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Hedge funds are affected by many laws and regulations
Hedge Fund Legislation and Regulation
The laws and regulations affecting a hedge fund represent one of the most complex topics addressed in this course book. One law firm that sets up
hedge funds and provides legal services to hedge funds created a handbook1 for its clients totaling 563 pages, with promises to produce at least a second volume to complete the tutorial. In contrast, this course book presents only a summary of the major legal issues.
INTRODUCTION TO FUND REGULATION
Hedge funds are affected by many laws and regulations even when they are exempt from certain provisions. Hedge funds must comply with these rules or make certain they are able to take advantage of exemptions.
Reasons for Regulating Securities Markets
Many of the laws and regulations governing securities markets trace their origin to the stock market crash of 1929 and the resulting depression. The laws passed in 1933 and 1934 as well as more recent rules and regulations have attempted to reform the securities markets for all investors. The state and federal securities laws seek to make the markets fair for all participants. The legislation also is designed to prevent abuses and punish offenders when abuse occurs. The rules are designed to protect naive investors from harm that less naive investors escape. Finally, the rules require adequate disclosure as one of the primary means of accomplishing these goals.
Reasons for Granting Exemptions
The legislators who drafted the securities markets legislation have generally provided exceptions to individuals and institutions with substantial income, wealth, investment experience, and investment sophistication. The rationale for these exemptions is that this group gets little benefit from paternalistic protection and would be better off with greater freedom to invest as they see fit. The exemptions arbitrarily draw a line (actually several lines) separating investors who qualify for exemption from investors who do not.
There are several reasons why certain investors should be exempted from some protective provisions of the securities laws. Investors in this group, if properly identified, should have sufficient resources to be able to afford to lose all of their investments in a particular exempt investment. This group should have sufficient knowledge to make sound investment decisions. This group can hire experts on accounting, tax, law, or other specializations if their own expertise is insufficient to evaluate an exempt investment. Many in this group could invest in hedge fund products in some way by establishing offshore investment vehicles that could sidestep rigid regulations. Finally, it may be easier to permit some financial products to exist as unregulated products rather than trying (perhaps unsuccessfully) to regulate them.
INVESTMENT COMPANY ACT FUND REGISTRATION
The Investment Company Act of 1940 requires investment companies to register with the U.S. Securities and Exchange Commission (SEC) and submit to SEC regulation. Hedge funds are investment companies and would have to register but for the exemption described next.
Hedge fund organizers gain exception by selling ownership as a private placement, which means, in part, that the manager must not make a public offering of securities anywhere in the world. So-called accredited investors may buy private placements and thereby be exempt from most of the Investment Company Act of 1940 and the Securities Act of 1933. Accredited investors are defined in Section 3(c)(1) of the Investment Company Act and include individuals who earn at least $200,000 ($300,000 with spouse) both in the current year and the previous two years or have net worth of at least $1 million or are certain institutions worth at least $5 million. Hedge funds can sell to not more than 100 investors under the Section 3(c)(1) exemption. The investor count is subject to certain integration rules and lookthrough provisions that affect how the number of investors is counted. Hedge funds that limit sales to qualified purchasers may admit not more than 499 investors. Section 3(c)(7) defines a qualified purchaser as an individual, family corporation, or family trust having net worth of at least $5 million or various businesses with net worth of at least $25 million made up entirely of qualified purchasers.
Finally, commodity pools may be exempt from the Investment Company Act as long as they trade only futures (they may own and trade government securities to maintain margin on the futures positions).
SECURITIES ACT OF 1933
The Securities Act regulates the issuance of securities. Hedge funds accept money from investors by selling stock or partnership interests in an investment company. However, those investment sales are exempt from the Securities Act as long as the interests are sold as private placements.
Regulation 506 of Regulation D provides a safe harbor definition of a private placement. In addition, Regulation 506 significantly lowers the socalled blue sky requirements (the collection of state laws affecting security issuance). The hedge fund must make no general solicitation and may not advertise. The regulation created the reasonable beliefs test, which means that the manager may approach an investor only if there is a reasonable basis for believing the investor is accredited and knowledgeable based on a prior relationship. The regulation allows the manager to sell only to accredited investors, although the manager may sell to no more than 35 nonaccredited investors in return for higher disclosure requirements.
