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ICOs: Non-US Persons and Investor Eligibility Considerations

As blockchain continues to evolve as a disruptive technology, the regulatory environment surrounding initial coin offerings (ICOs) by companies issuing digital tokens to investors remains uncertain and subject to much debate. As a result, many companies issuing ICOs are shunning US investors altogether to avoid US securities laws. Below, we will discuss the definition of a “US person” under Regulation S of the Securities Act, which effectively determines who can invest in such ICOs and the restrictions placed on such investors. Specifically, under what circumstances, if any, will a cryptocurrency hedge fund affiliated with a US manager be permitted to participate in unregistered ICOs? Further, if allowed to participate in unregistered ICOs, when will a participating cryptocurrency fund be permitted to resell the securities on the secondary market?

Definition of a US Person – Who Can Invest?

Many ICOs restrict their offerings to non-US persons. In doing so, these issuers generally use the Regulation S definition of a “US person” to determine investor eligibility. In most cases, determining whether an investor is a US person is straightforward, as the investor will either be a non-US resident or a company formed outside the US by non-US residents. However, the determination is not as clear when a foreign entity can be traced back to a US person. The definition, provided below, contains a somewhat ambiguous example at the end that, depending on one’s interpretation, could either permit or prohibit US-managed offshore cryptocurrency hedge funds from participating in certain foreign ICOs.

Under Regulation S, a US person is:

(i) Any natural person resident in the United States;

(ii) Any partnership or corporation organized or incorporated under the laws of the United States;

(iii) Any estate of which any executor or administrator is a U.S. person;

(iv) Any trust of which any trustee is a U.S. person;

(v) Any agency or branch of a foreign entity located in the United States;

(vi) Any non-discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary for the benefit or account of a U.S. person;

(vii) Any discretionary account or similar account (other than an estate or trust) held by a dealer or other fiduciary organized, incorporated, or (if an individual) resident in the United States; and

(viii) Any partnership or corporation if:

         (A) Organized or incorporated under the laws of any foreign jurisdiction; and

         (B) Formed by a U.S. person principally for the purpose of investing in securities not registered under the Act, unless it is organized or incorporated, and owned, by accredited investors             (as defined in § 230.501(a)) who are not natural persons, estates or trusts.

The last example above is the most relevant to US-based fund managers that sponsor offshore funds to accommodate non-US investors and tax-exempt US investors. The crux of the issue is whether an offshore cryptocurrency hedge fund would qualify as a US person and be prohibited from investing in an ICO limited to non-US persons.

There are two main considerations in determining whether an offshore cryptoccurency fund would qualify as a US person under (viii)(B) above; specifically, whether the offshore fund is formed by a US person or, in the alternative, if the offshore fund is owned by accredited investors who are not natural persons, estates, or trusts.1

Formed by a US Person

Whether an offshore fund is formed by a US person can be tricky. Typically, when sponsoring an offshore fund entity, the US-based manager will instruct its offshore counsel or some other offshore organization to facilitate the process of forming the entity. However, if the ICO looks through the literal formation of the fund and concludes that the fund is effectively formed for the benefit of the US manager, such US manager that established an offshore fund, either standalone or in a master-feeder or mini-master scenario2 , may have to overhaul its overall structure and create a non-US-based management company. Each new offshore management company would itself not be considered a US person and, arguably, could form an offshore hedge fund without concern for the interpretive issue created by (viii)(B)3.

Owned by Accredited Investors who are not Natural Persons

Even if the ICO issuer determines that the offshore fund was formed by a US person, the fund itself may still avoid qualification as a US person if it is owned entirely by accredited investors who are not natural persons.

In the standalone fund context, the fund must simply limit its investor pool to accredited entities. This is mostly impractical in the ICO realm as it may be difficult to entice institutional investors or other hedge funds to invest in a fund that is focused on such a cutting-edge and volatile investment opportunity. Accordingly, other fund structures may provide more favorable conditions.

In a mini-master structure, the feeder fund, as the non-US entity in the structure, would similarly have to prohibit individuals from investing in it. This presents the same problem as the standalone fund in that it may be impractical to limit a fund of this type to entity investors.

In a master-feeder structure, the two feeder funds are technically the only investors in the master fund. If the master fund is deemed to be formed by a US person, each feeder fund would have to be an accredited investor for the master fund to not be considered a US person. Each feeder fund may meet the requirements of an accredited investor by limiting its own investors to only accredited investors. In that case, since the master fund’s investor pool only consists of the feeder investors, each investor in the master fund would be an accredited investor that is not a natural person. Notwithstanding the foregoing, many ICOs contain additional verbiage prohibiting participation by entities that are US persons or that are beneficially owned by any US persons (the latter of which would be problematic for master-feeder structures regardless of accredited investor requirements). Fund managers will therefore need to read the ICO offering details closely to confirm whether a master-feeder structure limited to accredited investors is a viable option.

