Nearly Everything You Need to Know About Hedge Funds

(April 4, 2017) 

Important Disclaimers: Many readers will find this summary useful – especially hedge fund managers and attorneys who do not practice in this area (and even some attorneys who do). But please keep these disclaimers in mind. 

A fund manager’s success will not depend on laws and regulations, but this summary highlights an inescapable truth: A vast array of laws and regulations dictates what a fund manager must do and may not do. The explanations will show that good reasons underpin most requirements (not all). No reader should rely on this as legal advice, however, even if some examples appear to match the reader’s situation. Despite its title and though it is fairly long, this summary omits a few elements of the “vast array" and covers some others only briefly. A great deal is distilled here – to make it clear, and to focus on certain issues that tend to arise more often than others. A few more comprehensive summaries are available elsewhere on-line, and I recommend some of them – both generally and in combination with this summary. Some statements virtually cry out for footnotes or citations, but they have been left out – with a few important exceptions. This makes it even more important to consult with an attorney who practices in this area. I may be able and willing to help, but only if you are referred by another attorney or someone who knows both of us. Though much of the discussion applies to all types of private funds, it focuses on hedge funds, and many examples involve California. A particular subject may be covered more or less thoroughly than the reader desires. In several common situations where fund managers have solid grounds for more aggressive positions, I nevertheless advise a compliant approach because that will be simpler, quicker and less expensive. I intend to update this summary from time to time as laws, regulations, regulatory emphases and good practices change, but a reader should not assume it has been updated. For example, a date stated above may indicate that one or more parts of this summary were updated then, but other parts may not have been updated even though reasons may exist for those other parts to be updated as well.

Despite all this, many readers will find this summary useful – if they keep these disclaimers in mind. 

Contents

Navigation: Click on a heading below to go to corresponding section of body. In body, click on heading again to return to Table of Contents.                

Basic Private Fund Structures

Types of Private Investment Funds

          Hedge Funds

                    Why Are They Called Hedge Funds?

          Private Equity Funds

          Some Other Key Differences Between Hedge Funds and Private Equity Funds

          Funds of Funds

          Offshore Funds

          Series Funds

          Seed Investors

The Dangerous Imprecision of Registration"

          Avoiding Registration as an Investment Company

                    Integration of Affiliated Funds Under Section 3(c)(1)

                    Section 3(c)(7) Funds

          Avoiding Registration of Fund Offering

                    Regulation D

                              Form D

                    Public Non-Public Offering

                    Blue Sky Compliance

                    Issuance of Membership Interest in Fund Manager Entity

          Qualification to Do Business in Other States

          Registration of Fund Manager as Investment Adviser

Investor Eligibility Requirements

          Accredited Investor

          Qualified Client

          New Issues

          Other Investor Eligibility Requirements

Manager Compensation

          Asset-Based Management Fee

          Performance-Based Compensation

                    Mark to Market

                    High Water Mark

                    Book/Tax Differences

                    Hurdle Rates

                    Criticisms of Performance-Based Compensation

Performance Advertising

Solicitors

Offshore Funds

          Foreign Investors

          Tax-Exempt US Investors

          Master-Feeder Structures

Custody Issues

          SEC Custody Rule

          State Custody Rules

          Custody Rule Requirements

                    Qualified Custodian

                    Audited Financial Statements

Retirement Plan Issues

          Tax Issues

          Plan Assets

          Prohibited Transactions

Reporting, Record-Keeping and Client-Disclosure Obligations

Brokerage Issues

          Prime Brokers

          Best Execution and Soft Dollars

Hedge Fund Trading in Commodity Futures

Illiquid Fund Investments

Withdrawal Restrictions

          Lockups

          Gates

***************

Basic Private Fund Structures

A typical “domestic” fund (targeted at US taxable investors) is a limited partnership (most often) or a limited liability company (LLC), in either case formed under the laws of a US state, which may not be the state where the fund manager conducts business. Many funds are formed in Delaware, for example, even though few fund managers conduct business there. Fund investors almost never have management rights, other than irreducible statutory rights that have little if any practical value. The fund is managed exclusively by the fund manager, which nearly always is controlled by the fund sponsor (or is the fund sponsor itself).

The fund manager usually is a limited-liability entity too, most often an LLC – either formed in the state where the manager conducts business or formed in another state (Delaware, for example) and “qualified” to do business in the state where the manager conducts business. The fund itself may or may not also be “qualified” to do business in that state (see “The Dangerous Imprecision of ‘Registration’ – Qualification to Do Business in Other States” below).

Fund sponsors sometimes use two (or more) affiliated entities to manage a private fund – one to serve as the general partner (assuming the fund is a limited partnership rather than an LLC) and receive performance-based compensation, a second to serve as the investment adviser and receive asset-based management fees. (See “Manager Compensation below.) In such cases, the investment adviser entity usually enters into a separate management agreement with the fund. It may manage several separate investment funds (or just one) on behalf of the sponsor. The general partner entity may (but usually does not) have owners in addition to the fund sponsor or its affiliates – for example, “seed investors” who prefer to invest in the fund manager rather than (or in addition to) the fund (see “Types of Private Investment Funds – Seed Investors” below). 

For most domestic funds (though not for offshore funds – see generally “Offshore Funds” below), the fundamental “investment fund agreement” between investors and the fund sponsor/manager is a limited partnership agreement (if the fund is a limited partnership) or an operating agreement (if the fund is an LLC). 

