Tag Archives: hedge fund law

Hedge Fund Records

Access to Records under the Delaware Uniform Limited Partnership Act

A vast majority of hedge funds are structured as limited partnerships under the Delaware Uniform Limited Partnership Act (the DULPA).  The code is very flexible and allows the limited partnership agreement (LPA) to be drafted in a very manager-friendly manner. To the extent that a LPA is silent on an issue covered by the DULPA, the DULPA will control.

With regard to the record keeping requirement of hedge funds, many funds will include a default provision in the LPA which provides investors access to the records of the hedge fund upon reasonable notice to the general partner of the fund.  The records that the investors will have access to are listed in Section 17-305 of the DULPA, which I have reprinted below.  The requirements are fairly standard items which and should not pose an inconvenience to the general partner.

However, managers should note that by defaulting to the DULPA the manager may actually be providing investors in the fund with the potential right to access the name and contact information for other investors in the fund.  DULPA Section 17-305(a)(3) provides,

Each limited partner has the right, subject to such reasonable standards … to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner a current list of the name and last known business, residence or mailing address of each partner.

Of course, under this section the investor making such a request would need to show that the request was made a purpose reasonably related to such investors interest in the fund.  The manager would obviously be able to deny such a request if the investor did not present a good reason for the request.  The general partner would also have other potential remedies under Section 17-305(b) and Section 17-305(e).  The hedge fund offering documents could also be revised so as to restrict investors from having this right.

The full text of the section is reprinted below and can be found here.


§ 17-305. Access to and confidentiality of information; records.

(a) Each limited partner has the right, subject to such reasonable standards (including standards governing what information and documents are to be furnished, at what time and location and at whose expense) as may be set forth in the partnership agreement or otherwise established by the general partners, to obtain from the general partners from time to time upon reasonable demand for any purpose reasonably related to the limited partner’s interest as a limited partner:

(1) True and full information regarding the status of the business and financial condition of the limited partnership;

(2) Promptly after becoming available, a copy of the limited partnership’s federal, state and local income tax returns for each year;

(3) A current list of the name and last known business, residence or mailing address of each partner;

(4) A copy of any written partnership agreement and certificate of limited partnership and all amendments thereto, together with executed copies of any written powers of attorney pursuant to which the partnership agreement and any certificate and all amendments thereto have been executed;

(5) True and full information regarding the amount of cash and a description and statement of the agreed value of any other property or services contributed by each partner and which each partner has agreed to contribute in the future, and the date on which each became a partner; and

(6) Other information regarding the affairs of the limited partnership as is just and reasonable.

(b) A general partner shall have the right to keep confidential from limited partners for such period of time as the general partner deems reasonable, any information which the general partner reasonably believes to be in the nature of trade secrets or other information the disclosure of which the general partner in good faith believes is not in the best interest of the limited partnership or could damage the limited partnership or its business or which the limited partnership is required by law or by agreement with a third party to keep confidential.

(c) A limited partnership may maintain its records in other than a written form if such form is capable of conversion into written form within a reasonable time.

(d) Any demand under this section shall be in writing and shall state the purpose of such demand.

(e) Any action to enforce any right arising under this section shall be brought in the Court of Chancery. If a general partner refuses to permit a limited partner to obtain from the general partner the information described in subsection (a)(3) of this section or does not reply to the demand that has been made within 5 business days after the demand has been made, the limited partner may apply to the Court of Chancery for an order to compel such disclosure. The Court of Chancery is hereby vested with exclusive jurisdiction to determine whether or not the person seeking such information is entitled to the information sought. The Court of Chancery may summarily order the general partner to permit the limited partner to obtain the information described in subsection (a)(3) of this section and to make copies or abstracts therefrom, or the Court of Chancery may summarily order the general partner to furnish to the limited partner the information described in subsection (a)(3) of this section on the condition that the limited partner first pay to the limited partnership the reasonable cost of obtaining and furnishing such information and on such other conditions as the Court of Chancery deems appropriate. When a limited partner seeks to obtain the information described in subsection (a)(3) of this section, the limited partner shall first establish (1) that the limited partner has complied with the provisions of this section respecting the form and manner of making demand for obtaining such information, and (2) that the information the limited partner seeks is reasonably related to the limited partner’s interest as a limited partner. The Court of Chancery may, in its discretion, prescribe any limitations or conditions with reference to the obtaining of information, or award such other or further relief as the Court of Chancery may deem just and proper. The Court of Chancery may order books, documents and records, pertinent extracts therefrom, or duly authenticated copies thereof, to be brought within the State of Delaware and kept in the State of Delaware upon such terms and conditions as the order may prescribe.

(f) The rights of a limited partner to obtain information as provided in this section may be restricted in an original partnership agreement or in any subsequent amendment approved or adopted by all of the partners and in compliance with any applicable requirements of the partnership agreement. The provisions of this subsection shall not be construed to limit the ability to impose restrictions on the rights of a limited partner to obtain information by any other means permitted under this section.


Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Hedge Fund Law Blog Statistics | June 2009

Most Read Hedge Fund Law Articles for June

I wanted to take a little time to thank all of the people who read this blog and who take the time to comment on articles or send me questions – your interaction helps make this site more informative and a better resource for everyone.  If you have any questions related to any of the articles, I ask you send them to me through the contact form.  If you have an RSS reader, please consider subscribing to the hedge fund law RSS feed to stay up to date on the new content posted in this site.

Hedge Fund Visitors for June 2009

According to Google Analytics, the following is the information on the number and people who have visited the website during the past month:

  • Visits – 14,744  (of these 10,472 were new visitors)
  • Absolute Unique Visitors – 11,415
  • Pageviews – 33,031
  • Top Nations – United States, United Kingdom, India, Canada, Hong Kong, Switzerland, France, Australia, Singapore, Germany

Top 10 Hedge Fund Law Stories for June 2009

According to Google Analytics, the following is a list of the most popular hedge fund articles for the month of June:


Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Obama’s New Hedge Fund Regulation Plan

Draft Speaks of IA Registration for Hedge Fund Managers

As you have probably heard by now, Obama will be presenting his plan for an overhaul of the financial system later today.  I have reviewed a copy of Obama’s Financial Regulation Proposal Draft and have reprinted some of the important aspects of the proposal below.  In general the most immediate impact for hedge fund managers is that they will be required to register with the SEC as investment advisors.  In addition to hedge fund managers, private equity fund managers and VC fund managers will also need to register.

While we understand that these are just proposals, Congress too is excited to get on the registration bandwagon although I think it unlikely for us to see any regulation passed before the end of this year.  Even so, hedge fund managers may want to start thinking about how they are going to register as investment advisors and what plans they will need to be putting in place (or plan to put in place in the future).


The plan’s main goals are:

  1. Promote robust supervision and regulation of financial firms.
  2. Establish comprehensive supervision and regulation of financial markets.
  3. Propose comprehensive regulation of all OTC derivatives.
  4. Protect customers and investors from financial abuse.
  5. Raise international regulatory standards and improve international cooperation.

Other Points Addressed

Regarding Hedge Funds

All advisers to hedge funds (and other private pools of capital, including private equity funds and venture capital funds) whose assets under management exceed some modest threshold should be required to register with the SEC under the Investment Advisers Act.  The advisers should be required to report financial information on the funds they manageme that is sufficient to assess whether any fund poses a threat to fiancnail stability.

Harmonize Futures and Securities Regulation

The CFTC and the SEC should make recommendations to Congress for changes to statutes and regulations that would harmonize regulation of futures and securities.

Strengthen Investor Protection

The SEC should be given new toold to increase fairness for investors by establishing a fiduciary duty for broker-dealers offering investment advice and harmonizing the regulation of investment advisers and broker-dealers.

Expand the Scope of Regulation

We urge national authorities to implement by the end of 2009 the G-20 commitment to require hedge funds or their managers to register and disclose appropriate information necessary to assess the systemic risk they pose individually or collectively.

Specifical goals with regard to Hedge Funds

  • Data collection
  • SEC should conduct regular, periodic examinations of hedge funds
  • Reporting AUM and other fund metrics to the SEC
  • SEC would have ability to assess whether the fund or fund family is so large, highly leveraged , or interconnected that it poses a threat to fiancial stability


Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

NASAA Takes Sides on Proposed Hedge Fund Legislation

Endorses House Bill Over the Grassley-Levin Hedge Fund Bill

Last week the North American Securities Administrators Association (NASAA) announced its support of the Hedge Fund Adviser Registration Act of 2009, a house bill introduced earlier this year by Representatives Capuano and Castle.  The Hedge Fund Adviser Registration Act is one of two bills introduced in Congress which would effectively require many unregistered hedge fund managers to register with the SEC.  The other bill, the Hedge Fund Transparency Act, was introduced into the Senate by Senators Grassley and Levin.  While the Adviser Registration Act would close what some are calling a loophole in the Investment Advisers Act of 1940, the Transparency Act would create a whole new regime for regulating hedge fund entities (as opposed to the management company).  The Transparency Act also came under fire earlier this year for being poorly drafted.

The NASAA support was announced in the release we have reprinted below.  If you have any questions on this issue, please feel free to contact us.  Related hedge fund registration articles include:


May 28, 2009

NASAA Supports the Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

Legislation Would Require Hedge Fund Advisers to Register with SEC

WASHINGTON (May 28, 2009) – The North America Securities Administrators Association (NASAA) today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

The Hedge Fund Adviser Registration Act of 2009 (H.R. 711), sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE), addresses one of NASAA’s Core Principles for Financial Services Regulatory Reform – closing regulatory gaps.

“NASAA appreciates the efforts of Rep. Capuano and Rep. Castle to promote the regulation of hedge fund advisers in a manner that will provide greater transparency to the marketplace while not overburdening the hedge fund industry,” said NASAA President and Colorado Securities Commissioner Fred Joseph. “Advisers to hedge funds should be subject to the same standards of examination as other investment advisers.”

Because they qualify for a number of exemptions to federal and state registration and disclosure laws, hedge funds remain largely unregulated today. The SEC has attempted to require hedge fund managers to register as investment advisers, but that effort was overturned by a U.S. Court of Appeals decision. “Given the need for greater oversight and transparency in many corners of the financial services industry in the wake of the market meltdown, Congress should give the SEC explicit statutory authority to regulate hedge fund advisers as investment advisers,” Joseph said.

Joseph noted that the Managed Funds Association, which represents the hedge fund industry, now supports the registration of investment managers – including hedge fund managers – with the SEC. “This is a step in the right direction,” Joseph said. “While hedge funds did not cause the current economic and financial crisis facing the United States, they, along with the rest of the shadow banking industry, played a role. This reason alone is enough to require greater regulation of all parties in question.”

Joseph said NASAA will continue to press Congress for additional reforms of the hedge fund industry, including granting the SEC authority to require hedge funds to disclose their portfolios, including positions, leverage amounts and identities of counterparties, to the appropriate regulators; and appropriating the necessary funds to ensure that the regulators are sufficiently equipped, in terms of personnel and technology, to provide meaningful analysis of this data and to exercise proper oversight over hedge funds.

NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.

For more information:
Bob Webster, Director of Communications

Bay Area Hedge Fund Roundtable Event

Panel Discussion on State of Hedge Fund Industry

Yesterday afternoon (May 6th) the Bay Area Hedge Fund Roundtable, a group of professionals within the hedge fund industry, gathered for a panel presentation entitled “Change…Critical Legal, Tax, Acounting and Regulatory Updates You Need to Know.”  The presentation was moderated by Pamela S. Nichter (Osterweis Capital Management) and included the following panel participants:

Vincent J. Calcagno (Rothstein Kass)
Geoffrey Haynes (Shartsis Friese)
Tony Hassan (Ernst & Young)
Anita K. Krug (Howard Rice)

Presentations like these are great because they allow professionals to share insights into what is going on in different parts of the industry – many of the topics discussed allowed the panelists to really dig deep into the issues and provide some context to what is happening at both the regulatory and investor levels.  I took notes during the presentation and will summarize some of the main points discussed by each of the presenters (please don’t hold anything against the speakers if I mis-paraphrase or mis-interpret and as always nothing in this summary is tax or legal advice)…

Anita K. Krug

Anita discussed a number of the laws which have been discussed or proposed over the past 6 to 8 months including the following:

  • Barney Frank’s Recent Comments (see Reuters article)
  • Mary Shapiro’s Recent Comments (see Bloomberg article where Shapiro says she wants the ability to make rules regulating hedge funds)
  • Discussion of the Hedge Fund Transparency Act which was proposed in the Senate earlier this year (see also Overview of the Hedge Fund Transparency Act)
  • Hedge Fund Advisor Registration Act which was proposed in the House earlier this year
  • Geithner’s hedge fund proposals (see NY Times article for background information)
  • Discussion of the past short selling rules (see HFLB article) and the new short selling rules which will be closer to the old “uptick” rule (see SEC overview; note: I have not yet had an opportunity to thoroughly review these proposed rules)
  • European Rules which have been proposed which may have an effect on US based managers with EU investors (Anita raised many of the same issues which were also raised in this article)

Geoffrey Haynes and Vincent J. Calcagno

Geoffrey and Vincent went back and forth discussing some of the tax issues which managers are likely to face this year and potentially going forward.  This discussion included the following issues:

  • Discussion of the new offshore deferral rules by dint of new Section 457A of the Internal Revenue Code (see generally this alert).  Note: discussions on the ramifications of this new section to managers who currently have deferral arrangements took a majority of the time.  There are a number of issues involved including issues with side pockets, options, and non-conventional performance fee periods.
  • San Francisco Payroll Tax of 1.5% (see background on this issue here)
  • Discussion of the Levin proposal to tax the carried interest as ordinary income (see Hedge Fund Carried Tax Increase?).  [The panelists seemed to think that Congress would not vote on this bill until sometime in 2010 (if the bill was actually even voted on) with an effective date, if passed, of sometime in 2010 – the panelists did not seem to think it would be retroactively applied.]
  • Discussion of a bill which would eliminate UBTI for U.S. based non-taxable investors investing in U.S. hedge funds which utilize leverage (note: I was not aware of this bill and am not sure what bill exactly was referred to – please feel free to contact me if you know about this bill).  The panelists seemed to think this bill was likely DOA.
  • Discussion of the Stop Tax Haven Abuse Bill by Senator Levin (see Senator Levin’s press release)
  • Discussion of Obama’s Offshore Tax Plan (see generally the White House press release)

Tony Hassan

Tony discusses what is changing in the area of hedge fund operations.  Tony’s discussion of current topics was maybe one of the more important parts of the panel in terms of providing insight on current investing trends and due diligence requests.  Many of the items in this section were part of a dialogue between Tony and Vince as noted in the parenthesis below.

