1Can I advertise my hedge fund on the internet?
Rule 502(C) of Regulation D prohibits any form of a general solicitation or general advertising. However, where the web page is a "secure" page, and access is limited to "accredited investors" and contains other safeguards, it may be possible to craft such a page in such a way so as to comply with the prohibitions against general solicitation or advertising.
However, under recently enacted legislation, the "Jobs Act," offerings pursuant to Rule 506 (c) of Regulation D (hedge funds/private offerings) will not be deemed "public offerings" under the "federal securities laws" as a result of general advertising or general solicitation where investors are limited to accredited investors only. Thus, the JOBS Act is ultimately expected to allow a private fund relying on a 3(c)(1) or 3(c)(7) exemption to engage in general solicitation and general advertising.
This permits hedge fund mangers to engage in general advertising while maintaining their private offering exemption, so long as the offering is limited to accredited investors.
2Are registered brokers with a securities firms lawfully permitted to receive compensation in the form of a portion of the pool operator's ongoing performance allocations and management fees for the period of time during which the introduced investor is a limited partner in the pool for the sale of commodity pools securities (limited partnership interests) to introduced investors without being registered in some capacity with the CFTC?
CFTC regulations provide that a person is not required to register as an associated person in any capacity if that person is engaged in the solicitation of funds, securities, or property for a participation in a commodity pool, or the supervision of any person or persons so engaged, pursuant to registration with FINRA as a registered representative, registered principal, limited representative or limited principal, and that person does not engage in any other activity subject to regulation by the Commission.
See 17 C.F.R. § 3.12 Registration of associated persons of futures commission merchants, retail foreign exchange dealers, introducing brokers, commodity trading advisors, commodity pool operators and leverage transaction merchants.
3What is meant by a "Private Offering" or "Private Placement?"
The whole point of the private offering is to avoid burdensome registration and prospectus delivery requirements of the Federal Securities Laws. A "private offering" is exempted from such compliance.
Regulation D provides the "safe harbor" provisions which, if complied with, will have the effect of exempting the private offering from compliance with the registration and prospectus delivery requirements of the Federal Securities Laws. It does not exempt the offering and persons associated therewith from compliance with the fraud provisions of the Federal Securities Laws or compliance with the various State Securities Laws. However, pursuant to recent federal legislation, states are prohibited from imposing their blue sky regulation on securities offered pursuant to Rule 506 of Regulation D except for the filing of the Form D or a substantially similar form and the payment of filing fees.
4How do I offer to sell interest in my fund?
Rule 502(C) of Regulation D prohibits any form of a general solicitation or general advertising. Generally the interests in your hedge fund may sold by Registered Broker Dealers or officers of the management (general partner) to those persons with whom there has been a prior relationship.
5Are there any dollar offering limits on issuers of securities relying on Rule 506 of Regulation D?
6I have heard that hedge funds sell their interests only to "accredited investors." Is the hedge fund restricted to selling only to "accredited investors" and what is an "accredited investor"?
Rule 501 of Regulation D provides the definition "accredited investor" and provides that any person who comes within the following enumerated categories, or who the issuer reasonably believes to come within those categories, at the time of the sale of securities is an "accredited investor." Those categories include, banks or savings and loans association whether acting individually or as a fiduciary; any broker or dealer ; any insurance company, investment company registered under the Investment Company Act; employee benefits plan if the investment decision is made by a plan fiduciary as defined by such Act, which is either a bank, savings and loan association, insurance company, or registered advisor, or if the employee benefit plan has total assets in excess of $5 million or is a self-directed plan, with investment decisions made solely by persons who are accredited investors; any private business development company as defined by the Investment Advisors Act of 1940; any organization described in Section 501(c)(3) of the Internal Revenue Code, corporation, Massachusetts or similar business trust, or partnership, not formed for the specific purpose not formed for the specific purpose of acquiring securities offered, with total assets in excess of $5 million; any director, executive officer, or general partner of the issuer of the securities being offered or sold or any director, executive officer, or general partner of a general partner of that issue; any natural person whose individual net worth or joint net worth with that person's spouse at the time of his purchase exceeds $1 million, excluding the value of the principal residence; any natural person who had an individual income in excess of $200,000 for each of the two most recent years or joint income with that person's spouse in excess of $300,000 for each of those years and has a reasonable expectation of reaching the same income level in the current year; any trust with total assets in excess of $5 million not formed for the specific purpose of acquiring securities offered, whose purchase is directed by a sophisticated person as described in Section 230.506(b)(2)(ii); and, any entity in which all of the equity owners are accredited investors. Under Regulation D, a hedge fund can accept up to 35 non-accredited investors. However, Rule 502(B) requires that hedge funds offered to non-accredited investors have certain adequate financial statements.
