Category Archives: Laws

Sale of Viatical Investments as Securities (Washington State)

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This release is from the Washington State Department of Financial Institutions.

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In 1999, Securities Administrator Deborah Bortner sent out a letter to insurance agents in the State of Washington regarding the applicability of the state securities laws to the offer and sale of viatical settlement contracts to investors. Under such a contract, a terminally ill person sells the death benefit in his or her life insurance policy in return for cash that can be used for current expenses. Continue reading →

Overview of the Investment Company Act of 1940

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The Investment Company Act of 1940 (the “Investment Company Act”) is what gives structure to the hedge fund industry.  The Investment Company Act provides very strict regulations for entities which are “investment companies” such as mutual funds. While hedge funds do fall within the definition of “investment company” they will seek an exemption from the registration provisions because such restrictions are onerous. This article provides an overview of certain aspects of the Investment Company Act including the reason hedge funds seek exemption from the registration provisions and the definition of “investment company”.  In depth discussion of the exemptions for hedge funds under the Investment Company Act can be found elsewhere on this website.

Reason to seek exemption – Onerous Regulation

While the advantage for a mutual fund is that they can publicly advertise investments in their shares, there are many regulations which the mutual fund must follow.  These include:

  • Mutual funds must register their securities under the Securities Act and Investment Company Act, this is a long and very costly process.
  • Mutual funds must have a Board of Directors and 75% of the Board must be independent.  The Board must approve and vote on various items related to the mutual fund, include 12b-1 fees.
  • Mutual funds have certain investment restrictions.  Form example, mutual funds use of leverage is limited; there are percentage restrictions on investment into other mutual funds and hedge funds
  • Mutual funds have daily net asset value (NAV) calculations and daily redemptions.  Because of the possibility of daily redemption the mutual fund must keep a certain amount of cash available at all times.
  • Mutual funds can only be advised by a registered investment advisor.

Definition of Investment Company

Section 3(a)(1) of the Investment company act as follows:

When used in this title, “investment company” means any issuer which (A) is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities; (B) is engaged or proposes to engage in the business of issuing face-amount certificates of the installment type, or has been engaged in such business and has any such certificate outstanding; or (C) is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 percentum of the value of such issuer’s total assets (exclusive of Government securities and cash items) on an unconsolidated basis.

Exemption from registration under Section 3(c)(1)

Please see Section 3(c)(1) Hedge Funds

Exemption from registration under Section 3(c)(7)

Please see Section 3(c)(7) Hedge Funds

In addition to the above sections, below is the SEC’s description of the Investment Company Act of 1940 and its important provisions.  This description can also be found here.

Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. The full text of this Act is available at: http://uscode.house.gov/download/pls/15C2D.txt (Subchapter I). (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.)

Schedule 13D

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Below is information from the SEC’s website on Schedule 13D which can be found here.  Generally, hedge fund managers who must file Schedule 13D will have their hedge fund attorney submit this filing for them on their behalf.  Additionally, there may be other legal issues which arise and so it is advisable for the manager to discuss all aspects of an investment subject to the filing requirements of Section 13(d) of the Securities Exchange Act.

Schedule 13D

Schedule 13D is commonly referred to as a “beneficial ownership report.” The term “beneficial owner” is defined under SEC rules. It includes any person who directly or indirectly shares voting power or investment power (the power to sell the security).

When a person or group of persons acquires beneficial ownership of more than 5% of a voting class of a company’s equity securities registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D with the SEC. (Depending upon the facts and circumstances, the person or group of persons may be eligible to file the more abbreviated Schedule 13G in lieu of Schedule 13D.)

Schedule 13D reports the acquisition and other information within ten days after the purchase. The schedule is filed with the SEC and is provided to the company that issued the securities and each exchange where the security is traded. Any material changes in the facts contained in the schedule require a prompt amendment. The schedule is often filed in connection with a tender offer.

You can find the Schedules 13D for most publicly traded companies in the SEC’s EDGAR database. You can learn how to use EDGAR to find information about companies. You can find an HTML version of the Schedule and download a PDF version for easier printing.

For more information, please contact us.  Additional information can be found:

NFA to Begin Regulating FOREX

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The last unregulated space within the hedge fund industry was the retail foreign exchange (“Forex”) market.  As of November 30 of this year, many hedge fund managers which invest in the spot forex markets will need to be registered with the NFA.  More analysis on this to follow.

The press release and the new NFA rules follow below.

