Tag Archives: Section 3(c)(7)

Hedge Fund Law Questions

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

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

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

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

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

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

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

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

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

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

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

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

Hedge Fund Transparency Act Text

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Below is the actual text of the Hedge Fund Transparency Act.  (For the bill with page and line numbers please see: Hedge Fund Transparency Act (pdf)).

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111TH CONGRESS
1ST SESSION
S.

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

Mr. GRASSLEY (for himself and Mr. LEVIN) introduced the following bill; which was read twice and referred to the Committee on

A BILL

To require hedge funds to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the “Hedge Fund Transparency Act”.

SEC. 2. HEDGE FUND REGISTRATION REQUIREMENTS.

(a) DEFINITION OF INVESTMENT COMPANY.—Section 3(c) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)) is amended—(1) by striking paragraph (1); (2) by striking paragraph (7); (3) by redesignating paragraphs (2) through (6) as paragraphs (1) through (5), respectively; and (4) by redesignating paragraphs (8) through (14) as paragraphs (6) through (12), respectively.

(b) ADDITIONAL EXEMPTIONS.—Section 6 of the Investment Company Act of 1940 (15 U.S.C. 80a-6) is amended—(1) in subsection (a), by adding at the end the following:

“(6)(A) Subject to subsection (g), any issuer whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons, and which is not making and does not presently propose to make a public offering of its securities.

“(B) For purposes of this paragraph and paragraph (7), beneficial ownership—

“(i) by a company shall be deemed to be beneficial ownership by one person, except that, if the company owns 10 percent or more of the outstanding voting securities of the issuer, and is or, but for the exemption provided for in this paragraph or paragraph (7), would be an investment company, the beneficial ownership shall be deemed to be that of the holders of the outstanding securities (other than short-term paper) of such company; and

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

“(7)(A) Subject to subsection (g), any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of the acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or any other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

“(B) Notwithstanding subparagraph (A), an issuer is exempt under this paragraph if—”(i) in addition to qualified purchasers, outstanding securities of that issuer are beneficially owned by not more than 100 persons who are not qualified purchasers, if—”(I) such persons acquired any portion of the securities of such issuer on or before September 1, 1996; and “(II) at the time at which such persons initially acquired the securities of such issuer, the issuer was exempt under paragraph (6); and “(ii) prior to availing itself of the exemption provided by this paragraph—

“(I) such issuer has disclosed to each beneficial owner that future investors will be limited to qualified purchasers, and that ownership in such issuer is no longer limited to not more than 100 persons; and

“(II) concurrently with or after such disclosure, such issuer has provided each beneficial owner with a reasonable opportunity to redeem any part or all of their interests in the issuer, notwithstanding any agreement to the contrary between the issuer and such persons, for the proportionate share of that person of the net assets of the issuer.

“(C) Each person that elects to redeem under subparagraph (B)(ii)(II) shall receive an amount in cash equal to the proportionate share of that person of the net assets of the issuer, unless the issuer elects to provide such person with the option of receiving, and such person agrees to receive, all or a portion of the share of that person in assets of the issuer. If the issuer elects to provide such persons with such an opportunity, disclosure concerning such opportunity shall be made in the disclosure required by subparagraph (B)(ii)(I).

“(D) An issuer that is exempt under this paragraph shall nonetheless be deemed to be an investment company for purposes of the limitations set forth in subparagraphs (A)(i) and (B)(i) of section 12(d)(1) (15 U.S.C. 80a-12(d)(1)(A)(i) and (B)(i)) relating to the purchase or other acquisition by such issuer of any security issued by any registered investment company and the sale of any security issued by any registered open-end investment company to any such issuer.

“(E) For purposes of determining compliance with this paragraph and paragraph (6), an issuer that is otherwise exempt under this paragraph and an issuer that is otherwise exempt under paragraph (6) shall not be treated by the Commission as being a single issuer for purposes of determining whether the outstanding securities of the issuer exempt under paragraph (6) are beneficially owned by not more than 100 persons, or whether the outstanding securities of the issuer exempt under this paragraph are owned by persons that are not qualified purchasers. Nothing in this subparagraph shall be construed to establish that a person is a bona fide qualified purchaser for purposes of this paragraph or a bona fide beneficial owner for purposes of paragraph (6).”; and

(2) by adding at the end the following:

“(g) LIMITATION ON EXEMPTIONS FOR LARGE INVESTMENT COMPANIES.—

“(1) IN GENERAL.—An investment company with assets, or assets under management, of not less than $50,000,000 is exempt under subsection (a)(6) or (a)(7) only if that company—

“(A) registers with the Commission;
“(B) files an information form with the Commission under paragraph (2);
“(C) maintains such books and records as the Commission may require; and
“(D) cooperates with any request for information or examination by the Commission.

