United States of America

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1 United States of America Dechert LLP Kevin Scanlan 1. THE HISTORY OF HEDGE FUNDS IN the USA Alfred Winslow Jones, widely credited as the father of hedge funds, established what is believed to be the first hedge fund in the late 1940s. His strategy, now identified as a classic equity long/short strategy, sought to minimise risk in holding long-term stock positions by selling other stocks short. To do so, he divided stocks into two baskets, stocks that he believed would increase in value faster than the market in good times and decrease in value at a slower rate in bad times, and stocks that he believed would do the opposite. His strategy also employed leverage as a method of increasing returns. Over the ensuing years, Jones modified and enhanced his structure to that of a limited partnership and added a performance-based incentive compensation structure for himself as the managing partner. The four salient features of Jones fund, shared risk through a partnership, short selling, leverage and incentive-based compensation for the managing partner (or equivalent), have remained the prominent features of what has evolved into the modern day hedge fund. The hedging component of Jones strategy earned it the title hedge fund, a generic term that now encompasses a wide variety of strategies but has never been formally universally defined. Jones investment strategy, coupled with returns that far exceeded the best performing mutual fund at the time net of all fees, drew significant interest from both investors seeking enhanced returns and other professionals managing portfolios. The result was a surge in the establishment of hedge funds. Over time, managers moved away from Jones stock picking and hedging strategy towards more risky strategies, principally dependent on the use of leverage. This shift led to significant losses in 1969 and into the early 1970s, causing interest in hedge funds to abate somewhat until the 1980s, after which the hedge fund industry began to quickly grow in size. Based on data provided by Citi Prime Finance, the hedge fund industry s assets under management as of the end of August 2013 were $2.69 trillion. As the hedge fund industry expanded, its impact on the markets generally increased in tandem. In 1992, George Soros Quantum Investment Fund caused market turmoil when he wagered on the devaluation of the British pound, resulting in huge profits for his fund, but earning him the title of the man who broke the Bank of England. Further, the failure of hedge funds such as Long-Term Capital Management (LTCM) in the late european lawyer reference series 149

2 1990s and Amaranth Advisors in 2006 had a significant impact on certain markets. These events, coupled with other market events, including the farreaching fallout from the bankruptcy of Lehman Brothers in 2008 and the unearthing of the massive fraud committed by Bernard Madoff, have also had a significant effect on the hedge fund industry, bringing it under further scrutiny. Modern hedge funds employ a variety of strategies, including, among others, long only, long/short, market neutral, fixed-income arbitrage, convertible arbitrage, emerging markets, distressed, managed futures, event driven and energy focused. Leverage is still present frequently, but a fund does not need to employ leverage or hedge to fall within the hedge fund space. 2. Hedge funds today Hedge funds can be organised in a number of different jurisdictions, depending on factors such as the profile of the investors and tax considerations. In addition, hedge funds can take a number of different forms, eg, limited partnership, corporate or otherwise. As a general matter, US taxable investors prefer to invest in US domiciled funds and US tax-exempt investors and non-us investors prefer to invest in non-us vehicles. Although there is typically no prohibition on US taxable investors investing in non-us funds, certain US tax provisions generally make them an inefficient way (from a tax perspective) for US taxable investors to invest in hedge funds if the non-us fund is treated as a corporation for US tax purposes. Delaware has increasingly become the jurisdiction of choice for hedge funds established in the US. The two primary forms used in Delaware in connection with the establishment of hedge funds are the limited partnership and the limited liability company. Business trusts are also occasionally used, but they are not nearly as popular. Non-US funds are often established in the corporate form. With respect to US funds, the limited partnership is still a more popular structure than the limited liability company, due, in part, to the wellestablished case law and common law surrounding Delaware limited partnerships as well as historical preference and comfort from the investors perspective with the limited partnership form. 2.1 Limited partnerships General A limited partnership has a general partner, typically a limited liability company, which has the overall responsibility for the management of the limited partnership. The general partner usually has broad authority over the operations of the limited partnership, which can make the decision-making process more efficient than that of a non-us corporate fund where decisions are generally left to a board of directors. The general partner typically delegates the day-to-day management of the portfolio to an investment adviser, which is often an affiliate of the general partner. Investors in a limited partnership are referred to as limited partners, and they typically 150 european lawyer reference series