  • There is no secret that due diligence is a more central and important part of the investing process than it was previously.  (Tony and Vince)
  • Due diligence is also changing in many respects – at E&Y Tony has had specific requests from potential invests to send them directly the financial statements.  Of course this brings up many legal and client issues (the hedge fund, not the potential investor, is the client of E&Y) and because of this these requests are often denied. (Vince)
  • Managers are providing verified transparency “quarterly reviews” which aim to show investors that the fund’s assets are actually there.  (Vince)
  • Some funds are instituting a half-yearly audit (in addition to the end of year audit).  (Vince)
  • Some funds are instituting agreed upon procedure reports.  In these reports the auditor will come in an verify that certain procedures are being completed.  This may be especially important with regard to the valuation of the fund’s assets.  (Vince)
  • Tony noted that this is really a new form of due diligence and used the term “Hedge Fund Due Diligence 2.0” – a term I used in October of 2008 (see post).
  • Investor questions to hedge funds are changing.  While previous questions would have stopped after “Do you have a 3rd party administrator?”  Now the questioning continues – investors want to know about the administrators technical expertise, who exactly will be the account representative and what type of capital markets experience does that person or group have, what inputs will be used to value assets, etc.  Investors also want to know what sort of contingency plan is in place should the administrator fail or if there is a disaster; investors will want to know if the fund is keeping shadow books.  (Tony)
  • Tony also participated in the discussion with Pamela below with regard to managed accounts.

Pamela S. Nichter

Pamela, the moderator of the discussion, also weighted in on certain operational issues which fund managers should be prepared for in the new climate.  In general Ms. Nichter is seeing more investor requests and communications.  Now there is greater communication between the investor and the fund manager.  Ms. Nichter also discussed the trend toward greater liquidity and transparency through separate account structures.

Separate accounts are something that more and more investors are seeking but there are many considerations for managers.  Specifically separate accounts can be a drain on resources, especially if the investors request their own specific administrators or auditors.  Because of the greater amount of resources which need to go into the back office to handle what is in essence a more traditional asset management business, the manager must be ready to change the business model to a certain extent.  Specific issues will include:

  • having a robust trade allocation policy
  • understanding that there is likely to be a disparity of performance
  • potential registration issues
  • potential integration issues
  • performance reporting issues (may need to go back to GIPS)

Questions and Conclusion

After the panel finished their discussion the floor was open to questions.  During this time there were a number of good questions.  One issue focused on what will performance fees look like going forward which led to a discussion about creative performance fees (like instituting some sort of clawback provision like what is found in private equity funds).  Another issue was whether and to what extent the Managed Funds Association will be representing the industry during this time of legislative/regulatory changes.  The answer is that the MFA will be doing everything it possibly can to represent the hedge fund industry and it is our job to make sure that the MFA knows how the industry feels about many of the current legislative proposals.

Interpretive Release on Regulation D

There are occasionally times when questions arise as to the meaning of certain undefined terms within statutes or regulations.  Practitioners have a variety of different resources which can help shed light onto these undefined terms or at least provide background information or context.  Below is the SEC’s Interpretive Release on the Regulation D rules.  Please note that some of the items in this release may be superceeded by other SEC pronouncements or other lawmaking activities.

Other related hedge fund law articles include:


17 CFR Part 231
[Release No. 6455]
Interpretive Release On Regulation D
AGENCY: Securities and Exchange Commission.
ACTION: Publication of Staff Interpretations.

SUMMARY: The Commission has authorized the issuance of this release setting forth the views of its Division of Corporation Finance on various interpretive questions regarding the rules contained in Regulation D under the Securities Act of 1933. These views are being published to answer frequently raised questions with respect to the regulation.

FOR FURTHER INFORMATION CONTACT: David B. H. Martin, Jr., Office of Chief Counsel, Division of Corporation Finance, Securities and Exchange Commission, Washington, D.C. 20549, (202) 272-2573.

SUPPLEMENTARY INFORMATION: In Release No. 33-6389 (March 8, 1982) (47 FR 11251), the Commission adopted Regulation D (17 CFR 230.501-.506) which provides three exemptions from the registration requirements of the Securities Act of 1933 (the “Securities Act” or the “Act”) (15 U.S.C. 77a-77bbbb (1976 & Supp. IV 1980), as amended by the Bus Regulatory Reform Act of 1982, Pub. L. No. 97-261 §19(d), 96 Stat. 1121 (1982)).1 Regulation D became effective on April 15, 1982.

In the course of administering the regulation, the staff of the Division of Corporation Finance has answered numerous oral and written requests for interpretation of the new provisions. This release is intended to assist those persons who wish to make offerings in reliance on the exemptions in Regulation D by presenting the staff’s views on frequently raised questions. As indicated in Preliminary Note 3 to the regulation, Regulation D is intended to be a basic element in a uniform system of federal-state exemptions. As such, aspects of Regulation D have been incorporated in many state statutes and regulations. The interpretations set forth in this release relate only to the federal provisions.

Regulation D is composed of six rules, Rules 501-506. The first three rules set forth general terms and conditions that apply in whole or in part to the exemptions. The questions arising under Rules 50.1-503 fall into four general categories: definitions, disclosure requirements, operational conditions, and notice of sale requirements. The exemptions of Regulation D are set forth in Rules 504-506. Questions concerning those rules usually raise issues pertaining to more than one exemption. This release, an outline of which follows, is organized so as to reflect this pattern of inquiries.

I. Definitions — Rule 501

A. Accredited Investor — Rule 501(a) (Questions 1 – 30)

1. General

2. Certain Institutional Investors — Rules 501(a)(1) – (3)

3. Insiders — Rule 501(a)(4)

4. $150,000 Purchasers — Rule 501(a)(5)

a. $150,000 Purchase

b. 20 Percent of Net Worth Limitation

5. Natural Persons — Rules 501(a)(6) – (7)

6. Entities Owned By Accredited Investors — Rule 501(a)(8)

7. Trusts as Accredited Investors

B. Aggregate Offering Price — Rule 501(c) (Questions 31 – 36)

C. Executive Officer — Rule 501(f) (Question 37)

D. Purchaser Representative — Rule 501(h) (Questions 38 – 39)

II. Disclosure Requirements — Rule 502(b)

A. When Required (Questions 40 – 41)

B. What Required (Questions 42 – 51)

1. Non-reporting Issuers — Rule 502(b)(2)(i)

2. Reporting Issuers — Rule 502(b)(2)(ii)

C. General (Question 52)

III. Operational Conditions

A. Integration — Rule 502(a) (Question 53)

B. Calculation of Number of Purchasers — Rule 501(e) (Questions 54 – 59)

C. Manner of Offering — Rule 502(c) (Question 60)

D. Limitations on Resale — Rule 502(d) (Question 61)

IV. Exemptions

A. Rule 504 (Questions 62 – 65)

B. Rule 505 (Question 66)

C. Questions Relating to Rules 504 and 505 (Questions 67 – 71)

D. Rule 506 (Questions 72 – 73)

E. Questions Relating to Rules 504-506 (Questions 74 – 80)

V. Notice of Sale — Form D (Questions 81 – 92)

SEC DOCKET(1973-Current)
SEC-RELEASE Interpretive Release on Regulation D Release No. 33-6455

27 SEC-DOCKET 347-01

March 3, 1983

I. Definitions–Rule 501

A. Accredited Investor–Rule 501(a)

Defined in Rule 501(a), the term “accredited investor” is significant to the operation of Regulation D. 2 Under Rule 501(e), for instance, accredited investors are not included in computing the number of purchasers in offerings conducted in reliance on Rules 505 and 506. Also, if accredited investors are the only purchasers in offerings under Rules 505 and 506, Regulation D does not require delivery of specific disclosure as a condition of the exemptions. Finally, in an offering under Rule 506, the issuer’s obligation to ensure the sophistication of purchasers applies to investors that are not accredited. See Rule 506(b)(2)(ii).

The definition sets forth eight categories of investor that may be accredited. The following questions and answers cover certain issues under various of those categories. Given the frequency of questions regarding the application of the definition to trusts, however, there is a separate section addressing that area.

1. General

The definition of “accredited investor” includes any person who comes within or “who the issuer reasonably believes” comes within one of the enumerated categories “at the time of the sale of the securities to that person.” What constitutes “reasonable” belief will depend on the facts of each particular case. For this reason, the staff generally will not be in a position to express views or otherwise endorse any one method for ascertaining whether an investor is accredited.

(1) Question: A director of a corporate issuer purchases securities offered under Rule 505. Two weeks after the purchase, and prior to completion of the offering, the director resigns due to a sudden illness. Is the former director an accredited investor?

Answer: Yes. The preliminary language to Rule 501(a) provides that an investor is accredited if he falls into one of the enumerated categories “at the time of the sale of securities to that person.” One such category includes directors of the issuer. See Rule 501(a)(4). The investor in this case had that status at the time of the sale to him. 3

2. Certain Institutional Investors–Rules 501(a)(1)-(3)

(2) Question: A national bank purchases $100,000 of securities from a Regulation D issuer and distributes the securities equally among ten trust accounts for which it acts as trustee. Is the bank an accredited investor?

Answer: Yes. Rule 501(a)(1) accredits a bank acting in a fiduciary capacity. 4

(3) Question: An ERISA employee benefit plan will purchase $200,000 of the securities being offered. The plan has less than $5,000,000 in total assets and its investment decisions are made by a plan trustee who is not a bank, insurance company, or registered investment adviser. Does the plan qualify as an accredited investor?

Answer: Not under Rule 501(a)(1), Rule 501(a)(1) accredits an ERISA plan that has a plan fiduciary which is a bank, insurance company, or registered investment adviser or that has total assets in excess of $5,000,000. The plan, however, may be an accredited investor under Rule 501(a)(5), which accredits certain persons who purchase at least $150,000 of the securities being offered.

(4) Question: A state run, not-for-profit hospital has total assets in excess of $5,000,000. Because it is a state agency, the hospital is exempt from federal income taxation. Rule 501(a)(3) accredits any organization described in section 501(c)(3) of the Internal Revenue Code that has total assets in excess of $5,000,000. Is the hospital accredited under Rule 501(a)(3)?

Answer: Yes. This category does not require that the investor have received a ruling on tax status under section 501(c)(3) of the Internal Revenue Code. Rather, Rule 501(a)(3) accredits an investor that falls within the substantive description in that section. 5

(5) Question: A not-for-profit, tax exempt hospital with total assets of $3,000,000 is purchasing $100,000 of securities in a Regulation D offering. The hospital controls a subsidiary with total assets of $3,000,000. Under generally accepted accounting principles, the hospital may combine its financial statements with that of its subsidiary. Is the hospital accredited?

Answer: Yes, under Rule 501(a)(3). Where the financial statements of the subsidiary may be combined with those of the investor, the assets of the subsidiary may be added to those of the investor in computing total assets for purposes of Rule 501(a)(3). 6

3. Insiders–Rule 501(a)(4)

(6) Question: The executive officer of a parent of the corporate general partner of the issuer is investing in the Regulation D offering. Is that individual an accredited investor?

Answer: Rule 501(a)(4) accredits only the directors and executive officers of the general partner itself. Unless the executive officer of the parent can be deemed an executive officer of the Subsidiary, 7 that individual is not an accredited investor.

