Q1: What sort of legal structure should be used for the fund?
A: The typical investment fund structure for a U.S. domestic private investment fund (“hedge fund”) is a limited partnership, with separate entities serving as general partner and investment manager. Investors contribute capital to the limited partnership and receive partnership interests and a capital account in the partnership in return. The gains and losses attributable to the hedge fund’s performance are passed through to the investor’s capital accounts on a pro rata basis, subject to a performance allocation (discussed below). The use of limited liability companies for hedge funds is on the rise, but certain managers (such as Texas-based managers) will not use limited liability companies because of tax consequences in certain jurisdictions.
Q2: What sort of legal structure should be used for the investment management entity?
A: The simplest, least expensive and least complicated form for the management of a hedge fund is for an individual to serve as the general partner and investment manager of the hedge fund partnership. This form is very uncommon because it does not offer limited liability against certain third parties, such as creditors. Instead, most hedge funds are formed as limited partnerships with a limited liability company acting as the general partner. Often, for tax and other structural reasons, the general partner may be a limited partnership with its general partner being a limited liability company.
As noted above, the use of a limited liability company as a general partner of the hedge fund (or as the general partner of the general partner of the hedge fund) gives limited personal liability against certain third parties. The persons who manage a limited liability company general partner (the “principals”) will, however, still be subject to liabilities under the securities laws, for which the principals can be held to be personally liable irrespective of the legal form of the entity that serves as the general partner.
Another advantage of a limited liability company or limited partnership as a general partner is the opportunity it offers for estate planning. These entity general partners also provide the opportunity to offer equity interests to employees or strategic investors or to create certain incentive compensation arrangements for employees. For tax reasons in many jurisdictions, managers frequently use two separate entities at the management level, one serving as the general partner of the hedge fund partnership and one serving under a contract as the investment manager to the hedge fund partnership.
Q3: What is the typical compensation to the general partner?
A: The general partner of a hedge fund typically is entitled to an incentive allocation equal to twenty percent of the net profits allocated at the end of the year to each partner. This allocation is based on realized and unrealized gains and losses and is made on a partner by partner basis. It is important to note that managers that are registered as investment advisers are generally prohibited from collecting incentive allocations except from investors with a net worth over $2,000,000, or people who invest more than $1,000,000 in the hedge fund ("qualified clients")*, "qualified purchasers" (as described below) and certain “knowledgeable employees” of the investment manager, subject to limited grandfathering. The general partner or an affiliate also typically receives a management fee which is typically one percent to two percent of the net asset value of the hedge fund and paid quarterly in advance.
* The SEC is required to adjust the dollar thresholds to reflect inflation beginning in 2016 and every five years thereafter.
Q4: Are there typically any limitations on the compensation of the general partner?
A: For incentive allocations, there is usually a loss carry-forward provision that carries forward any losses previously allocated to a partner either for one year, some other period or without time limitation until the loss has been completely absorbed. If the loss carry-forward is without time limitation, it is usually called a “high water mark.” Additionally, sometimes general partners are subjected to a “hurdle rate,” or a condition to receipt of an incentive allocation based on the limited partners achieving a minimum specified return. Usually, the general partner gets a twenty percent incentive allocation with respect to all net profits as long as the limited partners receive the hurdle rate. In the event the hurdle rate is not earned, the general partner receives no incentive allocation for that year.
Some general partners implement a “rolling high water mark” that allows the general partner to collect incentive compensation or profits at a reduced rate when an investor’s account is below its high water mark. This incentivizes the general partner to continue operating the fund and try to earn back its losses, and helps ensure the manager is able to incentivize its traders and employees. Under the conventional high water mark, a general partner might be inclined to shut the fund down because without any performance compensation the general partner is working for free and likely unable to keep its employees.
Q5: What securities laws are applicable?
A: Historically, the offer and sale of securities within the United States has been subject to concurrent federal and state regulation under the Securities Act of 1933 (the “Securities Act”) and state blue sky laws. In order to avoid the registration and prospectus delivery requirements of the Securities Act, securities of hedge funds and offshore funds are typically offered in private placement transactions, which rely on the private placement “safe harbor” provisions of Regulation D or the safe harbor for offerings outside the United States contained in Regulation S.
In the past, a separate exemption from state registration or qualification requirements needed to be perfected under the blue sky law of each state where the securities were offered. However, under current law, states are prohibited from imposing their blue sky laws relating to registration or qualification of securities with respect to securities offered in a private placement pursuant to Rule 506 of Regulation D. States are still permitted to (and several do) (i) require “blue sky” notice filings which are similar to the Form D that is filed with the Securities and Exchange Commission (SEC) pursuant to Regulation D and (ii) collect filing fees. Since early 2009, the SEC has required that Form Ds be filed electronically, and many states accept the electronic filing for state law purposes. Current law prohibits states from regulating the content of offering documents or the terms of securities being offered, but several state securities authorities require filing of any private placement memoranda in connection with registration as an investment adviser. Certain states may regulate general partners and their employees (if applicable) as brokers, and require certain filings under their broker-dealer regulatory schemes prior to the offer of any securities in their jurisdictions. These filings can be burdensome and time consuming.
See “How can I sell interests in my fund” for additional important conditions to selling interests under securities laws.
Q6: What are the registration requirements for investment advisers?
A: Investment adviser regulation is split between the states and the SEC, but a few investment advisers escape regulation completely. Most state-registered investment advisers with less than $100,000,00, in assets under management are prohibited from registering with the SEC. However, investment advisers with less than $100,000,000, but more than $25,000,000, in AUM may still be required to register federally if (i) the adviser is required to be registered in the state in which it maintains its principal place of business but the state does not subject investment advisers registered in the state to examination by that state’s securities commissioner, agency or office (New York is currently the only state that does not inspect) or (ii) the state in which the adviser maintains its principal office and place of business provides an exemption that the adviser is eligible to use (irrespective of whether it opts to use it). If an adviser would be required to register with 15 or more states, then the adviser may, instead, elect to register with the SEC under section 203 of the Advisers Act.
The Advisers Act provides the following investment advisers with an exemption from federal registration:
• advisers whose sole clients are venture capital funds (as defined by the SEC)
• advisers whose sole clients are private funds* and have total AUM in the U.S. of less than $150,000,000
• advisers who provide investment advice solely to licensed small business investment companies (unless registered as a business development company)
• an adviser registered with the Commodity Futures Trading Commission as a commodity trading adviser and advises a private fund (provided the business of such adviser does not become predominantly the provision of securities-related advice)
• an adviser that has no place of business in the U.S., has less than $25,000,000 in AUM related to clients or investors located in the U.S., has fewer than 15 clients and investors in private funds in the U.S., and does not hold itself out to the U.S. public as an investment adviser.
