Monthly Archives: October 2008

Section 3(c)(7) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

In addition to the Section 3(c)(1) exemption discussed in a previous post, this article describes the section 3(c)(7) exemption.

A 3(c)(7) hedge fund is exempt under the Investment Company Act and must comply with two basic requirements: (1) the fund can have only qualified purchasers as investors and (2) the fund can have no more than 499 investors.  These requirements are detailed below.

Qualified Purchaser Requirement

There are two exemptions from the Investment Company Act registration provisions for hedge funds.  Under the first regulation, each investor must be a qualified purchaser.  Section 3(c)(7) states:

None of the following persons is an investment company within the meaning of this title: any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Generally, a qualified purchaser is an individual with a liquid net worth of $5 million or an institution with a net worth of $25 million. You will notice that in additional to the qualified purchaser requirement, the fund cannot make a public offering of its securities.  Because almost all hedge funds are offered pursuant to the Regulation D offering rules, this requirement will always be met.

500 or Fewer Investors

Unlike the Section 3(c)(1) exemption which limits the amount of investors in this type of fund, the Section 3(c)(7) exemption does not contain any such limit on the amount of qualified purchasers who can invest in the fund. However, hedge funds are subject to all of the federal securities laws which include the Securities Exchange Act of 1934.  Under the Exchange Act, Section 12(g)(1) provides that a Section 3(c)(7) hedge fund would be required to register under the Exchange Act as a reporting company if the hedge fund had more than $10,000,000 in assets and 500 or more investors.  As 3(c)(7) hedge funds are available only to qualified purchasers, the $10 million in assets would be an easy threshold to meet and this is why 3(c)(7) funds are limited to 499 investors.

While registration under Exchange Act is not as onerous as under the Securities Act of 1933, it is still undesirable for hedge fund managers.  If a hedge fund manager did register under the Exchange Act (which some have chosen to do, although mostly in the non-securities context), the fund would become a “reporting company” and would need to submit certain periodic reports to the SEC.  Because these reports are time consuming and expensive to produce, most 3(c)(7) hedge funds will specifically state that no more than 499 investors may participate in the offering.

Other related articles include:

Please contact us if you have any questions.

Overview of the Securities Exchange Act of 1934

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The Securities Exchange Act of 1934 (the “Exchange Act”) is a very important act for hedge fund managers.  This act affects many aspects of the hedge fund industry and Section 10 (and accompanying Rule 10b-5) is a central source of power for the SEC.  I have included an overview of the important sections of the Exchange Act and have also included the SEC’s summary discussion of the Act as well.  This is not meant to be exhaustive and you should discuss any questions you have with your hedge fund attorney.

Section 3 – Definitions

One of the more important questions in the hedge fund industry is whether or not the managers of hedge funds need to be registered as brokers under the Exchange Act.  The SEC has provided guidance on broker registration which indicates that hedge fund managers may be required to register as brokers.  While only a few of the very large hedge funds actually follow the prudent practice of registering a manager as broker, it is an issue which hedge fund managers should be aware of.

Below is the definition of a broker which is extremely broad.

The term “broker” means any person engaged in the business of effecting transactions in securities for the account of others.

Section 10 – Manipulative and Deceptive Devices

It is very important that hedge fund managers do not engage in manipulative or deceptive practices.  Because of the importance of this section, I have published it in its entirety:

It shall be unlawful for any person, directly or indirectly, by the use of any means or instrumentality of interstate commerce or of the mails, or of any facility of any national securities exchange-

(a)

(1) To effect a short sale, or to use or employ any stop-loss order in connection with the purchase or sale, of any security registered on a national securities exchange, in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

(2)Paragraph (1) of this subsection shall not apply to security futures products.

(b)To use or employ, in connection with the purchase or sale of any security registered on a national securities exchange or any security not so registered, or any securities-based swap agreement (as defined in section 206B of the Gramm-Leach-Bliley Act), any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Rules promulgated under subsection (b) that prohibit fraud, manipulation, or insider trading (but not rules imposing or specifying reporting or recordkeeping requirements, procedures, or standards as prophylactic measures against fraud, manipulation, or insider trading), and judicial precedents decided under subsection (b) and rules promulgated thereunder that prohibit fraud, manipulation, or insider trading, shall apply to security-based swap agreements (as defined in section 206B of the Gramm-Leach-Bliley Act) to the same extent as they apply to securities. Judicial precedents decided under section 17(a) of the Securities Act of 1933 and sections 9, 15, 16, 20, and 21A of this title, and judicial precedents decided under applicable rules promulgated under such sections, shall apply to security-based swap agreements (as defined in section 206B of the Gramm-Leach-Bliley Act) to the same extent as they apply to securities.