INVESTMENT ADVISERS ACT OF 1940
The Investment Advisers Act requires the investment advisers to register with the SEC and regulates the employees working for the investment adviser. Recall that a hedge fund usually has no employees but is instead a pool of cash and investments. The business organization that contains the employees and occupies office space is the hedge fund management company. This management company is an investment adviser hired by the fund and paid management and incentive fees for investment services.
Most hedge fund managers are exempt from registration because the Investment Adviser Act exempts advisers with fewer than 15 relationships from regulation. The hedge fund may have 100 or 499 investors, but the Investment Advisers Act acknowledges that the manager usually has only one customer (i.e., one hedge fund).
Some managers sponsor more than one hedge fund. In particular, a manager may have mirror funds in the United States and offshore that carry nearly identical positions. Some managers may also run separate accounts for certain investors with positions that closely resemble the hedge fund managed in parallel. These relationships could require a hedge fund manager to register as an investment adviser, but most managers limit the number of relationships to preserve their exemption. However, the SEC recently proposed requiring all hedge fund managers to register.
SECURITIES EXCHANGE ACT OF 1934
The Securities Exchange Act created the SEC, defined the duties of the SEC, and empowered the agency. The Act also defined certain illegal activities and required market participants to make certain disclosures.
The SEC is responsible for registering securities and registering and regulating securities market participants. But for the exemptions written into individual securities acts, a hedge fund would be regulated by the SEC in many ways. The sale of interests to investors (at least in the United States) would be controlled by the Securities Act of 1933 and enforced by the SEC. The day-to-day management of the investments by the management company would be controlled by the Investment Company Act of 1940 and enforced by the SEC. Finally, the marketing of hedge fund interests (unless outsourced) would require a hedge fund to register as a brokerdealer, as provided by the Securities Exchange Act.
The Securities Exchange Act established a policy of handing off a substantial portion of the monitoring and enforcement to self-regulating agencies. The Commodity Exchange Act (see next section) follows this pattern of mixing governmental and industry regulation, with the SEC regulating the securities markets and Commodity Futures Trading Commission (CFTC) regulating the futures and cash commodity markets. The New York Stock Exchange (NYSE), the Nasdaq over-the-counter market, and the National Association of Securities Dealers (NASD) all operate as self-regulating bodies.
COMMODITY EXCHANGE ACT
The Commodity Exchange Act regulates commodity pool operators and the commodity pools they manage. The Commodity Exchange Act will define a hedge fund as a commodity pool if a hedge fund trades futures or commodities. Many hedge funds therefore register as commodity pools and their managers register as commodity pool operators. There is no exemption used by hedge funds to escape regulation under the Commodity Exchange Act, except not trading futures and commodities (which really isnt an exemption).
However, if all investors are qualified eligible participants (QEPs), the fund may take an election in Section 4.7, which eases reporting requirements. A QEP is defined as an individual with $2 million in investments or $200,000 in margin (or a combination). Certain organizations with $5 million in assets, accredited individuals or organizations (under SEC Regulation D, Rule 501), or offshore individuals or organizations are also QEPs.
The Commodity Exchange Act charges the CFTC with regulating the industry. The Act also requires a self-regulating agency to regulate the individual participants. The National Futures Association (NFA) was created to implement the regulations required by the Commodity Exchange Act.
The CFTC imposes disclosure requirements and procedures for commodity industry participants. The CFTC and NFA require the hedge funds that register as commodity pools to submit audited financial statements to each agency. Each agency may subject the hedge fund to on-site audits.
EMPLOYEE RETIREMENT INCOME SECURITY ACT OF 1974
The Employee Retirement Income Security Act (ERISA) regulated qualified retirement accounts in the United States, including pension funds, various types of individual retirement accounts (IRAs), Keogh plans, simplified employee pension (SEP) plans, and other tax-deferred accounts. These retirement accounts are sometime called plan assets.
ERISA regulates the investment management of plan assets in many ways, including disclosure requirements, use of leverage, and risk tolerance, and holds the manager to the high standards of a fiduciary relationship. In contrast, investors in an exempt hedge fund are only protected from fraud, and managers are charged with few duties beyond honesty and fairness.