4. $150,000 Purchasers–Rule 501(a)(5)

This provision accredits any person 8 who satisfies two separate tests. To be accredited under Rule 501(a)(5), an investor must purchase at least $150,000 of the securities being offered, by one or a combination of four specific methods: cash, marketable securities, an unconditional obligation to pay cash or marketable securities over not more than five years, and cancellation of indebtedness. The rule also requires that “the total purchase price” may not exceed 20 percent of the purchaser’s net worth. The two tests under Rule 501(a)(5) must be considered separately. Thus, for instance, in computing the “total purchase price” for the 20 percent of net worth limitation, the investor may have to include amounts that could not be included towards the $150,000 purchase test.

a. $150,000 Purchase

(7) Question: Two issuers, a general partner and its limited partnership, are selling their securities simultaneously as units consisting of common stock and limited partnership interests. The issues are part of a plan of financing made for the same general purpose. If an investor purchases $150,000 of these units, would it satisfy the $150,000 purchase element of Rule 501(a)(5)?

Answer: Yes. The issuers are affiliated and the simultaneous sale of their separate securities as units for a single plan of financing would be deemed one integrated offering. Rule 501(a)(5) applies to a purchase “of the securities being offered.” The rule thus applies not to the securities of a particular issuer, but to the securities of a particular offering. 9

(8) Question: An investor will purchase securities in cash installments. Each installment payment will include amounts due on the principal as well as interest. If the total of all payments is $150,000, will the investor have purchased “at least $150,000 of the securities being offered” for purposes of Rule 501(a)(5)?

Answer: No. Under Rule 501(a)(5), any amount constituting interest due on the unpaid purchase price is not payment for the “securities being offered.”

(9) Question: The installment payments for interest in a limited partnership that will develop commercial real estate will be conditioned upon completion of certain phases of the project. Will the obligation to make those payments be deemed “an unconditional obligation to pay” for purposes of Rule 501(a)(5)?

Answer: Yes, as long as the only conditions relate to completion of successive stages of the development project.

(10) Question: An investor will purchase securities in a Regulation D offering by delivering $75,000 in cash and a letter of credit for $75,000. Will such a purchase satisfy the $150,000 element of Rule 501(a)(5)?

Answer: No. Because there is no assurance that the letter of credit will ever be drawn against, the staff does not deem it to be an unconditional obligation to pay.

(11) Question: In connection with the sale of limited partnership interests in an oil and gas drilling program, an investor in a Regulation D offering commits to pay subsequent assessments that are mandatory, non-contingent, and for which the investor will be personally liable. Will the commitment to pay the assessments constitute an “unconditional obligation to pay” under Rule 501(a)(5)?

Answer: Yes. The assessments are essentially installment payments for which the investor makes the investment decision at the time the limited partnership interest originally is purchased. 10

(12) Question: If the assessments in Question 11 are voluntary, contingent and non-recourse, can they be included in determining whether or not the investor has purchased $150,000 of the securities being offered?

Answer: No. voluntary assessments of this nature are not deemed to constitute an unconditional obligation to pay. 11

(13) Question: A purchaser of interests in a limited partnership makes a partial down payment and commits unconditionally to pay the balance over five years. Formation of the partnership is conditioned upon the sale of a specified number of interests. Under Rule 501(a)(5), when must the five year period for installment payments being to run?

Answer: Rule 501(a)(5) provides that the unconditional obligation is to be discharged “within five years of the sale of the securities to the purchaser.” For ease in the administration of an offering that is conditioned on a certain minimum level of sales, the staff believes it is reasonable to compute the length of installment obligations from the same date for the investors involved in reaching that minimum. Therefore, without any bearing on when the sale of the security actually occurs, the five-year time period of the investor’s obligation may be measured from the date such minimum level of sales has been reached. 12

b. 20 Percent of Net Worth Limitation

(14) Question: Where an investor makes installment payments composed of principal and interest, must the interest payments be included in computing the “total purchase price” for purposes of meeting the 20 percent of net worth limitation?

Answer: No. The interest is not part of the total purchase price but rather is an expense associated with financing the total purchase price.

(15) Question: A corporate investor will purchase $200,000 of the securities being offered for cash. Additionally, the investor will deliver an irrevocable letter of credit for $50,000 which the issuer will use as collateral in connection with a line of credit it will establish with a lending institution. Must the issuer include the $50,000 letter of credit when determining whether or not the purchaser’s total purchase price exceeds 20 percent of its net worth under Rule 501(a)(5)?

Answer: Yes. Since the investor has committed to pay the $50,000 at the election of the issuer, that amount must be included with other forms of consideration in order to measure what percentage of the investor’s net worth has been committed in the investment. 13

(16) Question: As part of the purchase of an interest in a sale and lease-back program, the purchaser will deliver “non-recourse” debt where the source of payment for the debt is limited exclusively to the income generated by the security being purchased or the assets of the entity in which the security is being purchased. Must the non-recourse debt be included in the total purchase price for purposes of the 20 percent of net worth limitation under Rule 501(a)(5)?

Answer: No. Because the investor has no personal liability for the non-recourse debt, and because no part of the investor’s assets at the time of purchase is available as a source of payment for the debt, the debt should not be included as part of the purchase price. 14

(17) Question: Where the purchaser is a natural person, Rule 501(a)(5) provides that the total purchase price may be measured against the purchaser’s net worth combined with that of a spouse. Would property held solely by one spouse be available for calculating the net worth of the other spouse who is making the $150,000 investment?

Answer: Yes.

(18) Question: An investment general partnership is purchasing securities in a Regulation D offering. The partnership was not formed for the specific purpose of acquiring the securities being offered. May the issuer consider the aggregate net worth of the general partners in calculating the net worth of the partnership?

Answer: Yes. An investment general partnership is functionally a vehicle in which profits and losses are passed through to general partners and in which the net worths of the general partners are exposed to the risk of partnership investments. 15

(19) Question: A totally held subsidiary 16 makes a cash investment of $200,000 in a Regulation D offering. May that subsidiary use the consolidated net worth of its parent in determining whether or not its total purchase price exceeds 20 percent of its net worth?

Answer: Yes. 17

5. Natural Persons–Rules 501(a)(6)-(7)

Rules 501(a)(6) and (7) apply only to natural persons. Paragraph (6) accredits any natural person with a net worth at the time of purchase in excess of $1,000,000. If the investor is married, the rule permits the use of joint net worth of the couple. Paragraph (7) accredits any natural person whose income has exceeded $200,000 in each of the two most recent years and is reasonably expected to exceed $200,000 in the year of the investment.

(20) Question: A corporation with a net worth of $2,000,000 purchases securities in a Regulation D offering. Is the corporation an accredited investor under Rule 501(a)(6)?

Answer: No. Rule 501(a)(6) is limited to “natural” persons.

(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.

(22) Question: May a purchaser take into account income of a spouse in determining possible accreditation under Rule 501(a)(7)?

Answer: No. Rule 501(a)(7) requires “individual income” over $200,000 in order to qualify as an accredited investor.

(23) Question: May a purchaser include unrealized capital appreciation in calculating income for purposes of Rule 501(a)(7)?

Answer: Generally, no.

6. Entities Owned By Accredited Investors–Rule 501(a)(8)

Any entity in which each equity owner is an accredited investor under any of the qualifying categories, except that of the $150,000 purchaser, is accredited under Rule 501(a)(8).

(24) Question: All but one of the shareholders of a corporation are accredited investors by virtue of net worth or income. The unaccredited shareholder is a director who bought one share of stock in order to comply with a requirement that all directors be shareholders of the corporation. Is the corporation an accredited investor under Rule 501(a)(8)?

Answer: No. Rule 501(a)(8) requires “all of the equity owners” to be accredited investors. The director is an equity owner and is not accredited. Note that the director cannot be accredited under Rule 501(a)(4). That provision extends accreditation to a director of the issuer, not of the investor.

(25) Question: Who are the equity owners of a limited partnership?

Answer: The limited partners.

7. Trusts as Accredited Investors

(26) Question: May a trust qualify as an accredited investor under Rule 501(a)(1)?

Answer: Only indirectly. Although a trust standing alone cannot be accredited under Rule 501(a)(1), if a bank is its trustee and makes the investment on behalf of the trust, the trust will in effect be accredited by virtue of the provision in Rule 501(a)(1) that accredits a bank acting in a fiduciary capacity.

(27) Question: May a trust qualify as an accredited investor under Rule 501(a)(5)?

Answer: Yes. The Division interprets “person” in Rule 501(a)(5) to include any trust. 18

(28) Question: In qualifying a trust as an accredited investor under Rule 501(a)(5), whose net worth should be considered in determining whether the total purchase price meets the 20 percent of net worth limitation test?

Answer: The net worth of the trust.

(29) Question: A trustee of a trust has a net worth of $1,500,000. Is the trustee’s purchase of securities for the trust that of an accredited investor under Rule 501(a)(6)?

Answer: No. Except where a bank is a trustee, the trust is deemed the purchaser, not the trustee. The trust is not a “natural” person.

(30) Question: May a trust be accredited under Rule 501(a)(8) if all of its beneficiaries are accredited investors?

Answer: Generally, no. Rule 501(a)(8) accredits any entity if all of its “equity owners” are accredited investors. The staff does not interpret this provision to apply to the beneficiaries of a conventional trust. The result may be different, however, in the case of certain non-conventional trusts where, as a result of powers retained by the grantors, a trust as a legal entity would be deemed not to exist. 19 Thus, where the grantors of a revocable trust are accredited investors under Rule 501(a)(6) (i.e. net worth exceeds $1,000,000) and the trust may be amended or revoked at any time by the grantors, the trust is accredited because the grantors will be deemed the equity owners of the trust’s assets. 20 Similarly, where the purchase of Regulation D securities is made by an Individual Retirement Account and the participant is an accredited investor, the account would be accredited under Rule 501(a)(8).

B. Aggregate Offering Price–Rule 501(c)

The “aggregate offering price,” defined in Rule 501(c), is the sum of all proceeds received by the issuer for issuance of its securities. The term is important to the operation of Rules 504 and 505, both of which impose a limitation on the aggregate offering price as a specific condition to the availability of the exemption. 21

(31) Question: The sole general partner of a real estate limited partnership contributes property to the program. Must that property be valued and included in the overall proceeds of the offering as part of the aggregate offering price?

Answer: No, assuming the property is contributed in exchange for a general partnership interest.

(32) Question: An owner of a mining or oil and gas property is selling interests in the property to investors for cash. The owner will retain a royalty interest in the property. Must any subsequent royalty payments be included in the aggregate offering price of the property interests?

Answer: No. Royalty payments to the seller of the property are treated as operating expenses, rather than capitalized costs for the property. As such, the royalty payments are not part of the consideration received by the issuer for issuance of the securities.

(33) Question: Where the investors pay for their securities in installments and these payments include an interest component, must the issuer include interest payments in the “aggregate offering price?”

Answer: No. The interest payments are not deemed to be consideration for the issuance of the securities. 22

(34) Question: An offering of interests in an oil and gas limited partnership provides for additional voluntary assessments. These assessments, undetermined at the time of the offering, may be called at the general partner’s discretion for developmental drilling activities. Must the assessments be included in the aggregate offering price, and if so, in what amount?

Answer: Because it is, unclear that the assessments will ever be called, and because if they are called, it is unclear at what level, the issuer is not required to include the assessments in the aggregate offering price. In fact, the assessments will be consideration received for the issuance of additional securities in the limited partnership. This issuance will need to be considered along with the original issuance for possible integration, or, if not integrated, must find its own exemption from registration.

(35) Question: In purchasing interests in an oil and gas partnership, investors agree to pay mandatory assessments. The assessments, essentially installment payments, are non-contingent and investors will be personally liable for their payment. Must the issuer include the assessments in the aggregate offering price?

Answer: Yes. 23

(36) Question: As part of their purchase of securities, investors deliver irrevocable letters of credit. Must the letters of credit be included in the aggregate offering price?

Answer: If these letters of credit were drawn against, the amounts involved would be considered part of the aggregate offering price. For this reason, in planning the transaction, the issuer should consider the full amount of the letters of credit in calculating the aggregate offering price.

C. Executive Officer–Rule 501(f)

The definition of executive officer in Rule 501(f) is the same as that in Rule 405 of Regulation C (17 CFR 230.405).

(37) Question: The executive officer of the parent of the Regulation D issuer performs a policy making function for its subsidiary. May that individual be deemed an “executive officer” of the subsidiary?

Answer: Yes.

D. Purchaser Representative–Rule 501(h)

A purchaser representative is any person who satisfies, or who the issuer reasonably believes satisfies, four conditions enumerated in Rule 501(h). Beyond the obligations imposed by that rule, any person acting as a purchaser representative must consider whether or not he is required to register as a broker-dealer under section 15 of the Securities Exchange Act of 1934 (the “Exchange Act”) (15 U.S.C. 78a-78kk (1976 & Supp. IV 1980)) or as an investment adviser under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-1-80b-21 (1976 & Supp. IV 1980)). 24

(38) Question: May the officer of a corporate general partner of the issuer qualify as a purchaser representative under Rule 501(h)?

Answer: Rule 501(h) provides that “an affiliate, director, officer or other employee of the issuer” may not be a purchaser representative unless the purchaser has one of three enumerated relationships with the representative. The staff is of the view that an officer or director of a corporate general partner comes within the scope of “affiliate, director, officer or other employee of the issuer.”

(39) Question: May the issuer in a Regulation D offering pay the fees of the purchaser representative?