Section 12

Section 12(g)(1) is important for hedge fund managers of Section 3(c)(7) hedge funds.  This provision provides that a Section 3(c)(7) hedge fund would need to register under the Exchange Act as a reporting company if the hedge fund had more than $10,000,000 in assets and 500 or more investors.

Section 13 Reporting Requirements

There are three main reporting items which hedge funds need to be aware of under Section 13.

Section 13(d) – hedge fund managers which “beneficially own” more than 5% of a class of publicly traded equity securities must file disclosure reports within 10 days of the acquisition of the 5% share.  Managers will file a Schedule 13D with the SEC.

Section 13(f) – requires hedge fund managers which have investment discretion over $100 million or more of publicly traded equity securities to file quarterly reports.  These quarterly reports disclose the amount and type of the hedge fund’s holdings.  Managers will file a Schedule 13F with the SEC.

Please also see a discussion of Section 13F filings for hedge funds.

Section 13(g) – certain hedge fund managers which “beneficially own” more than 5% of a class of publicly traded equity securities can make an alternative filing under this section in lieu of the Schedule 13D filing.     Managers will file a Schedule 13G with the SEC.

Section 16

Provides certain rules applicable to hedge funds which are involved in activist investing or getting involved in portfolio companies.  Section 16 applies if the fund owns more than 10% of a class of the public’s company’s outstanding equity securities.  Section 16 may also apply if directors or employees of  a hedge fund serve as an officer or director of a publicly traded company.

Section 28

Section 28(e) provides the statutory safe harbor for certain “soft dollar” practices.

In addition to the above sections, below is the SEC’s description of the Securities Exchange Act of 1934 and its important provisions.  This description can also be found here.

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Securities Exchange Act of 1934

With this Act, Congress created the Securities and Exchange Commission. The Act empowers the SEC with broad authority over all aspects of the securities industry. This includes the power to register, regulate, and oversee brokerage firms, transfer agents, and clearing agencies as well as the nation’s securities self regulatory organizations (SROs). The various stock exchanges, such as the New York Stock Exchange, and American Stock Exchange are SROs. The National Association of Securities Dealers, which operates the NASDAQ system, is also an SRO.

The Act also identifies and prohibits certain types of conduct in the markets and provides the Commission with disciplinary powers over regulated entities and persons associated with them.

The Act also empowers the SEC to require periodic reporting of information by companies with publicly traded securities.

Corporate Reporting

Companies with more than $10 million in assets whose securities are held by more than 500 owners must file annual and other periodic reports. These reports are available to the public through the SEC’s EDGAR database.

Proxy Solicitations

The Securities Exchange Act also governs the disclosure in materials used to solicit shareholders’ votes in annual or special meetings held for the election of directors and the approval of other corporate action. This information, contained in proxy materials, must be filed with the Commission in advance of any solicitation to ensure compliance with the disclosure rules. Solicitations, whether by management or shareholder groups, must disclose all important facts concerning the issues on which holders are asked to vote.

Tender Offers

The Securities Exchange Act requires disclosure of important information by anyone seeking to acquire more than 5 percent of a company’s securities by direct purchase or tender offer. Such an offer often is extended in an effort to gain control of the company. As with the proxy rules, this allows shareholders to make informed decisions on these critical corporate events.

Insider Trading

The securities laws broadly prohibit fraudulent activities of any kind in connection with the offer, purchase, or sale of securities. These provisions are the basis for many types of disciplinary actions, including actions against fraudulent insider trading. Insider trading is illegal when a person trades a security while in possession of material nonpublic information in violation of a duty to withhold the information or refrain from trading.

Registration of Exchanges, Associations, and Others

The Act requires a variety of market participants to register with the Commission, including exchanges, brokers and dealers, transfer agents, and clearing agencies. Registration for these organizations involves filing disclosure documents that are updated on a regular basis.

The exchanges and the National Association of Securities Dealers (NASD) are identified as self-regulatory organizations (SRO). SROs must create rules that allow for disciplining members for improper conduct and for establishing measures to ensure market integrity and investor protection. SRO proposed rules are published for comment before final SEC review and approval.

