Speech by SEC Commissioner:
Statement at Open Meeting to Propose Rules Regarding Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers with Less Than $150 Million in Assets Under Management, and Foreign Private Advisers and Implementing Amendments to the Investment Advisers Act of 1940
Commissioner Troy A. Paredes
U.S. Securities and Exchange Commission
November 19, 2010
Thank you, Chairman Schapiro.
The proposals before us this morning would implement certain provisions of the Dodd-Frank Act that amend the Investment Advisers Act of 1940.
The "Exemptions Release" proposes rule amendments that would implement the provisions of Dodd-Frank providing for new exemptions from registration for foreign private advisers; for advisers to venture capital (VC) funds; and for advisers to private funds with assets under management of less than $150 million.
The "Implementing Release" proposes rule amendments that, among other things, would implement the provisions of Dodd-Frank that raise the assets-under-management threshold for an investment adviser to register with the SEC and that eliminate the exemption from registration that Section 203(b)(3) of the Advisers Act had afforded advisers with fewer than 15 clients. The proposal also would impose public reporting obligations on certain investment advisers, including managers of venture capital funds, even though they would be exempt from registration as investment advisers.
The proposing releases seek comment on a range of topics, and, as always, I look forward to hearing commenters' views. However, in my remarks this morning, I am going to focus on one aspect of the recommendations: the implications for venture capital.
Before Dodd-Frank amended the Advisers Act, VC fund managers could avail themselves of Section 203(b)(3) of the Advisers Act, which provided an exemption from registration for an adviser with fewer than 15 clients. This private adviser exemption no longer exists. Instead, Dodd-Frank amended the Advisers Act to add new Section 203(l). Section 203(l) exempts managers of VC funds from having to register with the Commission, although VC fund managers may be subjected to reporting and recordkeeping requirements.
It matters that Congress put the new VC registration exemption in Section 203(l) of the Advisers Act instead of Section 203(b), where the former private adviser exemption was found. It matters because Section 204(a) of the Advisers Act only expressly exempts from SEC examination investment advisers that are exempt from registration under Section 203(b). A facial reading of Section 204(a), therefore, would indicate that a VC fund manager that is exempt from registration under Section 203(l) is subject to examination, since the VC registration exemption is not found in Section 203(b) of the Advisers Act.1
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With this statutory backdrop in mind, let me first turn to the question of: What is a "venture capital fund" for purposes of the Section 203(l) VC registration exemption? Dodd-Frank directs the Commission to define "venture capital fund."
To my mind, the VC fund registration exemption itself is backed by strong policy justifications. For example, having to satisfy new regulatory requirements could take time and effort, as well as financial resources, away from more productive endeavors that benefit fund investors and the companies backed by venture capital. As regulatory demands increase, time and effort that fund managers and other professionals could have spent analyzing investment opportunities or providing managerial guidance to startups and other early stage enterprises likely would be redirected to tend to new regulatory obligations.
Second, mounting regulatory mandates can erect barriers that discourage entry by new venture capital funds.
Third, additional regulation runs the risk of jeopardizing the benefits that venture capital contributes to our economy. To the extent venture capital funds are required to bear more regulatory burdens, I am concerned that their activities will be impeded, frustrating capital formation. To put it more concretely, when capital formation is frustrated, it becomes increasingly difficult for startups and other small businesses to finance the research and development of new ideas, to commercialize cutting-edge technologies and innovative products, and to create new jobs by entering the market or expanding their operations. Such undesirable results are not good for business; nor are they good for a venture capital fund's investors. And such an adverse outcome would not be good for our nation's economy.
Fourth, even when not statutorily required, VC funds provide meaningful disclosures to their investors because investors demand information, and fund investors perform their own effective diligence in evaluating whether to invest in a fund. Accordingly, there is some doubt, in my mind, as to whether there is any appreciable marginal investor protection benefit from subjecting a VC fund manager to additional regulation and oversight under the Advisers Act. Indeed, as I understand it, the investors in VC funds — which qualify as at least accredited investors and which in many instances are large institutions — have not generally insisted that VC fund managers register with the SEC.
Fifth, whatever the causes may have been of the financial crisis, blame cannot be placed on the venture capital industry. More to the point, given their lack of leverage, the nature of their investments, and the degree to which they are not interconnected with the rest of the financial system, it would be very difficult to conclude that venture capital funds pose a systemic risk. Congress recognized this in providing a registration exemption for VC fund advisers.
For these and other reasons, I am pleased that the VC registration exemption is part of Dodd-Frank, although I would have preferred to have seen the exemption effectuated through an amendment to Section 203(b) of the Advisers Act.