Answer: Yes. Nothing in Regulation D prohibits the payment by the issuer of the purchaser representative’s fees. Rule 501(h)(4), however, requires disclosure of this fact. 25

II. Disclosure Requirements–Rule 502(b)

A. When Required

Rule 502(b)(1) sets forth the circumstances when disclosure of the kind specified in the regulation must be delivered to investors. The regulation requires the delivery of certain information “during the course of the offering and prior to sale” if the offering is conducted in reliance on Rule 505 or 506 and if there are unaccredited investors. If the offering is conducted in compliance with Rule 504 or if securities are sold only to accredited investors, Regulation D does not specify the information that must be disclosed to investors. 26

(40) Question: An issuer furnishes potential investors a short form offering memorandum in anticipation of actual selling activities and the delivery of an expanded disclosure document. Does Regulation D permit the delivery of disclosure in two installments?

Answer: So long as all the information is delivered prior to sale, the use of a fair and adequate summary followed by a complete disclosure document is not prohibited under Regulation D. Disclosure in such a manner, however, should not obscure material information.

(41) Question: An issuer commences an offering in reliance on Rule 505 in which the issuer intends to make sales only to accredited investors. The issuer delivers those investors an abbreviated disclosure document. Before the completion of the offering, the issuer changes its intentions and proposes to make sales to non-accredited investors. Would the requirement that the issuer deliver the specified information to all purchasers prior to sale if any sales are made to non-accredited investors preclude application of Rule 505 to the earlier sales to the accredited investors?

Answer: No. If the issuer delivers a complete disclosure document to the accredited investors and agrees to return their funds promptly unless they should elect to remain in the program, the issuer would not be precluded from relying on Rule 505.

B. What Required

Regulation D divides disclosure into two categories: that to be furnished by non-reporting companies and that required for reporting companies. In either case, the specified disclosure is required to the extent material to an understanding of the issuer, its business and the securities being offered.

1. Non-Reporting Issuers–Rule 502(b)(2)(i)

If the issuer is not subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, 27 it must furnish the specified information “to the extent material to an understanding of the issuer, its business and the securities being offered.” For offerings up to $5,000,000, the issuer should furnish the “same kind of information” as would be contained in Part I of Form S-18, 28 except that only the most recent year’s financial statements need be certified. For offerings over $5,000,000, the issuer should furnish “the same kind of information” as would be required in Part I of an available registration statement. 29

(42) Question: When an issuer is required to deliver specific disclosure, must that disclosure be in written form?

Answer: Yes.

(43) Question: Form S-18 requires the issuer’s audited balance sheet as of the end of its most recently completed fiscal year or within 135 days if the issuer has been in existence for a shorter time. With a limited partnership that has been formed with minimal capitalization immediately prior to a Regulation D offering, must the Regulation D disclosure document contain an audited balance sheet for the issuer?

Answer: In analyzing this or any other disclosure question under Regulation D, the issuer starts with the general rule that it is obligated to furnish the specified information “to the extent material to an understanding of the issuer, its business, and the securities being offered.” Thus, in this particular case, if an audited balance sheet is not material to the investor’s understanding, then the issuer may elect to present an alternative to its audited balance sheet.

(44) Question: Is Securities Act Industry Guide 5 30 applicable in a $4,000,000 Regulation D offering of interests in a real estate limited partnership?

Answer: Rule 502(b)(2)(i)(A) requires the issuer to provide the same kind of information as that required in Part I of Form S-18. 31 Form S-18 directs the issuer’s attention to the Industry Guides, noting that such guides “represent Division practices with respect to the disclosure to be provided by the affected industries in registration statements.” In preparing its Regulation D offering material, therefore, an issuer of interests in a real estate limited partnership should consider Guide 5 in determining the disclosure that will be material to the investor’s understanding of the issuer, its business and the securities being offered.

(45) Question: In a $4,000,000 Regulation D offering of interests in an oil and gas limited partnership, what are the issuer’s disclosure obligations with respect to financial statements of the general partner?

Answer: Item 21(h) of Form S-18 provides that the issuer should furnish the audited balance sheet as of the end of the most recent fiscal year of any corporation or partnership that is a general partner of the issuer. For any general partner that is a natural person, in lieu of an audited balance sheet, the issuer may furnish a statement of that individual’s net worth in the text of the disclosure document, where assets and liabilities are estimated at fair market value with provisions for estimated income taxes on unrealized gains. 32

(46) Question: The issuer in a $3,000,000 Regulation D offering is a limited partnership that will acquire certain real estate operations with the offering proceeds. What is the appropriate consideration for disclosure of the operating history of these operations?

Answer: Item 21(g) of Form S-18, which provides special guidance for such disclosure, calls for the audited income statements of the operations, with certain exclusions, for the two most recent fiscal years. If the issuer can meet certain conditions, however, the instruction reduces that requirement to only one year of audited income statements. 33

Under Regulation D, Rule 502(b)(2)(i)(A) provides that only the financial statements for the issuer’s most recent fiscal year must be certified in an offering not in excess of $5,000,000. The staff is of the view that this provision applies to all financial statements in the disclosure document.

Thus, in the Regulation D offering described, the following considerations apply. If the issuer can meet the conditions in Item 21(g) of Form S-18, it may present one year of audited income statements on the operations to be acquired. If the issuer cannot meet the conditions in Form S-18, then it should present two years of income statements, only one of which must be audited.

(47) Question: If the issuer in Question 46 cannot obtain the financial statements on the operations to be acquired without unreasonable effort or expense, what further considerations are applicable under Regulation D?

Answer: Rule 502(b)(2)(i)(A) provides that “if the issuer is a limited partnership and cannot obtain the required financial statements without unreasonable effort or expense, it may furnish financial statements that have been prepared on the basis of federal income tax requirements and examined and reported on in accordance with generally accepted auditing standards by an independent public or certified accountant.” The staff interprets this provision to apply to all financial statements that the issuer presents in the offering document. Thus, the issuer described above may present tax basis operating statements on the operations to be acquired. 34

(48) Question: Has the Commission defined or will the staff issue interpretations on the term “unreasonable effort or expense?”

Answer: No. The meaning of “unreasonable effort or expense” depends on the particular facts and circumstances attending each case. Only the issuer will know the facts and circumstances and be able to evaluate them with respect to the requirements of the rule.

(49) Question: The issuer in a Regulation D offering of $7,000,000 is a corporation. That corporation is acquiring a business. The issuer is unable to obtain the financial statements for that business without unreasonable effort or expense. 35 What are the relevant considerations under Regulation D?

Answer: Rule 502(b)(2)(i)(B) provides that if the issuer is not a limited partnership and “cannot obtain audited financial statements without unreasonable effort or expense, then only the issuer’s balance sheet, which shall be dated within 120 days of the start of the offering, must be audited.” The staff has interpreted this provision in the context of Rule 3-05 of Regulation S-X to apply to the financial statements of the business being acquired. Thus, if the business being acquired is other than a limited partnership, and if the issuer cannot obtain audited financial statements of that business without unreasonable effort or expense, then the issuer may provide the relevant financial statements for the business being acquired on an unaudited basis so long as it also provides an audited balance sheet for that business dated within 120 days of the start of the offering, or, if appropriate, as of the date of acquisition of the business. 36

2. Reporting Issuers–Rule 502(b)(2)(ii)

If the issuer is subject to the reporting requirements of section 13 or 15(d) of the Exchange Act, Regulation D sets forth two alternatives for disclosure: the issuer may deliver certain recent Exchange Act reports (the annual report, the definitive proxy statement, and, if requested, the Form 10-K (17 CFR 249.310)) or it may provide a document containing the same information as in the Form 10-K or Form 10 (17 CFR 249.210) under the Exchange Act or in a registration statement under the Securities Act. In either case the rule also calls for the delivery of certain supplemental information.

(50) Question: Rule 502(b)(2)(ii)(B) refers to the information contained “in a registration statement on Form S-1.” Does this requirement envision delivery of Parts I and II of the Form S-1?

Answer: No. Rule 502(b)(2)(ii)(B) should be construed to mean Part I of Form S-1.

(51) Question: A reporting company with a fiscal year ending on December 31 is making a Regulation D offering in February. It does not have an annual report to shareholders, an associated definitive proxy statement, or a Form 10-K for its most recently completed fiscal year. The issuer’s last registration statement was filed more than two years ago. What is the appropriate disclosure under Regulation D?

Answer: The issuer may base its disclosure on the most recently completed fiscal year for which an annual report to shareholders or Form 10-K was timely distributed or filed. The issuer should supplement the information in the report used with the information contained in any reports or documents required to be filed under sections 13(a), 14(a), 14(c) and 15(d) of the Exchange Act since the distribution or filing of that report and with a brief description of the securities being offered, the use of the proceeds from the offering, and any material changes in the issuer’s affairs that are not disclosed in the documents furnished.

See Rule 502(b)(2)(ii)(C).

C. General

Rule 502(b)(2) also contains four general provisions applicable to all classes of issuer in all offerings where specified disclosure is required. These provisions govern exhibits, disclosure of additional information to non-accredited investors, the opportunity for further investor inquiries, and disclosure of certain additional information in business combinations.

(52) Question: In a Rule 505 or 506 offering of interests in a limited partnership where certain purchasers are not accredited investors, must the issuer obtain an opinion of counsel regarding the legality of the securities being issued or an opinion regarding the tax consequences of an investment in the offering?

Answer: Rule 502(b)(2)(iii) provides that the issuer is not required to furnish the exhibits that would accompany the form of registration or report governing the issuer’s disclosure document if the issuer identifies the contents of those exhibits and makes them available to purchasers upon written request prior to purchase. 37 Any form of registration to which the issuer refers in preparing its disclosure document under Regulation D requires that the issuer furnish the exhibits required by Item 601 of Regulation S-K. Item 601 requires that the issuer furnish, among other exhibits, an opinion of counsel as to the legality of the securities being issued. Thus, under Rule 502(b)(2)(iii), the issuer should identify the contents of this opinion of counsel and make it available to purchasers upon written request. Item 601 also sets forth certain requirements for an opinion as to tax matters. Such an opinion is required to support any representations in a prospectus as to material tax consequences. Thus, assuming the Regulation D issuer will make representations in the disclosure document as to material tax consequences of investing in a limited partnership, the issuer should identify the contents of and make available upon request an opinion supporting that discussion. 38

III. Operational Conditions

A. Integration–Rule 502(a)

Rule 502(a) achieves two purposes. First, it explicitly incorporates the doctrine of integration into Regulation D. Second, it establishes an exception to the operation of that doctrine.

Integration operates to identify the scope of a particular offering by considering the relationship between multiple transactions. It is premised on the concept that the Securities Act addresses discrete offerings and on the recognition that not every offering is in fact a discrete transaction. The integration doctrine prevents an issuer from circumventing the registration requirements of the Securities Act by claiming a separate exemption for each part of a series of transactions that comprises a single offering. Because the determination of whether transactions should be integrated into one offering is so dependent on particular facts and circumstances, the staff does not issue interpretations in this area. 39 The Note to Rule 502(a), however, does set forth a number of factors that should be considered in making an integration determination.

Rule 502(a) also sets forth an exception to the integration doctrine. It provides that a Regulation D offering will not be integrated with offers or sales that occur more than six months before or after the Regulation D offering. This six month safe harbor rule only applies, however, where there have been no offers or sales (except under an employee benefit plan) of securities similar to those in the Regulation D offering within the applicable six months. 40

(53) Question: An issuer conducts offering (A) under Rule 504 of Regulation D that concludes in January. Seven months later the issuer commences offering (B) under Rule 506. During that seven month period the issuer’s only offers or sales of securities are under an employee benefit plan (C). Must the issuer integrate (A) and (B)?

Answer: No. Rule 502(a) specifically provides that (A) and (B) will not be integrated. 41

B. Calculation of the Number of Purchasers–Rule 501(e)

Rule 501(e) governs the calculation of the number of purchasers in offerings that rely either on Rule 505 or 506. Both of these rules limit the number of non-accredited investors to 35. Rule 501(e) has two parts. The first excludes certain purchasers from the calculation. The second establishes basic principles for counting of corporations, partnerships, or other entities.

(54) Question: One purchaser in a Rule 506 offering is an accredited investor. Another is a first cousin of that investor sharing the same principal residence. Each purchaser is making his own investment decision. How must the issuer count these purchasers for purposes of meeting the 35 purchaser limitation?

Answer: The issuer is not required to count either investor. The accredited investor may be excluded under Rule 501(e)(1)(iv), and the first cousin may then be excluded under Rule 501(e)(1)(i). 42

(55) Question: An accredited investor in a Rule 506 offering will have the securities she acquires placed in her name and that of her spouse. The spouse will not make an investment decision with respect to the acquisition. How many purchasers will be involved?

Answer: The accredited investor may be excluded from the count under Rule 501(e)(1)(iv) and the spouse may be excluded under Rule 501(e)(1)(i). The issuer may also take the position, however, that the spouse should not be deemed a purchaser at all because he did not make any investment decision, and because the placement of the securities in joint name may simply be a tax or estate planning technique.

