the definition of venture capital fund or the 
grandfathering provision.
---------------------------------------------------------------------------

    \528\ Rule 203(l)-1(b).

---------------------------------------------------------------------------

[[Page 39683]]

    We have identified certain costs and benefits, discussed below, 
that may result from our definition of venture capital fund, including 
modifications to the proposal. As we discussed in the Proposing 
Release, the proposed rule was designed to: (i) Implement the directive 
from Congress to define the term venture capital fund in a manner that 
reflects Congress' understanding of what venture capital funds are, and 
as distinguished from other private funds such as private equity funds 
and hedge funds; and (ii) facilitate the transition to the new 
exemption.\529\ As discussed above, we have modified the proposed rule 
to give qualifying funds greater flexibility with respect to their 
investments, partly in response to comments we received.\530\ The final 
rule defines the term venture capital fund consistently with what we 
believe Congress understood venture capital funds to be,\531\ and in 
light of other concerns expressed by Congress with respect to the 
intended scope of the venture capital exemption.\532\
---------------------------------------------------------------------------

    \529\ See Proposing Release, supra note 26, discussion at text 
immediately preceding text accompanying n.273.
    \530\ See generally Section II.A.1.
    \531\ See supra notes 36-37 and accompanying and following text. 
See also infra note 535.
    \532\ See supra discussion at Section II.A.
---------------------------------------------------------------------------

    Approximately 26 comment letters addressed the costs and benefits 
of the proposed rule defining venture capital fund.\533\ As discussed 
below, most of these commenters did not provide empirical data to 
support their views. However, a number of venture capital advisers 
commenting on the proposed rule offered observations based upon their 
experiences managing venture capital funds and presented views on the 
potential impact of the proposed rule on their businesses and business 
practices.
---------------------------------------------------------------------------

    \533\ See, e.g., NVCA Letter; NYSBA Letter; Oak Investments 
Letter; Sevin Rosen Letter; SVB Letter; Trident Letter.
---------------------------------------------------------------------------

1. Benefits
    In the Proposing Release, we stated that based on the testimony 
presented to Congress and our research, we believed that venture 
capital funds currently in existence would meet most, if not all, of 
the elements of our proposed definition of venture capital fund.\534\ 
Several commenters agreed that the proposed rule is consistent with 
Congressional intent.\535\ Many venture capital advisers and related 
industry groups acknowledged that the proposed definition would 
generally encompass most venture capital investing activity that 
typically occurs,\536\ but expressed the concern that a venture capital 
fund may, on occasion, deviate from its typical investing pattern with 
the result that the fund could not satisfy all of the definitional 
criteria under the proposed rule with respect to each investment all of 
the time.\537\ Several commenters also expressed the concern that the 
final rule should provide sufficient flexibility to accommodate future 
business practices that are not known or contemplated today.\538\
---------------------------------------------------------------------------

    \534\ Proposing Release, supra note 26, at section IV.A.1.
    \535\ AFL-CIO Letter (``[T]he SEC has * * * generally provided 
appropriate definitions for each of the factors.''); AFR Letter 
(``[W]e believe that the exemption ultimately created in the [Dodd-
Frank Act] for venture capital funds must be narrowly defined so as 
to prevent it from undermining the requirement all other fund 
managers register. We believe that the language in the proposed rule 
meets this goal * * *''); Sen. Levin Letter (``[T]he proposed 
definition captures the essence of venture capital firms whose 
mission is to encourage the development and expansion of new 
business.''). See also DuFauchard Letter (``Congressional directives 
require the SEC to exclude private equity funds, or any fund that 
pivots its investment strategy on the use of debt or leverage, from 
the definition of VC Fund.'').
    \536\ See, e.g., Cook Children's Letter (``The Commission's 
definition of a venture capital fund does a thorough job capturing 
many of the aspects that differentiate venture capital funds from 
other types of private investment funds.''); Leland Fikes Letter; 
NVCA Letter (``[T]he Proposed Rules are generally consistent with 
existing venture capital industry practice * * *''). See also 
CompliGlobe Letter; DLA Piper VC Letter.
    \537\ See, e.g., ATV Letter; BIO Letter; NVCA Letter; Sevin 
Rosen Letter.
    \538\ See, e.g., NVCA Letter; Oak Investments Letter.
---------------------------------------------------------------------------

    For the reasons discussed above, we have modified the definition of 
venture capital fund. Our modifications include specifying a non-
qualifying basket \539\ and excluding from the 120-day limit with 
respect to leverage certain guarantees of portfolio company obligations 
by a qualifying fund.\540\ For the reasons discussed in greater detail 
above, we are adopting a limit of 20 percent for non-qualifying 
investments.\541\ In summary, the non-qualifying basket is designed to 
address commenters' concerns regarding occasional deviations from 
typical venture capital investing activity,\542\ inadvertent violations 
of the definitional criteria \543\ and flexibility to address evolving 
or future business practices.\544\ We considered these comments in 
light of our concerns that the exemption not be expanded beyond what we 
believe was the intent of Congress \545\ and that the definition not 
operate to foreclose investment funds from investment opportunities 
that would benefit investors but would not change the character of the 
fund.\546\ We concluded that a non-qualifying basket limit of 20 
percent would provide the flexibility sought by many venture capital 
fund commenters while appropriately limiting the scope of the 
exemption.\547\
---------------------------------------------------------------------------

    \539\ Rule 203(l)-1(a)(2).
    \540\ Rule 203(l)-1(a)(3).
    \541\ See generally Section II.A.
    \542\ See supra note 56.
    \543\ See supra note 58.
    \544\ See supra note 56.
    \545\ See supra notes 45 and 61 and accompanying text.
    \546\ See supra note 60.
    \547\ See supra note 72 and following text.
---------------------------------------------------------------------------

    We believe that the final rule (including the modifications from 
the proposal) better describes the existing venture capital industry 
and provides venture capital advisers with greater flexibility to 
accommodate existing (and potentially evolving or future) business 
practices and take advantage of investment opportunities that may 
arise. We also believe that the criteria under the final rule will 
facilitate transition to the new exemption, because it minimizes the 
extent to which an adviser seeking to rely on the venture capital 
exemption would need to alter its existing business practices, thus, 
among other things, reducing the likelihood of inadvertent non-
compliance.\548\
---------------------------------------------------------------------------

    \548\ For example, the final rule does not specify that a 
qualifying fund must provide managerial assistance or control each 
qualifying portfolio company in which the fund invests. A number of 
commenters indicated that venture capital funds may not provide 
sufficient assistance or exercise sufficient control in order to 
satisfy this element of the proposed definition. See, e.g., ESP 
Letter; Merkl Letter. The final rule also allows a qualifying fund 
to exclude investments in money market funds from the non-qualifying 
basket. A number of commenters indicated that money market funds are 
typically used by venture capital funds for cash management 
purposes. See, e.g., NVCA Letter. We expect that these modifications 
to the rule would avoid the cost of altering an adviser's existing 
business practices.
---------------------------------------------------------------------------

    As we discuss in greater detail above, many commenters arguing in 
favor of the modifications that we are adopting generally cited these 
benefits to support their views.\549\ Specifically, several commenters 
asserted that providing a limited basket for non-qualifying investments 
would benefit venture capital advisers relying on the venture capital 
exemption, and the U.S. economy, by facilitating job creation and 
capital formation \550\ and minimizing the extent to which a venture 
capital fund would need to alter

[[Page 39684]]

its typical business practices.\551\ Other commenters maintained that 
an approach providing advisers some flexibility on occasion to take 
advantage of promising investment opportunities that might not be 
typical of most venture capital activity would benefit those funds and 
their investors.\552\
---------------------------------------------------------------------------

    \549\ See, e.g., NVCA Letter; Oak Investments Letter; Quaker 
BioVentures Letter. See also supra discussion at Section II.A.1.
    \550\ See, e.g., NVCA Letter (stating that a low level of 15% 
would ``allow innovation and job creation to flourish within the 
venture capital industry''); Sevin Rosen Letter (a 20% limit would 
be ``flexible enough not to severely impair the operations of bona 
fide [venture capital funds], a critically important resource for 
American innovation and job creation'').
    \551\ See, e.g., McDonald Letter; Pine Brook Letter.
    \552\ See, e.g., DuFauchard Letter; Merkl Letter.
---------------------------------------------------------------------------

    We anticipate that a number of benefits, described by commenters, 
may result from allowing qualifying funds limited investments in non-
qualifying investments, including publicly traded securities, 
securities that are not equity securities (e.g., non-convertible debt 
instruments) and interests in other private funds.\553\ For example, 
increasing the potential pool of investors that could provide financing 
to publicly traded companies to include venture capital funds could 
facilitate access to capital for a portfolio company's expansion and 
growth.\554\ Including investments that are not equity securities could 
offer funds seeking to qualify as venture capital funds the flexibility 
to structure an investment in a manner that is most appropriate for the 
fund (and its investors), including for example to obtain favorable tax 
treatment, manage risks (such as bankruptcy protection), maintain the 
value of the fund's equity investment or satisfy the specific financing 
needs of a portfolio company.\555\ Including non-convertible bridge 
financing also would enable a portfolio company to seek such financing 
from venture capital funds if it is unable to obtain financing from 
traditional lending sources.\556\ In addition, permitting qualifying 
funds to invest in other underlying private funds could facilitate 
capital formation and enhance liquidity for the underlying private 
funds.\557\ Under the final rule, qualifying funds also would have 
increased flexibility to invest in portfolio companies through 
secondary market transactions. Commenters asserted that this would help 
align the interests of portfolio company founders with the interests of 
venture capital funds \558\ and prevent dilution of the venture capital 
fund's investment in the portfolio company.\559\
---------------------------------------------------------------------------

    \553\ Rule 203(l)-1(a)(2) (specifying that a qualifying fund 
must hold, immediately after the acquisition of any asset (excluding 
short-term holdings) no more than 20% of its committed capital in 
assets that are not qualifying investments); rule 203(l)-1(c)(3) 
(defining ``qualifying investment'').
    \554\ See, e.g., Lowenstein Letter; McDonald Letter; Mesirow 
Letter; Quaker BIO Letter; Trident Letter.
    \555\ See, e.g., Merkl Letter; Oak Investments Letter; Sevin 
Rosen Letter; Vedanta Capital Letter.
    \556\ NVCA Letter; Trident Letter.
    \557\ See, e.g., Cook Children's Letter; Leland Fikes Letter; 
Merkl Letter; SVB Letter.
    \558\ Sevin Rosen Letter.
    \559\ SVB Letter.
---------------------------------------------------------------------------

    Under the final rule, the non-qualifying basket is determined as a 
percentage of a qualifying fund's capital commitments, and compliance 
with the 20 percent limit is determined each time a qualifying fund 
makes any non-qualifying investment (excluding short-term holdings). We 
expect that calculating the size of the non-qualifying basket as a 
percentage of a qualifying fund's capital commitments, which will 
remain relatively constant during the fund's term, will provide 
advisers with a degree of predictability when managing the fund's 
portfolio and determining how much of the basket remains available for 
new investments. Moreover, we believe that by applying the 20 percent 
limit as of the time of acquisition of each non-qualifying investment, 
a fund is able to determine prospectively how much it can invest in the 
non-qualifying basket. We believe that this approach to determining the 
non-qualifying basket will appropriately limit a qualifying fund's non-
qualifying investments and ease the burden of determining compliance 
with the criterion under the rule.
    As discussed above, a qualifying fund can only invest up to 20 
percent of its capital commitments in non-qualifying investments, as 
measured immediately after it acquires any non-qualifying 
investment.\560\ The final rule treats as a qualifying investment any 
equity security of a qualifying portfolio company, or a company 
acquiring the qualifying portfolio company, that is exchanged for 
directly acquired equities issued by the qualifying portfolio company. 
This definition should benefit venture capital funds because it allows 
funds to participate in the reorganization of the capital structure of 
a portfolio company.\561\ It also provides qualifying funds with 
liquidity and an opportunity to take profits from their investments 
because they can acquire securities in connection with the acquisition 
(or merger) of a qualifying portfolio company by another company--
typical means by which venture capital funds exit an investment.\562\
---------------------------------------------------------------------------

    \560\ The rule requires a qualifying fund at the time it 
acquires an asset, to have no more than 20% of its capital 
commitments invested in assets that are not qualifying investments. 
Rule 203(l)-1(a)(2).
    \561\ See supra note 109 and following text.
    \562\ See, e.g., NVCA Letter; PTV Sciences Letter. The final 
rule defines equity securities broadly to cover many types of equity 
securities in which venture capital funds typically invest, rather 
than limit the definition solely to common stock. See supra notes 
95-96 and accompanying text. Our definition of qualifying portfolio 
company is similarly broad because it does not restrict qualifying 
companies to ``small or start-up'' companies. As we have noted in 
the Proposing Release and above, we believe that such definitions 
would be too restrictive and provide venture capital fund advisers 
with too little flexibility and limited options with respect to 
potential portfolio company investments. See supra discussion in 
Section II.A.1.a.
---------------------------------------------------------------------------

    The final rule excludes from the 120-day limit with respect to 
leverage any venture capital fund guarantees of portfolio company 
indebtedness, up to the value of the fund's investment in the 
company.\563\ We agree with several commenters who stated that 
guarantees of portfolio company indebtedness under these circumstances 
will facilitate a portfolio company's ability to obtain credit for 
working capital or business operations.\564\ Thus, we believe this 
provision, which is designed to accommodate existing business practices 
typical of venture capital funds, may contribute to efficiency, 
competition and capital formation.
---------------------------------------------------------------------------

    \563\ Rule 203(l)-1(a)(3).
    \564\ Oak Investments Letter; SVB Letter.
---------------------------------------------------------------------------

    The final rule excludes from the definition of qualifying portfolio 
company any company that borrows or issues debt if the proceeds of such 
borrowing or debt are distributed to the venture capital fund in 
exchange for the fund's investment in the company. This will allow 
qualifying funds to provide financing on a short-term basis to 
portfolio companies as a ``bridge'' between funding rounds.\565\ In 
addition, a portfolio company can obtain financing for working capital 
or expansion needs from typical lenders, effect shareholder buyouts and 
conclude a simultaneous debt and equity offering, without affecting the 
adviser's eligibility for the venture capital exemption. For the 
foregoing reasons, commenters maintained, and we agree, that this 
approach would facilitate compliance with the rule without restricting 
a portfolio company's access to financing or other capital.\566\ We 
believe that this provision of the final rule will benefit venture 
capital funds and their investors because it restricts a portfolio 
company's ability to incur debt that may implicate Congressional 
concerns regarding the use of leverage and effectively distinguishes 
advisers to venture capital funds from advisers to leveraged buyout 
private equity funds for which Congress did not provide an 
exemption.\567\
---------------------------------------------------------------------------

    \565\ See, e.g., supra note 181 and accompanying and following 
text.
    \566\ See, e.g., NVCA Letter; SVB Letter.
    \567\ As discussed above, we have imposed this limitation on 
qualifying portfolio companies because of the focus on leverage in 
the Dodd-Frank Act as a potential contributor to systemic risk as 
discussed by the Senate Committee Report, and the testimony before 
Congress that stressed the lack of leverage in venture capital 
investing. See supra notes 174 and 175.

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[[Page 39685]]

    Our final rule clarifies that an adviser seeking to rely on the 
venture capital exemption may treat as a private fund any non-U.S. fund 
managed by the adviser that does not offer its securities in the United 
States or to U.S. persons.\568\ This treatment will enable an adviser 
to rely on the exemption when it manages only funds that satisfy the 
venture capital fund definition, regardless of the funds' jurisdiction 
of formation and investor base. We believe that this treatment 
facilitates capital formation and competition because it would allow an 
adviser to sponsor and advise funds in different jurisdictions in order 
to meet the different tax or regulatory needs of the fund's investors 
without risking the availability of the exemption.
---------------------------------------------------------------------------

    \568\ See note accompanying rule 203(l)-1.
---------------------------------------------------------------------------

    The final rule includes several other characteristics that provide 
additional flexibility to venture capital advisers and their funds. For 
example, a qualifying fund cannot provide its investors with redemption 
or other liquidity rights except in extraordinary circumstances. 
Although venture capital funds typically do not permit investors to 
redeem their interests during the life of the fund,\569\ the approach 
of the final rule allows a venture capital fund to respond to 
extraordinary events, including redeeming investors from the fund, 
without resulting in a registration obligation for the fund's adviser. 
Under the final rule, a venture capital fund must affirmatively 
represent itself as pursuing a venture capital strategy to its 
investors, a criterion designed to preclude advisers to certain private 
funds from claiming an exemption from registration for which they are 
not eligible. We believe that this element will allow the Commission 
and the investing public (particularly potential investors) to 
determine and confirm an adviser's rationale for remaining unregistered 
with the Commission.\570\
---------------------------------------------------------------------------

    \569\ See supra notes 255-256 and accompanying text.
    \570\ See Merkl Letter (stating that a description of the 
investment strategy is a key element of any private placement 
memorandum).
---------------------------------------------------------------------------

    Because it takes into account existing business practices of 
venture capital funds and permits some flexibility for venture capital 
funds (and their managers) to adopt, or adapt to, new or evolving 
business practices, we believe that the final rule will facilitate 
advisers' transition to the new exemption. The rule generally limits 
investments of a qualifying fund, but creates a basket that will allow 
these funds flexibility to make limited investments that may vary from 
typical venture capital fund investing practices. The final rule also 
provides an adviser flexibility and discretion to structure 
transactions in underlying portfolio companies to meet the business 
objectives of the fund without creating significant risks of the kind 
that Congress suggested should require registration of the fund's 
adviser. We expect that this flexibility will benefit investment 
advisers that seek to rely on the venture capital exemption because 
they will be able more easily to structure and operate funds that meet 
the definition now and in the future, but will not permit reliance on 
the exemption by private fund advisers that Congress did not intend to 
exclude from registration.
    Our final rule also should benefit advisers of existing venture 
capital funds that fail to meet the definition of venture capital fund. 
Our grandfathering provision permits an adviser to rely on the 
exemption provided that each fund that does not satisfy the definition 
(i) has represented to investors that it pursues a venture capital 
strategy, (ii) has initially sold interests by December 31, 2010, and 
(iii) does not sell any additional interests after July 21, 2011.\571\ 
We expect that most advisers to existing venture capital funds that 
currently rely on the private adviser exemption would be exempt from 
registration in reliance on the grandfathering provision.\572\ As a 
result of this provision, we expect that advisers to existing venture 
capital funds that do not meet our definition will benefit because they 
can continue to manage existing funds without having to (i) weigh the 
relative costs and benefits of registration and modification of fund 
operations to conform existing funds with our definition and (ii) incur 
the costs associated with registration with the Commission or 
modification of existing funds. Advisers to venture capital funds that 
were launched by December 31, 2010 and meet the July 21, 2011 deadline 
for sales of all securities also would benefit from the grandfathering 
provision because they would not have to incur these costs. We believe 
that the grandfathering provision will promote efficiency because it 
will allow advisers to existing venture capital funds to continue to 
rely on the exemption without having to restructure funds that may not 
meet the definition.\573\ It also will allow advisers to funds that 
were launched by December 31, 2010 and can meet the other requirements 
of the grandfathering provision to rely on the exemption without the 
potential costs of having to renegotiate with potential investors and 
restructure those funds within the limited period before the rule is 
effective. After the effective date, advisers that seek to form new 
funds will have sufficient time and notice to structure those funds to 
meet the definition should they seek to rely on the exemption in 
section 203(l) of the Advisers Act.
---------------------------------------------------------------------------