Advisers relying on the first two exemptions listed above are subject to record retention requirements and are required to file a partial Form ADV on an annual basis.
An exemption from federal registration does not exempt a fund or fund manager from the anti-fraud provisions of the Advisers Act or from any state registration requirements. If an investment adviser is not registered with the SEC, it must consider whether it must register with the state regulatory authority. Hedge fund managers with a place of business in Texas must register as investment advisers under Texas law unless all investors in the fund are subject to a two year lock-up. Texas also has a regulatory regime for its registered investment advisers, thus preventing Texas-based investment advisers with less than $100,000,000 in AUM from being required to register federally. In New York, managers must register if they have six or more clients, with each fund being a client. New York, however, does not inspect its registered investment advisers and, therefore, the threshold for federal registration in New York is $25,000,000 even if the adviser is registered in New York.
Some managers feel it is easier to get investors to invest in the hedge fund if they register, but doing so limits (if the manager charges an incentive allocation as most hedge fund managers do) potential investors to “accredited investors” that are also qualified clients or qualified purchasers and certain knowledgeable employees of the investment manager.** Registered investment advisers who act as advisers to offshore funds and “qualified purchaser funds” described below are not subject to restrictions on incentive fees. Certain institutional investors will only place funds with registered investment advisers.
* Private funds are funds that would be an investment company under the Company Act if it were not for the exceptions provided by Section 3(c)(1) or 3(c)(7) of the Company Act. A “fund of one” does not satisfy the requirements for a private fund for the purposes of the $150 million exemption.
** Investment advisers registered in Texas are also subject to the above limitations on the performance compensation.
Q7: How can I sell interests in my funds?
A: Congress enacted the Jumpstart Our Business Startups Act (the “JOBS Act”) in 2012, which directed the SEC to relax the ability to communicate with potential investors in a private offering so long as it has taken reasonable steps to verify that all investors are accredited. Unfortunately, the SEC has not yet enacted the required rules under the JOBS Act. Until the JOBS Act rules are adopted, advisers must sell interests in affiliated funds very carefully. The private placement rules and related SEC interpretations currently in effect severely limit what you can do to sell interests in the fund. Generally speaking, you should have a pre-existing relationship with every offeree. You may send private placement memoranda to persons with whom you have pre-existing relationships with, provided they meet the sophisticated investor requirements of an accredited investor. Furthermore, to sell securities in a private placement to accredited investors requires a very low-key selling effort, which is subject to numerous restrictions in order to avoid engaging in a “general solicitation.” One should be even more careful if one is soliciting unaccredited investors.
The SEC staff has recently focused on the broker-dealer activities of marketing personnel. To avoid being required to register as a broker-dealer, advisers should avoid paying marketing personnel performance-based compensation or having a dedicated marketing group.
Q8: Should I limit my offering of limited partnership interest to accredited investors only?
A: In general, yes. The private placement exemption under Regulation D of the Securities Act is only available if you limit offerings to 35 persons who are non-accredited. The private placement rules also require the disclosure of much more in depth information similar to a registration statement if a non-accredited investor invests. In addition, the traditional wisdom is that accredited investors are less likely to sue than non-accredited investors and that juries are less sympathetic to accredited investors than they are to non-accredited investors. Furthermore, as noted above, incentive compensation can only be charged if the investor is a qualified client.
Q9: Can I take pension plan money?
A: Yes. However, most hedge funds limit participation by pension plans to no more than twenty-five percent of the value of the fund (or any class thereof) that can be held by employee benefit plan investors, such as ERISA plans, IRA’s and 401(k) plans in order to avoid being subject to ERISA. Those fund managers that wish to take more than the twenty-five percent threshold may qualify as a “qualified professional asset manager” under a Department of Labor exemption if they, among other things, are federally registered, have client assets under management in excess of $85,000,000, and have equity in excess of $1,000,000. If so qualified, the adviser is exempt from compliance with certain “prohibited transaction rules” under ERISA, which, without the exemption, typically make the operation of a hedge fund not practical.
Q10: Do I have to wait until I have a private placement memorandum (“PPM”) prepared before I can talk with people about the fund?
A: Although there is no per se requirement that a PPM ever be prepared in a private placement so long as no non-accredited investors invest in the fund, most funds are offered through use of a PPM. The purpose of having a PPM is to minimize one’s liability under the securities laws through warning investors of risks of investment and limiting the representations made about a fund and its management. To make an offer (and it is hard to imagine that “talking to someone” who later buys would not be making an offer) without delivering a PPM to some degree acts to defeat that purpose. While a general partner could attempt to claim that the later delivery of a PPM cures any securities liability, delivery of a PPM after investment may not be effective. No attempt should be made to “pre-sell” a fund prior to the delivery of a PPM.
Furthermore, the private placement rules require the delivery of a PPM and other required information to non-accredited investors and compliance with Rule 506 is required in order to be exempt from certain state blue sky law restrictions. Non-accredited investors should not be contacted prior to the delivery of the PPM.
Q11: Can I use third parties to sell the fund?
A: Yes, you can use third parties to sell the fund, but typically substantial investors will not consent to the use of their own money to pay commissions. Furthermore, in most cases anyone who sells your units must be licensed as a broker-dealer. Solicitation service agreements with broker-dealers must comply with certain disclosure requirements under the Advisers Act if managed accounts are also being offered.
Q12: Is there a difference between a “finder” and a broker-dealer in selling my interests?
A: Under both federal and the laws of most states, a person soliciting a securities transaction must be registered as a broker-dealer, except in very limited circumstances. If a hedge fund uses an unregistered broker-dealer to sell its interests, it will have violated applicable law and may have an obligation to refund investors’ money. Furthermore, the SEC has recently brought an action against a manager who retained an unregistered broker-dealer for “causing” the unregistered broker-dealer’s violation. The SEC uses electronic Form D fields regarding registration status of any soliciting to monitor compliance with this requirement.
Q13: What is a 3(c)(1) fund?
A: The reference to 3(c)(1) is to an exclusion from registration as an investment company pursuant to Section 3(c)(1) of the Investment Company Act (a law which mainly regulates mutual funds) (the “3(c)(1) Fund Exclusion”). Under this exemption, a hedge fund will not have to register under the Investment Company Act if its outstanding securities are not owned by more than 100 persons and the hedge fund has not conducted a public offering (a “3(c)(1) Fund”). Compliance with the Investment Company Act would be difficult, if not impossible, for most hedge fund managers. Accordingly, some hedge funds choose to rely on the 3(c)(1) Fund Exclusion and therefore must monitor the number of persons owning interests in the hedge fund.