Nearly all domestic funds are treated as “partnerships” for US income tax purposes. (An LLC may elect to be taxed as a “corporation,” but this rarely occurs.) Taxable income, gains, credits, deductions and other tax items are “passed through” to the investors and the manager, and usually are allocated among them according to the investment fund agreement – subject to tax-law restrictions requiring essentially that allocations reflect actual economics. A few important tax “elections” nevertheless may be made at the fund level by its “tax matters partner” – nearly always the fund manager or an affiliate. If an investor or the manager is in turn a pass-through entity (as the manager usually is, for example), the fund's tax items are passed through further to the entity's owner(s) and manager(s), where they are further allocated according to that entity's governing agreement.

Tax items are “passed through” whether or not any distribution is made by the fund. Though some private investment funds make “tax distributions” if cash is available (i.e. distributions intended to finance the recipients’ tax-payment obligations), most do not. Hedge funds, for example, ordinarily do not make distributions unless a withdrawal occurs, even if the hedge fund’s operations have generated a great deal of taxable income. As a result, hedge fund investors usually must finance income tax payments from other sources of cash, or make at least a partial withdrawal from the fund (if permitted at the time).

It is also important to note that “tax items” passed through to a fund’s owners may not reflect a fund’s actual value. With just a few exceptions that rarely matter to private funds, a portfolio gain is taxable only when the portfolio investment is liquidated (usually by sale), regardless of how much that investment may have risen (or fallen) in value since the fund acquired it. In contrast, the actual value of a portfolio investment will be taken into account for other important purposes – calculation of performance-based compensation, for example (see “Manager Compensation – Book/Tax Differences” below). Even for such purposes, however, “actual value” may reflect the book value of illiquid portfolio investments rather than their actual value (see “Illiquid Fund Investments” below).

Types of Private Investment Funds

The most common types of “multiple-investment” private funds are hedge funds and private equity funds (of which there are several important subsets, such as venture capital funds). Fundamental business differences dictate substantially different legal structures.

          Hedge Funds. “Hedge fund” has no legal definition, but is generally thought of as a private fund investing passively (usually) in securities of unaffiliated companies – most often in publicly traded common stocks or other equity securities. Unlike a private equity fund (see “Private Equity Funds” below), a hedge fund typically exists indefinitely, with both investors and portfolio investments entering and leaving the scene from time to time. Like a private equity fund, a hedge fund typically offers and sells its ownership interests privately to sophisticated investors who satisfy restrictive eligibility criteria (see “Investor Eligibility Requirements” below).

                    Why Are They Called Hedge Funds? There is no definitive answer to this often-asked question. One of the more persuasive: Registered investment companies (mutual funds) historically were prohibited from selling short. Private investment funds were not, and thus could use this common method of “hedging” against market risk. Many “hedge funds” hedge against risk in this and other ways, though not all do, and virtually no hedge fund is fully hedged.

          Private Equity Funds. Unlike a hedge fund, a private equity fund has a specified life (ten years, for example, though fund lives vary substantially). The term of a private equity fund usually may be extended – in the manager's discretion for one or several years, and often longer with investor approval. Extensions are more likely if extra time is needed to mature and liquidate portfolio investments. 

Though some private equity funds hold just one closing, many offer an early time window during which investors may commit capital to the fund (the first 12-18 months, for example); late-comer investors may be required to make “catch-up” contributions, possibly with interest or an equivalent supplement. 

The finite “life” of a private equity fund typically includes an early “investment period" during which investors’ capital commitments are “called” to finance portfolio investments identified by the manager (the first 3-4 years, for example), a middle period during which portfolio investments are monitored and liquidated (and a few "follow-on" investments may be made in existing portfolio companies), and an end period during which the remaining portfolio investments are liquidated, final distributions are made, and the fund is wound up and dissolved. Often the fund manager has authority to reinvest proceeds of a portfolio holding that is liquidated quickly or early; otherwise liquidation proceeds usually are distributed shortly after they are received (net of reserves kept to cover existing and future fund expenses). 

          Some Other Key Differences Between Hedge Funds and Private Equity Funds. A hedge fund investor’s committed capital usually is contributed in full up front (though the investor may voluntarily contribute additional capital later if the manager agrees). In contrast, private equity funds typically are funded through several “capital calls” made on investors during the early “investment period” as portfolio investments are identified by the manager, though smaller capital calls may occur during and after the investment period to pay (or reserve for) the fund’s operating expenses. Harsh penalties apply if an investor fails to satisfy a capital call (severe dilution, for example), and the defaulting investor will remain liable for the promised capital. Usually the manager has authority to increase the “call” on other investors to make up a shortfall caused by a defaulting investor, though no investor will be obligated to contribute more than his capital commitment.

Another key difference between hedge funds and private equity funds lies in their allocations and distributions to investors and the fund manager. A hedge fund investor usually will not recover his capital contribution (if ever) until he withdraws from the fund (partially or entirely) or the fund is terminated. In contrast, in a private equity fund, distributions of portfolio liquidation proceeds (as distinguished here from management fees – see “Manager Compensation” below) may be made exclusively to the investor until he has recovered his capital contributions – frequently with a specified “preferred return” on top of that (usually calculated as a percentage (annually) of the investor’s aggregate capital contributions), after which distributions typically are split between the investor and the manager in a manner that rewards the manager for good performance (for example, 80/20 in favor of the investor, sometimes with an intervening “catch-up” provision more favorable to the manager, aimed at raising its share to 20% of total distributions (in this example) before the 80/20 split takes effect). Nonetheless, in some private equity funds, especially those intended principally to generate current income rather than liquidation proceeds, the manager may receive distributions before an investor has recovered any of his capital contributions – though even such funds typically distribute the investor’s preferred return (if one has been specified) before the manager receives any distribution of current income.