(56) Question: An offering is conducted in the United States under Rule 505. At the same time certain sales are made overseas. Must the foreign investors be included in calculating the number of purchasers?

Answer: Offers and sales of securities to foreign persons made outside the United States in such a way that the securities come to rest abroad generally do not need to be registered under the Act. This basis for non-registration is separate from Regulation D and offers and sales relying on this interpretation are not required to be integrated with a coincident domestic offering. 43 Thus, assuming the sales in this question rely on this interpretation, foreign investors would not be counted.

(57) Question: An investor in a Rule 506 offering is a general partnership that was not organized for the specific purpose of acquiring the securities offered. The partnership has ten partners, five of whom do not qualify as accredited investors. The partnership will make an investment of $100,000. How is the partnership counted and must the issuer make any findings as to the sophistication of the individual partners?

Answer: Rule 501(e)(2) provides that the partnership shall be counted as one purchaser. The issuer is not obligated to consider the sophistication of each individual partner.

(58) Question: If the partnership in Question 57 purchases $200,000 of the securities being offered and if that amount does not exceed 20 percent of the partnership’s net worth, how should the partnership be counted?

Answer: Rule 501(e)(2), which provides that the partnership shall be counted as one purchaser, operates in tandem with Rule 501(e)(1). Thus, because the partnership is an accredited investor (in this case under Rule 501(a)(5)), the partnership may be excluded from the count under Rule 501(e)(2)(iv).

(59) Question: An investor in a Rule 506 offering is an investment partnership that is not accredited under Rule 501(a)(8). Although the partnership was organized two years earlier and has made investments in a number of offerings, not all the partners have participated in each investment. With each proposed investment by the partnership, individual partners have received a copy of the disclosure document and have made a decision whether or not to participate. How do the provisions of Regulation D apply to the partnership as an investor?

Answer: The partnership may not be treated as a single purchaser. Rule 501(e)(2) provides that if the partnership is organized for the specific purpose of acquiring the securities offered, then each beneficial owner of equity interests should be counted as a separate purchaser. Because the individual partners elect whether or not to participate in each investment, the partnership is deemed to be reorganized for the specific purpose of acquiring the securities in each investment. 44 Thus, the issuer must look through the partnership to the partners participating in the investment. The issuer must satisfy the conditions of Rule 506 as to each partner.

C. Manner of Offering–Rule 502(c)

Rule 502(c) prohibits the issuer or any person acting on the issuer’s behalf from offering or selling securities by any form of general solicitation or general advertising. The analysis of facts under Rule 502(c) can be divided into two separate inquiries. First, is the communication in question a general solicitation or general advertisement? Second, if it is, is it being used by the issuer or by someone on the issuer’s behalf to offer or sell the securities? If either question can be answered in the negative, then the issuer will not be in violation of Rule 502(c). Questions under Rule 502(c) typically present issues of fact and circumstance that the staff is not in a position to resolve. In several instances, however, the staff has been able to address questions under the rule.

In analyzing what constitutes a general solicitation, the staff considered a solicitation by the general partner of a limited partnership to limited partners in other active programs sponsored by the same general partner. In determining that this did not constituted a general solicitation the Division underscored the existence and substance of the pre-existing business relationship between the general partner and those being solicited. The general partner represented that it believed each of the solicitees had such knowledge and experience in financial and business matters that he or she was capable of evaluating the merits and risks of the prospective investment. See letter re Woodtrails-Seattle, Ltd. dated July 8, 1982.

In analyzing whether or not an issuer was using a general advertisement to offer or sell securities, the staff declined to express an opinion on a proposed tombstone advertisement that would announce the completion of an offering. See letter re Alma Securities Corporation dated July 2, 1982. Because the requesting letter did not describe the proposed use of the tombstone announcement and because the announcement of the completion of one offering could be an indirect solicitation for a new offering, the staff did not express a view. In a letter re Tax Investment Information Corporation dated January 7, 1983, the staff considered whether the publication of a circular analyzing private placement offerings, where the publisher was independent from the issuers and the offerings being analyzed, would violate Rule 502(c). Although Regulation D does not directly prohibit such a third party publication, the staff refused to agree that such a publication would be permitted under Regulation D because of its susceptibility to use by participants in an offering. Finally, in the letter re Aspen Grove dated November 8, 1982 the staff expressed the view that the proposed distribution of a promotional brochure to the members of the “Thoroughbred Owners and Breeders Association” and at an annual sale for horse owners and the proposed use of a magazine advertisement for an offering of interests in a limited partnership would not comply with Rule 502(c).

(60) Question: If a solicitation were limited to accredited investors, would it be deemed in compliance with Rule 502(c)?

Answer: The mere fact that a solicitation is directed only to accredited investors will not mean that the solicitation is in compliance with Rule 502(c). Rule 502(c) relates to the nature of the offering not the nature of the offerees.

D. Limitations on Resale–Rule 502(d)

Rule 502(d) makes it clear that Regulation D securities have limitations on transferability and requires that the issuer take certain precautions to restrict the transferability of the securities.

(61) Question: An investor in a Regulation D offering wishes to resell his securities within a year after the offering. The issuer has agreed to register the securities for resale. Will the proposed resale under the registration statement violate Rule 502(d)?

Answer: No. The function of Rule 502(d) is to restrict the unregistered resale of securities. Where the resale will be registered, however, such restrictions are unnecessary.

IV. Exemptions

A. Rule 504

Rule 504 is an exemption under section 3(b) of the Securities Act available to non-reporting and non-investment 45 companies for offerings not in excess of $500,000.

(62) Question: A foreign issuer proposes to use Rule 504. The issuer is not subject to section 15(d) and its securities are exempt from registration under Rule 12g3-2 (17 CFR 240.12g3-2). May this issuer use Rule 504?

Answer: Yes.

(63) Question: An issuer proposes to make an offering under Rule 504 in two states. The offering will be registered in one state and the issuer will deliver a disclosure document pursuant to the state’s requirements. The offering will be made pursuant to an exemption from registration in the second state. Must the offering satisfy the limitations on the manner of offering and on resale in paragraphs (c) and (d) of Rule 502?

Answer: Yes. An offering under Rule 504 is exempted from the manner of sale and resale limitations only if it is registered in each state in which it is conducted and only if a disclosure document is required by state law.

(64) Question: The state in which the offering will take place provides for “qualification” of any offer or sale of securities. The state statute also provides that the securities commissioner may condition qualification of an offering on the delivery of a disclosure document prior to sale. Would the issuer be making its offering in a state that “provides for registration of the securities and requires the delivery of a disclosure document before sale” if its offering were qualified in this state on the condition that it deliver a disclosure document before sale to each investor?

Answer: Yes. 46

(65) Question: If an issuer is registering securities at the state level, are there any specific requirements as to resales outside of that state if the issuer is attempting to come within the provision in Rule 504 that waives the limitations on the manner of offering and on resale in Rules 502(c) and (d)?

Answer: No. 47 The issuer, however, must intend to use Rule 504 to make bona fide sales in that state and not to evade the policy of Rule 504 by using sales in one state as a conduit for sales into another state. See Preliminary Note 6 to Regulation D.

B. Rule 505

Rule 505 provides an exemption under section 3(b) of the Securities Act for non-investment companies for offerings not in excess of $5,000,000.

(66) Question: An issuer is a broker that was censured pursuant to a Commission order. Does the censure bar the issuer from using Rule 505?

Answer: No. Rule 505 is not available to any issuer who falls within the disqualifications for the use of Regulation A (17 CFR 230.251-.264). See Rule 505(b)(2)(iii). One such disqualification occurs when the issuer is subject to a Commission order under section 15(b) of the Exchange Act. A censure has no continuing force and thus the issuer is not subject to an order of the Commission.

C. Questions Relating to Rules 504 and 505

Both Rules 504(b)(2)(i) and 505(b)(2)(i) require that the offering not exceed a specified aggregate offering price. The allowed aggregate offering price, however, is reduced by the aggregate offering price for all securities sold within the last twelve months in reliance on section 3(b) or in violation of section 5(a) of the Securities Act.

(67) Question: An issuer preparing to conduct an offering of equity securities under Rule 505 raised $2,000,000 from the sale of debt instruments under Rule 505 eight months earlier. How much may the issuer raise in the proposed equity offering?

Answer: $3,000,000. A specific condition to the availability of Rule 505 for the proposed offering is that its aggregate offering price not exceed $5,000,000 less the proceeds for all securities sold under section 3(b) within the last 12 months.

(68) Question: An issuer is planning a Rule 505 offering. Ten months earlier the issuer conducted a Rule 506 offering. Must the issuer consider the previous Rule 506 offering when calculating the allowable aggregate offering price for the proposed Rule 505 offering?

Answer: No. The Commission issued Rule 506 under section 4(2), and Rule 505(b)(2)(i) requires that the aggregate offering price be reduced by previous sales under section 3(b). 48

(69) Question: Seven months before a proposed Rule 504 offering the issuer conducted a rescission offer under Rule 504. The rescission offer was for securities that were sold in violation of section 5 more than 12 months before the proposed Rule 504 offering. Must the aggregate offering price for the proposed Rule 504 offering be reduced either by the amount of the rescission offer or the earlier offering in violation of section 5?

Answer: No. The offering in violation of section 5 took place more than 12 months earlier and thus is not required to be included when satisfying the limitation in Rule 504(b)(2)(i). The staff is of the view that the rescission offer relates back to the earlier offering and therefore should not be included as an adjustment to the aggregate offering price for the proposed Rule 504 offering.

(70) Question: Rules 504 and 505 contain examples as to the calculation of the allowed aggregate offering price for a particular offering. Do these examples contemplate integration of the offerings described?

Answer: No. The examples have been provided to demonstrate the operation of the limitation on the aggregate offering price in the absence of any integration questions.

(71) Question: Note 2 to Rule 504 is not restated in Rule 505. Does the principle of the note apply to Rule 505?

Answer: Yes. Note 2 to Rule 504 sets forth a general principle to the operation of the rule on limiting the aggregate offering price which is the same for both Rules 504 and 505. It provides that if, as a result of one offering, an issuer exceeds the allowed aggregate offering price in a subsequent unintegrated offering, the exemption for the first offering will not be affected.

D. Rule 506

(72) Question: May an issuer of securities with a projected aggregate offering price of $3,000,000 rely on Rule 506?

Answer: Yes. The availability of Rule 506 is not dependent on the dollar size of an offering.

(73) Question: Rule 506 requires that the issuer shall reasonably believe that each purchaser who is not an accredited investor either alone or with a purchaser representative has such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment. Former Rule 146 required the issuer to make a similar determination with respect to each offeree. Rule 506 is not an exclusive basis for satisfying the requirements of the private offering exemption in section 4(2). See Preliminary Note 3 to Regulation D. What is the Commission’s view of the relevance of the nature of the offerees in an offering that relies exclusively on section 4(2) as its basis for exemption from registration?

Answer: Clearly, in an offering relying exclusively on section 4(2) for an exemption from registration, all offerees who purchase must possess the requisite level of sophistication. The sophistication of each of those to whom the securities are offered who do not purchase is not a fact that in and of itself should determine mechanically the availability of the exemption; the number and the nature of the offerees, however, are relevant in determining whether an issuer has engaged in a general solicitation or general advertising that would preclude reliance on the exemption in section 4(2).

E. Questions Relating to Rules 504-506

(74) Question: If an issuer relies on one exemption, but later realizes that exemption may not have been made available, may it rely on another exemption after the fact?

Answer: Yes, assuming the offering met the conditions of the new exemption. No one exemption is exclusive of another.

(75) Question: May foreign issuers use Regulation D?

Answer: Yes. Recent amendments to Regulation D have clarified the disclosure requirements for foreign issuers. 49

(76) Question: Is Regulation D available to an underwriter for the sale of securities acquired in a firm commitment offering?

Answer: No. As Preliminary Note 4 indicates, Regulation D is available only to the issuer of the securities and not to any affiliate of that issuer or to any other person for resales of the issuer’s securities. See also Rule 502(d) which limits the resale of Regulation D securities.

(77) Question: Regulation T (12 CFR 220.1-.8) of the Federal Reserve Board imposes certain restrictions on brokers and dealers for the use of credit in the purchase of securities. Regulation T provides an exemption from those provisions for the arrangement of credit in a sale of securities that is exempt from the registration requirements of the Securities Act under section 4(2). See 12 CFR 220.7(g). What is the applicability of this provision to offerings conducted under Regulation D?

Answer: Regulation T is interpreted by the Federal Reserve Board which has expressed the view that the exemption from Regulation T in 12 CFR 220.7(a) is available for offerings conducted in reliance on Rules 505 and 506, 50 but not for those under 504. 51

(78) Question: A corporation proposes to implement an employee stock option plan for key employees. Can the issuer rely on Regulation D for an exemption from registration for the issuance of securities under the plan?

Answer: The corporation may use Regulation D for the sale of its securities under the plan to the extent that such offering complies with Regulation D. In a typical plan, the grant of the options will not be deemed a sale of a security for purposes of the Securities Act. The issuer, therefore, will be seeking an exemption for the issuance of the stock underlying the options. The offering of this stock generally will commence when the options become exercisable and will continue until the options are exercised or otherwise terminated. Where the key employees involved are directors or executive officers, such individuals will be accredited investors under Rule 501(a)(4) if they purchase securities through the exercise of their options. Other key employees may be accredited as a result of net worth or income under Rules 501(a)(6) or (a)(7).