Counting to 100 is not as straightforward as it might seem. Sometimes the 3(c)(1) Fund Exclusion or SEC interpretations force a fund to “look through” an entity investor and count each of the underlying beneficial owners of the entity based on certain percentage tests, which may increase the number of investors counting against the 100 investor limit. Also, certain knowledgeable employees, spouses of jointly held interests or interests held by one beneficial owner through multiple entities may not count (or only count as one investor) against the 100 investor limit. In addition, separate hedge funds that are managed by a single fund manager may be integrated for purposes of the 100 investor limit if the strategies employed by the funds are not sufficiently distinct.
Q14: What is a 3(c)(7) fund?
A: The reference to 3(c)(7) is to an exclusion from registration as an investment company pursuant to Section 3(c)(7) of the Investment Company Act (the “3(c)(7) Fund Exclusion”). This exclusion is available for a hedge fund, which limits its limited partners to individual investors (qualified purchasers) who own not less than $5,000,000 in investments, and to entities that own not less than $25,000,000 in investments, as defined by the SEC (a “3(c)(7) fund”). An entity that has less than $25,000,000, but which is beneficially owned by persons who are qualified purchasers may also be considered a qualified purchaser. For a number of tax and regulatory reasons, 3(c)(7) Funds still must limit the number of investors to fewer than 500.
Q15: Can a fund manager simultaneously operate both a 3(c)(1) fund and a 3(c)(7) fund which are substantially similar to each other?
A: Yes. Legislation passed in 1996 eliminates the application of the “integration” doctrine in this context. The integration doctrine was developed by the SEC staff to police the 100 security holder restriction on 3(c)(1) Funds. In broad terms, this doctrine requires two substantially identical funds to be treated as if they were a single fund for purposes of testing whether the 3(c)(1) Exclusion is available. While the new rule exempts properly constituted 3(c)(1) Funds and 3(c)(7) Funds from the integration principle, the principle still applies in most other cases.
Q16: Can the 3(c)(7) Fund Exclusion and the 3(c)(1) Fund Exclusion be combined in a single fund in which the investors consist of qualified purchasers plus up to 100 others?
A: No, except in the case of a fund that was in existence on September 1, 1996, and satisfies certain additional requirements.
Q17: Does the 3(c)(7) Fund Exclusion apply to an offshore fund that restricts ownership of its shares by United States persons exclusively to qualified purchasers but does not impose similar restrictions on its non-U.S. security holders?
A: Yes. Pursuant to the so-called Touche Remnant Doctrine, the SEC staff for a number of years has permitted offshore funds to sell their shares privately to up to 100 U.S. beneficial owners, without regard to the number of non-U.S. owners, by analogy to the 3(c)(1) Fund Exclusion. The same policy reasons have been extended to permit offshore funds to place their shares with an unlimited number of U.S. qualified purchasers.
Q18: What about trading commodities?
A: If a hedge fund trades in swaps (other than securities-based swaps) futures contracts or options thereon or another commodity pool, the fund would likely be considered a commodity pool under the Commodity Exchange Act, and the general partner or its delegee operator of the fund would have to register with the Commodity Futures Trading Commission (“CFTC”) through the National Futures Association (“NFA”) as a commodity pool operator (“CPO”) (and if a separate entity acts as investment adviser, it too may need to register as a CPO and/or commodity trading advisor(“CTA”)). Current CFTC regulations offer an exemption to registration to investment managers of hedge funds that limit a hedge fund’s investors to only accredited investors and commodities positions to (i) (in the aggregate) initial margin and premiums of less than five percent of the net assets of the hedge fund or (ii) a net notional value of less than one hundred percent of the hedge fund’s liquidation value. Operators of hedge funds that trade any swaps or futures in excess of the above thresholds are required to register as CPOs. CPOs would still be able to use the disclosure, reporting and recordkeeping exemption in Regulation 4.7.
Q19: Can I use my affiliated broker-dealer to execute trades on behalf of the hedge fund?
A: A hedge fund manager may generally use an affiliated broker-dealer to execute trades on behalf of the hedge fund, but in all cases the investment adviser of the hedge fund will be obligated to seek best execution on behalf of the fund and should disclose to investors the possibility of execution of trades by an affiliate.
Q20: Can I take soft dollars from brokers?
A: Yes, but the investment adviser should make certain that soft dollars are not used to circumvent the expense sharing arrangements set forth in the hedge fund partnership agreement and that the use is properly documented and disclosed to investors in the PPM. In addition, while managers are allowed to take soft dollar offers into consideration when selecting brokers, the brokers selected must offer best execution for investors, and soft dollars are only one factor that may be considered when making a selection. Managers generally use soft dollars only within the safe harbor of the Advisers Act, which limits soft dollars to research and research related expenses.
Q21: Are there any restrictions on my participating in IPOs?
A: Yes, a hedge fund must have a profit allocation procedure in place to deny or limit participation in profits from securities sold in initial public offerings (“new issues”) to certain categories of investors who are specified in the Financial Industry Regulatory Authority, Inc. (“FINRA”) rules. Without such a provision, the hedge fund can either chose not participate in new issues or not take FINRA restricted persons as investors. FINRA rules permit (i) restricted persons affiliated with the financial industry to have an aggregate of up to ten percent participation in new issues and (ii) persons affiliated with any public company issuer or certain non-public company issuers (the “affiliated issuer”) to have an aggregate of up to twenty five percent participation if the affiliated issuer is a recent, current or potential investment banking client of the underwriter placing the new issue.
Q22: Do I need to take a test to operate a general partner or investment manager of a fund?
A: The answer varies depending upon the state in which an investment manager or general partner is domiciled. In those jurisdictions that require a manager to register as an investment adviser, managers generally need to take a general securities law exam (usually Series 7 and Series 66) or the exam on state law (usually the Series 65 exam). CFAs are exempt from exam requirements in some states.
Management of investment advisers to private funds registered with the SEC are generally not required to take the above examinations, but some states require registration irrespective of SEC registration.
Q23: Can a partner satisfy its capital contribution requirements by contributing marketable securities to the hedge fund?
A: Yes, but under certain circumstances the contribution may be taxable to the contributing partner if the contribution results in a diversification of the partner’s interest. Generally speaking, if the partner contributes an already diversified portfolio of securities wherein not more than twenty-five percent of the value of the contributed portfolio is invested in the securities of one issuer and not more than fifty percent of the value of the contributed portfolio is invested in the securities of five or fewer issuers, there should be no current tax to pay. This issue can result in a series of calculations of some complexity. In addition, the contributing partner may be subject to tax on the “built-in gains” inherent in the contributed marketable securities when those securities are sold.
For a variety of tax and non-tax reasons, hedge funds generally do not accept contributions of marketable securities. To the extent a hedge fund does elect to accept marketable securities, a contributing partner will generally be required to provide the hedge fund with the acquisition date and tax basis of marketable securities, as well as any other information regarding the marketable securities as required by the hedge fund. Prospective investors should consult with their own tax advisors with respect to the contribution of marketable securities to a hedge fund.
