Corporations Code Section 25234 generally prohibits an investment adviser registered in California to be compensated on the basis of a share of capital gains. This prohibition is analogous to the prohibition found in Section 205(a)(1) of the Investment Advisers Act of 1940 (IAA). Congress included this prohibition because it was believed that performance fees might induce advisers in search or higher fees to take unwarranted risks with their clients’ funds. The Commissioner has adopted a rule that provides several exceptions, Rule 260.234. For example, an investment adviser is excepted when, among other things, the only clients entering into the investment advisory contract are “qualified clients”. Today, I’m focusing not on the exemption, but on the complexity of the definition.
The Commissioner’s rule defines “qualified clients” by reference to a federal regulation, Rule 205-3 under the IAA. The federal rule defines “qualified client” as, among others, a person who is a “qualified purchaser” as defined in Section 2(a)(51)(A) of yet another act, the Investment Company Act of 1940 (ICA). As an initial matter, it is important to recognize that the definition of “qualified purchaser” incorporated into Rule 260.234 is not the same as that found in Corporations Code Section 25102(n)(2).
Now, the statutory definition of “qualified purchaser” is no easy matter. It incorporates other terms defined in the ICA, including “company” (§ 2(a)(8)), “issuer” (§ 2(a)(22)) and “person” (§ 2(a)(28)). In addition, the Securities and Exchange Commission has adopted a rule under the ICA, Rule 2a51-1, that defines “investments” for purposes of the statute. That rule includes 10 separate definitions. Rule 2a51-1 also makes reference to a term defined in Rule 144A under the Securities Act of 1933 (Securities Act) - “qualified institutional buyer”. That rule refers to yet more acts, including the Securities Act, the ICA, the Small Business Investment Act of 1958 (SBIA), the Employee Retirement Income Security Act of 1974 (ERISA), the IAA, and the Securities Exchange Act of 1934. The SEC has adopted yet another rule, Rule 2a51-2, defining “beneficial owner” for purposes of the statute.
Rule 205-3 also employs its own set of definitions for defining “qualified purchaser” - “company” and “executive officer”. The definition of “company” leads you yet another statute – Section 202(a)(5) of the IAA. Moreover, it requires an understanding of who is required to be registered under the ICA.
The bottom line is that to understand the exemption in Rule 260.234, one must take into account at least 30 defined terms, including 14 terms defined by statutes in 6 separate federal acts (the IAA, ICA, SA, SBIA, SEA and ERISA) and 16 terms defined in federal rules adopted under at least 3 different federal acts (the IAA, ICA and SA).
In drafting this blog, I was tempted to refer to the complexity of the definition as “extraordinary”. Unfortunately, this level of complexity is not extraordinary, it is typical.