7Why are hedge funds limited to no more than 100 investors?
The so called 3(c)(1) Hedge Fund refers to a provision of the Investment Company Act that exempts hedge funds from certain registration and clients' requirements of the Investment Company Act of 1940 as long as there are less than 100 investors.
8Can a hedge fund be created to invest in other funds?
Yes. This is called a fund of funds. However, a fund created specifically for the purpose of investing in another fund and for the purpose of avoiding the limitation requirements on the number of investors, could violate the various provisions of the Federal Securities Law as it relates to numbers of investors and the qualification or status of investors.
9Is there a limitation on the amount of investors in a 3(c)(7) hedge fund?
The 3(c)(7) hedge fund offers securities to "qualified purchasers." There are no such limitations on the number of qualified purchasers under the Investment Company Act of 1940. However, where there are more than 500 investors in the limited partnership, the entity my be subject to classification as a "publicly traded entity. " Should that occur, the entity may lose its flow-through tax treatment which is one of the primary benefits of the hedge fund's limited partnership structure.
10An ERISA employee benefit plan will purchase $200,000 of the securities being offered. The plan has less than $5 million in total assets and its investment decisions are made by a plan trustee who is not a bank, insurance company, or registered investment advisor. Does the plan qualify as an accredited investor?
Not under Rule 501(a)(1). Rule 501(a)(1) accredits as ERISA plan that has a fiduciary which is a bank, insurance company or registered investment advisor, or that has total assets in excess of $5 million. The plan, however, may be an accredited investor under a different provision of Rule 501(a).
11May a trust qualify as an accredited investor?
If a bank is a trustee and makes the investment on behalf of the trust, the trust will be accredited by virtue of Rule 501(a)(1) that accredits a bank acting in a fiduciary capacity. It may also qualify as an accredited investor under Rule 501(a) because the SEC interprets "person" to include any trust.
12What is a Purchaser's Representative?
A Purchaser's Representative is a person who satisfies all of the following conditions or who the issuer reasonably believes satisfies all of the following conditions: is not an affiliate, director, officer or other employee of issuer, or the beneficial owner of 10% or more of any class of equities securities or 10% or more of the equity interest in the issuer except where the purchaser is (i) a relative of Purchaser's Representative by blood, marriage or adoption and not more remote than a 1st cousin; (ii) a trust or a state in which the Purchaser's Representative and any persons related to him have specified in Paragraph h(i) or h(iii) of this section collectively have more than 50% of the beneficial interest (excluding continued interest) or of which the Purchaser's Representative serves as trustee, executive or in a similar capacity; or, (iii) a corporation or other organization which the Purchaser's Representative and any persons related to him as specified in Paragraph h(i) or (h)1(ii) of this section collectively are the beneficial owners of more than 50% of the equity securities (excluding directors' qualifying shares) or equity interest; has such knowledge and experience in financial and business matters that he is capable of evaluating, alone, or together with other Purchaser Representatives of the purchaser, or together with the purchaser, the merits and risks of the prospective investment; is acknowledged by the purchaser in writing, during the course of the transaction, to be his Purchaser Representative in connection with evaluating the merits and risks of the prospective investment; and, discloses to the purchaser in writing a reasonable time prior to the sale of securities to that purchaser any material relationship to himself or his affiliates in the issuer or its affiliates that then exists, that is mutually understood to be contemplated, or that has existed at any time during the previous 2 years, and any compensation received or to be received as a result of such relationship.
