• Certain advisers to private funds would be required to report demographic information of the founding team of their portfolio companies with a California nexus beginning March 1, 2025.
• While the law focuses on venture capital funds, its broad definitions would capture other types of investment vehicles, including certain private equity funds and real estate funds.
• The nexus to California is also broadly defined, including a fund that is offered to investors in California though the adviser is not located in the state.
• Advisers should carefully review the law to determine if they need to comply.

California continues its initiatives to increase workplace diversity through a new law that will require certain funds with a nexus to California to report DEI information about the founding teams of their portfolio companies. While this new law focuses on venture capital funds, the definitions within the statute are broad enough to potentially capture private equity and other types of private funds. The law also broadly defines what constitutes a geographic nexus to California, potentially capturing advisers that are not physically located in the State of California.

The Fair Investment Practices by Investment Advisers act (“SB 54”) is a new law that mandates that investment advisers that manage venture capital or certain other private funds to report information about their portfolio companies, including demographic information about the founding members of their portfolio companies and the amount invested in the portfolio companies.¹ This information will be reported to the Civil Rights Department of California (the “Department”) on an annual basis and will be publicly available. This first report is due on March 1, 2025, and will cover the 2024 calendar year.

SB 54 mandates the Department to adopt a survey, which each adviser subject to SB 54 (referred to as “Covered Entities”) would be required to ask its portfolio companies to complete. The portfolio companies, however, may decline to complete the survey. Many terms in SB 54 are not defined, and it is unclear if the yet to be adopted survey will clarify the scope of SB 54.² For purposes of this Dechert OnPoint, we generally refer to “investment advisers,” while SB 54’s application may extend beyond investment advisers, and often refer to the commonly known term “portfolio company,” which SB 54 calls “businesses.”

Who Does SB 54 Apply To?

SB 54 applies to “Covered Entities,” which has a complicated, multi-step definition. This definition is expensive and could capture funds beyond what SB 54’s name would imply. A Covered Entity is (i) a venture capital company that (ii) meets certain operational requirements and (iii) has a geographic nexus to California.

1. A “venture capital company”³ is defined as an entity that:
   1. Annually, beginning on the entity’s initial capitalization, has at least fifty percent (50%) of its assets (other than short-term investments pending long-term commitment or distribution to investors), valued at cost, comprised of Venture Capital Investments or derivative investments;⁴
      1. A “Venture Capital Investment” is an acquisition of securities in an operating company as to which the investment adviser, the entity advised by the investment adviser, or an affiliated person either has or obtains management rights in such operating company.⁵
   2. Is a “venture capital fund” as defined in Rule 203(l)-1 under the Investment Advisers Act of 1940; or
   3. Is a “venture capital operating company” as defined in Rule 2510.3-101(d) under the Employee Retirement Income Security Act of 1974.
2. Pursuant to the operational requirements, the venture capital company must either:
   1. Be primarily engaged in the business of investing in, or providing financing to, startup, early-stage, or emerging growth companies; or
   2. Manage the assets on behalf of third-party investors.
3. The geographic nexus to California would be satisfied if the venture capital company is either:
   1. Headquartered in California;
   2. Has a significant presence or operational office in California;
   3. Makes Venture Capital Investments in businesses that are located in, or have significant operations in, California; or
   4. Solicits or receives investments from a person who is a resident of California.

The definition of a “venture capital company” is expansive and could capture private funds that would not traditionally be deemed to be venture capital funds. Under this definition, any fund where the adviser or the fund has or obtains management rights with respect to at least 50% of its assets would be deemed to be a Covered Entity if the fund has third party investors and a geographical nexus to California. The geographical nexus to California is broad enough that it would be triggered by merely offering the fund to a resident of California. This far-reaching definition would capture, for example, a private equity fund manager with a single asset special purpose vehicle (“SPV”) that receives management rights in its portfolio company if the SPV is offered to a potential investor who is a resident of California but does not invest in the SPV. SB 54 might also be triggered by a real estate fund that, in connection with investing in real estate, acquires an interest in a holding company, manages third party assets and has an office in California. In addition, a subsidiary of a corporate entity that invests in emerging technologies might also be subject to SB 54.

Complicating the application of this definition of “Covered Entity” is the limited guidance in what the terms used mean. For example, “emerging growth companies” and “significant operations” are not defined.

What Information is Required?

