Author Archives: Hedge Fund Lawyer

Overview of Regulation D for Hedge Funds

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Interests in hedge funds are securities which mean that hedge fund managers must follow the federal (and state) laws regarding the sale of securities to investors.  Typically, securities will need to be registered under the Securities Act of 1933 unless there is an exemption from the registration provisions.

There are two main exemptions from the registration provisions – Section 4(2) of the Securities Act and the Regulation D (also known as “Reg D”) safe harbor rules promulgated by the SEC under Section 4(2).  Typically hedge funds will offer their securities pursuant to the Regulation D safe harbor and specifically under Rule 506 which allows a hedge fund to offer an unlimited amount of interests to investors.

Below is a quick synopsis of the Regulation D rules (I have left out Rule 507 and Rule 508).  I have also posted all of the rules here: Regulation D Rules.  Most important to hedge fund managers will be Rule 502 which requires that the manager not engage in any public solicitation and Rule 506.

Rule 501 – Definitions and Terms Used in Regulation D

In general this rule defines certain terms used in the rest of the rules.  The most important definition is probably the accredited investor definition.

Rule 502 – General Conditions to Be Met

In general, this rule discusses certain aspects of the offering which should be met.  A fund’s attorney will be familiar with these issues.

Specifically, this rule addresses certain integration issues, the information which must be provided to investors who are not accredited investors and the limits of resale of interests in a Regulation D offering.  Most importantly, the rule does not allow fund managers to engage in any sort of general solicitation.  Because this is really the most important aspect of the rule for hedge fund managers, I will include this section explicitly below:

c.  Limitation on manner of offering. Except as provided in Rule 504(b)(1), neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

1.    Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

2.    Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising;

Provided, however, that publication by an issuer of a notice in accordance with Rule 135c shall not be deemed to constitute general solicitation or general advertising for purposes of this section; Provided further, that, if the requirements of Rule 135e are satisfied, providing any journalist with access to press conferences held outside of the United States, to meeting with issuer or selling security holder representatives conducted outside of the United States, or to written press-related materials released outside the United States, at or in which a present or proposed offering of securities is discussed, will not be deemed to constitute general solicitation or general advertising for purposes of this section.

Because of the broadness of this rule, hedge fund managers should consult with their attorney if they have any question regarding the prohibition on general advertising.

Rule 503 – Filings of Notice of Sales

In general this rule outlines of the requirement for hedge fund managers to file Form D with the SEC within 15 days of the first sale of securities.  See link below on blue sky filings for more information.

Rule 504 – Exemption for Limited Offerings and Sales of Securities Not Exceeding $1,000,000

This rule is known as the intrastate offering exemption, and generally this provides an exemption from registration if the offering  of hedge fund interests is made wholly intrastate and if the amount to be raised is less than $1million.  Few if any hedge funds will utilize this exemption.

Rule 505 –  Exemption for Limited Offers and Sales of Securities Not Exceeding $5,000,000

In general, this rule provides that an offering is exempt from registration if the issuer raises $5 million or less over any 12-month time period.  This rule also provides that there can be no more than 35 non-accredited investors.

Rule 506 – Exemption for Limited Offers and Sales without Regard to Dollar Amount of Offering

In general, this rule provides that an offering is exempt from registration if the fund raises money from no more than 35 non-accredited investors, provided that all non-accredited investors, either alone or with his purchaser representative(s), has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment.  This rule does allow a hedge fund to sell an unlimited dollar amount of interests.

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The discussion below from the SEC on regulation D offerings is aimed more at hedge fund investors and the hedge fund due diligence which such investors should engage in; the discussion can be found here.  Managers are urged to discuss the Regulation D offerings with their hedge fund attorneys.

Regulation D Offerings

Under the Securities Act of 1933, any offer to sell securities must either be registered with the SEC or meet an exemption. Regulation D (or Reg D) contains three rules providing exemptions from the registration requirements, allowing some smaller companies to offer and sell their securities without having to register the securities with the SEC. For more information about these exemptions, read our publications on Rules 504, 505, and 506 of Regulation D.

While companies using a Reg D exemption do not have to register their securities and usually do not have to file reports with the SEC, they must file what’s known as a “Form D” after they first sell their securities. Form D is a brief notice that includes the names and addresses of the company’s executive officers and stock promoters, but contains little other information about the company.