13Is the Private Investment Company (Hedge Fund) required to deliver a Private Offering Memorandum to a potential investor before accepting an investment?
No. However, the whole point of the Private Offering Memorandum is to limit the potential risk of the hedge fund by providing full disclosure to the investor.
14As the Hedge Fund Manager, am I permitted to use a broker/dealer with whom I am affiliated?
Yes. The manager may use an affiliated broker/dealer to execute trades but is obligated to seek the best execution for the fund and disclose the possibility of the execution of trades by the affiliate. However, the broker dealer may have its own restrictions.
15What is UBTI?
UBTI, Unrelated Business Taxable Income, is a concern to tax exempt investors in a hedge fund because the receipt of UBTI requires the tax exempt entity to file a tax return that it would not otherwise have to file and pay taxes on income that would otherwise be exempt, at the corporate rate. UBTI includes most business operations income and does not include interest, dividends and gains from the sale or exchange of capital assets. Hedge Funds trade their own securities and therefor the tax exempt investor's share of such income of the hedge fund is not UBTI and not subject to federal income tax. However, hedge funds may subject tax exempt entities to UBTI under certain circumstances where the hedge fund is borrowing or purchasing securities on margin. Such transactions may subject the tax exempt to UBTI tax.
16What is an Offshore Fund?
An Offshore Fund is located outside the United States. Typically, the offshore fund is created for investments by non-U.S. investors and certain U.S. tax exempt investors. Although the fund's securities transactions occur on U.S. Securities Exchanges, executed by the U.S. Fund Manager, its administration and audits are conducted offshore. Other than the execution of trades on U.S. Exchanges by U.S. Fund Managers, all other activities are conducted in the offshore jurisdiction. Should the offshore fund conduct activities in the U.S., it would likely incur adverse tax consequences as well as being subject to the United States Federal Securities Laws. The Offshore fund exist to provide an investment vehicle to the foreign investor and the U.S. tax exempt investor. When appropriately structured, the U.S. tax exempt investor in the Offshore fund will not be subject to UBTI.
17In addition to the filing of Form D with the SEC, does the hedge fund have any other filing requirements?
Yes. It must comply with state filing requirements.
18What do I have to do in order to form my Hedge Fund?
You will need to have your Private Offering Memorandum, Limited Partnership Agreement, and Subscription Documents. You will also have to prepare and file your Form D with the U.S. Securities and Exchange Commission as well as comply with filing requirements of the states where each of your investors are located. Then you need to be sure that your securities are sold with out violating the prohibition on general advertising.
19Since I have an account with the broker, do I need a checking account for the hedge fund?
Yes, you may find that your broker will not accept wire transfers to your funds account from your investor. Some brokers believe that the "know your customer" rules prohibit the acceptance of wire transfers from persons with whom the broker does not have a direct relationship. Your investor may be required to wire transfer their investment funds to the hedge fund's checking account and the hedge fund will wire transfer the funds to its brokerage account. Remember, to the broker, the hedge fund is the broker's customer, not the hedge fund's investor. Always contact the broker to determine whether it has a policy prohibiting direct wire transfers from investors to the hedge fund's account.
20If am currently registered with a broker can I start a hedge fund?