(79) Question: In an “all or none” or minimum-maximum Regulation D offering of interests in a limited partnership, the general partner proposes, if necessary, to purchase enough interests for the issuer to sell a specified level of interests by the specified expiration date of the offering. What disclosure and other considerations are relevant?

Answer: The staff is of the view that pursuant to Rule 10b-9 under the Exchange Act, the issuer must disclose the possibility that the general partner may make purchases of the limited partnership interests in order to meet the specified minimum. In addition, the issuer should disclose the maximum amount of the possible purchases. Finally, these purchases must be for investment and not resale. Questions regarding these views should be directed to the Division of Market Regulation, Office of Trading Practices, (202) 272-2874.

(80) Question: An issuer will conduct a Regulation D offering on an “all or none” basis within a specified time. What considerations are there for the issuer if it wishes to extend the offering beyond the specified time in order to sell the specified amount of securities? Answer: The staff is of the view that an offering may be extended beyond the specified time without resulting in a violation of Rule 10b-9 under the Exchange Act or, in the case of an offering in which a broker-dealer is a participant, Rule 15c2-4 under the Exchange Act, under the following conditions:

a. Prior to the specified expiration date, a reconfirmation offer must be made to all subscribers that discloses the extension of the offering and any other material information necessary to update previously provided disclosure.

b. The reconfirmation offer must be structured so that the subscriber affirmatively elects to continue his investment and so that those subscribers who take no affirmative action will have their funds returned to them.

c. The reconfirmation offer must be made far enough in advance of the specified expiration date so that any subscriber who does not elect to continue his investment will have his funds returned to him promptly after the specified expiration date.

Questions regarding these views should be directed to the Division of Market Regulation, Office of Trading Practices, (202) 272-2874.

V. Notice of Sale–Form D

Rule 503 requires the issuer to file a notice of sale on Form D. The notice must be filed not later than 15 days after the first sale, every six months thereafter, and no later than 30 days after the last sale. 52

(81) Question: Where can an issuer obtain copies of Form D and where must the form be filed?

Answer: Form D is available through the Public Reference Branch of the Commission’s main office, 450 5th Street, N.W., Washington, D.C. 20549, (202)272-7460, or any of its regional or branch offices. The form should be filed at the Commission’s main office. There is no filing fee.

(82) Question: In a minimum-maximum offering where subscription funds are held in escrow pending receipt of minimum subscriptions, when is the first Form D required to be filed?

Answer: In the context of Rule 503, the first sale takes place upon receipt of the first subscription agreement and the deposit of the first funds into escrow. The issuer, therefore, should file its first Form D not later than 15 days after the receipt of the first subscription agreement.

(83) Question: An issuer conducting a minimum-maximum offering has received subscriptions for the minimum number of interests needed to form the limited partnership. Subsequent to closing and formation of the partnership, the issuer continues to offer interests. After two months in which no sales take place, the issuer decides to terminate the offering. Because more than 30 days have elapsed since the last sale, how can the issuer comply with Rule 503 in the filing of its final Form D?

Answer: The staff is of the view that a final Form D may be filed not later than 30 days after the last sale or after the termination of the offering, whichever occurs later.

(84) Question: In an employee stock option plan, when would the first and last Form D be filed?

Answer: The first Form D should be filed not later than 15 days after the exercise of the first option. The final Form D would be due not later than 30 days after the exercise or expiration of the last outstanding option, whichever occurs later.

(85) Question: An issuer commences a Regulation D offering and files an original Form D not later than 15 days after the first sale. Subsequently, because no further sales are made, the issuer returns the money to the one investor and terminates the offering. How should the issuer reflect the unsuccessful offering on its Form D?

Answer: The issuer should file a final Form D indicating zero sales, investors, and proceeds.

(86) Question: If the issuer is a limited partnership, who would be considered the chief executive officer for purposes of Form D questions?

Answer: The chief executive officer of a limited partnership is that individual who fulfills the function of chief executive officer. That individual may be the chief executive officer of a corporate general partner.

(87) Question: What is a Standard Industrial Classification (C”) and where is it obtained?

Answer: The SIC is a code associated with a particular economic activity. The SIC system, developed by the Bureau of the Census under the auspices of the Office of Management and Budget, is used in classification of establishments by the type of activities in which they are engaged. An issuer’s SIC can be found in the Standard Industrial Classification Manual, a publication of the U.S. Government that may be obtained from the Superintendent of Documents and is generally available in public and university libraries.

(88) Question: Question 8 of Part A asks for the issuer’s CUSIP number. What is a CUSIP number?

Answer: CUSIP 53 is the trademark for a system that identifies specific security issuers and their classes of securities. Under the CUSIP plan, a CUSIP number is permanently assigned to each class and will identify that class and no other Generally, a CUSIP number will be assigned only to a class for which there is a secondary trading market. The operation of the CUSIP numbering system is controlled by the CUSIP Board of Trustees which awarded a contract to Standard & Poor’s Corporation to function as the CUSIP Service Bureau, the operational arm of the system. Issuers relying on Regulation D that do not have a class of securities with a secondary trading market and thus do not have a CUSIP number should answer Question 8 in the negative.

(89) Question: Part B of Form D requests statistical information about the issuer. In an offering of interests in a limited partnership to be formed, how should this part be answered?

Answer: The answers to Part B should be with respect to the partnership to be formed and will be zero or “not applicable.” This will reflect the statistical profile of a start-up issuer.

(90) Question: Question 2 to Part C requests certain information as to the number of accredited and non-accredited investors in a Rule 505 or 506 offering. Must an issuer make a finding as to accredited investors even if the issuer is not relying on the accredited investor concept in its offering?

Answer: No. Where an issuer under Rule 505 or 506 is not relying on the accredited investor concept for all or certain investors, it should treat those investors as non-accredited for purposes of this question.

(91) Question: Questions 5 and 6 to Part C request certain information regarding the offering expenses and the use of proceeds. May the issuer attach a separate schedule listing expenses and use of proceeds in lieu of completing these questions?

Answer: No. The Form D has been formulated for keypunching and entry of the information into an automatic data storage system. Failure to complete the questions on the form in the space provided frustrates the objectives of the form.

(92) Question: May the Form D be signed by the issuer’s attorney?

Answer: Form D may be signed on behalf of the issuer by anyone who is duly authorized.


n1 Prior releases leading to the adoption of Regulation D included Release No. 33-6274 (December 23, 1980) (46 FR 2631) in which the Commission considered and requested comments on various exemptions under the Securities Act and Release No. 33-6339 (August 7, 1981) (46 FR 41791) in which the Commission published proposed Regulation D for comment.

n2 The term also is essential to the operation of section 4(6) of the Securities Act which exempts certain transactions involving sales solely to accredited investors. The definition of accredited investor for section 4(6) is found at section 2(15) of the Securities Act and Rule 215 (17 CFR 230.321). Rule 501(a) combines and repeats those provisions. As a result, interpretations regarding the definition of “accredited investor” in Regulation D also apply to the definition of that term under section 4(6).

n3 Preliminary Note 6 to Regulation D would support a different analysis if it could be shown that the director’s appointment or resignation was “part of a plan or scheme to evade the registration provisions of the Act.”

n4 Rule 501(a)(1) refers to “any bank as defined in section 3(a)(2) of the Act.” Section 3(a)(2) provides that the term “bank” includes “any national bank.” Section 3(a)(2) also provides that where a common or collective trust fund is involved, the term “bank” has the same meaning as in the Investment Company Act of 1940 (the “Investment Company Act”) (15 U.S.C. 80a-1-80a-65 (1976 & Supp. IV 1980)). Section 2(a)(5) of the Investment Company Act defines “bank.”

n5 See letter re Voluntary Hospitals of America, Inc. dated November 30, 1982.

n6 See letter re Voluntary Hospitals of America, Inc. dated September 10, 1982.

n7 See Question 37.

n8 Section 2(2) of the Securities Act includes corporations and partnerships within the definition of “person.”

n9 See letter re Intuit Telecom Inc. dated March 24, 1982.

n10 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n11 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n12 See letter re Winthrop Financial Co., Inc. dated May 25, 1982.

n13 Note that this $50,000 is not deemed to be “an unconditional obligation to pay” and cannot be included in calculating whether or not the investor meets the $150,000 purchase test of Rule 501(a)(5). See Question 10.

n14 See letter to Lola M. Hale, Esq. dated July 1, 1982.

n15 See letter re Smith Barney, Harris Upham & Co. dated July 14, 1982.

n16 See 17 CFR 230.405 for the definition of “totally held subsidiary.”

n17 See letter re Federated Financial Corporation dated May 13, 1982.

n18 Section 2(2) of the Securities Act includes “a trust” within the definition of “person” but limits that inclusion to “a trust where the interest or interests of the beneficiary or beneficiaries are evidenced by a security.” The Division does not view that limitation as being necessary in the context of a trust as a purchaser of securities under Rule 501(a)(5).

n19 The result would also be different in the case of a business trust, a real estate investment trust, or other similar entities.

n20 See letter re Rule 501(a)(8) of Regulation D dated July 16, 1982.

n21 The basis for a limitation on the aggregate offering price derives from section 3(b) of the Securities Act. Section 3(b) accords authority to the Commission to adopt rules exempting any class of securities as long as no issue of securities is exempted “where the aggregate amount at which such issue is offered to the public exceeds $5,000,000.” See also section 4(6) which exempts a transaction involving offers and sales solely to one or more accredited investors “if the aggregate offering price of an issue” does not exceed the amount allowed under section 3(b).

n22 This presumes that the payments are in fact for interest. See Preliminary Note 6 to Regulation D.

n23 See letter to Kim R. Clark, Esq. dated November 8, 1982.

n24 See letters to Winstead, McGuire, Sechrest & Trimble dated February 21 and 25, 1975 and re Kenisa Oil Company dated April 6, 1982. Questions regarding registration as a broker-dealer should be directed to the Office of Chief Counsel, Division of Market Regulation, (202) 272-2844. Questions regarding registration as an investment adviser should be directed to the Office of Chief Counsel, Division of Investment Management, (202) 272-2030.

n25 Note 3 to Rule 501(h) points out that disclosure of a material relationship between the purchaser representative and the issuer will not relieve the purchaser representative of the obligation to act in the interest of the purchaser.

n26 As noted in Preliminary Note 1, Regulation D transactions are exempt from the registration requirements of the Securities Act, not the antifraud provisions. Thus, nothing in Regulation D states that an issuer need not give disclosure to an investor. Rather, the regulation provides that in certain instances the exemptions from registration will not be conditioned on a particular content, format or method of disclosure.

n27 An issuer is subject to section 13 reporting obligations if it has a class of securities registered under section 12 of the Exchange Act. An issuer is subject to section 15(d) reporting obligations if it has had a Securities Act registration statement go effective, or if in any year after the year of effectiveness, it has at least 300 holders of the class of securities to which the registration statement applied. In the latter instance, however, even if the issuer has 300 or more shareholders, it may not be subject to section 15(d) reporting obligations if it has had less than 500 shareholders and less than $3,000,000 in assets during the last three years. See Rule 15d-6 (17 CFR 240.15d-6) under the Exchange Act.

n28 See 17 CFR 239.28. Form S-18 is an abbreviated registration form for certain offerings not exceeding $5,000,000. The form is not available to issuers that report under the Exchange Act.

n29 Rules 502(b)(2)(i)(C) and 502(b)(2)(ii)(D) contain special provisions for foreign issuers recently adopted by the Commission. See Release No. 33-6437 (November 19, 1982) (47 FR 54764).

n30 The Commission adopted 53 Securities Act Guides in 1968 (Release No. 33-4936 (December 9, 1968) (33 FR 18617)) and 10 additional ones subsequently. The Guides served as an expression of the policies and practices of the Division of Corporation Finance. Most of those Guides have been incorporated into Regulation C (17 CFR 230.400-.494) and Regulation S-K (17 CFR 229.10-.802) (see Release No. 33-6383 (March 3, 1982) (47 FR 11380)) and thus were rescinded (see Release No. 33-6384 (March 3, 1982) (47 FR 11476)). Five of the Guides applicable to specific industries were not rescinded, however, and were redesignated. Guide 5, which was Guide 60, applies to the preparation of registration statement relating to interests in real estate limited partnerships. Guide 5 was revised in Release No. 33-6405 (June 3, 1982) (47 FR 25140).

n31 Form S-18 has been amended recently to permit its use by limited partnerships. Release No. 33-6406 (June 4, 1982) (47 FR 25126).

n32 The same general rule would be applicable to an offering in excess of $5,000,000. See Release No. SAB-40, Topic 6.D.3.d. (January 23, 1981).

n33 The parallel to this instruction under other forms of registration is Rule 3-14 of Regulation S-X (17 CFR 210.3-14). Rule 3-14 requires income statements for the three most recent fiscal years, unless the issuer meets certain conditions, in which case the issuer need present only one year of audited income statements.