    \571\ Rule 203(l)-1(b).
    \572\ A number of commenters specifically inquired about the 
scope of the holding out criterion and noted that under existing 
business practice venture capital funds may refer to themselves as 
private equity funds. As we discuss in greater detail above, we do 
not believe that the name used by a fund is the sole dispositive 
factor, and that satisfying the holding out criterion will depend on 
all of the facts and circumstances. See supra Section II.A.7. This 
criterion is similar to our general approach to antifraud provisions 
under the Federal securities laws and our rules.
    \573\ Many commenters supported the grandfathering provision, 
and one specifically cited the benefit of avoiding the need to alter 
fund terms to the potential detriment of fund investors. AV Letter.
---------------------------------------------------------------------------

    Finally, we believe that our definition would include an additional 
benefit for investors and regulators. Section 203(l) of the Advisers 
Act provides an exemption specifically for advisers that ``solely'' 
advise venture capital funds. Currently none of our rules requires that 
an adviser exempt from registration specify the basis for the 
exemption. We are adopting, however, rules that would require exempt 
reporting advisers to identify the exemption(s) on which they are 
relying.\574\ Requiring that venture capital funds represent themselves 
as such to investors should allow the Commission and the investing 
public (particularly potential investors in venture capital funds) to 
determine, and confirm, an adviser's rationale for remaining 
unregistered with the Commission. This element is designed to deter 
advisers to private funds other than venture capital funds from 
claiming to rely on an exemption from registration for which they are 
not eligible.
---------------------------------------------------------------------------

    \574\ See Implementing Adopting Release, supra note 32, at n.175 
and accompanying text.
---------------------------------------------------------------------------

    We believe that existing venture capital funds would meet most, if 
not all, of the elements of the final definition of venture capital 
fund. Nevertheless, we recognize that some advisers to existing venture 
capital funds that seek to rely on the exemption in section 203(l) of 
the Advisers Act might have to structure new funds differently to 
satisfy the definitional criteria under the final rule. To the extent 
that advisers choose not to

[[Page 39686]]

change how they structure or manage new funds they launch, those 
advisers would have to register with the Commission,\575\ which offers 
many benefits to the investing public and facilitates our mandate to 
protect investors. Registered investment advisers are subject to 
periodic examinations by our staff and are also subject to our rules 
including rules on recordkeeping, custody of client funds and 
compliance programs. We believe that in general Congress considered 
registration to be beneficial to investors because of, among other 
things, the added protections offered by registration. Accordingly, 
Congress limited the section 203(l) exemption to advisers solely to 
venture capital funds.
---------------------------------------------------------------------------

    \575\ See infra text following notes 585, 597-600 and 
accompanying text for a discussion of potential costs for advisers 
that would have to choose between registering or restructuring 
venture capital funds formed in the future.
---------------------------------------------------------------------------

    As noted above, we proposed, and are retaining in the final rule, 
certain elements in the portfolio company definition because of the 
focus on leverage in the Dodd-Frank Act as a potential contributor to 
systemic risk as discussed by the Senate Committee report,\576\ and the 
testimony before Congress that stressed the lack of leverage in venture 
capital investing.\577\ We expect that distinguishing between venture 
capital funds and other private funds that pursue investment strategies 
involving financial leverage that Congress highlighted for concern 
would benefit financial regulators mandated by the Dodd-Frank Act (such 
as the Financial Stability Oversight Council) with monitoring and 
assessing potential systemic risks. Because advisers that manage funds 
with these characteristics would be required to register, we expect 
that financial regulators could more easily obtain information and data 
regarding these financial market participants, which should benefit 
those regulators to the extent it helps to reduce the overall cost of 
systemic risk monitoring and assessment.\578\ We believe that investors 
will benefit from enhanced disclosure and oversight of the activities 
of private fund advisers by regulators, which in turn could contribute 
to a more efficient allocation of capital.
---------------------------------------------------------------------------

    \576\ See supra note 174.
    \577\ See supra note 175.
    \578\ See S. Rep. No. 111-176, supra note 6, at 39 (explaining 
the requirement that private funds disclose information regarding 
their investment positions and strategies, including information on 
fund size, use of leverage, counterparty credit risk exposure, 
trading and investment positions and any other information that the 
Commission in consultation with the Financial Stability Oversight 
Council determines is necessary and appropriate to protect investors 
or assess systemic risk).
---------------------------------------------------------------------------

2. Costs
    Costs for advisers to existing venture capital funds. As we 
discussed in the Proposing Release and above, we do not expect that the 
definition of venture capital fund would result in significant costs 
for unregistered advisers to venture capital funds currently in 
existence and operating.\579\ We estimate that currently there are 791 
advisers to venture capital funds.\580\ We expect that all these 
advisers, which we assume currently are not registered in reliance on 
the private adviser exemption, would continue to be exempt after the 
repeal of that exemption on July 21, 2011 in reliance on the 
grandfathering provision.\581\ We anticipate that such advisers to 
grandfathered funds will incur minimal costs, if any, to confirm that 
existing venture capital funds managed by the adviser meet the 
conditions of the grandfathering provision. We estimate that these 
costs would be no more than $800 to hire outside counsel to assist in 
this determination.\582\
---------------------------------------------------------------------------

    \579\ Proposing Release, supra note 26, at text immediately 
preceding text accompanying n.273.
    \580\ See NVCA Yearbook 2011, supra note 152, at Fig. 1.04 
(providing the number of ``active'' venture capital advisers, as of 
December 2010, that have raised a venture capital fund within the 
past eight years; 456 of the total number of venture capital 
advisers manage less than $100 million in capital).
    \581\ We estimate that these advisers (and any other adviser 
that seeks to remain unregistered in reliance on the exemption under 
section 203(l) of the Advisers Act or rule 203(m)-1 thereunder) 
would incur, on average, $2,311 per year to complete and update 
related reports on Form ADV, including Schedule D information 
relating to private funds. See Implementing Adopting Release, supra 
note 32, at section V.B.2. This estimate includes internal costs to 
the adviser of $2,032 to prepare and submit an initial report on 
Form ADV and $279 to prepare and submit annual amendments to the 
report. These estimates are based on the following calculations: 
$2,032 = ($4,064,000 aggregate costs / 2000 advisers); $279 = 
($558,800 aggregate costs / 2,000 advisers). Id. at nn.579-581 and 
accompanying text. We estimate that approximately two exempt 
reporting advisers would file Form ADV-H annually at a cost of $189 
per filing. Id., at n.596 and accompanying text. We further estimate 
that three exempt reporting advisers would file Form ADV-NR per year 
at a cost of $188 per year. Id., at nn.598-602 and accompanying 
text. We anticipate that filing fees for exempt reporting advisers 
would be the same as those for registered investment advisers. See 
infra note 598. These estimates, some of which differ from the 
estimates included in the Proposing Release, supra note 26, are 
discussed in more detail in the Implementing Adopting Release, supra 
note 32, at section V.B.2.
    \582\ As discussed in the Proposing Release, we expect that a 
venture capital adviser would need no more than 2 hours of legal 
advice to learn the differences between its current business 
practices and the conditions for reliance on the proposed 
grandfathering provision. We estimate that this advice would cost 
$400 per hour per firm based on our understanding of the rates 
typically charged by outside consulting or law firms. See Proposing 
Release, supra note 26, at n.293. We did not receive any comments on 
these cost estimates.
---------------------------------------------------------------------------

    We recognize, however, that advisers to funds that were launched by 
December 31, 2010 but have not concluded offerings to investors may 
incur costs to determine whether they qualify for the grandfathering 
provision. For example, these advisers may need to assess the impact on 
the fund of selling interests to initial third-party investors by 
December 31, 2010 and selling interests to all investors no later than 
July 21, 2011.\583\ We do not expect that the cost of evaluating the 
grandfathering provision would be significant, however, because we 
believe that most funds in formation represent themselves as funds that 
pursue a venture capital strategy to their potential investors \584\ 
and the typical fundraising period for a venture capital fund is 
approximately 12 months.\585\ Thus, we do not anticipate that venture 
capital fund advisers would have to alter typical business practices to 
structure or raise capital for venture capital funds being formed. 
Nevertheless, we recognize that after the final rule goes into effect, 
exempt advisers of such funds in formation may forgo the opportunity to 
accept investments from investors that may seek to invest after July 
21, 2011 in order to comply with the grandfathering provision.
---------------------------------------------------------------------------

    \583\ We did not receive any comments on the dates specified in 
the grandfathering provision. See also supra note 307.
    \584\ See supra note 572.
    \585\ See Breslow & Schwartz, supra note 241, at 2-22 (``Once 
the first closing [of a private equity fund] has occurred, 
subsequent closings are typically held over a defined period of time 
[the marketing period] of approximately six to twelve months.''). 
See also Dow Jones Report, supra note 242, at 22.
---------------------------------------------------------------------------

    To the extent that an existing adviser could not rely on the 
grandfathering provision with respect to funds in formation, we also 
expect that the adviser would not be required to modify its business 
practices significantly in order to rely on the exemption. Our final 
rule includes many modifications requested by commenters, such as the 
non-qualifying basket, and as a result, we expect that these 
modifications would reduce some of the costs associated with modifying 
current business practices to satisfy the proposed definitional 
criteria that commenters addressed.\586\ As we

[[Page 39687]]

discuss above, we believe that the final rule better reflects venture 
capital activity conducted by venture capital advisers that are likely 
to seek to rely on the exemption, and provides flexibility that will 
allow these funds to take advantage of new investment opportunities. To 
the extent that some commenters expressed concerns that they would have 
to divert personnel time from other functions to monitoring inadvertent 
failures to meet the definitional elements, we believe that the greater 
investment flexibility provided by the rule would offset most of these 
compliance costs.
---------------------------------------------------------------------------

    \586\ See, e.g., Charles River Letter; Gunderson Dettmer Letter; 
NVCA Letter (arguing that as proposed the rule would have required 
venture capital fund advisers to modify their business practices in 
order to be eligible for the exemption). See also ABA Letter; Davis 
Polk Letter; Oak Investment Letter; SVB Letter (discussing the 
potential costs associated with complying with various elements of 
the proposed rule such as managerial assistance, venture capital 
fund leverage and solely investing in qualifying portfolio 
companies).
---------------------------------------------------------------------------

    Our rule does not provide separate definitional criteria for non-
U.S. advisers seeking to rely on the exemption. These advisers might 
incur costs to the extent that cash management instruments they 
typically acquire may not be ``short-term holdings'' for purposes of 
the definition.\587\ We expect that these costs would be mitigated, 
however, to the extent that these advisers can continue to acquire 
these instruments using the non-qualifying basket.
---------------------------------------------------------------------------

    \587\ See, e.g., EFAMA Letter (asserting that a non-U.S. fund 
could not invest in non-U.S. equivalent cash holdings under the 
proposed rule).
---------------------------------------------------------------------------

    Costs for new advisers and advisers to new venture capital funds. 
We expect that existing advisers that seek to form new venture capital 
funds and investment advisory firms that seek to enter the venture 
capital industry will incur one-time ``learning costs'' to determine 
how to structure new funds they may manage to meet the elements of our 
definition. We estimate that on average, there are 23 new advisers to 
venture capital funds each year.\588\ We expect that the one-time 
learning costs would be no more than between $2,800 and $4,800 on 
average for an adviser if it hires an outside consulting or law firm to 
assist in determining how the elements of our definition may affect 
intended business practices.\589\ Thus, we estimate the aggregate cost 
to existing advisers of determining how the definition would affect 
funds they plan to launch would be from $64,400 to $110,400.\590\ As 
they launch new funds and negotiate with potential investors, these 
advisers would have to determine whether it is more cost effective to 
register or to structure the venture capital funds they manage to meet 
the definition. Such considerations of legal or other requirements, 
however, comprise a typical business and operating expense of 
conducting new business. New advisers that enter into the business of 
managing venture capital funds also would incur such ordinary costs of 
doing business in a regulated industry.\591\
---------------------------------------------------------------------------

    \588\ This is the average annual increase in the number of 
venture capital advisers between 1981 and 2010. See NVCA Yearbook 
2010, supra note 150, at Fig. 1.04; NVCA Yearbook 2011, supra note 
152, at Fig. 1.04.
    \589\ We expect that a venture capital adviser would need 
between 7 and 12 hours of consulting or legal advice to learn the 
differences between its current business practices and the 
definition, depending on the experience of the firm and its 
familiarity with the elements of the rule. We estimate that this 
advice would cost $400 per hour per firm based on our understanding 
of the rates typically charged by outside consulting or law firms.
    \590\ This estimate is based on the following calculations: 23 x 
$2,800 = $64,400; 23 x $4,800 = $110,400. We did not receive any 
comments on these cost estimates.
    \591\ For estimates of the costs of registration for those 
advisers that would choose to register, see infra notes 597-600.
---------------------------------------------------------------------------

    In the Proposing Release, we stated that we believed that existing 
advisers to venture capital funds would meet most, if not all, of the 
elements of the proposed definition.\592\ As discussed above, most 
commenters generally acknowledged that the proposed definition would 
generally encompass most venture capital investing activity that 
typically occurs.\593\ Several noted, however, that they might deviate 
from typical investing patterns on occasion or wanted the flexibility 
to invest small amounts of capital in investments that would be 
precluded by the proposed definition.\594\ Under the final rule, 
venture capital funds that qualify for the definition may invest in 
non-qualifying investments subject to availability of the non-
qualifying basket, including investments specified by some commenters. 
As a result of these modifications, the final definition is more 
closely modeled on current business practices of venture capital funds 
and provides advisers with flexibility to take advantage of investment 
opportunities. As a result, we do not anticipate that many venture 
capital fund advisers would have to change significantly the structure 
of new funds they launch.
---------------------------------------------------------------------------

    \592\ Proposing Release, supra note 26, at Section V.A.1.
    \593\ See supra note 51.
    \594\ See supra note 52.
---------------------------------------------------------------------------

    We also recognize that some existing venture capital funds may have 
characteristics that differ from the criteria in our definition. To the 
extent that investment advisers seek to form new venture capital funds 
with these characteristics, those advisers would have to choose whether 
to structure new venture capital funds to conform to the definition, 
forgo forming new funds, or register with the Commission. In any case, 
each investment adviser would assess the costs associated with 
registering with the Commission relative to the costs of remaining 
unregistered (and hence structuring funds to meet our definition in 
order to be eligible for the exemption). We expect that this assessment 
would take into account many factors, including the size, scope and 
nature of an adviser's business and investor base. Such factors will 
vary from adviser to adviser, but each adviser would determine for 
itself whether registration, relative to other choices, is the most 
cost-effective or strategic business option.
    The final rule may have effects on competition and capital 
formation. To the extent that advisers choose to structure new venture 
capital funds to conform to the definition, or choose not to form new 
funds in order to avoid registration, these choices could result in 
fewer investment choices for investors, less competition and less 
capital formation.\595\ For example, to the extent that new venture 
capital funds do not invest in non-qualifying investments in excess of 
the 20 percent basket in order to meet the definition, the final rule 
could decrease competition and capital formation. If venture capital 
funds invest less in non-qualifying investments or more in qualifying 
portfolio company securities that are qualifying investments, this 
could increase competition among qualifying portfolio companies or 
private funds that invest in such companies. To the extent that funds 
invest more in less risky but lower yielding non-qualifying 
investments, this could decrease competition among investors that seek 
to invest in qualifying investments. To the extent that advisers choose 
to register in order to structure new venture capital funds without 
regard to the definitional criteria or in order to expand their 
businesses (e.g., pursue additional investment strategies beyond 
venture capital investing or expand the potential investor base to 
include investors that are required to invest with registered 
advisers), these choices may result in greater investment choices for 
investors, greater competition and greater capital formation.\596\
---------------------------------------------------------------------------

    \595\ See, e.g., Lowenstein Letter; NVCA Letter; Venrock Letter.
    \596\ See, e.g., ``Asia's Cash-Poor Small Hedge Funds Vulnerable 
to U.S. Rules,'' Bloomberg.com (Feb. 23, 2011) (identifying two fund 
of funds managers that either require or prefer to allocate client 
assets to advisers registered with the Commission).
---------------------------------------------------------------------------

    Investment advisers to new venture capital funds that would not 
meet the definition would have to register and

[[Page 39688]]

incur the costs associated with registration (assuming the adviser 
could not rely on the private fund adviser exemption). We note that the 
costs of registration for advisers that do not qualify for the venture 
capital fund adviser exemption flow from the Dodd-Frank Act, which 
removed the private adviser exemption on which they currently rely.
    We estimate that the internal cost to register with the Commission 
would be $15,077 on average for a private fund adviser,\597\ excluding 
the initial filing fees and annual filing fees to the Investment 
Adviser Registration Depository (``IARD'') system operator.\598\ These 
registration costs include the costs attributable to completing and 
periodically amending Form ADV, preparing brochure supplements, and 
delivering codes of ethics to clients.\599\ In addition to the internal 
costs described above, we estimate that for an adviser choosing to use 
outside legal services to complete its brochure, such costs would be 
$5,000.\600\
---------------------------------------------------------------------------

