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Section 1061 Updates to Partnership Agreements

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Venture Capital, Private Equity & Real Estate Funds.

In anticipation of the March 15, 2023, filing deadline for partnership tax returns, we recommend that clients assess whether their fund partnership agreements are current regarding the implications of Section 1061 of the Internal Revenue Code (Section 1061). Section 1061 largely took effect on January 1, 2022, and was introduced as part of the 2017 Tax Cuts and Jobs Act in an effort to limit the favorable tax treatment afforded to some recipients of performance allocations or carried interest.

Under Section 1061, the holding period for certain applicable partnership interests (APIs) acquired in connection with the performance of substantial services was extended from one year to three years. This generally means that if a fund’s general partner holds an API for less than three years—or the API relates to an asset that has been held for less than three years—any resulting capital gains may be subject to recharacterization as short-term capital gains. Notably, however, the three-year extended holding period does not apply to capital gains and losses allocated to a holder of a capital interest when the right to share in profits is commensurate with the holder’s capital contributions (Capital Interest). In other words, Section 1061 generally does not apply to a general partner’s capital contributions and reinvested gains.

As a result, we recommend that fund general partners confirm their fund partnership agreements create separate accounts for tracking Capital Interests and performance allocations or carried interest. Additionally, fund general partners should confirm with their fund administrators that separate accounts for Capital Interests and performance allocations or carried interest are being maintained in the fund’s books and records. Absent such separate tracking, fund general partners run the risk of Section 1061 applying to their entire capital account regardless of the source of gains and losses. Please note that any such updates to fund partnership agreements should be made prior to March 15, 2023.

We encourage you to reach out to us if you would like for us to review your fund partnership agreement to assess whether it needs to be amended to address Section 1061. If you would like our assistance, feel free to reach out directly to Kevin Cott at kevin@cottlawgroup.com.

Year-End Client Letter

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

As we turn the page on 2022, we would like to highlight the following legal, regulatory and business matters that may affect you or your clients heading into the new year. As always, feel free to reach out to us should you have any questions.

Investment Advisers and Exempt Reporting AdvisersAnnual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA should also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, are due to the IARD by December 12, 2022.  Please visit www.iard.com for more information.

Form PF. An investment adviser must file Form PF if it (i) is registered or required to be registered with the SEC; (ii) advises one or more private funds; and (iii) has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders that have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

SEC Matters

New SEC Investment Adviser Marketing Rules are Now in Full Effect. The SEC’s new marketing rules took effect on November 4, 2022. As of that date, RIAs are no longer permitted to choose to comply with the previous advertising and cash solicitation rules.

Broadly, the new marketing rules include updates to (i) the definition of an advertisement; (ii) generally prohibited advertising practices; (iii) the parameters for including testimonials, endorsements and third-party ratings; and (iv) the parameters for including performance results. The SEC also amended the books and records rules to require investment advisers to maintain records of certain advertisements, as well as amended Form ADV to require advisers to disclose their marketing practices.

On September 19, 2022, the SEC released guidance regarding how examinations will focus on the new marketing rules. Specific areas of review will include whether advisers have (i) adopted and implemented written policies and procedures designed to prevent violations of the new rules; (ii) a reasonable basis for believing they can substantiate material statements of fact in advertisements; (iii) complied with the new rules regarding performance advertising; and (iv) followed the amendments to the books and records requirements and accurately completed the new portion of Form ADV relating to the marketing rules.

The new portion of Form ADV was added to Item 5 of Part 1A.

SEC Proposes Significant Changes in Private Fund Regulation. On February 9, 2022, the SEC proposed new rules and regulations under the Investment Advisers Act of 1940 applicable to both SEC-registered and unregistered private fund advisers. The intent of the proposed rules is to require fund managers “to provide transparency to their investors regarding the full cost of investing in private funds and the performance of such private funds.”

See our full blog post with a summary of the proposed rules here. Generally, the proposed rules require annual audits and quarterly statements for RIAs (in lieu of the surprise examination option) and prohibit certain activities for SEC-registered and unregistered private fund advisers. Notably, one of the proposed prohibited practices involves the use of side letters that provide select fund investors with favorable terms. Under the proposed rules, these side letters would need to be disclosed to all prospective and current investors. The initial comment period for the proposed rules was set to end on April 25, 2022. The SEC later extended the comment period to June 13, 2022.

SEC Proposes Amendments to Form PF. On August 10, 2022 the SEC proposed amendments to Form PF in an effort to bolster the Financial Stability Oversight Council’s ability to assess systemic risk along with the SEC’s regulatory authority over fund managers and its investor protection efforts. Generally, the proposed amendments seek to (i) enhance reporting by large hedge fund advisers on qualifying hedge funds; (ii) enhance reporting on basic information about advisers and the private funds they advise; (iii) enhance reporting concerning hedge funds; (iv) amend how advisers report complex structures; and (v) remove aggregate reporting for large hedge fund advisers.

Notable to the digital asset space, the proposed amendments add a new sub-asset class for digital assets and include a definition for the term “digital asset.” The SEC specifically requested comments with respect to how digital assets should be categorized and disclosed. The comment period ended on October 11, 2022.

SEC Charges Advisory Firms for Custody Rule and ADV Violations. On September 9, 2022, the SEC issued a press release detailing charges against multiple investment advisers for failing to comply with SEC custody rules and/or failing to update the status of their audited financial statements on Form ADV. The firms ultimately agreed to pay civil penalties totaling more than $1 million. In detailing the charges, the SEC re-emphasized that RIAs managing private funds should ensure they are distributing audited financial statements to investors in a timely manner and updating their Form ADVs when audited financial statements are received. Specifically, the SEC noted that if an RIA checks “Report Not Yet Received” under Part 1A, Schedule D, Section 7.B.23 of its Form ADV, it must promptly file an amendment when the report is available. ERAs should also keep this in mind to the extent their funds are subject to an annual audit.

The charges follow an SEC settlement with another registered adviser in March for failing to maintain adequate policies and procedures regarding the custody rule and failing to deliver audited statements in a timely manner. RIAs managing private funds should review their policies and procedures to confirm they are currently compliant.

SEC Proposes New Requirements for Outsourced Services. On October 26, 2022, the SEC proposed new rules for RIAs that prohibit outsourcing certain functions without appropriate due diligence and monitoring of the service providers. The proposed rules apply to “covered functions,” which are functions or services that (i) are “necessary to provide advisory services in compliance with the Federal securities laws”; and (ii) “if not performed or performed negligently, would be reasonably likely to cause a material negative impact on the adviser’s clients or on the adviser’s ability to provide investment advisory services.” The proposed rules outline the due diligence procedures required before retaining a service provider to perform a “covered function” and require advisers to obtain reasonable assurances that third-party recordkeepers meet certain enumerated standards regarding their recordkeeping procedures. The SEC is currently accepting comments regarding the proposed rules until December 27, 2022.

Commodity Trading Advisors and Commodity Pool Operators

Annual Reaffirmation of CPO Exemption. Commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on an exemption from registration with the Commodity Futures Trading Commission (CFTC) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June and September, as well as within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements by filing Form PF by the Form CPO-PQR deadline.

CPO and CTA Annual Report Updates. Registered CPOs—including CPOs utilizing the CFTC Regulation 4.7 exemption—must distribute an Annual Report to each participant in each pool that they operate, as well as submit a copy of the Annual Report and key financial balances to the National Futures Association (NFA), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that has not been updated within the past 12 months.

CFTC and NFA Matters

CFTC Releases Enforcement Results for 2022. On October 20, 2022, the CFTC released its annual enforcement results for the fiscal year 2022. In total, the CFTC obtained orders imposing over $2.5 billion in payments and filed 82 enforcement actions. Notably, 18 of the CFTC actions involved digital assets. The digital asset-related actions largely involved either unregistered exchange activity or untrue/misleading statements made in connection with digital assets. The CFTC has general authority over most digital asset derivative transactions and has broad anti-fraud authority over spot digital asset transactions. The CFTC’s Division of Enforcement has a task force specifically dedicated to digital assets, and we expect to see the CFTC continue to prioritize bringing regulatory actions in the digital assets space.

CFTC Finds DAO Liable as an Unincorporated Association. On September 22, 2022, the CFTC filed an enforcement action in the U.S. District Court for the Northern District of California charging a decentralized autonomous organization (DAO) with illegally offering retail commodity transactions in digital assets. The CFTC alleged the DAO solicited customers for its software protocol that allowed users “to open leveraged positions whose ultimate value was determined by the price difference between two digital assets from the time the position was established to the time it was closed.” The CFTC classified these transactions as retail commodity transactions that were unlawful since they did not take place on a designated contract market.

The founders of the protocol transferred the protocol from a limited liability company to the DAO and then touted the DAO’s ability to avoid regulation. However, the CFTC stated that the DAO and its members should nevertheless be liable based on the existence of the DAO as an unincorporated association. The CFTC also filed an enforcement action against the original LLC and its founders. Significantly, the enforcement action and order demonstrate the CFTC’s willingness to go after DAOs and their participants. Fund managers should keep this regulatory risk in mind when investing in decentralized finance (DeFi) projects involving DAOs.

Digital Assets Matters

FTX Fallout. On November 11, 2022, FTX Trading Ltd. and its affiliates (FTX) filed for Chapter 11 bankruptcy protection in Delaware. The bankruptcy sent shockwaves through the crypto industry not seen since the Mt. Gox collapse in 2014. We are actively working with our clients impacted by FTX’s collapse to develop appropriate responses, from both a legal and a business operations standpoint. Although the collapse is a repeat of financial fraud as old as time rather than an indictment of blockchain technology and decentralization (it is arguably the opposite), it does shine a light on the need for clearer regulation. We continue to expect the SEC to emerge as the leading regulator of crypto exchanges and tokens and are monitoring potential legislative responses from Congress. Although there appears to be bipartisan support for certain reforms such as separating custody from trading platforms, unique challenges remain such as how to prevent non-US exchanges that may fall outside the US regulatory regime from interacting with US customers.

SEC Scales Up Crypto Enforcement Team. On May 3, 2022, the SEC announced it was nearly doubling its Crypto Assets and Cyber Unit in its Division of Enforcement from 30 to 50 dedicated positions. The expanded Crypto Assets and Cyber Unit is tasked with focusing on securities law violations related to crypto asset offerings, exchanges and lending products, as well as DeFi platforms, non-fungible tokens (NFTs) and stablecoins. The expansion of the SEC’s crypto enforcement arm is consistent with SEC Chair Gary Gensler’s sustained push to establish the SEC as crypto’s chief regulator of the asset class.

DOJ Charges Former OpenSea Employee in First Digital Asset Insider Trading Scheme. On June 1, 2022, the US Attorney’s Office for the Southern District of New York and the Federal Bureau of Investigation announced charges against a former product manager at OpenSea, the world’s largest NFT marketplace, for a scheme to commit insider trading. The OpenSea employee allegedly used confidential information regarding which NFTs were going to be featured on OpenSea’s homepage to invest ahead of the announcements. Interestingly, the DOJ elected to sidestep the issue of whether the underlying NFTs were securities by charging the defendant with wire fraud and money laundering.

SEC Charges Former Coinbase Manager with Insider Trading. On July 21, 2022, the SEC announced insider trading charges against a former Coinbase product manager and others for trading ahead of multiple announcements regarding tokens that were being added to the Coinbase trading platform. The SEC appeared to use the charges to regulate through enforcement by explicitly noting that many of the underlying tokens are securities. While the SEC has previously identified tokens as securities, those charges typically involved direct enforcement actions against an issuer. As SEC Division of Enforcement Director Gurbir Grewal noted, the case highlights the SEC’s focus on treating many tokens as securities regardless of label.

SEC Charges Influencer for Touting Token. On October 3, 2022, the SEC announced charges against Kim Kardashian for touting EthereumMax tokens on her Instagram account without disclosing that she was paid $250,000 to publish the post. Ms. Kardashian agreed to settle the charges, cooperate with the SEC’s ongoing investigation and pay $1.26 million in penalties, disgorgement and interest. In addition to reinforcing the SEC’s position that many tokens are securities offerings subject to federal securities laws, the charges and settlement were a highly publicized warning to celebrities and influencers to avoid promoting tokens on their social media accounts without disclosing compensation received from the token issuer.