3 do not have any say in the management of the limited partnership. Limited partners own limited partnership interests or interests in the partnership Advantages A limited partnership has a number of advantages, the principal one being limited liability for investors (ie, a limited partner s liability is generally limited to its investment in the limited partnership). An additional advantage of a limited partnership is its flow-through tax treatment, whereby each limited partner is taxed directly on its share of partnership income, expenses, gains and losses while the partnership itself is not taxed. This is a significant advantage over a corporation and makes the partnership a tax efficient vehicle for investors Disadvantages The principal disadvantage associated with the limited partnership structure is that the general partner has unlimited liability for the obligations of the partnership Formation and governing document A limited partnership is formed by filing a certificate of limited partnership in the relevant state. The governing document for a limited partnership is a limited partnership agreement. Such agreements are typically lengthy and very detailed documents, setting out the principal terms of the partnership. This will typically include: its objects and purposes; the powers of the general partner; management fees and performance allocations; indemnification provisions; conflicts of interest; valuation; subscription and withdrawal procedures; transfers of interests; allocations of profits and losses; key-man provisions; termination of the partnership; and a section dealing with amendments to the limited partnership agreement. 2.2 Limited liability companies General Although historically not as popular as the limited partnership (due primarily to the fact that a limited liability company is a relatively new vehicle), a significant number of hedge funds are established as limited liability companies (LLCs). An LLC has one or more managing members that perform a role similar to that of the general partner in a limited partnership. The investors are called members and they hold membership interests or interests in the LLC Advantages LLCs typically have all the same advantages as the limited partnership, including flow-through tax treatment and limited liability Disadvantages The principal disadvantages of using an LLC is that: (i) certain states and municipalities may impose taxes on an LLC that they do not impose on european lawyer reference series 151

4 a limited partnership and certain foreign jurisdictions may tax LLCs as corporations; and (ii) there may be less certainty over whether certain legal principles (common law and otherwise) of limited partnerships apply to LLCs (since courts may look to limited partnership case law to interpret certain provisions of state law regarding LLCs) Formation and governing document An LLC is formed by filing a certificate of formation in the relevant state. The governing document for an LLC is typically referred to as an operating agreement or a limited liability company agreement, and generally sets forth the matters outlined above with respect to a limited partnership agreement. 2.3 Typical hedge fund structures Hedge funds can be established as a single fund, a feeder in a master-feeder structure or as a parallel fund Single fund This is the simplest structure involving one fund only, either onshore or offshore, that makes all of its investments directly. The principal advantage of such a structure is that it is relatively easy to set up, however the principal disadvantage is that a single fund generally only has tax attributes of interest (and therefore can effectively only be marketed) to a specific group of investors (eg, US taxable investors or non-us/us tax-exempt investors) Master feeder funds A master feeder structure typically involves a master fund (which holds the brokerage account and pursues the investment strategy for the fund group) in which two or more feeder entities invest all or substantially all of their assets. The most common type of master feeder fund structure typically involves a non-us master fund, one non-us feeder and one US domiciled feeder. The advantages of such a structure include easier administration (eg, no need to split trade tickets), economies of scale, larger critical mass and one performance record. In addition, it can be marketed to a wider group of eligible investors, with US taxable investors investing in the onshore feeder and non-us investors and tax-exempt US investors investing in the non-us feeder Parallel funds Parallel funds are similar in some ways to the master feeder, in that they typically comprise one US entity and one non-us entity that purchase and sell investments in an identical manner. However, the investment portfolios of the parallel funds may deviate due to regulatory, tax or other considerations associated with certain investments that may make such investments inappropriate for one fund or the other. The principal difference is that the funds trade independently; therefore there is a need for two separate portfolios and two separate brokerage accounts. This can result in disparate returns between the two parallel funds. 152 european lawyer reference series

5 3. Regulation OF Investment Advisers 3.1 Who is currently required to register? Persons and entities that provide advisory services within the US are governed on the federal level by the Investment Advisers Act of 1940, as amended (the Advisers Act). The Advisers Act broadly defines an investment adviser as any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as part of a regular business, issues or promulgates analyses or reports concerning securities. Whether or not a person is in the business will depend on how frequently the person gives advice about securities or engages in advisory type activities. Securities is broadly defined in the Advisers Act, and includes, without limitation, any note, stock, treasury stock, security future, bond, debenture and puts, calls and options on any security. Compensation includes direct and indirect economic or other benefits, including those received from persons other than those persons to whom advice is provided. The compensation element can be satisfied if a single fee is paid for a number of different services; a separate fee does not have to be charged for the advisory service. As a general matter, the manager of a hedge fund that invests in securities will fall within the definition of investment adviser, and will be required to so register unless an exemption from registration can be established. Set forth below is a general summary of the registration requirements to which hedge fund managers are subject. 3.2 Private fund adviser exemption An investment adviser who acts solely as an investment adviser to qualifying private funds is exempt from registration with the Securities and Exchange Commission (the SEC) so long as such adviser s regulatory assets under management (as determined under Item 5.F of Form ADV) in the United States are less than $150 million (the private fund adviser exemption). A qualifying private fund is defined broadly as any private fund that is not registered under the US Investment Company Act of 1940, as amended (the Investment Company Act), and has not elected to be treated as a business development company pursuant to section 54 of the Investment Company Act. A private fund means any issuer that would be an investment company under the Investment Company Act, but for the exceptions set forth in Section 3(c)(1) or Section 3(c)(7) of the Investment Company Act. However, such an investment adviser still will be required to maintain such records and provide the SEC with such reports as the SEC determines necessary and appropriate in the public interest or for the protection of investors. Thus, investment advisers to qualifying private funds with less than $150 million in regulatory assets under management in the United States (Regulatory AUM) will, at a minimum, be subject to recordkeeping and annual reporting requirements, as determined by the SEC. The SEC would further require that each investment adviser relying on the private european lawyer reference series 153

