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Expanded Accredited Investor Definition FAQs

Frequently Asked Questions About New Accredited Investor Definition

There has been much discussion about the recent amendments to the “accredited investor” definition adopted on August 26, 2020 (the “Amendments”) by the Securities and Exchange Commission (“SEC”). We have provided a more detailed overview of all the Amendments here, but wanted to address many of the common questions we are receiving from clients specifically regarding the Amendments to the accredited investor definition. Please send us any other questions and we will update the below as they come in…

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Will a person who is a contractor to the management company or fund qualify as an accredited investor now?

The Amendments provide that a “knowledgeable employee” (as defined in Rule 3c-5(a)(4) of the Investment Company Act of 1940) of a 3(c)(1) or 3(c)(7) fund will now be considered an accredited investor. We have been asked by a few clients whether this expanded definition includes contractors. Because the definition of a knowledgeable employee does not include contractors and has not been altered by the Amendments or otherwise, contractors do not currently qualify as accredited investors under this expanded definition.

What about the professional certification designation?

A natural person holding at least one professional certification or designation or credential in good standing from a qualifying educational institution will now be considered an accredited investor.

To determine whether an investor meets this criteria, the SEC will consider: (i) whether the certification, designation or credential results from an examination or series of examinations administered by a self-regulatory organization, other industry body or accredited educational institution; (ii) whether the examination(s) are reliably designed to demonstrate an individual’s comprehension and sophistication in the areas of securities and investing; (iii) whether an investor obtaining such certification, designation or credential can reasonably be expected to have sufficient knowledge and experience in financial and business matters to evaluate the merits and risks of a prospective investment; and (iv) whether it is publicly made available by the self-regulatory organization or other industry body (or is otherwise independently verifiable) that an investor holds the certification, designation or credential.

The professional certifications, designations or credentials currently recognized by the SEC to satisfy this criterion will be posted on the SEC’s website. One important item to note is that an investor does not need to practice in the field(s) related to the certification, designation or credential to meet the good standing requirement, except to the extent that continued affiliation with a firm is required to maintain such certification, designation or credential.

What has prompted this modernization of the accredited investor definition?

Whether an investor meets the definition of an accredited investor has been one of the most important considerations when determining whether an investor is eligible to invest in private capital markets. The primary purpose of this qualification has been to determine whether an investor based solely on an investor’s income or net worth (because they presumably would be able to withstand a loss in the investment). The effects of the limited tests have prevented many investors from partaking in private capital markets, regardless of their actual financial sophistication. Thus, after years of discussions, the SEC has expanded the accredited investor definition to provide new measures of determining financial sophistication that more holistically determine financial sophistication. These Amendments should decrease the economic barrier-to-entry in our private capital markets and result in the participation of newly qualified accredited investors with more diverse backgrounds.

When do the Amendments become effective?

The Amendments will become effective 60 days after publication in the Federal Register. As of the date we are posting this FAQ, the Amendments have not yet been posted to the Federal Register.

What kind of legal documents need to be updated to reflect the Amendments?

The accredited investor definition is used in many different legal documents in many different contexts so the the exact document that will need to be revised or updated will depend on the facts of the situation.

In the private fund context, the Amendments will generally only trigger necessary updates to the private fund subscription documents. While the “old” language is still accurate, it does not encompass all potential accredited investor categories so the language could still be used once the Amendments are effective but will not encompass all categories of potential accredited investor.

Once the Amendments are posted to the Federal Register, we will reach out to our clients to discuss updating their subscription documents.

Do the Amendments change the type of investor a California Exempt Reporting Adviser (“CA ERA”) may charge performance fees from?

No. The private fund adviser exemption in California, which is available only to advisers who provide advice solely to “qualifying private funds”, only permits CA ERAs to charge performance fees to “qualified clients”, as defined in the Investment Advisers Act of 1940. The Amendments do not change this limitation.

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Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact us.

SEC Expands Definition of Accredited Investor

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New definition to be effective before end of year

On August 26, 2020, the SEC Commissioners voted to adopt amendments to expand the definition of “accredited investor” and “qualified institutional buyer”. Historically the test for accredited investor status was only based on a person’s income or net worth but has now been expanded in a limited fashion to include persons with certain financial designations. The amendments will become effective 60 days after publication in the Federal Register, which is expected within 1-2 weeks. Below we have highlighted the applicable updates and we will continue to provide information on this topic as it develops.

For more information, please also see the SEC Press Release and Fact Sheet.