In some private equity funds, the distribution “waterfall” is calculated separately for each portfolio investment (which may require especially careful allocations of fund investment capital and expenses among multiple portfolio investments). In others, it is calculated “collectively” for all portfolio investments, in which case the manager may receive no distribution until (if ever) at or near the end of the fund’s life if investors have not yet recovered their capital contributions (plus their preferred return, if one has been specified). In still other private equity funds, the distribution waterfall takes account of all portfolio investments liquidated (or written off) to date, but not portfolio investments that have not yet been. Depending on the arrangement, the investment fund agreement may include a “claw-back” provision that requires the fund manager to return some distributions when the fund is terminated (or earlier, in some cases) if distributions to investors have been insufficient to return their capital contributions (and a preferred return, if one has been specified). 

While any of these arrangements may delay considerably a fund manager’s receipt of performance-based compensation, private equity fund managers typically receive an asset-based management fee along the way – usually based on investors’ capital commitments during the early “investment period,” and thereafter based on the amount of fund capital actually called and invested in portfolio companies. See generally “Manager Compensation” below, which explains other differences between hedge funds and private equity funds in the amount and timing of manager compensation.

          Funds of Funds. Not all private investment funds invest directly in portfolio securities. One variety – a “fund of funds” – invests instead in other private investment vehicles, usually other funds (or, less often, in separate investment accounts) managed by unaffiliated advisers that, in turn, invest in portfolio securities (“underlying funds”). The “value added” by the manager of a fund of funds lies principally in his wise choice of underlying funds and careful monitoring of their performance. In some cases, a fund of funds will expand investors' opportunities by pooling sufficient capital to satisfy high minimum-investment requirements of underlying funds (though this may raise certain investor-counting and investor-eligibility issues for underlying funds – not discussed here). 

A fund of funds presents many of the same legal issues as other private investment funds, but a few others too.

Because managers of underlying funds usually charge investors (including a fund of funds investor) both an asset-based management fee and performance-based compensation (see “Manager Compensation” below), a fund of funds manager may charge lower compensation to investors – possibly applying a reduced percentage to calculate each type of compensation, possibly charging only one or the other of the two types of compensation (i.e. either an asset-based management fee or performance-based compensation, but not both). Some fund of funds managers, however, charge the same forms and amounts of compensation as a “direct” fund manager, on the ground that they are performing an equally valuable service for their investors: choosing and monitoring investments (the underlying funds) that produce attractive returns for their investors.

A fund of funds manager may (or may not) diversify the fund’s investments by spreading investment capital among underlying fund managers who use different strategies or invest in different industry sectors or geographical areas. The manager also may seek to boost performance by shifting investment capital occasionally from poor-performing underlying funds to more promising funds. For this reason and others, managers of underlying funds sometimes are reluctant to accept an investment from a fund of funds.

Investor withdrawals from a fund of funds often are more restricted, since they usually require a corresponding withdrawal by the manager from one or more underlying funds (yet another source of annoyance for managers of underlying funds). Because underlying funds nearly always have substantial advance-notice withdrawal requirements of their own, and also may impose lockups or gates or other withdrawal restrictions (see “Withdrawal Restrictions” below), a fund of funds usually will require investors to give longer advance notice to withdraw funds, and may be authorized to suspend withdrawals or delay withdrawal distributions if the fund is unable to make timely withdrawals from underlying funds. 

Some special “custody” rules apply to funds of funds (see “Custody Issues – Custody Rule Requirements” below), most of which make compliance easier. For example, while the SEC Custody Rule generally requires that certificates representing a fund's portfolio securities be held by an independent “qualified custodian” (usually a brokerage firm or bank), this requirement usually does not apply to a fund of funds because it holds “uncertificated” securities – for example, an ownership interest in an underlying fund, typically represented only by signed subscription documents. For another example, while a “direct” hedge fund may avoid certain burdensome requirements under “custody” rules by delivering audited financial statements to fund investors within 120 days after fiscal year-end, a fund of funds is granted an additional 60 days to do this (i.e. 180 days after fiscal year-end), since completion of its audit often must await audit reports from underlying funds.

          Offshore Funds. See “Offshore Funds” below.

          Series Funds. If certain conditions are satisfied, laws in Delaware and a few other states permit either a limited partnership or an LLC to form one or more “series funds” without the need to create a separate entity. Each series fund is a separate series of ownership interests in the “parent” entity, with its own separate assets, liabilities and investment purpose. If a series fund is properly operated separately from its “parent” entity, the series fund and its assets will not be subject to claims against the “parent” entity or any other series fund, and vice-versa.

For example, if a hedge fund named XYZ Fund, LP forms “XYZ Series Fund 1” to invest only in equity securities issued by a company named Healthco (a health care company), XYZ Series Fund 1 can sell its ownership interests solely to investors who desire to invest in Healthco but have no desire to participate in other portfolio investments that XYZ Fund, LP may make. A series fund need not be so narrowly focused, however. For example, XYZ Series Fund 1 may be established to invest broadly in health care companies (or even in securities generally, without restriction),  rather than merely to invest in Healthco.

A “series fund” may (or may not) be structured differently from its “parent” entity or another series fund of the same parent. For example, if XYZ Fund, LP is a hedge fund that invests broadly in publicly traded common stocks, XYZ Series Fund 1 nevertheless may be structured as a private equity fund that invests only in non-public preferred stock of ABC Corporation.

Series funds have several advantages – notably the ease with which they can be established. A new limited partnership or LLC need not be created. They also have certain drawbacks, though most are practical and, one hopes, may diminish over time. For example, some banks, brokerage firms, accountants, and other service providers – even some government agencies – are unfamiliar with the series fund structure, which occasionally leads to confusion and delay in opening accounts and similar administrative matters.