6 fund adviser exemption be subject to examination by the SEC, the anti-fraud provisions of section 206 of the Advisers Act, and the SEC s pay-to-play rules. In order to rely on the private fund adviser exemption, a US-based adviser may not have more than $150 million in total Regulatory AUM. However, a non-us private fund adviser whose only US clients are qualifying private funds would only need to include assets managed from a place of business in the United States in calculating whether it falls under the $150 million threshold (ie, if the non-us adviser has no place of business in the US and its only US clients are qualifying private funds, it can have an unlimited amount of investors and assets in these US qualifying private funds without any risk of triggering registration, because it will be deemed to have no Regulatory AUM in the United States ). 3.3 Foreign private adviser exemption Non-US advisers to private funds can rely on an exemption from registration to the extent that they satisfy the requirements of a foreign private adviser (the foreign private adviser exemption). A foreign private adviser is any investment adviser that: (i) has no place of business in the US; (ii) has, in total, fewer than 15 clients and investors in the United States in private funds advised by the investment adviser; (iii) has less than $25 million (which dollar threshold the SEC may increase) in Regulatory AUM that are attributable to clients in the US and investors in the US in private funds advised by the investment adviser; and (iv) neither holds itself out generally to the public in the US as an investment adviser nor advises registered investment companies or certain business development companies. Because the term in the United States, as used in the foreign private adviser exemption, is used differently than under the private fund adviser exemption (please see below), this exemption is likely to be much less useful to non-us advisers seeking clients or investors in the US Definition of investor The foreign private adviser exemption defines a private fund investor generally as any person who would be included in determining: (i) the number of beneficial owners of the outstanding securities of a private fund under section 3(c)(1) of the Investment Company Act; or (ii) whether the outstanding securities of a private fund are owned exclusively by qualified purchasers under section 3(c)(7) of the Investment Company Act. Specifically, the foreign private adviser exemption requires advisers, when counting the number of US investors and clients for purposes of the foreign private adviser exemption: to look through any nominee account to count each beneficial owner of the account as an investor; to count holders of equity and debt securities of a private fund as investors; 154 european lawyer reference series

7 in a master-feeder structure, to look through to the US investors in a feeder fund formed or operated for the purpose of investing in a master fund advised by the adviser and count those investors; and to count as an investor any holder of an instrument (such as a total return swap or other structured product) that effectively transfers the risk of investing in a private fund from the record owner of the private fund s securities to the instrument holder Definition of clients The foreign private adviser exemption includes a safe harbour for counting clients similar to the safe harbour currently afforded by Rule 203(b)(3)-1 of the Advisers Act. Further, the foreign private adviser exemption requires an adviser to count as a client any person for whom the adviser provides investment advisory services without compensation. The foreign private adviser exemption also specifies that an adviser would not need to count a private fund as a client if the adviser counted any US investor in that private fund as an investor Definition of in the United States The foreign private adviser exemption is premised on the adviser having no place of business in the United States, having fewer than 15 clients and investors in private funds in the United States, and having less than $25 million of Regulatory AUM attributable to clients and investors in the United States. The foreign private adviser exemption defines in the United States for these purposes generally by reference to Regulation S under the US Securities Act of 1933, as amended (the Securities Act), which generally looks to the residency of the client or investor. Further, the rules promulgated under the foreign private adviser exemption clarify that a person who is currently in the United States under the Regulation S definition may be treated as not being in the United States if such person was not in the United States at the time of becoming a client or investing in a private fund advised by the adviser. 3.4 State registration issues Even if a private fund adviser falls within an exemption from registration at the SEC level, the state in which a US adviser has a place of business may require the adviser to register as an adviser with that state. A non-us adviser providing investment advice to US persons in circumstances under which it cannot avail itself of an SEC exemption, will generally be obligated to register with the SEC and, as an SEC-registered adviser, will avoid adviser registration at the state level. 4. Taxation 4.1 Tax issues for hedge fund investors As outlined above, most hedge funds that are domiciled in the US are established as limited partnerships or LLCs in order to take advantage of the flow-through tax treatment afforded by these vehicles. In general, this european lawyer reference series 155

