In a recent enforcement action announced by the Securities and Exchange Commission (SEC), the issue of how one investment adviser can affect the exemption status of related advisers under the Investment Advisers Act of 1940 (Advisers Act) has come into focus. The action serves as a timely reminder for fund managers considering a spinout from an existing investment adviser or forming a new entity that shares management teams or operational functions with another investment adviser. In such cases, it is critical to assess whether the SEC would consider these related, but separately organized, advisers as operationally integrated. The SEC has long admonished that it will treat as a single adviser two or more affiliated advisers that are separate legal entities but operationally integrated, which could result in a requirement for one or both advisers to register under the Advisers Act. (See Exemptions for Advisers to Venture Capital Funds, Private Fund Advisers With Less Than $150 Million in Assets Under Management, and Foreign Private Advisers, at 125 (June 22, 2011). For a high-level overview of the exemptions from registration as an investment adviser available to fund managers, see our April 2024 blog post, “Securities Laws Fundamentals for Venture Capital Fund Managers.”)
What is operational integration?
A fundamental principle under the Advisers Act is that an adviser cannot indirectly do something that would be unlawful for it to do directly. This means investment advisers and their affiliates cannot circumvent their registration requirements under the Advisers Act by forming separate entities if they are ultimately “operationally integrated.” As an example, an investment adviser relying on the venture capital adviser exemption (VC exemption) must not advise any client that is not a venture capital fund. A fund manager relying on the VC exemption might wonder if it can simply form a separate legal entity to manage a secondary fund, continuation vehicle, fund of funds, crypto fund or another type of fund that would not satisfy the “venture capital fund” requirements under the Advisers Act. Unsurprisingly, the concept of operational integration would not permit such a simple workaround.
As another example, an investment adviser relying on the private fund adviser exemption (PF exemption) must advise only private funds and have regulatory assets under management (i.e., gross assets under management) of less than $150 million. A fund manager relying on the PF exemption could not simply set up a new investment adviser entity every time its regulatory assets under management near $150 million to avoid registration.
While the determination of whether an adviser and its affiliates are operationally integrated depends on the facts and circumstances, the basic framework for conducting such an analysis is a five-factor test that the SEC staff established in a no-action letter to Richard Ellis. Under that framework, an adviser may be regarded as having a separate, independent existence and deemed to be functioning independently of an affiliated adviser if it:
- Is adequately capitalized.
- Has a buffer between its personnel and the affiliated adviser – such as a board of directors, a majority of whose members are independent of the affiliated adviser.
- Has employees, officers and directors who, if engaged in providing advice in its day-to-day business, are not otherwise engaged in the investment advisory business of the affiliated adviser.
- Itself makes the decisions as to what investment advice is to be communicated to – or is to be used on behalf of – its clients, and has and uses sources of investment information not limited to its affiliated adviser.
- Keeps its investment advice confidential until communicated to its clients.
While larger organizations often have multiple adviser entities that can – and do – establish adequate separation to achieve operational independence, in our experience, it is much more challenging for smaller organizations to do the same. In addition to the cost and expense typically associated with having separate operations, we find that the separation of investment personnel and investment advice is not practical and is often inconsistent with commercial objectives.
The SEC’s enforcement actions
Since the Richard Ellis no-action letter was published, the SEC has brought a handful of enforcement actions involving operational integration. Two were brought in June 2014 against affiliated advisers TL Ventures and Penn Mezzanine Partners Management. One was brought in July 2017 against affiliated advisers Bradway Financial and Bradway Capital Management. The final one was brought in September 2024 against ACP Venture Capital Management Fund.
While all of these enforcement actions were settled, they nevertheless provide valuable insight into what the SEC considers – beyond the factors outlined in Richard Ellis – when determining whether separately formed adviser entities are operationally integrated. Specifically, the SEC cited the following in these enforcement actions:
- Sharing the same office with no physical separation.
- Sharing the same email domain and phone number.
- Sharing the same technology systems.
- Marketing materials that reference a “partnership” between the advisers and an ability to leverage and benefit from such relationship, including outsourcing of back-office functions.
- Managing directors of one adviser serving on the investment committee of the other adviser and soliciting investors for funds managed by the second adviser.
- Lack of information security policies and procedures to protect investment advisory information from disclosure to one another.
- Employees of one adviser routinely using their email addresses associated with the other adviser in conducting business and communicating with outside parties about and on behalf of the first adviser.
In the settled actions, either one or both affiliated entities sought to rely on the VC exemption or the PF exemption. The SEC found that on an integrated basis, taking into consideration the factors above, the advisers were not eligible for the exemption they sought because they either advised a type of client not permitted under the applicable exemption, or they exceeded the regulatory assets under management permitted under the PF exemption.
Notably, the enforcement actions from 2014 and 2017 involved adviser entities that were clearly under common control and had at least one individual that owned more than 25% of each adviser entity. In the most recent enforcement action, no individual owned more than 25% of each adviser entity. The only common owner was an individual who owned 50% of adviser A and 20% of adviser B. That individual, however, served as the chief compliance officer of both adviser A and adviser B. Moreover, the other 50% owner of adviser A served as an accounting consultant to adviser B, and two individuals who each owned a 40% interest in adviser B (one of whom was the president of adviser B) co-managed certain funds of adviser A. According to the SEC’s settlement order, adviser A and adviser B also had other overlap in personnel, including other investment personnel, and no physical separation.
We note the limited overlap in the ownership of adviser A and adviser B because, in general, operational integration involves affiliated advisers, and affiliated advisers under the Advisers Act typically means there is at least one individual that owns more than 25% of each adviser. This is because affiliates are defined as being in a controlling, controlled by or under common control relationship, and control is generally presumed to exist when a person owns more than 25% of the voting interest in an entity, while control is presumed to not exist when a person owns 25% or less of the voting interest in an entity. That said, the Advisers Act defines the term “control” as the power to exercise a controlling influence over the management or policies of a company. A common owner with a 25% voting interest in each entity is not a requisite for two entities to be under common control.
Key takeaway for fund managers
For our clients and fund managers generally, the most important takeaway from the recent enforcement action is probably the reminder that the Advisers Act prohibits investment advisers from doing indirectly what they cannot do directly. Whether or not two entities have identical owners, substantial overlap in owners or limited overlap in owners, if they are operated as an integrated business without adequate policies and procedures to separate their advisory activities, then the analysis as to whether the VC exemption or the PF exemption applies would need to be conducted treating both entities as a single adviser.
We know that the decision to register as an investment adviser is not taken lightly by exempt fund managers. To this end, if you are considering setting up a new entity to navigate around the registration and exemption requirements, we recommend reaching out to your Cooley contact to discuss operational integration. The recent enforcement action could mark a renewed focus by the SEC on this topic.
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