Restrictions Placed on Investors

Even if an investor qualifies as a non-US person under Regulation S and can participate in the ICO, it may still be subject to additional restrictions.

Regulation S provides a safe harbor for securities offerings that take place outside of the United States. Securities that rely on the safe harbor are exempted from US securities registration requirements. To qualify for the exemption, the securities must be offered in an offshore transaction and the issuer must make no directed selling efforts in the United States. Both requirements apply to all issuers seeking safe harbor under the regulation. However additional requirements may apply depending on the type of security being offered and the equivalent category the security falls under.

Under Regulation S, securities are split into 3 categories, each with its own set of limitations.

Category 1 securities must be offered in a foreign offering and issued by non-US issuers who believe that no substantial US market interests exist for their securities. No additional restrictions are placed on Category 1 securities.

Category 2 securities include equity securities of a reporting foreign issuer and debt securities of a reporting or a non-reporting foreign issuer. Category 2 securities are subject to a 40-day distribution compliance period.

Category 3 securities are securities that do not fall into either Category 1 or Category 2.

An offshore ICO would not fall under Category 1 because a substantial US interest most likely exists for the corresponding coin4. Further, the ICO would not fall under Category 2 as the issuer of the ICO is likely not a reporting issuer and the security is not a debt security. Consequently, an offshore ICO would typically fall under Category 3 of Regulation S and carry the corresponding restrictions.

The Category 3 restrictions most relevant to investors in ICOs are the resell restrictions. A non-reporting issuer of Category 3 securities must restrict its offering for a one-year distribution compliance period that generally begins at closing. Resales of these securities are also subject to the distribution compliance period. During the compliance period, no securities can be sold/resold to US persons or to a non-US person for the benefit of a US person. Therefore, investors in the ICO may only resell their security to non-US persons for one year from closing and can resell their security to US-persons after that one-year period ends.

Conclusion

As a novel instrument, ICOs provide fund managers with unique investment opportunities. However, ICOs present equally unique challenges to fund managers due to the unsettled regulatory environment surrounding them. As such, US fund managers should take care to consult qualified legal counsel early during the fund launch process and for ongoing help with evaluating eligibility to invest in certain ICOs.

 


[1] If the fund is an offshore fund, it automatically meets the requirement of (viii)(A).

[2] US based managers typically use either a master-feeder or a mini-master structure. The master-feeder structure involves two feeder funds, one based in the US and one based outside of the US, that both invest all their capital in a master fund that is also based outside the US. The mini-master structure involves an offshore feeder fund that invests solely in a US master fund.

[3] However, this assumes that the ICO only looks through to the management company of the fund investing in the ICO and not to the US-based, affiliated management companies and/or principals of those companies.

[4] A substantial US market interests exists “where (i) U.S. securities exchanges and NASDAQ in the aggregate constituted the single largest market for such class of securities in the issuer’s prior fiscal year, or (ii) 20% or more of trading in the class of equity securities during such period occurred in such U.S. markets and less than 55% of trading in such securities took place during that period through the facilities of the securities markets or a single foreign country (17 CFR 230.902).” An offshore ICO would generally qualify for (ii) in the preceding definition as a significant portion of trading in the asset class takes place in the US.



Regulation CF Update

Last Year, we discussed the SEC’s most recent attempt to implement Title III of the Jumpstart Our Business Startups Act (JOBS Act) through the establishment of a new rule, Regulation Crowdfunding (Regulation CF). Regulation CF became effective on May 16, 2016, and this February the SEC released a white paper outlining Regulation CF offerings initiated in the first six months (May 16, 2016-December 31, 2016).

To recap, Regulation CF allows issuers to raise up to $1 million over a 12-month period from individual investors. Issuers that utilize Regulation CF are required to utilize a funding portal or broker-dealer. Additionally, there are limits to the amount each individual investor can invest. Over a 12-month trailing period, investors with an annual income or net worth of less than $100,000 may invest, among all securities offered under Regulation CF, the greater of (i) $2,000 or (ii) 5% of the lesser of their annual income or net worth. Over a 12-month trailing period, investors with an annual income and net worth of at least $100,000 may invest, among all securities offered under Regulation CF, the lesser of (i) 10% of their annual income and (ii) 10% of their net worth.

