Current legal landscape for investment managers raising funds in the U.S.

Benedicte Gravrand, Opalesque Exclusive:

Stephen C. Tirrell, Partner at global law firm Bingham McCutchen, New York, talked to Opalesque about the existing legal landscape for new investment managers who want to raise private funds in the U.S., with a focus on the Investment Advisers Act, the Securities Act, the Investment Company Act, the Exchange Act and the JOBS Act.
Opalesque: Please tell me about the legal landscape that investment managers have to consider when raising any private fund in the United States.

Stephen Tirrell: Essentially there are four different regulations that we have to consider; the Investment Advisers Act, the Securities Act, the Investment Company Act, and the Exchange Act.

They act in one or more fashion with respect to either the advisory entity or the fund entity. And in each instance, at least in the Securities Act and the Investment Company Act, there are exemptions from registration that private fund managers typically rely on with respect to the private funds that they sponsor.

The Securities Act is the Act that governs the offering of shares to investors in the market. Typically private funds don’t register their shares under the Securities Act with the Securities and Exchange Commission (SEC) but rely on an exemption from registration. Therefore, no registration filing is required; however fund managers are required to file a Form D, which is a notice filing that is filed electronically with the SEC. There is no registration statement; we just make a private offering to accredited investors under the Securities Act. And as long as the manager has a reasonable belief that the investors are accredited investors, as defined under the Securities Act, and follow certain other guidelines, they can offer those shares privately to those investors.

As for the Investment Company Act, this is the Act that people generally consider governs registered investment funds or mutual funds here in the United States. Most funds rely on either 3C1 or 3C7, which are exceptions to registration under that Act, such that the private funds aren’t considered registered investment companies or public investment companies under the Act.

The Advisers Act actually governs the investment adviser entity, and Dodd-Frank certainly changed the landscape with respect to the rules and regulations governing investment advisers under the Advisers Act. Previously, many private fund managers relied on an exemption from registration under Section 203(b) (3). The Dodd-Frank Act rescinded that exemption. Now under the revised rules, almost all investment advisers located in the United States either have to register with the SEC, or the state in which they operate. There are still exemptions to registration that investment advisers may qualify for but those exemptions are narrower after the passage of Dodd-Frank.

The Exchange Act is a twofold issue for fund managers. On the one hand, the Act essentially limits the number of investors that a private investment fund relying upon Section 3(c) (7) of the Investment Company Act can admit before they have to register the shares under the Exchange Act. That limit is 499 investors.

The Exchange Act is important for fund managers in another regard; because most private fund managers are continually raising assets, many hire placement agents, finders or solicitors, and when you are operating in the U.S. or you are offering to U.S. persons, the solicitor or placement agent needs to be an “associated person” of a registered broker-dealer, which means he or she is required to be affiliated with a registered broker-dealer here in the United States. Unfortunately, in some instances, these placement agents have not been registered broker-dealers. The SEC has stepped up its enforcement in this area; in fact there are two recent enforcement cases that deal with funds that have used unregistered broker-dealers or persons that are not affiliated with a registered broker-dealer in order to raise assets. The consequence of hiring an unregistered broker-dealer to solicit investors can be severe. Private fund managers really need to consider the registration status of the people they are dealing with when they are contracting with third parties to help them place assets.

Opalesque: And for the Securities Act and the Investment Company Act, has anything changed?

Stephen Tirrell: In the Investment Company Act, no.

In the Securities Act, there have been minor adjustments to some of the definitions, such as the definition of an accredited investor which has changed in the last few years, but not in a major fashion. Basically the rules focused on the definition of an accredited investor: it’s either a net income test or a net worth test. A net income test is that an individual has made $200,000 and has reasonable belief that they will continue to make $200,000, or with their spouse $300,000 over the next two years. The net worth test is $1 million, and again, you can count your primary residence, but how the liabilities associated with the primary residence are counted towards that $1 million has changed slightly.

Opalesque: What about the JOBS Act?

The JOBS Act, which was signed into law by President Obama in July of last year, mandated the SEC to finalize rules dealing with how companies can sell their shares.

Generally under the Securities Act, one of the tenets of making a private offering in the United States is that the issuer must not make a general solicitation, which is generally considered to be some sort of advertising. So what you don’t typically see, although not in all cases, is hedge funds or private funds market or advertise their offerings in the United States.

If you are deemed to be making a general solicitation such as on an Internet website, in magazines, whatever goes to the public at large, the issuer may be deemed to have violated the ban on general solicitation and may not be able to make a good private offering under the Securities Act. This means they can’t qualify for that exemption we discussed earlier and, absent some other exemption, may be required to register their shares under the Securities Act.

The JOBS Act mandated that Congress come up with rules to rescind that ban on general solicitations.

When that Act was first signed into law, hedge fund managers and private advisers said “we can start advertising and marketing our hedge funds in a general solicitation and therefore not have to worry about our status, our private offering status under the Securities Act.” The problem has been that, although Congress signed it into law, the SEC has not yet come up with final rules as to how to implement that law.

Opalesque: Do you think new funds are in a bit of a limbo at the moment, not knowing exactly how to position themselves with regards to advertising?

Stephen Tirell: I have had clients that have approached me in a number of occasions and said, “can we start taking advantage of this law? Congress signed it into law, can we not start advertising, whether it be advertising just the performance, advertising that we are open and we are accepting subscriptions?”

My response is no, the SEC hasn’t yet finalized rules as to how to follow the law.

Opalesque: Yes. But the JOBS Act will really be more about letting hedge funds publish their results on their website, letting the media talk about their performance openly, whereas now it’s difficult. They are not exactly going to start advertising in the newspapers or billboards…

Stephen Tirrell: Don’t be so sure of that. There are always people and companies that are going to push the boundaries. I do think you will see more advertising in trade magazines and maybe billboards.

Even when and if those rules go into effect that rescind the ban on general solicitation, what advisers have to consider are the rules and regulations governing advertising and governing the performance advertising in particular. There will be a lot more emphasis on performance advertising, particularly considering it will be out there in the public domain. They really have to pay attention to those rules and what the SEC staff has said historically regarding performance advertising.

Opalesque: You talked about five different Acts that new fund managers should take into account. Is there anything else within the legal landscape that they should be wary of?

Stephen Tirrell: There have been a lot of changes over the last few years in regards to regulation. Every couple of months, there is a new regulation that’s being promulgated, such as pay-to-play rules with respect to how investment advisers interact with government officials. There are filing obligations, such as Form PF. There are new regulations governing how investment advisers trade futures and options, how they trade derivatives under Dodd-Frank. There are different registration statuses under the CFTC with the NFA.

And so there are panoply of new rules and regulations to consider when an adviser is looking to start a new business and launch new funds, many of which have created higher barriers to entry into the market.

Given the change in legal and regulatory landscape, choosing your service providers, whether it be legal, compliance, administrators and others, is more important now than it ever has been before.

Bingham published in December’12 a summary of some of the significant changes that occurred in 2012 and certain “best practices” that one should consider in preparing for 2013. Bingham’s Recommended Annual Review for Hedge Fund and Other Private Fund Advisers can be viewed here:
Article Source: http://www.bingham.com/Alerts/2012/12/Recommended-Annual-Review-for-Hedge-Fund-and-Other-Private-Fund-Advisers

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