Notice I-08-26

October 16, 2008

Effective Date of NFA Compliance Rules 2-41 and 2-42: Disclosure by Forex Pool Operators and Trading Advisors

NFA has received notice that the Commodity Futures Trading Commission has approved NFA Compliance Rules 2-41 and 2-42. The new rules will become effective on November 30, 2008. Accordingly, after November 30th Members that manage forex accounts on behalf of customers or offer pools trading forex must provide prospective clients and pool participants with a disclosure document that has been filed with NFA prior to use. The new rules only apply if the forex pool or the person for whom the forex account is being managed is not an eligible contract participant as defined in Section 1a(12) of the Commodity Exchange Act. A forex pool, however, may not claim to be an eligible contract participant by virtue of Section 1a(12)(A)(v)(II) or (III) of the Commodity Exchange Act.

The disclosure document must provide disclosures similar to those currently required under CFTC Part 4 regulations. Finally, a Member operating a pool subject to the new rules must provide periodic (monthly or quarterly) account statements and an annual report to the pool participants.

Copies of the new rules are attached for your convenience. Additionally, NFA’s February 29, 2008, submission letter to the CFTC contains a more detailed explanation of the changes. You can access an electronic copy of the submission letter at http://www.nfa.futures.org/news/newsRuleSubLetter.asp?ArticleID=2101.

Questions concerning these changes should be directed to Mary McHenry, Senior Manager, Compliance ([email protected] or 312-781-1420) or Susan Koprowski, Manager, Compliance ([email protected] or 312-781-1288).

COMPLIANCE RULES

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Part 2 – RULES GOVERNING THE BUSINESS CONDUCT OF MEMBERS REGISTERED WITH THE COMMISSION

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RULE 2-41. FOREX POOL OPERATORS AND TRADING ADVISORS

(a) Pool Operators. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate operating or soliciting funds, securities, or property for a pooled investment vehicle that is not an eligible contract participant as defined in Section 1a(12) of the Act must comply with this section (a) if it enters into or intends to enter into any transaction described in NFA Bylaw 1507(b)(1) except as described in NFA Bylaw 1507(b)(3). For purposes of this section, a pooled investment vehicle may not claim to be an eligible contract participant by virtue of Section 1(a)(12)(A)(v)(II) or (III) of the Act.

(1) For each such pooled investment vehicle, the Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential pool participant that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective pool participant who is not an eligible contract participant no later than the time it delivers the subscription agreement for the pool. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.24, 4.25, and 4.26 as if operating a pool trading on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.24(b)(1) must be replaced by the following if the pool does not trade on-exchange contracts and must be added as a separate statement if the pool trades both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

YOU SHOULD CAREFULLY CONSIDER WHETHER YOUR FINANCIAL CONDITION PERMITS YOU TO PARTICIPATE IN A POOLED INVESTMENT VEHICLE. IN SO DOING, YOU SHOULD BE AWARE THAT THIS POOL ENTERS INTO TRANSACTIONS THAT ARE NOT TRADED ON AN EXCHANGE, AND THE FUNDS THE POOL INVESTS IN THOSE TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND THE POOL HAS A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, THE POOL’S CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, THE POOL IS A GENERAL CREDITOR AND ITS CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN POOL FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

FOREX TRADING CAN QUICKLY LEAD TO LARGE LOSSES AS WELL AS GAINS. SUCH TRADING LOSSES CAN SHARPLY REDUCE THE NET ASSET VALUE OF THE POOL AND CONSEQUENTLY THE VALUE OF YOUR INTEREST IN THE POOL. IN ADDITION, RESTRICTIONS ON REDEMPTIONS MAY AFFECT YOUR ABILITY TO WITHDRAW YOUR PARTICIPATION IN THE POOL.

INVESTMENTS IN THE POOL MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT, ADVISORY, AND BROKERAGE FEES, AND THE POOL MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH EXPENSE (SEE PAGE [insert page number]) AND A STATEMENT OF THE PERCENTAGE RETURN NECESSARY TO BREAK EVEN, THAT IS, TO RECOVER THE AMOUNT OF YOUR INITIAL INVESTMENT (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND OTHER FACTORS NECESSARY TO EVALUATE YOUR PARTICIPATION IN THIS POOL. THEREFORE, BEFORE YOU DECIDE TO PARTICIPATE YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT, INCLUDING A DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS POOL NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

(b) Trading Advisors. Except for Members who meet the criteria in Bylaw 306(b) and Associates acting on their behalf, any Member or Associate managing, directing or guiding, or soliciting to manage, direct, or guide, accounts or trading on behalf of a client that is not an eligible contract participant as defined in Section 1a(12) of the Act by means of a systematic program must comply with this section (b) if it intends to manage, direct, or guide the client’s account or trade in transactions described in NFA Bylaw 1507(b).

(1) The Member or Associate must prepare a Disclosure Document and must file it with NFA at least 21 days before soliciting the first potential client that is not an eligible contract participant.