8 means that the entity itself does not pay US federal income taxes but each investor pays taxes on its distributive share of income, gain, expenses and losses; therefore avoiding what is known as double tax. The following is a brief summary of a number of tax-related issues that hedge funds should consider US trade or business considerations non-us funds Non-US investment funds generally seek to avoid the adverse US income tax consequences associated with being engaged in a US trade or business. Section 864(b)(2) of the US Internal Revenue Code of 1986, as amended (the Code), provides a safe harbour (the Safe Harbour) applicable to a non-us person (other than a dealer in securities) that engages in the US in trading securities (including contracts or options to buy or sell securities) for its own account pursuant to which such non-us person will not be deemed to be engaged in a US trade or business. The Safe Harbour also provides that a non-us person (other than a dealer in commodities) that engages in the US in trading commodities for its own account is not deemed to be engaged in a US trade or business if the commodities are of a kind customarily dealt in on an organised commodity exchange and if the transaction is of a kind customarily consummated at such place. If certain of the activities of a non-us fund were determined not to be of the type described in the Safe Harbour (eg, the origination of loans is one activity that may fall outside of the Safe Harbour), the activities of such entity could constitute a US trade or business, in which case the entity would be subject to US income and branch profits tax on the income and gain from those activities (assuming the entity is treated as a corporation, which is common practice) Non-US investors Non-US investors investing in US domiciled hedge funds will become subject to certain US tax reporting obligations (as well as be required to pay tax on: (i) any US income effectively connected with the conduct of a trade or business in the US as they would in a non-us fund; or (ii) certain types of US income that is not effectively connected income such as dividends paid by a US corporation). Therefore, to lessen US tax reporting obligations, most non-us investors choose to invest in entities established outside of the US (eg, the Cayman Islands), which entities generally choose to be treated as a corporation and not a flow-through entity Unrelated business taxable income Generally, a tax-exempt US person is exempt from federal income tax on certain categories of income, such as dividends, interest, capital gains and similar income realised from securities investment or trading activity. This general exemption from tax, however, does not apply to the unrelated business taxable income (UBTI) of a tax-exempt US person. Generally, except as noted above with respect to certain categories of exempt trading activity, UBTI includes income or gain derived from a trade 156 european lawyer reference series

9 or business, the conduct of which is substantially unrelated to the exercise or performance of the tax-exempt US person s exempt purpose or function. UBTI may also be generated by: (i) income derived by a tax-exempt US person from debt-financed property; and (ii) gains derived by a tax-exempt US person from the disposition of debt-financed property. In order to avoid UBTI, a tax-exempt US person will typically invest in non-us hedge funds that are treated as corporations for US tax purposes. In addition, funds in which tax-exempt US persons invest will often create blockers for debt financed investments to avoid having UBTI flow directly to the investors of the fund. The blocker will typically be a subsidiary corporation that pays dividends to the fund FATCA In order to reduce offshore tax abuses, the US enacted the Foreign Account Tax Compliance Act (FATCA), which imposes a new reporting and withholding regime on foreign financial institutions (which is defined very broadly but would include non-us private funds) and certain other non-us entities to identify certain direct or indirect US account holders or owners. Foreign financial institutions additionally will be required to report identified US accounts to the US Internal Revenue Service and, in some instances, withhold tax from certain payments made to noncompliant holders. Compliance with FATCA is enforced through a new 30% withholding tax imposed on certain US source payments and potentially other payments made to non-compliant foreign financial institutions and other non-compliant non-us entities. Withholding will begin phasing in on 1 July New Internal Revenue Service (IRS) reporting forms are in the works that will affect the subscription documents that are needed once the forms are finalised. 4.2 Tax treatment for US hedge fund managers In general, the tax issues faced by a US hedge fund manager are very straightforward. A US hedge fund management company is generally formed as a US tax transparent entity such as a partnership or LLC and the entity itself does not pay any tax to the United States. Instead, the tax obligation is passed on to the owners of the hedge fund management company, who must pay tax on their attributable portion of the manager s net income. 5. The Distribution of Hedge Funds in the US Two of the most significant US federal securities Acts covering the activities of hedge funds are the Securities Act and the Investment Company Act. 5.1 The Securities Act The Securities Act covers the offer and sale of securities and generally requires the registration of securities with the SEC. Section 5 of the Securities Act generally requires registration of any security offered or sold through the use of any means of United States european lawyer reference series 157