Being a stock broker at a firm does not prevent the broker from starting a hedge fund. However, NASD Conduct Rule 3040 prohibits associated persons from participating in any manner in a securities transaction outside their regular course of employment with a member firm, without providing prior written notice to and receiving prior written approval from the member firm. If the associated person is to receive selling compensation, he must provide his firm written notice describing in detail the proposed transaction. If the firm approves the participation, the firm must record the transaction on its books and records and supervise "as if the transaction were executed on behalf of the member." The SEC has stated, "selling away is a serious violation, and Rule 3040 is designed not only to protect investors from unmonitored sales, but also to protect securities firms from exposure to loss and litigation in connection with sales made by persons associated with them."Jim Newcomb, Exchange Act Rel. No. 44945, 2001 SEC LEXIS 2172 (Oct. 18, 2001).
21Is the investment manager or general partner of a hedge fund required to register with the SEC in order to operate a hedge fund?
There is an exemption from registration at the SEC level where an investment adviser has less than 15 clients and the adviser does not hold itself out to the public as an investment adviser. Because the hedge fund itself is considered a single "client" of the adviser, this affords the adviser an exemption from registration. Investment advisers with less than $25 million are not permitted to register and may be subject to the state law and applicable rules.
22Is the investment manager or general partner of a hedge fund required to register as a state registered investment advisor in the state where it maintains its office?
Since each state has its own registration requirements which are also interpreted in conjunction with the National Securities Market Improvement Act of 1996 and other Federal Statutes and Rules. In some instances, where the Investment Adviser services a particular kind of defined client; has had fewer than a certain number of clients within a 12 month consecutive period; and does not hold itself out to the public as an "Investment Adviser;" such an Investment Adviser may be exempt from that states registration requirement. In each instance, it is important that the law of the state in question must be reviewed for compliance. The impact on state registration of the recent changes at the Federal level in registration requirements for Hedge Fund mangers is yet unknown.
23Is the investment manager or general partner of a hedge fund required to register as an investment advisor in the state where it has advisory clients?
Here too, each state has its own registration requirements, generally the registration requirements are dependent upon the number of advisory clients located in the particular state and whether the Investment Adviser is located in the state in question. Since the Investment Adviser or investment manager of the hedge fund has as its client, the hedge fund itself, generally, it does not seem appropriate for it to register in the various states where the fund's investors are located. Again, it is important that the law of the state in question be reviewed for compliance.
24Are there exemptions from registration as a commodity pool operator for a small hedge fund?
Section 4.7 of Commodity Future Trading Commission Rules provides for certain exemptions from certain requirements with respect to commodity pool operators making offerings to qualified eligible persons or commodity trading advisors with respect to advising qualified eligible persons. Under Section 4.7, the pool operator is exempted from certain disclosure compliance requirements. Specifically, Section 4.21 with respect to required delivery of a pool disclosure document, Section 4.24 with respect to the contents of the disclosure document in general, Section 4.25 with respect to requirements relating to the disclosure of past performance and Section 4.26 with regard to use amendment and filing of a disclosure document. The Section 4.7 exemption is not an exemption from registration as a commodity pool operator or commodity trading advisor. Section 4.13 generally provides for exemption from registration as a commodity pool operator. Before its amendment in August of 2003, a person was not required to register as a commodity pool operator if the person did not receive any compensation or payment directly or indirectly; operated only one commodity pool at a time; was not otherwise required to register with the commission; and either the person or other person involved with the pools does any advertising in connection with the pool or to the total gross capital contributions for participation units in all pools that are operated, or intends to operate, do not in the aggregate exceed $400,000 and none of the pools operated have more than 15 participants. This is referred to as the "small pool exemption." Section 4.13(a)(3) generally provides for exemption from registration as a commodity pool operator where: Aggregate initial margin and premiums do not exceed 5% of the liquidation value of the portfolio and the aggregate net motional value of the positions does not exceed 100% of the liquidation value of the pool portfolio. Section 4.13(a)(4) generally provides for exemption from registration as a commodity pool operator where: The person reasonably believes, at the time of investment (or, in the case of an existing pool, at the time of conversion to a pool meeting the criteria of paragraph (a)(4) of this section), that: (A) Each natural person participant (including such person's self-directed employee benefit plan, if any), is a "qualified eligible person," as that term is defined in section 4.7(a)(2); This exemption can not be claimed if the natural person participants only meet the 4.7(a)(3) portfolio requirement.