The full text of this Act can be read at: http://uscode.house.gov/download/pls/15C2B.txt. (Please check the Classification Tables maintained by the US House of Representatives Office of the Law Revision Counsel for updates to any of the laws.)

Section 28(e) of the Securities Exchange Act of 1934

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Section 28(e) – Exchange, broker, and dealer commissions; brokerage and research services

(1) No person using the mails, or any means or instrumentality of interstate commerce, in the exercise of investment discretion with respect to an account shall be deemed to have acted unlawfully or to have breached a fiduciary duty under State or Federal law unless expressly provided to the contrary by a law enacted by the Congress or any State subsequent to June 4, 1975, solely by reason of his having caused the account to pay a member of an exchange, broker, or dealer an amount of commission for effecting a securities transaction in excess of the amount of commission another member of an exchange, broker, or dealer would have charged for effecting that transaction, if such person determined in good faith that such amount of commission was reasonable in relation to the value of the brokerage and research services provided by such member, broker, or dealer, viewed in terms of either that particular transaction or his overall responsibilities with respect to the accounts as to which he exercises investment discretion. This subsection is exclusive and plenary insofar as conduct is covered by the foregoing, unless otherwise expressly provided by contract: Provided, however, That nothing in this subsection shall be construed to impair or limit the power of the Commission under any other provision of this title or otherwise.

(2) A person exercising investment discretion with respect to an account shall make such disclosure of his policies and practices with respect to commissions that will be paid for effecting securities transactions, at such times and in such manner, as the appropriate regulatory agency, by rule, may prescribe as necessary or appropriate in the public interest or for the protection of investors.

(3) For purposes of this subsection a person provides brokerage and research services insofar as he–

(A) furnishes advice, either directly or through publications or writings, as to the value of securities, the advisability of investing in, purchasing, or selling securities, and the availability of securities or purchasers or sellers of securities;

(B) furnishes analyses and reports concerning issuers, industries, securities, economic factors and trends, portfolio strategy, and the performance of accounts; or

(C) effects securities transactions and performs functions incidental thereto (such as clearance, settlement, and custody) or required in connection therewith by rules of the Commission or a self-regulatory organization of which such person is a member or person associated with a member or in which such person is a participant.

(4) The provisions of this subsection shall not apply with regard to securities that are security futures products.

Section 12(g)(1) of the Securities Exchange Act of 1934

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Section 12(g)(1)

Every issuer which is engaged in interstate commerce, or in a business affecting interstate commerce, or whose securities are traded by use of the mails or any means or instrumentality of interstate commerce shall—(a) within one hundred and twenty days after the last day of its first fiscal year ended after July 1, 1964, on which the issuer has total assets exceeding $10,000,000 and a class of equity security (other than an exempted security) held of record by seven hundred and fifty or more persons; and (b) within one hundred and twenty days after the last day of its first fiscal year ended after two years from July 1, 1964, on which the issuer has total assets exceeding $10,000,000 and a class of equity security (other than an exempted security) held of record by five hundred or more but less than seven hundred and fifty persons, register such security by filing with the Commission a registration statement (and such copies thereof as the Commission may require) with respect to such security containing such information and documents as the Commission may specify comparable to that which is required in an application to register a security pursuant to subsection (b) of this section. Each such registration statement shall become effective sixty days after filing with the Commission or within such shorter period as the Commission may direct. Until such registration statement becomes effective it shall not be deemed filed for the purposes of section 18. Any issuer may register any class of equity security not required to be registered by filing a registration statement pursuant to the provisions of this paragraph. The Commission is authorized to extend the date upon which any issuer or class of issuers is required to register a security pursuant to the provisions of this paragraph.

Section 13(g) of the Securities Exchange Act of 1934

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Section 13(g) – Statement of equity security ownership

(1) Any person who is directly or indirectly the beneficial owner of more than 5 per centum of any security of a class described in subsection (d)(1) shall send to the issuer of the security and shall file with the Commission a statement setting forth, in such form and at such time as the Commission may, by rule, prescribe–

(A) such person’s identity, residence, and citizenship; and

(B) the number and description of the shares in which such person has an interest and the nature of such interest.

(2) If any material change occurs in the facts set forth in the statement sent to the issuer and filed with the Commission, an amendment shall be transmitted to the issuer and shall be filed with the Commission, in accordance with such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

(3) When two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a “person” for the purposes of this subsection.