    \597\ This estimate is based upon the following calculations: 
$15,077 = ($9,627,871 aggregate costs to complete Form ADV / 750 
advisers expected to register with the Commission) + ($8,509,000 
aggregate costs to complete private fund reporting requirements / 
3,800 advisers expected to provide private fund reports). See 
Implementing Adopting Release, supra note 32, at nn.612-618 and 
accompanying text for a more detailed discussion of these costs. 
This also assumes that the performance of this function would most 
likely be equally allocated between a senior compliance examiner and 
a compliance manager. See id., at n.608. Data from SIFMA's 
Management & Professional Earnings in the Securities Industry 2010, 
modified to account for an 1,800-hour work-year and multiplied by 
5.35 to account for bonuses, firm size, employee benefits and 
overhead, suggest that costs for these positions are $235 and $273 
per hour, respectively.
    \598\ Filing fees paid for submitting initial and annual filings 
through the IARD currently range from $40 to $225 based on the 
amount of assets an adviser has under management. The current fee 
schedule for registered advisers may be found on our Web site at 
http://www.sec.gov/divisions/investment/iard/iardfee.shtml. See 
Implementing Adopting Release, supra note 32, at n.566-567 and 
accompanying text (assuming for purposes of the analysis that exempt 
reporting advisers will pay a fee of $225 per initial or annual 
report).
    \599\ Part 1 of Form ADV requires advisers to answer basic 
identifying information about their business, their affiliates and 
their owners, information that is readily available to advisers, and 
thus should not result in significant costs to complete. Registered 
advisers must also complete Part 2 of Form ADV and file it 
electronically with us. Part 2 requires disclosure of certain 
conflicts of interest and could be prepared based on information 
already contained in materials provided to investors, which could 
reduce the costs of compliance even further.
    \600\ See Implementing Adopting Release, supra note 32, at 
n.729.
---------------------------------------------------------------------------

    New registrants would also face costs to bring their business 
operations into compliance with the Advisers Act and the rules 
thereunder. These costs, however, will vary significantly among 
advisers depending on the adviser's size, the scope and nature of its 
business, and the sophistication of its compliance infrastructure, but 
in any case would be an ordinary business and operating expense of 
entering into any business that is regulated.
    We estimated in the Proposing Release that the one-time costs to 
new registrants to establish a compliance infrastructure would range 
from $10,000 to $45,000, while ongoing annual costs of compliance and 
examination would range from $10,000 to $50,000.\601\ Some commenters 
suggested that these estimates are too low. Commenters identifying 
themselves as ``middle market private equity fund'' advisers estimated 
that they would incur one-time registration and compliance costs 
ranging from $50,000 to $600,000, followed by ongoing annual compliance 
costs ranging from $50,000 to $500,000.\602\ Commenters identifying 
themselves as advisers to venture capital funds, however, provided much 
lower estimates for one-time registration and compliance costs ranging 
from $75,000 to $200,000, followed by ongoing annual compliance costs 
ranging from $50,000 to $150,000.\603\
---------------------------------------------------------------------------

    \601\ See Proposing Release, supra note 26, at n.303 and 
accompanying text. Our estimate was based on the expectation that 
most advisers that might choose to register for business reasons 
have already built compliance infrastructures as a matter of good 
business practice. Nevertheless, we expect advisers will incur costs 
for outside legal counsel to evaluate their compliance procedures 
initially and on an ongoing basis. We estimate that the costs to 
advisers to establish the required compliance infrastructure will 
be, on average, $20,000 in professional fees and $25,000 in internal 
costs including staff time. These estimates were prepared in 
consultation with attorneys who, as part of their private practice, 
have counseled private fund advisers establishing their 
registrations with the Commission. We included a range because we 
believe there are a number of unregistered advisers of private funds 
whose compliance operations are already substantially in compliance 
with the Advisers Act and that would therefore experience only 
minimal incremental ongoing costs as a result of registration. In 
connection with previous estimates we have made regarding compliance 
costs for registered advisers, we received comments from small 
advisers estimating that their annual compliance costs would be 
$25,000 and could be as high as $50,000. See, e.g., Comment Letter 
of Joseph L. Vidich (Aug. 7, 2004). Cf. Comment Letter of Venkat 
Swarna (Sept. 14, 2004) (estimating costs of $20,000 to $25,000). 
These comment letters were submitted in connection with the Hedge 
Fund Adviser Registration Release, supra note 14, and are available 
on the Commission's Internet Web site at http://www.sec.gov/rules/proposed/s73004.shtml.
    \602\ See, e.g., Comment Letter of Atlas Holdings (Jan. 21, 
2011) (``Atlas Letter'') (estimating $500,000 in 2011 and $350,000 
per year thereafter for compliance manuals and oversight, employee 
trading records, legal documentation, and the hiring of additional 
compliance employees); Comment Letter of Sentinel Capital Partners 
(Jan. 16, 2011) (``Sentinel Letter'') (estimating between $500,000-
$600,000 in 2011 and more than $375,000 per year thereafter for 
compliance manuals and oversight, employee trading records, legal 
documentation, and the hiring of additional compliance employees); 
Comment Letter of Charlesbank Capital Partners (Jan. 21, 2011) 
(``Charlesbank Letter'') (``[A]lthough impossible to quantify at 
this point given the absence of regulations, we anticipate a 
substantial cost associated with ongoing compliance.''); Comment 
Letter of Crestview Advisors, LLC (Jan. 19, 2011) (``Crestview 
Letter'') (estimating annual costs of $300,000-$500,000); Comment 
Letter of Azalea Capital (Feb. 17, 2011) (``Azalea Letter'') 
(estimating $50,000 to $100,000 per year); Comment Letter of Gen Cap 
America, Inc. (Jan. 21, 2011) (``Gen Cap Letter'') (estimating 
$150,000-$250,000 per year). See also Memorandum to File No. S7-37-
10, dated March 17, 2011, concerning a meeting with certain private 
fund representatives, avail. at http://www.sec.gov/comments/s7-37-10/s73710-124.pdf (``File Memorandum'') (estimating that costs for 
small firms range from $100,000-$200,000 (exclusive of salary costs 
for a CCO)).
    \603\ See VIA Letter (estimating an initial cost of $75,000 or 
more and ongoing costs of $50,000 to $150,000 per year); Pine Brook 
Letter (estimating initial costs of $125,000 to $200,000 and ongoing 
compliance costs of $100,000-150,000 per year).
---------------------------------------------------------------------------

    Although some advisers may incur these costs, the costs of 
compliance for a new registrant can vary widely among advisers 
depending on their size, activities, and the sophistication of their 
existing compliance infrastructure. Advisers, whether registered with 
us or not, may have established compliance infrastructures to fulfill 
their fiduciary duties towards their clients under the Advisers Act. 
Generally, costs will likely be less for new registrants that have 
already established sound compliance practices and more for new 
registrants that have not yet established sound practices.
    For example, some commenters specifically included in their cost 
estimates compensation costs for hiring a dedicated chief compliance 
officer (``CCO'').\604\ Our compliance rule, however, does not require 
advisers to hire a new individual to serve as a full-time CCO, and the 
question of whether an adviser can look to existing staff to fulfill 
the CCO requirement internally is firm-specific.\605\
---------------------------------------------------------------------------

    \604\ See, e.g., Katten Foreign Insurance Letter (``In addition, 
there are added salary costs for hiring a chief compliance officer. 
In all, costs could be expected to total hundreds of thousands of 
dollars and hundreds of hours of personnel time for each new 
registrant.''); Comment Letter of Cortec Group (Jan. 14, 2011) 
(``Cortec Letter'') (``Furthermore, the Act requires we add a 
compliance officer (who has to be a senior-level executive), at a 
minimum annual compensation of $200,000, yet we do not engage in any 
activity the Act wishes to monitor.''). Other commenters may have 
included such costs in their estimates although they did not provide 
details on individual components. See, e.g., Crestview Letter (``As 
part of these new regulations, we are required to develop a 
compliance program; hire a compliance officer; custody our private 
company stock certificates, which are worthless to any party not 
part of the original purchase agreement; and register with the 
SEC.'')
    \605\ See Advisers Act rule 206(4)-(7) (requiring, among other 
things, an adviser registered or required to be registered under the 
Advisers Act to designate an individual (who is a supervised person) 
responsible for administering the policies and procedures). In 
determining whether existing staff can fulfill the CCO requirement, 
advisers may consider factors such as the size of the firm, the 
complexity of its compliance environment, and the qualifications of 
current staff.

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[[Page 39689]]

    Although we recognize that some newly registering advisers will 
need to designate someone to serve as CCO on a full-time basis, we 
expect these will be larger advisers--those with many employees and a 
sizeable amount of investor assets under management. Because there is 
no currently-available comprehensive database of unregistered advisers, 
we cannot determine the number of these larger advisers in operation. 
These larger advisers that are not yet registered likely already have 
personnel who perform similar functions to a CCO, in order to address 
the adviser's liability exposure and protect its reputation.
    In smaller advisers, the designated CCO will likely also fill 
another function in the adviser, and perform additional duties 
alongside compliance matters. Advisers designating a CCO from existing 
staff may experience costs that result from shifting responsibilities 
among staff or additional compensation, to the extent the individual is 
taking on additional compliance responsibilities or giving up other 
non-compliance responsibilities. Costs will vary from adviser to 
adviser, depending on the extent to which an adviser's staff is already 
performing some or all of the requisite compliance functions, the 
extent to which the CCO's non-compliance responsibilities need to be 
lessened to permit allocation of more time to compliance 
responsibilities, and the value to the adviser of the CCO's non-
compliance responsibilities.\606\
---------------------------------------------------------------------------

    \606\ Although some commenters noted that requiring existing 
employees to assume compliance-related responsibilities would 
involve costs, they did not provide sufficient information on which 
we could estimate these costs.
---------------------------------------------------------------------------

    Some commenters asserted that the costs of ongoing compliance would 
be substantial.\607\ We anticipate that there may be a number of 
currently unregistered advisers whose operations are already 
substantially in compliance with the Advisers Act and that would 
therefore experience only minimal incremental ongoing costs as a result 
of registration. There likely are other currently unregistered 
advisers, however, who will face additional ongoing costs to conduct 
their operations in compliance with the Advisers Act, and these costs 
may be significant for some of these advisers.
---------------------------------------------------------------------------

    \607\ See supra note 602.
---------------------------------------------------------------------------

    We do not have access to information that would enable us to 
determine these additional ongoing costs, which are predominantly 
internal to the advisers themselves. Incremental ongoing compliance 
costs will vary from adviser to adviser depending on factors such as 
the complexity of each adviser's activities, the business decisions it 
makes in structuring its response to its compliance obligations, and 
the extent to which it is already conducting its operations in 
compliance with the Advisers Act. Indeed, the broad range of estimated 
costs we received reflects the individualized nature of these costs and 
the extent to which they may vary even among the relatively small 
number of commenters who provided cost estimates.\608\
---------------------------------------------------------------------------

    \608\ Compare Azalea Letter (estimated ongoing compliance costs 
of $50,000 to $100,000 per year) with Crestview Letter (estimated 
ongoing compliance costs of $300,000 to $500,000 per year). See also 
Charlesbank Letter (stating that costs associated with ongoing 
compliance are impossible to quantify at this point).
---------------------------------------------------------------------------

    Some commenters expressed concern that compliance costs would be 
prohibitive in comparison to their revenues or in relation to their 
size or activities.\609\ We note, however, that an adviser is required 
to adopt policies and procedures that take into consideration the 
nature of that adviser's operations.\610\ We have explained that, 
accordingly, we would expect smaller advisers without conflicting 
business interests to require much simpler policies and procedures than 
larger advisers that, for example, have multiple potential conflicts as 
a result of their other lines of business or their affiliations with 
other financial service firms.\611\ The preparation of these simpler 
policies and procedures and their administration should be much less 
burdensome.\612\
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    \609\ See, e.g., Crestview Letter (``The cost of complying with 
these new regulations is estimated to be $300,000-$500,000 per year, 
which is a significant sum for a firm that invests in two to three 
private companies each year in relation to the benefit it 
provides.''); Azalea Letter (``The cost of complying with these new 
regulations is estimated to be $50,000 to $100,000 per year, which 
is a significant sum for a firm that invests in two to three private 
companies each year.''); Gen Cap Letter (``The cost of complying 
with these new regulations is estimated to be $150,000-$250,000 per 
year, which is a significant sum for a firm that invests in two to 
three private companies each year in relation to the benefit it 
provides.'').
    \610\ See Compliance Programs of Investment Companies and 
Investment Advisers, Investment Advisers Act Release No. 2204 (Dec. 
17, 2003) [68 FR 74714 (Dec. 24, 2003)], discussion at section 
II.A.1.
    \611\ Id. See also id. at n.13 (noting that even small advisers 
may have arrangements, such as soft dollar agreements, that create 
conflicts; advisers of all sizes, in designing and updating their 
compliance programs, must identify these arrangements and provide 
for the effective control of the resulting conflicts).
    \612\ Id., discussion at section II.A.1.
---------------------------------------------------------------------------

    We also note that approximately 570 smaller advisers currently are 
registered with us.\613\ These advisers have absorbed the compliance 
costs associated with registration, notwithstanding the fact that their 
assets under management are likely to be smaller than those of an 
adviser managing one venture capital fund of average size (e.g., with 
$107.8 million in venture capital under management \614\) that may be 
required to register because it cannot rely on the venture capital 
exemption or the private fund adviser exemption. Moreover, as we 
explained in the Proposing Release, in connection with previous 
estimates we have made regarding compliance costs for registered 
advisers, we received comments from small advisers estimating that 
their annual compliance costs would be $25,000 and could be as high as 
$50,000.\615\ Finally, as we noted in the Proposing Release, to the 
extent there would be an increase in registered advisers, there are 
benefits to registration for both investors and the Commission.\616\
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    \613\ See Implementing Adopting Release, supra note 32, at n.823 
and accompanying text (noting that, based on data from the 
Investment Adviser Registration Depository as of April 7, 2011, 572 
advisers registered with the Commission were small advisers).
    \614\ See NVCA Yearbook 2011, supra note 152, at 9, Fig. 1.0.
    \615\ See Proposing Release, supra note 26, at n.303. See also 
supra note 601.
    \616\ See supra text following note 575.
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    We do not believe that the definition of venture capital fund is 
likely to affect whether advisers to venture capital funds would choose 
to launch new funds or whether persons would choose to enter into the 
business of advising venture capital funds because, as noted above, we 
believe the definition, as revised, reflects the way most venture 
capital funds currently operate. Thus, for example, we eliminated the 
managerial assistance criterion in the proposed definition, expanded 
the short-term instruments in which venture capital funds can invest 
and provided for a non-qualifying basket. These elements in the 
proposal could have resulted in costs to advisers that manage venture 
capital funds with business or cash management practices inconsistent 
with those proposed criteria and that sought to rely on the 
exemption.\617\ As a result, we expect that the definition is not 
likely to significantly affect the way in which investment advisers to 
these funds do

[[Page 39690]]

business and thus compete. For the same reason, we do not believe that 
our rule is likely to have a significant effect on overall capital 
formation.
---------------------------------------------------------------------------

    \617\ See supra notes 548, 586 and accompanying text.
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    Other Costs. Some commenters argued in favor of a narrow definition 
of venture capital fund in order to preclude advisers to other types of 
funds from relying on the definition.\618\ One commenter expressed the 
concern that the definition should be narrow so that advisers generally 
would be subject to a consistent regulatory regime,\619\ and another 
supported incorporating substantive Advisers Act rules, such as 
custody, as a condition for reliance on the various exemptions in order 
to protect investors.\620\ To the extent that our final rule includes 
broader criteria and results in fewer registrants under the Advisers 
Act, we acknowledge that this could have an adverse impact on 
investors.\621\
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    \618\ See supra note 43.
    \619\ CalPERS Letter. See also NASAA Letter (supported adding 
substantive requirements to the grandfathering provision).
    \620\ CPIC Letter.
    \621\ See supra text accompanying and following note 575 
(discussing benefits that result from registration).
---------------------------------------------------------------------------

    Moreover, to the extent that our final rule includes broader 
criteria and results in fewer registrants, this also could reduce the 
amount of information available to regulators with respect to venture 
capital advisers relying on the exemption. Under the final rule, 
immediately after it acquires any non-qualifying investment (excluding 
short-term holdings), no more than 20 percent of a qualifying fund's 
capital commitments may be held in non-qualifying investments 
(excluding short-term holdings). As a result, initially, and possibly 
for a period of time during the fund's term (subject to compliance with 
the other elements of the rule), it may be possible for non-qualifying 
investments to comprise most of a qualifying fund's investment 
portfolio. The proposal would have required a qualifying fund to be 
comprised entirely of qualifying investments, which would have enabled 
regulators and investors to confirm with relative ease at any point in 
time whether a fund satisfied the definition. Modifying the definition 
to include a non-qualifying basket determined as a percentage of a 
qualifying fund's capital commitments may increase the monitoring costs 
that regulators and investors may incur in order to verify that a fund 
satisfies the definition, depending on the length of the fund's 
investment period and the frequency with which the fund invests in non-
qualifying investments.
    A number of commenters expressed concerns with certain elements of 
the proposed rule, which we are not modifying. Several commenters 
suggested that the rule specify that the leverage limit of 15 percent 
be calculated without regard to uncalled capital commitments because 
they were concerned about the potential for excessive leverage.\622\ We 
acknowledge that a leverage limitation which includes uncalled capital 
commitments could result in a fund incurring, in the early stages of 
the fund's life, a significant degree of leverage by the fund relative 
to the fund's overall assets. We believe, however, that the 120-day 
limit would mitigate the effects of any such leverage that is incurred 
by a venture capital fund seeking to satisfy the definition.
---------------------------------------------------------------------------

    \622\ AFR Letter; AFL-CIO Letter.
---------------------------------------------------------------------------

    Several commenters also argued that the definition of qualifying 
portfolio company should include certain subsidiaries that may be owned 
by a publicly traded company, such as research and development 
subsidiaries, that may seek venture capital funding.\623\ As a result 
of our final rule, these types of subsidiaries may have reduced access 
to capital investments by qualifying funds, although this cost would be 
mitigated by a qualifying fund's investments made through the non-
qualifying basket.
---------------------------------------------------------------------------

    \623\ BCLBE Letter; Dechert General Letter; Gunderson Dettmer 
Letter.
---------------------------------------------------------------------------

    Other commenters argued that the definition of venture capital fund 
should include funds of venture capital funds.\624\ We have not 
modified the rule to reflect this request, because we do not believe 
that defining the term in this manner is consistent with the intent of 
Congress.\625\ To the extent that an adviser to a fund of venture 
capital funds ceases business or ceases to offer new funds in order to 
avoid registration with the Commission, this could reduce the pool of 
potential investors investing in venture capital funds,\626\ and 
potentially reduce capital formation for potential qualifying portfolio 
companies.
---------------------------------------------------------------------------

    \624\ See, e.g., Cook Children's Letter; Merkl Letter; SVB 
Letter.
    \625\ See supra notes 204-206.
    \626\ See generally Merkl Letter; SVB Letter.
---------------------------------------------------------------------------