While the Department has not yet adopted the survey for the founding team members⁶ to complete, SB 54 does mandate what a Covered Entity is required to report, which includes:

1. Demographic information about the founding teams of all Venture Capital Investment in businesses in which the Covered Entity made in the prior calendar year; these demographic categories include gender identity, race, ethnicity, disability status, LGBTQ+ identification, status as a veteran and whether the individual is a resident of California;
2. The number of Venture Capital Investments to businesses primarily founded by diverse founding team members, broken down by percentage of overall investments for each demographic category made in the prior calendar year;
3. The total amount of Venture Capital Investments in businesses primarily founded by diverse founding team members for each demographic category made in the prior calendar year; and
4. For each business in which a Venture Capital Investment was made during the prior calendar year, the total amount invested and its principal place of business.

SB 54 states that the information regarding the founding team members will be anonymized, but it is not clear if the names of the businesses will be anonymized, thereby helping to thwart reverse engineering to find out specific information about individual founders.

What Happens to this Information?

The information submitted by a Covered Entity would be subject to the public records laws and available for public inspection. Further, SB 54 mandates that the Department make the information available on its website in a manner that is easily searchable and downloadable. In addition, SB 54 states that the Department may use any of the information “in furtherance of its statutory duties, including, but not limited to, using the information in a civil action brought by the [D]epartment.”⁷

Accordingly, this information may have a far-reaching dissemination and, depending on how the information is presented, the ability to expose personal information, of founders. Combined with other publicly available information, there is the possibility that individuals would be able to piece together information and expose private data about individuals.

What Happens if a Report is Not Submitted?

If a Covered Entity fails to submit the required report within 60 days of its due date, the Department has the authority to commence court proceedings seeking specified relief, including monetary penalties.

What Happens Next?

In Governor Newsom’s own signing statement, he admitted that SB 54 has certain “problematic provisions” and “unrealistic timelines.”⁸ His administration plans to propose cleanup language as part of the 2024-25 Governor's Budget. The survey to be adopted by the Department may also provide clarity on how the provisions are intended to apply.

Nonetheless, SB 54 has been criticized for having the potential to mislead and inflate diversity data, being counterproductive to the cause of diversity.⁹ While the information is anonymized, for a portfolio company with a limited founding team, there could be disclosure of information that may be easily traceable to the individuals on the team. The law raises concerns under privacy laws in the United States and in other countries with strong privacy protections such as the members states of the European Union. While the law is intended to promote diversity, it does so from a limited perspective: it ignores the reality that funds that invest internationally may have what the United States would deem to be a “diverse team” due to the geographic location of the team. It also ignores the reality that certain types of gender identity and LGTBQ+ status in certain countries may lead to criminal penalties and other repercussions.

It is reasonably possible that the act will be challenged in court. As of the date of publication, no lawsuits have been filed that challenge this law, but advisers should monitor developments in this area. In addition, advisers should monitor whether any other jurisdictions adopt similar legislation as part of their DEI initiatives.¹⁰

1. The Fair Investment Practices by Investment Advisers, Senate Bill 54, Ch. 594, Statutes of 2023 (October 8, 2023).
2. In addition, AB 54, as adopted, is drafted in a manner that appears to limit its application. Entities that may be subject to AB 54 should review carefully the text of AB 54 to determine if they would need to comply with this new law.
3. Cal. Code Regs. tit. 10, § 260.204.9(a)(4).
4. “Derivative investment” is defined as an acquisition of securities by a venture capital company in the ordinary course of its business in exchange for an existing venture capital investment either (i) upon the exercise or conversion of the existing venture capital investment or (ii) in connection with a public offering of securities or the merger or reorganization of the operating company to which the existing venture capital investment relates. Cal. Code Regs. tit. 10 § 260.204.9(a)(6)
5. Cal. Code Regs. tit. 10, § 260.204.9(a)(5).
6. A “founding team member” is defined as either (1) a person who (a) had an initial ownership interest in the portfolio company, (b) contributed to the concept of, research for, development of, or work performed by the portfolio company before its initial shares were issued and (c) was not a passive investor in the portfolio company; or (2) certain executives of the portfolio company, including the chief executive officer, president, chief financial officer or manager of a portfolio company, or a role with a similar level of authority. Senate Bill 54, Ch. 594, § 22949.85(a)(4)
7. The Fair Investment Practices by Investment Advisers, Senate Bill 54, Ch. 594, § 22949.85(d)(3), Statutes of 2023 (October 8, 2023).
8. Id.
9. National Venture Capital Association, Letter to the Honorable Nancy Skinner re: SB 54 (August 28, 2023).
10. For example, the Financial Conduct Authority, a financial regulatory body in the United Kingdom, is engaging with firms to improve diversity and inclusion in financial services. For more information see Dechert OnPoint: FCA Proposes a New Regulatory Framework on Diversity and Inclusion.