From May 15, 2016 through December 31, 2016, there were 163 unique offerings (on a Form C) seeking a target amount of $18 million. While most of the 163 offerings are still ongoing, as of December 31, 2016, 28 offerings filed documents signifying completion (on a Form C-U). Those 28 offerings raised approximately $8 million. Here are additional takeaways from the first six months of Regulation CF:

Characteristics of the Offering

• The average offering set a target of $110,000. The median amount was $53,000.
• Of the 28 offerings that filed a Form C-U, issuers raised an average of $290,000 and a median amount of $171,000 for a total of $8.1 million.
• The average target duration for an offering was 4.5 months.
• Issuers offered equity in 36% of the offerings; debt in 20% of the offerings; and other security types such as units, convertibles, simple arrangements for revenue sharing (SAFEs), and other revenue sharing and membership interests in 44% of all offerings.

Issuer Characteristics

• The average issuer age was 28.7 months (18 months median). 21% of all issuers were incorporated less than three months before initiating an offering.
• Issuers had a median of three employees.
• The median issuer had $43,000 in assets and an average of $210,000 in assets, although 21% of all issuers had no assets.
• The median issuer had $0 in revenue. 60% of all issuers were pre-revenue.
• The average net loss of the most recent fiscal year was $147,900, and only 9% of all issuers generated positive income in their most recent fiscal year.
• The average debt/asset ratio was 5.2; the median was 0.7.

Intermediary Characteristics

• 21 intermediaries participated in Regulation CF offerings (13 funding portals and 8 broker-dealers)
• The top 5 intermediaries (Wefunder Portal LLC, StartEngine Capital LLC, Trucrowd Inc., Nextseed Us LLC, and Dreamfunded Marketplace LLC) constituted 71% of all offerings.
• The average fee as a percent of proceeds for funding portals was 5.1% and the median was 5%. The average fee as a percent of proceeds for broker-dealers was 7.7% and the median was 7%.
• Funding portals took a financial interest in 16% of their offerings. Funding portals took an average 2.4% financial interest in issuers, while broker-dealers took an average financial interest of 5.2%.

Regulation CF appears to be a fairly popular method of raising funds. Issuers utilized Regulation CF in 163 unique offerings in its first six months, compared to Regulation A+’s 147 offerings in its first 16 months. Given the average target amount is $110,000, and the average target offering timetable is 4.5 months, it appears that issuers are electing to utilize Regulation CF for quick access to relatively small amounts of capital.

From the data, we can see that the typical issuer fits into the definition of a startup company. The typical Regulation CF issuer has been in business for less than three years, zero revenue, little to no assets, few employees and moderate amounts of debt. Given the relatively low cost of raising funds (~5-7% intermediary fees), Regulation CF might be the cheapest or most effective method of raising capital until these small, up-and-coming companies can begin to generate revenue.

It will take quite some time to determine the success or failure of Regulation CF. From May 15, 2016 through December 31, 2016, 28 of the 163 offerings filed completion documents, reporting approximately $8 million in raised capital. We will continue to monitor the capital raising activity of Regulation CF as well as the outcome for the issuers that conduct offerings pursuant to Regulation CF.

Please feel free to reach out to us if you have any additional questions or if you think that Regulation CF could be a viable option for your investment offering.

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

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.

Guest Post: SEC to Examine Compliance with Whistleblower Provisions

As even casual followers of SEC enforcement actions are aware, whistleblower provisions under Dodd-Frank remain a hot-button topic among investment advisers and the investing public in general–the SEC awarded over $57 million to 13 whistleblowers during the 2016 fiscal year, which is more than in all previous years combined. In light of a recent risk alert on the subject issued by the SEC, below is a guest post by Todd Kaplan of Cloudbreak Compliance Group, LLC (“Cloudbreak”), re-posted here with Cloudbreak’s permission. Cloudbreak is a boutique consulting firm that provides fund managers with regulatory compliance support. For more information regarding Cloudbreak’s services, please see their contact information below the post.  

SEC to Examine Compliance with Whistleblower Provisions

On October 24, 2016, the Securities and Exchange Commission (the “SEC”) issued a Risk Alert stating that it is examining advisers’ compliance with key whistleblower provisions under the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Whistleblower Provisions”).

As part of this initiative, the SEC will focus on a variety of documents to assess whether they violate the Whistleblower Provisions, including Compliance Manuals, Codes of Ethics, employment agreements and severance agreements.  In particular, the SEC is seeking any provisions that:  (a) purport to limit the types of information that an employee may convey to the SEC or other authorities, and (b) require departing employees to waive their rights to any individual monetary recovery in connection with reporting information to the government.  The Risk Alert highlights certain provisions that may cause concern, including those that:

  • Require an employee to represent that he or she has not assisted in any investigation involving the adviser;
  • Prohibit any and all disclosures of confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations;
  • Require an employee to notify and/or obtain consent from the adviser prior to disclosing confidential information, without any exception for voluntary communications with the SEC concerning possible securities laws violations; or
  • Purport to permit disclosures of confidential information only as required by law, without any exception for voluntary communications with the SEC concerning possible securities laws violations.