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

    As discussed in Section II.B, rule 203(m)-1 exempts from 
registration under the Advisers Act any investment adviser solely to 
private funds that has less than $150 million in assets under 
management in the United States. The rule implements the private fund 
adviser exemption, as directed by Congress, in section 203(m) of the 
Advisers Act and includes provisions for determining the amount of an 
adviser's private fund assets for purposes of the exemption and when 
those assets are deemed managed in the United States.\627\
---------------------------------------------------------------------------

    \627\ See supra Sections II.B.2-3.
---------------------------------------------------------------------------

1. Benefits
    Method of Calculating Private Fund Assets. As discussed in Section 
II.B.2 above and in the Implementing Adopting Release, we are revising 
the instructions to Form ADV to provide a uniform method for 
calculating assets under management that can be used for regulatory 
purposes, including determining eligibility for Commission, rather than 
state, registration; reporting assets under management for regulatory 
purposes on Form ADV; and determining eligibility for the private fund 
adviser exemption under section 203(m) of the Advisers Act and rule 
203(m)-1 thereunder and the foreign private adviser exemption under 
section 203(b)(3) of the Advisers Act.\628\ We believe that this 
uniform approach will benefit regulators (both state and Federal) as 
well as advisers, because only a single determination of assets under 
management is required for purposes of registration and exemption from 
Federal registration.
---------------------------------------------------------------------------

    \628\ See supra notes 332-336 and accompanying text.
---------------------------------------------------------------------------

    The instructions to Form ADV previously permitted, but did not 
require, advisers to exclude certain types of managed assets.\629\ As a 
result, it was not possible to conclude that two advisers reporting the 
same amount of assets under management were necessarily comparable 
because either adviser could have elected to exclude all or some 
portion of certain specified assets that it managed. We expect that 
specifying in rule 203(m)-1 that assets under management must be 
calculated according to the instructions to Form ADV will increase 
administrative efficiencies for advisers because they will have to 
calculate assets under management only once for multiple purposes.\630\ 
In addition, we believe this

[[Page 39691]]

will minimize costs relating to software modifications, recordkeeping, 
and training required to determine assets under management for 
regulatory purposes. We also believe that the consistent calculation 
and reporting of assets under management will benefit investors and 
regulators because it will provide enhanced transparency and 
comparability of data, and allow investors and regulators to analyze on 
a more cost effective basis whether any particular adviser may be 
required to register with the Commission or is eligible for an 
exemption.
---------------------------------------------------------------------------

    \629\ See Form ADV: Instructions to Part 1A, instr. 5.b(1), as 
in effect before the amendments adopted in the Implementing Adopting 
Release, supra note 32.
    \630\ See supra Section II.B.2. As discussed below, we are 
permitting advisers to calculate their private fund assets annually 
in connection with their annual updating amendments to their Forms 
ADV, rather than quarterly as proposed. Requiring annual, rather 
than quarterly, calculations will be less costly for advisers.
---------------------------------------------------------------------------

    Many commenters generally expressed support for the implementation 
of a uniform method of calculating assets under management in order to 
maintain consistency for registration and risk assessment 
purposes.\631\ Indeed, even some commenters who suggested that we 
revise aspects of the method of calculating regulatory assets under 
management nonetheless recognized the benefits provided by a uniform 
method of valuing assets for regulatory purposes.\632\
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    \631\ See supra note 339.
    \632\ See, e.g., AIMA Letter (suggested modifications to the 
method of calculating regulatory assets under management but also 
stated ``[w]e agree that a clear and unified approach for 
calculation of AUM is necessary and we believe that using as a 
standard the assets for which an adviser has `responsibility' is 
appropriate''); O'Melveny Letter (argued that the calculation of 
regulatory assets under management as proposed ``does not provide a 
suitable basis to determine whether a fund adviser should be subject 
to the SEC's regulation'' but also ``agree[s] with the SEC that 
`uniformity in the method for calculating assets under management 
would result in more consistent asset calculations and reporting 
across the industry and, therefore, in more coherent application of 
the Advisers Act's regulatory requirements and of the SEC staff's 
risk assessment program''').
---------------------------------------------------------------------------

    We believe that the valuation of private fund assets under rule 
203(m)-1 will benefit advisers that seek to rely on the private fund 
adviser exemption. Under rule 203(m)-1, each adviser annually must 
determine the amount of its private fund assets, based on the market 
value of those assets, or the fair value of those assets where market 
value is unavailable.\633\ We are requiring advisers to fair value 
private fund assets so that, for purposes of the exemption, advisers 
value private fund assets on a meaningful and consistent basis. As we 
stated in the Proposing Release, we understand that many, but not all, 
advisers to private funds value assets based on their fair value in 
accordance with GAAP or other international accounting standards that 
require the use of fair value.\634\ We acknowledged in the Proposing 
Release that some advisers to private funds may not use fair value 
methodologies, which may be more difficult to apply when the fund holds 
illiquid or other types of assets that are not traded on organized 
markets.\635\
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    \633\ See rule 203(m)-1(c) (requiring an adviser to calculate 
private fund assets annually, in accordance with General Instruction 
15 to Form ADV, which together with rule 204-4 requires advisers 
relying on the exemption to determine their private fund assets 
annually, in connection with the adviser's annual updating 
amendments to its Form ADV). See also rules 203(m)-1(a)(2); 203(m)-
1(b)(2); 203(m)-1(d)(1) (defining ``assets under management'' to 
mean ``regulatory assets under management'' in item 5.F of Form ADV, 
Part 1A); 203(m)-1(d)(4) (defining ``private fund assets'' to mean 
the ``assets under management'' attributable to a ``qualifying 
private fund''). As discussed above, advisers are not required to 
fair value real estate assets in certain limited circumstances. See 
supra note 366 and accompanying text.
    \634\ See Proposing Release, supra note 26, discussion at 
section V.B and n.196. See also ABA Letter (recommending that the 
Commission consider using a standard of ``fair value'' for valuing 
assets and further recommending that if assets were calculated on a 
net basis, private funds should be required to prepare audited 
annual financial statements in accordance with GAAP (or another 
accounting standard acceptable to the Commission), and to maintain 
such financial statements under section 203(m)(2)); O'Melveny Letter 
(agreeing with the statement in the Proposing Release that many 
private funds value assets based on fair value, and noting that 
private equity funds in particular are among the private funds that 
generally do not fair value).
    \635\ See Proposing Release, supra note 26, discussion at 
section V.B. See also infra Section V.B.2.
---------------------------------------------------------------------------

    Frequency of Calculations and the Transition Period. Rule 203(m)-
1(c) specifies that an adviser relying on the exemption must calculate 
its private fund assets annually, in accordance with General 
Instruction 15 to Form ADV, rather than quarterly, as proposed. 
Advisers registered with us and with the states, and now advisers 
relying on rule 203(m)-1, must calculate their assets under management 
for regulatory purposes annually in connection with their annual 
updating amendments to Form ADV. We expect that requiring these types 
of advisers to calculate their assets under management for regulatory 
purposes on the same schedule, and using the same method, will increase 
efficiencies for these advisers.
    The annual calculation also will allow advisers that rely on the 
exemption to maintain the exemption despite short-term market value 
fluctuations that might result in the loss of the exemption if, for 
example, the rule required daily valuations or, to a less significant 
extent, quarterly valuations as proposed.\636\ Annual calculations 
should benefit these advisers by allowing them to avoid the cost of 
more frequent valuations, including costs (such as third-party quotes) 
associated with valuing illiquid assets, which may be particularly 
difficult to value because of the lack of frequency with which such 
assets are traded.\637\ Requiring annual, rather than quarterly, 
calculations thus responds to concerns expressed by commenters who 
argued that quarterly calculations would (i) impose unnecessary costs 
and burdens on advisers, some of whom might not otherwise perform 
quarterly valuations; and (ii) inappropriately permit shorter-term 
fluctuations in assets under management to require advisers to 
register.\638\
---------------------------------------------------------------------------

    \636\ See, e.g., ABA Letter (``[A] semi-annual or annual 
measuring period would perhaps be more appropriate, and [] a longer 
measuring period would provide an adviser that is exempt from 
registration under the Private Fund Adviser Exemption assistance in 
avoiding issues arising from temporary increases in asset 
values.''); AIMA Letter (``Asset valuation is a substantial 
administrative task and is currently undertaken annually for other 
purposes (for example, Form ADV), so that a requirement for annual 
valuation would appear to strike a fair balance between ensuring 
that firms whose AUM is at or above the applicable threshold are 
`captured' and avoiding both complications with short-term market 
value fluctuations and over-burdening investment advisers.'').
    \637\ See, e.g., Dechert Foreign Adviser Letter (``[T]he Foreign 
Asset Manager submits that a yearly calculation (rather than a 
quarterly calculation) would be more appropriate, as some private 
funds may not provide for quarterly calculations of their NAV.''); 
Katten Foreign Advisers Letter (argued for annual calculations, 
noting that ``[m]any advisers only determine their aggregate assets 
under management on an annual basis''); NASBIC/SBIA Letter (``Unless 
sought by the adviser, evaluations on whether to register should be 
made no more often than an annual basis.''); Seward Letter (``We 
believe that annual measurement of assets for purposes of 
determining an adviser's ability to rely on the private fund adviser 
exemption would be consistent with the approach established under 
NSMIA.'').
    \638\ See AIMA Letter; Dechert Foreign Adviser Letter; Dechert 
General Letter; EFAMA Letter; Katten Foreign Advisers Letter; Merkl 
Letter; Seward Letter.
---------------------------------------------------------------------------

    An adviser relying on the exemption that reports private fund 
assets of $150 million or more in its annual updating amendment to its 
Form ADV will not be eligible for the exemption and must register under 
the Advisers Act unless it qualifies for another exemption. If the 
adviser has complied with all Commission reporting requirements 
applicable to an exempt reporting adviser as such, however, it may 
apply for registration under the Advisers Act up to 90 days after 
filing the annual updating amendment, and may continue to act as a 
private fund adviser, consistent with the requirements of rule 203(m)-
1, during this transition period.\639\
---------------------------------------------------------------------------

    \639\ See supra Section II.B.2.b; rule 203(m)-1(c) (requiring 
advisers to calculate their private fund assets annually, in 
accordance with General Instruction 15 to Form ADV); General 
Instruction 15 to Form ADV; rule 204-4.

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[[Page 39692]]

    The transition period should benefit certain advisers. As discussed 
above, an adviser that has ``complied with all [Commission] reporting 
requirements applicable to an exempt reporting adviser as such'' may 
apply for registration with the Commission up to 90 days after filing 
an annual updating amendment reflecting that the adviser has private 
fund assets of $150 million or more, and may continue to act as a 
private fund adviser, consistent with the requirements of rule 203(m)-
1, during this transition period.\640\ In addition, by requiring annual 
calculations of private fund assets, we are allowing advisers to whom 
the transition period is available 180 days after their fiscal year-
ends to register under the Advisers Act.\641\ We expect that providing 
these advisers additional time to register will reduce the burdens 
associated with registration by permitting them to register in a more 
deliberate and cost-effective manner, as suggested by some 
commenters.\642\
---------------------------------------------------------------------------

    \640\ See supra note 378 (explaining that the transition period 
is available to an adviser that has complied with ``all [Commission] 
reporting requirements applicable to an exempt reporting adviser as 
such,'' rather than ``all applicable Commission reporting 
requirements,'' as proposed).
    \641\ An adviser must file its annual Form ADV updating 
amendment within 90 days after the end of its fiscal year and, if 
the transition period is available, may apply for registration up to 
90 days after filing the amendment. We proposed, in contrast, to 
give advisers three months to register with us after becoming 
ineligible to rely on the exemption due to an increase in the value 
of their private fund assets as reflected in the proposed quarterly 
calculations.
    \642\ See, e.g., Sadis & Goldberg Implementing Release Letter 
(``Three (3) months provides an insufficient amount of time for an 
investment adviser to (i) complete its ADV Parts 1, 2A and 2B, 
including the newly required narrative brochure and brochure 
supplement; (ii) submit its completed application to the Commission 
through IARD; and (iii) receive its approval from the Commission, 
which may take up to forty-five (45) days.''); Shearman Letter 
(``Our experience is that registering an investment adviser firm in 
a thoughtful and deliberate manner is often closer to a six-month 
task (that can sometimes take even longer depending on the need to 
engage new or additional service providers to the firm or its 
funds), so that an at least 180-day transition period would be more 
appropriate.'').
---------------------------------------------------------------------------

    Assets under Management in the United States. Under rule 203(m)-
1(a), all of the private fund assets of an adviser with a principal 
office and place of business in the United States are considered to be 
``assets under management in the United States,'' even if the adviser 
has offices outside of the United States.\643\ A non-U.S. adviser must 
count only private fund assets it manages at a place of business in the 
United States toward the $150 million limit under the exemption.
---------------------------------------------------------------------------

    \643\ As discussed above, the rule looks to an adviser's 
principal office and place of business as the location where it 
directs, controls and coordinates its advisory activities. Rule 
203(m)-1(d)(3).
---------------------------------------------------------------------------

    As discussed below, we believe that this interpretation of ``assets 
under management in the United States'' offers greater flexibility to 
advisers and reduces many costs associated with compliance.\644\ These 
costs could include difficult attribution determinations that would be 
required if assets are managed by teams located in multiple 
jurisdictions or if portfolio managers located in one jurisdiction rely 
heavily on research or other advisory services performed by employees 
located in another jurisdiction. Most commenters who addressed the 
issue supported the proposal to treat ``assets under management in the 
United States'' as those assets managed at a U.S. place of 
business.\645\
---------------------------------------------------------------------------

    \644\ See, e.g., Merkl Letter (stated that this interpretation 
would be easier to apply than the alternative interpretation about 
which we sought comment which looks to the source of the assets).
    \645\ See, e.g., Debevoise Letter (``In particular, it is our 
view that the discussion of the proposed definition of the term 
`assets under management in the United States' is a fair reflection 
of the policy underlying Section 203(m) of the Advisers Act (as 
amended by the Dodd-Frank Act) and is consistent with prior 
Commission and Staff statements concerning the territorial scope of 
the Advisers Act.''); MAp Airports Letter; Non-U.S. Adviser Letter 
(``By adopting a very pragmatic and sensible jurisdictional approach 
to regulation, the Commission is appropriately recognizing general 
principles of international comity and the fact that activities of 
non-U.S. advisers outside the United States are less likely to 
implicate U.S. regulatory interests.''). Cf. Sen. Levin Letter 
(stated that advisers managing assets in the United States of funds 
incorporated outside of the United States ``are exactly the type of 
investment advisers to which the Dodd-Frank Act's registration 
requirements are intended to apply''). See also supra note 386.
---------------------------------------------------------------------------

    To the extent that this interpretation may increase the number of 
advisers subject to registration under the Advisers Act, we anticipate 
that our rule also will benefit investors by providing more information 
about those advisers (e.g., information that would become available 
through Form ADV, Part I). We further believe that this will enhance 
investor protection by increasing the number of advisers registering 
pursuant to the Advisers Act and by improving our ability to exercise 
our investor protection and enforcement mandates over those newly 
registered advisers. As discussed above, registration offers benefits 
to the investing public, including periodic examination of the adviser 
and compliance with rules requiring recordkeeping, custody of client 
funds and compliance programs.\646\
---------------------------------------------------------------------------

    \646\ See supra text preceding, accompanying, and following note 
575.
---------------------------------------------------------------------------

    Territorial Approach. Under rule 203(m)-1(b), a non-U.S. adviser 
with no U.S. place of business may avail itself of the exemption even 
if it advises non-U.S. clients that are not private funds, provided 
that it does not advise any U.S. clients other than private funds.\647\ 
We believe that this aspect of the rule, which looks primarily to the 
principal office and place of business of an adviser to determine 
eligibility for the exemption, will increase the number of non-U.S. 
advisers that may be eligible for the exemption. As with other 
Commission rules that adopt a territorial approach, the private fund 
adviser exemption is available to a non-U.S. adviser (regardless of its 
non-U.S. advisory or other business activities) in recognition that 
non-U.S. activities of non-U.S. advisers are less likely to implicate 
U.S. regulatory interests and in consideration of general principles of 
international comity. This aspect of the rule is designed to encourage 
the participation of non-U.S. advisers in the U.S. market by applying 
the U.S. securities laws in a manner that does not impose U.S. 
regulatory and operational requirements on a non-U.S. adviser's non-
U.S. advisory business.\648\
---------------------------------------------------------------------------

    \647\ By contrast, a U.S. adviser may ``solely advise private 
funds'' as specified in the statute. Compare rule 203(m)-1(a)(1) 
with rule 203(m)-1(b)(1).
    \648\ See supra note 393 and accompanying text.
---------------------------------------------------------------------------

    We believe that our interpretation of the availability of the 
private fund adviser exemption for non-U.S. advisers, as reflected in 
the rule, will benefit those advisers by facilitating their continued 
participation in the U.S. market with limited disruption to their non-
U.S. advisory or other business practices.\649\ This approach also 
should benefit U.S. investors and facilitate competition in the market 
for advisory services to the extent that it maintains or increases U.S. 
investors' access to potential advisers. Furthermore, because non-U.S. 
advisers that elect to avail themselves of the exemption would be 
subject to certain reporting requirements,\650\ we believe that our 
approach will increase the availability of information publicly 
available to U.S. investors who invest in the private funds advised by 
such exempt but reporting non-U.S. advisers.
---------------------------------------------------------------------------

    \649\ See supra Section II.B.3.
    \650\ See Implementing Adopting Release, supra note 32, 
discussion at section II.B.
---------------------------------------------------------------------------

    Most of the commenters who considered this aspect of the rule 
supported it, citing, among other benefits, that this interpretation 
would effectively protect U.S. markets and investors and is consistent 
with the Commission's overall territorial

[[Page 39693]]

approach to Advisers Act regulation.\651\ For example, one commenter 
stated that the ``jurisdictional approach to only considering U.S. 
activities for non-U.S. advisors is prudent as it focuses on what 
causes systematic [sic] risks to the U.S.'' \652\ Another noted that 
non-U.S. persons dealing with non-U.S. advisers would not expect to 
benefit from the protections provided by the Advisers Act.\653\ Another 
stated that this approach, together with our interpretation of ``assets 
under management in the United States,'' will ``avoid the issues 
associated with conflicting and overlapping regulation.'' \654\
---------------------------------------------------------------------------

