This chapter presents a general overview of the principal
U.S. regulatory requirements that are applicable to private
investment funds and their managers.
U.S. Investment Company Act of 1940
Private investment funds are not subject to U.S. Securities
and Exchange Commission ("SEC") registration as
mutual funds, because they rely on one of the two exemptions
from such registration found in Sections 3(c)(1) and 3(c)(7)
of the U.S. Investment Company Act of 1940 (the "1940
Act").
Section 3(c)(1)
A privately offered fund (see discussion below relating to
private placements under the "Securities Act of 1933")
that has no more than 100 beneficial owners (generally, in
the case of non-U.S. funds, only U.S. beneficial owners need
to be counted) is not required to register as an investment
company under Section 3(c)(1) of the 1940 Act (and is referred
to as a "3(c)(1) fund"). In a 3(c)(1) fund, when
counting beneficial owners, there will be a look-through to:
(i) the underlying investors of any fund-of-funds, other passive
investment vehicle relying upon Section 3(c)(1) or Section
3(c)(7) (discussed below) or registered investment company
owning 10% or more of the 3(c)(1) fund, (ii) those participants
of any self-directed pension plan that have individually elected
to have their plan monies invested in the 3(c)(1) fund, and
(iii) the owners of any entity formed for the purpose of investing
in the 3(c)(1) fund (i.e., if 40% or more of the entity's
assets are invested in the 3(c)(1) fund). There may also be
an "integration" of the beneficial owners of other
3(c)(1) funds that have similar investment objectives. Note
that a husband and wife who are investing jointly in a 3(c)(1)
fund will only count as one investor, as will a person who
invests in his individual capacity and through an IRA.
Section 3(c)(7)
A privately offered fund in which each
investor is a qualified purchaser (generally, an individual
with $5 million or more in "investments" or an entity
with $25 million or more in "investments") is exempt
from registration as an investment company under Section 3(c)(7)
of the 1940 Act (and is referred to as a "3(c)(7) fund").
"Investments" is broadly defined by the SEC and
includes securities, cash and cash equivalents, real estate
held for investment purposes, and many other items; however,
when calculating investments, any acquisition indebtedness
must be deducted. While there is no explicit investor limitation
in Section 3(c)(7) (such as the 100 beneficial owner limitation
found in Section 3(c)(1)), in order for a 3(c)(7) fund to
avoid being considered a "reporting company" under
relevant U.S. securities laws, it should have no more than
499 investors.
Knowledgeable Employees
Certain persons who are executive officers of the fund or
its manager or who participate in the investment activities
of the fund are "knowledgeable employees" and need
not be counted for purposes of the 100 beneficial owner limitation
under Section 3(c)(1) and need not be "qualified purchasers"
under Section 3(c)(7).
U.S. Securities Act of 1933
As mentioned above, private
investment fund interests must always be offered and sold
on a private placement basis.
Generally, such an offering will be made pursuant to the "safe
harbor" private placement requirements of Regulation
D to prospective investors with whom there is a substantive
pre-existing relationship. No form of general solicitation
or advertising may be used, such as cold calls, use of the
media, public interviews or password-free websites. Typically,
the offering is made only to "accredited investors",
which essentially means individuals that have at least a $1
million net worth and entities that have at least $5 million
in total assets. Subject to other applicable legal requirements,
the fund may also have up to 35 unaccredited investors, all
of whom should be financially sophisticated.
Separately, Regulation S provides another exemption for the
private placement of securities outside of the U.S. Under
Regulation S, the offer and sale must be made to a person
outside of the U.S. and the seller must not engage in any
"directed selling efforts" in the U.S. Typically,
Regulation S is relied upon in connection with the private
placement of a non-U.S. fund to non-U.S. investors.
U.S. Investment Advisers Act of 1940
Many private investment
fund managers are exempt from registration as investment advisers
with the SEC because they have fewer than 15 clients over
a 12-month period and do not hold themselves out to the public
as investment advisers (e.g., no advertisements in the yellow
pages or newspapers, no password-free websites). For this
purpose, a private investment fund generally counts as one
client, as does each separately managed account.
If a private investment fund manager is registered as an
investment adviser with the SEC, it will, among other things:
(i) have to file and periodically amend a Form ADV, (ii) be
subject to periodic SEC audits, (iii) be permitted to charge
performance fees only to those clients who represent that
they are "qualified clients" (generally, a $1.5
million net worth; however, in the case of a 3(c)(1) fund-of-funds
or similar fund investing in the fund, each of the investing
fund's investors must meet this criteria), and (iv) need to
adopt various procedures and policies, including procedures
relating to its custody of client funds, proxy voting and
insider trading. As discussed in further detail below, individual
states may require investment adviser registration, even if
the manager is exempt from SEC registration.
