U.S. Regulation Of Private Investment Funds

Thursday, January 1, 2004 - 01:00
Seward & Kissel LLP

This article presents a general overview of the principal U.S. regulatory requirements that are applicable to private investment funds (such as hedge funds, private equity funds and venture capital funds).

Investment Company Act Of 1940

Private investment funds are not subject to Securities and Exchange Commission ("SEC") registration as mutual funds, because they rely on one of the two exemptions from such registration found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940 (the "1940 Act").

Section 3(c)(1)

A privately offered fund (see discussion below relating to private placements) that has no more than 100 beneficial owners (generally, in the case of non-U.S. funds, only U.S. beneficial owners need to be counted) is not required to register as an investment company under Section 3(c)(1) of the 1940 Act (and is referred to as a "3(c)(1) fund"). In a 3(c)(1) fund, when counting beneficial owners, there will be a look-through to: (i) the underlying investors of any fund-of-funds or registered investment company owning 10 percent or more of the 3(c)(1) fund, (ii) those participants of any self-directed pension plan that have individually elected to have their plan monies invested in the 3(c)(1) fund, and (iii) the owners of any entity formed for the purpose of investing in the 3(c)(1) fund (i.e., if 40 percent or more of the entity's assets are invested in the 3(c)(1) fund). There may also be an "integration" of the beneficial owners of other 3(c)(1) funds that have similar investment objectives. Note that a husband and wife who are investing jointly in a 3(c)(1) fund will only count as one investor.

Section 3(c)(7)

A privately offered fund in which each investor is a qualified purchaser (generally, an individual with $5 million or more in "investments" or an entity with $25 million or more in "investments") is exempt from registration as an investment company under Section 3(c)(7) of the 1940 Act (and is referred to as a "3(c)(7) fund"). "Investments" is broadly defined by the SEC and includes securities, cash and cash equivalents, and real estate held for investment purposes; however, any acquisition indebtedness must be deducted. While there is no explicit investor limitation in Section 3(c)(7) (such as in Section 3(c)(1)), in order for a 3(c)(7) fund to avoid being considered a "reporting company" under relevant U.S. securities laws, it should have no more than 499 investors.

Knowledgeable Employees

Certain "knowledgeable employees" of the fund or manager need not be counted for purposes of the 100 beneficial owner limitation under Section 3(c)(1) and need not be "qualified purchasers" under Section 3(c)(7).

Securities Act Of 1933

As mentioned above, private investment fund interests must always be offered and sold on a private placement basis.

Generally, such an offering will be made pursuant to the private placement requirements of Regulation D to prospective investors with whom there is a substantive pre-existing relationship. No form of general solicitation or advertising may be used and typically the offering is made only to "accredited investors" (essentially individuals that have at least a $1 million net worth and entities that have at least $5 million in total assets). Subject to other applicable legal requirements, the fund may also have up to 35 unaccredited investors.

Separately, Regulation S provides another exemption for private placements outside of the U.S. The offer and sale must be made to a person outside of the U.S. and the seller must not engage in any "directed selling efforts" in the U.S. Typically, Regulation S is relied upon in connection with the private placement of a non-U.S. fund to non-U.S. investors.

Investment Advisers Act Of 1940

Many private investment fund managers are exempt from registration as investment advisers with the SEC because they have fewer than 15 clients over a 12-month period and do not hold themselves out to the public as investment advisers. For this purpose, a private investment fund generally counts as one client, as does each separately managed account.

If a private investment fund manager is registered as an investment adviser, it will, among other things: (i) have to file and periodically amend a Form ADV, (ii) be subject to periodic SEC audits, (iii) be permitted to charge performance fees only to those clients who represent that they are "qualified clients" (generally, a $1.5 million net worth; however, in the case of a 3(c)(1) fund-of-funds or similar fund investing in the fund, each of the investing fund's investors must meet this criteria), and (iv) need to adopt various procedures and policies, including procedures relating to its custody of client funds, proxy voting and insider trading.

Commodity Exchange Act

If a private investment fund utilizes any type of futures (including single stock futures), even if just for hedging or on a de minimis basis, Commodity Futures Trading Commission ("CFTC") registration of the manager as a commodity pool operator and, possibly, commodity trading advisor may be required. The CFTC registration requirement would also apply to the managers of: (i) non-U.S. funds with a U.S. jurisdictional nexus, and (ii) funds-of-funds that invest in other funds that trade in futures.

