NY Metro Hedgefund Law & News

Registered Investment Companies engaging in Futures Transactions May Lose Blanket Exemption from Treatment as Commodities Pool Operators.

The National Futures Association (“NFA”) has petitioned the Commodity Futures Trading Commission (“CFTC”) to amend  CFTC Rule 4.5, which provides an exclusion to the definition of “commodity pool operator” for  certain eligible persons who would otherwise be considered as commodity pool operators.  In that regard CFTC Rule 4.5 provides an exclusion from "commodity pool operator" treatment for investment companies registered under the Investment Company Act of 1940. 

The exclusion is important because persons who are considered as “commodity pool operators” are required to register as such with the CFTC. Moreover, investment advisors to commodities pool operators are required to register as “commodity trading advisors” with the CFTC.

 The NFA petition is now seeking to limit the scope of the CFTC Rule 4.5 exclusion for investment companies registered under the Investment Company Act of 1940.  See Petition of the National Futures Association to Amend Rule 4.5, 75 Fed. Reg. 56997 (September 17, 2010).

Proposed Amendments

The NFA proposed amendments would impose the following restrictions on registered investment companies in order for them to be able to be qualify for the CFTC Rule 4.5 exclusion:

 •   Bona Fide Hedging Purposes, 5% Limit - Use of commodity futures or commodity options contracts will need to be solely for bona fide hedging purposes, provided that the aggregate initial margin and premiums for any non-hedging positions, which may only be held by the qualifying entity, will not exceed 5% of the liquidation value of that qualifying entity's portfolio.

•   Market Restrictions - Such entity will not be marketed to the public as a commodity pool or otherwise as a vehicle for trading in or otherwise seeking investment exposure to, the commodity futures or commodity options markets.

Prior to 2003 rule changes, registered investment companies seeking exclusion under Rule 4.5 were subject to certain trading and marketing restrictions.  The NFA proposed amendments are substantially similar to those previous restrictions, although the juxtapostion of a seeming total ban on non-hedged positions along with a seeming allowance of de minimis (5%) non-hedged positions is confusing.

 Important Dates

 Comments on the NFA petition to amend CFTC Rule 4.5 must be received on or before October 18, 2010.

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 Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

 

SEC Sweep of Funds of Funds and Advisers

A number of sources have reported on an ongoing SEC sweep of funds of funds and investment advisers making or recommending investments in underlying hedge and private equity funds to uncover conflicts of interest and lapses in oversight of client funds.

Among other items, the SEC is seeking the names of hedge funds that were considered but rejected as well as the names of all third party consultants who were involved in the decisions to hire or reject a fund.

The SEC will also be examining the personal accounts of individual managers of funds of funds or investment advisers to see if any unfair advantage was taken of special knowledge they obtained in such positions such as front running or betting against client orders. The sweep letter also asks for dates and amounts of client withdrawals, details of any revenue sharing agreements, and trade blotters for both clients and managers.

Sources report that the initial SEC inquiry is to firms with $100MM to $15BB in assets under management.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Hedge Funds Post 0.55% Average Loss for Month of August

Hedge fund performance managed to outpace broader market indices, but nonetheless posted an average loss of 0.55% for the month of August, according to Hennessee Group LLC. 

Market commentators noted that fund managers were hurt by the poor performance of the overall stock market.  Over that same period, the Dow Jones Industrial Average (“DJIA”) was down 4.31%, with the S&P 500 losing 4.7%.

July saw hedge funds post their only gain in the past four months, with the average fund up 1.9%.  This followed losses the previous two months, with 1.35% and 3.01% declines in June and May, respectively, according to Hennessee Group.

Performance by Investment Strategy

Hedge Fund Research, another consulting firm reporting on hedge fund performance, provides the following strategy-specific data:

•   Short-Bias - Short-bias funds performed well for the month of August, posting a gain of 3.0%.

•    Macro Funds - Macro funds showed a gain of 2.16% for the month of August.

•   Event-Driven - Funds specializing in event-driven strategies were nearly flat for the month of August.

