In our previous post , we addressed a set of questions regarding the ability of an investment adviser to a private fund to remain exempt from investment-adviser registration in Texas by relying on the “grandfathering” provision of Texas State Securities Board Rule 109.6, as amended on March 31, 2014, if the private fund has not accepted “new beneficial owners” since March 31, 2014.  In this post, we address the following set of questions regarding such an adviser’s transition to being an “exempt reporting adviser” under new Texas State Securities Board Rule 139.23, also effective March 31, 2014:

If an adviser to a hedge fund that is a “3(c)(1) Fund” (as defined in Rule 139.23) has been relying on the grandfathering provision of New Rule 109.6 and the fund receives investment from “new beneficial owners” after March 31, 2014, do the existing investors who originally invested in the fund before March 31, 2014 (“Existing Investors”) need to be “qualified clients,” or do only the investors admitted to the fund after March 31, 2014 need to be “qualified clients”?  If the Existing Investors must be “qualified clients,” as of what date must they be “qualified clients”?

An adviser to a private fund that admits new investors or beneficial owners after March 31, 2014 can no longer rely on the grandfathering provision of New Rule 109.6 and must transition to reliance on Rule 139.23 if it wishes to remain exempt from registration.  Rule 139.23 provides an exemption from investment-adviser registration under the Texas Securities Act for “private fund advisers” (as defined in Rule 139.23), subject to certain conditions.  In addition to the general conditions that apply to all private fund advisers, subsection (c) of Rule 139.23 imposes two additional conditions on advisers to certain 3(c)(1) Funds like hedge funds.  To qualify for the exemption, an adviser to a 3(c)(1) Fund (other than a “private equity fund,” “venture capital fund,” or “real estate fund,” as those terms are defined in Rule 139.23) must:

Subsection (c)(1) of Rule 139.23 provides that each investor in (or ‘beneficial owner” of) the private fund must meet the definition of a “qualified client” in SEC Rule 205-3 under the federal Investment Advisers Act  “at the time the securities are purchased from the issuer.”

This specified time – at the time of purchase or investment – certainly makes sense if the investment is made in the fund while the adviser is relying on Rule 139.23.  (It also makes sense if the investment was made when the private fund adviser was previously registered with the Texas State Securities Board and the hedge fund charged a performance fee, because the registered adviser was required to qualify each investor as a qualified client at the time of investment.)  If, however, an adviser wishes to transition from the exemption under the grandfathering provision of New Rule 109.6 to the exemption under Rule 139.23, neither the rules nor the FAQs address whether Existing Investors who invested while the adviser was relying on the exemption under Texas State Securities Board Rule 109.6 in effect before March 31, 2014 (“Former Rule 109.6”), or who made an additional investment while the adviser was relying on the grandfathering provision of New Rule 109.6, must be qualified clients and, if so, as of what date.

Of course, it does not make any sense to read subsection (c)(1) of Rule 139.23 to require that an Existing Investor, who invested while the adviser was exempt under Former Rule 109.6 have been a “qualified client” at the time of the Existing Investor’s original investment, because Former Rule 109.6 did not, and the grandfathering provision of New Rule 109.6 does not, require investors to be qualified clients as a condition to the exemption.   Rule 139.23, however, does not grandfather Existing Investors from the “qualified client” requirement.  Then, at what time must an Existing Investor be a qualified client?

From conversations with other persons knowledgeable about Rule 139.23, it appears that the answer to the question is that each Existing Investor in the fund must be a qualified client at the time the adviser transitions to reliance on Rule 139.23 and at the time of each subsequent investment (if any) by the Existing Investor.  Accordingly, an adviser that desires to transition from the exemption under the grandfathering provision of New Rule 109.6 to the exemption under Rule 139.23 must ensure that each Existing Investor who remains a “beneficial owner” in a 3(c)(1) Fund is a qualified client, and (correspondingly) that any Existing Investor who is not a qualified client has been redeemed from the fund, at the time of that transition.  (It also appears that a previously registered private fund adviser that wishes to deregister and rely on the exemption under Rule 139.23 does not have to determine that its existing investors are qualified clients at the time of transition if it determined that those investors were qualified clients at the time of each investment.)

We also understand that, in determining the status of an Existing Investor who was not previously determined to be a qualified client, the time of the adviser’s transition to reliance on Rule 139.23 from reliance on the grandfathering provision of New Rule 109.6 is in effect “the time the securities are purchased from the issuer” by the Existing Investor under subsection (c)(1) of Rule 139.23. Accordingly, just as the status of a new investor as a qualified client in the fund is measured only on the date of each investment, and not thereafter, the status of an Existing Investor as a qualified client after the time of transition is not important for the adviser’s reliance on the exemption afforded by Rule 139.23, unless the Existing Investor wishes to make additional investments.  Rule 139.23 requires that each investor be a qualified client at the time of each investment made after March 31, 2014.