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New Accredited Investor Definition

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Fund Managers Should Amend Subscription Documents

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

Revising Subscription Documents

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

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

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

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

(b) REVIEW AND ADJUSTMENT.—

(1) INITIAL REVIEW AND ADJUSTMENT.—

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

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

(2) SUBSEQUENT REVIEWS AND ADJUSTMENT.—

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

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

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

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

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SEC Discussion on New Net Worth Rules

Section 179. Rule 215 – Accredited Investor

Question 179.01

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

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

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Cole-Frieman & Mallon LLP provides legal support and hedge fund registration services to all types of investment managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

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

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This question came to us yesterday:

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

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

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

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

Filing Form D

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While hedge funds are not generally “regulated,” they are subject to the requirements of the Securities Act of 1933 (and potentially Regulation D). Generally this will mean that each hedge fund will have to file a Form D with (1) the SEC and (2) each state in which the fund has an investor. Form D must be filed with the SEC within 15 days of the first sale to the investor, each state will have different requirements.

In addition to the Form D, each state will generally require the partnership to submit a Form U-2 and the payment of an administrative fee. These administrative fees can range from $75 to $500; a few states may charge more. (Note: the fund itself, not the management company, will typically pay for this expense.) These items will generally need to be submitted to each state within 15 days of the date of the first sale in each state (note: New York requires its Form 99 to be filed prior to a first subscription from a New York resident).

The firm which submits these filings on your behalf will typically need the following information for each subscription:

  • Residence of investor
  • Amount of subscription
  • Whether the investor is “accredited” or not

Monthly Feature: Hedge fund offering documents

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The central reason that beginning hedge fund managers need a lawyer is that the lawyer will prepare the offering documents for the fund. The offering documents are designed to comply with the requirements of the federal securities laws as interests in the fund (whether the fund is a limited partnership or a limited liability company). Specifically the offering documents will most likely be drafted to conform to the requirements of Rule 506 of Regulation D under the Securities Act of 1933.

The offering documents are the necessary paperwork that the manager must give to prospective investors. The offering documents will look very similar to a mutual fund prospectus. The three parts of the offering documents are:

  1. The private placement memorandum (also sometimes called the offering memorandum). The private placement memorandum (also known as the “PPM”), is the main offering document. It provides the prospective investor with information on the structural and business aspects of the fund.
  2. The limited partnership agreement (or, if the fund is an LLC, the operating agreement). The limited partnership agreement (also known as the “LPA”), is the actual governing legal document. It provides a description of the rights of the investors and the manager. When an investor becomes a “partner” in the fund, the investor is executing the limited partnership agreement.
  3. The subscription documents. The subscription documents are the documents which provide the manager with background information on the investor. These documents include assurance and warranties by the potential investor that the potential investor is qualified to invest in the offering. These documements usually include the signature page to the LPA.

A more in depth description of the potential parts of the offering documents follows:

Private Placement Memorandum

While each law firm’s general PPM template is different, they all share many of the same items of information which are included. Below is a non-exhaustive list of some of the major sections of the PPM which you are likely to find in all offering documents.

  • Coverage
  • Legends and securities laws notices
  • Table of contents
  • Summary
  • Use of proceeds
  • Investment Program
  • Risk factors
  • Description of the management company and managers
  • Discussion of fees (Management fees, Performance fees)
  • Manner of valuing the investments
  • Discussion of conflicts of interest
  • Discussion of brokerage
  • Discussion of litigation of the investment manager
  • Discussion of financial statements of the fund
  • A summary of the LPA or Operating Agreement
  • Discussion of service providers
  • Tax disclosures
  • ERISA disclosures
  • Other notices (privacy notice, definition of investors qualified to invest, disclosure on the lack of transferability, etc.)

Limited Partnership Agreement

Like the PPM, each law firm has a different way to draft the LPA. For instance, some law firms will craft a lengthy definition section at the very beginning, other law firms will have definitions attached as an appendix, other firms will define specific terms throughout the document. A very rough guideline of the items which are in the LPA include:

  • Coverpage
  • Table of contents
  • Preamble
  • Defintions
  • Information on formation (business office, registered agent, length of fund, etc.)
  • Capitalization structure (initially and on a going-forward basis)
  • Manner of allocation of profits and losses (including the various tax allocation provisions)
  • Manner of distributions and withdrawals
  • Rights and duties of the management company
  • Rights and duties of the investors
  • Information on accounting, books and records
  • Transfer rights
  • Dissolution of the partnership; winding up
  • Manner of final distributions
  • Grant of power of attorney
  • Miscellaneous provisions (headings, amendments, applicable law, jurisdiction)

Subscription Documents

The subscription documents from one firm to another may differ fairly substantially. Some firms have separate subscription documents for individual investors and for institutional investors. Some firms include the necessary representations with the actual subscription agreement. The basic information included in the subscription documents includes:

  • Coverpage with certain legal disclaimers
  • Directions on how to complete the subscription documents
  • Subscription agreement (including certain acknowledgements, representations and warranties)
  • Investor suitability questions (may be embedded in the subscription agreement) – generally accredited investor, qualified client, or qualified purchaser status
  • LPA investor signature page

If a fund accepts non-accredited investors, the manager will need to make sure that the non-accredited investor meets certain that the non-accredited investor, together if applicable with their purchaser representative, is sufficiently sophisticated to understand the risks of making an investment in the fund. These supplemental representations can be made either in the subscription documents or in a supplement to the subscription documents.