U.S. Commodity Exchange Act and related U.S. National
Futures Association Rules
If a private investment fund
utilises any type of futures (including single stock futures),
even if just for hedging or on a de minimis basis, U.S. Commodity
Futures Trading Commission ("CFTC") registration
of the fund's manager as a commodity pool operator and, possibly,
commodity trading adviser may be required. The CFTC registration
requirement would also apply to the managers of: (i) non-U.S.
funds with a U.S. jurisdictional nexus (such as those funds
with a U.S. manager, U.S. director(s) and/or U.S. investors),
and (ii) funds-of-funds that invest in other funds that trade
in futures. Forward contracts, swaps, certain synthetic derivatives
developed by prime brokers and stock index options generally
are not considered futures.
Among other things, CFTC registration usually requires the
passage by certain management personnel of a Series 3 exam,
unless the commodity trading is limited and done solely for
hedging/risk management purposes, in which case a waiver from
the examination requirement may be sought. CFTC registration
also imposes various reporting, recordkeeping and disclosure
obligations, which may, to some degree, be mitigated, if the
fund is able to rely on the exemptions provided by CFTC Rule
4.7 (i.e., all of the investors in the fund are "qualified
eligible persons", which essentially means accredited
investors with a $2 million securities portfolio) or Rule
4.12(b) (i.e., essentially, the fund limits its futures exposure
to no greater than 10% commodity futures margin and premiums,
but the fund's investors do not have to meet the Rule 4.7
criteria). A Rule 4.7 fund would not have to file a disclosure
document with the CFTC, while a 4.12(b) fund would have to
make such a filing, although there would be less disclosure
required in a 4.12(b) fund's disclosure document than in a
disclosure document for a fund that could not rely on Rule
4.12(b).
A manager may, however, seek registration relief if:
- it is a non-US manager trading only non-US futures;
- the fund's participants are accredited investors, knowledgeable
employees and certain family trusts formed by accredited investors
and the manager claiming this exemption operates the fund
such that it meets one of the following trading limitations
(whether or not for hedging) at all times: (1) the aggregate
initial margin and premiums required to establish commodity
positions will not exceed 5% of the liquidation value of the
fund's portfolio after taking into account unrealised profits
and losses on any such positions (provided that with respect
to an option that is in-the-money at the time of purchase,
the in-the-money amount may be excluded in computing the 5%)
or (2) the aggregate net notional value of such positions
will not exceed 100% of the liquidation value of the fund's
portfolio after taking into account unrealized profits and
losses on any such positions;
- 1) each fund participant that is a natural person is
a "qualified purchaser" (generally, a person owning
investments of not less than $5 million), knowledgeable employee
(including principals of the manager) or a non-U.S. person
and (2) each fund participant that is a non-natural person
is either a "qualified eligible person" (generally,
owning a securities portfolio of at least $2 million), an
accredited investor (generally, having assets in excess of
$5 million) or a non-U.S. person or entity. There is no trading
limitation under this exemption; or
- in the case of a fund-of-funds manager, it can meet the
requirements set forth in (ii) or (iii) above, noting that
the CFTC has adopted Appendix A to Part 4 of its Rules illustrating
how the trading limitations in (ii) above would apply to a
fund-of-funds manager.
Also of relevance, U.S. National Futures Association ("NFA")
Compliance Rule 2-38 requires all commodity pool operators
and commodity trading advisers to establish a written contingency
plan and to provide the NFA with emergency contact information.
U.S. Employee Retirement Income Security Act of 1974 ("ERISA")
Most private investment fund managers (including non-U.S.
funds) will limit the investment by benefit plan assets in
the fund to less than 25% of the value of any class of securities
within their funds. Benefit plan assets include assets of
both U.S. and non U.S. employee benefit plans, governmental
plans, pension plans, 401k plans, 403b plans, Keogh plans,
IRAs and entities that themselves have 25% or more benefit
plan assets (e.g., group trusts). If a fund reaches the 25%
threshold, there are many ERISA issues to contend with, including
bonding, SEC registration of the manager as an investment
adviser, custody matters, soft dollar restrictions, added
liabilities and prohibited transaction rules. In certain cases,
the fund may be able to exceed the 25% threshold without being
subject to certain of the requirements set forth above, if,
for example, the manager is a "qualified professional
asset manager" or the fund is a "venture capital
operating company".