If you are thinking about investing in a Reg D company, you should access EDGAR Company Search to determine whether the company has filed Form D. If the company has filed a Form D, you can request a copy. If the company has not filed a Form D, this should alert you that the company might not be in compliance with the federal securities laws.

You should always check with your state securities regulator to see if they have more information about the company and the people behind it. Be sure to ask whether your state regulator has cleared the offering for sale in your state. You can get the address and telephone number for your state securities regulator by calling the North American Securities Administrators Association at (202) 737-0900 or by visiting its website. You’ll also find this information in the state government section of your local phone book.
For more information about the SEC’s registration requirements and common exemptions, read our brochure, Q&A: Small Business & the SEC.

HFLB note: other articles you may be interested in are:

Please contact us if you have any questions.

Hedge Fund Investors Overview

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The lifeblood of the hedge fund industry are hedge fund investors, those persons and institutions which put their money at risk with the hope of generating positive investment returns.  While there have been recent predictions of large amounts of investor money leaving the hedge fund space due to poor performance, there are many potential hedge fund investors who are just beginning to warm to the idea of investing in a hedge fund.

Who can invest in a hedge fund?

In general there are two types of hedge funds which are open to different types of investors.

Section 3(c)(1) hedge funds are open to investors who are both accredited investors and qualified clients. An accredited investor is generally an individual with a $1 million dollar net worth (can include the equity in the investor’s primary residence) or an individual who has made $200,000 in each of the two most recent years (or joint income with that person’s spouse in excess of $300,000 in each of those years) and has a reasonable expectation of reaching the same income level in the current year.  A qualified client is generally an individual with a $1.5 million dollar net worth.  Because investors will need to be both an accredited investor and a qualified client, many hedge fund managers will just say that the investor needs to be a qualified client as it has the higher net worth threshold.

Section 3(c)(7) hedge funds are open to qualified purchasers, which is a higher net worth threshold than for the accredited investor or qualified client standard.  A qualified purchaser is generally an individual investor with a $5 million dollar liquid net worth (cannot include the equity of the investor’s primary residence).

Occasionally you will see some Section 3(c)(1) hedge funds which allow non-accredited investors to invest in the fund.  In such instances, the fund will typically charge the non-accredited investor a higher management fee because the non-accredited investor cannot be charged a performance fee.  In general, hedge fund managers will not allow non-accredited investors into the hedge fund except for very close family and friends.

Why would someone invest in a hedge fund?

Hedge funds have historically been viewed as nimble investment vehicles run by savvy managers who are able to produce steady and absolute returns.  Hedge funds come in a variety of different sizes (from the one-man shops to the multi-billion dollar operations) and strategies.  The great diversity of funds and their investment objectives is what makes them exciting, but which also makes it difficult to describe them as a whole.  Suffice it to say that whatever investment strategy an investor is looking for, there is a hedge fund which would be able to meet the needs of that investor.

Who can recommend hedge fund investments?

Hedge fund investments are made through private placements according to the Regulation D offering rules.  This means that only the hedge fund manager and certain hedge fund brokers can offer an investor interests in a hedge fund, and that is only if the manager or the broker has a pre-existing relationship with the investor.  There are some ways which investors can gain access to hedge funds, most notably through hedge fund databases.

What should an investor do before investing in a hedge fund?

At a minimum an investor should carefully read the hedge fund’s offering documents.  An investor should also discuss any questions or concerns with the hedge fund manager.  Additionally, I always recommend that investors conduct some sort of due diligence on the hedge fund and the manager.

HFLB note: we are not recommending that readers invest in hedge funds and we are not recommending any specific hedge funds.  If an investor makes an investment into a hedge fund, any such investments should be made only after consultation with such investor’s legal and accounting advisors.

Other articles you may be interested in:

Overview of New Form D for Hedge Funds

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As we noted in a previous post about filing Form D online, Form D has been changed and I believe that the new Form D is a great improvement and is more appropriate for hedge fund offerings.  As we’ve noted before, many of the securities laws were drafted in the 1930s and 1940s and have not been overhauled to accommodate the current practices within the securities industry.  With the new Form D, we see a giant step forward and commend the SEC on producing a form which asks questions which are appropriate for both operating businesses and hedge funds.

The new Form D is cleaner and easier to read.  There is plenty of space for explanations if a hedge fund’s structure does not exactly fit the parameters of a specific question.  The new Form D also has great instructions on how to complete the various items.