Additional Compliance Matters

Verification of New Issues Status. Fund managers must conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed using negative consent letters.

Annual Audited Financial Statements. RIAs that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

Annual Compliance Review. RIAs should review their compliance program annually. The annual review should evaluate, at a minimum, the firm’s Code of Ethics, privacy policy, marketing policies, recordkeeping procedures, the Business Continuity plan, trading restrictions, trading practices, conflicts of interest, ERISA disclosures and compliance violation procedures.

Each RIA must also provide its investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment. When amending Form D, the fund should review the entire form and ensure all information is up to date.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements.

If you require assistance with any of the above items, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com. As always, we appreciate your continued business and support. From all of us at Cott Law Group, we wish you a happy and healthy New Year.

Proposed Rule Changes for Private Fund Advisers

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On February 9, 2022, the Securities and Exchange Commission (SEC) proposed new rules (Proposed Rules) under the Investment Advisers Act of 1940 (Advisers Act) that, if adopted, would significantly impact private fund advisers. Below is a high-level summary of the Proposed Rules and their potential impact on affected advisers.

Annual Audit Requirement

The Proposed Rules would require SEC-registered advisers to obtain annual audited financial statements for each private fund they advise. Fund auditors would also be required to promptly notify the SEC if a modified opinion is issued or the auditor’s engagement is terminated.

Notably, the audit requirement under the Proposed Rules is a separate and distinct requirement from custody requirements pursuant to Rule 206(4)-2 under the Advisers Act, i.e. the Proposed Rules do not permit advisers to elect a surprise examination in lieu of an audit.

Quarterly Statements

Under the Proposed Rules, SEC-registered advisers would be required to provide quarterly account statements to investors in each private fund they advise. The statements would need to be presented in a standardized format that includes a “detailed accounting” of specific fee and expense disclosures, portfolio investment compensation paid to the adviser or its affiliates, standardized fund performance information based on the type of fund (i.e. “liquid” vs. “illiquid”), etc. The statements would need to be provided within 45 days of the end of each calendar quarter.

Prohibited Activities

The Proposed Rules would prohibit both SEC-registered and unregistered advisers from certain activities with respect to private funds, including the following:

  • Providing preferential treatment to certain investors via side letter agreements (Side Letters) with respect to redemption rights or access to information regarding portfolio holdings or exposures, if the adviser reasonably expects such preferential treatment would have a material, negative effect on other investors (although not outright prohibited, certain other preferential terms—including fee discounts and additional investment rights—would need to be disclosed in writing to prospective and current investors);
  • Reducing clawbacks of carried interest paid to the adviser to be net of taxes;
  • Reimbursing, indemnifying or limiting the liability of the adviser for breaches of fiduciary duties, willful misfeasance, bad faith, recklessness or negligence in providing services to a private fund;
  • Charging private funds for accelerated monitoring fees, costs related to examinations or investigations of the advisers or adviser regulatory and compliance costs;
  • Borrowing funds from a private fund; and
  • Allocating costs related to portfolio investments held by multiple funds and/or co-investment vehicles on a non-pro rata basis.

With respect to the prohibited activities in connection with Side Letters, the lack of a “grandfathering” provision would be uniquely challenging for existing advisers affected by the Proposed Rules; such advisers would effectively have to choose between complying with the Proposed Rules or breaching a previously granted Side Letter provision.

A public comment period regarding the Proposed Rules will remain open for 60 days following publication on the SEC website or 30 days following publication in the Federal Register, whichever is longer. The Proposed Rules would mark a landmark shift in SEC regulation of private fund advisers, and we will continue to monitor any related developments. Should you have any questions regarding this alert or the Proposed Rules in general, feel free to contact Kevin Cott at kevin@cottlawgroup.com.

Year-End Client Letter

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

As we turn the page on 2021, we would like to highlight the following legal, regulatory and business matters that may affect you or your clients heading into the new year. As always, feel free to reach out to us should you have any questions.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV. Each registered investment adviser (RIA) and exempt reporting adviser (ERA) must file an annual updated amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA should also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for Securities and Exchange Commission (SEC) and state RIAs, as well as SEC ERAs, were due to the IARD by December 13, 2021.  Please visit www.iard.com for more information.

Form PF. An investment adviser must file Form PF if it (i) is registered or required to be registered with the SEC; (ii) advises one or more private funds; and (iii) has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Form 13H Amendments. All large traders who have made a Form 13H filing with the SEC are required to submit an annual filing within 45 days of the end of each calendar year.

New Rules for New York Investment Adviser Representatives. Prior to February 1, 2021, New York did not require investment adviser representatives, principals, supervisors or solicitors (IARs) to register with the state. Effective as of February 1, 2021, IARs representing a New York RIA or SEC RIA with a New York place of business are required to register. Absent a waiver, IARs must either pass the Series 65 exam or a combination of the Series 7 and Series 66 exams within 2 years prior to filing for registration. IARs were generally required to register by August 31, 2021, absent certain exemptions.

SEC Matters

SEC Increases Qualified Client Thresholds. On June 17, 2021, the SEC adopted amendments to the definition of “qualified client” under the Securities Act of 1933. The amendments increased the dollar amount thresholds for the “assets-under-management” test and the “net worth” test, respectively, from $1 million to $1.1 million and from $2.1 million to $2.2 million. Adjustments to the net worth and assets-under-management thresholds are made every five years to account for inflation.

The amendments became effective on August 16, 2021, and do not apply retroactively to contractual relationships entered prior to the effective date. Advisers to separately managed accounts and/or private funds relying on Section 3(c)(1) of the Investment Company Act of 1940 should review and update their investment advisory contracts and/or offering documents to reflect the new thresholds. Further details regarding the amendments can be found here.

SEC Adopts Modernized Marketing Rule for Investment Advisers. On December 22, 2020, the SEC adopted amendments to Rule 206(4)-1 under the Advisers Act to create a single, consolidated rule (Marketing Rule) that replaced separate advertising and cash solicitation rules. The Marketing Rule represents a significant overhaul of adviser marketing rules with a stated goal of shifting to “principles-based provisions designed to accommodate the continual evolution and interplay of technology and advice.” Among other changes, the Marketing Rule: (i) expands the scope of which communications, materials and activities are considered “advertisements”; (ii) replaces the per se violations of the Advisers Act with a more flexible, principles-based approach (potentially granting advisers the ability to use marketing materials in certain circumstances that include specific recommendations, testimonials, third-party ratings, etc.); and (iii) allows the use of hyperlinks and layered disclosures under certain conditions.

Advisers should reevaluate all methods by which they currently communicate with current and prospective clients, including their current marketing materials, solicitation arrangements, recordkeeping practices and social media policies. The Marketing Rule became effective on May 4, 2021, but advisers have until November 4, 2022, to comply with the new rule. More information regarding the Marketing Rule and the current transition period can be found here.

Commodity Trading Advisors and Commodity Pool Operators

Annual Reaffirmation of CPO Exemption. Commodity pool operators (CPOs) and commodity trading advisors (CTAs) relying on an exemption from registration with the Commodity Futures Trading Commission (CFTC) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Form CPO-PQR and Form CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September, and within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and the CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, such advisers must file Form PF by the Form CPO-PQR deadline.

CPO and CTA Annual Report Updates. Registered CPOs, including CPOs utilizing the CFTC Regulation 4.7 exemption, must distribute an Annual Report to each participant in each pool that they operate, as well as submit a copy of the Annual Report and key financial balances to the National Futures Association (NFA), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

CPOs should also check the date of the most recent disclosure document of each pool they operate. CPOs are generally prohibited from soliciting clients with a disclosure document that is more than 12 months old.

CFTC and NFA Matters

Changes to Form CPO-PQR. As of the March 31, 2021, reporting date, the CFTC has revised and streamlined Form CPO-PQR. The revised Form CPO-PQR now has one schedule (Schedule A), and all reporting CPOs must file the revised Form CPO-PQR every quarter, regardless of size. The CFTC has also attempted to make the form more user-friendly.

CFTC Establishes Climate Risk Unit. On March 17, 2021, Acting CFTC Chairman Rostin Behnam announced the establishment of the Climate Risk Unit (CRU). The CRU will assess the efficacy of derivatives products in addressing climate-related risks in the financial system. As part of its mission, the CRU will represent the CFTC in industry discussions to reduce carbon emissions worldwide. The CRU also intends to facilitate dialogue regarding emerging climate risks, aid in the development of new “net-zero” products, support development of climate-related market risk data and evaluate effectiveness of other tools in accelerating products and services that promote climate-friendly practices.

New Notice Requirements for CPOs. Effective as of June 30, 2021, CPOs are subject to newly adopted NFA Compliance Rule 2-50 (Rule 2-50). Rule 2-50 requires CPOs to report the following occurrences to the NFA with respect to each commodity pool they operate: (i) the inability to fulfill its obligations to investors or an unplanned liquidation of the pool; (ii) the inability to meet margin calls; (iii) the inability to make redemptions in accordance with subscription agreements; (iv) freezing redemptions in preparation for ceasing operations; and (v) receiving notice from a counterparty that the pool is in default. All pools operated by a CPO—including pools relying on the CFTC Regulation 4.13(a)(3) de minimis exemption—are subject to Rule 2-50. The NFA released Interpretive Notice 9080 to provide examples of when notice is not required (e.g., if a CPO reasonably expects to meet the margin call within the time prescribed by its Futures Commission Merchant (FCM)).

NFA Updates Branch Office Inspection Requirement and Physical Examination Requirement. In light of the pandemic, the NFA released a notice to allow Members who were temporarily working from home to exempt their home office from the definition of a “branch office.” The notice, released in March 2021, was made permanent starting September 23, 2021. In NFA Interpretive Notice 9002, the definition of a “branch office” was revised to exclude “any location where one or more associated persons (APs) from the same household live or rent/lease (e.g., a shared or co-workspace).”

The exemption for home offices was not the only change caused by the pandemic. Through the end of 2021, Members are allowed to conduct their annual inspection of each branch office remotely. While the annual inspection is still required, the ability to do so virtually is in line with current public health policies. The NFA will also allow Members to conduct virtual inspections of branch offices in 2022, if appropriate given applicable risks.

Financial Industry Regulatory Authority (FINRA) Matters

FINRA Amends Rules 5122 and 5123 to Include Retail Communications. Effective October 1, 2021, FINRA amended Rules 5122 and 5123 to expand the filing requirements of broker dealers. Under the previous versions of the rules, member firms were required to file any private placement memorandum (PPM), term sheet or other offering documents used in connection with a private placement offering. Under the amended rules, such firms are also required to file any “retail communications” used in connection with private placement offerings (e.g., pitchbooks, slide presentations, fact sheets). The amended rules effectively formalize a common practice—most broker dealers have historically filed such retail communications simultaneously alongside the required PPMs or term sheets.

Digital Assets Matters

El Salvador Adopts Bitcoin as Legal Tender. On September 7, 2021, EL Salvador became the first country to adopt Bitcoin as legal tender. With the change, each company in El Salvador became required to accept Bitcoin as payment, and each citizen was gifted $30 in Bitcoin for utilizing the government’s e-wallet. President Nayib Bukele hoped the adoption of Bitcoin would stimulate the country’s economy in part by reducing transaction costs and increasing efficiency in international transactions. El Salvador remains the only country to adopt such a policy.

Rulemaking Petition Sent to SEC on Non-Fungible Tokens (NFTs). On April 12, 2021, Arkonis Capital, a registered broker dealer, submitted a rulemaking petition to the SEC requesting guidance on NFTs. In the petition, Arkonis posits scenarios under which an NFT may be deemed a “security”. They also argue that if an NFT relates to an existing asset and is marketed as a collectible with a public assurance of authenticity on the blockchain, it should not be considered a security.

Arkonis further states that should the SEC deem an NFT to be a security, the platform facilitating the sale and/or trading of such NFT could be required to register with the SEC as an exchange. Given these regulatory implications, Arkonis petitioned the SEC to publish guidance regarding when an NFT is a security and the resulting registration requirements. As of December 2021, the SEC has not released the requested guidance.