10 interstate commerce. Section 4(a)(2) of the Securities Act and Regulation D thereunder provide a private placement exemption from Securities Act registration. Section 4(a)(2) of the Securities Act exempts from registration under the Securities Act any offer or sale of a security by an issuer that does not involve a public offering. The statute gives no guidance as to the requirements to qualify for this private placement exemption, but SEC interpretations and case law have established various factors to be considered in determining whether a particular offering is public or private. These factors include: (i) the number of offerees and their relationship to each other and to the issuer; (ii) the nature of the offerees (ie, their sophistication and ability to fend for themselves in investment matters); (iii) the size of the offering; (iv) the manner of the offering; and (v) restrictions on resale. There is no controlling element, rather, all surrounding facts and circumstances are considered in determining whether an offering of securities constitutes a private placement. In order to clarify the private placement exemption, the SEC adopted Rule 506 of Regulation D as a safe harbour under section 4(a)(2) of the Securities Act. This means that an offering made in accordance with the provisions of Rule 506 is deemed to have complied with section 4(a)(2). Rule 506 provides that an offering is deemed to comply with section 4(a)(2) if, among other things: (i) sales are made only to accredited investors and up to 35 other purchasers that do not qualify as accredited investors; (ii) there is no general solicitation or advertising involved with the offering; and (iii) the persons acquiring the securities buy the securities for investment and not for resale. Accredited investors generally include: (i) an individual whose net worth (or joint net worth with that person s spouse) exceeds $1 million (excluding the value of one s primary residence), or whose income was in excess of $200,000 in each of the preceding two years (or, together with that person s spouse, in excess of $300,000 in each of the preceding two years) and who reasonably expects to reach the same level of income in the current year; and (ii) corporations, partnerships, trusts or foundations with total assets in excess of $5 million. Effective 23 September, 2013, the SEC adopted final rules that disqualify securities offerings involving certain felons and other bad actors from relying on Rule 506 of Regulation D where an issuer or specified covered persons have had a disqualifying event (the Bad Actor Rule). Disqualifying events under the Bad Actor Rule include, very generally: (1) criminal convictions; (2) court injunctions and restraining orders; (3) final orders of certain state and federal regulators (eg, state securities, banking and insurance regulators); 158 european lawyer reference series

11 (4) SEC disciplinary orders relating to brokers, dealers, municipal securities dealers, investment advisers and investment companies and their associated persons; (5) suspension or expulsion from membership in, or suspension or bar from association with a member of, a securities self-regulatory organisation; (6) SEC stop orders and orders suspending a Regulation A exemption; and (7) US Postal Service false representation. Covered persons (ie, essentially persons associated with an issuer such as a private fund whose bad acts can disqualify the private fund from reliance on Rule 506) include: (1) the entity seeking to sell securities pursuant to Rule 506 (the issuer ) and any predecessor of the issuer or affiliated issuer; (2) any director, executive officer, other officer participating in the offering, general partner or managing member of the issuer; (3) any beneficial owner of 20% or more of the issuer s outstanding voting equity securities, calculated on the basis of voting power; (4) any investment manager to an issuer that is a pooled investment fund and any director, executive officer, other officer participating in the offering, general partner or managing member of any such investment manager, as well as any director, executive officer or officer participating in the offering of any such general partner or managing member; (5) any promoter connected with the issuer in any capacity at the time of the sale; (6) any person that has been or will be paid (directly or indirectly) remuneration for solicitation of purchasers in connection with sales of securities in the offering; and (7) any director, executive officer, other officer participating in the offering, general partner, or managing member of any such compensated solicitor. Regulation D requires hedge funds to file a short notice (Form D) with the SEC within 15 days of the first sale of interests to US investors. Failure to file the Form D could complicate the hedge fund s ability to comply with state blue sky filing requirements Non-US investors Regulation S under the Securities Act provides general guidance as to when offers and sales of securities are deemed to occur outside the United States and is also a safe harbour rule. A typical non-us hedge fund complies with Regulation S by meeting the requirements of Rule 903(a) under Regulation S. Rule 903(a) requires that: (i) the offer or sale is made in an offshore transaction; and (ii) no directed selling efforts are made in the United States by the issuer, distributor, or any affiliates, or any person acting on behalf of the foregoing General solicitation or advertising Pursuant to Rule 502(c) of Regulation D, offers for securities in private placements may not be made by means of a general solicitation or general european lawyer reference series 159

12 advertising. In order to ascertain whether a particular communication is permissible in connection with a private placement, the following questions should be asked: is the communication a general solicitation or general advertisement? is the communication made by or on behalf of the issuer to offer or sell the securities? If the answer to either of the questions is no, the communication should be permissible under the safe harbour provided by Regulation D, however, in certain circumstances further investigation may be required. There is no definitive answer as to what constitutes a general solicitation or general advertising, however, there are some bright line rules. In particular, any advertisement, article, notice or other communication published in any newspaper, magazine or similar media, broadcast over the television or radio, or available on a publicly accessible internet website is considered a general solicitation and must be avoided. In addition, any seminar or meeting whose attendees have been invited by any general solicitation or general advertising is also prohibited Websites The internet is an important communication tool for hedge funds and advisers in maintaining relationships with investors. As outlined above, any advertisement, article, notice or other communication available on a publicly accessible internet website is considered a general solicitation and must be avoided. Therefore, access to such websites must be strictly controlled and sufficient procedures must be put in place to ensure that only eligible investors are permitted to access the content and a waiting period of at least 30 days is instituted before an investor may invest in the hedge fund. Such procedures include the issuance of a user identification number and password to users. Funds and investment advisers must exercise caution in the use of hyperlinks to third party websites, as the linked materials could be deemed to be part of the hedge fund s materials. Hedge funds relying on Regulation S for non-us offerings should ensure the website contains a disclaimer to the effect that the offer is directed to investors outside the US only, and is not open to US investors. In addition, access should be restricted so that only investors that confirm their status as non-us persons are permitted to access materials. In addition, there should be sufficient procedures in place to ensure that sales to US persons are not permitted Pre-existing relationship A pre-existing relationship between an issuer (or a person acting on its behalf) and the person solicited is a factor that can be used to establish that no general solicitation or general advertising was used in connection with the offer. The relationship must be sufficient to show that the issuer had adequate information to evaluate the person s sophistication and financial circumstances to establish that he or she is an eligible investor for the offering. It is not always sufficient to rely on the fact that an investor was 160 european lawyer reference series