Please note that hedge fund managers should have a hedge fund lawyer or compliance person complete and submit Form D on their behalf.  The SEC expects that each Form D will take approximately 4 hours to complete.  Please click to view a copy of the new Form D .

Items by Item run through of the new Form D is below:

Item 1. Issuer’s Identity – background information on the issuer including name, entity type, year of organization.

Item 2. Principal Place of Business and Contact Information

Item 3. Related Persons – should include the hedge fund manager;  additionally there is a continuation page where the manager will include key members of the management entity.

Item 4. Industry Group – there is a specific box for hedge or other investment funds.  This is a significant improvement over the old Form D which did not include anything like this.

Item 5. Issuer Size – hedge funds will now provide an aggregate net asset value range, which is a more appropriate inquiry.

Item 6. Federal Exemptions and Exclusions Claimed – here most hedge funds will check at least a couple of boxes, your attorney or compliance professional will be able to help you with this.

Item 7. Type of Filing – you will provide information on whether this is a new filing or an amendment to a previous filing.  The instructions to the Form D provide a list of times when it is necessary to file an amendment.

Item 8. Duration of Offering – generally hedge fund interests are offered on a continual bases and the hedge fund will accordingly indicate that the offering will last greater than one year.

Item 9. Type(s) of Securities Offered – the hedge fund will typically check two boxes here.

Item 10. Business Combination Transaction

Item 11. Minimum Investment – old Form D also required this information

Item 12. Sales Compensation – if a hedge fund uses a broker or a third party marketer to raise money then the hedge fund will need to provide certain information on the broker or third party marketer.

Item 13. Offering and Sales Amounts – here hedge funds will typically check “Indefinite” where appropriate.

Item 14. Investors – the SEC requests information on whether there have been sales to persons who are not accredited investors (typically referred to as non-accredited investors)

Item 15.  Sales Commissions and Finders’ Fees Expenses – here the hedge fund will provide more information on the transactions discussed in Item 12.

Item 16. Use of Proceeds

Other related articles of interest:

Hedge Fund Administration – New Issues for Managers to Consider

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I came across another very good article which examines the new landscape of the hedge fund industry and brings up some pertinent points which both hedge fund managers and investors should be aware of.  The issue is that many of the prime brokerage firms and very large global banks have established administration businesses to cater to the ever growing hedge fund industry.  While this expansion gives managers more choices for administration (and arguably better service as admin and other back office functions, like banking, can be handled by one organization), it does create new risks that both managers and investors should investigate.  This article details some of the issues which should be considered; these issues should probably be talking points between the manager and the administrator during the process of choosing an administrator.   The original article can be found here: www.castlehallalternatives.com.

How will the credit crisis impact the administration industry?

In the past two weeks, Fortis has been rescued not once, but twice.  While hardly at the top of the priority list in times of global economic meltdown, it’s still an interesting question to ask what would have happened to Fortis’ administration business if the bank had ceased operations.

Thinking of a different point, it’s also ironic – and fortuitous – that Lehman was one of the few of the prime brokers which had not decided to create a fund admin sideline to help attract managers to the firm’s PB services.

In this environment, however, both hedge fund managers and investors need to evaluate the stability and viability of fund administration entities.  There is both a possibility of direct bankruptcy and also a risk that a parent entity in financial distress could decide to close a peripheral admin business in short order.
We can immediately think of several issues:

1) If the administrator goes bankrupt, do funds have a contingency plan in place to enable them to continue operations?  Do hedge funds have copies (ideally electronic) of the administrator’s accounting which could be given to a new provider?

While audit firms in the US may not agree with us (they tend to audit the manager’s accounting and largely ignore the admin), the offshore administrator’s accounting forms the official books and records of a hedge fund.  If the administrator is no longer in business, does the fund have a contingency plan to recover those records so that the next NAV can be struck on a timely basis?

2) Administrators usually control cash movements for subscriptions, redemptions and fund expense payments.

Do these cash movements pass through a cash account within the administrator?  This would, of course, expose a fund to loss if cash is sitting in an account at the time of bankruptcy.

More discreetly, does the administrator use some form of commingled Escrow account to receive incoming subscriptions and perhaps hold cash until anti money laundering procedures have been completed?  Are hedge funds sure that these assets are properly segregated and controlled?

Separately, if the administrator is the only one with signing authority over the offshore bank account, can the manager withdraw any residual cash and process new redemption and expense payments if the signatories are no longer available?