The definition of "venture capital fund" that we are voting on reflects a thoughtful approach that is flexible in a number of respects and that strives to accommodate the reality of how venture capital funds operate and invest. I support the recommendation, including, I should add, the aspects of the proposal that relate to the exemption for private fund advisers with less than $150 million in assets under management and the aspects of the proposal that relate to the foreign private advisers exemption.
While I welcome all the comments we will receive, I am particularly interested in comments that address the following:
Under the proposed definition of "venture capital fund," a qualifying portfolio company cannot borrow "in connection with" a venture capital fund's investment. Is the proposal clear enough about what "in connection with" means? Are there typical financing structures that combine borrowing by a portfolio company and an equity investment by a venture capital fund? Should there be any limit on the ability of a portfolio company to borrow "in connection with" a VC fund's investment so long as the VC fund itself is not leveraged in excess of the proposed definition's limitation on leverage?
Under the proposal, venture capital funds that invest as a group would only satisfy the definition of "venture capital fund" if each fund or its adviser offered and, if the offer were accepted, provided managerial assistance to the portfolio company or exercised control. Should the rule expressly permit the members of the group to designate which fund or funds will offer and provide managerial assistance on behalf of the entire group? Would this or some other approach better enable funds to allocate their expertise and resources efficiently? Under what circumstances, if any, do venture capital funds invest in a company without offering to provide managerial assistance?
The proposed "venture capital fund" definition limits a fund to investing in companies that are not publicly traded when the investment is made. In what circumstances might a venture capital fund desire to make an investment in a publicly-traded company? Would the definition's restriction on such investments disproportionately impact a particular type of venture-backed company or a particular industry sector? How might we build flexibility into the definition of "venture capital fund" to permit VC funds to invest in publicly-traded companies but without unduly expanding the scope of the VC registration exemption to encompass non-venture capital funds?
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Turning to the Implementing Release, I am willing to support the recommendation, although I do so with hesitation. Among other things, the Commission is proposing certain public reporting requirements for VC fund managers that are exempt from Advisers Act registration. I think there is a legitimate question as to whether or not the degree of reporting the proposal looks to impose on VC fund managers is "necessary or appropriate in the public interest or for the protection of investors," as is required under the Advisers Act for the Commission to impose these regulatory burdens.
That said, as already mentioned, a plain reading of Section 204(a) of the Advisers Act would lead to the conclusion that, notwithstanding the VC registration exemption, a VC fund manager is subject to examination by the SEC. One concern, then, is how the Commission should exercise its examination authority.
Without conceding that the SEC should examine VC fund managers that are exempt from registration, to the extent such advisers are examined, the Commission staff should do so in a way that is efficient and that minimizes the disruption to the manager and the fund. My preliminary assessment is that the limited information we propose to collect from VC fund managers would better position us to do just that by giving the SEC the kind of basic information that would allow us to allocate our examination resources responsibly — which is to say, in a way that does not unduly burden the venture capital industry.
Particularly given my hesitation in mandating public reporting by VC fund managers, I very much look forward to hearing from commenters. What are the likely out-of-pocket financial costs of complying with the proposed disclosure obligations? Would complying with these obligations distract managers and other VC fund professionals from their investment activities? To what extent, if any, would these regulatory requirements — particularly when coupled with the prospect of an examination — discourage a potential manager from starting a new VC fund? Is any of the information that would be disclosed proprietary or otherwise competitively sensitive? If so, in what ways would public disclosure disadvantage VC funds and, by extension, their investors and portfolio companies?
I hope commenters will address these questions in some detail.
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I want to conclude with two overarching thoughts.
First, as the Commission, we should ensure that the VC registration exemption is consequential in practice. In other words, the daylight between the regulatory burdens a registered adviser must shoulder and those that an adviser that is exempt from registration must bear must be meaningful for the difference between being registered and unregistered to matter. I would be very troubled if, over time, the Advisers Act regulatory regime that applies to exempt advisers came to closely resemble the regime that governs registered advisers. Such a result would largely negate the purpose behind the VC registration exemption that Congress saw fit to enact.
Second, there is no question that firms need capital. A great idea combined with a great business plan does not get very far without financing at a reasonable cost. For early stage and other smaller companies, access to venture capital can be essential to getting off the ground and developing as a commercially viable business. In fact, many companies that have received venture financing over the years are global leaders today, and many solutions to vexing problems have and undoubtedly will come from venture-backed companies. This is all to emphasize the high cost to all of us if regulation were to unduly burden the venture capital industry.
Finally, I want to join my colleagues in thanking the staff — particularly those from the Division of Investment Management — for your dedication and efforts on these proposals.