SEC Chair Gensler Discusses the Regulation of Cryptocurrency Under Existing Authorities. On September 14, 2021, Gary Gensler, the SEC Chair, testified before the Senate Banking Committee regarding the SEC’s authority to regulate the cryptocurrency market. During the testimony, Gensler responded to questions about gaps in the current regulatory regime by stating the SEC and the CFTC have “a great deal of authority” with regard to digital assets and “a great deal of clarity” in determining which digital assets meet the definition of a security. The gaps, he clarified, exist in the coordination amongst the different regulatory agencies—specifically, the SEC, the CFTC and the banking agencies.

Gensler also testified in October before the House Committee on Financial Services regarding cryptocurrency regulation. When asked about whether certain cryptocurrencies are securities, Gensler declined to comment on any specific token and reiterated that any token that passes the Howey Test is a security. Specifically, he stated “[T]he securities laws are quite clear. If you’re raising money from somebody else, and the investing public has a reasonable anticipation of profits based on the efforts of others, that fits within the securities law.”

First Bitcoin Futures ETF Launches. On October 18, 2021, ProShares launched the Bitcoin Strategy ETF, the first Bitcoin-focused exchange traded fund listed on a national exchange. Trading under “BITO”, the fund does not directly invest in Bitcoin but provides exposure to Bitcoin futures contracts. As of November 11, 2021, BITO had net assets of over $1.4 billion. Two other national Bitcoin futures ETFs launched shortly after the launch of BITO.

SEC Rejects Spot Bitcoin ETF. On November 12, 2021, the SEC rejected a proposed rule change to list shares of the VanEck Bitcoin Trust on the Cboe BZX Exchange. In its rejection, the SEC stated that the exchange did not meet its burden as a national securities exchange under the Securities Exchange Act of 1934 “to prevent fraudulent and manipulative acts and practices” and “to protect investors and the public interest.” The ruling is consistent with past statements from SEC Chair Gensler and other SEC actions demonstrating a preference for Bitcoin futures ETFs over spot Bitcoin ETFs.

Coinbase Files for Futures and Derivatives Trading. On September 16, 2021, Coinbase confirmed that it filed an application with the NFA to register as an FCM. As an FCM, Coinbase would be able to offer cryptocurrency futures and derivatives trading to U.S. persons on its platform. The application is still pending.

Ripple Lawsuit. In December 2020, the SEC sued Ripple Labs Inc. and two of its executives for allegedly conducting a $1.3 billion unregistered securities offering for XRP, its token. The SEC claims that XRP is a security because it was distributed by Ripple in a centralized manner and represents an investment in the company. Ripple disputes these claims, asserting that the SEC failed to release proper guidance on digital asset regulation and is attempting to utilize an outdated regulatory scheme on a novel industry. The Ripple case is ongoing, and its outcome could significantly affect the digital asset industry in the U.S.

SEC Fines Poloniex for Operating Unregistered Digital Asset Exchange. On August 9, 2021, the SEC announced that Poloniex LLC agreed to pay more than $10 million to settle charges of operating an unregistered digital asset exchange. The order states that Poloniex’s platform facilitated buying and selling digital assets, including digital assets that met the definition of a security. While operating the exchange, Poloniex instituted an internal review mechanism where it determined how likely certain digital assets were to be deemed securities. However, the SEC stated that Poloniex offered the ability to trade digital assets that were at “medium risk” under Poloniex’s policy and, as a result, certain digital assets meeting the definition of a security were available to trade on the platform.  This case reinforces the SEC’s authority over the digital asset industry, but the SEC did not go into detail on which specific digital assets met the definition of a security. 

CFTC Fines Kraken for Offering Margin Trading in the U.S. On September 28, 2021, the CFTC issued an order settling charges against Payward Ventures, Inc. d/b/a Kraken for illegally offering margined retail commodity transactions in digital assets and failing to register as an FCM. From June 2020 to July 2021, Kraken allowed customers to purchase digital assets (including Bitcoin) using margin. The CFTC found that “actual delivery” of the underlying assets did not occur, meaning the transactions met the definition of “retail commodity transactions.” Such transactions fall under the CFTC’s jurisdiction and are treated similarly to traditional futures contracts. The CFTC found the transactions to be unlawful because they did not take place on a designated contract market and Kraken acted as an unregistered FCM by soliciting and accepting the transactions.

BitMEX Moves All Operations Offshore as Remedial Measures in CFTC Action. On August 10, 2021, the CFTC announced that a U.S. district court entered a consent order against five companies that operated the BitMEX cryptocurrency derivatives trading platform. The order required BitMEX to pay a $100 million civil monetary penalty. As part of its remedial measures, BitMEX no longer maintains any substantive operations or business functions in the U.S. BitMEX also certified to the CFTC that anyone located in the U.S. is prohibited from accessing the platform. BitMEX’s remedial measures places it in line with other platforms offering digital asset derivative transactions solely outside the U.S.

Additional Compliance Matters

Verification of New Issues Status. Fund managers must conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed using negative consent letters.

Annual Audited Financial Statements. RIAs that manage private funds are generally required to distribute audited financial statements to each fund investor within 120 days of each year-end.

Annual Compliance Review. RIAs should review their compliance program annually. The annual review should evaluate, at a minimum, the firm’s Code of Ethics, privacy policy, marketing policies, recordkeeping procedures, the Business Continuity plan, trading restrictions, trading practices, conflicts of interest, ERISA disclosures and compliance violation procedures.

Each RIA must also provide its investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment. When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any applicable state renewal requirements. Note that issuers selling securities in New York in reliance on an exemption under Regulation D are required to file Form D and pay related filing fees through the Electronic Filing Depository. As of February 1, 2021, New York does not accept any Form 99 submissions and no longer requires issuers to file a notarized Form U-2.

Regulatory Alert: SEC Expands Definition of Accredited Investor

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On August 26, 2020, the U.S. Securities and Exchange Commission (“SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933. As previously covered, the amendments expand the definition of an accredited investor in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Notably, the updated definition of an accredited investor will allow more investors to participate in hedge funds and other alternative investment funds by adding new categories of qualifying natural persons and entities. The amendments became effective on December 8, 2020 and can be viewed here.

Below is a summary of key changes to the definition of an accredited investor included in the amendments:

  1. Credentialed Individuals. Individuals may now qualify as accredited investors based on certain professional certifications, designations or credentials. Initially, the SEC designated the Series 7, Series 65 and Series 82 licenses as qualifying credentials. The SEC may add other qualifying credentials pursuant to future orders.
  2. Knowledgeable Employees. “Knowledgeable employees”, as defined in Rule 3c-5(a)(4) under the Investment Company Act of 1940 (“Company Act”), of private investment funds will be deemed accredited investors when making investments in such funds. Notably, expanding the definition of an accredited investor to include knowledgeable employees will allow funds with assets of $5 million or less to permit such employees to invest in the funds without jeopardizing the fund’s status as an accredited investor (i.e., an entity in which all equity owners are accredited investors).
  3. Additional Entities. An accredited investor now includes SEC- and state-registered investment advisers, exempt reporting advisers, rural business investment companies and limited liability companies with more than $5 million in assets. The new definition also adds a category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that (i) own “investments,” as defined in Rule 2a51-1(b) under the Company Act, in excess of $5 million; and (ii) that was not formed for the specific purpose of investing in the securities offered.
  4. Family Offices. Certain “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act of 1940, will now qualify as accredited investors.
  5. Spousal Equivalents. Spousal equivalents may now pool their finances for the purpose of qualifying as accredited investors. The SEC specifically noted that spousal assets do not need to be held jointly to be included in the pooled finances calculation.

Private investment funds and other issuers that currently rely on Regulation D of the Securities Act to offer securities to investors should work with legal counsel to amend their subscription documents and offering materials to reflect the updated definition of an accredited investor. If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Approves Modernizing Amendments to Accredited Investor Definition

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On August 26, 2020, the U.S. Securities and Exchange Commission (the “SEC”) adopted amendments to the definition of “accredited investor” under the Securities Act of 1933 (the “Act”). The SEC proposed the amendments on December 18, 2019 in an effort to more effectively identify institutional and individual investors that have the knowledge and expertise to participate in private capital markets. Ultimately, the updated definition allows more investors to participate in private offerings by adding new categories of natural persons and entities that may qualify as accredited investors.

The SEC’s press release on the amendments and the full text of the final rule can be found here.  In addition, our previous blog post discussing the proposed amendments in detail can be found here.

Below is a summary of the amendments to the accredited investor definition as provided by the SEC. The amendments are set to become effective 60 days after publication in the Federal Register.

The amendments to the accredited investor definition in Rule 501(a) of the Act:

  1. Add a new category to the definition that permits natural persons to qualify as accredited investors based on certain professional certifications, designations or credentials or other credentials issued by an accredited educational institution, which the SEC may designate from time to time by order. In conjunction with the adoption of the amendments, the SEC designated by order holders in good standing of the Series 7, Series 65, and Series 82 licenses as qualifying natural persons.  This approach provides the SEC with flexibility to reevaluate or add certifications, designations, or credentials in the future.  Members of the public may wish to propose for the SEC’s consideration additional certifications, designations or credentials that satisfy the attributes set out in the new rule;
  2. Include as accredited investors, with respect to investments in a private fund, natural persons who are “knowledgeable employees” of the fund;
  3. Clarify that limited liability companies with $5 million in assets may be accredited investors and add SEC- and state-registered investment advisers, exempt reporting advisers, and rural business investment companies (RBICs) to the list of entities that may qualify;
  4. Add a new category for any entity, including Indian tribes, governmental bodies, funds, and entities organized under the laws of foreign countries, that own “investments,” as defined in Rule 2a51-1(b) under the Investment Company Act, in excess of $5 million and that was not formed for the specific purpose of investing in the securities offered;
  5. Add “family offices” with at least $5 million in assets under management and their “family clients,” as each term is defined under the Investment Advisers Act; and
  6. Add the term “spousal equivalent” to the accredited investor definition, so that spousal equivalents may pool their finances for the purpose of qualifying as accredited investors.

If you have any questions regarding the amendments to the accredited investor definition, please do not hesitate to contact Kevin Cott at kevin@cottlawgroup.com.

SEC Proposes Updates to Accredited Investor Definition

Written by Kevin Cott on . Posted in Digital Assets & Cryptocurrency Funds, Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

On December 18, 2019, the U.S. Securities and Exchange Commission (the “SEC”) issued a press release highlighting proposed amendments to the definition of an “accredited investor” under the Securities Act of 1933 (the “Act”). We expect private fund managers to embrace the proposed changes, as the amendments seek to permit more investors to participate in private capital markets by including new categories of qualifying natural persons and entities and solidifying previous interpretive positions held by the SEC. Below is a short summary of the notable proposed additions to the definition. The SEC’s full press release and the complete proposal can be found here.

  1. Professional Certificates and Knowledgeable Employees of a Fund

The proposed definition will add two new categories applicable to individual investors. First, the new definition will allow natural persons who hold professional certifications to be considered accredited investors regardless of their financial condition. The SEC states in the proposal that it expects this category will initially include holders of Series 7, 65, or 82 licenses but mentions holders of other degrees and certifications (CFA, CPA, MBA) as possible inclusions as well.

Second, the new definition will include a specific carve out for “knowledgeable employees” of a private fund. The carve out will be similar to the current category for directors, executive officers, or general partners of the issuer but will apply more broadly to include knowledgeable employees as currently defined in Rule 3c-5 of the Act.

  1. Registered Investment Advisors, RBICs, and LLCs

While the current definition of accredited investor includes various entity types, the SEC is seeking to add three additional entity types that it feels are sophisticated enough to be considered accredited. Specifically, the SEC is proposing to add state and SEC registered investment advisers, approved rural business investment companies (as defined in the Consolidated Farm and Rural Development Act), and certain limited liability companies.

The inclusion of certain LLCs is of particular note because the current definition does not specifically refer to LLCs. Under the new definition, the SEC will add LLCs to the list of entities that are considered accredited as long as they have total assets in excess of $5 million and were not formed for the specific purpose of acquiring the securities being offered.

  1. Certain Family Offices and Family Clients

The SEC is also proposing a new category of accredited investors that includes any “family office” with at least $5 million in assets under management and its “family clients,” as those terms are defined under the Advisers Act. The SEC is also proposing that the family office must not be formed for the specific purpose of acquiring the securities offered and that the family office be directed by a person with the requisite knowledge and experience in financial and business matters to ensure the family office is capable of evaluating the merits and risks of the prospective investment.