(4) In determining, for purposes of this subsection, any percentage of a class of any security, such class shall be deemed to consist of the amount of the outstanding securities of such class, exclusive of any securities of such class held by or for the account of the issuer or a subsidiary of the issuer.

(5) In exercising its authority under this subsection, the Commission shall take such steps as it deems necessary or appropriate in the public interest or for the protection of investors (A) to achieve centralized reporting of information regarding ownership, (B) to avoid unnecessarily duplicative reporting by and minimize the compliance burden on persons required to report, and (C) to tabulate and promptly make available the information contained in any report filed pursuant to this subsection in a manner which will, in the view of the Commission, maximize the usefulness of the information to other Federal and State agencies and the public.

(6) The Commission may, by rule or order, exempt, in whole or in part, any person or class of persons from any or all of the reporting requirements of this subsection as it deems necessary or appropriate in the public interest or for the protection of investors.

Section 13(f) of the Securities Exchange Act of 1934

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Section 13(f) Reports by institutional investment managers

(1) Every institutional investment manager which uses the mails, or any means or instrumentality of interstate commerce in the course of its business as an institutional investment manager and which exercises investment discretion with respect to accounts holding equity securities of a class described in subsection (d)(1) of this section having an aggregate fair market value on the last trading day in any of the preceding twelve months of at least $100,000,000 or such lesser amount (but in no case less than $10,000,000) as the Commission, by rule, may determine, shall file reports with the Commission in such form, for such periods, and at such times after the end of such periods as the Commission, by rule, may prescribe, but in no event shall such reports be filed for periods longer than one year or shorter than one quarter. Such reports shall include for each such equity security held on the last day of the reporting period by accounts (in aggregate or by type as the Commission, by rule, may prescribe) with respect to which the institutional investment manager exercises investment discretion (other than securities held in amounts which the Commission, by rule, determines to be insignificant for purposes of this subsection), the name of the issuer and the title, class, CUSIP number, number of shares or principal amount, and aggregate fair market value of each such security. Such reports may also include for accounts (in aggregate or by type) with respect to which the institutional investment manager exercises investment discretion such of the following information as the Commission, by rule, prescribes–

(A) the name of the issuer and the title, class, CUSIP number, number of shares or principal amount, and aggregate fair market value or cost or amortized cost of each other security (other than an exempted security) held on the last day of the reporting period by such accounts;

(B) the aggregate fair market value or cost or amortized cost of exempted securities (in aggregate or by class) held on the last day of the reporting period by such accounts;

(C) the number of shares of each equity security of a class described in subsection (d)(1) of this section held on the last day of the reporting period by such accounts with respect to which the institutional investment manager possesses sole or shared authority to exercise the voting rights evidenced by such securities;

(D) the aggregate purchases and aggregate sales during the reporting period of each security (other than an exempted security) effected by or for such accounts; and

(E) with respect to any transaction or series of transactions having a market value of at least $500,000 or such other amount as the Commission, by rule, may determine, effected during the reporting period by or for such accounts in any equity security of a class described in subsection (d)(1) of this section–

(i) the name of the issuer and the title, class, and CUSIP number of the security;

(ii) the number of shares or principal amount of the security involved in the transaction;

(iii) whether the transaction was a purchase or sale;

(iv) the per share price or prices at which the transaction was effected;

(v) the date or dates of the transaction;

(vi) the date or dates of the settlement of the transaction;

(vii) the broker or dealer through whom the transaction was effected;

(viii) the market or markets in which the atransaction was effected; and

(ix) such other related information as the Commission, by rule, may prescribe.

(2) The Commission, by rule or order, may exempt, conditionally or unconditionally, any institutional investment manager or security or any class of institutional investment managers or securities from any or all of the provisions of this subsection or the rules thereunder.

(3) The Commission shall make available to the public for a reasonable fee a list of all equity securities of a class described in subsection (d)(1) of this section, updated no less frequently than reports are required to be filed pursuant to paragraph (1) of this subsection. The Commission shall tabulate the information contained in any report filed pursuant to this subsection in a manner which will, in the view of the Commission, maximize the usefulness of the information to other Federal and State authorities and the public. Promptly after the filing of any such report, the Commission shall make the information contained therein conveniently available to the public for a reasonable fee in such form as the Commission, by rule, may prescribe, except that the Commission, as it determines to be necessary or appropriate in the public interest or for the protection of investors, may delay or prevent public disclosure of any such information in accordance with section 552 of Title 5. Notwithstanding the preceding sentence, any such information identifying the securities held by the account of a natural person or an estate or trust (other than a business trust or investment company) shall not be disclosed to the public.