“(2) INFORMATION FORM.—The information form required under paragraph (1) shall be filed at such time and in such manner as the Commission shall require, and shall—

‘(A) be filed electronically;
“(B) be filed not less frequently than once every 12 months;
“(C) include—
“(i) the name and current address of—
“(I) each natural person who is a beneficial owner of the investment company;
“(II) any company with an ownership interest in the investment company; and
“(III) the primary accountant and primary broker used by the investment company;
“(ii) an explanation of the structure of ownership interests in the investment company;
“(iii) information on any affliation that the investment company has with another financial institution;
“(iv) a statement of any minimum investment commitment required of a limited partner, member, or other investor;
“(v) the total number of any limited partners, members, or other investors; and
“(vi) the current value of—
“(I) the assets of the investment company; and
“(II) any assets under management by the investment company; and

“(D) be made available by the Commission to the public at no cost and in an electronic, searchable format.”.

SEC. 3. IMPLEMENTING GUIDANCE AND RULES.

(a) FORMS AND GUIDANCE.—Not later than 180 days after the date of enactment of this Act, the Securities and Exchange Commission shall issue such forms and guidance as are necessary to carry out this Act.

(b) RULES.—The Securities and Exchange Commission may make a rule to carry out this Act.

8 SEC. 4. ANTI–MONEY LAUNDERING OBLIGATIONS.

(a) PURPOSE.—It is the purpose of this section to safeguard against the financing of terrorist organizations and money laundering.

(b) IN GENERAL.—An investment company that relies on paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, as the basis for an exemption under that Act shall establish an anti-money laundering program and shall report suspicious transactions under subsections (g) and (h) of section 5318 of title 31, United States Code.

(c) RULEMAKING.—

(1) IN GENERAL.—The Secretary of the Treasury, in consultation with the Chairman of the Securities and Exchange Commission and the Chairman of the Commodity Futures Trading Commission, shall, by rule, establish the policies, procedures, and controls necessary to carry out subsection (b).

(2) CONTENTS.—The rule required by paragraph (1)—

(A) shall require that each investment company that receives an exemption under paragraph (6) or (7) of section 6(a) of the Investment Company Act of 1940 (15 U.S.C. 80a-6(a)(6) and (7)), as amended by this Act, shall—

(i) use risk–based due diligence policies, procedures, and controls that are reasonably designed to ascertain the indentity of and evaluate any foreign person (including, where appropriate, the nominal and beneficial owner or beneficiary of a foreign corporation, partnership, trust, or other foreign entity) that supplies or plans to supply funds to be invested with the advice or assistance of such investment company; and

(ii) be subject to section 5318(k)(2) of title 31, United States Code; and (B) may incorporate elements of the proposed rule for unregistered investment companies published in the Federal Register on September 26, 2002 (67 Fed. Reg. 60617) (relating to anti–money laundering programs).

(3) PUBLICATION DATE.—The Secretary of the Treasury, shall—

(A) propose the rule required by this subsection not later than 90 days after the date of enactment of this Act; and

(B) issue the rule required by this subsection in final form not later than 180 days after the date of enactment of this Act.

(d) EFFECTIVE DATE.—Subsection (b) shall take effect 1 year after the date of enactment of this Act, whether or not a final rule is issued under subsection (c), and the failure to issue such rule shall in no way affect the enforceability of this section.

SEC. 5. TECHNICAL CORRECTIONS.

(a) SECURITIES ACT OF 1933.—Section 3(a) of the Securities Act of 1933 (15 U.S.C. 77c(a)) is amended—(1) in paragraph (2)—(A) by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; and (B) by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (2) in paragraph (4), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (3) in paragraph (13), by striking “section (3)(c)(14)” and inserting “section 3(c)(12)”.

(b) SECURITIES EXCHANGE ACT OF 1934.—The Securities Exchange Act of 1934 (15 U.S.C. 78a et seq.) is amended—

(1) in section 3(a) (15 U.S.C. 78c(a))—(A) in paragraph (12)(A)—(i) in clause (iii), by striking “section 3(c)(3)” and inserting “section 3(c)(2)”; (ii) in clause (v), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (iii) in clause (vi), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; (B) in paragraph (12)(C), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (C) in paragraph (54)(A)—(i) in clause (ii), by striking “exclusion from the definition of investment company pursuant to section 3(c)(7)” and inserting “exemption under section 6(a)(7)”; and (ii) in clause (vii), by striking “section 3(c)(2)” and inserting “section 3(c)(1)”; (2) in section 3(g) (15 U.S.C. 78c(g)) by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”; and (3) in section 12(g)(2) (15 U.S.C. 78l(g)(2))—(A) in subparagraph (D), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and (B) in subparagraph (H), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”.