As justification for the addition, the SEC believes that these family offices have the minimum amount of assets under management to sustain the risk of loss and that the additional requirements will safeguard against improper reliance. The SEC generally expects all family offices to be accredited under the new definition.

  1. Entities Owning at Least $5 Million in Investments

In addition to including the enumerated entities above, the SEC is also proposing a catch-all category that will allow any entity owning investments in excess of $5 million that is not formed for the specific purpose of acquiring the securities being offered to be deemed accredited. This new category is meant to include all existing entity forms not already contemplated by the current definition, such as Indian tribes or governmental bodies.

  1. Codification of SEC Interpretations of the Current Rule

As part of the proposed definition, the SEC is codifying certain existing interpretations of the current definition. Of note, the SEC will codify two important interpretations applying to entities owned solely by accredited investors and individuals pooling combining finances with spousal equivalents.

The current definition of accredited investor includes any entity in which all the equity owners are accredited investors. However, the definition does not state whether one should look through any underlying entities that are not natural persons. Consistent with the SEC’s existing interpretation of the current definition, the proposed definition specifically states that one may look through any equity owners that are entities to the ultimate natural person owners.

The current definition allows “spouses” to pool together their finances to meet the relevant thresholds. However, the definition does not explicitly extend to spousal equivalents such as domestic partnerships or civil unions. Consistent with its current interpretation, the SEC is proposing this amendment because it sees no reason to distinguish between these types of relationships and believes that the new definition will remove any unnecessary barriers to investment opportunities for spousal equivalents.

Private Lending Funds: When is a note a security?

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance.




With significant growth in the hard money lending industry in recent years, many sponsors of private lending funds have requested guidance regarding whether the underlying loans and other debt instruments in such funds are considered “securities” under the Securities Act of 1933 (“Securities Act”), the Investment Company Act of 1940 (“ICA”) and the Investment Advisers Act of 1940 (“Advisers Act”) (collectively, “Acts”).  Below is a general overview of what types of notes fall under the purview of the Acts.

Each of the Acts contains an identical definition of what constitutes a security, including “any note” and “evidence of indebtedness.” A common misconception is that all investment instruments are similarly categorized for the purposes of the Securities Act, the ICA and the Advisers Act. However, the SEC and the Supreme Court have taken the position that the scope of the term “security” varies under each Act. Because the Acts are generally targeted toward separate entities and intended to achieve different objectives, instruments deemed not to be securities for purposes of one Act may be regarded by the SEC as securities for the purposes of another Act. Ultimately, whether the underlying loans purchased or originated by a private lending fund are deemed securities can have far-reaching impacts on the fund and its sponsor, including investment adviser registration requirements for the sponsor and the number of investors that can be admitted to the fund.

Securities Act of 1933

For the purposes of the Securities Act, the Supreme Court held in Reves v. Ernst & Young that every note is presumed to be a security, but that presumption can be rebutted by showing that the note bears a strong resemblance to a judicially crafted list of notes that are presumed not to be securities. Included in this list of non-securities are:

  1. note delivered in consumer financing
  2. note secured by a mortgage on a home
  3. short-term note secured by a lien on a small business or some of its assets
  4. note evidencing a character loan to a bank customer
  5. short-term note secured by an assignment of accounts receivable
  6. note which formalizes an open-account debt incurred in the ordinary course of business

While the Supreme Court did not elaborate on the scope of each of these categories, it did adopt a “family resemblance” test which is a purpose-based approach to determining whether an investment instrument closely resembles one of the judicially-crafted family of instruments that are not considered securities. The family resemblance test asks the following questions to assist in making the determination if the context and purpose of an instrument closely resembles a category of notes from the list:

  1. Is the purpose of the debt transaction to raise money for the general use of a business enterprise or to finance substantial investments and is the purchaser motivated primarily by the profit the notes are expected to generate for the business?
  2. Does the issuer’s plan of distribution seek to establish some form of common trading in the notes, either for speculative or investment purposes?
  3. Is there a reasonable public expectation that the instruments should be treated as “securities”?
  4. Is there some mitigating factor such as the existence of another regulatory scheme that sufficiently protects investors, thereby rendering strict application of securities laws unnecessary?

Based on the judicially crafted family of notes, particularly the first two examples, and the family resemblance test, it is likely that the Supreme Court would hold that hard money loans backed by mortgages, for example, would not be considered securities.

The Securities Act diverges from the ICA and the Advisers Act by including exceptions to the definition of securities.  For example, the Securities Act states that any note with a maturity date of less than nine months is presumed not to be a security. However, the ICA and the Advisers Act do not contain such a presumption. Therefore, under the Securities Act, notes with a term of less than nine months are presumed not to be securities, whereas under the ICA and the Advisers Act, such notes must overcome a presumption that they are securities in order to be exempt from the regulations of those Acts. The various notes that are presumed not to be securities under the Securities Act demonstrates the narrower scope of the definition of securities under the Securities Act than that of the ICA and Advisers Act.

Investment Company Act of 1940

Hard money loans are lending instruments in which a lender offers funds to a borrower in exchange for a promissory note secured by the borrower’s assets, typically real estate. It has been established that all promissory notes are securities under the ICA. Because the Supreme Court issued the list of non-security notes based on its interpretation of the Securities Act, we cannot be certain whether the Supreme Court or the SEC would hold this list of notes to be securities under the ICA or the Advisers Act.

Additionally, promissory notes with a maturity date of less than nine months do not contain the presumption that they are not securities under the ICA. Therefore, promissory notes of any term can be deemed securities and the fund issuing promissory notes may be subject to the ICA.

Assuming hard money loans are deemed securities under the ICA, a private lending fund can be structured in a way that exempts it from being considered an investment company under Sections 3(c)(1), 3(c)(7) or 3(c)(5) of the ICA.

Section 3(c)(1) of the ICA provides an exemption from the definition of an investment company for private offerings “whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 persons.” Essentially, to avoid being considered an investment company, the lending fund can be offered to no more than 100 persons, accredited or non-accredited, and comply with advertising restrictions, such as not advertising details of the fund to the public. Section 3(c)(7) also provides an exemption for private funds and requires that the outstanding securities are owned exclusively by “qualified purchasers.”

Section 3(c)(5) of the ICA offers an exemption to registration for issuers primarily engaged in acquiring mortgages and similar real estate interests. Specifically, Section 3(c)(5)(C) provides that “any person who is primarily engaged in purchasing or otherwise acquiring mortgages and other liens on and interests in real estate” is not an investment company. Therefore, a lender of hard money loans backed by mortgages would likely not be subject to the ICA. This exemption is often the most utilized by lending funds because it does not impose other restrictions, such as investor type or count limits and advertising rules.

However, for a lender to qualify for the 3(c)(5)(C) exemption, they cannot issue redeemable securities, face-amount certificates of the installment type, or periodic payment plan certificates. Because a lender cannot issue redeemable securities under this exemption, the lender must be structured as a closed-end fund to qualify for the exemption. The lender must also satisfy the “Asset Composition Test.” The Asset Composition Test requires:

  1. at least 55% of its assets consist of “mortgages and other liens on and interests in real estate” (called “qualifying interests”) and the remaining 45% of its assets consist primarily of “real estate-type interests”;
  2. at least 80% of its total assets consist of qualifying interests and real estate-type interests; and
  3. no more than 20% of its total assets consist of assets that have no relationship to real estate.

Investment Advisers Act of 1940

While the SEC has not issued formal guidance as to whether it would take a similar position as it does with the ICA with respect to the Advisers Act and default to all promissory notes being deemed securities, the Bureau of National Affairs has stated that because of the investment characteristics that exist when loans are pooled together or when advice about loan investments is given, loans either are or may be treated as securities under the ICA and the Advisers Act.

If hard money loans and similar investment instruments were to be deemed securities under the Advisers Act, the sponsor may need to register as an investment adviser with the SEC or the appropriate state securities bureau, depending on a variety of factors. Registering as an investment adviser can impose significant regulatory burdens on a lender, including disclosure of all material facts and conflicts of interest, prohibitions against the lender acting as principal for its own account, limitations on advertising, safeguarding the client’s collateral, record examinations, etc.

Ultimately, whether private investment lenders are subject to the Acts depends on the structure and the purpose of the instruments, the availability of exemptions from being deemed an investment company and / or an investment adviser and the purpose for which the SEC is evaluating the loans. Because the definition of a security under each of the Acts varies, fund sponsors must be mindful of how the underlying loans will be structured on the front end of launching a private lending fund and should consult qualified legal counsel to confirm compliance with applicable securities laws.

US Treasury Report: Potential Implications for Private Placements, Exempt Offerings and Finders

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

The U.S. Department of the Treasury released a report this month outlining issues and recommendations in U.S. Capital Markets that the Treasury hopes will promote economic growth while maintaining investor protection. The Treasury report discussed measures that may facilitate the public offering and IPO process, as well as steps that could potentially facilitate capital raising for private placements (Regulation D) and other exempt offerings (Regulation CF and Regulation A+) associated with the JOBS Act. The following is a summary of the Treasury’s discussion on private placements and exempt offerings.

Regulation A+

The Treasury report focused its discussion of Regulation A+ on Tier II, which allows issuers to raise up to $50 million in what some may consider a “mini IPO” due to reduced disclosure and ongoing reporting requirements (we have a more in depth discussion of Regulation A+ here and here). The Treasury report provided three recommendations to Tier II of Regulation A+.

First, the Treasury recommended expanding Regulation A+ to Exchange Act reporting companies. Current, publicly traded companies are prohibited from utilizing Regulation A+ and must utilize other exemptions such as Regulation D to raise capital outside of traditional public offerings. The Treasury stated expanding Regulation A+ to Exchange Act reporting companies could provide public companies with lower-cost means of raising capital as well as increase awareness of Regulation A+ availability.

Second, in an effort to increase liquidity in the secondary market, the Treasury recommended that state securities regulators update regulations to facilitate secondary market trading of Tier 2 securities, or, alternatively, that the SEC use its authority to preempt state registration requirements for Tier II offerings. Currently, federal securities laws do not impose trading restrictions for Tier 2 securities. State securities laws, however, may prohibit secondary market transactions that do not comply with state-level registration requirements. Tier II offerings are already exempt from state blue sky registration requirements, and it is the Treasury’s position that eliminating state-specific secondary market requirements would increase the marketability and liquidity of Regulation A+ offerings.

Finally, the Treasury recommended the Tier II offering limit be increased to $75 million. The Treasury cited the Financial Choice Act that passed in the House for policy rationale. The Treasury stated and increase in the Tier II amount to $75 million would reduce costs associated with raising capital for private companies.

Regulation CF

The Treasury outlined concerns with the relative complexity and costs associated with using Regulation CF (discussed here and here) as opposed to simply conducting a private placement. The Treasury stated that the overall difficulty and cost associated with a Regulation CF offering may result in less-attractive companies pursuing funding from less sophisticated investors, who may not have the expertise to evaluate the investments. The Treasury recommended five primary changes to Regulation CF.

1. Allow single-purpose crowdfunding vehicles advised by a RIA that could potentially have a lead investor conduct due diligence, pool assets of other investors, and receive carried interest compensation;
2. Allow accredited investors to invest an unlimited amount of capital;
3. Change investment limits to the greater of 5% or 10% annual income or net worth from the lesser test currently imposed;
4. Raise the maximum revenue requirement for Regulation CF issuers to $100 million to $25 million; and
5. Raise the limit on offering amount to $5 million (currently $1 million) to lower offering costs per dollar raised.

Regulation D

The Treasury allocated a significant portion of its report to maintaining the efficacy of private capital markets, but only provided two recommendations for Regulation D. The Treasury’s recommendations focused on expanded access to private placements.

First, the Treasury recommended expanding the definition of an accredited investor. It is the Treasury’s position that an accredited investor could be broadened to include any investor who is advised on the merits of making a Regulation D investment by a fiduciary (such as a federal or state RIA). The Treasury also proposed including financial professionals, such as investment adviser and broker-dealer representatives, in the definition of an accredited investor.

Second, the Treasury recommended reviewing the provisions in the Securities Act and Investment Company Act that restrict unaccredited investors from investing in private funds containing Rule 506 offerings. The Treasury bolstered its position by stating unaccredited investors could further diversify investment portfolios through access to a well-diversified portfolio of private placements.