(4) In exercising its authority under this subsection, the Commission shall determine (and so state) that its action is necessary or appropriate in the public interest and for the protection of investors or to maintain fair and orderly markets or, in granting an exemption, that its action is consistent with the protection of investors and the purposes of this subsection. In exercising such authority the Commission shall take such steps as are within its power, including consulting with the Comptroller General of the United States, the Director of the Office of Management and Budget, the appropriate regulatory agencies, Federal and State authorities which, directly or indirectly, require reports from institutional investment managers of information substantially similar to that called for by this subsection, national securities exchanges, and registered securities associations, (A) to achieve uniform, centralized reporting of information concerning the securities holdings of and transactions by or for accounts with respect to which institutional investment managers exercise investment discretion, and (B) consistently with the objective set forth in the preceding subparagraph, to avoid unnecessarily duplicative reporting by, and minimize the compliance burden on, institutional investment managers. Federal authorities which, directly or indirectly, require reports from institutional investment managers of information substantially similar to that called for by this subsection shall cooperate with the Commission in the performance of its responsibilities under the preceding sentence. An institutional investment manager which is a bank, the deposits of which are insured in accordance with the Federal Deposit Insurance Act [12 U.S.C.A. § 1811 et seq.], shall file with the appropriate regulatory agency a copy of every report filed with the Commission pursuant to this subsection.

(5)

(A) For purposes of this subsection the term “institutional investment manager” includes any person, other than a natural person, investing in or buying and selling securities for its own account, and any person exercising investment discretion with respect to the account of any other person.

(B) The Commission shall adopt such rules as it deems necessary or appropriate to prevent duplicative reporting pursuant to this subsection by two or more institutional investment managers exercising investment discretion with respect to the same account.

Section 13(d) of the Securities Exchange Act of 1934

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Section 13(d) – Reports by persons acquiring more than five per centum of certain classes of securities

(1) Any person who, after acquiring directly or indirectly the beneficial ownership of any equity security of a class which is registered pursuant to section 12, or any equity security of an insurance company which would have been required to be so registered except for the exemption contained in section 12(g)(2)(G), or any equity security issued by a closed-end investment company registered under the Investment Company Act of 1940 or any equity security issued by a Native Corporation pursuant to section 1629c(d)(6) of Title 43, is directly or indirectly the beneficial owner of more than 5 per centum of such class shall, within ten days after such acquisition, send to the issuer of the security at its principal executive office, by registered or certified mail, send to each exchange where the security is traded, and filed with the Commission, a statement containing such of the following information, and such additional information, as the Commission may by rules and regulations, prescribe as necessary or appropriate in the public interest or for the protection of investors–

(A) the background, and identity, residence, and citizenship of, and the nature of such beneficial ownership by, such person and all other persons by whom or on whose behalf the purchases have been or are to be effected;

(B) the source and amount of the funds or other consideration used or to be used in making the purchases, and if any part of the purchase price is represented or is to be represented by funds or other consideration borrowed or otherwise obtained for the purpose of acquiring, holding, or trading such security, a description of the transaction and the names of the parties thereto, except that where a source of funds is a loan made in the ordinary course of business by a bank, as defined in section 3(a)(6), if the person filing such statement so requests, the name of the bank shall not be made available to the public;

(C) if the purpose of the purchases or prospective purchases is to acquire control of the business of the issuer of the securities, any plans or proposals which such persons may have to liquidate such issuer, to sell its assets to or merge it with any other persons, or to make any other major change in its business or corporate structure;

(D) the number of shares of such security which are beneficially owned, and the number of shares concerning which there is a right to acquire, directly or indirectly, by (i) such person, and (ii) by each associate of such person, giving the background, identity, residence, and citizenship of each such associate; and

(E) information as to any contracts, arrangements, or understandings with any person with respect to any securities of the issuer, including but not limited to transfer of any of the securities, joint ventures, loan or option arrangements, puts or calls, guaranties of loans, guaranties against loss or guaranties of profits, division of losses or profits, or the giving or withholding of proxies, naming the persons with whom such contracts, arrangements, or understandings have been entered into, and giving the details thereof.