Q24: Will the short swing profits rules of the federal securities laws ever be applicable to my hedge fund?
A: The short swing profits rules of the federal securities laws will be applicable to any hedge fund to the extent that it acquires ten percent or more of the outstanding securities of an issuer that has securities registered with the SEC or has director representative on a public company’s board of directors. The short swing profits rules essentially provide that profits obtained through the purchase and sale or sale and purchase of an equity security within a six month period must be repaid to the issuer. The short swing profits rules only apply to officers, directors and ten percent shareholders of publicly traded companies. The short swing profit rules may be applicable to a hedge fund if a principal is an officer or director of a publicly traded company in which the hedge fund owns any securities. Registered investment advisers are generally exempt from the short swing profit rules so long as they acquire the securities for passive purposes and in the ordinary course of business.
Q25: Will my hedge fund be subject to the two percent floor and three percent limitation on the deductibility for federal income tax purposes of business expenses?
A: If the hedge fund is classified as a trader and not an investor, they are not subject to these restrictions on deductibility of expenses.
Q26: What is UBTI and why should a hedge fund manager care?
A: Tax-exempt organizations, including qualified pension and profit sharing trusts and individual retirement accounts, are generally exempt from federal income taxation. However, such organizations are subject to taxation on their “unrelated business taxable income” (“UBTI”). UBTI includes income from most business operations; however, it generally does not include interest, dividends and gains from the sale or exchange of capital assets. Because hedge funds trade for their own accounts in debt and equity securities, their income will consist almost exclusively of interest, dividends and gains from the sale of capital assets. Consequently, a tax-exempt investor’s distributive share of such income of a hedge fund will not be UBTI and will not be subject to federal income tax. Tax-exempt investors will be subject, however, to federal income tax on their distributive share of any other income of a hedge fund that is classified as UBTI, as well as the portion of any income and gains that is derived through a hedge fund from property with respect to which there is acquisition indebtedness.
Hedge fund borrowings would give rise to UBTI if the related investment were to give rise to any income during the taxable year or years in which such borrowing was outstanding or if the related investment were disposed of at a gain within twelve months after such borrowing was repaid. Further, an investment by a hedge fund will result in acquisition indebtedness (i) if indebtedness incurred before the investment would not have been incurred but for the investment, (ii) if the investment is actually made with the use of borrowed funds or (iii) if the investment necessitates future borrowings and this eventuality was foreseeable at the time the investment was made. For example, if a hedge fund were to purchase stock in a company and finance one-half of the purchase price with debt and then sell the stock for a gain, the hedge fund would have UBTI equal to one-half of the gain offset by one-half of the net interest cost. A tax-exempt organization will be subject to a tax return filing requirement if it takes into account $1,000 or more of gross income in computing UBTI. The receipt of UBTI by a tax-exempt organization generally will not affect its tax-exempt status if the investment is not otherwise inconsistent with the nature of its tax-exemption. Short sales transactions involving publicly traded securities do not generally give rise to UBTI, but, as in all matters relating to taxes, it is wise to check with your tax advisor.
As a general proposition tax-exempt investors do not like to receive UBTI principally because it requires them to prepare and file a tax return on Form 990T, which they would not otherwise have to file and pay taxes on that income at the corporate rate. Therefore, they will generally avoid hedge funds that generate UBTI.
Q27: What is an offshore fund?
A: Offshore funds are investment vehicles, organized outside the U.S., which offer their securities primarily to non-U.S. investors (and, as noted above, to U.S. tax-exempt investors in some instances). However, these funds do have contacts with the U.S. First, the fund’s portfolios typically consist of securities of U.S. issuers, which are usually traded in U.S. securities markets. Secondly, the managers of these funds are generally U.S. money managers. U.S. fund managers typically create offshore funds in Caribbean jurisdictions, although a European offshore entity may be more appropriate if a significant number of European investors are involved.
Q28: Should I create an offshore fund?
A: Offshore funds are typically created by investment managers who have significant potential investors outside the U.S. The advantage of an offshore fund is that the investors in the fund would generally not be subject to U.S. taxation as long as the fund complied with certain rules established by the Internal Revenue Service. Offshore funds are also attractive to U.S. tax-exempt investors as a way to avoid UBTI.
Offshore funds can increase the costs and administrative burdens of launching and operating a hedge fund. In addition to the expense of engaging local counsel, it is typical for offshore fund jurisdictions to require the fund to, among other things, have independent directors, maintain a third party administrator licensed in that jurisdiction and file its offering documents and subsequent amendments with the local monetary authority. The cost of each of these items varies based on the jurisdiction, the entity type and the complexity of the fund.
An offshore fund generally makes sense only if a money manager has significant clients or prospects who reside outside the U.S. or who are U.S. tax-exempt entities. When initially breaking into non-U.S. markets, many U.S. money managers will utilize their contacts that have significant experience and resources in the investment community outside the U.S. Money managers often permit these “sponsors” to invest in their offshore funds on favorable terms or pay them a finder’s fee for investors that are brought to the table.
Q29: Where should I establish my offshore fund?
A: The answer to this question for most money managers is one of the Caribbean tax haven jurisdictions. Which of these jurisdictions is chosen will often depend on the type of entity that is desired and the cost structure of the fund. For example, the Cayman Islands and Bermuda have developed comprehensive schemes for the organization and administration of investment funds that provide additional security to potential investors, but the costs of establishing and maintaining a fund in the Cayman Islands or Bermuda are generally higher than many of the other Caribbean jurisdictions.
Although some money managers with significant European investor interest establish funds in European offshore jurisdictions such as the Isle of Man, Jersey and Ireland, we have found that the time difference creates administrative difficulties for U.S. managers. The Organization of Economic Cooperation and Development (“OECD”) has developed a list of jurisdictions with “harmful tax practices,” that could have a significant impact on the choice of offshore jurisdiction.
Q30: What is a “master/feeder” structure and should I create one?
A: A “master/feeder” structure is one in which assets from domestic and offshore “feeder” funds are dropped into a “master” fund, which serves as the investment entity for the feeders. A master fund is a general or limited partnership or similar structure that is treated as a pass-through entity for U.S. federal income tax purposes. The master fund is often formed in the same jurisdiction as the offshore feeder fund. A diagram of a typical master/feeder structure follows:
Master/feeder structures provide significant benefits for money managers, including, among other things:
• having one investment entity instead of multiple entities
• allowing the feeder funds to aggregate their assets at the master fund level in order to participate in certain private placements that each individual feeder fund could not have otherwise participated in
• allowing the manager to take an incentive allocation at the master fund level rather than a performance-based fee at the feeder fund level, which may be more favorable to the manager from a tax perspective.