Accredited Investor Definition Update

Individuals

With respect to individuals, the following will now also be accredited investors:

(1) individuals with certain qualifying professional certifications, designations and other credentials (currently includes Series 7, Series 65, and Series 82 licensed individuals); and

(2) individuals who are “knowledgeable employees” (which expands the definition from only certain directors, executive officers, etc).

For individuals, the amendments also clarify that natural persons may include the income from “spousal equivalents” for the purposes of calculating joint income and net worth. “Spousal equivalent” is generally defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.

Entities

With respect to entities, the following will now also qualify as accredited investors:

(1) SEC and state-registered investment advisers;

(2) rural business investment companies;

(3) limited liability companies with total assets in excess of $5 million and not formed for the specific purpose of acquiring the securities offered;

(4) entities owning “investments,” as defined in Rule 2a51-1(b) of the Act, in excess of $5 million [note: the intent of this category (4) entities meeting an investments-owned test is to include Native American tribes and other federal, state, territorial, and local government bodies within the accredited investor definition]; and

(5) family offices with at least $5 million in assets under management and their family clients.

Qualified Institutional Buyer Definition Update

Along with the accredited investor update, the definition of “qualified institutional buyer” in Rule 144A will be updated to include entities and any institutional investors that meet the $100 million in securities owned and invested threshold. The scope of the new amendments include Native American tribes, governmental bodies, and bank-maintained collective investment trusts.

Conclusion

While these changes are incremental rather than radical, they are a step in the right direction and hopefully portend further expansion of the definition to allow greater access to the private capital markets. Those parties (investment managers and private placement sponsors) who want to take advantage of the expanded definition will need to speak with legal counsel about updating applicable subscription documents. We will be providing further updates on timing and other matters as they develop.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

New Accredited Investor Definition

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Fund Managers Should Amend Subscription Documents

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) immediately changed the definition of accredited investor. Prior to the enactment of the Act, an accredited investor could use the value of their primary residence to compute the $1,000,000 net worth requirement. Now, investors may not use the value of their primary residence to determine their net worth. The mortgage or indebtedness on the primary residence, also, does not count against net worth except to the extent that the indebtedness exceeds the fair market value of the residence (see SEC discussion below).

Revising Subscription Documents

Some managers have subscription documents which describe the prior manner of calculating net worth for accredited investors. Such managers should immediately revise their subscription documents. Additionally, if a manager accepts investments from previous individual investors who have declared they are “accredited investors,” the manager should have such investors verify they meet the new net worth requirement. Generally the manager can accomplish this through a fairly simple verification or confirmation form. For those managers who have administration firms process subscription documents, the administration firm should be providing these verification forms to the subscribing investors. With respect to individual investors who are not making additional subscriptions, there is no current requirement to verify their net worth under the new rules.

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Below are the Dodd-Frank laws dealing with the new accredited investor standard.

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) IN GENERAL.—The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

(b) REVIEW AND ADJUSTMENT.—

(1) INITIAL REVIEW AND ADJUSTMENT.—

(A) INITIAL REVIEW.—The Commission may undertake a review of the definition of the term ‘‘accredited investor’’, as such term applies to natural persons, to determine whether the requirements of the definition, excluding the requirement relating to the net worth standard described in subsection (a), should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIFICATION.—Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ‘‘accredited investor’’, excluding adjusting or modifying the requirement relating to the net worth standard described in subsection (a), as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

(2) SUBSEQUENT REVIEWS AND ADJUSTMENT.—

(A) SUBSEQUENT REVIEWS.—Not earlier than 4 years after the date of enactment of this Act, and not less frequently than once every 4 years thereafter, the Commission shall undertake a review of the definition, in its entirety, of the term ‘‘accredited investor’’, as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIFICATION.—Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ‘‘accredited investor’’, as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

SEC. 415. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 3 years after the date of enactment of this Act.

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SEC Discussion on New Net Worth Rules

Section 179. Rule 215 – Accredited Investor

Question 179.01

Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the “value of the primary residence” of the investor. How should the “value of the primary residence” be determined for purposes of calculating an investor’s net worth?

Answer: Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

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Hedge Fund Law Blog Notes For Week

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Adviser Registration, Accredited Investors, Carried Interest, Insider Trading, Cap and Trade

Below are some thoughts on some of the major issues over the last couple of weeks.

Have a great Memorial Day Weekend!

