Exempt Reporting Advisers: Five Common Myths
This article highlights five myths about exempt reporting advisers. For purposes of this article, an “exempt reporting adviser” (ERA) is a private fund adviser that is exempt from registration either i) under Section 203(l) of the Investment Advisers Act (“venture capital fund adviser exemption”) which exempts from SEC registration an investment adviser that acts as an adviser solely to 1 or more venture capital funds, or ii) under Section 203(m) of the Investment Advisers Act (“private fund adviser exemption”) which exempts from SEC registration an investment adviser that acts as an adviser solely to private funds (i.e. 3(c)(1) funds and 3(c)(7) funds) and has assets under management in the United States of less than $150 million.
Myth #1: ERAs are not Subject to Requirements Under the Advisers Act
While not subject to registration with the SEC, ERAs are still subject to certain provisions and rules under the Advisers Act and other federal laws applicable to financial institutions. Although not routinely examined ERAs are subject to SEC examinations, and examinations of ERAs have led to enforcement cases in recent years.
Pay to Play Violations. ERAs are subject to Rule 206(4)-5 under the Advisers Act (the “Pay to Play Rule”). The Pay to Play Rule was adopted to address arrangements whereby investment advisers contribute to government officials who have influence over the selection of advisers to manage government assets. The Pay to Play Rule prohibits registered investment advisers and ERAs from providing investment advisory services for compensation to a government entity for two years if the firm or its covered associates make political contributions over a de minimis threshold to certain officials of a government entity. Importantly, no intent or quid pro quo arrangement is required for a pay to play violation.
The SEC has enforced the Pay to Play Rule to an almost strict liability standard where there is no defense for a registered investment adviser or ERA violating the Rule. Several ERAs have faced enforcement actions forced to pay fines and forego management fees for pay to play violations relating to relatively small political contributions (See Canaan Management, LLC dtd 9/15/22 regarding a $1,000 contribution by a covered associate to a candidate for Governor of California; Highland Capital Partners LLC dtd 9/15/22 regarding a $1,000 contribution by a covered associate to a candidate for Governor of Massachusetts; StarVest Management, Inc. dtd 9/15/22 regarding $1,000 and $400 contributions by covered associates to a candidate for Mayor of New York).
Recordkeeping Requirements. Section 204 of the Advisers Act requires investment advisers to make and keep such records and to make and disseminate such reports as the SEC may prescribe by rule. The Advisers Act has an express exemption from this requirement for certain exempt advisers (such as foreign private advisers) but not for ERAs. Accordingly, ERAs could be subject to SEC recordkeeping requirements, and the SEC will have the authority to examine such records. Specific recordkeeping obligations, which could significantly increase ERAs' compliance costs, have not been established but could be the subject of future SEC rulemaking.
Policies Regarding Material Nonpublic Information ("MNPI"). Section 204A of the Advisers Act includes a general requirement that all advisers subject to Section 204 (which includes ERAs) "establish, maintain and enforce written policies and procedures reasonably designed, taking into consideration the nature of such investment adviser's business, to prevent the misuse in violation of [the Advisers] Act or the Securities Exchange Act of 1934, or the rules or regulations thereunder, of material, nonpublic information by such investment adviser or any person associated with such investment adviser." ERAs should consider the nature of their business and establish appropriate written policies designed to prevent the misuse of MNPI.
FTC Safeguards Rule. In 2021 the Federal Trade Commission (“FTC”) adopted the Safeguards Rule pursuant to its authority under the Gramm-Leach-Bliley Act. The Safeguards Rule applies to all investment advisers that are not registered with the SEC, including ERAs and state registered advisers. Firms subject to the Safeguards Rule must develop a Written Information Security Program (“WISP”) that establishes controls for periodic risk assessments, appropriate security defenses (encryption, multi-factor authentication, access controls etc.), staff training, oversight of 3rd party providers, and incidence response plans.
Fiduciary Duty and Disclosure Obligations. ERAs are subject to Section 206 of the Advisers Act and Rule 206(4)-8 under the Advisers Act. Rule 206(4)-8 prohibits a private fund adviser from making untrue or misleading statements of material fact to investors or prospective investors, and otherwise engaging in fraud with respect to investors or prospective investors.
Myth #2: ERAs are not Subject to SEC Examination
Although not routinely examined, ERAs are subject to SEC examination. Immediately following the adoption of Dodd-Frank, the SEC commented that ERAs would not be subject to routine examination and would only be examined for “cause”. In more recent years, however, the SEC has included ERAs as part of its routine examination program. While ERAs should consider themselves less likely to be examined than registered investment advisers, ERAs should not consider themselves exempt from examination and are well advised to conduct their business, recordkeeping and compliance program as if they could be examined.
Myth #3: ERAs are Exempt From State Regulatory Requirements
While investment advisers registered with the SEC are exempt from state registration requirements (due to the preemption of federal registration requirements over state registration requirements), the same cannot be said for ERAs. While the North American Securities Administrators Association (NASAA) has adopted a model rule providing for a registration exemption for private fund advisers similar to the SEC, only a small minority of states have adopted the Model Rule. Accordingly, ERAs need to understand the registration requirements and applicable exemptions in the state(s) in which they operate or maintain an office. Many states exempt ERAs from registration subject to certain conditions. One of the typical conditions for exemption is a requirement that the private funds managed by the ERA are subject to an annual audit.
In addition to registration requirements, ERAs can be subject to other state regulatory requirements. First and foremost, the states retain investigatory and enforcement jurisdiction with respect to ERAs. States retain the authority to investigate fraud in their jurisdiction. Most states also have privacy laws, which typically apply to any business operating in the state’s jurisdiction regardless of registration status. Certain states require ERAs doing business in their state to comply with recordkeeping requirements, including rules relating to proxy voting policies. ERAs should check the relevant states’ securities regulations to ensure they are in compliance with all applicable requirements.
An ERA that qualifies for SEC registration (e.g. those with AUM exceeding $100m, or if based in NY exceeding $25m AUM) might consider registering with the SEC as a means to avoid the uncertainty of having to register with a state or multiple states.
Myth #4: An ERA With An Affiliated Adviser Can Remain Exempt
Some ERAs operate as part of a larger organization with other affiliated advisers. ERAs should be cautioned that to the extent an ERA is operationally integrated with an advisory affiliate (registered or unregistered), the SEC may view the advisory affiliates collectively and determine that the ERA is not qualified for an exemption from registration. In a recent case (See In the Matter of ACP Venture Capital Management Fund LLC dtd 9/20/24), the SEC took enforcement action for registration violations against an ERA with a registered advisory affiliate because the two advisers had overlapping owners, overlapping managers, overlapping advisory personnel, and overlapping operations including shared office space. In order to manage regulatory risk, an ERA with advisory affiliates should obtain a legal opinion regarding the ERA’s operational independence and exemption from registration, and should adopt and implement appropriate controls to ensure that operational independence is maintained.
Myth #5: ERAs Don’t Need to Have a Compliance Program, Written Compliance Policies and Procedures
ERAs are not required under the Advisers Act to adopt compliance policies or procedures since Rule 206(4)-7 only applies to registered investment advisers. However, establishing and implementing a compliance program is certainly a “best practice” and appropriate risk management measure. As stated above, certain regulatory requirements are applicable to ERAs including pay to play, recordkeeping, MNPI protections, fiduciary duty and disclosure obligations, privacy and information security. An effectively implemented compliance program can be the first line of defense against a violation of the securities laws to which ERAs are subject. An ERA that has an established compliance program will have the added benefit of being able to hit the ground running once registered.