Finders Regulatory Structure

The Treasury also included a recommendation regarding finders. Currently, firms and individuals are generally required to register with the SEC, FINRA, and any relevant states in order to receive transaction-based compensation in connection with effecting a securities transaction. Thus, finders that are unaffiliated with a broker-dealer are likely operating in an unlicensed capacity. The Treasury recommended the SEC, FINRA, and states propose a new “broker-dealer lite” regulatory scheme for finders and other intermediaries that assist small companies with capital formation.

Final Thoughts

The Treasury’s report emphasized removing regulations imposed by federal and state securities regulatory authorities and SROs. Practically speaking, many of the Treasury’s proposals have a very small likelihood of fully coming to fruition (such as recommending all states ease Regulation A+ secondary market requirements and/or offer broker-dealer lite). However, some of the Treasury’s recommendations may be able to gain traction or have already been explored by federal regulators (i.e. expanding the definition of accredited investors to financial professionals was original the SEC’s idea).

Given the Treasury’s lack of jurisdiction over securities-related policy and rules, it will be up to federal and state regulators and legislative bodies to enact the Treasury’s recommended policies. The Treasury’s report does, however, provide us some insight into the current administration’s priorities in capital market regulation.

DOL Fiduciary Rule: Impact on Hedge Fund Managers

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance.

Background

On June 9, 2017, the Department of Labor (“DOL”) effected a new regulation  expanding the definition of a “fiduciary” under the Employee Retirement Income Security Act of 1974 (“ERISA”) and Section 4975 of the Internal Revenue Code of 1986 (“Code”) (the “Fiduciary Rule”). Prior to the publication of the Fiduciary Rule, investment managers of private funds could effectively avoid designation as an ERISA fiduciary by limiting the aggregate investment in a fund by ERISA-covered plans and Individual Retirement Accounts (collectively, “Benefit Plans”) to less than 25% of the fund’s total assets under management (“AUM”).

While the 25% AUM exemption is still in place at the fund level, the Fiduciary Rule creates a new set of circumstances under which a fund manager could be deemed a fiduciary as a result of providing investment advice to a Benefit Plan in connection with the Benefit Plan’s “decision to invest” or to “maintain an investment” in a fund. Under the new rule, fund managers that make recommendations to Benefit Plans regarding the advisability of a particular investment or management decision are considered fiduciaries. The Fiduciary Rule defines recommendation as “a communication that, based on its content, context and presentation, would reasonably be viewed as a suggestion that the advice recipient engage in or refrain from taking a particular course of action.”

What does this mean for Fund Managers?

Due to the broad definition of the term recommendation, this means that fund managers may become subject to ERISA fiduciary obligations simply by communicating with a Benefit Plan investor regarding its decision to invest in or withdraw from a fund, including the decision to maintain or increase an investment in a fund. The Fiduciary Rule does provide some examples of communications that would not be considered investment recommendations, such as general circulation newsletters, remarks and presentations at speeches and conferences, general market data, and performance reports. In contrast, if a fund manager were to recommend a particular fund (including any fund in which it manages), discuss withdrawal or reallocation of funds, or tailor advice to a particular Benefit Plan, such communication would likely be deemed investment advice and subject the manager to ERISA fiduciary obligations.

Safe Harbor

The Fiduciary Rule contains a key safe harbor for Benefit Plan transactions conducted through independent fiduciaries with financial expertise (the “Safe Harbor”). Specifically, fund managers will not be classified as ERISA fiduciaries if:

  1. The fund manager provides the above-described recommendations to an independent fiduciary;
  2. The fund manager knows and receives assurances that the independent fiduciary (i) has the responsibility to act as fiduciary for the Benefit Plan and (ii) appropriate experience and knowledge to do so;
  3. The fund manager discloses to the independent fiduciary that the manager is (i) not undertaking to provide impartial investment advice and (ii) not giving advice in a fiduciary capacity; and
  4. The fund manager receives no compensation in connection with the investor’s decision to invest in the fund.

For the purposes of the Safe Harbor, the Fiduciary Rule defines independent fiduciaries as:

  1. A U.S. regulated and supervised bank;
  2. A U.S. qualified insurance carrier;
  3. A federal or state investment adviser;
  4. A registered broker-dealer; or
  5. An independent fiduciary that holds, manages, or controls assets of at least $50 million.

Options for Fund Managers

Fund managers with mostly larger, institutional clients may elect to solely accept funds from Benefit Plans represented by an expert fiduciary. While this would prevent these fund managers from receiving compensation in connection with the transaction (i.e. investment management fee or finder’s fee), it would still allow the collection of management fees and performance allocations on fund assets. We advise fund managers that solely elect to accept expertly managed Benefits Plans to update their offering documents to include (i) disclosures that the fund manager is not acting as a fiduciary and (ii) representations from each Benefit Plan investor that contain sufficient information to establish the transaction qualifies for the Safe Harbor.

Fund managers that elect to accept non-expertly managed Benefit Plans, however, should take precautions to ensure no advice is given to make or maintain an investment in a fund.  Fund managers that provide such advice may be classified as fiduciaries of these non-expertly managed Benefit Plans, which would subject any management fee and performance allocation to scrutiny under the prohibited transactions provision of Section 4975 of the Code, primarily involving fiduciary conflict of interest issues.  With these considerations in mind, we advise fund managers that elect to accept non-expertly managed Benefit Plans (such as self-directed IRA and 401(k) plans and small ERISA Plans) to do the following:

  1. Assess whether current Benefit Plan investors fall under the Safe Harbor or another exemption. Investments made by Benefits Plans of the owners of a fund manager and “friends and family” investors would not be subject to the Fiduciary Rule if the investors are not paying fees to the fund manager and not subject to a performance allocation.
  2. Review all marketing and communication material to current or prospective investors to ensure that communications could not be perceived as a recommendation to invest maintain an investment in the fund.
  3. Attach or incorporate disclosures into the offering documents that the fund manager is not acting as a fiduciary and that nothing in the offering documents should be construed as ERISA fiduciary investment advice.

While fund managers may elect to take the above-listed precautions, given the uncertainty of how the DOL will enforce the Fiduciary Rule, the wisest option may be to refrain from taking on new Benefit Plan investors and/or taking additional contributions from existing Benefit Plan investors that are not represented by an expert fiduciary. The above-steps are general guidelines, and fund managers that elect to continue to accept capital from non-expertly managed Benefit plans should have their offering and marketing materials reviewed by qualified counsel to ensure the materials do not contain any information that could be deemed an investment recommendation. Even fund managers that solely elect to accept capital from expertly managed Benefit Plans should consult counsel to ensure the terms of the Safe Harbor are met with respect to each Benefit Plan investor.

Future of the Fiduciary Rule

Although the rule has already gone into effect with relaxed oversight, the DOL issued a temporary enforcement policy stating it will not take enforcement action against persons working diligently and in good faith until January 1, 2018. While the DOL has indicated it will not overturn the Fiduciary Rule without legal cause, it has also stated it will continue its review of the Fiduciary Rule during this transitional period. The current administration has voiced strong opposition to the Fiduciary Rule, and the proposed Financial CHOICE Act, which recently passed in the House, could potentially repeal the Fiduciary Rule (although the Act has not garnered much traction in the Senate).

We will continue to closely monitor developments regarding the Fiduciary Rule. In the meantime, feel free to reach out to us if you have any questions concerning the Fiduciary Rule or need assistance updating existing fund subscription documents to address the new rule.

Hedge Fund Marketing Practices: Checking in on Rule 506(c)

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Uncategorized.

The overwhelming majority of hedge funds and private equity funds rely on an exemption from registration found in Rule 506 under Regulation D of the Securities Act. Prior to September 2013, Rule 506 was restrictive in that it required hedge fund managers to establish a pre-existing relationship with investors and placed a firm prohibition on general solicitation and advertising practices.

As we have previously written regarding hedge fund advertising rules, in September 2013 the SEC expanded Rule 506 to include an alternative exempt offering framework. Under new Rule 506(c), issuers may engage in general solicitation and advertising practices when offering securities, provided that all purchasers of the securities are verified (more below) accredited investors. Under the expanded Rule 506 framework, issuers have the option to continue to rely on the original Rule 506 exemption—now found under Rule 506(b)—which still prohibits general solicitation and advertising practices.

Although the establishment of Rule 506(c) removed the general solicitation and advertising prohibition—effectively freeing fund managers to advertise hedge fund offerings through television, newspapers, websites, etc.—relatively few issuers have opted to take advantage of it. In January 2016, SEC Chair Mary Jo White stated that from September 2013 through late 2015, 506(c) offerings only had a $71 billion market as opposed to the $2.8 trillion market for 506(b) offerings. This is likely due in part to the heightened verification requirement of Rule 506(c); whereas Rule 506(b) allows potential investors to self-certify their accredited status, Rule 506(c) requires that issuers take “reasonable steps” to verify the accredited status of each investor. Rule 506(c) sets out three primary methods of verification:

Income: Issuers can review any I.R.S. form that reports the investor’s income for the two most recent years. This includes, but is not limited to, Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040. In addition to I.R.S. forms stating the investor’s income for the two most recent years, an investor must make written representation that he or she has a reasonable expectation of reaching the income level necessary to qualify as an accredited investor.

Net Worth: Issuers can review documentation dated within the prior three months to determine whether an investor meets the requisite net worth to qualify as an accredited investor. For assets, issuers can review bank statements, brokerage statements, certificates of deposits, tax assessments, and other appraisal reports by third parties. With respect to liabilities, issuers can utilize a consumer report from a nationwide consumer reporting agency.

Professional Verification: Issuers can obtain written confirmation from persons or entities that have taken reasonable steps to verify the investor is an accredited investor within the prior three months and has determined that the investor is an accredited investor. This includes a registered broker-dealer; an investment adviser in good standing with the SEC; a licensed attorney in good standing under his or his jurisdiction; or a CPA who is registered and in good standing under the laws of the place of his or her residence or principal office.

Although the above-listed safeguards will apply to most new purchasers, the SEC also included a safeguard for issuers that obtain a written certification from an accredited investor who purchased securities pursuant to 506(b) from the issuer prior to September 23, 2013, if that same issuer conducts a Rule 506(c) offering at a later date.

While the heightened verification requirement of Rule 506(c) does require more effort and due diligence on behalf of the issuer, the ability to publicly advertise may help issuers raise additional capital. Rule 506(c) provides the above-listed safe harbors, but the SEC has indicated issuers may be able to satisfy verification obligations through other means. In addition, there has been a rise in independent, third-party verifiers that are willing to conduct accredited investor status verification and certification for issuers in accordance with the Rules.

Please feel free to contact us if you have any questions regarding exempt offerings under Rule 506(c) or other aspects of Regulation D.

Year-End Compliance Alert for Investment Managers

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Uncategorized, Venture Capital, Private Equity & Real Estate Funds.

As we approach the final quarter of 2016, we would like to take this opportunity to remind you of the following legal, regulatory and compliance obligations that may apply to certain investment managers heading into 2017.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year-end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the Securities and Exchange Commission (“SEC”), advises one or more private funds and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year-end.

Investment Adviser Registration Depository (“IARD”) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC ERAs are due to the IARD by December 16, 2016.  Please visit www.iard.com for more information, fee schedules and payment options.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year-end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year-end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter-end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year-end. An independent certified public accountant must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Regulatory and Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

SEC Increase to Qualified Client Threshold Reminder.  On June 14, 2016, the SEC issued an order increasing the dollar amount of the net worth threshold in Rule 205-3 under the Investment Advisers Act of 1940 from $2,000,000 to $2,100,000. Rule 205-3 provides an exemption from the prohibition on performance-based compensation where the client entering into the advisory contract is a “qualified client’ as defined in the rule. As a result, SEC registered investment advisers and certain state registered and exempt advisers subject to the qualified client requirement will need to consult with counsel and update their advisory agreements and fund offering documents prior to the effective date.

Alert: SEC Increases Qualified Client Threshold

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Uncategorized, Venture Capital, Private Equity & Real Estate Funds.