    \651\ ABA Letter; Debevoise Letter; Dechert Foreign Adviser 
Letter; Gunderson Dettmer Letter; Katten Foreign Advisers Letter; 
MAp Airports Letter; Merkl Letter; Wellington Letter.
    \652\ Wellington Letter.
    \653\ Debevoise Letter. See also ABA Letter (``When, in the 
private fund context, United States investors invest with a non-
United States-based investment manager, they understand they are not 
being afforded the investor protection safeguards of the United 
States Investment Advisers Act.''); Avoca Letter (``It is reasonable 
to assume that U.S. investors who purchase shares of a private fund 
(as defined in section 202(a)(29)) will not expect an investment 
adviser that has no United States presence to be registered with the 
U.S. SEC as an investment adviser.'').
    \654\ ABA Letter.
---------------------------------------------------------------------------

    Rule 203(m)-1(b) uses the term ``United States person,'' which 
generally incorporates the definition of a ``U.S. person'' in 
Regulation S.\655\ We believe that generally incorporating the 
definition of a ``U.S. person'' in Regulation S will benefit advisers, 
because Regulation S provides a well-developed body of law that, in our 
view, appropriately addresses many of the questions that will arise 
under rule 203(m)-1. Moreover, advisers to private funds and their 
counsel currently must be familiar with the definition of ``U.S. 
person'' under Regulation S in order to comply with other provisions of 
the Federal securities laws. Commenters generally supported defining 
``United States person'' by reference to Regulation S, confirming that 
the definition is well developed and understood by advisers.\656\
---------------------------------------------------------------------------

    \655\ Rule 203(m)-1(d)(8) (defining a ``United States person'' 
as any person that is a ``U.S. person'' as defined in Regulation S, 
except that any discretionary account or similar account that is 
held for the benefit of a United States person by a dealer or other 
professional fiduciary is a United States person if the dealer or 
professional fiduciary is a related person of the investment adviser 
relying on rule 203(m)-1 and is not organized, incorporated, or (if 
an individual) resident in the United States). As discussed above, 
two commenters that generally supported our incorporation of the 
definition in Regulation S also urged us to modify our proposed 
definition in certain respects. See supra notes 409-413 and 
accompanying text. We decline to accept these suggestions for the 
reasons discussed in Section II.B.4, and we continue to believe that 
advisers will benefit from the efficiencies created by our general 
incorporation of the definition of ``U.S. person'' in Regulation S.
    \656\ AIMA Letter; CompliGlobe Letter; Debevoise Letter; Dechert 
General Letter; Gunderson Dettmer Letter; Katten Foreign Advisers 
Letter; O'Melveny Letter.
---------------------------------------------------------------------------

    We also are adding a note to rule 203(m)-1 that clarifies that a 
client will not be considered a United States person if the client was 
not a United States person at the time of becoming a client of the 
adviser.\657\ This will benefit non-U.S. advisers, which might, absent 
this note, incur costs in trying to determine whether they would be 
permitted to rely on rule 203(m)-1 if one of their existing non-U.S. 
clients that is not a private fund becomes a United States person, for 
example if a natural person client residing abroad relocates to the 
United States.\658\ The non-U.S. adviser could at that time be 
considered to have a United States person client other than a private 
fund.
---------------------------------------------------------------------------

    \657\ See supra Section II.B.4.
    \658\ See EFAMA Letter (argued that an analogous note in the 
foreign private adviser exemption, revised consistent with its 
comments, ``also should apply to the `private fund adviser 
exemption' and the `venture capital fund exemption' ''); IFIC Letter 
(``We ask for clarification from the SEC as to whether it will apply 
the [analogous note to the foreign private adviser exemption] in 
other contexts for purposes of compliance with the U.S. Federal 
securities laws, including compliance with Rule 12g3-2(b) of the 
1934 Act.'').
---------------------------------------------------------------------------

    Definition of a Qualifying Private Fund. We proposed to define a 
``qualifying private fund'' as ``any private fund that is not 
registered under section 8 of the Investment Company Act of 1940 (15 
U.S.C 80a-8) and has not elected to be treated as a business 
development company pursuant to section 54 of that Act (15 U.S.C. 80a-
53).'' \659\ We are modifying rule 203(m)-1 to also permit an adviser 
to treat as a ``private fund,'' and thus as a ``qualifying private 
fund,'' an issuer that qualifies for an exclusion from the definition 
of ``investment company,'' as defined in section 3 of the Investment 
Company Act, in addition to those provided by section 3(c)(1) or 
3(c)(7) of that Act.\660\ Absent this modification, an adviser to a 
section 3(c)(1) or 3(c)(7) fund would lose the exemption if the fund 
also qualified for another exclusion.\661\ For example, an adviser to a 
section 3(c)(1) or 3(c)(7) fund would lose the exemption if the fund 
also qualified for another exclusion, even though the adviser may be 
unaware of the fund so qualifying and the fund does not purport to rely 
on the other exclusion.
---------------------------------------------------------------------------

    \659\ See proposed rule 203(m)-1(e)(5).
    \660\ Rule 203(m)-1(d)(5). An adviser relying on this provision 
must treat the fund as a private fund under the Advisers Act and the 
rules thereunder for all purposes (e.g., reporting on Form ADV). Id.
    \661\ A fund that qualifies for an additional exclusion would 
not be a private fund, because a ``private fund'' is a fund that 
would be an investment company as defined in section 3 of the 
Investment Company Act but for section 3(c)(1) or 3(c)(7) of that 
Act. See supra Section II.B.1.
---------------------------------------------------------------------------

    Expanding the range of potential ``qualifying private funds,'' 
therefore, should benefit advisers to funds that also qualify for other 
exclusions by permitting these advisers to rely on the exemption.\662\ 
It also will prevent advisers from violating the Advisers Act's 
registration requirements solely because their funds qualify for 
another exclusion. In addition, advisers will not be required to incur 
the time and expense required to assess whether the funds they advise 
also qualify for an additional exclusion.
---------------------------------------------------------------------------

    \662\ See, e.g., Dechert General Letter (argued that advisers 
should be permitted to treat as a private fund for purposes of rule 
203(m)-1 a fund that qualifies for another exclusion from the 
definition of ``investment company'' in the Investment Company Act 
in addition to section 3(c)(1) or 3(c)(7), such as section 
3(c)(5)(C), which excludes certain real estate funds).
---------------------------------------------------------------------------

2. Costs
    Assets under Management in the United States. As noted above, under 
rule 203(m)-1, we look to an adviser's principal office and place of 
business as the location where the adviser directs, controls or has 
responsibility for the management of private fund assets, and therefore 
as the place where all the adviser's assets are managed.\663\ Thus, a 
U.S. adviser must include all of its private fund assets under 
management in determining whether it exceeds the $150 million limit 
under the exemption. We also look to where day-to-day management of 
private fund assets may occur for purposes of a non-U.S. adviser, whose 
principal office and place of business is outside of the United 
States.\664\ A non-U.S. adviser therefore would count only the private 
fund assets it manages at a place of business in the United States in 
determining the availability of the exemption. This approach is similar 
to the way we have identified the location of the adviser for 
regulatory purposes under our current rules,\665\ and we believe it is 
the way in which most advisers would have interpreted the exemption 
without our rule.\666\
---------------------------------------------------------------------------

    \663\ See supra note 385 and accompanying text.
    \664\ See supra note 384 and accompanying text.
    \665\ See supra note 385 and accompanying text.
    \666\ We do not believe that the statutory text refers to where 
the assets themselves may be located or traded or the location of 
the account where the assets are held. In today's market, using the 
location of assets would raise numerous questions of where a 
security with no physical existence is ``located.'' Although 
physical stock certificates were once sent to investors as proof of 
ownership, stock certificates are now centrally held by securities 
depositories, which perform electronic ``book-entry'' changes in 
their records to document ownership of securities. This arrangement 
reduces transmittal costs and increases efficiencies for securities 
settlements. See generally Bank for International Settlements, The 
Depository Trust Company: Response to the Disclosure Framework for 
Securities Settlement Systems (2002), http://www.bis.org/publ/cpss20r3.pdf. An account also has no physical location even if the 
prime broker, custodian or other service that holds assets on behalf 
of the customer does. Each of these approaches would be confusing 
and extremely difficult to apply on a consistent basis.

---------------------------------------------------------------------------

[[Page 39694]]

    We believe that our approach will promote efficiency because 
advisers are familiar with it, and we do not anticipate that U.S. 
advisers to private funds would likely change their business models, 
the location of their private funds or the location where they manage 
assets as a result of the rule. As noted in the Proposing Release, we 
expect that non-U.S. advisers may, however, incur minimal costs to 
determine whether they have assets under management in the United 
States. We estimate that these costs would be no greater than $6,730 
per adviser to hire U.S. counsel and perform an internal review to 
assist in this determination, in particular to assess whether a non-
U.S. affiliate manages a discretionary account for the benefit of a 
United States person under the rule.\667\
---------------------------------------------------------------------------

    \667\ We estimated in the Proposing Release that a non-U.S. 
adviser would need no more than 10 hours of external legal advice 
(at $400 per hour) and 10 hours of internal review by a senior 
compliance officer (at $294 per hour) to evaluate whether the 
adviser would qualify for the exemption provided by rule 203(m)-1, 
for a total estimated cost of $6,940. We did not receive any 
comments on these estimates. We are, however, decreasing this 
estimate slightly, to $6,730, to account for more recent salary data 
reflecting a $273 per hour wage for senior compliance officers. See 
supra note 597. One commenter suggested that we presume for non-U.S. 
advisers, like U.S. advisers, that all of their private fund assets 
are managed at their principal office and place of business. Katten 
Foreign Advisers Letter. We decline to adopt this suggestion for the 
reasons discussed above. See supra notes 388-389 and accompanying 
text. In addition, the commenter did not convince us that the costs 
we estimate a non-U.S. adviser would incur in determining if it has 
assets under management in the United States justify foregoing our 
approach and its attendant benefits. To the extent the commenter 
suggests that we adopt an alternative interpretation to conserve our 
resources, we note that any interpretation that requires additional 
advisers to register will contribute to our workload, and 
registration provides benefits of its own, as discussed above.
---------------------------------------------------------------------------

    As noted above, because the rule is designed to encourage the 
participation of non-U.S. advisers in the U.S. market, we believe that 
it will have minimal regulatory and operational burdens on non-U.S. 
advisers and their U.S. clients. Non-U.S. advisers may rely on the rule 
if they manage U.S. private funds with more than $150 million in assets 
at a non-U.S. location as long as the private fund assets managed at a 
U.S. place of business are less than $150 million. This could affect 
competition with U.S. advisers, which must register when they have $150 
million in private fund assets under management regardless of where the 
assets are managed.
    In contrast to the many commenters who supported our approach, one 
commenter argued that treating U.S. and non-U.S. advisers differently 
would disadvantage U.S.-based advisers by permitting non-U.S. advisers 
to accept substantial amounts of money from U.S. investors without 
having to comply with certain U.S. regulatory requirements, and would 
cause advisers to move offshore or close U.S. offices to avoid 
regulation.\668\
---------------------------------------------------------------------------

    \668\ Portfolio Manager Letter. See also Tuttle Implementing 
Release Letter (argued that businesses may move offshore if they 
become too highly regulated in the United States).
---------------------------------------------------------------------------

    As we explained in the Proposing Release, we believe that our 
interpretation recognizes that non-U.S. activities of non-U.S. advisers 
are less likely to implicate U.S. regulatory interests and is in 
keeping with general principles of international comity.\669\ The rule 
also is designed to encourage the participation of non-U.S. advisers in 
the U.S. market by applying the U.S. securities laws in a manner that 
does not impose U.S. regulatory and operational requirements on a non-
U.S. adviser's non-U.S. advisory business.\670\ Non-U.S. advisers 
relying on rule 203(m)-1 will remain subject to the Advisers Act's 
antifraud provisions and will become subject to the requirements 
applicable to exempt reporting advisers. Moreover, the commenter 
appears to suggest that an adviser that moves offshore to avoid 
registering under the Advisers Act would not be subject to any 
regulation as an investment adviser, but we understand that most non-
U.S. advisers to private funds locate in major financial centers in 
jurisdictions that regulate investment advisers. We therefore believe 
that any competitive consequences to U.S. advisers will be 
diminished.\671\
---------------------------------------------------------------------------

    \669\ See supra note 392 and accompanying text.
    \670\ See supra note 393 and accompanying text.
    \671\ See also supra Section II.B.3. We also decline to accept a 
separate commenter's suggestion to permit U.S. advisers to exclude 
assets managed at non-U.S. offices. See supra notes 395-396 and 
accompanying and following text.
---------------------------------------------------------------------------

    As we acknowledged in the Proposing Release, to avail themselves of 
rule 203(m)-1, some advisers might choose to move their principal 
offices and places of business outside of the United States and manage 
private funds at those locations.\672\ This could result in costs to 
U.S. investors in private funds that are managed by these advisers 
because they would not have the investor protection and other benefits 
that result from an adviser's registration under the Advisers Act. We 
do not expect that many advisers would be likely to relocate for 
purposes of avoiding registration, however, because, as we explained in 
the Proposing Release, we understand that the primary reasons for 
advisers to locate in a particular jurisdiction involve tax and other 
business considerations.\673\
---------------------------------------------------------------------------

    \672\ See Proposing Release, supra note 26, discussion at 
section V.B.2.
    \673\ We note that the two commenters that suggested U.S. 
advisers might relocate to rely on the rule provided no data as to 
the likelihood that this would occur or the number or types of 
advisers who might relocate, and neither refuted our contention that 
the primary reasons for advisers to locate in a particular 
jurisdiction involve tax and other business considerations. See 
Portfolio Manager Letter; Tuttle Implementing Release Letter.
---------------------------------------------------------------------------

    We also note that if an adviser did relocate, it would incur the 
costs of regulation under the laws of most of the foreign jurisdictions 
in which it may be likely to relocate, as well as the costs of 
complying with the reporting requirements applicable to exempt 
reporting advisers, unless it also qualified for the foreign private 
adviser exemption. We do not believe, in any case, that the adviser 
would relocate if relocation would result in a material decrease in the 
amount of assets managed because that loss would likely not justify the 
benefits of avoiding registration, and thus we do not believe our rule 
is likely to have an adverse effect on capital formation.
    One commenter also proposed that we adopt an alternative approach 
that would look to the source of the assets.\674\ Under this 
alternative approach, a non-U.S. adviser would count the assets of 
private funds attributable to U.S. investors towards the $150 million 
threshold, regardless of the location where it manages private funds, 
and a U.S. adviser would exclude

[[Page 39695]]

assets that are not attributable to U.S. investors. As a result, more 
U.S. advisers might be able to rely on rule 203(m)-1 under this 
alternative interpretation. To the extent that non-U.S. advisers have 
U.S. investors in private funds that they manage at a non-U.S. 
location, fewer non-U.S. advisers would be eligible for the exemption. 
Thus, this alternative could increase costs for those non-U.S. advisers 
that would have to register but reduce costs for those U.S. advisers 
that would not have to register.
---------------------------------------------------------------------------

    \674\ Portfolio Manager Letter (``If you raise significant money 
here you should be on the same level playing field as the fund 
managers located here so that we can compete fairly.''). See also 
Merkl Letter (suggested that it ``may be useful'' to look both to 
assets managed from a U.S. place of business and assets contributed 
by U.S. private fund investors to address both investor protection 
and systemic risk concerns). Another commenter suggested that we 
determine the ``assets under management in the United States'' for 
U.S. advisers by reference to the amount of assets invested, or ``in 
play,'' in the United States. Dougherty Letter. We decline to adopt 
this approach because it would be difficult for advisers to 
ascertain and monitor which assets are invested in the United 
States, and this approach thus would be confusing and extremely 
difficult to apply on a consistent basis. See supra note 394 and 
accompanying and following text.
---------------------------------------------------------------------------

    This alternative approach also could adversely affect U.S. 
investors to the extent that it discouraged U.S. advisers from managing 
U.S. investor assets. A U.S. adviser might avoid managing assets from 
U.S. investors because, under this alternative interpretation, the 
assets would be included in determining whether the adviser was 
eligible to rely on rule 203(m)-1. This could reduce competition for 
the management of assets from U.S. investors. The likelihood of U.S. 
advisers seeking to avoid registration in this way might be mitigated, 
however, to the extent that the loss of managed assets of U.S. 
investors would exceed the savings from avoiding registration.
    Method of Calculating Private Fund Assets. Rule 203(m)-1 
incorporates the valuation methodology in the instructions to Form ADV, 
which requires advisers to use the market value of private fund assets, 
or the fair value of private fund assets where market value is 
unavailable, when determining regulatory assets under management and to 
include in the calculation certain types of assets advisers previously 
were permitted to exclude. The revised instructions also clarify that 
this calculation must be done on a gross basis.
    We acknowledged in the Proposing Release that some private fund 
advisers may not use fair value methodologies.\675\ As we explained 
there, the costs incurred by those advisers to use fair valuation 
methodologies would vary based on factors such as the nature of the 
asset, the number of positions that do not have a market value, and 
whether the adviser has the ability to value such assets internally or 
would rely on a third party for valuation services.\676\ Nevertheless, 
we continue to believe that the requirement to use fair value would not 
result in significant costs for these advisers, particularly in light 
of our decision to require annual, rather than quarterly, valuations. 
We also understand that private fund advisers, including those that may 
not use fair value methodologies for reporting purposes, perform 
administrative services, including valuing assets, internally as a 
matter of business practice.\677\
---------------------------------------------------------------------------

    \675\ See supra note 634 and accompanying and following text. In 
addition, we estimate in the Implementing Adopting Release, based on 
registered advisers' responses to Items 5.D, 7.B, and 9.C of Form 
ADV, that approximately 3% of registered advisers have at least one 
private fund client that is not audited, and that these advisers 
therefore may incur costs to fair value their private fund assets. 
See Implementing Adopting Release, supra note 32, at nn.634-641 and 
accompanying text. We also estimate in that release that each of 
these registered advisers that potentially would incur costs as a 
result of the fair value requirement would incur costs of $37,625 on 
an annual basis. Id., at n.641 and accompanying text. This is the 
middle of the range of the estimated fair value costs, which range 
from $250 to $75,000 annually. Id. See also infra notes 680-681 and 
accompanying text.
    \676\ See Proposing Release, supra note 26, at n.323 and 
accompanying text.
    \677\ For example, a hedge fund adviser may value fund assets 
for purposes of allowing new investments in the fund or redemptions 
by existing investors, which may be permitted on a regular basis 
after an initial lock-up period. An adviser to private equity funds 
may obtain valuations of portfolio companies in which the fund 
invests in connection with financing obtained by those companies. 
Advisers to private funds also may value portfolio companies each 
time the fund makes (or considers making) a follow-on investment in 
the company. Private fund advisers could use these valuations as a 
basis for complying with the fair valuation requirement applicable 
to private fund assets.
---------------------------------------------------------------------------