Not surprisingly, hedge fund managers avoid being classified as managers of plan assets. If plan assets comprise 25 percent or more of a hedge fund, the hedge fund is deemed to be plan assets and the manager and the fund are controlled by ERISA. Hedge funds monitor the portions of their funds attributable to plan assets and most managers reserve the right to return any money to investors if the investment puts them at risk of being regulated as a pension fund.
UNRELATED BUSINESS TAXABLE INCOME
Congress created a tax called the unrelated business income tax (UBIT) to prevent tax abuse and to promote fair play in the business community. The Internal Revenue Service was concerned that individuals or companies might form a tax-exempt entity (for example, a church, foundation, or endowment) and run an otherwise taxable business through the tax-exempt organization solely to avoid being taxed. Taxpaying businesses also complained that tax-exempt businesses had an unfair advantage in competing with taxable businesses because the tax-exempt businesses didnt pay tax on the profits of their businesses.
The tax was not meant to apply to investments made by tax-exempt businesses, so the law made an effort to distinguish investing activities from business activities. The nature of some hedge fund investments, coupled with the flow-through tax treatment of hedge fund returns (partnership or limited liability corporation) can trigger UBIT.
Hedge funds that have significant interest expenses may force an otherwise tax-exempt investor to pay UBIT. Income expenses exist primarily as borrowing expenses for hedge funds that use leverage. Strategies that use leverage, including many arbitrage strategies and most bond strategies, may produce large enough interest expense to require tax payments.
Tax-exempt investors can usually avoid UBIT by not using strategies that might generate interest expenses or by investing in offshore hedge funds instead of domestic (U.S.) funds. Because the offshore funds are generally organized as corporations, they do not flow interest expense on to their investors. Instead, the tax-exempt investor receives dividends (possibly) and capital gains or losses.
USA PATRIOT ACT
The Uniting and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism Act (USA Patriot Act) was passed by Congress shortly after the terrorist attack on the World Trade Center on September 11, 2001. The Act contains many provisions, but the sections that affect hedge funds most are the parts of the Act restricting money laundering.
The Act specifies many procedures and requires the manager to train employees to ensure compliance. The Act imposes a duty on hedge funds to know quite a bit about their investors. Prior to the existence of the Patriot Act, hedge funds only had to have a reasonable basis to believe their investors were suited to invest, and the Section 3(c)(1) or Section 3(c)(7) exemptions described earlier provided a basis. The duties required by the Patriot Act will become clearer over time, but advisers recommend that hedge funds gather considerably more background information than previously and probably should take steps to verify the information to assure compliance with the Act.
QUESTIONS AND PROBLEMS
8.1 Considering the complications imposed on hedge funds to take ad
vantage of registration exemptions, why dont hedge funds just register their securities and register their management companies as investment advisers?
8.2 You run a hedge fund organized under the exemption Section 3(c)(1).
You currently have 99 investors. Are you permitted to admit a senior trader as a partner in your hedge fund?
8.3 Suppose the trader in question 8.2 does not have enough income or
wealth to be an accredited investor. Is this employee permitted to invest in your hedge fund?
8.4 A wealthy investor has a net worth of $10 million but admits to hav
ing little or no knowledge of investments. He invests in a hedge fund as a limited partner. The hedge fund admits the investor as a qualified purchaser on the basis of the investors net worth. Later, the investor loses his hedge fund investment because of losses in the position of the hedge fund. Can he sue for restitution based on the argument that due to his inexperience as an investor he was not a qualified purchaser?
8.5 An offshore hedge fund has nearly 499 investors. What can the man
ager do to permit it to accept additional investors into the fund? 8.6 A domestic hedge fund has nearly 499 investors. What can the manager do to permit it to accept additional investors into the fund? 8.7 Under what circumstances does a tax-exempt investor need to worry that an investment in a hedge fund would require the hedge fund to pay unrelated business income tax?
8.8What are some of the problems for hedge funds complying with theUSA Patriot Act?8.9How do exemptions affect a hedge funds exposure to fraud rules?8.10Is it always true that investors receive less disclosure from a privatelyplaced hedge fund investment than from a registered investment account
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