On June 14, 2016, the Securities and Exchange Commission (“SEC”) issued an order (“Order”) increasing the dollar amount of the net worth threshold in Rule 205-3 under the Investment Advisers Act of 1940 from $2,000,000 to $2,100,000. Rule 205-3 provides an exemption from the prohibition on performance-based compensation where the client entering into the advisory contract is a “qualified client’ as defined in the rule. Effective August 15, 2016, revised Rule 205-3 will define a “qualified client” as a person that:

• has at least $1,000,000 under the management of the investment adviser immediately after entering into the contract; or
• the investment adviser reasonably believes, immediately prior to entering into the contract, either (i) has a net worth (together, in the case of a natural person, with assets held jointly with a spouse) of more than $2,100,000 or (ii) is a qualified purchaser as defined in section 2(a)(51)(A) of the Investment Company Act of 1940.

Advisers should be relieved to know that the increase in the net worth threshold is not retroactive (i.e. an advisory agreement or subscription agreement for a private investment fund entered into prior to the August 15, 2016 effective date should not be affected by the modification to the qualified client threshold). However, advisory agreements or subscription agreements entered on or after the effective date will be subject to the new threshold.

As a result, SEC registered investment advisers and certain state registered and exempt advisers subject to the qualified client requirement will need to consult with counsel and update their advisory agreements and fund offering documents prior to the effective date. Please do not hesitate to contact us should you have any questions or need assistance making the required updates.

A copy of the Order is available at: https://www.sec.gov/rules/other/2016/ia-4421.pdf.

Year-End Compliance Alert for Investment Managers

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

With 2015 coming to a close, we would like to take this opportunity to remind you of key legal, regulatory and compliance obligations that may apply to you or your clients heading into 2016. As always, please contact us should you have any questions or require assistance with respect to any of the following matters.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the SEC, advises one or more private funds, and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year end.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter’s end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year end. An independent CPA must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC exempt reporting advisers are due to the IARD by December 12, 2015.  Please visit www.iard.com for more information, fee schedules and payment options.

Please feel free to contact us should you have any questions or require assistance with respect to any of the aforementioned items.

Guest Post: Starting Your Hedge Fund

Written by Kevin Cott on . Posted in Hedge Funds. No Comments on Guest Post: Starting Your Hedge Fund

As any hedge fund manager will attest, choosing the right service providers for your fund will be critical to your fund’s success. For many fund managers—particularly managers launching their first funds—hiring an experienced hedge fund consultant to serve as an independent resource and sounding board during the fund formation process is invaluable.

Below is a guest post on the subject by Trevor L. Zeh, an independent hedge fund consultant we work with often. For more information regarding Trevor’s services, please see his contact information below the post.

Starting Your Hedge Fund

Like any other small business endeavor, there are many avenues you can take to opening your hedge fund.  Many aspiring hedge fund managers are already employed directly in the financial services industry by financially advising clients, trading managed accounts, or acting as a portfolio manager on behalf of an institution.  That is why time is the most valuable resource.  Allowing a hedge fund advisor to quarterback the launch process can not only save valuable time allowing the soon-to-be manager to continue with his daily responsibilities, but this guidance is usually coupled with cost savings as well.  Before partnering with a consultant, there are a handful of pointers to keep in mind.

Independent advisors equal value.  There are a litany of boutique hedge fund services firms and large institutions with hedge fund launch divisions that you can work with to open your fund.  These launch companies often act as a pipeline for the associated/parent company’s core services and products.  The advice you receive can be tainted as the advisor’s goal is to launch your fund with their employer’s best interests in mind, not yours or your investors.  This consultant-like guidance is often marketed as a “value add” service by the ancillary division, but in reality, it is simply a sales channel.   These relationships can be valuable if you know without a shadow of a doubt that you want to work with the specific firm.  If you want unbiased advice not tied to any one firm or product in particular, working with an independent advisor represents the purest path to launch.

An independent advisor has the ability to essentially cooperate with any vendor on your behalf since they are not fettered to an employer’s partnerships.  This capability represents a clear, external perspective.  Consultants know in what situations certain service providers shine and where their weaknesses lie.  Prospective hedge fund managers that are not leveraging a consultant’s direct experience of working with various service providers have to rely on marketing materials and initial interviews with lawyers, administrators, auditors, custodians, IT/infrastructure vendors, etc. to make a decision.  An advisor’s value is compounded further if he/she has worked with a substantial amount of funds with similar characteristics such as yours (AuM, strategy, length of track record, etc.).  Successfully growing a hedge fund around the parameters of the alternative investment industry’s best practices is easiest done through independent guidance that has done it many times before with different service providers, vendors, and partners.

Your consultant can be your most important business relationship for your fund.  This single connection leads you to your fund’s best-suited service providers and advises on what deliverables from these providers to sign off on.  Managers can sometimes get caught up in the dream of running a large fund instead of focusing on the proven fundamentals that can realistically assist them in achieving their goals.  For example, when managers feel like they have something special they often want it marketable to everyone.  This is not the correct strategy.  I have worked with a handful of managers that immediately want to launch a master-feeder or a mini-master fund structure as this would allow their strategy to be investable by the majority of global investors.  I often talk managers out of doing this in the early stages of their fund’s growth.  It is better to start small and to build the fund around the initial traunch of committed investors versus launching various entities for potential investors that are not even committed yet.  You can always expand your operations.  I always advise doing this once it is to the benefit of the fund and when the proper amount of capital is present to do so.

This leads me to my next point: after launching your fund, market to those outside your front door.  I witness many emerging managers wanting to attend national and global conferences, reaching out to institutions, chasing that dream.  This blanket marketing approach is trudging uphill in true form.  Not only does it cost thousands of dollars in travel expenses and conference tickets, but it represents a large amount of your time.  Time that would be better spent connecting with firms and individuals within driving distance.  I guide managers to have a laser-focused approach when marketing their fund post recent inception.  How large of an allocation can your fund handle compared to your fund’s current AuM?  $5m?  $10m?  $25m?  Figure out that amount (investors often do not want their subscription to represent >10% of the fund’s total AuM, unless it’s a potential seeding arrangement), then focus your attention on the investors that are actively seeking the unique factors that are representative of your fund within the subscription amount your fund can handle.  Face-to-face meetings are invaluable.  Market in a way that will allow you to have a close, personal relationship with your potential investors versus having to book a plane each time a meeting is called for.

Cost is certainly a factor that managers need to keep an active eye on.  Some startup fund managers I have worked with want to initially hire the largest, internationally recognizable service providers as they believe it will assist in their marketing efforts.  This may be beneficial if you already have strong relationships with institutional investors that require this of you, but for the great majority of fund launches, you will not see a ROI doing this.  It is often best to hire boutique, specialized providers.  Not only are their costs reflective of their boutique-like size, but their servicing, deliverables, and advice often rival, and sometimes even surpass, that of the larger firms.  There are many smaller providers that have a phenomenal name and reputation in the space.  Your fund can always naturally grow into the larger firms when the times comes.  In the meantime, hire the specialized providers that are prepared and willing to grow with you.

It is also helpful to note that you will want to work with an independent consultant that is entrepreneurial.  After all, launching a hedge fund is synonymous with launching a small business, so collaborating with a consultant who is open minded and has small business acumen is invaluable for laying the foundation to grow your fund.

—–

Trevor L. Zeh has connected and collaborated with managers for going on 5 years to establish hedge funds, incubator funds, and various pooled alternative investment vehicles.

His consultation is focused on providing the reputable and transparent infrastructure necessary to attracting and marketing to investors.  Trevor has capital-saving strategic partnerships with the leading alternative investment service providers and professionals including hedge fund and private equity fund attorneys, auditors, administrators, custodians, marketers, IT/infrastructure professionals, and business intelligence software providers.

Trevor works with start-up and emerging managers to bring their funds to fruition.  His launch processes are efficient, dependable, and tailored to your specific needs.

You can contact Trevor at 1-646-820-5720 for a complimentary consultation.  His experience and a handful of references can be found on his LinkedIn profile,www.linkedin.com/in/trevorlzeh.

Year-End Compliance Alert

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds.

With 2014 coming to a close, we would like to take this opportunity to remind you of key legal, regulatory and compliance obligations that may apply to you as you transition into 2015.

Investment Advisers and Exempt Reporting Advisers

Annual Amendment of Form ADV.  Each registered investment adviser (“RIA”) and exempt reporting adviser (“ERA”) must file an annual updating amendment to its Form ADV. The annual amendment must be filed within 90 days of the adviser’s fiscal year end.

Each RIA must also provide to each client an updated Form ADV Part 2A brochure and a summary of material changes to the brochure, if any (or simply a summary of material changes, if any, accompanied by an offer to provide the updated brochure).

Form PF. An investment adviser must file Form PF if it is registered or is required to be registered with the SEC, advises one or more private funds, and has at least $150 million in private fund assets under management. Investment advisers must file Form PF on an annual basis within 120 days of the fund’s fiscal year end.

Commodity Pool Operators and Commodity Trading Advisors

Annual Reaffirmation of CPO Exemption. Commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”) relying on an exemption from registering with the Commodity Futures Trading Commission (“CFTC”) are required to reaffirm their exemption eligibility within 60 days of the calendar year end.

Forms CPO-PQR and CTA-PR. Registered CPOs and CTAs must file Forms CPO-PQR and CTA-PR, respectively, using the NFA’s EasyFile system. Registered CPOs must file Form CPO-PQR on a quarterly basis within 60 days of the quarters ending in March, June, and September and within 90 days of the calendar year end. Registered CTAs must file Form CTA-PR on a quarterly basis within 45 days of each quarter’s end.

Advisers that are dually registered with the SEC and CFTC may satisfy certain Form CPO-PQR filing requirements when they file Form PF. In order to take advantage of this, the adviser must file Form PF by its Form CPO-PQR deadline.

CPO and CTA Annual Updates. Registered CPOs must distribute an Annual Report to each participant in each pool that it operates, as well as submit a copy of the Annual Report and key financial balances from it to the National Futures Association (“NFA”), within 90 days of the pool’s fiscal year end. An independent CPA must certify the Annual Report.

Additionally, CPOs and CTAs must prepare and file with the NFA an Annual Questionnaire and Annual Registration Update and pay their NFA membership dues and fees.

Additional Compliance Matters

Verification of New Issues Status.  Fund managers need to conduct an annual verification of each account to ensure investors are eligible to participate in initial public offerings or new issues pursuant to FINRA Rules 5130 and 5131. While the initial verification requires affirmative representations by account holders, FINRA allows subsequent verifications to be completed through the use of negative consent letters.

Annual Privacy Policy Notice.  Each registered investment adviser must provide it investors with a copy of its privacy policy on an annual basis, even if no changes have been made to the privacy policy.

Form D Annual Amendments.  Form D filings for funds maintaining continuous offerings must be amended annually, on or before the anniversary of the Form D filing or the filing of the most recent amendment.  When amending Form D, the fund must update the entire form.

Blue Sky Filings.  Fund managers should review their state blue sky filings to ensure they have met any renewal requirements.

Investment Adviser Registration Depository (IARD) Renewal Fees. Annual renewal fees for SEC and state registered investment advisers as well as SEC exempt reporting advisers were due to the IARD by December 12, 2014.  Please visit www.iard.com for more information, fee schedules and payment options.

Please feel free to contact us should you have any questions or require assistance with respect to any of the aforementioned items.

California: An Illustrative Example of Dodd-Frank’s Impact upon Investment Advisers at the State Level

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds. No Comments on California: An Illustrative Example of Dodd-Frank’s Impact upon Investment Advisers at the State Level

Although most investment advisers are aware of the adjusted thresholds for federal and state registration under the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), one of the ongoing challenges for advisers is complying with registration requirements at the state level, especially as state regulators scramble to recalibrate their investment adviser laws to better comport with federal law. Each state presents its own unique, evolving set of registration requirements and available exemptions from registration to advisers prohibited from registering with the Securities and Exchange Commission (“SEC”) (generally advisers with less than $100 million in assets under management (“AUM”)) and with a place of business in the state. With that in mind, it is especially important in the post-Dodd-Frank regulatory environment that advisers remain informed and up-to-date with respect to applicable state requirements.

Take California, for example. Prior to Dodd-Frank, California-based advisers avoided registration by a state analogue to a federal exemption. The exemption allowed a private advisor that did not hold itself out to the public as an investment adviser and had fewer than fifteen clients in the preceding twelve months to avoid registration, provided that the advisor had at least $25 million in AUM. Dodd-Frank repealed the federal exemption, which led to a state-level abandonment of the exemption, as well. Many states, including California, sought to create a replacement rule to exempt private funds from registration. On August 27, 2012 the California Department of Corporations (“CDC”) adopted a new exemption from the state’s investment adviser registration requirements for advisers to only “qualified private funds.”[1]

Qualifying private funds include any fund relying on the exemptions from registration found in Sections 3(c)(1) and 3(c)(7) of the Investment Company Act of 1940, as amended, as well as venture capital funds.[2] The adviser seeking exemption must only manage qualifying funds; any non-qualifying funds or managed accounts prevent the adviser from seeking exemption under the private fund exemption.