Each series fund requires its own tax identification number (EIN), and will be treated as an investment fund separate from the “parent” entity for various purposes. For example, a registered investment adviser must disclose (on its on-line Form ADV) certain information about each “private investment fund” for which it performs advisory services. (Even “exempt reporting advisers” must disclose essentially the same information – see generally “The Dangerous Imprecision of ‘Registration’ – Registration of Fund Manager as Investment Adviser” below.) If, for example, XYZ Fund, LP is a hedge fund whose manager also has established five more-focused series funds –– the manager must identify six separate “private investment funds” on its Form ADV: XYZ Fund, LP itself, and each of the five series funds.

The fund manager will need a separate investment fund agreement, subscription agreement and disclosure document (among other documents) for each series fund, and must determine separately whether each series fund must “qualify” to do business in one or more states (see “The Dangerous Imprecision of ‘Registration’ – Qualification to Do Business in Other States” below). Separate financial statements must be prepared for each series fund (each audited, if required for any reason, as often is the case), and each must report tax information separately to its owners (and file entity-level tax returns, where this is required of entities generally) separately from the “parent” entity and any other series fund. In short, for several important purposes, each series fund must be treated as if it were an entity separate from the “parent” entity, notwithstanding the ease with which a series fund may be created.

          Seed Investors. Some investors – typically called “seed investors” – prefer to invest in the manager entity (and/or the sponsor entity, if they are separate) rather than in the fund, or to invest in both the manager (or sponsor) and the fund, thus “seeding” the fund with a substantial initial investment from a respected investor that may facilitate the fund manager's capital-raising efforts. 

Seed arrangements raise several special issues, most beyond the scope of this summary. Some differences naturally exist between the interests of the fund manager and those of the seed investor, though usually they can be resolved without difficulty. For example, the fund manager may prefer that the seed investor’s capital be allocated mostly (or even entirely) to an investment in the fund rather than in the manager entity. A fund investment, after all, is what other investors will be offered, and the manager may be concerned that other investors will demand terms similar to what the seed investor has been granted (notably, an intererest in the manager entity). The manager also may be reluctant to grant the seed investor (or anyone else) a long-term or general interest in the manager entity, or even a right to invest in future investment vehicles that the manager may establish. The seed investor, in contrast, will often want precisely those things, since its strong belief in the manager (or its principal) usually will be what attracts the seed investor in the first place. 

For another example, if the seed investor does invest a substantial amount in the fund, it may insist on a right to withdraw sooner than the manager may like (for example, so that the seed investor’s capital will be available to establish similar arrangements with other fund managers). The fund manager may be reluctant, however, to permit the seed investor to cut short its perceived “seal of approval,” concerned that an early withdrawal might cause other fund investors to wonder whether the seed investor has lost faith in the manager. A compromise may take account of how much capital has been raised from other investors when the seed investor proposes to withdraw, with the seed investor insisting that it should be free to move on once the purpose of the arrangement – the attraction of capital from other investors – has been substantially accomplished, and that the manager should be grateful if that happens earlier than anticipated.

Several other important issues typically arise in seed-investor arrangements – again, beyond the scope of this summary – though managers and seed investors usually strike sensible compromises that enable the manager to make use of what can be an invaluable advantage in early capital-raising efforts.

The Dangerous Imprecision of “Registration"

The term “registration” is often used with potentially dangerous imprecision, especially by actual or prospective fund managers. It has one or more of several different meanings.

          The Dangerous Imprecision of “Registration” – Avoiding Registration as an Investment Company. If not structured and operated properly, the fund itself may need to register as an “investment company” under the Investment Company Act of 1940 (ICA). All private investment funds seek to avoid this, and a failure usually will have unacceptably severe adverse consequences. 

Nearly all private funds rely on one or both of two exclusions from “investment company” status under the ICA – Sections 3(c)(1) and 3(c)(7). The Section 3(c)(1) exclusion is more frequently relied on. It has no “investor eligibility” requirements (though other laws and rules usually dictate such requirements – see “Investor Eligibility Requirements” below). The exemption is available to any “investment company” (which includes most private investment funds) that has no more than 100 owners and is not making or planning a public offering of its securities. For most hedge funds, Section 3(c)(1) is available if the fund has 99 or fewer investors. Special “counting rules” may increase (or decrease) the number of investors for this purpose, though those rules rarely affect the outcome of the Section 3(c)(1) analysis.

                    Integration of Affiliated Funds Under Section 3(c)(1). If a fund has (or expects soon to have) more investors than are allowed under Section 3(c)(1), the fund manager has several alternatives, though fewer than may first appear. Suppose, for example, that XYZ Fund 1, LP is a domestic hedge fund that invests broadly in publicly traded equity securities. If the fund manager simply forms “XYZ Fund 2, LP” to do the same thing for investors 100-198, the two funds probably would be “integrated” (i.e. combined) under Section 3(c)(1). The two funds would not actually be combined, but would be treated as if they were combined to determine whether the Section 3(c)(1) exclusion is available. In this example, neither Fund 1 nor Fund 2 would be excluded under Section 3(c)(1) because the “integrated” fund would have more than 100 owners, even if the Section 3(c)(1) exclusion had previously been available to Fund 1.

There are several ways to avoid "integration." Continuing with this example, if XYZ Fund 2, LP were formed to invest solely in health care stocks (rather than broadly in publicly traded equity securities), the two funds probably would not be “integrated” because each fund reasonably would appeal to a separate group of investors (though it is possible that integration nevertheless would occur in this example – especially if XYZ Fund 1, LP historically had invested only in health care stocks even though its investment authority was formally broader).