(2) If any material change occurs in the facts set forth in the statements to the issuer and the exchange, and in the statement filed with the Commission, an amendment shall be transmitted to the issuer and the exchange and shall be filed with the Commission, in accordance with such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

(3) When two or more persons act as a partnership, limited partnership, syndicate, or other group for the purpose of acquiring, holding, or disposing of securities of an issuer, such syndicate or group shall be deemed a “person” for the purposes of this subsection.

(4) In determining, for purposes of this subsection, any percentage of a class of any security, such class shall be deemed to consist of the amount of the outstanding securities of such class, exclusive of any securities of such class held by or for the account of the issuer or a subsidiary of the issuer.

(5) The Commission, by rule or regulation or by order, may permit any person to file in lieu of the statement required by paragraph (1) of this subsection or the rules and regulations thereunder, a notice stating the name of such person, the number of shares of any equity securities subject to paragraph (1) which are owned by him, the date of their acquisition and such other information as the Commission may specify, if it appears to the Commission that such securities were acquired by such person in the ordinary course of his business and were not acquired for the purpose of and do not have the effect of changing or influencing the control of the issuer nor in connection with or as a participant in any transaction having such purpose or effect.

(6) The provisions of this subsection shall not apply to–

(A) any acquisition or offer to acquire securities made or proposed to be made by means of a registration statement under the Securities Act of 1933;

(B) any acquisition of the beneficial ownership of a security which, together with all other acquisitions by the same person of securities of the same class during the preceding twelve months, does not exceed 2 per centum of that class;

(C) any acquisition of an equity security by the issuer of such security;

(D) any acquisition or proposed acquisition of a security which the Commission, by rules or regulations or by order, shall exempt from the provisions of this subsection as not entered into for the purpose of, and not having the effect of, changing or influencing the control of the issuer or otherwise as not comprehended within the purposes of this subsection.

How to Register as an Investment Advisor

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Many hedge fund managers come from brokerage firms or other investment advisory firms and may, accordingly, have some of the FINRA licenses like a Series 7 or a Series 65.  However, most managers have not registered an as investment advisor and do not understand the process.  This guide is designed to familiarize managers with the  investment advisor registration process.

Investment Advisor Compliance Firm

First, you will want to find a firm that will help you through the process of registering as an investment advisor.  A hedge fund lawyer or a hedge fund compliance firm (usually consisting of former SEC or state securities commission examiners) will be able to help you with this process. Potential investment advisors should not try to go through the registration process by themselves – it will take too much time and subject the advisor to potential liability.

Jurisdiction

The manager can register as an investment advisor with the SEC or the state securities commission of the state in which the manager resides.  The manager should have a conversation with the lawyer or complaice firm regarding the pros and cons of the registration with the SEC or state.  Generally, however, a manager will only be able to register with the SEC if the manager has at least $25 million under management.

Cost

The costs should be the same for the advisor whether they go with a hedge fund lawyer or with a compliance firm.  Generally, for state-registered investment advisers, the professional fees run anywhere from $2,500-$3,500 for the registration.  For SEC-registered investment advisors, the professional fees will run anywhere from $4,000 to $8,000 depending on the complexity of the investment advisory firm.
The above costs are service provider fees and do not include the fees an investment advisor firm will pay to the state of residence of the investment advisor.  Such fees will generally include the following:

  • IA firm registration fee (State registered IAs only)
  • IA representative fee
  • Form U-4 fee
  • Notice filing fee (SEC registered IAs only)
  • Other miscellaneous fees

Tests

The manager who is registering to be an investment advisor will typically need to have taken and passed the Series 65 exam within the two years prior to registration.  Most all states will also allow managers to register if they have the Series 7 exam and the Series 66 exam.  Since most managers who have the Series 7 will not have the Series 66, the managers will need to take this exam.

Additionally, most states will not require a manager to have any of the above exams if they have one of the following designations

  • Chartered Financial Planner (CFP);
  • Chartered Financial Consultant (ChFC);
  • Personal Financial Specialist (PFS);
  • Chartered Financial Analyst (CFA); or
  • Chartered Investment Counselor (CIC).