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Hedge Fund Regulation and Registration – While the Private Fund Investment Advisers Registration Act of 2010 was passed this month in the Senate, there has not been as much discussion in the news about this issue and manager registration. I expected that we would hear more, especially with regard to the following issues:

Section 407 – Exemption of VC Funds
Section 408 – Exemption from Reporting Requirements for Private Equity Funds
Section 410 – State Authority for Managers with AUM of up $100MM (this is generally a bad idea in my opinion and we will be writing a post about this soon…)
Section 412 – Adjusting Definition of Accredited Investor (see also below)

I imagine we will hear more as the Senate and House begin to reconcile their two bills and before President Obama signs the final Financial Reform bill into law, which some think may happen before the July 4th holiday.

Definition of Accredited Investor – The Senate version of the Financial Reform bill will change the definition of an “accredited investor” in the future. Generally “accredited investors” are those individuals with a net worth of $1,000,000. Under current regulations, individuals can include the equity in their private residence when determining their net worth. In the future, they will need to exclude the equity in their private residence when determining their net worth. This potentially may have a deleterious effect on the hedge fund industry, but also on other industries which rely on private placements.

According to some sources, at least one Senator is asking that the definition of accredited investor be expanded to include state and local governments. I agree with this approach – if the Senate is taking the time to mess with the definition right now then the Senate should spend a little time addressing other issues. For instance, the definition of accredited investor should also be expanded to include Native American Tribes. I have specifically talked with the SEC staff about this issue a couple of years ago and they have categorically refused to issue a no-action or other interpretive release on this issue – we believe that now is the time to include Native American Tribes in the definition of accredited investor.

For more information, please see the Native American Capital, LP policy briefing and the National Congress of American Indians letter to the SEC on this issue.

See also Perkins Coie discussion of this issue.

Carried-Interest Issue -it looks like the carried interest tax laws will be changing in 2011. In addition to hedge fund managers, managers to other pooled investment vehicles will be greatly affected (such as VC and private equity fund managers, as well as real estate fund managers). The change in the laws will likely affect more VC and PE managers than hedge fund managers because of the nature of the underlying gains in the respective investment vehicles (VC and PE fund managers typically have mostly long term capital gains and hedge fund managers may have a combination of long term and short term capital gains). There is likely to be a large number of industry groups which come out in opposition to the changes in the next couple of weeks.

We do not agree with the proposed changes – it seems as though Congress is specifically attacking an easy target in the investment management community.

Insider Trading Issue – just today the SEC announced an insider trading case brought against a hedge fund manager Pequot Capital Management, Inc., and its Chairman and CEO Arthur Samberg. This issue has been thoroughly discussed most recently after the Galleon affair. Hedge funds managers and compliance personnel need to be even more vigilant about establishing comprehensive compliance programs and making sure that traders are not engaging in insider trading. Please see our previous thoughts on Hedge Funds and Insider Trading.

Green Tech/ Cap and Trade – clean and green tech continue to gain traction in the investment management industry as a bill which would create federal carbon cap and trade system was introduced recently. Next weekend the South Asian Bar in San Francisco will have a panel discussion. entitled “Green 2 Green: Carbon Credits, Renewable Energy Certificates and the New Markets driving the Clean Energy Economy”. According to the program,

Attendees will receive a quick primer on market-based regulatory responses to climate change designed to foster the development of renewable power plants and spur long term investment in clean and sustainable energy. Panelists will address state and federal legislation setting green house gas emission caps, establishing renewable portfolio standards, and creating new markets for carbon credits and renewable energy certificates. We’ll discuss the regulatory origins and key characteristics of these and other green commodities, as well as the structure and rules of markets created to transition industry and consumers from the present carbon economy toward tomorrow’s clean energy economy.

Mallon P.C. will be represented at the panel discussion so please come and talk to us there.

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Qualified Eligible Person (QEP) Definition

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The securities laws can be written obtusely and the definition of a qualified eligible person (QEP) may be one of the best examples of this. There is no quick and easy definition of a what a QEP is so we are trying to make it as easy as possible to understand. This post discusses the importance of the classification, provides the overview of the definition and then provides a link to the actual statutory language.

Why QEP Definition is Important for CPOs

The definition of QEP is important for commodity pool operators (CPOs) in a couple of situations. The first is the 4.13(a)(4) exemption from the registration provisions for a CPO that provides advice to a commodity pool with only QEPs. The second situation where a CPO will need to make sure the investors are QEPs is if they want to take advantage of the Rule 4.7 exemption. The Rule 4.7 exemption allows CPOs to follow less-strict reporting requirements with regard to the commodity pool they manage. These two exemptions essentially provide for reduced regulatory oversight of a CPO who provides advisory services to these class of investors.