A more certain way to avoid integration in this example would be to create the second fund as an "offshore” fund (i.e. formed under the laws of some non-US jurisdiction  see generally “Offshore Funds” below). Even if the offshore fund invests in exactly the same portfolio securities as an affiliated domestic fund, at exactly the same time, the two funds will not be integrated under Section 3(c)(1).

                    Section 3(c)(7) Funds. Another certain way to avoid “integration” of separate funds under Section 3(c)(1) is to create a second fund that relies instead on the Section 3(c)(7) exclusion from “investment company” status under the ICA. A Section 3(c)(7) fund is often called a “qualified purchaser fund” because each investor must be a “qualified purchaser” as defined in ICA Section 2(a)(51), a more restrictive investor-eligibility test than typically applies in a Section 3(c)(1) fund. (For example, an individual “qualified purchaser” ordinarily must hold at least $5,000,000 in “investments.”)

A Section 3(c)(7) fund has several advantages over a Section 3(c)(1) fund. First, there is no limit on the number of investors, though the eventual applicability of another law (the Securities Exchange Act of 1934) practically limits a Section 3(c)(7) fund to 499 investors – very rarely a concern for private investment funds. Second, and most important here, a Section 3(c)(7) fund will not be “integrated” under Section 3(c)(1) with an affiliated Section 3(c)(1) fund, even if the two funds invest in exactly the same securities at exactly the same time. 

Some advantages of a Section 3(c)(7) fund are not immediately obvious, but nonetheless may be important. For example, if a California fund manager relies on the California “private fund adviser” exemption to avoid registering in California (see “The Dangerous Imprecision of ‘Registration’ – Registration of Fund Manager as Investment Adviser” below), several additional requirements of that exemption (for example, the obligation to deliver audited financial statements to fund investors within 120 days after each fiscal year end) will not apply to a Section 3(c)(7) fund managed by the adviser.

On the other hand, a Section 3(c)(7) fund has at least one potential disadvantage: its restriction to “qualified purchasers,” a higher eligibility threshold than some investors in a Section 3(c)(1) fund may be able to reach.

A hedge fund need not “elect” to rely on either Section 3(c)(1) or Section 3(c)(7). Either or both exclusions will be available if the hedge fund satisfies the requirements, whether intentionally or inadvertently. Nevertheless, depending on which exclusion the fund manager intends to rely on, it will need to collect from investors the information required to support the exclusion claim. A manager relying on Section 3(c)(1) may be reluctant to ask prospective investors whether they also satisfy the more stringent “qualified purchaser” test – especially if some otherwise-eligible prospects decline to invest because they do not. Failure to collect such information, however, may make it difficult or impossible for the fund to claim the Section 3(c)(7) exclusion.

Some fund managers adopt a “hybrid” approach to this key “investor eligibility” question. They do not strictly require that an investor be a “qualified purchaser” (i.e. they rely on Section 3(c)(1) rather than Section 3(c)(7) to establish the fund’s exclusion from “investment company” status under the ICA), but they nevertheless ask a prospective investor additional questions and for supporting information to determine whether the investor is a "qualified purchaser." Depending on the answers and supporting information received, the fund manager may be able to claim that the fund is eligible for the Section 3(c)(7) exclusion (and it may be easier for the fund manager, later, to “allocate" investors between separate but identical Section 3(c)(1) and 3(c)(7) funds managed by the fund manager – often the principal reason for this “hybrid” approach). 

In some cases, however, the drawbacks of such a “hybrid” approach may outweigh its potential benefits. At the least, it will require that prospective investors complete the “qualified purchaser” portion of the fund subscription documents and that all investors indeed be “qualified purchasers.” If one or more of them is not (or if an investor’s “qualified purchaser” status cannot be determined and is not certain – for example, because the investor has declined to complete the “qualified purchaser” portion of the fund subscription documents), the Section 3(c)(7) exclusion probably will not be available. Some prospective investors may resent being asked  additional questions, or to provide supporting information, necessary to establish their “qualified purchaser” status – in most cases, a substantially higher financial hurdle than must be cleared to establish one's status as an “accredited investor” or a “qualified client” – especially if the investor has been told that “qualified purchaser” status is not required to invest in the fund.

          The Dangerous Imprecision of “Registration” – Avoiding Registration of Fund Offering. “Registration” also may refer to the fund's offer and sale of ownership interests to investors. Those interests are “securities” whose offer and sale must be registered under the Securities Act of 1933 (and state “blue sky" laws) unless exemptions are available. No private investment fund will choose to register its offering with the SEC or in any state.

                    Regulation D. Most funds rely on the federal registration exemption available for certain “non-public offerings” under Rule 506(b) – part of Regulation D (Rules 500-508) under the Securities Act of 1933 (though see “The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Public Non-Public Offering” below, which describes a rarely used (by private funds) but technically available alternative exemption under Rule 506(c)). The Rule 506(b) exemption will satisfy state “blue sky” laws as well, though a state filing and fee payment usually will be required, and some fund managers may prefer to satisfy blue sky laws in some other way (see “The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Blue Sky Compliance” below).

Rule 506 includes numerous requirements (beyond the scope of this Summary), including a “bad actor” disqualification described in Rule 506(d). Fund managers typically take various steps (including inquiries to prospective investors) aimed at identifying a “bad actor” who might jeopardize the fund’s Rule 506(b) exemption. 