Master funds may, however, raise issues under U.S. securities laws and limit the ability to differentiate strategies among the various feeder funds. The desirability of a master/feeder structure will depend on the strategy and goals of the individual manager as well as the overall fund structure.
Q31: What happens if a hedge fund offers interests in an offshore fund to U.S. investors?
A: To the extent that U.S. investors are solicited, many of the legal considerations applicable to domestic funds (such as the Advisers Act, the Investment Company Act and federal and state securities laws) will need to be analyzed. It also raises certain issues for taxable U.S. investors. For example, the fund will likely be considered a passive foreign investment company (“PFIC”) for U.S. tax purposes, which may have adverse tax consequences for taxable U.S. investors. Also, a U.S. person that has a financial interest in any non-U.S. financial account, which generally includes offshore funds, must prepare and file the Report of Foreign Bank and Financial Accounts (“FBAR form”) each year. Penalties for failure to file an FBAR form are substantial.
Q32: What are my obligations with respect to anti-money laundering and identity theft?
A: Under trade sanction regulations adopted through the Department of Treasury’s Office of Foreign Asset Control (“OFAC”), hedge funds, or any other person having minimal contacts with the United States, are prohibited from accepting subscriptions from or on behalf of certain specifically identified persons set forth on the OFAC list. OFAC considers whether an investment adviser or other financial institution has implemented effective policies in determining whether to take enforcement actions. Such policies and procedures may be undertaken by the adviser or outsourced to the hedge fund administrator. Offshore jurisdictions also typically have anti-money laundering laws and regulations that will apply to offshore investment funds.
Advisers with client or investor accounts that permit third party transfers or that are creditors for its clients are required to develop policies that are reasonably designed to identify, detect and respond to identity theft red flags. Many advisers, however, prohibit such third party transfers and are, therefore, not technically subject to the rules.
Q33: What custody rules apply?
A: SEC rules require that all client assets, other than certain privately offered securities, must be held by a qualified custodian, which is typically a bank or other financial institution. The custody rules also require that the investment adviser inform its clients of the identity of the custodian and that either the custodian or the adviser deliver quarterly account statements to the clients. In addition, an adviser with custody must (i) undergo an annual surprise examination by an independent public accountant registered with the Public Accounting Oversight Board (“PCAOB”) to verify client assets; (ii) have a reasonable belief after due inquiry that any qualified custodian maintaining client assets sends account statements directly to advisory clients; and (iii) if the adviser or a related person acts as qualified custodian of client assets, obtain or receive from the related person, a report on internal controls relating to the custody of client assets prepared by an independent PCAOB-registered public accountant. Advisers to pooled investment vehicles like hedge funds are exempt from the annual surprise audit and the requirement to provide quarterly account statements to clients if the adviser delivers to clients an audited annual financial statements prepared by a PCAOB registered accountant within 120 days of the end of the fiscal year, or within 180 days of the end of the fiscal year for hedge fund of funds.
Q34: What policies must I develop and maintain?
A: The SEC requires each investment adviser to adopt written policies and procedures reasonably designed to prevent violations by the adviser and its supervised persons of the Advisers Act and rules. In addition, the investment adviser should have a code of ethics governing employees, their personal trading and insider trading. Such policies and procedures and their effectiveness must be internally reviewed at least annually. An adviser is also required to designate a chief compliance officer, an individual to be responsible for the administration of the adopted policies and procedures.
Q35: What obligations do I have to protect investor information?
A: The general partner or investment adviser to a hedge fund is subject to federal rules (the “privacy rules”) requiring the adoption of certain procedures designed to maintain and protect the privacy of information it obtains concerning its investors from inappropriate disclosures to third-parties. The privacy rules also require the general partner or adviser to give initial and annual notices about these policies and procedures to prospective and existing investors. The privacy rules apply to investment advisers even if they are not registered with the SEC or any other financial services industry regulator. In addition to the privacy rules, if the investment adviser is registered with the SEC, CFTC or other regulatory body, the adviser is also subject to any additional regulations adopted by such organization.
Q36: What do I have to tell my hedge fund investors about voting proxies?
A: In the course of managing accounts or funds, an investment adviser may be required to exercise its proxy voting authority on behalf of clients, including hedge funds holding securities. Rule 206(4)-6 of the Advisers Act prohibits an investment adviser from exercising proxy voting authority with respect to client securities, unless the investment adviser (i) adopts and implements written policies and procedures that are reasonably designed to ensure that the adviser votes proxies in the clients’ best interests, (ii) describes its proxy voting procedures to its clients in its ADV brochure and provides copies upon request and (iii) discloses to clients how they may obtain information on how the investment adviser voted their proxies.
In addition, a registered investment adviser must maintain all records of:
• proxy statements and materials received on behalf of clients
• proxy votes that are made on behalf of the clients
• documents that were material to a proxy vote
• written requests from clients regarding voting history and
• responses to such requests.
Q37: What are my record-keeping requirements?
A: The SEC imposes extensive recordkeeping requirements on registered investment advisers and attaches considerable importance to these provisions. Generally speaking, Rule 204-2 of the Advisers Act requires an adviser to maintain two types of records:
• typical business accounting records
• certain records regarding the adviser’s clients that the SEC believes an adviser should keep in light of the special fiduciary nature of its business, including copies of all written communications relating to any advice or recommendations given or proposed to be given to clients; any receipts; records of the disbursement or delivery of funds or securities and records regarding the placing or execution of any order to purchase or sell any security.
The records required to be maintained under Rule 204-2 must be maintained in an easily accessible place for at least five years from the end of the adviser’s fiscal year during which the last entry was made, with the first two years being in the office of the adviser. These requirements survive the termination or discontinuance of the adviser. In addition, the records are subject to reasonable periodic or special examinations by the SEC.
The SEC believes that this policy encompasses all forms of written communication, including e-mails. It is recommended that all registered investment advisers develop a comprehensive record-keeping policy, including provisions for e-mail retention. A copy of the adviser’s policies and procedures must also be maintained.
Persons trading swaps and persons registered with the CFTC are subject to additional recordkeeping obligations.
Q38: What do I need to know about rules and regulations on short-selling?
A: Due to its concerns regarding persistent failures to deliver and potentially abusive “naked” short selling for certain securities (selling shares “short” without first having borrowed them), the SEC adopted Regulation SHO, which became effective in early 2005. This regulation requires broker-dealers to locate a source of borrowable shares prior to selling short, to close out open short positions if not closed out within the business day following the settlement day and to not display prices for short sales (other than exempt short sales) of less than or equal to the national best bid price for when the price of the securities has declined more than ten percent during a single day.
The SEC also adopted an anti-fraud rule in 2008 that addresses intentional naked short selling. The rule makes deception of a broker-dealer or other market participant regarding the ability to deliver securities at settlement a deceptive practice if delivery is not actually made.