13 previously an investor to establish a pre-existing relationship. The SEC uses a facts and circumstances test to determine whether a preexisting relationship exists. Effective as of 23 September, 2013, based on a US Congressional mandate set forth in the Jumpstart Our Business Startups Act, the SEC amended Rule 506 by including a new Rule 506(c) that removes the prohibition against general solicitation or general advertising to an offering made pursuant to Rule 506(c) provided that all purchasers of the securities in that offering are accredited investors. In order to rely on Rule 506(c), issuers must take reasonable steps to verify the accredited investor status of purchasers, which requires a higher level of due diligence than a general private placement under Rule The Investment Company Act Registration of a fund under the Investment Company Act involves extensive regulation, and hedge funds typically attempt to avoid so registering by relying on one of the private investment fund exceptions from the definition of investment company found in sections 3(c)(1) and 3(c)(7) of the Investment Company Act Section 3(c)(1) Section 3(c)(1) of the Investment Company Act which, until the creation of the 3(c)(7) exception, was the most commonly relied upon exception provides an exemption from registration for a hedge fund that can meet both of the following tests: the outstanding securities of the fund must not be beneficially owned by more than 100 persons (which are generally defined as either natural persons or a company); and the fund must not make or propose to make a public offering of its securities. Please note that this prong is not breached by use of Rule 506(c) of the Securities Act. Although beneficial ownership by a company would typically be deemed to be beneficial ownership by one person, in some instances the SEC requires the hedge fund to look-through to the underlying investors of the company and count the company s beneficial owners in determining whether the investee hedge fund has more than 100 persons. For example, if an underlying investor in a section 3(c)(1) fund is another section 3(c)(1) fund or a section 3(c)(7) fund that owns 10% or more of the outstanding voting securities of the investee fund, the investee fund will need to count towards its 100 investor limit the beneficial owners of the investor fund. Knowledgeable employees of a section 3(c)(1) fund are not counted towards the 100 person limit. For these purposes, a knowledgeable employee would include executive officers and certain investment personnel Section 3(c)(7) Section 3(c)(7) of the Investment Company Act excepts from the definition of investment company funds that are owned exclusively by qualified european lawyer reference series 161

14 purchasers, provided that such funds and are not making or proposing to make a public offering. Similar to the discussion above regarding the Section 3(c)(1) exception, reliance on Rule 506(c) by a private fund to offer interests in the fund does not breach the prohibition against making a public offering. A qualified purchaser is generally defined to include the following: natural persons who own at least $5 million in investments (as such term is defined for purposes of the Investment Company Act); certain family-owned companies, partnerships, trusts or similar entities that own at least $5 million in investments; certain trusts that are not formed for the specific purpose of acquiring the interests in the section 3(c)(7) fund, as to which the trustee or other person authorised to make decisions with respect to the trust, and each settlor or other person who has contributed assets to the trust, is a qualified purchaser; entities that, in the aggregate, own and invest on a discretionary basis at least $25 million in investments; entities that are beneficially owned by qualified purchasers; and most qualified institutional buyers (as defined in Rule 144A of the Securities Act), which term generally encompasses institutions that own at least $100 million of investment securities. Section 3(c)(7) funds may also be required, in certain circumstances, to look-through an investor that is an entity formed for the specific purpose of making the investment to determine whether beneficial owners of the investing entity are, in fact, qualified purchasers. It should also be noted, however, that while the qualified purchaser test appears to be more difficult to meet than the accredited investor standard, not all qualified purchasers will qualify as accredited investors and vice versa. 5.3 Broker-dealer issues The US Securities Exchange Act of 1934, as amended (the Exchange Act), broadly defines the terms broker and dealer, respectively, to include most persons buying or selling securities as agent or for their own accounts as part of the business of trading securities. Section 15 of the Exchange Act generally requires that any broker or dealer using the US mail or other instruments of interstate commerce (eg, telephone calls into or originating from the United States) to effect or induce transactions in securities register with the SEC. If a hedge fund sells its securities to US residents directly, rather than through a dealer, the fund itself should not need to register with the SEC as a broker-dealer. Rule 3a4-1 under the Exchange Act provides a safe harbour from broker registration requirements for any associated person of an issuer, if that person meets specific conditions. In particular, such person must not be subject to a statutory disqualification, must not be affiliated with a brokerdealer and should not receive commissions on the interests that they sell or otherwise be compensated in a manner that reflects the success of their selling efforts. 162 european lawyer reference series