    A number of commenters objected to the requirement to determine 
private fund assets based on fair value, generally arguing that the 
requirement would cause those advisers that did not use fair value 
methods to incur additional costs, especially if the private funds' 
assets that they manage are illiquid and therefore difficult to fair 
value.\678\ As discussed in Section II.B.2, we are sensitive to the 
costs this new requirement will impose, and we requested comment in the 
Proposing Release on our estimates concerning the costs related to fair 
value. Commission staff estimates that such an adviser would incur 
$1,320 in internal costs to conform its internal valuations to a fair 
value standard.\679\ In the event a fund does not have an internal 
capability for valuing specific illiquid assets, we expect that it 
could obtain pricing or valuation services from an outside 
administrator or other service provider. Staff estimated that the cost 
of such a service would range from $1,000 to $120,000 annually, which 
could be borne by several funds that invest in similar assets or have 
similar investment strategies.\680\ We did not receive any comments on 
these estimates. These estimates, however, assumed that an adviser 
would be required to calculate the fair value of its private funds 
assets quarterly, as required by rule 203(m)-1 as proposed. We are 
reducing the estimated range to $250 to $75,000 annually to reflect 
that rule 203(m)-1 requires advisers to calculate their private fund 
assets annually, rather than quarterly as proposed.\681\
---------------------------------------------------------------------------

    \678\ See, e.g., Gunderson Dettmer Letter; Merkl Letter; 
O'Melveny Letter; Seward Letter; Wellington Letter.
    \679\ We estimated in the Proposing Release that such an adviser 
would incur $1,224 in internal costs to conform its internal 
valuations to a fair value standard. See Proposing Release, supra 
note 26, at n.325. We received no comments on this estimate. We are, 
however, increasing this estimate slightly, to $1,320, to account 
for more recent salary data. This revised estimate is based upon the 
following calculation: 8 hours x $165/hour = $1,320. The hourly wage 
is based on data for a fund senior accountant from SIFMA's 
Management & Professional Earnings in the Securities Industry 2010, 
modified by Commission staff to account for an 1800-hour work-year 
and multiplied by 5.35 to account for bonuses, firm size, employee 
benefits and overhead.
    \680\ These estimates are based on conversations with valuation 
service providers. We understand that the cost of valuation for 
illiquid fixed income securities generally ranges from $1.00 to 
$5.00 per security, depending on the difficulty of valuation, and is 
performed for clients on a weekly or monthly basis. We understand 
that appraisals of privately placed equity securities may cost from 
$3,000 to $5,000 with updates to such values at much lower prices. 
For purposes of this cost benefit analysis, we are estimating the 
range of costs for (i) a private fund that holds 50 fixed income 
securities at a cost of $5.00 to price and (ii) a private fund that 
holds privately placed securities of 15 issuers that each cost 
$5,000 to value initially and $1,000 thereafter. We believe that 
costs for funds that hold both fixed-income and privately placed 
equity securities would fall within the maximum of our estimated 
range. We note that funds that have significant positions in 
illiquid securities are likely to have the in-house capacity to 
value those securities or already subscribe to a third-party service 
to value them. We note that many private funds are likely to have 
many fewer fixed income illiquid securities in their portfolios, 
some or all of which may cost less than $5.00 per security to value. 
Finally, we note that obtaining valuation services for a small 
number of fixed income positions on an annual basis may result in a 
higher cost for each security or require a subscription to the 
valuation service for those that do not already purchase such 
services. The staff's estimate is based on the following 
calculations: (50 x $5.00 x 4 = $1,000); (15 x $5,000) + (15 x 
$1,000 x 3) = $120,000).
    \681\ The staff's revised estimate is based on the following 
calculations: (50 x $5.00 = $250; 15 x $5,000 = $75,000). See also 
supra note 680.
---------------------------------------------------------------------------

    In addition, as discussed above, we have taken several steps to 
mitigate these costs.\682\ While many advisers will calculate fair 
value in accordance with GAAP or another international accounting 
standard,\683\ other advisers acting consistently and in good faith may 
utilize another fair valuation standard.\684\ While these other 
standards may not provide the quality of information in financial 
reporting (for

[[Page 39696]]

example, of private fund returns), we expect these calculations will 
provide sufficient consistency for the purposes that regulatory assets 
under management serve in our rules, including rule 203(m)-1.\685\
---------------------------------------------------------------------------

    \682\ See supra notes 363-366 and accompanying text.
    \683\ See supra note 364 and accompanying text.
    \684\ See supra note 365 and accompanying text.
    \685\ See supra note 366 and accompanying text.
---------------------------------------------------------------------------

    Use of the alternative approaches recommended by commenters (e.g., 
cost basis or any method required by the private fund's governing 
documents other than fair value) would not meet our objective of having 
more meaningful and comparable valuation of private fund assets, and 
could result in a significant understatement of appreciated assets. 
Moreover, these alternative approaches could permit advisers to 
circumvent the Advisers Act's registration requirements. Permitting the 
use of any valuation standard set forth in the governing documents of 
the private fund other than fair value could effectively yield to the 
adviser the choice of the most favorable standard for determining its 
registration obligation as well as the application of other regulatory 
requirements. For these reasons and those discussed in the Implementing 
Adopting Release, commenters did not persuade us that the extent of the 
additional burdens the fair value requirement would impose on some 
advisers to private funds would be inappropriate in light of the value 
of a more meaningful and consistent calculation by all advisers to 
private funds.
    We also do not expect that advisers' principals (or other 
employees) generally will cease to invest alongside the advisers' 
clients as a result of the inclusion of proprietary assets, as some 
commenters suggested.\686\ If private fund investors value their 
advisers' co-investments as suggested by these commenters, we expect 
that the investors will demand them and their advisers will structure 
their businesses accordingly.\687\
---------------------------------------------------------------------------

    \686\ See, e.g., ABA Letter; Katten Foreign Advisers Letter; 
Seward Letter.
    \687\ See supra note 347 and accompanying text.
---------------------------------------------------------------------------

    One commenter also argued that including proprietary assets would 
deter non-U.S. advisers that manage large sums of proprietary assets 
from establishing U.S. operations and employing U.S. residents.\688\ 
Such an adviser, however, would not be ineligible for the private fund 
adviser exemption merely because it established U.S. operations. As 
discussed in Section II.B, a non-U.S. adviser may rely on the private 
fund adviser exemption while also having one or more U.S. places of 
business, provided it complies with the exemption's conditions.
---------------------------------------------------------------------------

    \688\ Katten Foreign Advisers Letter.
---------------------------------------------------------------------------

    Some commenters objected to calculating regulatory assets under 
management on the basis of gross, rather than net, assets. They argued, 
among other things, that gross asset measurements would be 
confusing,\689\ complex,\690\ and inconsistent with industry 
practice.\691\ However, nothing in the current instructions suggests 
that liabilities should be deducted from the calculation of an 
adviser's assets under management. Indeed, since 1997, the instructions 
have stated that an adviser should not deduct securities purchased on 
margin when calculating its assets under management.\692\ Whether a 
client has borrowed to purchase a portion of the assets managed does 
not seem to us a relevant consideration in determining the amount an 
adviser has to manage, the scope of the adviser's business, or the 
availability of the exemptions.\693\
---------------------------------------------------------------------------

    \689\ Dechert General Letter. See also Implementing Adopting 
Release, supra note 32, at n.80 and accompanying text.
    \690\ MFA Letter.
    \691\ See, e.g., Merkl Letter; Shearman Letter. See also supra 
note 351.
    \692\ See Form ADV: Instructions for Part 1A, instr. 5.b.(2), as 
in effect before it was amended by the Implementing Adopting Release 
(``Do not deduct securities purchased on margin.''). Instruction 
5.b.(2), as amended in the Implementing Adopting Release, provides 
``Do not deduct any outstanding indebtedness or other accrued but 
unpaid liabilities.'' See Implementing Adopting Release, supra note 
32, discussion at section II.A.3.
    \693\ See id.
---------------------------------------------------------------------------

    Moreover, we are concerned that the use of net assets could permit 
advisers to highly leveraged funds to avoid registration under the 
Advisers Act even though the activities of such advisers may be 
significant and the funds they advise may be appropriate for systemic 
risk reporting.\694\ One commenter argued, in contrast, that it would 
be ``extremely unlikely that a net asset limit of $150,000,000 in 
private funds could be leveraged into total investments that would pose 
any systemic risk.'' \695\ But a comprehensive view of systemic risk 
requires information about certain funds that may not present systemic 
risk concerns when viewed in isolation, but nonetheless are relevant to 
an assessment of systemic risk across the economy. Moreover, because 
private funds are not subject to the leverage restrictions in section 
18 of the Investment Company Act, a private fund with less than $150 
million in net assets could hold assets far in excess of that amount as 
a result of its extensive use of leverage. In addition, under a net 
assets test such a fund would be treated similarly for regulatory 
purposes as a fundamentally different fund, such as one that did not 
make extensive use of leverage and had $140 million in net assets.
---------------------------------------------------------------------------

    \694\ See id., at n.82 and preceding and accompanying text.
    \695\ ABA Letter.
---------------------------------------------------------------------------

    The use of gross assets also need not cause any investor confusion, 
as some commenters suggested.\696\ Although an adviser will be required 
to use gross (rather than net) assets for purposes of determining 
whether it is eligible for the private fund adviser or the foreign 
private adviser exemptions (among other purposes), we would not 
preclude an adviser from holding itself out to its clients as managing 
a net amount of assets as may be its custom.\697\
---------------------------------------------------------------------------

    \696\ See, e.g., Dechert General Letter. See also Implementing 
Adopting Release, supra note 32, at n.80 and accompanying text.
    \697\ See supra note 357.
---------------------------------------------------------------------------

    Definition of a Qualifying Private Fund. As discussed above, we 
modified the definition of a ``qualifying private fund'' to include an 
issuer that qualifies for an exclusion from the definition of 
``investment company,'' as defined in section 3 of the Investment 
Company Act, in addition to those provided by section 3(c)(1) or 
3(c)(7) of that Act. To the extent advisers are able to rely on the 
exemption as a result of this modification, investors and the 
Commission will lose the benefits registration would provide. This 
modification does, however, benefit advisers, as discussed above, and 
investors (and the Commission) will still have access to the 
information these advisers will be required to file as exempt reporting 
advisers.
    Solely Advises Private Funds. Some commenters asserted, in effect, 
that advisers should be permitted to combine other exemptions with rule 
203(m)-1 so that, for example, an adviser could advise venture capital 
funds with assets under management in excess of $150 million in 
addition to other, non-venture capital private funds with less than 
$150 million in assets under management.\698\ One commenter argued 
that, by declining to adopt this view, we are imposing unnecessary 
burdens, particularly on advisers who advise both small private funds 
and small business investment companies.\699\ But as we discuss in 
Section II.B.1, the approach the commenter suggests runs contrary to 
the language of section 203(m), which directs us to provide an 
exemption ``to any investment adviser of private funds, if each of such 
investment adviser acts solely as an adviser to private funds and

[[Page 39697]]

has assets under management in the United States of less than 
$150,000,000.'' Thus, we believe that the costs to advisers that may 
have to register because they do not advise solely private funds with 
assets under management in the United States of less than $150 million 
flow directly from the Dodd-Frank Act.
---------------------------------------------------------------------------

    \698\ NASBIC/SBIA Letter; Seward Letter.
    \699\ NASBIC/SBIA Letter.
---------------------------------------------------------------------------

    Assessing Whether the Exemption Is Available and Costs of 
Registration and Compliance. We estimate each adviser may incur between 
$800 to $4,800 in legal advice to learn whether it may rely on the 
exemption.\700\ We did not receive any comments concerning these 
estimates. We also estimate that each adviser that registers would 
incur registration costs, which we estimate would be $15,077,\701\ 
initial compliance costs ranging from $10,000 to $45,000, and ongoing 
annual compliance costs ranging from $10,000 to $50,000.\702\ Some 
commenters suggested that these estimates are too low, and estimated 
that they would incur one-time registration and compliance costs 
ranging from $50,000 to $600,000, followed by ongoing annual compliance 
costs ranging from $50,000 to $500,000.\703\ Although some advisers may 
incur these costs, we do not believe they are representative, as 
discussed above.\704\ Moreover, as discussed above, commenters 
identifying themselves as ``middle market private equity fund'' 
advisers provided the highest estimated costs, but these commenters 
generally would not qualify for the private fund adviser exemption we 
are required to provide under section 203(m).\705\ We also note that 
the costs of registration for advisers that do not qualify for the 
private fund adviser exemption flow from the Dodd-Frank Act, which 
removed the private adviser exemption on which they currently rely.
---------------------------------------------------------------------------

    \700\ We estimate that a private fund adviser would obtain 
between 2 and 12 hours of external legal advice (at a cost of $400 
per hour) to determine whether it would be eligible for the private 
fund adviser exemption.
    \701\ See supra note 597 and accompanying text.
    \702\ See supra note 601 and accompanying text.
    \703\ See supra notes 602-603 and accompanying text.
    \704\ See supra Section V.A.2.
    \705\ We note that the advisers that gave us these estimates for 
registration costs have assets under management in excess of the 
$150 million threshold and they are not representative of advisers 
that would qualify for the private fund adviser exemption. See supra 
notes 602-603 and accompanying text. We also note that approximately 
570 smaller advisers currently are registered with us. See supra 
note 613 and accompanying text. These advisers have absorbed the 
compliance costs associated with registration, notwithstanding the 
fact that their revenues are likely to be smaller than those of a 
typical adviser that will be required to register as a result of 
Congress's repeal of the private adviser exemption (e.g., an adviser 
to private funds with $150 million or more of assets under 
management in the United States, or a ``middle market'' private 
equity adviser). See, e.g., Atlas Letter (middle market private 
equity adviser with $365 million of assets under management); Cortec 
Letter (middle market private equity adviser with less than $750 
million of assets under management). See also supra note 614 and 
accompanying text.
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C. Foreign Private Adviser Exemption

    Section 403 of the Dodd-Frank Act replaces the current private 
adviser exemption from registration under the Advisers Act with a new 
exemption for any ``foreign private adviser,'' as defined in new 
section 202(a)(30) of the Advisers Act.\706\ We are adopting, 
substantially as proposed, new rule 202(a)(30)-1, which defines certain 
terms in section 202(a)(30) for use by advisers seeking to avail 
themselves of the foreign private adviser exemption, including: (i) 
``Investor;'' (ii) ''in the United States;'' (iii) ``place of 
business;'' and (iv) ``assets under management.'' \707\ We are also 
including in rule 202(a)(30)-1 the safe harbor and many of the client 
counting rules that appeared in rule 203(b)(3)-1.\708\
---------------------------------------------------------------------------

    \706\ See supra notes 415-418 and accompanying text. The new 
exemption is codified as amended section 203(b)(3). See supra 
Section II.C.
    \707\ Rule 202(a)(30)-1(c).
    \708\ See supra Section II.C. Rule 203(b)(3)-1, which we are 
rescinding with the Implementing Adopting Release, provides a safe 
harbor for determining who may be deemed a single client for 
purposes of the private adviser exemption. We are not, however, 
carrying over rules 203(b)(3)-1(b)(4), (5), or (7). See supra notes 
316, 420 and 425 and accompanying text.
---------------------------------------------------------------------------

    Rule 202(a)(30)-1 clarifies several provisions used in the 
statutory definition of ``foreign private adviser.'' First, the rule 
includes a safe harbor for counting clients, which previously appeared 
in rule 203(b)(3)-1, and which we have modified to account for its use 
in the foreign private adviser context. Under the safe harbor, an 
adviser would count certain natural persons as a single client under 
certain circumstances.\709\ Rule 202(a)(30)-1 also includes another 
provision of rule 203(b)(3)-1 that permits an adviser to treat as a 
single ``client'' an entity that receives investment advice based on 
the entity's investment objectives and two or more entities that have 
identical owners.\710\ As proposed, we are omitting the ``special 
rule'' that allowed advisers not to count as a client any person for 
whom the adviser provides investment advisory services without 
compensation.\711\ Finally, the rule includes two provisions that 
clarify that advisers need not double-count private funds and their 
investors under certain circumstances.\712\
---------------------------------------------------------------------------

    \709\ Rule 202(a)(30)-1(a)(1).
    \710\ Rule 202(a)(30)-1(a)(2)(i)-(ii). In addition, rule 
202(a)(30)-1(b)(1) through (3) contain the following related 
``special rules:'' (1) An adviser must count a shareholder, partner, 
limited partner, member, or beneficiary (each, an ``owner'') of a 
corporation, general partnership, limited partnership, limited 
liability company, trust, or other legal organization, as a client 
if the adviser provides investment advisory services to the owner 
separate and apart from the investment advisory services provided to 
the legal organization; (2) an adviser is not required to count an 
owner as a client solely because the adviser, on behalf of the legal 
organization, offers, promotes, or sells interests in the legal 
organization to the owner, or reports periodically to the owners as 
a group solely with respect to the performance of or plans for the 
legal organization's assets or similar matters; and (3) any general 
partner, managing member or other person acting as an investment 
adviser to a limited partnership or limited liability company must 
treat the partnership or limited liability company as a client.
    \711\ See rule 203(b)(3)-1(b)(4); supra notes 425-427 and 
accompanying text.
    \712\ See rule 202(a)(30)-1(b)(4) (an adviser is not required to 
count a private fund as a client if it counts any investor, as 
defined in the rule, in that private fund as an investor in the 
United States in that private fund); rule 202(a)(30)-1(b)(5) (an 
adviser is not required to count a person as an investor if the 
adviser counts such person as a client in the United States). See 
also supra note 429.
---------------------------------------------------------------------------

    Second, section 202(a)(30) provides that a ``foreign private 
adviser'' eligible for the new registration exemption cannot have more 
than 14 clients ``or investors in the United States.'' We are defining 
``investor'' in a private fund in rule 202(a)(30)-1 as any person who 
would be included in determining the number of beneficial owners of the 
outstanding securities of a private fund under section 3(c)(1) of the 
Investment Company Act, or whether the outstanding securities of a 
private fund are owned exclusively by qualified purchasers under 
section 3(c)(7) of that Act.\713\ We are also treating as investors 
beneficial owners of ``short-term paper'' issued by the private fund, 
who must be qualified purchasers under section 3(c)(7) but are not 
counted as beneficial owners for purposes of section 3(c)(1).\714\
---------------------------------------------------------------------------

