Tag Archives: 3(c)(1)

Non-Accredited Investors in Hedge Funds

Many start-up hedge fund managers want to know if their friends and family can invest in the start-up hedge fund.  Most of the time, such friends and family do not fall within the definition of accredited investor under the Regulation D rules. The regulation D rules allow a maximum of 35 non-accredited investors to invest in any single offering.  Because a hedge fund offering is continuous, the limit of 35 non-accredited investors is cumulative.  That means that over the life of the fund there can be no more than 35 non-accredited investors (as opposed to 35 non-accredited investors in the fund at any single point in time). Continue reading

Overview of the Investment Company Act of 1940

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.)

Question: hedge fund investor and qualification requirements

Question: I wanted to inquire as to legalities for a new hedge fund formation. My question is can I get by the limit of 500 investors and qualification requirements. I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Answer: Let’s break down your question first:

“…can I get by the limit of 499 investors and qualification requirements”

A little preliminary background on hedge fund laws may be helpful. Hedge funds are investment vehicles which, by definition, would be subject to the registration requirements of the federal Investment Company Act of 1940. This means that, absent an exemption from registration, these funds would need to be regulated as mutual funds under the ICA. Many funds do not want to be registered as such because the regulations under the ICA are extremely onerous.

Luckily, the ICA contains two different exemptions for hedge funds – the Section 3(c)(1) exemption and the Section 3(c)(7) exemption. Under the 3(c)(1) exemption a hedge fund manager can accept investments from up to 99 outside investors. Generally these investors will need to be “accredited investors” and may also need to be “qualified clients” (these requirements come from other federal securies acts, and state laws, as appropriate). Under the 3(c)(7) exemption, a hedge fund manager can accept investments from an unlimited amount of “qualified purchasers.” A “qualified purchaser” is a very high net worth individual or institution (generally those persons who own $5 million in “investable” assets, which does not include a person residence). Because of other federal rules, a 3(c)(7) fund will often limit the amount of qualified purchaser investors to 500. Because many beginning hedge fund managers do not have a rolodex filled with “qualified purchaser” contacts, many of these start-up managers will initially begin a 3(c)(1) fund.

To your question, assuming you run a 3(c)(7) fund, you can “get by” the 499 investor limit but you would be subject to other federal laws. The 499 investor limit is in place because of the Securities Exchange Act of 1934 (“34 Act”). While most hedge funds do not need to register their securities because of the private offering exemption (Regulation D) under the Secutities Act of 1933, the hedge fund would still potentially be subject to registration under the 34 Act. The 34 Act requires an issuer (the hedge fund) to register its securities if (1) it has $10 million or more in total assets as of the end of a fiscal year and (2) has a class of equity interests which are owned by 500 or more persons. Generally a 3(c)(7) fund will have no problem meeting the first requirement and therefore the limit to 499 investors keeps such a fund from the registration provisions of the 34 Act.

So the answer to the first part of the question is yes – if you want to register your fund under the 1934 Act.

The second part of the question is no – unless you want to register under the ICA.

The next question you asked was:

I mean is there another type of fund to start with same freedom and lack of regulation with breadth of trading types, but that can accept investors with net worth under $250,000…and more than 500 of them?

Yes, you can start a registered fund – either (1) a mutual fund or (2) a fund registered under the 1933 Act. As noted above mutual funds are very highly regulated and a hedge fund manager probably does not want to start a mutual fund. The considerations involved in starting a mutual fund are considerable, and the legal costs to establish a mutual fund will be anywhere from about $50,000 to $150,000, whereas the legal costs to establish a hedge fund will be anywhere from $15,000 – $45,000 depending on the strategy. When establishing a mutual fund there are other considerations such as distribution and administration which can quickly escalate all costs.

If you only trade forex and certain types of futures, you may be able to do a registered fund (under the 1933 Act), but that is a longer and more expensive process than a traditional hedge fund. The legal costs to establish a fund registered under the 1933 act will be similar to the costs to establish the mutual fund. Additionally, the distribution and administration costs will need to be considered.

Please feel free to email any hedge fund questions you have through our contacts page. I will attempt to answer all questions and may post yours on this site.