It should be noted that according to Hedge Fund Research, the average fund posted a 0.17% gain in August, in contrast to the average loss of 0.55% for funds tracked by the Hennessee Group.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

Securities Act of 1933: Regulation D “Safe Harbor” Provisions

Securities Act of 1933

 The Securities Act of 1933 (“Securities Act”), as amended, is a federal law providing for the registration of securities with the Securities and Exchange Commission (“SEC”).  While hedge fund interests do fit the definition of a “security” under the Securities Act, Regulation D “Safe Harbor” provisions govern the limited offer and sale of securities without registration.  See Regulation D.  Rule 506 is the most widely relied upon exemption under Regulation D, with qualifying funds permitted to raise an unlimited amount of capital.  This article is designed to outline not only the Rule 506 exemption, but also Rule 504 and Rule 505 exemptions under the Regulation D Safe Harbor provisions.

Requirements for Meeting Regulation D

Rule 501 - Definitions and Terms Used in Regulation D

The most relevant portion of Rule 501 is the definition of an “accredited investor.”

•   Accredited Investor - Although there are several categories available to satisfy this standard, there are two generally relied upon approaches for individual investors. The more prominent is the ‘net worth’ standard of $1MM, exclusive of primary residence.  As an alternative for individual investors there is  the ‘net income’ test, requiring income in excess of $200,000 in each of the two most recent years or joint income with one’s spouse in excess of $300,000 in each of those years and a reasonable expectation of reaching the same income level in the current year.  For the institutional investor, the most common standard met is having total assets in excess of $5MM.

Rule 502 - General Conditions to Be Met

Rule 502 provides conditions for funds qualifying under the Regulation D Safe Harbor provisions.  Issued securities must comply with certain integration rules, and limits on resale.  A fund must also furnish certain information to any non-accredited investors in any offering.

Most notable among these conditions, Rule 502 contains public offering restrictions in accordance with rule 4(2) of the Securities Act.

•   No Public Offering of Securities - Neither the issuer nor any person acting on its behalf shall offer or sell the securities by any form of general solicitation or general advertising, including, but not limited to, the following:

         - Any advertisement, article, notice or other communication published in any newspaper, magazine, or similar media or broadcast over television or radio; and

      - Any seminar or meeting whose attendees have been invited by any general solicitation or general advertising.

There are certain exceptions for activities held outside of the United States, including journalist access to press conferences, meetings with an issuer or its selling representatives, and press-related materials.

Rule 503 - Filing of Notice of Sales

Rule 503 governs the filing of Form D with the SEC.  An issuer offering or selling securities in reliance on Rule 504, Rule 505 or Rule 506 shall file with the SEC five copies of a notice on Form D no later than 15 days after the first sale of securities. This is to  filed electronically and needs to be updated annually as long as the securities offering in question is open to investors.

Rule 504 - Exemption for Limited Offerings and Sales of Securities Not Exceeding $1,000,000 

Rule 504 provides an exemption to registration where no more than $1MM of securities are offered during any 12 month period.  Securities Exchange Act of 1934 companies (those subject to the reporting requirements of section 13 or 15(d) thereof), investment companies, and certain development stage companies may not employ the Rule 504 exemption. 

Note that under certain conditions, Rule 504 exempt companies may engage in general solicitation in connection with securities.

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

Rule 505 provides an exemption to registration where no more than $5MM of securities are offered during any 12 month period, and there is a limited number of non-accredited investors in any offering.  Investment companies may not employ the Rule 505 exemption.

•   Limitation on Number of Purchasers - Requires that there are no more than, or the issuer reasonably believes there are no more than, 35 non-accredited investor purchasers of securities from the issuer in any offering under this exemption.

Rule 506 - Exemption for Limited Offers and Sales without Regard to Dollar Amount of Offering 

Rule 506 provides an exemption where a fund meets conditions for both the nature of investors, and the number of non-accredited investors in any offering.  Qualifying funds are permitted to raise an unlimited amount of capital.

• Limitation on Number of Purchasers - Requires that there are no more than, or the issuer reasonably believes that there are no more than, 35 non-accredited investor purchasers of securities from the issuer in any offering under this exemption.
  

• Nature of Purchasers - Each non-accredited investor, either alone or with his purchaser representative(s), must have such knowledge and experience in financial and business matters that he is capable of evaluating the merits and risks of the prospective investment, or the issuer reasonably believes immediately prior to making any sale that such purchaser comes within this description.
  