    \713\ See rule 202(a)(30)-1(c)(2); supra Section II.C.2. In 
order to avoid double-counting, the rule allows an adviser to treat 
as a single investor any person who is an investor in two or more 
private funds advised by the adviser. See rule 202(a)(30)-1, at note 
to paragraph (c)(2).
    \714\ See rule 202(a)(30)-1(c)(2)(ii); supra notes 453-462 and 
accompanying text. Consistently with section 3(c)(1) and section 
(3)(c)(7) of the Investment Company Act, the final rule, unlike the 
proposed rule, does not treat knowledgeable employees as 
``investors.'' Cf. proposed rule 202(a)(30)-1(c)(1)(i).
---------------------------------------------------------------------------

    Third, rule 202(a)(30)-1 defines ``in the United States'' generally 
by incorporating the definition of a ``U.S. person'' and ``United 
States'' under Regulation S.\715\ In particular, we define ``in the 
United States'' in rule 202(a)(30)-1 to mean: (i) With respect to any 
place of business, any such place

[[Page 39698]]

located in the ``United States,'' as defined in Regulation S; \716\ 
(ii) with respect to any client or private fund investor in the United 
States, any person who is a ``U.S. person'' as defined in Regulation 
S,\717\ except that under the rule, any discretionary account or 
similar account that is held for the benefit of a person ``in the 
United States'' by a non-U.S. dealer or other professional fiduciary is 
a person ``in the United States'' if the dealer or professional 
fiduciary is a related person of the investment adviser relying on the 
exemption; and (iii) with respect to the public, in the ``United 
States,'' as defined in Regulation S.\718\
---------------------------------------------------------------------------

    \715\ Rule 202(a)(30)-1(c)(3). See supra Section II.C.3.
    \716\ See 17 CFR 230.902(l).
    \717\ See 17 CFR 230.902(k). We are allowing foreign advisers to 
determine whether a client or investor is ``in the United States'' 
by reference to the time the person became a client or acquires 
securities issued by the private fund. See rule 202(a)(30)-1, at 
note to paragraph (c)(3)(i).
    \718\ See 17 CFR 230.902(l).
---------------------------------------------------------------------------

    Fourth, rule 202(a)(30)-1 defines ``place of business'' to have the 
same meaning as in Advisers Act rule 222-1(a).\719\ Finally, for 
purposes of rule 202(a)(30)-1, we are defining ``assets under 
management'' by reference to ``regulatory assets under management'' as 
determined under Item 5 of Form ADV.\720\
---------------------------------------------------------------------------

    \719\ See rule 202(a)(30)-1(c)(4); rule 222-1(a) (defining 
``place of business'' of an investment adviser as: ``(1) An office 
at which the investment adviser regularly provides investment 
advisory services, solicits, meets with, or otherwise communicates 
with clients; and (2) Any other location that is held out to the 
general public as a location at which the investment adviser 
provides investment advisory services, solicits, meets with, or 
otherwise communicates with clients.''). See supra Section II.C.4.
    \720\ Rule 202(a)(30)-1(c)(1); Form ADV: Instructions to Part 
1A, instr. 5.b(4). See also supra Section II.C.5.
---------------------------------------------------------------------------

1. Benefits
    We are defining certain terms included in the statutory definition 
of ``foreign private adviser'' in order to clarify the meaning of these 
terms and reduce the potential administrative and regulatory burdens 
for advisers that seek to rely on the foreign private adviser 
exemption. As noted above, our rule references definitions set forth in 
other Commission rules under the Advisers Act, the Investment Company 
Act and the Securities Act, all of which are likely to be familiar to 
non-U.S. advisers active in the U.S. capital markets.
    As we discussed in the Proposing Release, we anticipate that by 
defining these terms we will benefit non-U.S. advisers by providing 
clarity with respect to the terms that advisers would otherwise be 
required to interpret (and which they would likely interpret with 
reference to the rules we reference).\721\ Our approach provides 
consistency among these other rules and the new exemption. This should 
limit non-U.S. advisers' need to undertake additional analysis with 
respect to these terms for purposes of determining the availability of 
the foreign private adviser exemption.\722\ We believe that the 
consistency and clarity that results from the rule will promote 
efficiency for non-U.S. advisers and the Commission. Commenters that 
expressed support for the proposed definitions confirmed that the 
references to other rules will allow advisers to apply existing 
concepts and maintain consistency with current interpretations.\723\
---------------------------------------------------------------------------

    \721\ See Proposing Release, supra note 26, at n.350 and 
accompanying text.
    \722\ This is true for all of the definitions except for 
``assets under management.'' An adviser that relies on the foreign 
private adviser exemption must calculate its assets under management 
according to the instructions to Item 5 of Form ADV only for 
purposes of determining the availability of the exemption. As 
discussed above, rule 202(a)(30)-1 includes a reference to Item 5 of 
Form ADV in order to provide for consistency in the calculation of 
assets under management for various purposes under the Advisers Act. 
See supra note 497 and accompanying text.
    \723\ See, e.g., Dechert General Letter (with respect to the 
definition of ``investor''); Dechert Foreign Adviser Letter and IFIC 
Letter (noting that the proposed definition of ``in the United 
States'' has the benefit of relying on existing guidance that is 
generally used by investment advisers); O'Melveny Letter (with 
respect to the definition of ``U.S. person'').
---------------------------------------------------------------------------

    For example, for purposes of determining eligibility for the 
foreign private adviser exemption, advisers must count clients 
substantially in the same manner as they counted clients under the 
private adviser exemption.\724\ In identifying ``investors,'' advisers 
can generally rely on the determination made to assess whether the 
private fund meets the counting or qualification requirements under 
section 3(c)(1) or 3(c)(7) of the Investment Company Act.\725\ In 
determining whether a client, an investor, or a place of business is 
``in the United States,'' or whether it holds itself out as an 
investment adviser to the public ``in the United States,'' an adviser 
generally will apply the same analysis it would otherwise apply under 
Regulation S.\726\ In identifying whether it has a place of business in 
the United States, an adviser will use the definition of ``place of 
business'' as defined in Advisers Act rule 222-1, which is used to 
determine whether a state may assert regulatory jurisdiction over the 
adviser.\727\
---------------------------------------------------------------------------

    \724\ See supra Section II.C.1.
    \725\ See supra note 432 and accompanying text.
    \726\ See supra notes 471-472 and accompanying text.
    \727\ See supra Section II.C.4. Under section 222 of the 
Advisers Act, a state may not require an adviser to register if the 
adviser does not have a ``place of business'' within, and has fewer 
than 6 client residents of, the state.
---------------------------------------------------------------------------

    As noted above, the definitions of ``investor'' and ``United 
States'' under our rule rely on existing definitions, with slight 
modifications.\728\ Our rule also incorporates the safe harbor that 
appeared in rule 203(b)(3)-1 for counting clients, except that it no 
longer allows an adviser to disregard clients for whom the adviser 
provides services without compensation.\729\ We are making these 
modifications (collectively, the ``modifications'') in order to 
preclude some advisers from excluding certain assets or clients from 
their calculation so as to avoid registration with the Commission and 
the regulatory requirements associated with registration.\730\ Without 
a definition of these terms, advisers would likely rely on the same 
definitions we reference in rule 202(a)(30)-1, but without the 
modifications. We expect, therefore, that the rule likely will have the 
practical effect of narrowing the scope of the exemption, and thus 
likely will result in more advisers registering than if it reflected no 
modifications from the current rules.
---------------------------------------------------------------------------

    \728\ See supra Sections II.C.2 and II.C.3.
    \729\ See supra Section II.C.1.
    \730\ See supra notes 453-462 and accompanying and following 
text and notes 474-477 and accompanying text. See also infra notes 
744-747 for an estimate of the costs associated with registration.
---------------------------------------------------------------------------

    The final rule does not include one of the modifications we 
proposed. The final rule does not treat knowledgeable employees as 
investors, consistent with sections 3(c)(1) and 3(c)(7).\731\ As some 
commenters noted, treating knowledgeable employees in the same manner 
for purposes of the definition of investor and sections 3(c)(1) and 
3(c)(7) will simplify advisers' compliance with these regulatory 
requirements.\732\ In addition, as a result of this treatment of 
knowledgeable employees, more non-U.S. advisers will be able to rely on 
the exemption.
---------------------------------------------------------------------------

    \731\ See supra notes 448-452 and accompanying text.
    \732\ See Seward Letter; Shearman Letter.
---------------------------------------------------------------------------

    We believe that any increase in registration as compared to the 
number of non-U.S. advisers that might have registered if we had not 
adopted rule 202(a)(30)-1 will benefit investors. Investors whose 
assets are, directly or indirectly, managed by the non-U.S. advisers 
that will be required to register will benefit from the increased 
protection afforded by Federal registration of the adviser and 
application to the adviser of all of the requirements of the Advisers 
Act. As

[[Page 39699]]

noted above, registration offers benefits to the investing public, 
including periodic examination of the adviser and compliance with rules 
requiring recordkeeping, custody of client funds and compliance 
programs.\733\
---------------------------------------------------------------------------

    \733\ See supra text accompanying and following note 575.
---------------------------------------------------------------------------

2. Costs
    As discussed in the Proposing Release, we do not believe our 
definitions will result in significant costs for non-U.S. 
advisers.\734\ Non-U.S. advisers that seek to avail themselves of the 
foreign private adviser exemption will incur costs to determine whether 
they are eligible for the exemption. We expect that these advisers will 
consult with outside U.S. counsel and perform an internal review of the 
extent to which an advisory affiliate manages discretionary accounts 
owned by a U.S. person that would be counted toward the limitation on 
clients in the United States and investors in the United States. We 
estimate these costs will be $6,730 per adviser.\735\
---------------------------------------------------------------------------

    \734\ See Proposing Release, supra note 26, at section V.C.2.
    \735\ See supra note 667 and accompanying text. As noted above, 
we are decreasing this estimate to $6,730 to account for more recent 
salary data. Id. We did not receive any comments on the costs we 
estimated advisers would incur to perform this internal review.
---------------------------------------------------------------------------

    Without the rule, we believe that most advisers would have 
interpreted the new statutory provision by reference to the same rules 
that rule 202(a)(30)-1 references. Without our rule, some advisers 
would have likely incurred additional costs because they would have 
sought guidance in interpreting the terms used in the statutory 
exemption. By defining the statutory terms in a rule, we believe that 
we are providing certainty for non-U.S. advisers and limiting the time, 
compliance costs and legal expenses non-U.S. advisers would have 
incurred in seeking an interpretation, all of which could have 
inhibited capital formation and reduced efficiency. Advisers will also 
be less likely to seek additional assistance from us because they can 
rely on relevant guidance that we have previously provided with respect 
to the definitions that rule 202(a)(30)-1 references. We also believe 
that non-U.S. advisers' ability to rely on the definitions that the 
rule references and the guidance provided with respect to the 
referenced rules will reduce Commission resources that would have 
otherwise been applied to administering the foreign private adviser 
exemption, which resources can be allocated to other matters.
    Our instruction allowing non-U.S. advisers to determine whether a 
client or investor is ``in the United States'' by reference to the time 
the person became a client or an investor acquires securities issued by 
the private fund should also reduce advisers' costs.\736\ Advisers will 
make the determination only once and will not be required to monitor 
changes in the status of each client and private fund investor. 
Moreover, if a client or an investor moved to the United States, the 
adviser would not have to choose among registering with us, terminating 
the relationship with the client, or forcing the investor out of the 
private fund. Some commenters agreed that the instruction will benefit 
advisers.\737\
---------------------------------------------------------------------------

    \736\ See rule 202(a)(30)-1, at note to paragraph (c)(3)(i); 
supra note 476 and accompanying text.
    \737\ See Dechert General Letter (``The note provides helpful 
relief at a time when advisory clients often move across 
international borders while keeping an existing relationship with a 
financial institution.''); IFIC Letter (the proposed approach ``is 
consistent with the current interpretations on which Canadian 
advisers have relied for many years, and will ensure continuity and 
certainty in their business operations.'').
---------------------------------------------------------------------------

    Some commenters disagreed with the Proposing Release's explanation 
of how the exemption's requirement that an adviser look through to 
private fund investors would apply with respect to certain structures, 
such as master-feeder funds and total return swaps.\738\ In both 
respects, we note that the obligation to look through certain 
transactions stems from section 208(d) of the Advisers Act (section 
48(a) of the Investment Company Act with respect to sections 3(c)(1) 
and 3(c)(7)) as it applies to an adviser's obligations to look through 
to private fund investors for purposes of the foreign private adviser 
exemption. Thus, any costs associated with the statutory provisions 
that prohibit any person from doing indirectly or through or by another 
person anything that would be unlawful to do directly flow from those 
provisions, rather than any definitions we are adopting.
---------------------------------------------------------------------------

    \738\ See Dechert General Letter; EFAMA Letter. See also supra 
notes 442-444 and accompanying text. As we discussed above, for 
purposes of the look-through provision, the adviser to a master fund 
in a master-feeder arrangement must treat as investors the holders 
of the securities of any feeder fund formed or operated for the 
purpose of investing in the master fund rather than the feeder 
funds, which act as conduits. In addition, an adviser must count as 
an investor any owner of a total return swap on the private fund 
because that arrangement effectively provides the risks and rewards 
of investing in the private fund to the swap owner.
---------------------------------------------------------------------------

    Some commenters expressed concern that the look-through requirement 
contained in the statutory definition of a ``foreign private adviser'' 
could impose significant burdens on advisers to non-U.S. funds, 
including non-U.S. retail funds publicly offered outside of the United 
States.\739\ Two of these commenters stated, for example, that in their 
view a non-U.S. fund could be considered a private fund as a result of 
independent actions of U.S. investors, such as if a non-U.S. 
shareholder of a non-U.S. fund moves to the United States and purchases 
additional shares.\740\ If these funds were ``private funds,'' their 
advisers would, if seeking to rely on the foreign private adviser 
exemption, be required to determine the number of private fund 
investors in the United States and the assets under management 
attributable to them.
---------------------------------------------------------------------------

    \739\ See AFG letter; Dechert Foreign Adviser Letter; EFAMA 
Letter; Shearman Letter.
    \740\ Dechert Foreign Adviser Letter; EFAMA Letter. See also 
supra note 464 and accompanying text.
---------------------------------------------------------------------------

    As we explain above, if an adviser reasonably believes that an 
investor is not ``in the United States,'' the adviser may treat the 
investor as not being ``in the United States.'' Moreover, we understand 
that non-U.S. private funds currently count or qualify their U.S. 
investors in order to avoid regulation under the Investment Company 
Act.\741\ A non-U.S. adviser would need to count the same U.S. 
investors (except for holders of short-term paper with respect to a 
fund relying on section 3(c)(1)) in order to rely on the foreign 
private adviser exemption. In this respect, therefore, the look-through 
requirement of the foreign private adviser exemption will generally not 
impose any new burden on advisers to non-U.S. funds.
---------------------------------------------------------------------------

    \741\ This practice is consistent with positions our staff has 
taken in which the staff has stated it would not recommend 
enforcement action in certain circumstances. See, e.g., Goodwin 
Procter No-Action Letter, supra note 294; Touche Remnant No-Action 
Letter, supra note 294. See also sections 7(d), 3(c)(1), and 3(c)(7) 
of the Investment Company Act. See also, e.g., Canadian Tax-Deferred 
Retirement Savings Accounts Release, supra note 294, at n.23 (``The 
Commission and its staff have interpreted section 7(d) to generally 
prohibit a foreign fund from making a U.S. private offering if that 
offering would cause the securities of the fund to be beneficially 
owned by more than 100 U.S. residents.'').
---------------------------------------------------------------------------

    As discussed in the Proposing Release, the modifications will 
result in some costs for non-U.S. advisers who might change their 
business practices in order to rely on the exemption.\742\ Some non-
U.S. advisers may have to choose to register under the Advisers Act or 
to limit the scope of their contacts with the United States in order to 
rely on the statutory exemption for foreign private advisers (or the 
private fund adviser exemption).\743\ As noted above, we have

[[Page 39700]]

estimated the costs of registration to be $15,077.\744\ In addition, we 
estimate that registered advisers would incur initial costs to 
establish a compliance infrastructure, which we estimate would range 
from $10,000 to $45,000 and ongoing annual costs of compliance and 
examination, which we estimate would range from $10,000 to 
$50,000.\745\ Some commenters suggested that these estimates are too 
low, and estimated that they would incur one-time registration and 
compliance costs ranging from $50,000 to $600,000, followed by ongoing 
annual compliance costs ranging from $50,000 to $500,000.\746\ Although 
some advisers may incur these costs, we do not believe they are 
representative, as discussed above.\747\ Moreover, as discussed above, 
commenters identifying themselves as ``middle market private equity 
fund'' advisers provided the highest estimated costs, but these 
commenters generally would not qualify for the foreign private adviser 
exemption (e.g., because these advisers generally appear to have places 
of business in the United States).
---------------------------------------------------------------------------

    \742\ See Proposing Release, supra note 26, at n. 362 and 
accompanying and following text.
    \743\ See, e.g., O'Melveny Letter (argued that because the 
foreign private adviser is subject to a low statutory asset 
threshold, it is likely ``that the cost of enhanced regulatory 
compliance [resulting from advisers registering or filing reports 
required of advisers relying on rule 203(m)-1] may, as a commercial 
matter, have to be borne solely by U.S. investors, which would 
affect their net returns''; the commenter also stated that, 
alternatively, ``many non-U.S. advisers with less significant 
amounts of U.S. assets invested in their funds may choose to 
restrict the participation by U.S. investors rather than attempt to 
comply with the Proposed Rules and, thereby, decrease the 
availability of potentially attractive investment opportunities to 
U.S. investors''). We note, however, that the benefits and costs 
associated with the elimination of the private adviser exemption are 
attributable to the Dodd-Frank Act, including the costs of 
registration incurred by advisers that previously relied on that 
exemption but that will have to register because they do not qualify 
for another exemption. In addition, the benefits and costs 
associated with the reporting requirements applicable to advisers 
relying on the private fund adviser exemption are associated with 
the separate rules that impose those requirements. See Implementing 
Adopting Release, supra note 32, at section II.B.
    \744\ See supra note 597 and accompanying text.
    \745\ See supra note 601 and accompanying text.
    \746\ See supra notes 602-603 and accompanying text.
    \747\ See supra Section V.A.2.
---------------------------------------------------------------------------