                              Form D. With an important exception, a private fund’s offering may (or may not) comply with Rule 506(b) even though the fund manager has taken no affirmative step to comply. The exception is Rule 503(a)(1), which states that the issuer (the fund, here) in a Rule 506 offering must file a "Form D" with the SEC not later than 15 calendar days after the first sale in the offering. (The Form D must be filed on-line, which requires certain filing codes that the issuer must first obtain from the SEC by filing a notarized Form ID – not to be confused with the Form D). 

Nevertheless, the Form D filing requirement is not really an “exception.” Despite the unequivocal statement of that requirement in Rule 503(a)(1), a Rule 506 exemption will be available even if a Form D is filed late, or not at all – provided, of course, that the other conditions of the exemption are satisfied. See, for example, SEC Release 33-8891 (37 FR 10592 (February 27, 2008) (https://www.sec.gov/rules/final/2008/33-8891fr.pdf), at page 10593: "In 1989, we amended the Regulation D exemptions [which include Rule 506] to eliminate the filing of Form D information as a condition to their availability [citing Release No. 33–6825 (Mar. 15, 1989) [54 FR 11369]]. At that time, we also added Rule 507 to Regulation D to provide an incentive for issuers to make a Form D filing, even though it was no longer a condition to the availability of the Regulation D exemptions [again citing Release No. 33–6825].” See also Rule 508(a), which states that a “failure to comply” with [Rule 506] “will not result in the loss of the exemption” if  (among other conditions) “a good faith and reasonable attempt was made to comply with all applicable terms of [Rule 506].” This "good faith and reasonable attempt” requirement does not apply to Rule 503 (the Form D filing provision), and the  "applicable terms” of Rule 506 do not include any Form D filing requirement. Rule 506 does not even mention Rule 503 (or any other Form D filing requirement); nor does Rule 508.

If a Form D is not filed, Rule 508(a) places the burden on the issuer to establish certain elements of the Rule 506(b) exemption – though it is unclear what, if anything, Rule 508(a) adds to the mix, since the burden of establishing all elements of any registration exemption has always rested on the issuer and Rule 508(a) adds nothing to that burden (indeed, it explicitly reduces the issuer’s burden in several respects). In any case, as explained above, establishing the Rule 506(b) exemption will not require any showing that a Form D was filed (since, as explained above, Rule 506 does not require any such filing and Rule 508(a) does not add any such requirement); conversely, establishing that a Form D was filed will not establish that the Rule 506(b) exemption was available if in fact it was not. In addition to Rule 508(a), in the unlikely (but possible) event that the SEC files a court action against the fund manager for violations of securities laws, Rule 507(a) may bar future reliance on a Regulation D exemption if the SEC obtains an injunction because the fund (or certain related parties) failed to file a Form D in an earlier offering. 

While neither consequence is likely to have practical significance to most hedge fund managers (indeed, if the SEC takes the unusual and serious step of filing a court action, a fund manager’s failure to have filed a Form D is likely to be among the least of its legal concerns), a failure to file a Form D does beg a question whose answer might lead to further difficulties:

“Why did the issuer not file a Form D?”

Some attorneys, academics and others have argued persuasively, often on philosophical and/or privacy grounds, that an issuer may be fully aware of the Form D filing "requirement" and yet have sound reasons not to file one. Some add that a Form D filing does little or nothing to protect investors, which, they point out, is understood to be the principal objective of securities laws and regulations. While the SEC takes issue with such critics, at least on some points, its principal concern, frankly, is not an issuer that knowingly chooses not to file a Form D on such grounds. Its principal concern is with issuers who fail to file a Form D either because they are sloppy or – even worse – because they are unaware of Rule 506(b) requirements entirely. If a Form D has not been filed, the SEC may well suspect that the issuer also has failed to comply with other Rule 506(b) requirements that are not optional. If for no other reason, filing a Form D will at least show that the issuer is aware of the Form D filing requirement, and thus is probably also aware of Rule 506(b)'s other (non-optional) requirements.

A middle ground may be worth considering: The fund manager might file an initial Form D for the fund’s offering, thereby demonstrating at least that the manager is aware of Form D and, hence, of Regulation D. The manager presumably will answer “yes” to the Form D question of whether the offering will last more than one year (true for most hedge funds). That “yes” answer will trigger an “annual amendment” filing obligation under Rule 503(a)(3)(iii) (and other amendment filings may be required). Since even the initial Form D will not have been required to claim the Rule 506(b) exemption, however (see above), failing to amend a not-required Form D will not prevent the fund from continuing to rely on the Rule 506(b) exemption. Nonetheless, that “yes” answer may induce one or more regulators (or others) to ask the fund manager why one or more annual amendments (and, possibly, other amendments) were not filed. While there may be several possible answers to this question – including, for example, that the fund manager neglected to calendar the amendment-filing deadline, or perhaps did not know an amendment was required – the explanation may well be that the fund manager prefers not to publicize the information reported on a Form D (which is instantly available on-line), especially the dollar amount sold to fund investors in the offering. (The initial Form D may be, and often is, filed before any sales have occurred in the offering, which means that sales information will not have been disclosed.) Some fund managers may not care whether others learn this information – indeed, some fund managers may be eager to publicize their fund-raising prowess. But most fund managers will not want others to learn this information – or at least they will prefer not to publicize it on-line – since disclosure is not required to claim the Rule 506(b) exemption. For such a fund manager, this “middle ground” alternative may be a sensible course, though the manager should keep in mind that regulators (or others) nevertheless may ask why the initial Form D was not amended. Explaining this in a way that satisfies a regulator may require considerable tact – though ultimately, of course, a regulator’s satisfaction (or not) will not change the key fact: A Form D filing is not required to establish the Rule 506(b) exemption.