Portfolio Disclosure Requirements
There are currently a number of rules, regulations and interpretations
requiring private investment fund managers to disclose certain
fund holdings.
U.S. Securities Exchange Act of 1934 ("Exchange Act")
A Schedule 13G filing with the SEC, the issuer and the applicable
exchange is generally required if a passive investment position
of greater than 5% (but less than 20%) of the outstanding
securities of a class of publicly-traded "equity"
security registered under the Exchange Act is beneficially
owned (looking at all accounts over which there is investment
discretion). A Schedule 13D filing is generally required if
the position size is 20% or greater, is between 5% and 20%
and is not passive, or the person is a director or officer
of the issuer (again, looking at all accounts over which there
is investment discretion). 13G and 13D filings are required
soon after the initial trigger is met and at various other
times to reflect certain changes in status, however, 13G filings
are not required as frequently and are not as extensive as
13D filings. The manager and certain of its principals (and,
sometimes the fund itself) are reporting persons on these
schedules.
A quarterly Form 13F filing with the SEC is generally required
if in the prior year the assets (other than personal assets)
managed at the end of any month by the manager were in excess
of $100 million in equity securities (typically, publicly-traded
long U.S. equities, options, warrants and certain convertible
securities) over which there is investment discretion. The
SEC provides a quarterly list of the securities disclosable
on Form 13F.
A Form 3, 4 or 5 filing with the SEC, the issuer and the
applicable exchange is generally required by a director, officer
or a 10% or more beneficial owner of any class of a publicly-traded
"equity" security or derivative security registered
under the Exchange Act (looking at all accounts over which
there is investment discretion). Under Section 16 of the Exchange
Act, "short swing profits" may have to be disgorged
to the issuer with respect to purchases and sales or sales
and purchases made within six months of each other (which,
for purposes hereof, may include routine transactions such
as rebalancing trades and in-kind distributions). Generally,
Form 3 filings are required within 10 days after the initial
trigger is met, Form 4 filings are required within two business
days after a transaction in the subject security to reflect
certain changes in ownership status, and Form 5 filings are
required annually to reflect certain other ownership changes.
The manager and certain of its principals (and, sometimes
the fund) are reporting persons on these forms.
U.S. Hart Scott Rodino Antitrust Improvements Act of 1976
A filing with both the Federal Trade Commission and the Department
of Justice is usually required for each fund prior to any
acquisition that results in an aggregate position of $50 million
or more in the assets and/or voting securities of an issuer
being held (regardless of whether the voting securities are
publicly-traded). A fee ranging from $45,000 for transactions
below $100 million to $280,000 for transactions of $500 million
or more must accompany the filing. However, if a private investment
fund is able to satisfy either the passive investor exemption
(i.e., the acquisition is solely for investment and the acquiring
person would end up holding no more than 10% of the issuer's
voting shares) or the institutional investor exemption (i.e.,
generally, banks, insurance companies, broker-dealers, registered
investment companies and similar institutions), it will not
have to make a filing.
U.S. Generally Accepted Accounting Principles ("U.S.
GAAP")
Under Statements of Position 95-2 and 01-1, private investment
funds whose audited financial statements are prepared in accordance
with U.S. GAAP are required, in a condensed schedule of investments,
to categorise their investments by security type, by country
or region, and by industry. In addition, disclosure of investments
constituting more than 5% of net assets must be made. While
some private investment funds have previously provided financial
statements that take an exception to U.S. GAAP and thus avoid
having to make these disclosures, an April 2003 auditing interpretation
will no longer permit such an exception and will generally
require such information to be provided.
Customer/Client Information Requirements
Various rules have been passed by the SEC, FTC and CFTC requiring
disclosure to certain U.S. clients of the firm's privacy procedures,
whenever a new client relationship is established and on an
annual basis thereafter. A paragraph outlining such procedures
may be added to the fund's subscription agreement and such
policy must also be given out on an annual basis. The privacy
rules are applicable to registered and unregistered investment
advisers, as well as commodity pool operators.
The FTC has also adopted a related rule requiring all financial
institutions, including private investment funds, to adopt
a written programme which contains administrative, technical
and physical safeguards appropriate to their situation to
protect the security, confidentiality and integrity of customer
information from unauthorised disclosure, misuse, alteration
or destruction. The programme should, among other things,
designate a coordinating employee and identify foreseeable
internal and external risks. Moreover, service providers dealing
with such information (e.g., administrators) will have to
contractually agree to comply with the rule.