3) If administrators complete anti money laundering and know your customer checks, does the hedge fund have access to these records to prove that AML has been performed in the event that the admin is bankrupt?

4) Does the hedge fund have access to the full shareholder’s register / list of partners capital accounts to identify all investor balances in the event that the administrator is bankrupt?

More generally, it’s worth noting that many administration companies are small, independent firms which may not be well capitalized.  In an environment which sees a sharp fall in hedge fund assets through both negative performance and net redemptions, administrators’ fees will also fall. Administrator financial viability is, therefore, a real issue for both managers and investors as we navigate the coming year.

HFLB note – other related articles include:

Press Release: Hedge Fund White Paper Indicates Growth in Family Office Investments

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The press release below discusses a report on investments in hedge funds by single family offices.  The report finds that single family offices are willing to invest in hedge funds and also lays out some of the major concerns about hedge fund investing.  The central issue for single family offices is transparency in the underlying hedge fund.  This indicates that hedge funds are likely to see a rise in the request for due diligence on the fund and management company.

SINGLE FAMILY OFFICES BOLSTER ALTERNATIVE INVESTMENT SECTOR

New Survey from CPA Firm Rothstein Kass Finds Nearly 75% of Single Family Offices Invest in Hedge Funds
Almost 60% Plan to Increase Allocations to Alternative Investments in the Next 12 Months

Roseland, NJ – October 14, 2008 – The alternative investment sector will continue to benefit from increasing asset allocations from Single Family Offices (SFOs), according to “On the Rise,” the latest research report sponsored by CPA firm Rothstein Kass. The white paper, co-sponsored by G Capital highlights the growing relationship between the alternative investment community and SFOs, entities established to serve the needs of individual high-net-worth families. “On the Rise” was co-authored by Russ Alan Prince, a leading authority and counselor on private wealth, and Hannah Shaw Grove, a widely recognized expert on behaviors and finances of high-net-worth individuals. Among notable findings:

  • Almost three-quarters of SFOs currently invest in hedge funds, with nearly 60% of this group planning additional allocations in the coming year
  • SFOs with hedge fund allocations hold an average of 3.2 hedge funds or fund-of funds in the portfolio
  • Nearly 70% of SFOs with hedge fund allocations report that these investments have met or exceeded performance expectations over the past 12 months
  • Over 80% of respondents reported 24 month performance was ‘as expected’ or better
  • More than 70% of SFOs with hedge fund allocations report “lack of transparency” as a key concern. Other concerns sited include lock-up periods (60%), style drift (55%) and fraud (37%)

“Single Family Offices are trusted and highly valued by high-net-worth families they serve because of the individualized attention and customized solutions they provide to holistic wealth management. However, our research suggests that persistent market volatility has placed added importance on the asset allocation function. As SFOs consider an ever-expanding range of investment options, they are increasingly turning to the alternative investment sector and its proven ability to deliver superior returns independent of underlying market conditions,” said Rick Flynn, a Principal in Rothstein Kass’ Family Office Group. “Moreover, our findings suggest that performance continues to drive alternative investment allocations. Nearly 70% of those polled said that performance over the last 12 months has been ‘as expected’ or ‘better than expected.’”

The “On the Rise” survey was based on telephone interviews with 146 SFOs and was concluded in August 2008. Investable assets ranged from $312.2 million to $1.3 billion, with a median of roughly $500 million. Just under 60% of the firms polled are based in the Americas, with the balance operating in Europe (21%) and Asia (20%). Additional results were generated from only those entities with reported allocations to the alternative investment sector. For the purposes of this research, SFOs are defined as “created exclusively for or by a single exceptionally wealthy family to provide control, negotiating leverage, and a defense for family members.”

“’On the Rise’ details the latest evidence of the growing interrelation between SFOs and the alternative investment community. While high-net-worth individuals generally recognize advantages of hedge fund investing, they are frequently confounded by the growing roster of products and services available. SFOs have had great success in bridging this knowledge gap,” said Peter Gerhard, Chief Executive Officer of G Capital Management LLC. “Still, lingering challenges face this blossoming relationship. Both transparency (73%) and style drift (55%) rated as key concerns among respondents. It seems that although high-net-worth families are comfortable involving SFOs in the asset allocation process, they themselves retain a level of involvement. Investors need to feel confident that the funds that have been selected are not only good choices in the moment, but reflect overarching and longer-term investment objectives.”