    In any case, non-U.S. advisers will assess the costs of registering 
with the Commission relative to relying on the foreign private adviser 
or the private fund adviser exemption. This assessment will take into 
account many factors, which will vary from one adviser to another, to 
determine whether registration, relative to other options, is the most 
cost-effective business option for the adviser to pursue. If a non-U.S. 
adviser limited its activities within the United States in order to 
rely on the exemption, the modifications might have the effect of 
reducing competition in the market for advisory services or decreasing 
the availability of certain investment opportunities for U.S. 
investors. If the non-U.S. adviser chose to register, competition among 
registered advisers would increase. One commenter asserted that 
treating holders of short-term paper as investors could result in a 
U.S. commercial lender to a fund being treated as an investor, leading 
non-U.S. advisers to avoid U.S. lenders.\748\ To the extent that the 
modification included in the definition of ``investor'' causes a non-
U.S. adviser seeking to rely on the foreign private adviser exemption 
to limit U.S. investors in a private fund's short-term notes, the 
modification could have an adverse effect on capital formation and 
reduce U.S. lenders as sources of credit for non-U.S. funds. However, 
unless the extension of credit by a fund's broker-dealer or custodian 
bank results in the issuance of a security by the fund to its creditor, 
the creditor would not be considered an investor for purposes of the 
foreign private adviser exemption.\749\
---------------------------------------------------------------------------

    \748\ See Shearman Letter.
    \749\ See Reves v. Ernst & Young, 494 U.S. 56 (1990). See also 
supra note 458 and accompanying text.
---------------------------------------------------------------------------

    As a result of the rule's reference to the method of calculating 
assets under management under Form ADV, non-U.S. advisers will use the 
valuation method provided in the instructions to Form ADV to verify 
compliance with the $25 million asset threshold included in the foreign 
private adviser exemption.\750\ Among other things, these instructions 
require advisers to use the market value of private fund assets, or the 
fair value of private fund assets where market value is unavailable, 
when determining regulatory assets under management and to include in 
the calculation certain types of assets advisers previously were 
permitted to exclude.\751\ Most commenters addressed the components of 
the new method of calculation in reference to the calculation of 
``regulatory assets under management'' under Form ADV, or with respect 
to the calculation of private fund assets for purposes of the private 
fund adviser exemption.\752\
---------------------------------------------------------------------------

    \750\ See supra Section II.C.5.
    \751\ See supra Section II.B.2.a.
    \752\ See Implementing Adopting Release, supra note 32, 
discussion at section II.A.3; supra Section II.B.2.a. Among those 
commenters who addressed the components specifically with respect to 
the foreign private adviser exemption, one noted that because of the 
requirement to include proprietary assets in the calculation, 
``managers, in order to qualify for the [exemption], will have an 
incentive to reduce their personal commitments to the private funds, 
and manage their own assets individually.'' See ABA Letter. This 
result, argues the commenter, will not be in the best interest of 
investors, who benefit from managers having ``skin the game.'' As 
discussed in Section II.B.2, if private fund investors value their 
advisers' co-investments as suggested by the commenter, we expect 
that the investors will demand them and their advisers will 
structure their businesses accordingly.
---------------------------------------------------------------------------

    As discussed in the Proposing Release, some non-U.S. advisers to 
private funds may value assets based on their fair value in accordance 
with GAAP or other international accounting standards that require the 
use of fair value, while other advisers to private funds currently may 
not use fair value methodologies.\753\ We noted above that the costs 
associated with fair valuation will vary based on factors such as the 
nature of the asset, the number of positions that do not have a market 
value, and whether the adviser has the ability to value such assets 
internally or relies on a third party for valuation services.\754\ 
Nevertheless, we do not believe that the requirement to use fair value 
methodologies will result in significant costs for these advisers to 
these funds.\755\ Commission staff estimates that such advisers will 
each incur $1,320 in internal costs to conform its internal valuations 
to a fair value standard.\756\ In the event a fund does not have an 
internal capability for valuing illiquid assets, we expect that it will 
be able to obtain pricing or valuation services from an outside 
administrator or other service provider. Staff estimated that the 
annual cost of such a service will range from $1,000 to $120,000 
annually, which could be borne by several funds that invest in similar 
assets or have similar investment strategies.\757\ We did not receive 
any comments on these estimates.
---------------------------------------------------------------------------

    \753\ See Proposing Release, supra note 26, at n.365 and 
accompanying text.
    \754\ See supra note 676 and accompanying text.
    \755\ See supra text following note 676.
    \756\ See supra note 679.
    \757\ See supra note 680.
---------------------------------------------------------------------------

VI. Regulatory Flexibility Certification

    The Commission certified in the Proposing Release, pursuant to 
section 605(b) of the Regulatory Flexibility Act,\758\ that proposed 
rules 203(l)-1 and 203(m)-1 under the Advisers Act would not, if 
adopted, have a significant economic impact on a substantial number of 
small entities.\759\ As we explained in the Proposing Release, under 
Commission rules, for the purposes of the Advisers Act and the 
Regulatory Flexibility Act, an investment adviser generally is a small

[[Page 39701]]

entity if it: (i) Has assets under management having a total value of 
less than $25 million; (ii) did not have total assets of $5 million or 
more on the last day of its most recent fiscal year; and (iii) does not 
control, is not controlled by, and is not under common control with 
another investment adviser that has assets under management of $25 
million or more, or any person (other than a natural person) that had 
$5 million or more on the last day of its most recent fiscal year 
(``small adviser'').\760\
---------------------------------------------------------------------------

    \758\ 5 U.S.C. 605(b).
    \759\ See Proposing Release, supra note 26, at section VI.
    \760\ Rule 0-7(a) (17 CFR 275.0-7(a)).
---------------------------------------------------------------------------

    Investment advisers solely to venture capital funds and advisers 
solely to private funds in each case with assets under management of 
less than $25 million would remain generally ineligible for 
registration with the Commission under section 203A of the Advisers 
Act.\761\ We expect that any small adviser solely to existing venture 
capital funds that would not be ineligible to register with the 
Commission would be able to avail itself of the exemption from 
registration under the grandfathering provision. If an adviser solely 
to a new venture capital fund could not avail itself of the exemption 
because, for example, the fund it advises did not meet the definition 
of ``venture capital fund,'' we anticipate that the adviser could avail 
itself of the exemption in section 203(m) of the Advisers Act as 
implemented by rule 203(m)-1. Similarly, we expect that any small 
adviser solely to private funds would be able to rely on the exemption 
in section 203(m) of the Advisers Act as implemented by rule 203(m)-1.
---------------------------------------------------------------------------

    \761\ Section 203A of the Advisers Act (prohibiting an 
investment adviser that is regulated or required to be regulated as 
an investment adviser in the State in which it maintains its 
principal office and place of business from registering with the 
Commission unless the adviser has $25 million or more in assets 
under management or is an adviser to a registered investment 
company).
---------------------------------------------------------------------------

    Thus, we believe that small advisers solely to venture capital 
funds and small advisers to other private funds will generally be 
ineligible to register with the Commission. Those small advisers that 
may not be ineligible to register with the Commission, we believe, 
would be able to rely on the venture capital fund adviser exemption 
under section 203(l) of the Advisers Act or the private fund adviser 
exemption under section 203(m) of that Act as implemented by our rules. 
For these reasons, we certified in the Proposing Release that rules 
203(l)-1 and 203(m)-1 under the Advisers Act would not, if adopted, 
have a significant economic impact on a substantial number of small 
entities. Although we requested written comments regarding this 
certification, no commenters responded to this request.

VII. Statutory Authority

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

List of Subjects in 17 CFR Part 275

    Reporting and recordkeeping requirements; Securities.

Text of Rules

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

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

0
1. The general authority citation for Part 275 is revised to read as 
follows:

    Authority:  15 U.S.C. 80b-2(a)(11)(G), 80b-2(a)(11)(H), 80b-
2(a)(17), 80b-3, 80b-4, 80b-4a, 80b-6(4), 80b-6(a), and 80b-11, 
unless otherwise noted.
* * * * *

0
2. Section 275.202(a)(30)-1 is added to read as follows:


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

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

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

    (c) Definitions. For purposes of section 202(a)(30) of the Act (15 
U.S.C. 80b-2(a)(30)):
    (1) Assets under management means the regulatory assets under 
management

[[Page 39702]]

as determined under Item 5.F of Form ADV (Sec.  279.1 of this chapter).
    (2) Investor means:
    (i) Any person who would be included in determining the number of 
beneficial owners of the outstanding securities of a private fund under 
section 3(c)(1) of the Investment Company Act of 1940 (15 U.S.C. 80a-
3(c)(1)), or whether the outstanding securities of a private fund are 
owned exclusively by qualified purchasers under section 3(c)(7) of that 
Act (15 U.S.C. 80a-3(c)(7)); and
    (ii) Any beneficial owner of any outstanding short-term paper, as 
defined in section 2(a)(38) of the Investment Company Act of 1940 (15 
U.S.C. 80a-2(a)(38)), issued by the private fund.

    Note to paragraph (c)(2): You may treat as a single investor any 
person who is an investor in two or more private funds you advise.

    (3) In the United States means with respect to:
    (i) Any client or investor, any person who is a U.S. person as 
defined in Sec.  230.902(k) of this chapter, except that any 
discretionary account or similar account that is held for the benefit 
of a person in the United States by a dealer or other professional 
fiduciary is in the United States if the dealer or professional 
fiduciary is a related person, as defined in Sec.  275.206(4)-2(d)(7), 
of the investment adviser relying on this section and is not organized, 
incorporated, or (if an individual) resident in the United States.

    Note to paragraph (c)(3)(i): A person who is in the United 
States may be treated as not being in the United States if such 
person was not in the United States at the time of becoming a client 
or, in the case of an investor in a private fund, each time the 
investor acquires securities issued by the fund.

    (ii) Any place of business, in the United States, as that term is 
defined in Sec.  230.902(l) of this chapter; and
    (iii) The public, in the United States, as that term is defined in 
Sec.  230.902(l) of this chapter.
    (4) Place of business has the same meaning as in Sec.  275.222-
1(a).
    (5) Spousal equivalent has the same meaning as in Sec.  
275.202(a)(11)(G)-1(d)(9).
    (d) Holding out. If you are relying on this section, you shall not 
be deemed to be holding yourself out generally to the public in the 
United States as an investment adviser, within the meaning of section 
202(a)(30) of the Act (15 U.S.C. 80b-2(a)(30)), solely because you 
participate in a non-public offering in the United States of securities 
issued by a private fund under the Securities Act of 1933 (15 U.S.C. 
77a).

0
3. Section 275.203(l)-1 is added to read as follows:


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

    (a) Venture capital fund defined. For purposes of section 203(l) of 
the Act (15 U.S.C. 80b-3(l)), a venture capital fund is any private 
fund that:
    (1) Represents to investors and potential investors that it pursues 
a venture capital strategy;
    (2) Immediately after the acquisition of any asset, other than 
qualifying investments or short-term holdings, holds no more than 20 
percent of the amount of the fund's aggregate capital contributions and 
uncalled committed capital in assets (other than short-term holdings) 
that are not qualifying investments, valued at cost or fair value, 
consistently applied by the fund;
    (3) Does not borrow, issue debt obligations, provide guarantees or 
otherwise incur leverage, in excess of 15 percent of the private fund's 
aggregate capital contributions and uncalled committed capital, and any 
such borrowing, indebtedness, guarantee or leverage is for a non-
renewable term of no longer than 120 calendar days, except that any 
guarantee by the private fund of a qualifying portfolio company's 
obligations up to the amount of the value of the private fund's 
investment in the qualifying portfolio company is not subject to the 
120 calendar day limit;
    (4) Only issues securities the terms of which do not provide a 
holder with any right, except in extraordinary circumstances, to 
withdraw, redeem or require the repurchase of such securities but may 
entitle holders to receive distributions made to all holders pro rata; 
and
    (5) Is not registered under section 8 of the Investment Company Act 
of 1940 (15 U.S.C. 80a-8), and has not elected to be treated as a 
business development company pursuant to section 54 of that Act (15 
U.S.C. 80a-53).
    (b) Certain pre-existing venture capital funds. For purposes of 
section 203(l) of the Act (15 U.S.C. 80b-3(l)) and in addition to any 
venture capital fund as set forth in paragraph (a) of this section, a 
venture capital fund also includes any private fund that:
    (1) Has represented to investors and potential investors at the 
time of the offering of the private fund's securities that it pursues a 
venture capital strategy;
    (2) Prior to December 31, 2010, has sold securities to one or more 
investors that are not related persons, as defined in Sec.  275.206(4)-
2(d)(7), of any investment adviser of the private fund; and
    (3) Does not sell any securities to (including accepting any 
committed capital from) any person after July 21, 2011.
    (c) Definitions. For purposes of this section:
    (1) Committed capital means any commitment pursuant to which a 
person is obligated to:
    (i) Acquire an interest in the private fund; or
    (ii) Make capital contributions to the private fund.
    (2) Equity security has the same meaning as in section 3(a)(11) of 
the Securities Exchange Act of 1934 (15 U.S.C. 78c(a)(11)) and Sec.  
240.3a11-1 of this chapter.
    (3) Qualifying investment means:
    (i) An equity security issued by a qualifying portfolio company 
that has been acquired directly by the private fund from the qualifying 
portfolio company;
    (ii) Any equity security issued by a qualifying portfolio company 
in exchange for an equity security issued by the qualifying portfolio 
company described in paragraph (c)(3)(i) of this section; or
    (iii) Any equity security issued by a company of which a qualifying 
portfolio company is a majority-owned subsidiary, as defined in section 
2(a)(24) of the Investment Company Act of 1940 (15 U.S.C. 80a-
2(a)(24)), or a predecessor, and is acquired by the private fund in 
exchange for an equity security described in paragraph (c)(3)(i) or 
(c)(3)(ii) of this section.
    (4) Qualifying portfolio company means any company that:
    (i) At the time of any investment by the private fund, is not 
reporting or foreign traded and does not control, is not controlled by 
or under common control with another company, directly or indirectly, 
that is reporting or foreign traded;
    (ii) Does not borrow or issue debt obligations in connection with 
the private fund's investment in such company and distribute to the 
private fund the proceeds of such borrowing or issuance in exchange for 
the private fund's investment; and
    (iii) Is not an investment company, a private fund, an issuer that 
would be an investment company but for the exemption provided by Sec.  
270.3a-7 of this chapter, or a commodity pool.
    (5) Reporting or foreign traded means, with respect to a company, 
being subject to the reporting requirements under section 13 or 15(d) 
of the Securities Exchange Act of 1934 (15 U.S.C. 78m or 78o(d)), or 
having a security listed or

[[Page 39703]]

traded on any exchange or organized market operating in a foreign 
jurisdiction.
    (6) Short-term holdings means cash and cash equivalents, as defined 
in Sec.  270.2a51-1(b)(7)(i) of this chapter, U.S. Treasuries with a 
remaining maturity of 60 days or less, and shares of an open-end 
management investment company registered under section 8 of the 
Investment Company Act of 1940 (15 U.S.C. 80a-8) that is regulated as a 
money market fund under Sec.  270.2a-7 of this chapter.

    Note:  For purposes of this section, an investment adviser may 
treat as a private fund any issuer formed under the laws of a 
jurisdiction other than the United States that has not offered or 
sold its securities in the United States or to U.S. persons in a 
manner inconsistent with being a private fund, provided that the 
adviser treats the issuer as a private fund under the Act (15 U.S.C. 
80b) and the rules thereunder for all purposes.



0
4. Section 275.203(m)-1 is added to read as follows:


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

    (a) United States investment advisers. For purposes of section 
203(m) of the Act (15 U.S.C. 80b-3(m)), an investment adviser with its 
principal office and place of business in the United States is exempt 
from the requirement to register under section 203 of the Act if the 
investment adviser:
    (1) Acts solely as an investment adviser to one or more qualifying 
private funds; and
    (2) Manages private fund assets of less than $150 million.
    (b) Non-United States investment advisers. For purposes of section 
203(m) of the Act (15 U.S.C. 80b-3(m)), an investment adviser with its 
principal office and place of business outside of the United States is 
exempt from the requirement to register under section 203 of the Act 
if:
    (1) The investment adviser has no client that is a United States 
person except for one or more qualifying private funds; and
    (2) All assets managed by the investment adviser at a place of 
business in the United States are solely attributable to private fund 
assets, the total value of which is less than $150 million.
    (c) Frequency of Calculations. For purposes of this section, 
calculate private fund assets annually, in accordance with General 
Instruction 15 to Form ADV (Sec.  279.1 of this chapter).
    (d) Definitions. For purposes of this section:
    (1) Assets under management means the regulatory assets under 
management as determined under Item 5.F of Form ADV (Sec.  279.1 of 
this chapter).
    (2) Place of business has the same meaning as in Sec.  275.222-
1(a).
    (3) Principal office and place of business of an investment adviser 
means the executive office of the investment adviser from which the 
officers, partners, or managers of the investment adviser direct, 
control, and coordinate the activities of the investment adviser.
    (4) Private fund assets means the investment adviser's assets under 
management attributable to a qualifying private fund.
    (5) Qualifying private fund means any private fund that is not 
registered under section 8 of the Investment Company Act of 1940 (15 
U.S.C. 80a-8) and has not elected to be treated as a business 
development company pursuant to section 54 of that Act (15 U.S.C. 80a-
53). For purposes of this section, an investment adviser may treat as a 
private fund an issuer that qualifies for an exclusion from the 
definition of an ``investment company,'' as defined in section 3 of the 
Investment Company Act of 1940 (15 U.S.C. 80a-3), in addition to those 
provided by section 3(c)(1) or 3(c)(7) of that Act (15 U.S.C. 80a-
3(c)(1) or 15 U.S.C. 80a-3(c)(7)), provided that the investment adviser 
treats the issuer as a private fund under the Act (15 U.S.C. 80b) and 
the rules thereunder for all purposes.
    (6) Related person has the same meaning as in Sec.  275.206(4)-
2(d)(7).
    (7) United States has the same meaning as in Sec.  230.902(l) of 
this chapter.
    (8) United States person means any person that is a U.S. person as 
defined in Sec.  230.902(k) of this chapter, except that any 
discretionary account or similar account that is held for the benefit 
of a United States person by a dealer or other professional fiduciary 
is a United States person if the dealer or professional fiduciary is a 
related person of the investment adviser relying on this section and is 
not organized, incorporated, or (if an individual) resident in the 
United States.

    Note to paragraph (d)(8): A client will not be considered a 
United States person if the client was not a United States person at 
the time of becoming a client.


    Dated: June 22, 2011.

    By the Commission.
Elizabeth M. Murphy,
Secretary.
[FR Doc. 2011-16118 Filed 7-5-11; 8:45 am]
BILLING CODE 8011-01-P