Anti-Money Laundering Requirements
Since the passage of the USA PATRIOT Act in late 2001, there
have been various regulatory proposals relating to anti-money
laundering made by the U.S. Treasury Department ("Treasury").
On 18 September 2002, the Treasury issued a proposed rule
governing all Section 3(c)(1) and 3(c)(7) private investment
funds that: (i) have $1 million or more in assets, (ii) are
organised under the laws of the U.S. or any state therein,
organised, operated or sponsored by a U.S. person, or sell
ownership interests to any U.S. person, and (iii) permit their
owners to redeem interests within two years of their purchase.
While most hedge funds would be covered by the rule, most
private equity funds and venture capital funds would be exempt.
The proposed rule requires that, within 90 days following
the publication of a final rule, funds covered by the rule
must implement a written AML programme "reasonably designed
to prevent the company from being used for money laundering
or the financing of terrorist activities". Each institution
will be expected to tailor its programme to fit its particular
business, taking into consideration its size, activities,
location, risks and vulnerabilities. The four required elements
of an AML programme would include the: (i) development of
internal policies, procedures and controls, (ii) provision
for independent testing, (iii) designation of a compliance
officer, and (iv) establishment of an ongoing employee training
programme. Moreover, the proposed rule also contains a requirement
that a fund files a notice with the Treasury no later than
90 days after it first becomes subject to the rule. The notice
must include certain information about the fund, the fund's
manager, sponsor and compliance officer, total assets under
management and the number of investors in the fund.
On 31 December 2002, the Treasury, the U.S. Federal Reserve
and the SEC issued a joint report to the U.S. Congress pursuant
to the USA PATRIOT Act with respect to private investment
funds that recommends: (i) adoption of the above rule and
(ii) requiring all covered funds to establish customer identification
and verification programmes.
While final action is still pending as of the writing of
this chapter, many private investment funds have already begun
to adopt anti-money laundering programmes in anticipation
of final rules, and in response to similar rules affecting
their funds passed in other jurisdictions and/or rules that
may be imposed on their fund by fund service providers who
are themselves subject to their own anti-money laundering
requirements.
U.S. Tax Considerations
Depending on the fund's jurisdiction, the location of its
manager, the location and tax status of its investors, as
well as the securities and other instruments that the fund
is trading, there may be pertinent U.S. tax issues that will
need to be dealt with, including, without limitation, structuring
the management companies and the funds, making "check-the-box"
elections, providing tax and other information to certain
investors, determining trader/investor status, establishing
fee deferral arrangements for the manager, dealing with applicable
tax shelter regulations and many other items.
State and Local Issues
Blue Sky Filings
Private investment funds making offers and sales to U.S. investors
will need to comply with applicable state "blue sky"
laws. Generally, a state blue sky filing will need to be made
within 15 days after the first sale of a fund interest in
each state (other than New York, which requires a filing before
the first offer), and a one-time filing of a Form D will have
to be made with the SEC after the first sale by the fund.
Non-U.S. funds will also be required to make blue sky filings
with regard to their U.S. investors. Amendments to such filings
may be required if material changes occur or as otherwise
may be required by the applicable state's law. A number of
states (e.g., Florida, New Jersey, Colorado, Illinois) have
de minimis, institutional investor or other exemptions; however,
before relying on any such exemptions, counsel should be consulted.
Investment Adviser Registration
There are also state-specific rules that may require state
investment adviser registration, even if the manager is exempt
from SEC registration, especially where the manager's principal
office is located in such state. While many states have de
minimis or institutional investor exemptions, in a number
of states (e.g., Texas), registration will virtually always
be required.
Taxation
A manager needs to also be aware of the tax issues in the
state in which it and/or the fund is located, both at the
state and local levels. An analysis of such issues may result
in a different structure for the fund and/or its management
vehicles.
Conclusion
The U.S. regulation of private investment funds continues
to evolve. As the SEC, the U.S. Senate, the U.S. House of
Representatives, the Treasury and other regulators conduct
their own investigations of the industry, possible results
may include: (i) requiring managers to register as investment
advisers with the SEC (either by eliminating the fewer than
15 clients exception or requiring managers having a certain
level of assets under management to register), (ii) requiring
increased publicly available information regarding investments,
and (iii) changing the investor criteria necessary to invest
in private investment funds.