In light of the Risk Alert, advisers may wish to ensure that they have adopted policies and procedures to comply with the Whistleblower Provisions.

Advisers may also wish to review their Compliance Manuals, Codes of Ethics, employment agreements, severance agreements and any other documents imposing confidentiality obligations on employees to determine whether they contain any provisions that are inconsistent with the Whistleblower Provisions.  Potential remedial actions could include:

  • Revising documents on a going-forward basis to make it clear that nothing contained in them prohibits employees/former employees from voluntarily communicating with the SEC or other authorities regarding possible violations of law or from recovering a SEC whistleblower award;
  • Providing general notice to employees, or notice to employees who signed restrictive agreements, of their right to contact the SEC or other authorities; and
  • Contacting former employees who signed severance agreements to inform them that the company does not prohibit them from communicating with the SEC or seeking a whistleblower award.

For more information regarding Cloudbreak Compliance Group, LLC, please visit their website or contact Todd Kaplan at todd@cloudbreakcompliance.com.


Legal Disclaimer: Cloudbreak is a compliance consulting firm and does not provide legal advice.  This guest post contains general information only.  Cloudbreak is not, by means of this guest post, rendering professional advice or services.  Before making any decision or taking any action that might affect your business, you should consult with your legal counsel and other qualified professional advisers.  This guest post is presented without any warranty or representation as to its accuracy or completeness.  Cloudbreak assumes no responsibility to update this guest post based on events after its publication.

 

Intrastate Crowdfunding Update

On October 26, 2016, the Securities and Exchange Commission (“SEC”) adopted final rules regarding intrastate crowdfunding offerings. The final rules amend Securities Act Rule 147 to update the safe harbor protections under Section 3(a)(11) of the Securities Act, so that issuers may continue to use state law exemptions that are conditioned upon compliance with both Section 3(a)(11) and Rule 147.

As background, the Jumpstart Our Business Startups (“JOBS”) Act was signed into law in 2012, but the SEC did not adopt final rules implementing Title III of the JOBS Act until October 30, 2015. During this regulatory limbo, many states—including Georgia (see below)—decided to jump start the process by enacting their own legislation permitting intrastate offerings in reliance upon the federal exemption.

Each company relying on the federal intrastate offering exemption must (i) be organized in the state where it is offering the securities; (ii) carry out a significant amount of its business in that state; and (iii) make the particular offer and sale of securities only to residents of that state. The issuing company is also responsible for ensuring that securities offered under the intrastate exemption are neither sold to any out-of-state residents nor resold to residents of other states with a certain time-period (typically nine months). Beyond that, the SEC is effectively deferring to the states to oversee intrastate crowdfunding offerings.

With that in mind, all participating states require issuers to do one of the following:

  • register their intrastate securities offering with that state’s securities commission; or
  • qualify for an exemption from state registration.

Although registering securities offerings at the state level is not as costly and onerous as registering securities offerings with the SEC, it can still be a burden. The intrastate crowdfunding exemption can therefore be a useful tool for local businesses looking to raise limited capital from local investors in a cost-effective and timely manner.

To its credit, Georgia was an intrastate crowdfunding pioneer. In 2011, Georgia became the second state (after Kansas) to enact an intrastate crowdfunding exemption when it enacted the Invest Georgia Exemption (“IGE”). Initially, Georgia-based companies could raise up to $1 million through the IGE; however, in October of 2015 Georgia increased the cap to $5 million to address issuer concerns regarding the usefulness of the exemption.

Companies relying on the IGE must meet the following requirements:

  • The issuer is a for-profit business entity formed in Georgia and registered with the Secretary of State;
  • The transaction qualifies for the federal exemption for intrastate offerings in Section 3(a)(11);
  • The issuer raises no more than $5 million from Georgia resident investors; and
  • The issuer accepts no more than $10,000 from each non-accredited investor.

Additionally, an issuer must file a notice—called a “Form GA-1”—with the state securities commissioner before the use of “general solicitation” or the 25th sale of the security, whichever occurs first. The notice must contain the names and addresses of the following persons:

  • The issuer;
  • All persons involved in the offer or sale of securities on behalf of the issuer; and
  • The bank or other depository institution in which investor funds will be deposited.

Each state intrastate exemption is unique. State exemptions may vary with respect to the cap on the amount that can be raised, the amount allowed from each non-accredited investor, the number of non-accredited investors allowed per security offering, whether the security must be offered on an equity crowdfunding portal, etc. To ensure compliance with current intrastate exemptions, we strongly suggest contacting an attorney familiar with these types of offerings.

As always, feel free to contact us should you have any questions regarding this post.

Year-End Compliance Alert for Investment Managers

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

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.

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.

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.