Definition of QEP

A qualified eligible person is an investor who fits into one of two distinct groups: (1) investors who do not need to meet the portfolio requirement and (2) investors who need to meet the portfolio requirement.

1. Investors who do not need to meet the portfolio requirement:

The following are considered to be QEPs regardless of whether or not they meet the portfolio requirement:

registered futures commission merchants
registered broker or dealers
registered commodity pool operators (under certain conditions, see rule for more details)
registered commodity trading advisors (under certain conditions, see rule for more details)
state or SEC registered investment advisers (under certain conditions, see rule for more details)
qualified purchasers
knowledgeable employee of the CPOs
certain persons related to advisers to exempt from registration as a CPO or CTA
trusts (under certain conditions, see rule for more details)
501(c)(3) organizations (under certain conditions, see rule for more details)
non-United States persons
certain entities in which all of the owners/participants are QEPs

2. Investors who need to meet the portfolio requirement:

The following will be considered to be QEPs only if they meet the portfolio requirement described below:

investment companies registered under the Investment Company Act (i.e. mutual funds)
certain business development companies (defined under both the Investment Company Act and Investment Advisers Act)
banks, savings and loan associations, and other like institutions acting for their own accounts or for the account of a QEP
insurance companies acting for their own account or for the account of a qualified eligible person
plans established and maintained by various governments and related bodies for the benefit of their employees, if such plan has total assets in excess of $5,000,000
employee benefit plans within the meaning of the ERISA (under certain conditions, see rule for more details)
501(c)(3) organizations with total assets in excess of $5,000,000
corporations, business trusts, partnerships, LLCs or similar business ventures with total assets in excess of $5,000,000 and not formed for the specific purpose of participating in the exempt investment program
a natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of either his purchase in the exempt pool or his opening of an exempt account exceeds $1,000,000 [HFLB note: this is one part of the accredited investor definition]
a natural person who had an individual income in excess of $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 [HFLB note: this is one part of the accredited investor definition]
pools, trusts, insurance company separate accounts or bank collective trusts, with total assets in excess of $5,000,000 (under certain conditions, see below)
other entities authorized by law to engage in such transactions (under certain conditions, see rule for more details)

3. Portfolio Requirement

If an investor is one of the entities described in (2) above, it will also need to meet the portfolio requirement. The portfolio requirement can be met in one of three ways:

Owns securities and other investments with an aggregate market value of at least $2MM;
Has had on deposit with a FCM at least $200K in exchange-specified initial margin and option premiums for commodity interest transactions in the 6 months prior to the investment; or
Has a combination of the two above. For example, has $1MM in securities/investments and $100K in exchange-specified initial margin in the 6 months prior to the investment

The above definitions have been shortened for the purpose of providing a general overview. When determining whether an investor meets the qualified eligible person definition the CPO should take special care to make sure that the investor meets the full definition which can be found here. Generally the investor will make these representations in the subscription documents which are drafted by the hedge fund attorney.

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Other related Hedge Fund Law Blog articles include:

Bart Mallon, Esq. runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.

Accredited Investor Net Worth Question

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Most hedge funds will require investors to be “accredited investors.” In general, a natural person is deemed to be an accredited investor if (1) the natural person has an individual net worth, or joint net worth with the person’s spouse, that exceeds $1 million at the time of the purchase (i.e. investment into the hedge fund) or (2) the natural person has an income exceeding $200,000 in each of the two most recent years or joint income with a spouse exceeding $300,000 for those years and a reasonable expectation of the same income level in the current year. (See generally Accredited Investor Definition.)

One common question is “does net worth include the equity a person has in their personal residence?” The answer is yes. The SEC specifically addressed this question in their Interpretive Release On Regulation D. Below is the actual text from the release which is applicable to this question:

(21) Question: In calculating net worth for purposes of Rule 501(a)(6), may the investor include the estimated fair market value of his principal residence as an asset?

Answer: Yes. Rule 501(a)(6) does not exclude any of the purchaser’s assets from the net worth needed to qualify as an accredited investor.

Note the difference between accredited investors and qualified purchasers with respect to this issue. Individuals cannot include equity in their personal residence for the purpose of meeting the “qualified purchaser” definition.