25If I start up a Fund of Funds and allocate among equity and futures funds what kinds of registration issues do I need to be concerned with?
As a Fund of Funds you must be aware of each particular states Investment Advisor rules. Many states have exemptions from registration. Also if you intend to invest in futures or commodity funds, you should register with the National Futures Association (NFA) and the Commodity Futures Trading Commission (CFTC) as a Commodity Pool Operator (CPO). This CPO's associated person must successfully complete the NASD Series 3 examination.
26Must a finder be registered as a broker-dealer?
Generally, No. Generally a finder does not have to be registered as a broker-dealer if its finder's activities are limited. A "broker" under the Securities Exchange Act of 1934 is "any person engaged in the business of effecting transactions in securities for the account of others." The SEC staff has found activities such as (a) participating in presentations or negotiations, (b) making any recommendations concerning securities, (c) receiving transaction-based compensation, (d) structuring a transaction or making recommendations regarding the nature of the securities, whether to issue securities or to assess the value of securities sold, and (e) continuing involvement in sales of securities to trigger broker-dealer registration obligations. However, a number of states, Texas and California for example, take the position that only a registered representative (broker) may receive kind of compensation.
27Are there any other types of finders available to issuers in a private placement?
Yes. Rule 3a4-1 provides a non-exclusive safe harbor from the definition of a broker for persons associated with an issuer who are engaged in securities-related activities incident to their duties on behalf of the issuer. See Securities Exchange Act Rel. No. 22172 (June 27, 1985). Employees and possibly individual affiliates of an issuer who are not registered representatives of broker-dealers may be considered "associated persons" for purposes of Rule 3a4-1, in which case they may be exempt from registration and will be permitted to engage in limited sales activities pursuant to the Rule's safe harbor.
28What is meant by the 25% limitation on ERISA assets investment in a Hedge Fund?
The Departments of Labor Regulation defines the use of ERISA assets. ERISA Assets include self-employed persons, and individual retirement accounts in pooled investment vehicles. Section 403 (a) requires that generally all assets of an employee benefit plan shall be held in Trust by one or more Trustees. Section 3(21) defines a fiduciary to include any person who exercises discretionary authority or control over the management of Plan Assets. Section 404 provides that a fiduciary must discharge responsibilities in accordance with fiduciary standards of care as set forth in Section 404 (a) (1); that is, (a) solely in the interest of the participants and beneficiaries of the plan (b) with the care skill prudence and diligence under circumstances then prevailing that a prudent man acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and would like aims; and (c) with respect to an investment of a Plan Asset, by diversifying the investments of the plan so as to minimize the risk of large losses.
Section 406 also prohibits a fiduciary from causing a plan knowingly or negligently, to engage in prohibited transactions with "parties-in-interest." A party-in-interest includes the plan sponsor a person providing services to the plan, a person in control of the plan sponsor, a person controlled by any of the forgoing or an employee, affiliate or relative of any of the forgoing. Section 4975 of the Internal Revenue Code imposes excise taxes on "prohibited transaction" the definition of which is similar to the definition of prohibited transactions under 406 of ERISA. Taxes range from 15% of the amount involved each year up to 100% of the amount involved if corrective action is not undertaken within a certain time period. Section 502 (1) of ERISA imposes upon a fiduciary a civil penalty equal to 20% of the amount received from such fiduciary as a result of a settlement agreement or judicial preceding involving a breech of fiduciary duty. Section 406 also prohibits a fiduciary from dealing with plan assets for his own interests or account, acting in any transaction in which his interest are adverse to those of the plan or receiving consideration for his personal account in connection with any transaction involving plan assets. Section 409 imposes personal liability upon a fiduciary who breeches his duties and responsibilities. Section 405 provides that a plan fiduciary may under certain circumstances be liable for a breech of fiduciary responsibility by a co-fiduciary or for improper delegation of investment authority. Section 412 requires that with certain exceptions a plan fiduciary shall be bonded. Section 403 (a) provides that the trustee shall have the exclusive authority and discretion to manage and control the assets of the plan unless the plan provides that the trustee is subject to the discretion of a named fiduciary or the authority is delegated to an investment manager who is either a bank, an insurance company, or registered as an investment advisor under the Investment Advisor Act 1940.