Disqualification from Regulation D

Rule 507 - Disqualifying Provision Relating to Exemptions Under Rule 504, Rule 505 and Rule 506 

Rule 507 provides that no exemption under Regulation D will be available if an issuer has been found to be in violation of Rule 503  Form D filing requirements.

Rule 508 - Insignificant Deviations from a Term, Condition or Requirement of Regulation D 

Rule 508 describes conditions for certain insignificant violations not resulting in the loss of exemption under Regulation D.

Note that violations of general solicitation rules, maximum dollar limits or number of purchasers will be deemed significant.

“Bad Actors” Provision

As set forth in the Dodd-Frank Bill, the SEC will promulgate rules that disqualify “bad actors” from relying on the Rule 506 exemption under Regulation D.  Currently, these rules only apply to Rule 505 exemptions.  The SEC will issue this set of rules by July 21, 2011.

The new provisions bar an individual that: 

(1) is subject to a final order of an appropriate regulatory body that bars the person from association with an entity regulated by such authority, engaging in the business of securities, insurance, or banking, or engaging in savings association or credit union activities, or constitutes a final order based on a violation of any law or regulation that prohibits fraudulent, manipulative, or deceptive conduct within the 10-year period ending on the date of the filing of the offer or sale; or 

(2) has been convicted of any felony or misdemeanor in connection with the purchase or sale of any security or involving the making of any false filing with the Commission. 

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 Regulation D provisions relate to transactions exempted from the registration requirements of section 5 of the Securities Act.  Such transactions are not exempt from the anti fraud, civil liability, or other provisions of the federal securities laws. 

Nothing in these rules obviates the need to comply with any applicable state law relating to the offer and sale of securities.  Regulation D is intended to be a basic element in a uniform system of Federal-State limited offering exemptions consistent with the provisions of sections 18 and 19(c) of the Act.  In those states that have adopted Regulation D, or any version of Regulation D, special attention should be directed to the applicable state laws and regulations, including those relating to registration of person who receive remuneration in connection with the offer and sale of securities, to disqualification of issuers and other persons associated with offerings based on state administrative orders or judgments, and to requirements for filings of notices of sales. 

It is important to note that hedge funds are subject to all federal securities laws, and while this article discusses a particular set of registration exemptions to the Securities Act of 1933 under Regulation D, there are several other important federal laws for sponsors and managers to keep in mind: 

         •   Securities Exchange Act of 1934

         •   Investment Advisers Act of 1940

         •   Investment Company Act of 1940

         •   Commodities Exchange Act

 

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

 

Dodd Frank Act - Primer on the Volcker Rule

Under the so-called Volcker Rule (the "Rule") of the Dodd Frank Act a banking entity except as permitted by other parts of the Rule is prohibited from:

1. engaging in proprietary trading, and
2. from aquiring or retaining any interest in or sponsorship of a hedge fund or private equity fund. 

The permitted activities are:

1. investment in US government and agency obligations, certain obligations of US government related issuers such as Fannie Mae and Freddie Mac, and US state and local obligations
2. underwriting and market making  activities to the extent they are not designed to exceed reasonably expected near term demands of clients, customers or counterparties
3. hedging activities designed to reduce risk to the banking entity
4. the purchase, sale, acquisition, or disposition of securities or other instruments on behalf of customers
5. investments in one or more small business investment companies as defined in the Small Business Investment Company Act of 1958, investments designed to promote the public welfare, and investments that are qualified rehabilitation expenditures with regard to a qualified rehabilitated building or certified historic structure
6. insurance company investments for its general account permitted by insurance company investment laws, subject to certain insurance, banking, and financial oversight 
7. organization and offering of a private equity or hedge fund to which the banking entity provides bona fide trust, fiduciary services, or investment advisory services - subject to numerous additional conditions
8. certain proprietary trading activity conducted solely outside the US
9. certain hedge fund and private equity fund activity conducted solely outside the US

There are a number of limitations on the foregoing exceptions. The most important pertains to Item 7 and limits the banking entity, subject to a number of other limitations, to making (i)  an investment for up to a 3% interest  in a proprietary  private equity or  hedge fund and (ii) an amount up to 3% of the banking entity's Tier I capital in all such funds. However, a banking entity is permitted to provide temporary seed capital of up to 100% of a new fund for up to one year.