Persons subject to Section 16 are generally prohibited from selling securities short unless only “selling against the box.” Additional prohibitions apply for the sale of put contracts. Persons subject to Section 16 should discuss their short sale activities with a securities lawyer before effecting any such sale.
Q39: Are managers of hedge funds subject to additional fraud liabilities?
A: Rule 206(4)-8 under the Advisers Act prohibits advisers to pooled investment vehicles (including hedge funds), whether or not registered with the SEC, from making false or misleading statements to current or prospective investors in such vehicles. While the rule appears to be similar to other anti-fraud rules at first glance, this rule is much broader in that it is not limited to transactions, so it applies continuously to adviser activity, and it prohibits other fraudulent or misleading conduct, apart from misleading statements.
Q40: What are the annual compliance requirements frequently applicable to hedge fund and managers?
A: Investment advisers to hedge funds are commonly required to update certain information on an annual basis: Form D amendments, new-issue certifications, Form ADV information and privacy policies.
All hedge funds engaged in a continuing offering are required to file an annual amendment to their Form Ds on the electronic form on or before the first anniversary of the filing of the notice of sales on Form D or the filing of the most recent amendment to the notice of sales on Form D, if the offering is continuing at that time.
Hedge fund advisers should consider whether there are any state “blue sky” filing obligations in connection with the offering or sale of interests in the funds. The applicable state laws of most jurisdictions require blue sky filings for the sale of fund interests. The deadline for such filings is generally 15 days after the date of the first sale of interests in any particular jurisdiction (with a few limited exceptions, such as New York and Idaho, which may require pre-sale filings). State blue sky filings consist of a Form D and some combination of a Form U-2 and payment of a filing fee. New York requires an additional disclosure document (Form 99). Please note that a few jurisdictions have no blue sky filing requirements, while others have exemptions from blue sky filing requirements for certain categories of investors, such as institutional accredited investors.
Pursuant to FINRA Rule 5130, a member of FINRA is prohibited from selling a New Issue - defined to include many securities sold pursuant to an initial public offering - to any client, unless such member receives a representation from its client within the previous 12 months that the client is not a “restricted person,” and restricted persons do not have more than a de minimis ownership in said client. To comply with the annual representation requirements in good faith, hedge fund advisers should reconfirm that the restricted person status of investors in its affiliated funds have not changed since the certification made in the subscription documents. This annual certification may be obtained through “negative consent” letters.
Registered investment advisers must file Form PF within 120 days after the end of the fiscal year and CPOs must file within 90 days after the end of the year. Large hedge fund advisers and CPOs must file Form PF and Form CPO-PR, respectively, within 60 days after the end of each quarter. Every registered CPO must file a shortened Form CPO-PQR on a quarterly basis within 60 days of the end of the quarter. Registered CTAs must file Form CTA-PR on an annual basis for 2012 but on a quarterly basis starting on September 30, 2013.
CPOs and advisers to private fund must distribute their audited financials within 90 or 120 days after the end of the fiscal year.
Q41: What are the filing requirements for Form ADV and what does it entail?
A: Form ADV consists of two parts: Part 1 and Part 2. With respect to Part I of Form ADV, SEC registered investment advisers (and most state-registered investment advisers) are required to annually update and file Part I with the SEC and with individual state regulators, if applicable. Updates are generally due electronically on the SEC’s Investment Adviser Registration Depository (IARD) system within 90 days of the adviser’s fiscal year end.
Form ADV Part 2 requires that:
• information must be presented in narrative format using “plain English” to describe 18 various aspects of an adviser’s business in a prescribed order (the “brochure”)
• it must be electronically filed with the SEC through the IARD system, which allows public access to the form
• a supplement to the electronically filed brochure relating to persons providing investment advice or contacting clients or prospective clients must be provided to such clients, subject to certain exceptions (the “supplement”).
Unlike the brochure, the supplement is not filed with the SEC and advisers are required to maintain copies of all supplements and amendments in their files.
Advisers must deliver the brochure to a prospective client prior to or at the time when the adviser enters into an advisory contract with the client. In addition, the supplement must be delivered to the client before or at the time when certain key investment personnel of the adviser begin providing advisory services to that client. Interim updates to the brochure or supplement will be required when a material change occurs, such as changes with respect to disciplinary information. Annually, within 120 days of the end of their fiscal year, advisers will be required to deliver either an updated brochure and supplement that includes a summary of any material changes, or a summary of any material changes, along with an offer to provide an updated brochure and supplement.
Q42: What is Form PF and when do I have to file it?
A: Registered investment advisers with more than $150 million in private fund assets, calculated in the aggregate with certain parallel managed accounts, must file Form PF on at least an annual basis. The information required to be reported varies depending on the type of funds and the assets under management. Most investment advisers to private funds are required to report within 120 days after the end of the fiscal year, but those investment advisers with $1.5 billion or more in assets under management related to hedge funds as of the end of any month in the quarter preceding the previous quarter (“large hedge fund advisers”) are required to file Form PF within 60 days after the end of each quarter.
Form PF requests extensive information regarding the adviser and each private fund it advises, including fund returns, risk metrics, exposures, investor liquidity and profile. Large hedge fund advisers and an adviser that has $2 billion or more in private equity fund assets under management must provide additional information regarding its hedge funds or private equity funds, respectively. Furthermore, the form requires more granular detail about hedge funds managed if a large hedge fund adviser advises any private funds with more than $500 million in net asset value. The definitions of hedge fund and private equity fund are sometimes counterintuitive and should be discussed with a lawyer familiar with SEC rules.
Q43: What are Forms CPO-PQR and CTA-PR and when do I have to file them?
All registered CPOs, including those using the exemption from certain regulatory requirements under CFTC Regulation 4.7, are required to file a Form CPO-PQR through the National Futures Association’s “Easy File System.” The Easy File System changes the information required depending on the aggregate assets under management of the CPO to request information required by either the CFTC or the NFA’s version of the form. The NFA’s version of Form CPO-PQR (the “NFA-PQR”) is a subset of the information contained in the CFTC’s version of Form CPO-PQR (the “CFTC-PQR”). The NFA-PQR consists of most of Schedule A of CFTC-PQR and the schedule of investments in Schedule B. All registered CPOs must file NFA-PQR within 60 days after the end of the first, second and third quarters of the year and 90 days after the end of the fourth quarter. The CFTC requires all registered CPOs to file CFTC-PQR on at least an annual basis within 90 days after the end of the year. A large CPO (i.e., a CPO with aggregate AUM of $1.5 billion or more at the close of business during the previous quarter) must file CFTC-PQR within 60 days after each calendar quarter during which it satisfied the large CPO threshold. All other CPOs must file the appropriate parts of CFTC-PQR within 90 days after the end of the calendar year.