Please contact us if you have a question on this issue or if you would like to start a hedge fund. If you would like more information, please see our articles on starting a hedge fund. Other related hedge fund law articles include:

Hedge Fund Law Questions

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Recently I have received a few good hedge fund law questions. Please remember that these answers are general discussions of the law and should not be a substitute for actual legal advice. This discussion does not form an attorney-client relationship, please see our disclaimer.

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Question: [with reference to the new Hedge Fund Registration article] So what’s to say a hedge fund can’t just become the outside advisor to a series of managed accounts? If so, does the fund still need to register?

Answer: Many hedge fund management companies do provide individual account management outside of the hedge fund. Typically this is described as hedge fund separately managed accounts. There are many reasons why a manager may have such accounts, including the fact that many large institutional investors require that their assets be managed in this way.

With regard to registration, yes a manager may have to register as an investment advisor if he manages separately managed accounts outside of the hedge fund. There are two separate levels of registration – State and SEC. Generally the SEC does not require a manager to register unless the manager has 14 or less clients over the last 12 months. This generally means that a hedge fund manager can have 13 separately managed account clients (in addition to the hedge fund) without implicating the SEC registration requirements (see Hedge Fund Registration Exemption). However, states are free to adopt their own registration laws and many would require a manager with 5 separately managed account clients (in addition to the hedge fund) to register as an investment advisor with the state securities commission.

Each manager’s situation is unique and if the manager has specific questions regarding his legal or registration status he should discuss with legal counsel. Additionally, if the Hedge Fund Transparency Act is passed, it is likely that hedge fund managers with $50 million or more of AUM will need to register as investment advisors with the SEC.

Question: Regarding the 3c7 Funds, does the counting of investors require a ‘look through’? I.e. If an qualified investor was a Fund of Funds, would the counting up to the limit of 500 investors require counting the underlying investor of the Fund of Funds?

Answer: If the investing fund was also a Section 3(c)(7) hedge fund then there would be no “look through.” If the investing fund was a Section 3(c)(1) hedge fund then there would be certain issues which the Section 3(c)(1) would need to take into consideration. We will be writing a post about this issue shortly.

Question: What happens if you are NOT an accredited investor, but you have already been allowed to invest into a hedge fund that requires you to be an accredited investor?

Answer: I am not quite sure how this would happen but I believe there might be two separate ways. First, the investor may have lied in the hedge fund subscription documents. The subscription documents require the investor to make certain representations regarding the investor’s net worth. Generally hedge fund managers have no duty to inquire further about the representations made in the subscription documents. If this happens then generally the investor will not receive the protections under the law for non-accredited investors.

Second, the investor may have been an accredited investor at the time the subscription documents were signed and, because of outside circumstances, the investor later becomes a non-accredited investor. In this instance the newly non-accredited investor should immediately contact the hedge fund manager and inform him of the new circumstances.

Question: Can you recommend a cost-effective (cheap) administrator for a hedge fund start up?

Answer: Yes. It is common for me to provide clients with recommendations for all service providers including hedge fund administrators. There are many hedge fund administration firms and there are many low cost providers which I can put you in touch with. Usually I will want to get to know you and your firm before I make recommendations. If you are interested, please contact us now.

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:

Hedge Fund Service Providers
Hedge Fund Due Diligence

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.

What happens if a hedge fund doesn’t do proper diligence to ascertain that a client meets the qualified purchaser standards?

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This question came to us yesterday:

Question: What happens if a hedge fund doesn’t do proper diligence to ascertain that a client meets the qualified purchaser standards? Does the hedge fund have to register or notify the SEC?

Answer: In practice I don’t know how this would happen unless someone at the hedge fund management company was completely asleep at the wheel.

The job of the hedge fund attorney is to provide the hedge fund offering documents to the manager and to inform the manager of how the offering documents should be completed. The hedge fund’s subscription documents usually include some sort of investor questionnaire where the investor will need to make certain representations to the hedge fund manager. One of these representations will be whether the investor is an accredited investor and, if the fund is a 3(c)(7) fund, whether the investor is a qualified purchaser. When the investor returns the subscription documents (and before the investor has sent a wire to the fund), the manager should make sure that the offering documents have been completed in their entirety and correctly. If a manager has a question about whether the investor has completed the subscription documents correctly, the manager should bring up such questions or concerns with the hedge fund attorney. In the event that the manager does not receive properly completed subscription documents, the manager should discuss this issue immediately with the attorney.

I cannot think of any reason why a hedge fund manager would have to register as an investment advisor because of incomplete (or improperly completed) subscription documents.