n34 See letter re Winthrop Financial Co., Inc. dated May 25, 1982. In response to inquiries regarding the appropriateness of tax basis financial statements, issuers should refer to Statement on Auditing Standards No. 14, Special Reports, American Institute of Certified Public Accountants, December 1976.

n35 The issuer should refer to Rule 3-05 of Regulation S-X (17 CFR 210.3-05) for the disclosure guidelines on businesses to be acquired. If the offering were for less than $5,000,000 and the issuer were thus referring to Form S-18, Item 21(d) of that form provides a parallel rule on businesses to be acquired.

n36 See letter re Walnut Valley Special Cable TV Fund dated May 13, 1982.

n37 This provision is similar to that found in former Rule 146 at paragraph (e)(1)(ii)(c).

n38 See letters to Hecker & Phillips dated December 22, 1982 and Hopper, Kanouff, Smith and Peryam dated September 10, 1982.

n39 See Release No. 33-6253 (October 28, 1980) (45 FR 72644); letters re Security Bancorp, Inc. dated January 21, 1980 and Kearney Plaza Company dated March 8, 1979.

n40 The Note to Rule 502(a) also points out that certain foreign offerings are not integrated with domestic exempt offerings.

n41 Rule 502(a), however, does not provide a safe harbor to the possible integration of offering (C) with either offering (A) or (B). In resolving that question, the issuer should consider the factors listed in the Note to Rule 502(a).

n42 The Note to Rule 501(e) provides that the issuer must satisfy all other conditions of Regulation D with respect to purchasers that have been excluded from the count. Thus, for instance, the issuer would have to ensure the sophistication of the first cousin under Rule 506(b)(2)(ii).

n43 See Release No. 33-4708 (July 9, 1964) (29 FR 828), Preliminary Note 7 to Regulation D and Note to Rule 502(a).

n44 See letter re Madison Partners Ltd. 1982-1 dated January 18, 1982. See also letter re Kenai Oil & Gas, Inc. dated April 27, 1979.

n45 The Division is of the view that the provision in Rules 504 and 505 that bars an investment company from using the exemptions should be construed to mean an investment company as that term is defined in section 3 of the Investment Company Act.

n46 See letter to Geraldine D. Green dated November 22, 1982.

n47 See letter re Freeport Resources, Inc. dated December 9, 1982.

n48 Note that under Rule 502(a) these offerings may not have to be integrated because they are separated by six months.

n49 See Release No. 33-6437 (November 19, 1982) (47 FR 54764).

n50 Letters from Laura Homer Securities Credit Officer, Board of Governors of the Federal Reserve System to Ardith Eymann, Esq., Chief Counsel, Division of Market Regulation, Securities and Exchange Commission (April 10, 1982) and to Mrs. Mary E. T. Beach, Associate Director, Securities and Exchange Commission (January 8, 1982).

n51 Letter from Laura Homer, Securities Credit Officer, Board of Governors of the Federal Reserve System to Alan G. Rosenberg, Esq. (May 20, 1982).

n52 A Form D is also required to be filed in connection with an offering conducted pursuant to section 4(6). See 17 CFR 239.500.

n53 The acronym “CUSIP” derives from the title of the American Banker’s Association committee that developed the CUSIP system–Committee on Uniform Security Identification Procedures.

Series 30 Exam Information

Overview of Series 30 Exam

The Series 30 exam is a National Futures Association sponsored exam which is required for those persons who are branch office managers of a NFA member firm (see our post on CPO and CTA Branch Office Information).  Generally if a NFA Member firm (such as a CPO or CTA) has a branch office (any place of business other than the main office), the firm will need to make sure that a branch office manager is employed at each such branch office.

Exam Specifics

  • Branch Manager Examination.
  • 50 True/False and Multiple Choice questions.
  • One hour long.
  • $70.
  • 70% correct answers required to pass

Signing up for the Exam

The Series 30, like all of the other exams sponsored by the NFA, is administered by FINRA.  Accordingly, an applicant will need to first register to take the exam by completing a FINRA Form U-10.  After the U-10 has been completed, submitted and processed, the applicant will be “in the FINRA system” and will be able to sign up for an exam time at either a Prometric or Pearson testing facility.  Applicants can determine available times and locations by visiting these websites.  The test is generally given a number of times a day, six days a week.

Series 30 Exam Topics



The following is a general listing of the major subject areas covered by the examination and does not represent an exhaustive list of the actual test questions.

A. General

  • Books and records, preparation and retention
  • Order tickets, preparation and retention
  • Written option procedures
  • Handling of customer deposits
  • NFA Compliance Rule 2-9, supervision of employees
  • Business Continuity and Disaster Recovery Plan
  • Registration requirements—who needs to be registered, sponsor verifi cation, NFA Bylaw 1101, AP termination notices, temporary licenses
  • NFA disciplinary process
  • Reportable positions
  • NFA Arbitration Rules
  • On-site audits of branch offices
  • Bona fide hedging transactions
  • Trading on foreign exchanges

B. CPO/CTA General

  • Registration requirements
  • Books and records to be maintained
  • Reports to customers
  • Bunched orders

C. CPO/CTA Disclosure Documents

  • Management and incentive fees
  • Performance records
  • How long a CPO or CTA can use a disclosure document
  • Conflicts of interest
  • Pool units purchased by principals
  • Business backgrounds of principals
  • Amendments to disclosure documents
  • Disclosure of disciplinary actions
  • NFA review of document before each use

D. NFA Know Your Customer Rule

  • Client information required
  • Responsibility to obtain additional client information
  • Risk disclosures

E. Disclosure by CPOs and CTAs Required for Costs Associated with Futures Transactions

  • Disclosure of upfront fees and expenses
  • Effect of upfront fees and organizational expenses on net performance

F. Disclosure by FCMs and IBs Required for Costs Associated with Futures Transactions

  • Explanation of fees and charges to customers

G. IB General

  • Accepting funds from customers
  • Guarantee agreements
  • Responsibilities of guarantor FCM
  • Minimum net capital requirements
  • Time stamping of order tickets
  • Books and records to be maintained

H. General Account Handling and Exchange Regulations

  • Risk Disclosure Statement
  • Margin requirements
  • Stop loss orders
  • Preparing orders
  • Proprietary accounts
  • Positions limits and reporting requirements
  • Trade confirmations

I. Discretionary Account Regulation

  • Requirements relating to discretionary accounts
  • Supervision and review of discretionary accounts

J. Promotional Material (Compliance Rule 2-29)

  • Definition of promotional material
  • Standardized sales presentations
  • Use of a third-party consulting or advertising firm
  • Reprints of articles from industry publications
  • Recordkeeping of promotional material
  • Past performance
  • Hypothetical trading results
  • Written procedures for promotional material
  • Supervisory review of promotional material

K. Anti-Money Laundering Requirements

  • Developing policies, procedures and internal controls
  • Customer identification program and recordkeeping
  • Detection and reporting of suspicious activity
  • Training staff to monitor trading activity
  • Recordkeeping
  • Designation of individual or individuals (“compliance officer”) to be responsible for overseeing the program
  • Employee training program Independent audit function

Other NFA Information

The NFA also has this to say about the Series 30 exam:

Branch Manager Examination – Futures (Series 30)

NFA must receive evidence that individuals applying to be a branch office manager have passed the Series 30. However, NFA will not require evidence that they have passed the Series 30 if, since the date they last ceased acting as a branch office manager, there has not been a period of two consecutive years during which they have not been registered as an AP. Additionally, individuals whose sponsor is a registered broker-dealer may, in lieu of the Series 30, provide proof that they are qualified to act as a branch office manager or designated supervisor under the rules of FINRA.

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

Hedge Fund Carried Interest Tax Increase?

Legislation Introduced to Eliminate Carried Interest “Loophole”

As we are all well aware, the partnership structure of hedge funds allows the management companies of these funds to receive an “allocation” of the fund’s income.  Under general partnership taxation principles, this allocation is taxed to the management company (and the other investors in the hedge fund) according to the characteristic of that income (at the partnership level).  That is, if the income was long-term capital gain at the partnership level, such income would be allocated to all partners (including the management company) and would retain such characterization.  Long-term capital gains are currently taxed at 15% (as compared to a 35% tax rate for most ordinary income).

Last week Representative Sander Levin reintroduced legislation to tax the carried interest at ordinary tax rates.  The tax would only apply to the managers of partnerships to the extent that such managers did not have an underlying investment in the fund.  I will not introduce any political opinions regarding such a tax, but I will note that I take issue with the way that the press and lawmakers define the issue.  The most glaring omission in all of these reports is that the carried interest (or performance allocation) is only taxed at long-term capital gains rates if there are underlying long-term capital gains.  These articles (including the press release reprinted below) insinuate that all allocations made to a manager will be subject to long-term capital gains rates.  Not all income to hedge funds is long term capital gain – in fact, many hedge funds have no long-term capital gains at all because their programs focus on short term or intermediate term trades.

We have discussed this issue a number of times before and believe that the best way for this issue to be addressed is through the political process and we hope that all lawmakers involved take a considered and academic approach when crafting any future tax legislation (see Hedge Fund Taxes may Increase Under Obama).

The press release below is from the office of Representative Sander Levin and provides a sort of question and answer regarding the proposed legislation.  I am interested to read your comments on this issue below.


For Immediate Release
April 3, 2009

Hilarie Chambers
Office: 202.225.4961

Levin Reintroduces Carried Interest Tax Reform Legislation

Bill to Tax Fund Managers’ Compensation at Same Rates as All Americans

(Washington D.C.)- Rep. Sander Levin today reintroduced legislation to tax carried interest compensation at the same ordinary income tax rates paid by other Americans.  Currently, the managers of private investment partnerships are able to receive compensation for these services at the much lower capital gains tax rate rather that the ordinary income tax rate by virtue of their fund’s partnership structure.

“This is a basic issue of fairness,” said Rep. Levin. “Fund managers are receiving compensation for managing their investors’ money.  They should not pay the 15% capital gains rate on their compensation when millions of other hard-working Americans, many of whose income is performance-based, pay ordinary rates of up to 35%.  The President’s budget recognizes that this is unfair.  The House of Representatives has recognized that it is unfair, and this year I hope we can act to change the law.”

The legislation clarifies that any income received from a partnership, capital or otherwise, in compensation for services provided by the employee is subject to ordinary tax rates.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested themselves in the partnership.

“This proposal is not about taxing investment, it’s about ensuring that all compensation is treated equally for tax purposes.  Anyone who actually invests money in these funds will continue to receive capital gains treatment, including the managers.  So there is no reason to expect that the amount of capital available for these kinds of investments will be reduced,” concluded Levin.

Levin introduced similar legislation in the 110th Congress, which was subsequently included in several tax packages approved by the Ways & Means Committee and the House of Representatives.  A similar proposal is also included in President Obama’s FY 2010 budget request.


Levin Carried Interest Legislation – H.R. 1935

H.R. 1935 would treat the “carried interest” compensation received by investment fund managers as ordinary income rather than capital gains.  In exchange for providing the service of managing their investors’ assets, fund managers often they receive a portion of the fund’s profits, or carried interest, usually 20 percent.  H.R. 1935 clarifies that this income is subject to ordinary income tax rates rather than the much lower capital gains rate.

Carried Interest: The Basics

Why is Congress concerned about this issue?

Many investment funds are structured as partnerships in which investors become limited partners and the funds’ managers are the general partner.  The managers often take a considerable portion of their compensation for managing the funds’ investments as a share of the funds’ profits using a mechanism called “carried interest.”  Partnership profits are taxed not to the partnership; instead partners are taxed on allocations of partnership income, and the nature of that income (capital or ordinary) “flows-through” to the partners.  As a result, the investment managers are able to have income for performance of services taxed at the 15% capital gains rate.  Essentially they are able to pay a lower tax rate on income from their work than other Americans simply because of the structure of their firm.

What does the legislation do?

It clarifies that any income received from a partnership, capital or otherwise, in compensation for services is ordinary income for tax purposes.  As a result, the managers of investment partnerships who receive a carried interest as compensation will pay regular income tax rates rather than capital gains rates on that compensation.  The capital gains rate will continue to apply to the extent that the managers’ income represents a reasonable return on capital they have actually invested in the partnership.

What kinds of investment firms will be affected?

This is part of a broad consideration of tax fairness.  The principle at work is that compensation for services should be treated as ordinary income and taxed accordingly, regardless of its source.  Any investment management firm that takes a share of an investment fund’s profits as its compensation (i.e. in the form of carried interest), will be affected.  This will apply to any investment management firm without regard to the type of assets, whether they are financial assets or real estate.  The test is the form of compensation, not the type of assets the firm is managing, its investment strategy, or the amount of compensation involved.

What is the effective date of the legislation?

This legislation is designed to create a structure under which this income should be taxed.  Decisions on the effective date will be made as part of the legislative process.

Carried Interest: Myths vs. Facts

Myth: This is a tax increase on investment that will hurt economic growth.

Fact: Investors are not affected by this legislation at all.