There are other good reasons to file a Form D with the SEC – at least the inital Form D – required or not. For example, issuers rely in many states on a “blue sky” exemption available for offerings made under a federal Rule 506(b) exemption (see “The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Blue Sky Compliance” below). These blue sky exemptions usually require the issuer to file a copy of the Form D as filed with the SEC (and to pay a state filing fee, and perhaps to file a consent to service of process as well). Needless to say, if the issuer has not filed a Form D with the SEC, the issuer will be unable to file a copy of that Form D with a state. The issuer may argue to a state’s officials that a Form D filing is not required, either with the SEC or with the state. Any such effort, however, is likely to add considerable expense and delay to an issuer’s blue sky compliance, and is unlikely in any event to persuade skeptical state officials, who are accustomed to receiving an as-filed Form D when such a blue sky exemption is being claimed. This may not be a practical problem for the fund if an alternate blue sky exemption is available in a state (see “The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Blue Sky Compliance” below), but it may be a considerable problem if the issuer intends to rely on the state’s blue-sky exemption for Rule 506 offerings. 

                              Public Non-Public Offering. Most hedge fund offerings are made under Rule 506(b) (part of Regulation D), which requires that the offering be “non-public.” Rule 506(c), however, allows an offering to be made under the Rule 506 exemption even if the offering is “public” under traditional tests (though a Rule 506(c) offering nevertheless is classified as “non-public" for several important reasons – for example, the Section 3(c)1) exclusion from “investment company” status under the Investment Company Act of 1940 (see “Avoiding Registration as an Investment Company” above)).

Rule 506(c) may be less appealing than it first sounds. Among other requirements, each purchaser in a Rule 506(c) offering must be an accredited investor – rarely an issue, since a hedge fund investor usually must be an accredited investor for other reasons. Often more burdensome, though, is the requirement that the issuer take “reasonable steps to verify” each purchaser's accredited investor status. This requirement reflects the SEC's expectation that Rule 506(c) offerings – because they are not limited to “non-public” methods – are more likely to result in the securities being sold to investors who are “strangers” to the issuer. 

For this reason, although issuers in non-public offerings under Rule 506(b) have long been expected to have a reasonable basis for believing that accredited investors are in fact accredited, satisfaction of the “reasonable steps to verify” condition in Rule 506(c) requires more. A veritable cottage industry has developed, with the SEC's blessing, in which third-party firms essentially “pre-verify” accredited investors, who thereafter may be solicited by multiple issuers in Rule 506(c) offerings (provided the verification is updated periodically). 

Whether the issuer or a third-party verifier performs the verification, an investor in a Rule 506(c) offering must provide substantially more information than typically is requested from investors in a non-public offering under Rule 506(b) (though some issuers demand such information from investors even in a non-public Rule 506(b) offering). For example, the investor might deliver copies of prior years' income tax returns, or a personal financial statement prepared by the investor's accountant. These and other “verification” methods may be objectionable to many prospective hedge fund investors, even those (or perhaps especially those) who undoubtedly are accredited investors. For this reason, a fund manager should consider whether the advantages of Rule 506(c) – notably, freedom to use “public” methods to offer the fund's ownership interests – outweigh the disadvantage of investors’ predictable objections to the required verification steps. When one keeps in mind that a private-fund investor usually must be a “qualified client” as well (which, under the test most often satisfied by investors, requires a substantial net worth – see generally “Investor Eligibility Requirements – Qualified Client” below), it may be that very few “strangers” to the manager ultimately will invest in a hedge fund offering under Rule 506(c). 

For this reason (and others), most fund managers rely on the old-fashioned “non-public” exemption under Rule 506(b). It prohibits “public” offering methods but, on the other hand, does not require the burdensome “reasonable steps to verify” each purchaser's accredited investor status that Rule 506(c) requires.

                    Blue Sky Compliance. A fund’s offer and sale of ownership interests to investors must be exempt from registration not only under the federal Securities Act of 1933, but also under applicable state securities laws – usually called “blue sky” laws. While the coverage of blue sky laws may be more extensive, ordinarily the fund must comply with those laws at least in each state where an investor resides. 

If the fund’s offer and sale of ownership interests is an exempt non-public offering under Rule 506 (see "The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Regulation D" above), federal law prohibits any state from imposing restrictions on the offering other than to require that the issuer (i.e. the fund) file a copy of the Form D as filed with the SEC (and a consent to service of process, if the state desires) and pay a state-prescribed filing fee. Most states (not all, as will become clear below) have adopted such laws or regulations. 

A fund need not satisfy a state’s blue sky law in this way, however. All states have alternate registration exemptions. Some of them require a filing and fee payment, but others (called “self-executing" exemptions) require no filing or fee payment. Minnesota law, for example – to pick a state almost at random – provides a self-executing exemption for certain non-public offerings if no more than 35 purchasers will be present in Minnesota during any 12-month period (excluding all “accredited investors” from this count, among others). No filing or fee payment is required if the fund sells to fewer than 11 Minnesota purchasers during any 12-month period. While this self-executing exemption may be risky for a Minnesota-based fund manager, it may be sufficient for, say, a California-based manager whose fund investors may include just one or a few Minnesota residents. Many other states have similar (or more attractive) self-executing exemptions. While some fund managers may prefer to submit a copy of the SEC-filed Form D in such states (provided the state authorizes that) and pay the state-prescribed fee, other managers may prefer to rely on a self-executing exemption and thus file nothing and pay nothing if the exemption conditions are satisfied. 