Additionally, private funds must be owned entirely by accredited investors and provide audited annual reports by an independent accountant. Further, a private fund adviser may only rely on the exemption if:

  • neither the adviser nor its advisory affiliates have any “bad actor” disqualifications;
  • the adviser files a truncated Form ADV for exempt reporting advisers with the CDC; and
  • the adviser pays the required registration and annual renewal fees.

In addition, an investment advisers relying on a now-defunct exemption is grandfathered in to the foregoing exemption provided that the adviser stops selling interests in applicable funds to non-accredited investors, does not charge performance fees to subsequent non-qualified clients, and complies with all relevant registration and reporting requirements.

Keep in mind that the foregoing analysis is a high-level overview of the new exemption and its impact upon affected advisers only. For a more comprehensive analysis of updated investment adviser laws and their potential impact on your firm – whether based in California or another affected state – please feel free to contact us for a free consultation.


[1] The full revision text is available at http://www.corp.ca.gov/Regulations/Licensees/1811B.pdf.

[2] Jason Wallace, IA brief: California broadens scope of private-adviser exemption, Reuters, Sept. 12 2012; available at http://blogs.reuters.com/financial-regulatory-forum/2012/09/12/ia-brief-california-broadens-scope-of-private-adviser-exemption/

Form PF

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds. No Comments on Form PF

As part of the ongoing effort to provide greater transparency to the investment management industry in the wake of the financial crisis of 2008, earlier this year the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) proposed Rule 204(b)-1 under the Investment Advisers Act of 1940.  Significantly, Rule 204(b)-1 requires SEC registered investment advisers to report information about private funds on newly developed Form PF, marking a major sea change in the regulatory oversight of hedge funds and other private investment funds.

On October 26, 2011, the SEC voted to adopt the version of Rule 204(b)-1 summarized below (the CFTC is expected to vote on the rule shortly, after which a jointly approved final rule can be released).  Due to intense lobbying from hedge fund advocacy groups, several important concessions are reflected in the current version of the rule.

Initial reports on Form PF will be required in two stages: (1) Advisers with $5 billion or more in assets under management (“AUM”) must file the initial form within 60 days of the quarter ending June 30, 2012; and (2) advisers with AUM of $150 million or more but less than $5 billion must file the initial form within 60 to 120 days of the end of 2012.

Form PF will be filed with the SEC through the Financial Industry Regulatory Authority (“FINRA”), the largest independent regulator for all securities firms doing business in the U.S. and the operator of the Investment Adviser Registration Depository (“IARD”).  FINRA will impose a $150 filing fee for each Form PF annual/quarterly update.

We will provide further analysis of the final rule once it has been released.  In the interim, managers of private funds are encouraged to begin familiarizing themselves with Form PF in preparation for the rule’s implementation.  Proposed Form PF can be found here.  Although smaller fund advisers will initially be unaffected by the enhanced reporting requirements of Form PF, such managers should be mindful of the increased transparency initiative nonetheless, especially as states continue to track changes in federal securities laws at the state level.

Please contact us if you have any questions regarding Form PF or its potential impact on fund managers.

Regulation D

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Uncategorized, Venture Capital, Private Equity & Real Estate Funds. No Comments on Regulation D

Hedge funds are typically structured as private placements in order to avoid registering their interests under the Securities Act of 1933 (“Securities Act”).  In particular, Section 4(2) of the Securities Act exempts from registration transactions not involving any public offering.  However, the availability of the Section 4(2) exemption is subjective and, at times, ambiguous.  To better clarify the availability of the Section 4(2) exemption, the Securities and Exchange Commission (“SEC”) adopted Regulation D (“Reg D”), a collection of certain safe harbor exemptions from registration of private offerings that effectively serve as the backbone of the “private placement exemption.”

Reg D provides three alternative safe harbors in Rules 504, 505, and 506; however, Rule 506 is generally the most relevant exemption for private funds, as it allows funds to offer securities without regard to the dollar amount of the offering. Below is a brief description of Rules 501 through 506.

Rule 501 – Definitions and Terms Used in Regulation D

Rule 501 provides definitions of certain terms found in Rules 502 to 508, most notably the definition of an “accredited investor.”

Rule 502 – General Conditions to Be Met

Rule 502 details the conditions private funds must meet to qualify for a Reg D exemption, including integration issues, information requirements and limitations on resale.  However, the most relevant condition for fund managers is typically the limitation on the manner of the offering, which prohibits any form of general solicitation or general advertising of the underlying securities.  The solicitation and advertising restrictions are an integral aspect of all Reg D offerings, and should be discussed in detail with a qualified hedge fund attorney prior to marketing the fund.

Rule 503 – Filing of Notice of Sales

Rule 503 requires a private fund relying on Reg D to file a notice of sale on Form D with the SEC within fifteen days after the first sale of an interest in the fund.  Although states cannot require a private fund to register its Rule 506 offering with them, states can require notice filings (typically a copy of Form D) and associated filing fees under applicable Blue Sky laws.

Rule 504 – Exemption for Limited Offers and Sales of Securities Not Exceeding $1,000,000

Rule 504 provides an exemption for the offer and sale of up to $1,000,000 of securities over any 12-month period.  Rule 504 applies primarily to certain intrastate offerings.

Rule 505 – Exemption for Limited Offers and Sales of Securities Not Exceeding $5,000,000

Rule 505 provides an exemption for the offer and sale of up to $5,000,000 of securities over any 12-month period. Issuers may sell securities to an unlimited number of accredited investors plus no more than 35 non-accredited investors.

Rule 506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering

Rule 506 provides an exemption for the offer and sale of securities without regard to the dollar amount of the offering. For this reason, the vast majority of hedge funds and private equity funds rely on the Rule 506 exemption from registration.  Rule 506 is similar to Rule 505 in that funds may issue securities to an unlimited number of accredited investors and up to 35 non-accredited investors. Often referred to as the “sophistication” element, Rule 506 requires non-accredited investors to have “such knowledge and experience in financial and business matters that [they are] capable of evaluating the merits and risks of the prospective investment.”

Please contact us for a free consultation if you have any questions regarding Regulation D or starting a fund in general.

Commodity Pool Operator and Commodity Trading Advisor Registrations

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance. No Comments on Commodity Pool Operator and Commodity Trading Advisor Registrations

Pursuant to the Commodity Exchange Act (“CEA”), advisers who utilize futures contracts, options on futures or retail off-exchange forex contracts in their trading programs are generally required to register as a commodity pool operator (“CPO”) and/or commodity trading advisor (“CTA”), as appropriate, unless they qualify for an available exemption from registration.  This article provides a general overview of the CPO/CTA registration process.

A CPO is an individual or organization which operates and solicits funds for a commodity pool, including a hedge fund that trades futures contracts, options on futures or retail off-exchange forex contracts.  A CTA is more broadly defined to include an individual or organization which, for compensation or profit, advises others as to the value of or the advisability of buying or selling futures contracts, options on futures or retail off-exchange forex contracts.  In other words, a CPO is most always also a CTA by definition, whereas an individual or organization may be a CTA and not a CPO.  The key distinction is whether the adviser manages a pooled investment vehicle.

(Note: Prior to the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (“Dodd-Frank”), off-exchange retail forex was excluded from the jurisdiction of the Commodity Futures Trading Commission (“CFTC”).  However, in large part prompted by Dodd-Frank, the CFTC published final rules on August 30th, 2010 effectively making off-exchange retail forex markets subject to regulation by the CFTC and National Futures Association (“NFA”).  Advisers to funds and/or separate managed accounts who utilize forex trading and have not become registered CPOs and/or CTAs (or filed an available exemption) could be subject to significant sanctions, and should consult a qualified hedge fund attorney immediately to begin undertaking appropriate compliance measures.)

All registered CPOs and CTAs who manage or exercise discretion over customer accounts must be Members of NFA.  In addition, all CPO/CTA registrants are required to file the following:

  • A completed online Form 7-R;
  • A non-refundable $200 application fee; and
  • Membership dues (if applicable) of $750.

CPO/CTA registrants must also file applications for its Principals and Associated Persons that include the following:

  • A completed online Form 8-R;
  • Fingerprint cards;
  • Proficiency requirements (generally, a passing score on the Series 3 exam); and
  • A non-refundable $85 application fee for each Principal and Associated Person.

Lastly, all CPO/CTA registrants engaged in retail off-exchange forex are also required to:

  • Apply to become a forex firm by completing online Form 7-R; and
  • Have at least one Principal that is also an approved Forex Associated Person.

Please contact us for a free consultation if you have any questions regarding the CPO/CTA registration process.

State Blue Sky Regulation

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Uncategorized, Venture Capital, Private Equity & Real Estate Funds. No Comments on State Blue Sky Regulation

At the federal level, sales of securities are subject to the Securities Act of 1933 (“Securities Act”) and the SEC rules enacted thereunder.  Sales of securities are also regulated at the individual state level under state securities laws, often called “Blue Sky” laws.  Each state’s respective Blue Sky laws apply to offers and sales of securities within the state.

Although states are prohibited from requiring the registration of securities exempt from registration under the Securities Act, states may require issuers of securities to make notice filings concerning the securities they sell.  These required notice filings, often called “Blue Sky Notice Filings,” inform each state’s securities division of the type of business being conducted (directly or indirectly) within the state.  Hedge funds must make a Blue Sky Notice Filing in each state in which one of its investors resides.  In most cases, Blue Sky Notice Filings must be made with respect to a fund within fifteen days of the date of first sale within each state.  New York, a notable exception, requires that a Blue Sky “pre-filing” be made before any securities are sold within the state.

Before making a Blue Sky Notice Filing on your behalf, most hedge fund attorneys will require that you provide them with the following: 1) each investor’s name; 2) each investor’s state of residence; 3) the amount of each investor’s investment(s); and 4) the date of first sale within each state.

Blue Sky Notice Filings can be an extensive and complicated process, especially since each state imposes its own requirements and fees.  For reference, below are the respective Blue Sky Notice Filing fees and form requirements for each state as of the date of this post:

Alabama

Filing Fee: $300

Required Form(s): Manual Form D

Alaska

Filing Fee: $600-$1,100

Required Form(s): Electronic Form D

Arizona

Filing Fee: $250

Required Form(s): Electronic Form D

California

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Colorado

Filing Fee: $75

Required Form(s): Electronic Form D with original signature

Connecticut

Filing Fee: $150

Required Form(s): Electronic or Manual Form D

Delaware

Filing Fee: None

Required Form(s): Electronic Form D, Form U-2

Florida

*No Blue Sky Notice Filing Required*

Georgia

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Hawaii

Filing Fee: $100

Required Form(s): Electronic or Manual Form D, Form U-2

Idaho

Filing Fee: $50

Required Form(s): Electronic Form D, Form U-2

Illinois

Filing Fee: $100

Required Form(s): Electronic Form D

Indiana

Filing Fee: None

Required Form(s): Manual Form D

Iowa

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Kansas

Filing Fee: $250

Required Form(s): Electronic or Manual Form D

Kentucky

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Louisiana

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Maine

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

Maryland

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Michigan

Filing Fee: $100

Required Form(s): Electronic Form D

Minnesota

Filing Fee: $100 +

Required Form(s): Electronic Form D, Form U-2

Mississippi

Filing Fee: $300

Required Form(s): Electronic or Manual Form D, Form U-2

Missouri

Filing Fee: $100

Required Form(s): Electronic Form D

Montana

Filing Fee: $200 +

Required Form(s): Electronic Form D, Form U-2

Nebraska

Filing Fee: $200

Required Form(s): Electronic Form D

Nevada

Filing Fee: $500

Required Form(s): Electronic or Manual Form D

New Hampshire

Filing Fee: $500

Required Form(s): Form

New Mexico

Filing Fee: $350

Required Form(s): Electronic Form D with authentication email, Form U-2

New York

Filing Fee: $1,200 (NYS Dept. of Law), $35 & $150 (Department of State)

Note: Must be paid with 3 separate checks

Required Form(s): Electronic Form D, Form U-2 (one original, one copy)

North Carolina

Filing Fee: $350

Required Form(s): Electronic Form D

North Dakota

Filing Fee: $100

Required Form(s): Electronic Form D

Ohio

Filing Fee: $100

Required Form(s): Electronic Form D, Form U-2

Oklahoma

Filing Fee: $250

Required Form(s): Electronic Form D, Form U-2

Oregon

Filing Fee: $250

Required Form(s): Electronic Form D

Rhode Island

Filing Fee: $300

Required Form(s): Electronic Form D, Form U-2

South Carolina

Filing Fee: $300

Required Form(s): Electronic Form D

South Dakota

Filing Fee: $250

Required Form(s): Electronic Form D

Tennessee

Filing Fee: $500

Required Form(s): Electronic Form D

Texas

Filing Fee: up to $500

Required Form(s): Electronic Form D

Utah

Filing Fee: $100

Required Form(s): Electronic or Manual Form D with original signature

Vermont

Filing Fee: $600

Required Form(s): Electronic Form D, Form U-2

Virginia

Filing Fee: $250

Required Form(s): Electronic or Manual Form D

Washington

Filing Fee: $300

Required Form(s): Electronic Form D

West Virginia

Filing Fee: $125

Required Form(s): Electronic Form D, Form U-2

Wisconsin

Filing Fee: $200

Required Form(s): Electronic Form D

Wyoming

Filing Fee: $200

Required Form(s): Electronic Form D with original signature underneath electronic signature

 

Please contact us if you would like assistance with your fund’s Blue Sky Notice Filings or have any questions regarding the process in general.

