“Do I need to register as an investment adviser?” Part 2
In Part 1 of this article discussing real estate syndicators’ obligations under the investment adviser laws, I provided you with the not-so-good news that the SEC and the state securities regulators really do want managers and general partners to real estate investment funds to register as investment advisers even though they are “only” providing advice with respect to real estate and not securities. In this article, I discuss an important exemption to the Texas investment adviser registration requirements.
In Texas, Rule §139.23 of Title 7, Part 7 of the Texas Administrative Code is titled “Registration Exemption for Investment Advisers to Private Funds”. TAC Rule §139.23 exempts advisers to “real estate funds” (among other types of funds). Under § 139.23(a)(5), a “real estate fund” is defined by reference to the definition provided in the instructions to Form ADV. The Form ADV instructions define a “real estate fund” as “any private fund that is not a hedge fund, that does not provide investors with redemption rights in the ordinary course, and that invests primarily in real estate and real estate related assets.” TAC §139.23(a)(2) defines “private fund” identically to Section 202(a)(29) of the Investment Advisers Act of 1940, as amended, which is by reference to Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended (the “Investment Company Act”).
Sections 3(c)(1) and 3(c)(7) of Investment Company Act provide two exemptions from the federal laws regulating the registration of investment companies (e.g., mutual funds, exchange-traded funds (ETFs), real estate investment trusts (REITs), or unit investment trusts (UITs)). A Section 3(c)(1) fund is any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons and which is not making and does not presently propose to make a public offering of its securities. A Section 3(c)(7) fund is 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. Under Investment Company Act Section 2(a)(51), a qualified purchaser generally is an individual having a net worth of $5 million, or a business entity having a net worth of $25 million. Section 3(c)(7) funds generally limit the number of investors to fewer than 2,000 because upon accepting the 2,000th investor, the fund would become subject to the reporting requirements of the Securities Exchange Act of 1934, as amended, under Section 12(g) thereof.
To qualify for the Texas private fund adviser exemption under Rule 139.23 (described above), you must be advising a real estate investment fund that qualifies for the exemptions under either Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. The clients I typically represent sometimes struggle to fund their deals solely with accredited investors, so this requires them to rely on the securities registration (as opposed to investment adviser registration) exemption found in Rule 506(b) of Regulation D, which allows sales to up to 35 non-accredited investors who are “sophisticated”. Notably, Rule 506(b) does not allow the use of general solicitation or advertisement (which Rule 506(c) does). Because some of the investors may not be accredited, the fund will not qualify for the exemption in Section 3(c)(7) because that exemption requires that investors be solely “qualified purchasers”. A Section 3(c)(1) fund may rely on the exemption found in Rule 506(b), accept up to 35 non-accredited but “sophisticated” investors (see here for a discussion about what constitutes “sophistication”), and because there is no general solicitation or advertising, the requirement under Section 3(c)(1) that the issuer is not making a “public offering of its securities”.
Texas’ private fund adviser registration exemption requires the adviser to file Part 1 of Form ADV with FINRA and with the State Securities Board. This is a fairly straight-forward and simple notice filing, but the filing of the Form ADV does require at least one of the adviser’s principals to be designated as an Investment Adviser Representative. That individual will create an account with FINRA and will be assigned a Central Registration Depository, or “CRD” number issued by FINRA. Thereafter, the adviser is subject to surprise examination and audit by the Securities Board. Best practices would require the adviser to adopt policies and procedures reasonably designed to ensure compliance with the laws and regulations applicable to investment advisers, who, in similar fashion to general partners of a partnership and managers of a limited liability company, owe their investors fiduciary duties.
For more information about taking advantage of the private fund adviser exemption from the investment adviser registration rules, please contact me.