There are also restrictions on the types of transactions which a banking entity which is the manager, investment adviser, or sponsor to a hedge fund or private equity fund may enter into with the fund. There is an explicit permission to provide prime brokerage services - again subject to numerous requirements.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.

 

 

 

Sponsors and Managers: Beware Benefit Plan Investors in Your Fund(s)

The assets of a hedge fund in which benefit plan investors have invested will not be considered “plan assets” if the equity participation in the fund by “benefit plan investors” is not “significant” (the “25% Limit”).  If a hedge fund does not comply with the 25% Limit, and the hedge fund does not meet one of the other exceptions under the Plan Asset Regulations, then the assets of the hedge fund will be deemed “plan assets” for purposes of  ERISA and Section 4975 of the Code, with adverse consequences.

 Investments in hedge funds by pension plans governed by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), or the “prohibited transaction” rules of Section 4975 of the Internal Revenue Code of 1986, as amended (the “Code”), raise special issues for the managers of those funds.  Depending upon the structure and operation of a hedge fund, its assets may be considered “plan assets” for purposes of ERISA and Section 4975 of the Code.  For the reasons discussed below, hedge fund managers typically seek to structure their funds so that their assets are not characterized as “plan assets” for purposes of ERISA and the Code.  This article outlines the requirements of, and legal and practical issues raised by, compliance with the “25% Limit” - the approach that hedge fund managers commonly use so that their funds’ assets are not considered “plan assets” for purposes of ERISA and Section 4975 of the Code.

The Department of Labor’s (“DOL”) plan asset regulations (the “Plan Asset Regulations”) define what constitutes “plan assets.” The Plan Asset Regulations provide as a general rule that, when an employee benefit plan governed by ERISA or Section 4975 of the Code (a “Plan”) invests in an entity, the Plan’s assets include the Plan’s investment but do not, solely by reason of such investment in the entity, include any of the underlying assets of the entity. However, as in the case of a hedge fund, where the Plan’s investment is an equity interest that is not a publicly offered security or a security issued by a company that is registered under the 1940 Act, the Plan’s assets include both the equity interest and an undivided interest in each of the underlying assets of the hedge fund unless one of the exceptions in the Plan Asset Regulations is satisfied. The exception most commonly used by hedge funds provides that assets of a hedge fund in which a Plan has invested will not be considered “plan assets” if the equity participation in the fund by “benefit plan investors” is not “significant”, defined to mean not over 25%. 

If a hedge fund does not comply with the 25% Limit, and the hedge fund does not meet one of the other exceptions under the Plan Asset Regulations, then the assets of the hedge fund will be deemed “plan assets” for purposes of ERISA and Section 4975 of the Code. The consequences of this would include:

• the hedge fund’s manager would be a fiduciary of each Plan investor governed by ERISA, and the manager’s activities would be subject to the general fiduciary requirements of Section 404 of ERISA;

• all of the hedge fund’s activities would be subject to the prohibited transaction rules of Section 406 of ERISA and Section 4975 of the Code. Among other things, transactions with affiliates would be restricted, and performance fees charged by the hedge fund manager would need to be structured to ensure compliance with applicable DOL guidelines; and

• in many instances, failure to comply with the 25% Limit would result in a withdrawal or redemption of the capital committed by Plans, which may have a material adverse impact on a hedge fund’s operations.

The Plan Asset Regulations define a “benefit plan investor” broadly as:

• any employee benefit plan, whether or not subject to ERISA and whether or not covering U.S. employees (including governmental plans, church plans and non-U.S. plans);

• any plan described in Section 4975(e)(1) of the Code, including individual retirement accounts and Keogh plans; and any entity whose underlying assets include “plan assets” by reason of an employee benefit plan’s investment in the entity (e.g., insurance company separate accounts or collective investment vehicles, including other hedge funds, that do not comply with the 25% Limit). Thus, the term “benefit plan investor” includes plans that are not themselves subject to ERISA.

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Robert Kiggins, Esq. of McCarthy Fingar LLP, is author of the blog, and may be reached at (914) 385-1024 or rkiggins@mccarthyfingar.com.