Offshore Funds

Written by Kevin Cott on . Posted in Hedge Funds, Venture Capital, Private Equity & Real Estate Funds. No Comments on Offshore Funds

Although they continue to grow in popularity, there are still some general misconceptions regarding the nature and use of offshore hedge funds.  This article addresses the various reasons for organizing offshore funds, the most common jurisdictions for offshore funds and the typical structure of offshore funds.

Reasons for Organizing an Offshore Hedge Fund

Investor Confidentiality

Offshore funds are often preferable for non-U.S. investors concerned about confidentiality, particularly with avoiding disclosure to U.S. tax and regulatory authorities.  Whereas all investors in domestic funds are ordinarily identified through fund tax returns, the identities of non-U.S. investors in offshore funds are not ordinarily reported to the IRS or other U.S. regulatory authorities for tax or other purposes.  Although the preference to invest in offshore funds for confidentiality purposes partly arises out of habit and convention, offering an offshore fund to non-U.S. investors can nonetheless be a significant marketing advantage.

Tax Advantages

Offshore funds are generally preferable for U.S. tax-exempt investors – such as pension plans and charitable organizations – who want to avoid unrelated business taxable income (characterized as debt-financed income under Code section 514), which is taxable to tax-exempt investors.  Because an offshore fund is ordinarily structured as a corporation instead of a partnership (in contrast to a domestic fund), the debt-financed income is not deemed to pass-through to the tax-exempt investors.

Offshore Fund Jurisdictions

The two leading jurisdictions to establish an offshore fund are the Cayman Islands (“Cayman”) and the British Virgin Islands (“BVI”), both of which are discussed below.

Cayman Islands

The Cayman has developed into the preeminent global jurisdiction for offshore funds, due in part to its “no tax” status (Cayman does not impose its own tax burden on investment funds or investors in such funds), as well as its sophisticated regulatory system and favorable laws.  The Cayman Islands Monetary Authority (“CIMA”) is the regulatory authority that oversees the Mutual Funds Law, Cayman’s primary legislation with respect to investment funds.  The majority of Cayman based funds are required to register with CIMA; however, funds in which the shares are held by not more than fifteen investors, the majority of which are capable of removing the directors, are exempted from CIMA registration.

British Virgin Islands

The BVI is another popular jurisdiction for offshore funds.  Like the Cayman, the BVI features favorable tax treatment, as well as a sophisticated regulatory system and industry-friendly laws.  Organizing an offshore fund in the BVI also tends to be easier and considerably less expensive than other offshore jurisdictions.  A standard BVI fund is organized as a BVI business company under the BVI Business Companies Act, recognized as either a private fund or a professional fund with the BVI Financial Services Commission pursuant to the Securities and Investment Business Act.  Professional funds are available only to “professional investors” (typically, a person with a net worth in excess of $1,000,000) who subscribe for a minimum of $100,000.  Private funds are less restrictive, but are allowed no more than fifty investors and the shares must be offered on a private basis.

Offshore Fund Structures

Stand-Alone Fund

This is the most common structure for offshore managers with no U.S. presence and who therefore expect to gear the fund predominately to non-U.S. investors (and possibly U.S. tax exempt investors).  This is simply the offshore equivalent to launching a stand-alone domestic fund.

Side-by-Side Structure

In a side-by-side structure, the manager establishes a domestic stand-alone fund and an offshore stand-alone fund in order to offer the same strategy to non-U.S. investors and U.S. tax-exempt investors as it does to U.S. taxable investors.  However, there are certain inherent inefficiencies in managing side-by-side funds; for example, the manager must allocate trades (i.e. “split” tickets) among its domestic fund and offshore fund while trying to achieve equivalent performance returns between the funds.

Master-Feeder Structure

To overcome the inherent inefficiencies of managing side-by-side funds, amanagers often elect to organize “master-feeder” structures.  The standard master-feeder structure comprises one “master” fund and two “feeder funds.”  The feeder funds are typically (1) a domestic fund for U.S. taxable investors and (2) an offshore fund for non-U.S. investors and U.S. tax-exempt investors.  Both feeder funds in turn invest all their capital in the master fund, which is also typically an offshore investment vehicle, with all portfolio investment activities conducted at the master fund level.  In addition to the cost-control benefits and administrative efficiency of a master-feeder structure, master-feeder funds can oftentimes be structured more tax-efficiently.  However, forming a master-feeder fund triggers a variety of nuanced structural and accounting considerations that should be discussed with a qualified hedge fund attorney on the front-end.  As with all fund structures, it is important that managers seek an experienced hedge fund lawyer familiar with the issues involved and able to help determine the most appropriate structure for each particular situation.

Please contact us for a free consultation if you are interested in launching an offshore fund or would like to discuss the offshore fund formation process in greater detail.

SEC Order Raises Performance Fee Thresholds

Written by Kevin Cott on . Posted in Hedge Funds, Regulatory & Compliance, Venture Capital, Private Equity & Real Estate Funds. No Comments on SEC Order Raises Performance Fee Thresholds

On July 12, 2011, the Securities and Exchange Commission (“SEC”) approved an order (“Order”) increasing the dollar amount thresholds necessary for an investor to qualify as a “qualified client” under Rule 205-3 under the Investment Advisers Act of 1940 (“Advisers Act”).  A “qualified client” is currently defined under Rule 205-3 as an investor that (i) has at least $750,000 in assets under management with the investment adviser or (ii) has a net worth of more than $1.5 million.  The Order carries out a requirement of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) to adjust the respective thresholds for inflation.

Effective September 19, 2011, the assets under management requirement will be increased to $1 million and the net worth requirement will be increased to $2 million.  SEC registered investment advisers (and many state registered investment advisers) are precluded from charging performance-based compensation to investors that are not qualified clients.  As such, the increased thresholds will significantly inhibit the ability of affected advisers to charge performance-based compensation to certain investors.

Advisers affected by the Order should contact qualified legal counsel immediately to confirm compliance with the increased thresholds and assure that all subscription agreements and investment management agreements are updated accordingly.  Absent further guidance from the SEC, we do not currently believe that existing investors with an affected adviser will need to be recertified as qualified clients, provided such investors do not contribute additional capital to the adviser after September 19, 2011.

The Order can be read in its entirety here.

If you have any questions regarding this alert or related matters, please contact us today.

How to Start a Hedge Fund

Written by Kevin Cott on . Posted in Hedge Funds. No Comments on How to Start a Hedge Fund

Starting a hedge fund can seem like a daunting process for first time fund managers.  In practice, forming a hedge fund is a relatively straightforward process, provided the manager has a reasonable understanding of the steps involved to successfully launch a fund.  This article summarizes the hedge fund formation process from inception to launch.

Preliminary steps

First and foremost, the manager should develop a clear vision of the investment strategy and overall structure of the fund.  Will the fund be a traditional hedge fund, a commodity pool, a forex fund, etc.?  Will the fund be geared towards private equity and/or real estate based investments?  Will capital be allocated to short-term trades or long-term investments?  Will the fund be a domestic fund or an offshore fund (typically domiciled in the British Virgin Islands or Cayman Islands)?  What will be the fees and withdrawal terms?  What differentiates the fund from existing fund strategies?  Have any assets from family and friends been soft-circled for the fund?  The more thought given to overall fund structure and investment strategy on the front-end, the easier the process will be going forward.

The next step in the hedge fund formation process will be selecting a hedge fund attorney.  Choosing appropriate legal counsel is critical, as the hedge fund attorney will assist the manager with fleshing out the structure and terms of the fund, as well as guide the manager through the overall process of launching the fund.  Qualified legal counsel should be able to assist the manager with each of the steps outlined below.

Entity formation

The hedge fund lawyer will help form the fund and the management company.  The fund is typically established as a Delaware limited partnership, whereas the management company is typically established as a limited liability company in the manager’s state of residence.  The respective entity formation documents for the fund and the management company (along with the respective tax identification numbers for each entity) can then be used to open bank accounts for both the fund and the management company, as well as a brokerage account for the fund.

Preparing Offering Documents: Private Placement Memorandum, Limited Partnership Agreement and Subscription Documents

Preparing appropriate offering documents for the fund is the primary legal work involved with starting a hedge fund.  Only an experienced hedge fund attorney with a clear understanding of the structure and terms of the fund should draft the offering documents for the fund; poorly drafted offering documents will not only be a major hurdle towards attracting outside investors, but can expose the manager to significant liability in connection with the offering of interests in the fund.  The offering documents consist of:

1)      The private placement memorandum (“PPM”).  The PPM serves two purposes: (1) it is a marketing material for the fund; and (2) it should disclose to potential investors all facts material to a decision whether to invest in the fund.

2)      The limited partnership agreement (“LPA”).  The LPA is the governing contract for the fund between the management company and the investors.  Much of the LPA will mirror the structure and terms of the fund disclosed in the PPM.

3)      The subscription documents.  The subscription documents include the terms of an investment in the fund, representations and warranties that the investor is qualified to invest in the fund, and general representations and warranties pertaining to applicable securities, anti-money laundering and other laws and regulations, as appropriate.  The subscription documents are oftentimes bifurcated into two separate booklets for individual and institutional investors, respectively.

Registration

For domestic funds, depending on the types of instruments traded, assets under management, and place of business of the management company, the management company may need to register as (i) an investment adviser with the U.S. Securities and Exchange Commission or one or more state securities divisions; and/or (ii) a commodity pool operator with the U.S. Commodity Futures Trading Commission and National Futures Association.  Qualified legal counsel should be engaged to advise the manager as to whether registration is necessary (including applicable proficiency requirements) and, if so, manage the registration process on behalf of the manager.

Other Service Providers

The hedge fund attorney should also be able to assist the manager with the selection of other service providers for the fund, including a hedge fund administrator, a prime or introducing broker, and an auditor (if required) for the fund.

Marketing the Fund and Raising Capital

Once all previous steps have been completed, the fund is ready to be launched.  Initially, the manager will typically focus on raising capital from friends, family and other members of the manager’s personal network.  Eventually, third-party marketers may be used to raise capital for the fund provided each such individual is properly licensed to sell interests in the fund.  All marketing activities should be discussed beforehand with the hedge fund attorney, and all marketing and promotional materials (including websites) should be reviewed by the hedge fund attorney to assure compliance with applicable federal and state law.

Assuming there are no registration requirements, the entire process of launching a hedge fund can be completed in less than one month, depending on the complexity of the fund and the manager’s timeframe.  The keys to a successful launch are acquiring a keen understanding of the process on the front-end and hiring an experienced hedge fund attorney to assist with the launch each step of the way.

Please contact us for a free consultation if you are interested in starting a fund or would like to discuss the hedge fund formation process in greater detail.