Hannah Terhune Articles

Overview of U.S. Hedge Fund Law

In the United States, hedge funds are regulated under Regulation D of the Securities Act of 1933. However, there is an exemption that allows you to make a private placement of your hedge fund without having to register the security with the U.S. Securitiesand Exchange Commission (SEC) and each state (an expensive and time-consuming process). The attorneys that create your offering documents will ensure that the disclosures in the documents will allow you to achieve this exemption. The exemption is great news, and all the states honor this exemption from registration.

If you desire the exemption, you probably want to form what is known as a Section 3(c)(1) fund (from the Investment Company Act of 1940). That kind of a fund allows you to have fewer than 100 investors, up to 35 of whom can be non-accredited investors. A typical hedge fund manager has only one client — the hedge fund. The individuals that buy into the hedge fund are the investors. Hedge funds and their advisers are governed primarily by the Investment Company Act of 1940, the Securities Act of 1933 and the Investment Advisers Act of 1940.

Securities Act of 1933

Often referred to as the truth in securities law, the Securities Act of 1933 has two basic objectives: require that investors receive financial and other significant information concerning securities being offered for public sale; and prohibit deceit, misrepresentations, and other fraud in the sale of securities. Section 5 of the Securities Act mandates the registration with the SEC of public securities offerings and the delivery to purchasers of a prospectus containing specified categories of information about the issuer and the securities being offered, unless there is an available exemption from the registration requirements. Since limited partnership, LLC and other interests offered to investors in the case of a typical hedge fund fall within the definition of the term securities for purposes of the federal securities laws, the hedge funds must either register the offer and sale of the securities or rely on an exemption from registration. Offerings of hedge fund securities in the United States generally rely on the private offering exemption in Section 4(2) of the Securities Act or Rule 506 promulgated under that Section to avoid the registration and prospectus delivery requirements of Section 5.

The Private Offering Exemption of the Securities Act

Section 4(2) of the Securities Act exempts from the registration and prospectus delivery requirements of Section 5 any transactions by an issuer not involving any public offering. The Section 4(2) exemption, commonly known as the private offering or private placement exemption, requires no notice or other filing or regulatory approval as a prerequisite for its availability.

Regulation D and Rule 506

Rule 506 of Regulation D under the Securities Act is a set of requirements issued by the SEC to govern hedge funds. Although compliance with the Rule 506 requirements is not required to establish the availability of a private offering exemption, satisfaction of the conditions of the rule entitles an issuer to claim the Section 4(2) exemption. In this sense, Rule 506 establishes safe harbor criteria for the private offering exemption, but is not the exclusive means of establishing entitlement to the exemption. Because of a degree of uncertainty as to the availability of the Section 4(2) exemption, many hedge funds tailor their offering and sale procedures to the criteria specified in Rule 506.

Investment Advisers Act of 1940

This law regulates investment advisers. With certain exceptions, this Act requires that firms or sole practitioners compensated for advising others about securities investments must register with the SEC and conform to regulations designed to protect investors.

Investment Company Act of 1940

This Act regulates the organization of companies, including mutual funds, that engage primarily in investing, reinvesting, and trading in securities, and whose own securities are offered to the investing public. The regulation is designed to minimize conflicts of interest that arise in these complex operations. The Act requires these companies to disclose their financial condition and investment policies to investors when stock is initially sold and, subsequently, on a regular basis. The focus of this Act is on disclosure to the investing public of information about the fund and its investment objectives, as well as on investment company structure and operations. It is important to remember that the Act does not permit the SEC to directly supervise the investment decisions or activities of these companies or judge the merits of their investments. Most hedge funds have substantial investments in securities that would cause them to fall within the definition of investment company under the Investment Company Act. Hedge funds, however, typically rely on one of two statutory exclusions from the definition of investment company, which enables them to avoid the regulatory provisions of that Act.

Section 3(c)(1) Exclusion

Section 3(c)(1) of the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities are beneficially owned by not more than 100 investors and which does make a public offering of its securities. Hedge funds relying on Section 3(c)(1) may not make a public offering. These hedge funds must comply with Section 4(2) of the Securities Act, and frequently do so by relying on the safe harbor available under Regulation D under that Act. Consequently, hedge funds may offer their securities only to accredited investors, and may not engage in any general solicitation or general advertising of their shares.

Section 3(c)(7) Exclusion

Section 3(c)(7) of the Investment Company Act excludes from the definition of investment company any issuer whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are qualified purchasers, and which is not making a public offering of its securities. A hedge fund relying on Section 3(c)(7) may accept an unlimited number of qualified purchasers for investment in the fund. As a practical matter, however, most funds relying on Section 3(c)(7) have no more than 499 investors in order to avoid the registration and reporting requirements of the Securities Exchange Act of 1934 (Exchange Act).

Section 3(c)(7) Qualified Purchasers

Section 2(a)(51) of the Investment Company Act generally define qualified purchaser to be: (1) any natural person who owns not less than $5 million in investments; (2) any family-owned company (as described in that section) that owns not less than $5 million in investments; (3) any other trust the trustee and settlor(s) of which are qualified purchasers that was not formed for the specific purpose of acquiring the securities of the Section 3(c)(7) fund; and (4) any person acting for its own account or the accounts of other qualified purchasers, that owns and invests on a discretionary basis not less than $25 million in investments.

Offerings to Accredited Investors

The safe harbor protection most often relied upon by hedge funds under Rule 506 exempts offerings that are made exclusively to accredited investors. While Rule 506(b)(2)(i) limits the number of purchasers in a Rule 506 transaction to 35, this numerical limitation becomes irrelevant if the offering is made only to accredited investors because Rule 501(e)(1)(iv) provides that accredited investors are not counted for purposes of determining whether the issuer has exceeded the 35-purchaser limit. Issuers are permitted under these provisions to sell securities to an unlimited number of accredited investors. In addition, if the offering is made only to accredited investors, no specific information is required to be provided to prospective investors.