If the assets of the fund are considered plan assets the trustee may have improperly delegated its investment authority unless the managers and general partners of the fund are either named fiduciaries of the ERISA Plan limited partners or properly appointed as an investment manager within the meaning of Section 3 (38) of ERISA. Moreover, unless the fund manager is a bank or insurance company, it must be registered as an investment advisor under the Investment Advisors Act of 1940 to serve as an ERISA Investment manager.
Under the regulations, if a retirement plan purchases an equity interest in an entity, underlying assets will be considered plan assets unless (a) the equity interest is a publicly offered security; (b) the equity interest is a security of a registered investment company; (c) The entity is an operating company; or (d) Benefit plan ownership of equity securities is not significant. The underlying assets are not significant where such assets represent less than 25% of the value of the class of equity security of the entity. Thus, for a hedge fund, a significant benefit plan participation would be an investment of 25% or more by a benefit plan investor in the hedge fund.
It is to be noted however, that only an equity investment in an entity can cause an underlying assets of that entity to be plan assets. The acquisition of debt instruments will generally not result in plan asset treatment.
29Are hedge funds that trade currency on the "spot" market, ForEx, required to register with the Commodity Futures Trading Commission?
On September 1, 2010 the National Futures Association issued a Notice to Members ("Notice") stating that the NFA will begin accepting registration applications from forex firms and individuals on September 2.
The "Notice" further stated that any retail forex entity that does not complete the registration process by October 18, 2010 will be unable to conduct retail forex business until registration and all necessary approvals and designations are granted. Anyone currently registered as an IB, CPO, CTA or AP that is conducting forex business, must still apply for Forex Firm or Forex AP approval.
All individuals who solicit retail off-exchange forex business or who supervise that activity must take and pass two exams. One is the National Commodity Futures Examination (Series 3) and the other is the Retail Off-Exchange Forex Examination (Series 34), a new exam focusing exclusively on forex-related questions. Every approved Forex Firm (RFED, FCM, IB, CPO or CTA) must have at least one principal who is registered as an AP or FB and who is approved as a Forex AP.
30There have been a number of questions concerning the payment of performance fees to state registered investment advisers. One such question is as follows: Is a state registered investment adviser receiving performance fees subject to the SEC Qualified Client limitations set forth in the Investment Advisers Act Rule 205-3 if: the investment adviser is a state registered investment advisor that is registered in a state which has no qualified client rule or registered in a state with a qualified client rule which has an "assets under management" threshold or "net assets" threshold which less than the threshold applicable to SEC registered investment advisers by IAA Rule 205-3; and, the investment adviser has less than 25 million in assets (and therefore is prohibited from registering as an SEC investment advisor) and, the investment adviser provides investment advice to more than 15 clients?
Yes, such an investment adviser receiving performance fees is subject to the Rule 205-3 limitations. The SEC Chief Counsel's office takes the position that, if the only reason the advisor isn't registered with the SEC is because it has under 25 million, then the prohibition of Section 205 of the Investment Advisers Act and the exemption contained Investment Advisers Act Rule 205-3 apply. If the Advisor fits into one of the 203(b) exemptions (for example, has less than 15 clients + not advising a registered IC + no holding out to the public), then the prohibition of Section 205 of the Investment Advisers Act and the exemption contained Investment Advisers Act Rule 205-3 do not apply, regardless of whether the Advisor is prohibited from registering with the SEC.
31How to start a Hedge Fund?