Among other things, CFTC registration may require the passage by certain personnel of a Series 3 exam and also imposes various reporting, recordkeeping and disclosure obligations. These obligations may, to some degree, be mitigated, if the fund is able to rely on the exemptions provided by CFTC Rule 4.7 (i.e., all fund investors are "qualified eligible persons," which essentially means accredited investors with a $2 million securities portfolio) or Rule 4.12(b) (i.e., essentially, the fund limits its futures exposure to no greater than 10 percent commodity futures margin and premiums, but the fund's investors do not have to meet the Rule 4.7 criteria). A Rule 4.7 fund would not have to file a disclosure document with the CFTC, while a 4.12(b) fund would, although there would be less disclosure required than in a disclosure document for a fund that could not rely on Rule 4.12(b).

A manager may, however, seek registration relief if:

(i) it is a non-U.S. manager trading only non-U.S. futures;

(ii) the fund's participants are accredited investors and knowledgeable employees and the manager claiming this exemption operates the fund such that (whether or not for hedging) at all times: (1) the aggregate initial margin and premiums required to establish commodity positions will not exceed 5 percent of the liquidation value of the portfolio or (2) the aggregate net notional value of such positions will not exceed 100 percent of the liquidation value of the portfolio;

(iii) each fund participant that is (1) a natural person is a "qualified purchaser" (generally, a person owning investments of not less than $5 million), knowledgeable employee or a non-U.S. person and (2) a non-natural person is either a qualified eligible person, an accredited investor or a non-U.S. person or entity; or

(iv) in the case of a fund-of-funds manager, it can meet the requirements set forth in (ii) or (iii) above, noting that the CFTC has adopted Appendix A to Part 4 of its Rules illustrating how the trading limitations in (ii) above would apply to a fund-of-funds manager.

Employee Retirement Income Security Act Of 1974 ("ERISA")

Most private investment fund managers (including non-U.S. funds) will limit the investment by benefit plan assets in the fund to less than 25 percent of the value of any class of securities within their funds. Benefit plan assets include assets of both U.S. and non-U.S. employee benefit plans, governmental plans, pension plans, 401k plans, IRAs and entities that themselves have 25 percent or more benefit plan assets. If a fund reaches the 25 percent threshold, there are many ERISA issues to contend with, including bonding, SEC registration as an investment adviser, custody matters, soft dollar restrictions, added liabilities and prohibited transaction rules. In certain cases, the fund may be able to exceed the 25 percent threshold without being subject to certain of the requirements set forth above, if, for example, the manager is a "qualified professional asset manager" or the fund is a "venture capital operating company."

Anti-Money Laundering ("AML") Requirements

Since the passage of the USA PATRIOT Act, there have been various proposals relating to AML made by the Treasury Department ("Treasury"). On September 18, 2002, the Treasury issued a proposed rule governing all Section 3(c)(1) and 3(c)(7) private investment funds that: (i) have $1 million or more in assets, (ii) are organized under the laws of the U.S. or any state therein, organized, operated or sponsored by a U.S. person, or sell ownership interests to any U.S. person, and (iii) permit their owners to redeem interests within two years of their purchase. While most hedge funds would be covered by the rule, most private equity funds and venture capital funds would be exempt. The proposed rule requires that funds covered must implement a written AML program. An AML program would include the: (i) development of internal policies, procedures and controls, (ii) provision for independent testing, (iii) designation of a compliance officer, and (iv) establishment of an ongoing employee training program. Moreover, the proposed rule requires that a fund file a notice with the Treasury with information about the fund, the manager and its investors. While a final rule is still pending, many private investment funds have already begun to adopt AML programs in anticipation of final rules.

Tax Considerations

Depending on the fund's jurisdiction, the location of its manager, the location and tax status of its investors, as well as the securities and other instruments that the fund is trading, there may be pertinent tax issues that will need to be dealt with, including, without limitation, structuring the management companies and the funds, making "check-the-box" elections, providing tax and other information to certain investors, determining trader/investor status, establishing fee deferral arrangements for the manager, dealing with applicable tax shelter regulations, and many other items.

Steven B. Nadel is a Partner at the New York law firm of Seward & Kissel LLP, the law firm that established the very first hedge fund in 1949. Mr. Nadel concentrates in private investment funds (including hedge funds, funds-of-funds, private equity funds, commodity pools and group trusts) and related investment management matters. Mr. Nadel may be contacted at (212) 574-1231 or nadel@sewkis.com.