(c) INVESTMENT COMPANY ACT OF 1940.—The Investment Company Act of 1940 (15 U.S.C. 80a-1 et seq.) is amended—

(1) in section 2(a)(51) (15 U.S.C. 80a-2(a)(51))—(A) in subparagraph (A)(i), by striking “excepted under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”; and (B) in subparagraph (C)—(i) by striking “that, but for the exceptions provided for in paragraph (1) or (7) of section 3(c), would be an investment company (hereafter in this paragraph referred to as an ‘excepted investment company’)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a) (hereafter in this paragraph referred to as an ‘exempt investment company’)”; (ii) by striking “section 3(c)(1)(A)” and inserting “section 6(a)(6)(B)(i)”; and (iii) by striking “excepted” each place that term appears and inserting “any exempt”;

(2) in section 6 (15 U.S.C. 80a-6)—(A) in subsection (a)—(i) in paragraph (2), by striking “section 3(c)(1)” and inserting “section 6(a)(6)”; and (ii) in paragraph (5)(A)(iv), by striking “that would be an investment company except for the exclusions from the definition of the term ‘investment company’ under paragraph (1) or (7) of section 3(c)” and inserting “that is exempt under paragraph (6) or (7) of section 6(a)”; and (B) in subsection (f), by striking “excluded from the definition of an investment company by section 3(c)(1)” and inserting “exempt under section 6(a)(6)”;

(3) in section 7(e) (15 U.S.C. 80a-7(e)), by striking “section 3(c)(10)(B)” and inserting “section 3(c)(8)(B)”; and

(4) in section 30 (15 U.S.C. 80a-29) in each of subsections (i) and (j), by striking “section 3(c)(14)” each place that term appears and inserting “section 3(c)(12)”.

(d) INVESTMENT ADVISERS ACT OF 1940.—The Investment Advisers Act of 1940 (15 U.S.C. 80b-1 et seq.) is amended—

(1) in section 203(b) (15 U.S.C. 80b-3(b))—(A) in paragraph (4) by striking “section 3(c)(10)” each place that term appears and inserting “section 3(c)(8)”; and (B) in paragraph (5), by striking “section 3(c)(14)” and inserting “section 3(c)(12)”; and (2) in section 205(b) (15 U.S.C. 80b-5(b))— (A) in paragraph (2)(B), by striking “section 3(c)(11)” and inserting “section 3(c)(9)”; and (B) in paragraph (4), by striking “excepted from the definition of an investment company under section 3(c)(7)” and inserting “exempt under section 6(a)(7)”.

(e) INTERNAL REVENUE CODE OF 1986.—Section 851(a)(2) of the Internal Revenue Code of 1986 (relating to the definition of regulated investment company) is amended by striking “section 3(c)(3)” and inserting “section 3(c)(2)”.

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Please contact us if you would like more information on hedge fund registration, or if you would like our firm to help you with the hedge fund registration process.  Other related hedge fund law articles include:

Section 3(c)(7) Hedge Funds

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Almost all hedge funds which trade securities are deemed to be “investment companies” under the Investment Company Act of 1940.  All “investment companies” are required to register under the Investment Company Act (like all mutual funds must do) unless the “investment company” falls within an exemption from the registration provisions.

In addition to the Section 3(c)(1) exemption discussed in a previous post, this article describes the section 3(c)(7) exemption.

A 3(c)(7) hedge fund is exempt under the Investment Company Act and must comply with two basic requirements: (1) the fund can have only qualified purchasers as investors and (2) the fund can have no more than 499 investors.  These requirements are detailed below.

Qualified Purchaser Requirement

There are two exemptions from the Investment Company Act registration provisions for hedge funds.  Under the first regulation, each investor must be a qualified purchaser.  Section 3(c)(7) states:

None of the following persons is an investment company within the meaning of this title: any issuer, the outstanding securities of which are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making and does not at that time propose to make a public offering of such securities. Securities that are owned by persons who received the securities from a qualified purchaser as a gift or bequest, or in a case in which the transfer was caused by legal separation, divorce, death, or other involuntary event, shall be deemed to be owned by a qualified purchaser, subject to such rules, regulations, and orders as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors.

Generally, a qualified purchaser is an individual with a liquid net worth of $5 million or an institution with a net worth of $25 million. You will notice that in additional to the qualified purchaser requirement, the fund cannot make a public offering of its securities.  Because almost all hedge funds are offered pursuant to the Regulation D offering rules, this requirement will always be met.

500 or Fewer Investors

Unlike the Section 3(c)(1) exemption which limits the amount of investors in this type of fund, the Section 3(c)(7) exemption does not contain any such limit on the amount of qualified purchasers who can invest in the fund. However, hedge funds are subject to all of the federal securities laws which include the Securities Exchange Act of 1934.  Under the Exchange Act, Section 12(g)(1) provides that a Section 3(c)(7) hedge fund would be required to register under the Exchange Act as a reporting company if the hedge fund had more than $10,000,000 in assets and 500 or more investors.  As 3(c)(7) hedge funds are available only to qualified purchasers, the $10 million in assets would be an easy threshold to meet and this is why 3(c)(7) funds are limited to 499 investors.

While registration under Exchange Act is not as onerous as under the Securities Act of 1933, it is still undesirable for hedge fund managers.  If a hedge fund manager did register under the Exchange Act (which some have chosen to do, although mostly in the non-securities context), the fund would become a “reporting company” and would need to submit certain periodic reports to the SEC.  Because these reports are time consuming and expensive to produce, most 3(c)(7) hedge funds will specifically state that no more than 499 investors may participate in the offering.

Other related articles include:

Please contact us if you have any questions.