About Rothstein Kass:

Rothstein Kass is a premier financial services firm, recognized nationally as a top service provider to the alternative investment industry. The Firm provides audit, tax, accounting and consulting services to hedge funds, fund of funds, private equity funds, brokerdealers and registered investment advisors. Rothstein Kass is recognized nationally as a top service provider to the industry through its Financial Services Group. The Financial Services Group consults on a wide range of organization, operational and regulatory issues. The Firm also advises on fund structure, both inside and outside the US, compliance and financial reporting, as well as tax issues from a federal, state, local and international compliance perspective. Rothstein Kass has offices in New York, New Jersey, California, Colorado, Texas and the Cayman Islands. www.rkco.com

The Rothstein Kass Family Office Group offers a wide range of financial, wealth planning and lifestyle management services to family offices and high-net-worth individuals, including family members, business owners and members of the financial services, entertainment and sports industries. Composed of seasoned financial professionals and certified public accountants, the Rothstein Kass Family Office Group applies proven expertise with the utmost discretion and attention.

About G Capital Management LLC

By leveraging state-of-the-art capital markets expertise and select advanced planning concepts, G Capital has raised the bar for the next generation of family offices. In addition to the highly effective and sophisticated solutions its family members require, the organization’s structure and capabilities create an efficient, scalable and profitable operating environment that can be readily adapted to capture new businesses opportunities.

About the Authors:

Russ Alan Prince is the world’s leading authority on private wealth, the author of 40 books on the topic, and a highly-sought counselor to families with significant global resources, and their advisors. He is co-author of Fortune’s Fortress: A Primer on Wealth Preservation for Hedge Fund Professionals.
www.RussAlanPrince.com

Hannah Shaw Grove is a widely recognized author, columnist, speaker and an expert on the mindset, behaviors, concerns, preferences and finances of high-net-worth individuals. She is co-author of Inside the Family Office: Managing the Fortunes of the Exceptionally Wealthy.
www.HSGrove.com

Section 3(c)(1) 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.

There are two separate exemptions from the registration provisions of the Investment Company Act.  This post deals with the more common Section 3(c)(1) exemption which generally requires that the hedge fund have 100 or fewer investors.

Not Owned by More Than 100 Investors

A 3(c)(1) hedge fund is exempt under the Investment Company Act provided that the fund is beneficially owned by not more than 100 investors and is not making a public offering of its securities.  The actual text of Section 3(c)(1) provides:

None of the following persons is an investment company within the meaning of this title: Any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than one hundred persons and which is not making and does not presently propose to make a public offering of its securities. Such issuer shall be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) [15 USCS § 80a-12(d)(1)(A)(i), (B)(i)] governing the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer. For purposes of this paragraph:

(A) Beneficial ownership by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 per centum or more of the outstanding voting securities of the issuer, and is or, but for the exception provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of such company’s outstanding securities (other than short-term paper).

(B) Beneficial ownership by any person who acquires securities or interests in securities of an issuer described in the first sentence of this paragraph shall be deemed to be beneficial ownership by the person from whom such transfer was made, pursuant to such rules and regulations as the Commission shall prescribe as necessary or appropriate in the public interest and consistent with the protection of investors and the purposes fairly intended by the policy and provisions of this title, where the transfer was caused by legal separation, divorce, death, or other involuntary event.

Certain Look Through Rules

Part A above provides “look through” provisions for certain entity investors.  This rule provides that if another 3(c)(1) hedge fund (the “Investor Fund”) owns more than 10% of another 3(c)(1) hedge fund (the “Investee Fund”) then the Investee Fund would count all of the investors of the Investor Fund as investors as well.  This rule is designed to prevent the pyramiding of 3(c)(1) funds to avoid the application of the mutual fund registration rules.  Through various no-action letters the SEC has provided further guidance in this area which we will be writing about shortly.

Types of 3(c)(1) Investors

Generally speaking investors in Section 3(c)(1) hedge funds will be both accredited investors and qualified clients.  A 3(c)(1) fund must limit its investors to qualified clients if it wants to charge a performance fee.

Other related articles include:

For more information on mutual funds in general, mutual fund investment programs and investing in mutual funds, please see investing in no load mutual funds.  No load mutual funds are funds which do not have a front or back end load because the distribution fees are usually paid through section 12b-1 fees.

Please contact us if you have any questions.

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.