It is important, of course, to be sure that a self-executing exemption indeed is available, since adverse consequences may follow from a failure to satisfy the blue sky laws of an investor’s state. (The Minnesota exemption just mentioned, for example, will be unavailable if the issuer uses an unregistered solicitor in Minnesota – see generally “Solicitors” below). Often most important to a fund manager, the investor may have a right to demand his money back (rescission) if a blue sky violation occurred, even if his account has declined in value since he invested – indeed, that is when an investor is most likely (if ever) to cite a blue-sky violation. If there is any doubt about the availability of a self-executing blue sky exemption, it may be safer simply to file a copy of the SEC-filed Form D and pay the prescribed filing fee (if the state authorizes this). On the other hand, that alternative involves a risk too: If the fund’s offering does not comply with Rule 506 (even if the offering is eligible for some other federal-law exemption), filing its SEC-filed Form D in the investor’s state will be pointless, resulting in a blue sky violation if the fund has not satisfied the conditions of an alternate blue sky exemption.

While federal law allows a state to adopt a blue sky statute or regulation that exempts a Rule 506 offering if the SEC-filed Form D is submitted to the state along with the prescribed filing fee (and a consent to service of process, if the state desires), a state is not required to do this. Very few states have passed up this opportunity to collect almost cost-free additional revenue (which, ironically, has increased rather than reduced the blue-sky compliance burden and expense of many issuers, as some states have offset this “SEC-filed Form D” blue sky exemption by eliminating one or more self-executing exemptions). Nevertheless, a few states have not adopted any such statute or regulation – notably Florida and New York. If a state declines or neglects to do so, federal law prohibits the state from imposing other restrictions on an offering that complies with Rule 506. (This is indisputable for a non-public offering under Rule 506(b), and most securities attorneys believe it is true as well for a “public non-public offering” under Rule 506(c) (see “The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering – Regulation D – Public Non-Public Offering” above), even though Rule 506(c) was adopted (in 2013) many years after the federal “pre-emption” statute, which Congress passed at a time (1996) when Rule 506 permitted only non-public offerings.) 

In some states that have not established an “SEC-filed Form D” exemption – for example, Florida – state regulators acknowledge that an offer and sale of a “federal covered security” (which includes securities issued in a Rule 506 offering) is exempt under the state’s blue sky laws (at least if made by officers or employees of the issuer (or its general partner) or by a licensed broker-dealer – see, for example, Florida Statutes, 2015, Section 517.07(1)). No filing or fee payment is required. In contrast, regulators in at least one other large state – New York – do not acknowledge this (though they do not deny it either – they simply decline to answer the question if it is posed to them, and indeed it would be inappropriate for them to answer it). New York maintains a burdensome and expensive exemption-filing scheme under its blue sky law (nearly $1,400 in filing fees alone under an exemption often available to private funds), though New York securities lawyers generally advise clients that no New York filing is required for a Rule 506 offering (and the New York State Bar Association has published a frequently-cited position paper unequivocally stating that). Nevertheless, for various reasons, a fund occasionally may make a blue sky filing in New York for a Rule 506(b) offering, required or not.

                    The Dangerous Imprecision of “Registration” – Issuance of Membership Interest in Fund Manager Entity. A fund ownership interest issued to an investor unquestionably is a "security," requiring that the fund satisfy one or more registration exemptions under the Securities Act of 1933 and state blue sky laws (see preceding portions of this The Dangerous Imprecision of ‘Registration’ – Avoiding Registration of Fund Offering” section). The "security" status of an ownership interest in the manager entity may be less clear. 

If an ownership interest in the manager entity is sold to an investor – a "seed investor," for example, who invests in the manager entity rather than in the fund (or invests in both) – that ownership interest almost certainly will be a “security” (see “Types of Private Investment Funds – Seed Investors” above). The ownership interest(s) issued by the manager entity to its principal(s), however, may or may not be a “security,” at least based on traditional tests, since the principal nearly always will be active in the manager-entity’s business and typically will pay very little for his ownership interest in the manager entity. 

The fund manager nevertheless should anticipate that one or more governmental agencies may take the position that the principal's ownership interest in the manager entity is a "security" and that, accordingly, the offer and sale of that interest must satisfy the requirements for registration exemptions under the federal Securities Act of 1933 and state blue sky laws. Under the Securities Act of 1933, such an exemption will almost certainly be available, without any filing or fee payment being required, under Section 4(a)(2), which exempts offers and sales "not involving any public offering." A similar "self-executing" exemption may be available under applicable state blue sky laws, but some states (California, for example) may require a filing and a fee payment. While the fund manager might prefer to argue that its principal's ownership interest in the manager entity is not a "security,” citing traditional indicia of “security” status (arguments that would have considerable merit, frankly), usually it will be simpler, quicker and less expensive to make the state blue sky filing and pay the associated fee.

          The Dangerous Imprecision of “Registration” – Qualification to Do Business in Other States. “Registration” also may refer to the “qualification” – or not – of the manager entity, and possibly of the fund itself, to transact intrastate business in a state other than where it was formed. For example, if the fund is a Delaware limited partnership and the manager is a Delaware LLC conducting its advisory business in California, the manager entity will need to “qualify” to do business in California. (Indeed, the manager entity may simply be formed in the state where it conducts its advisory business, obviating the need to “qualify” in that state.) “Qualification” is a formal registration process that aims to “level the playing field” for in-state and out-of-state companies (and individuals) who “transact intrastate business" in a state. Every state has a statute that defines the scope of its “qualification” requirement, most of which aim to reach as far as permitted by the US constitution (which grants the federal government exclusive authority over “interstate commerce”).

Some attorneys also advise that the hedge fund itself