The requirement to file NFA-PQR applies to all registered CPOs irrespective of whether they file Form PF and remains consistent irrespective of the level of assets that a CPO operates. The information required by CFTC-PQR, however, varies with the type of filer. All CPOs are required to file Schedule A. Large CPOs and CPOs with more than $150 million in AUM, but less than $1.5 billion in AUM (“mid-sized CPOs”) are required to file a separate Schedule B with respect to each pool operated during the relevant period. Large CPOs must file Part 1 of Schedule C and large CPOs that operate commodity pools with an NAV of $500 million or more as of the close of business of the relevant period must complete Part 2 of Schedule C. Much of the information is duplicative of Form PF; registered CPOs to private funds that file Form PF are not required to file Schedules B or C of CFTC-PQR for the pools reported on Form PF, but the filing of Form PF does not impact the obligation to file NFA-PQR or complete the schedule of investments.
As indicated above, the filing is through the NFA’s Easy File System. Whether a person is completing the NFA-PQR or the CFTC-PQR will be dictated by the CPO’s response to certain questions, but which form is being completed or that is requiring a response is not always clear to the person completing the form.
All CTAs registered or required to register with the CFTC are required to complete Form CTA-PR within 45 days after the end of the fiscal year, beginning with the first fiscal year ending after December 15, 2012. Entities registered as both CPOs and CTAs are required to complete Schedule A of Form CTA-PR in addition to completing the applicable schedules of Form CPO-PQR (and Form PF, if applicable). Note that the NFA is planning to require Form CTA-PR on a quarterly basis, but not before the end of the second quarter of 2013. Form CTA-PR is a significantly shorter and easier form to complete than Form CPO-PQR.
Q44: What other service providers do I need?
A: In addition to the U.S. legal counsel, the following service providers are usually selected for starting a hedge fund:
• an independent auditor (preferably a well-known and established auditing firm)
• an administrator
• one or more prime brokers (usually also act as custodians)
• for an offshore fund, fund legal counsel licensed and practicing in the relevant offshore jurisdiction.
You may also consider hiring a compliance consultant to assist with developing and maintaining policies and procedures.
Q45: Will I have to file a 13F report?
A: If you hold long positions in certain U.S. publicly traded equity securities valued at more than $100,000,000, you are required to file a Schedule 13F with the SEC listing your portfolio holdings on a quarterly basis. Although the 13F regulations permit confidential filings, in practice, confidential treatment requests are often rejected by the SEC absent compelling reasons.
Q46: When will a hedge fund have 13D or 13G filing obligations?
A: Hedge funds may be required to make a filing on Schedule 13D or Schedule 13G with the SEC (and send copies of the filing to the principal exchange on which the securities are registered and the issuer of the securities) if the hedge fund acquires five percent or more of the outstanding securities of any class of a publicly traded company. The Schedule 13D or 13G provides information with respect to the acquiring entity and the purpose of the acquisition. An amendment to a Schedule 13D must be filed if there is a material change in investment intention of the hedge fund or if the percentage of outstanding securities of the issuer held by the filer changes by more than one percent.
Registered investment advisers holding securities in the ordinary course of business and other investment advisers that hold less than twenty percent of the securities of an issuer on a strictly passive basis are exempt from the Schedule 13D filing obligations and, instead, are generally allowed to file a short-form Schedule 13G. An amendment to a Schedule 13G must be filed at the end of each year in which there is any change in the ownership of the securities and generally, if the percentage of outstanding securities of the issuer held by the filer changes by more than five percent or exceeds ten percent of the outstanding shares. Each of these filings must be made through the SEC’s electronic filing system.
Q47: When will I be required to file a Form 13H?
A: A person with investment discretion directly or with its affiliates over accounts that engage in transaction in exchange-traded securities that equal or exceed (i) 2 million shares or $20 million in market value in any calendar day or (ii) 20 million shares or $200 million in market value in any calendar month (a “large trader”) is required to file Form 13H. Form 13H sets out basic information regarding the structure of the trader and the brokers it uses. The SEC will then provide the large trader with a larger trader identification number that the large trader will provide to each of its broker-dealers to associate with its accounts.
Q48: What is FATCA and how will it affect my offshore fund?
A: The Hiring Incentives to Restore Employment (HIRE) Act of 2010 added Sections 1471 through 1474 to the U.S. Internal Revenue Code. These provisions, known as the Foreign Account Tax Compliance Act, or “FATCA,” impose a withholding tax of 30 percent on (i) U.S.-source interest, dividends and certain other types of income, and (ii) the gross proceeds from the sale or disposition of assets that produce such types of income, which are received by a foreign financial institution (FFI), unless such foreign financial institution enters into an FFI agreement with the U.S. Internal Revenue Service (IRS) to obtain certain information as to the identity of the direct and indirect owners of accounts in such institution. If a foreign financial institution was formed in a jurisdiction that has entered into an intergovernmental agreement (IGA) with the United States, then the foreign financial institution will not be required to enter into an FFI agreement and will instead be required to comply with its jurisdiction’s local information reporting requirements in order to avoid the imposition of the withholding tax.
Although FATCA became effective by statute on January 1, 2013, withholding on U.S.-source interest, dividends and certain other types of income will not apply until January 1, 2015. Withholding on gross proceeds will not apply until July 1, 2017. The IRS has released the U.S. Department of the Treasury’s (Treasury) final regulations and other guidance, which will be used in implementing the FATCA provisions. The Treasury regulations and guidance contain a number of phased-in dates for compliance with their various provisions, and additional guidance (including the final forms to be used to determine compliance with the FATCA provisions) is forthcoming.
Offshore funds generally will be considered to be foreign financial institutions for FATCA purposes and therefore will be required to enter into an FFI agreement with the IRS (unless subject to the provisions of an IGA) and obtain a global intermediary identification number (GIIN) in order to avoid the imposition of the withholding tax. Offshore funds that enter into an FFI agreement (and obtain a GIIN) by April 25, 2014, will be included on the first publicly available list of foreign financial institutions, which is expected to be released by the IRS in June 2014.
Investment managers who want their offshore funds to be FATCA-compliant should consult with their fund administrators, accountants and legal counsel regarding the adoption of compliance procedures to collect and verify the identity of their investors ahead of April 25, 2014.
Q49: What is AIFMD and when will it affect me?