15 Rule 3a4-1 generally is most useful for officers and directors of a fund or of its investment manager who, as part of the duties they perform to fund or investment manager, promote investments in the fund. Prior to permitting any such persons to promote a fund, however, careful consideration should be given to all circumstances to ensure that the promotion efforts comply with the applicable requirements of the Exchange Act. 6. Miscellaneous 6.1 US Employee Retirement Income Security Act of 1974, as amended The US Employee Retirement Income Security Act of 1974, as amended (ERISA), is the US statutory scheme that governs the operation and administration of most private US pension and welfare benefit plans. It imposes special duties on, and prohibits certain transactions by, persons who are defined to be fiduciaries with respect to such plans. Some provisions of ERISA are included not only in the labour provisions of the US statutes (what are commonly, and hereafter, referred to as ERISA) but also in the Code, such as the prohibited transaction rules and the tax imposed on UBTI received by tax-exempt entities. One factor that will determine whether, or to what extent, provisions of ERISA or the Code will apply to an investment manager is whether the assets it is managing are plan assets. ERISA and the Code will only apply to an investment manager s management of assets to the extent its client is subject to ERISA and/or the Code. In general, ERISA covers all employee benefit plans, which include both employee pension benefit plans (plans, funds or programmes maintained by an employer, an employee organisation or both, that provide retirement income to, or result in a deferral of income by, employees ) and employee welfare benefit plans (plans are programmes that provide medical, hospital, accident, death, disability or similar benefits to employees ). There are certain kinds of plans that are not subject to ERISA and/or the Code (such as individual retirement accounts and Keogh plans for self-employed people). Whether an investment adviser is managing plan assets when it is managing a pooled investment vehicle depends on whether assets of that pooled vehicle are deemed to include plan assets. A US Department of Labor (DOL) regulation and section 3(42) of ERISA provide that when ERISA plans invest in a pooled fund, that fund s assets will not be deemed to include plan assets if benefit plan investors (as defined under ERISA) do not own 25% or more of the value of any class of equity interests in the fund. Non-US retirement plans, governmental plans and other plans that are not subject to Title I of ERISA or section 4975 of the Code may generally invest on an unlimited basis without affecting the benefit plan investor percentage. A determination of whether benefit plan investor ownership breaches the 25% threshold must be made after each acquisition of an equity interest in the fund. The DOL has taken the position that the redemption of an interest in a fund constitutes an acquisition triggering a determination of significant benefit plan investor participation. european lawyer reference series 163

16 If a fund allows benefit plan investor ownership of any class of equity interest of the fund to breach the 25% threshold, the fund s investment manager must be prepared to comply with the provisions of ERISA and the Code to which it becomes subject as a consequence. Some of those provisions include those that: (i) impose responsibilities and duties on persons who are fiduciaries with respect to plans subject to ERISA; (ii) prescribe the methods by which ERISA plan assets may be held outside the jurisdiction of the US district courts; (iii) require that ERISA fiduciaries be bonded; and (iv) prohibit engaging with plan assets in certain kinds of transactions (referred to as prohibited transactions). 6.2 CFTC Regulation Many hedge fund managers may wish to acquire commodity interests for hedging or speculative purposes. Commodity interests include instruments such as futures contracts, options on futures contracts, options on commodities and commodity-based swaps (which will include many overthe-counter derivatives such as total return swaps on broad-based securities indices and interest rate swaps). The US Commodity Futures Trading Commission (the CFTC) administers the US Commodity Exchange Act (the CEA), a comprehensive federal framework for regulation of transactions in such commodity interests. An investment fund is considered a commodity pool subject to CFTC regulation if the fund transacts in commodity interests to any extent. In general, the operator of a commodity pool must register with the CFTC as a commodity pool operator (CPO) and one who manages or directs an account which trades in futures or who gives advice about futures trading must register with the CFTC as a commodity trading advisor (CTA) Exemptions The CFTC rules and regulations do, however, set forth a few exemptions from CPO and CTA registration. CFTC Rule 4.13(a) provides an exemption from CPO registration for CPOs that manage privately offered commodity pools that limit their trading in commodity interests. The Rule 4.13(a)(3) exemption is available to a CPO of privately offered commodity pools: (i) that only engage in a de minimis amount of trading in commodity interest positions (discussed below); (ii) that are not marketed as vehicles for trading in the commodity futures or commodity options markets ; and (iii) whose participants are, among other things, non-united States persons or accredited investors as defined in Regulation D of the Securities Act. To meet the de minimis standard, the commodity interest positions, whether used for bona fide hedging or not, must: (i) have a net notional value not exceeding 100% of the portfolio s liquidation value (after taking into account unrealised profits and unrealised losses on any such 164 european lawyer reference series