(2) The Member or Associate must deliver the Disclosure Document to a prospective client who is not an eligible contract participant no later than the time it delivers the agreement to manage, direct, or guide the client’s account or trading. Any information delivered before the Disclosure Document must be consistent with the information in the Disclosure Document.

(3) The Disclosure Document must comply with the requirements in CFTC Regulations 4.34, 4.35, and 4.36 as if managing, directing, or guiding accounts or trading in on-exchange futures contracts. The term “commodity interest” in those regulations should be read to include forex transactions, and the Risk Disclosure Statement required by CFTC Regulation 4.34(b)(1) must be replaced by the following if the managed, directed, or guided account or trading will not include transactions in on-exchange contracts and must be added as a separate statement if it will include transactions in both on-exchange contracts and forex.

RISK DISCLOSURE STATEMENT

THE RISK OF LOSS IN FOREX TRADING CAN BE SUBSTANTIAL. YOU SHOULD THEREFORE CAREFULLY CONSIDER WHETHER SUCH TRADING IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. IN CONSIDERING WHETHER TO TRADE OR TO AUTHORIZE SOMEONE ELSE TO TRADE FOR YOU, YOU SHOULD ALSO BE AWARE OF THE FOLLOWING:

FOREX TRANSACTIONS ARE NOT TRADED ON AN EXCHANGE, AND THOSE FUNDS DEPOSITED WITH THE COUNTERPARTY FOR FOREX TRANSACTIONS MAY NOT RECEIVE THE SAME PROTECTIONS AS FUNDS USED TO MARGIN OR GUARANTEE EXCHANGE-TRADED FUTURES AND OPTIONS CONTRACTS. IF THE COUNTERPARTY BECOMES INSOLVENT AND YOU HAVE A CLAIM FOR AMOUNTS DEPOSITED OR PROFITS EARNED ON TRANSACTIONS WITH THE COUNTERPARTY, YOUR CLAIM MAY NOT RECEIVE A PRIORITY. WITHOUT A PRIORITY, YOU ARE A GENERAL CREDITOR AND YOUR CLAIM WILL BE PAID, ALONG WITH THE CLAIMS OF OTHER GENERAL CREDITORS, FROM ANY MONIES STILL AVAILABLE AFTER PRIORITY CLAIMS ARE PAID. EVEN CUSTOMER FUNDS THAT THE COUNTERPARTY KEEPS SEPARATE FROM ITS OWN OPERATING FUNDS MAY NOT BE SAFE FROM THE CLAIMS OF OTHER GENERAL AND PRIORITY CREDITORS.

THE HIGH DEGREE OF LEVERAGE THAT IS OFTEN OBTAINABLE IN FOREX TRADING CAN WORK AGAINST YOU AS WELL AS FOR YOU. THE USE OF LEVERAGE CAN LEAD TO LARGE LOSSES AS WELL AS GAINS.

MANAGED ACCOUNTS MAY BE SUBJECT TO SUBSTANTIAL CHARGES FOR MANAGEMENT AND ADVISORY FEES AND THE ACCOUNT MAY NEED TO MAKE SUBSTANTIAL TRADING PROFITS TO AVOID DEPLETING OR EXHAUSTING ITS ASSETS. THIS DISCLOSURE DOCUMENT CONTAINS A COMPLETE DESCRIPTION OF EACH FEE TO BE CHARGED TO YOUR ACCOUNT BY THE ACCOUNT MANAGER. (SEE PAGE [insert page number]).

THIS BRIEF STATEMENT CANNOT DISCLOSE ALL THE RISKS AND SIGNIFICANT ASPECTS OF THE FOREX MARKETS. THEREFORE, YOU SHOULD CAREFULLY REVIEW THIS DISCLOSURE DOCUMENT BEFORE YOU TRADE, INCLUDING THE DESCRIPTION OF THE PRINCIPAL RISK FACTORS OF THIS INVESTMENT (SEE PAGE [insert page number]).

NATIONAL FUTURES ASSOCIATION HAS NEITHER PASSED UPON THE MERITS OF PARTICIPATING IN THIS TRADING PROGRAM NOR THE ADEQUACY OR ACCURACY OF THIS DISCLOSURE DOCUMENT.

RULE 2-42. FOREX POOL REPORTING

(a) Except for Members who meet the criteria in Bylaw 306(b), any Member operating a pool that trades forex must comply with the requirements in CFTC Regulation 4.22 in the same manner as would be applicable to the operation of a pool trading on-exchange futures contracts. The term “commodity interest” in that regulation should be read to include forex transactions.

(b) A Member may file with NFA a request for an extension of time in which to file the annual report in the same form as provided for in CFTC Regulation 4.22(f).

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.

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

3 Replies

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.