Any person or institution who invests money in a fund whose managers receive a carried interest will continue to pay the capital gains rate on their profits.  In fact, the bill explicitly protects the investments that fund managers make themselves.  To the extent they have put their own money in the fund, managers still get capital gains treatment, but to the extent they are being compensated for managing the fund, they will have to pay ordinary income tax rates like other service providers.   Since investors are not affected, there is no reason to believe that the amount of capital available for these kinds of investments will be reduced at all.

Myth: Taxing carried interest is just about raising revenue.

Fact: Fairness requires treating all taxpayers who provide services the same.

This proposal would raise revenue, but it is not just an offset.  Congress has a responsibility ensure that our tax code is fair, that it makes sense.  A broad spectrum of experts, including the Chairman of the Cato Institute and senior economic advisors to the last three Republican Presidents, agree that carried interest really represents a performance based fee that investors are paying to fund managers and that it should be taxed accordingly.  Allowing some service providers to pay the 15 percent capital gains rate on their income when everyone else has to pay up to 35 percent risks undermining people’s confidence in our voluntary tax system.

Myth: Fund Managers are just like entrepreneurs who get founder’s stock in their company, so they too should be taxed at the capital gains rate.

Fact: Fund Managers are fundamentally different than the founder of a company.

When someone starts an enterprise, he or she actually owns that business.  Sometimes that business becomes enormously valuable, but quite often it fails altogether and the entrepreneur loses her business. When an investment partnership purchases an asset, be it a stake in a small start-up company, a large corporation that wants to go private, a portfolio of securities, or a piece of real estate, the partnership does truly own those assets.  The general partner or fund manager though is really only an “owner” to the extent he or she has contributed capital to the partnership.  The carried interest the general partner receives for managing the fund’s assets is a right to a portion of the fund’s profit, not to the fund’s actual assets: the manager has no downside risk.  If the fund fails completely and all of the partnership’s assets are lost, the limited partners have lost their money.  The manager has lost the time and energy he has put into the running the fund, and the potential to share in the profits, but he is not actually out of pocket.

Myth: Fund managers deserve capital gains treatment because a carried interest is risky.

Fact: Many other forms of compensation are risky, and they are all ordinary income.

When a company gives its CEO stock options, it is trying to give her an incentive to increase the company’s share price, to growth the value of shareholders’ investment.  If the CEO does a good job and the share price goes up, she pays ordinary income tax rates when she exercises those options.  Real estate agents only make money if they actually sell a house, no matter how hard they work.  Authors receive a portion of their book’s profits.  Waiters get tips based on the quality of the service they provide.  All of these people pay ordinary income tax rates on their compensation.  Only private equity and other fund managers get to pay capital gains rates on their compensation.

Myth: Taxing carried interest will hurt the pension funds that invest in these funds.

Fact: This has nothing to do with pension funds and their returns will not be affected.

One pension trustee, who also happens to be a hedge fund manager, called the idea that this debate is about workers’ pensions “ludicrous.”  As tax-exempt investors, pension fund certainly will not be affected directly, and the assumption that fund managers can charge higher fees than they do today as a result of their having to pay ordinary income rates is extremely questionable. In fact, an attorney representing the hedge fund industry testified before the Ways & Means Committee that investors would be unlikely to accept increased fees.  The National Conference on Public Employee Retirement Systems has said that its members do not believe this legislation will affect them.

Myth: This change to the taxation of carried interest will harm every “mom and pop” partnership in America.

Fact: The change would only affect those partnerships where service income is being improperly converted to capital gains.

This legislation would have no effect whatsoever on the vast majority of partnerships that are engaged in ongoing businesses and whose profits are already being properly taxed an ordinary income tax rates.  It does apply to investment fund partnerships where the investors in the fund choose to compensate the people managing their assets through a carried interest.  In practice, this means hedge funds, private equity funds, venture capital funds and real estate partnerships.  The reality is that the fund managers and general partners who would be asked to pay ordinary income tax rates on their compensation are a very small, very well-paid group of professionals.  It is also important to note that the bill does not discriminate among partnerships based on the kind of assets they purchase.


Other related hedge fund tax articles:

MFA Releases Sound Practices Guide for Hedge Funds

Guide Focuses on Hedge Fund Risk Management and Other Operational Issues

Unfortunately the new world of hedge fund investing and hedge fund due diligence has become more complicated and hedge fund management companies now need to increase their focus on operational and business issues.  While many managers are happy to attend to their trading strategies and risk management procedures, the managers who will be able to grow their AUM most successfully in the coming years are those managers who focus on many of the business and operational issues which investors are now wholly concerned with.  The updated 2009 Sound Practices guide by the Managed Funds Association (press release below) provides an outline of the major issues which managers should address with respect to their businesses.

Overview of Sound Practices Guide

The Sound Practices guide is similar to the President’s Working Group report Hedge Fund Best Practices, but also includes more information for managers.  I skimmed through the Sound Practices guide (it is 277 pages) and found that much of the information is extremely useful.  One of the overarching themes of the guide is that it does not ask managers to take the “one size fits all” approach, but asks managers to individually assess whether or not a certain practice is appropriate for their particular business.

I found the section dealing with the disclosures and hedge fund offering documents particular good.  As a reminder to hedge fund managers, offering documents should be updated at least annually, or more frequently if there are material changes in the fund’s investment program, structure or management company.  Additionally, any changes to offering documents should be communicated to all existing investors (either by sending out a new PPM or through another type of disclosure).

Other sections I was particularly interested in were: (i) the section dealing with investor letters and communications, (ii) side letters and parallel separately managed accounts (which are becoming more popular), (iii) valuation and policies, (iv) risk management, (v) due diligence, (vi) AML.  A due diligence guide for hedge fund investors was also included, but I felt like this was a pretty weak DD questionnaire – managers are likely to receive much more detailed requests for information.

Recommendation for Hedge Fund Managers

I recommend that hedge fund managers who are immediately seeking capital from institutions and high net worth investors read through this Sound Practices guide and take notes.  Managers should reach each practice and asses whether it applies to their fund operations and, if so, how such a practice should be implemented.  Managers may want to highlight certain items and ask their attorney what they should do.  These sound practices will help managers to create strong businesses which are able to grow over the long run.



Managed Funds Association Takes Steps to Restore Investor Confidence with Enhanced Best Practices & Investor Due Diligence Recommendations

WASHINGTON, Mar 31, 2009 — Managed Funds Association (MFA) today took steps to restore investor confidence in the markets with the release of its newly enhanced Sound Practices for Hedge Fund Managers, including a due diligence questionnaire for investors to use as they consider whom to trust with their investments.

The 2009 edition of Sound Practices, MFA’s fifth version of its pioneering guidance that was first published in 2000, incorporates the recommendations provided in the final President’s Working Group’s (PWG) Best Practices for the Hedge Fund Industry Report of the Asset Managers’ Committee plus additional guidance that goes above and beyond the scope of those recommendations.

Richard H. Baker, MFA President and CEO, said, “The hedge fund industry has a strong role in helping to restore financial stability and investor confidence, and to hasten economic recovery. While policy makers consider sweeping regulatory reforms in the U.S. and abroad, and economic leaders gather for the G-20 in London, on April 2, the hedge fund industry is taking steps to restore investor trust through the promotion of sound business practices and tools for investors to use as they conduct ongoing due diligence of money managers.”

Sound Practices is the cornerstone of the Association’s initiative to collaborate with international organizations with the goal of establishing uniform global principles and guidance. MFA, the PWG Asset Managers’ Committee and the Alternative Investment Management Association (AIMA) have committed to providing the Financial Stability Forum (FSF) with a set of unified principles of best practices before April 30, 2009.

“The hedge fund industry recognizes its responsibilities as liquidity providers and risk dispersers in the markets, and continues to take the lead in its approach to disclosure and investor protection as well as active market disciplines such as risk management and valuation which contribute to market soundness and investor protection. This latest edition of MFA’s seminal Sound Practices concludes many months of diligent work by leading hedge fund managers, service providers and MFA staff to provide updates and revisions for voluntary adoption by hedge fund managers.

“MFA has a decade-long tradition of robust Sound Practices. Today, more than ever before, investors will benefit from our due diligence questionnaire as they undertake robust diligence when considering an investment in a hedge fund. Investors can also benefit from reviewing the recommendations in Sound Practices as they consider operational, governance and other matters as part of their diligence when making an investment.” added Baker.

The 2009 edition of Sound Practices provides comprehensive updates in every area of guidance including recommendations for disclosure and responsibilities to investors; valuation policies and procedures; risk management; trading and business operations; compliance, conflicts of interest, and business practices; anti-money laundering; and business continuity and disaster recovery practices.

Major Revisions

Sound Practices is a dynamic blueprint written by the industry, for the industry, to provide peer-to-peer guidance to:

  • Strengthen business practices of the hedge fund industry through a strong framework of internal policies and practices;
  • Encourage individualized assessment and application of recommendations on one size does not fit all; and
  • Enhance market discipline in the global financial marketplace.

The revised edition includes substantially updated and expanded guidance in seven areas:

  • Disclosure and Investor Protection: Establishes practices intended to assist a hedge fund in fulfilling its responsibilities to its investors;
  • Valuation: Establishes a framework, governance and policies and procedures for valuations of assets;
  • Risk Management: Establishes an overall approach to risk monitoring, measurement and management. Also describes types of risk and recommendations on management thereof;
  • Trading and Business Operations: Establishes policies and procedures for management of trading operations including relationships with counterparties, use of service providers, accounting, technology, best execution and soft dollar arrangements;
  • Compliance, Conflicts and Business Practices: Establishes guidance for the adoption of a culture of compliance including a code of ethics, compliance manual, record keeping, conflicts of interest, training/education of personnel and more;
  • Anti-Money Laundering: Updates MFA’s seminal AML guidance; and
  • Business Continuity/Disaster Recovery: Establishes general principles, contingency planning, crisis management and disaster recovery.

Baker noted that, “Ultimately, each hedge fund manager must determine whether and how to tailor these Sound Practices to its individual business. We believe that the strong business practices in Sound Practices are an important complement to a smart regulatory framework and that strong business practices and robust investor diligence are critical to addressing investor protection concerns.”

For a copy of Sound Practices please visit: www.managedfunds.org

About Managed Funds Association

MFA is the voice of the global alternative investment industry. Its members are professionals in hedge funds, funds of funds and managed futures funds, as well as industry service providers. Established in 1991, MFA is the primary source of information for policy makers and the media and the leading advocate for sound business practices and industry growth. MFA members include the vast majority of the largest hedge fund groups in the world who manage a substantial portion of the approximately $1.5 trillion invested in absolute return strategies. MFA is headquartered in Washington, D.C., with an office in New York. For more information, please visit: www.managedfunds.org


Other related hedge fund law articles include

Hedge Fund Law – State Law Issues

Dealing with Ambiguous State Securities Laws

An issue which often arises during the planning phase of the hedge fund formation process is whether certain state securities or investment advisory laws or regulations apply to a certain fact situation.  Many times these issues arise in the context of investment advisor registration (especially with regard to “custody” and net worth requirements), but they can also apply to less common issues (such as spot forex registration and matters involving commodities and futures licensing).  The problem is not only that the laws and regulations may not apply to a specific situation (many state laws are based on a model code which was written over 50 years ago), but also that there are no judicial or administrative actions which can provide valuable insight into how the state or the enforcement division would view a similar situation.

Unfortunately it can be very hard to receive clarification on these laws and regulations  and sometimes reaching out to state regulators can be an exercise in futility.  In a recent call with the California Department of Corporations (which is in charge of, among other things, administering the state securities laws) I was practically scolded by the staff attorney for first reaching out to the state to determine if they had any informal thoughts on my question.  In situations where we cannot receive informal guidance from a state, the client may choose to request a no-action letter from the state with regard to their situation.

Requesting a No-Action Letter or Interpretive Opinion

NASAA, the North American Securities Administrators Association, has provided this description of no-action letters and interpretive opinions:

Many state securities regulators have the authority issue “no-action letters” in which staff confirms that a transaction carried out under a set of assumed facts will not result in a recommendation for enforcement action.  Some states also issue “interpretive opinions” in which staff provides guidance by indicating how a provision of law applies to a situation presented.

Generally states will allow groups to submit either request.  The request letter will include a restatement of the applicable facts and laws and an argument as to why the requested relief or opinion should be granted.  The attorney will draft this letter on behalf of the manager.  The manager will also need to pay a fee to the state, usually $100-$300 to receive an answer to the request letter.  There is no guarantee that the state will agree with manager and grant any relief.  It will usually take a minimum of 30 days to receive an answer from the state.

Unfortunately the process is both expensive and time consuming.

Fixing the Problem

There are many problems with the federalism system with regard to securities regulation.  One of the biggest issues is the lack of uniformity between the state laws and the disparity between states with regard to enforcement.  I posted an article yesterday about what NASAA is doing this area.  I commend NASAA for taking this step forward – it will be a big improvement over the current system and hopefully will lead to more uniform laws (and application of those laws) throughout the states.  However, this is not a panacea and we are unlikely to see truly fair and efficient enforcement of laws unless there is a wholesale scrapping of the current system and unfortunately even then we are still left with federalism which provides state securities commissions with powers that most do not understand how to deal with.

Ultimately this increases costs to the managers and ultimately investors.