17 positions it has entered into); or (ii) be established with aggregate initial margin, premiums and required minimum security deposit for retail forex transactions not exceeding 5% of the portfolio s liquidation value (after taking into account unrealised profits and losses and excluding in-themoney amounts for commodity options that were in the money at the time of purchase). Please note there are three other potential CPO registration exemptions set forth in CFTC Rules 3.10(c)(3), 30.4(c) and 30.5 that are primarily of benefit to non-us managers. With respect to Rule 3.10(c)(3): (i) the CPO must be located outside of the United States; (ii) the commodity pool and its investors must all be located outside of the United States; and (iii) the pool is trading commodity interests on US exchanges. With respect to the exemption provided by Rule 30.4(c): (i) the pool must be exempt from registration under the Investment Company Act; (ii) the pool must be trading solely non-us futures and options; and (iii) no more than 10% of the investors in the pool may be US persons and the aggregate value of the pool held by US persons may not exceed 10%. Finally, under the exemption provided by Rule 30.5, the commodity pool is able to exceed the 10% threshold set forth in Rule 30.4(c) to the extent the CPO is located outside of the United States and the pool trades solely non- US futures or options. With respect to CTA exemptions, some of the most commonly used exemptions are set forth in CFTC Rules 4.14(a)(5) and 4.14(a)(10). Pursuant to CFTC Rule 4.14(a)(5), a person is not required to register as CTA if the person is exempt from registration as a CPO and the person s advice is directed solely to, and for the sole use of, the pool(s) for which it is so exempt. CFTC Rule 4.14(a)(10) provides a CTA exemption for persons who, during the preceding 12 months, have not furnished commodity trading advice to more than 15 persons and who do not hold themselves out generally to the public as a CTA. There may be other CPO and CTA exemptions upon which a CPO and CTA can rely, so it is important to carefully review all of the potential options in this space. 6.3 New Issues New Issues are securities issued in an initial public offering in which a member of the US Financial Industry Regulatory Authority (FINRA) (formerly the National Association of Securities Dealers or NASD) is a part of the underwriting syndicate. A hedge fund may invest in New Issues only in accordance with the requirements of FINRA Rule 5130, which permits investors to participate in the profits and losses from investments in New Issues subject to certain restrictions (the New Issues Rule). The New Issues Rule provides that persons associated with broker-dealers and other financial-type accounts (such as portfolio managers who manage assets for institutional investors) (restricted european lawyer reference series 165

18 persons) are limited in their ability to invest in New Issues. The rules currently imposed provide, inter alia, that allocations of profits and losses from New Issues to the accounts of restricted persons are only permissible where either: (i) beneficial ownership by restricted persons does not exceed in the aggregate 10% of the New Issues account; or (ii) beneficial ownership by restricted persons does exceed 10% of the New Issues account, but no more than 10% of the profits and losses from the New Issues account are allocated to restricted persons. In addition, FINRA Rule 5131 (Rule 5131) prohibits quid pro quo allocations and spinning of New Issues to favoured customers, such as certain executive officers and directors of potential investment banking clients, in exchange for investment banking business. FINRA members will ask private funds for certain representations and additional information regarding the hedge fund and its investors in order to ensure that the FINRA members are not allocating New Issues in violation of Rule Generally a hedge fund s offering documents will contain a questionnaire in its application form or subscription agreement designed to ascertain whether any investors are restricted persons or persons subject to Rule This will enable the fund to determine how it will need to structure its investments in New Issues in order to be in compliance with the New Issues Rule and Rule Reporting of significant positions in US equity securities Investment managers and funds that have discretion over, or beneficially own, more than specified amounts of US equity securities registered under the Exchange Act, may have to report these holdings to the SEC. Depending on the circumstances, an investment manager and/or fund may be required to file Form 13F, Schedule 13D, Schedule 13G or a combination of these with the SEC. It should be noted that other filings may be triggered as well, so it is important to get advice in this area should the fund acquire a significant amount of the stock of an issuer. These reporting obligations apply to all investment managers and funds regardless of whether they are registered with the SEC and regardless of where they are organised. The following is a summary of the filing requirements Form 13F This must be filed by institutional investment managers (ie, investment managers exercising investment discretion with respect to section 13(f) securities aggregated across all accounts having an aggregate fair market value on the last trading day in any month of any calendar year of at least US$100 million) within 45 days after the end of each calendar year with respect to which the investment manager is an institutional investment manager and within 45 days after the last day of each of the first three calendar quarters of the subsequent calendar year. 166 european lawyer reference series