A: The Alternative Investment Fund Managers Directive (“AIFMD”) is a piece of European-wide legislation. It totally overhauls the regime governing the marketing and management of alternative investment funds in Europe. It changes the law relating to private placement of interest in alternative investment funds in every EU member state. It will have relevance to any manager who is seeking to market their funds to investors in the EU and will also impact U.S. managers seeking to manage EU domiciled funds in the future. On July 22, 2013, the AIFMD is due to be implemented in every member state in the European Union. Additional information on the AIFMD and answers to some key questions that will help U.S. asset managers prepare for the changes in regulation can be found in our client alert “Changes to Rules on the Private Placement of Investment Funds in Europe: Top Ten FAQs for U.S. Asset Managers in 2013.”
Q50: What are the other regulatory filings hedge fund managers may have to make?
A: Besides the filings mentioned above, advisers to hedge funds may have to file a Form 144; a Form 3, 4 or 5; or a filing with the FTC under the Hart-Scott-Rodino Antitrust Improvements Act of 1976.
A Form 144 should be filed as notice of a proposed sale of restricted or control securities, or securities held by an affiliate of the issuer in reliance on Rule 144 of the Securities Act, when the amount sold during any three month period exceeds 5,000 shares or units, or has an aggregate sales price in excess of $50,000. The form is filed with the SEC and the principal national securities exchange, if any, on which such security is traded and is publicly available.
Forms 3, 4 and 5
A statement of ownership filed by directors, officers or owners of more than ten percent of a class of equity securities of a public company. The initial filing is on Form 3 and changes are reported on Form 4. The annual statement of beneficial ownership of securities is on Form 5. The statements contain information on a reporting person’s relationship to the company and on purchases and sales of the company’s equity securities in order to track compliance with the short swing profits rules discussed above.
Form 3 reporting is triggered by (i) acquisition of more than ten percent of equity securities of a public company; (ii) the reporting person becoming a director or officer; or (iii) if a reporting person is a ten percent owner, the equity securities becoming publicly traded, as the case may be. Form 4 reporting is triggered by any open market purchase, sale or an exercise of options of those reporting under Form 3. Form 5 reporting is required annually for those insiders having exempt transactions not reported on Form 4. These statements are filed with the SEC and are publicly available.
Q51: What other filings would commodity funds managers have to make?
A: CPO and CTA Registration Forms 7-R and 8-R: Available Exemption
The documents required for registration with the CFTC as a CPO or CTA are:
• a completed Form 7-R (which provides CPO or CTA information)
• a completed Form 8-R (which provides biographical data) and fingerprint card for each principal (defined to include executive officers, directors, and ten percent owners), branch office manager and associated person (defined to include persons soliciting fund interests or accounts or supervising persons so engaged), as well as proof of passage of the “Series 3” exam for each associated person (unless the CPO or CTA only trades swaps or swaps and only a de minimis amount of futures)
• proof of passage of the “Series 3” and futures branch officer manager exams for each branch office manager.
After a person is registered with the SEC as a CPO or CTA, it will be required to provide regular reports to its investors.
CPOs and CTAs to commodity pools that principally trade in commodity futures or security futures* may rely on the exemption in CFTC Regulation 4.7, which requires the CPO and the CTA to register with the CFTC but provides relief from certain portions of the disclosure and reporting requirements so long as all the interests in the fund are owned by certain “qualified eligible persons” consisting of certain securities and commodities industry participants, and persons who satisfy certain investment ownership, net asset or net income thresholds. Many of the qualified eligible persons that are not industry participants or qualified purchasers (as defined below) must also meet a portfolio requirement, i.e. a minimum securities or commodities ownership threshold.
If CPOs or CTAs use Regulation 4.7, they will be exempt from the extensive periodic reporting requirements. Instead, they will be required to prepare and distribute a quarterly report regarding the commodity pool’s net asset value within 30 days of the end of each fiscal quarter and an annual report within 90 calendar days of the end of the fiscal year. The quarterly report must reflect:
• the net asset value of the pool as of the end of the relevant period
• the change in net asset value from the end of the previous reporting period
• either the net asset value per unit as of the end of the relevant period or the total value of the investor’s interest or share, all computed in accordance with GAAP or IFRS, as appropriate. If the fund consists of series, structured with a limitation to liability, the CPO may present information for only that series.
The annual report must include a statement of operations for the relevant year in compliance with GAAP or IFRS, as appropriate, including footnote disclosures. As with periodic reports, information may be provided only with respect to a series if it is isolated from other series.
The annual report also must include a legend on the cover page that the CPO or CTA has made a claim for exemption, an affirmation by a person authorized to bind the CPO and either a certificate by an independent public accountant or an offer to provide a certified audit upon the request of a majority in interest of the unaffiliated limited partners of the fund.
CPOs and CTAs using Regulation 4.7 will be exempt from the requirement to keep records set forth in CFTC regulations for non-exempt CPOs and CTAs. They must, however, maintain all books and records prepared in connection with the fund, including records relating to the qualifications of QEPs and substantiating any performance claims. They must also maintain the periodic and annual reports described above. The timeframe and method of retaining such records are specifically set forth in the CFTC regulations.
Speculative Position Limit Exemption
This application is filed for exemption from speculative position limits. Exchanges generally have speculative positions limits for physical commodities and stock index contracts, and the CFTC has limited speculative position for certain agricultural commodities. Exemptions from such limits are generally available for hedging transactions. Financial contracts, such as interest rate contracts, generally have “position accountability” levels rather than strict position limits. Accounts or account controllers exceeding position accountability levels must justify their positions to an exchange or the CFTC upon request. Generally, an application for any speculative position limit exemption must show that such position is a bona fide hedging, risk management, arbitrage or spread position. The filing is made with the appropriate exchange in the case of physical commodities and stock index contracts and with the CFTC in the case of certain agricultural commodities.
The CFTC adopted position limits that incorporated futures, swaps that reference certain futures contracts and certain contracts executed pursuant to the rules of a foreign board of trade as a single limit, but the United States District Court for the District of Columbia vacated the CFTC’s position limits. It is generally expected that the CFTC will re-propose the position limits backed by more substantial economic analysis to satisfy the courts in the near future. CFTC’s position limits also require the filing of forms to claim exemptions that would permit the trader to exceed the position limits.
This notification is filed prior to the consummation of certain mergers, acquisitions, joint ventures or acquisitions of more than a certain value of assets or voting securities (currently $70.9 million). The notification includes information about the transaction and the participants in the transaction. As a general matter, both the acquiring person and the acquired person must file notifications when either the acquiring person or the acquired person is engaged in U.S. commerce or any activity affecting U.S. commerce, and either of the two threshold tests is met.
Acquisitions of voting securities are exempt from filing if they are made “solely for the purpose of investment” and if, as a result of the acquisition, the securities held do not exceed ten percent of the outstanding voting securities of the issuer. Securities are acquired solely for investment purposes if the person acquiring the securities has no intention of participating in the formulation, determination or direction of the basic business decisions of the issuer.
* A separate related exemption applies for a CTA for a commodity pool for which it is also a CPO.