We have received a number of questions over the last few months regarding the new Texas investment-adviser-registration exemptive rules that became effective on March 31, 2014. These questions have concerned both (1) the “grandfathering” provision of new or amended Texas State Securities Board Rule 109.6 which allows an adviser to private funds to continue to rely on the exemption under Rule 109.6 as in effect before March 31, 2014 (“Former Rule 109.6”), and (2) the conditions required for an adviser to rely on the exemption for “exempt reporting advisers” under new Texas State Securities Board Rule 139.23.
For example, an investment adviser that sponsors and manages a hedge fund in Texas that was formed and operating before March 31, 2014 has expressed its desire to remain exempt from the investment-adviser-registration requirement under the Texas Securities Act. Before the new rules became effective, the adviser was exempt under Former Rule 109.6 because, among other things, the hedge fund does not permit any natural-person investor to redeem his interest within two years of purchasing the interest. With the effectiveness of New Rule 109.6, an adviser to a “private fund” (as defined in new Rule 139.23) may not continue to rely on Former Rule 109.6 unless the adviser qualifies for the “grandfathering” provision included in subsection (e) of New Rule 109.6. After March 31, 2014, the adviser could continue to rely on the grandfathering provision so long as the private fund ceases to accept new beneficial owners (see the Texas State Securities Board’s “Private Fund Adviser FAQs”). The adviser has posed two sets of questions related to its reliance on the grandfathering provision of New Rule 109.6 as well as its ability to qualify for the “exempt reporting adviser” exemption under Rule 139.23:
- Does the hedge fund’s acceptance of an additional investment from an existing investor who originally invested in the fund before March 31, 2014 (an “Existing Investor”) prevent the adviser from relying on the grandfathering provision of New Rule 109.6? If not, must the additional investment be subject to a “two-year lock-up” as required by Former Rule 109.6 if the Existing Investor is a natural person?
- If the hedge fund is a “3(c)(1) Fund” (as defined in Rule 139.23) that accepts investments from “new beneficial owners” after March 31, 2014, so that the adviser (if it wishes to remain exempt) must transition from reliance on the grandfathering provision of New Rule 109.6 to reliance on Rule 139.23, do each of the Existing Investors need to be “qualified clients,” or do only the new 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”?
We address the first set of questions in this post, and will address the second set of questions in a subsequent post.
To continue to be exempt under the grandfathering provision of New Rule 109.6 after March 31, 2014, an adviser must meet the conditions stated in subsection (e) of that Rule. One of the conditions is that the private fund must cease to accept any “new beneficial owner” of the fund after March 31, 2014. “New beneficial owner” is not defined in or by the new rules. Nevertheless, the State Securities Board’s release proposing new Rule 109.6 (or the amendments to Former Rule 109.6), its release adopting that Rule (or those amendments), and the FAQs each include statements interpreting “new beneficial owner.” Those statements explain that certain transferees from Existing Investors in a fund, such as certain donees of gifts from Existing Investors, are not considered “new beneficial owners.” But New Rule 109.6 and the FAQs do not, and the two releases did not, indicate whether an adviser relying on the grandfathering provision would be able to continue that reliance if the adviser’s fund accepted additional investments from Existing Investors after March 31, 2014. In other words, does the fund’s acceptance of an additional investment from an Existing Investor after March 31, 2014 violate the condition that the fund must cease to accept any “new beneficial owner” after March 31, 2014?
From conversations with other persons knowledgeable about New Rule 109.6, it appears that the answer is that the hedge fund’s acceptance of an additional investment from an Existing Investor would not violate the condition to the grandfathering provision, because the Existing Investor would not become a “new beneficial owner” of the fund by virtue of its additional investment. Nevertheless, each such additional investment must comply with Former Rule 109.6, including a two-year lock-up if the investment is made by a natural person. Therefore, the adviser could continue to rely on the grandfathering provision of New Rule 109.6, and would not need to transition to reliance on Rule 139.23, with its “exempt-reporting-adviser” filing requirements. Each additional investment in the fund by an Existing Investor who is a natural person, however, may not be subject to redemption by the Existing Investor within two years from the date of the investment.