Forms

The investment advisor will need to complete a wide variety of forms during the registration process.  These forms include:

IARD entitlement Forms – “IARD” stands for the Investment Adviser Registration Depository which is sponsored by the SEC and the NASAA (the association of state securities regulations, www.nasaa.org) but which is operated by FINRA.  As the IARD system is an online system, these forms need to be manually completed and processed by FINRA before you can begin the registration process.  The forms can be found here: IARD Entitlement Forms

Form ADV – this is the form which all investment advisors complete.  When a firm is registered with the SEC or the state, then the filings can be seen here by typing in the advisor’s name.  Please see Form ADV.  (HFLB note: we will have a detailed guide on Form ADV coming out soon.)

Form ADV Part II – this is the part of Form ADV which provides more information on the advisor’s activities.  It is sometimes refered to as the investment advisory “brochure.”  Please see Form ADV Part II.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Form U4 – this form will need to be completed for all members of the firm which will be investment advisor representatives.  If such members have been in the securities industry for a while, they will likely already have a U4 on file with FINRA.  (HFLB note: we will have a detailed guide on Form ADV Part II coming out soon.)

Registration Timeline

Your compliance provider will be able to help you determine how long it will take to become registered as an investment advisor.  Generally SEC registration will be quicker than state registration and many times registration can be completed within 2 to 4 weeks.

State registration is more difficult to determine and will depend on the state of registration.  A state like California may take 6 to 8 weeks.  A state like South Carolina will take about 2 weeks, it just depends and you should discuss this issue with your compliance provider if the registration is time sensitive.

Other helpful articles include:

Please contact us if you would like to register your firm as an investment advisor or if you have any questions on the above.

Overview of Hedge Fund Investment Advisors

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It is often said that hedge funds are unregistered or lightly regulated investment pools.  While this is correct, there are certain regulations which an investment manager must follow, including certain regulations under the Investment Advisers Act of 1940 (and the securities laws of the hedge fund manager’s state of residence).  These regulations may require a hedge fund manager to be registered as an investment advisor.

Definition

In general terms, an investment advisor is any person (or company) which receives remuneration for providing investment advice to a client.  This will include all hedge fund managers.

Registration or Exemption

While all hedge fund managers will fall within the definition of investment advisor, not all hedge fund managers will need to be registered. An investment advisor will need to be registered with the U.S. Securities and Exchange Commission or with the state securities division if the advisor does not fall within an exemption from the registration provisions.  The exemption may be at the federal level, the state level, or both.  (Please see this article on the Section 203(b)(3) exemption.)

Other Requirements

All investment advisors are fiduciaries and must act in the best interest of their clients.  Investment advisors (whether or not such advisor is registered) will need to adhere to the anti-fraud provision of the Investment Adviser’s Act of 1940.

Other helpful articles on investment advisors include:

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Hedge Fund Performance Fees

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The hedge fund performance fee (also known as the “performance allocation,” the “incentive allocation,” the “incentive fee,” among other aliases), is a periodic fee which is calculated as a percentage of any gains of a hedge fund over a predetermined period of time.

The fee is normally taken on both realized and unrealized gains of the hedge fund.

How often do most managers take the performance fee?

The performance fee can be taken over any predetermined period of time.  For most hedge fund managers, the performance fee is taken on a yearly basis.  However, many managers will take the performance fee on a quarterly basis as well.  Some managers (mostly in the forex and futures arenas) will take a performance fee on a monthly basis.

The manager should consider the characteristics of the hedge fund strategy when determining the appropriate time period to measure performance.  If a manager is a long-term investor holding positions for 12 or more months, then it would not really be appropriate to take a performance fee on a quarterly or monthly basis.  However, for a day trader or a forex manager, who is in and out of multiple positions on a daily basis, it might make sense to have a performance fee period of shorter than one year.

What is the most common performance fee?

The most common performance fee is 20% of the gains of the fund during the performance fee period.  For managers who have shown exceptional returns over a long period of time the performance fees may be as high as 40% or 50%.

For hedge fund-of-funds the performance fee is typically 10%.  Sometimes hedge fund-of-funds will have performance fees as low as 5% and as high as 15%.

What are some of the variations of the performance fee structure?

Some managers will only take performance fees over a hurdle rate, or a minimum return required before the performance fee is taken.  Some managers will have a graduated performance fee structure where the performance fee will increase as the returns to the fund increase.

Also you should note that the hedge fund may not always have a performance fee when there are gains if the gains to not exceed the hedge fund high watermark.

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