HEDGE FUND PRIMER

FOR INVESTMENT ADVISERS

Charles H. Field
Chapin Fitzgerald LLP
June 1, 2014

2014 Charles H. Field

HEDGE FUND PRIMER

FOR INVESTMENT ADVISERS

CONTENTS

INTRODUCTION

TYPES OF FUNDS
Traditional Private Fund
Private Equity/Venture Capital Funds
Hybrid Funds
Fund of Funds

2
2
2
2
3

STRUCTURING THE FUND

Limited Partnerships and Limited Liability Companies
The Master-Feeder Fund Structure

4
4
5

MARKETING THE FUND TO CLAIM AN EXEMPTION FROM INVESTMENT

COMPANY REGISTRATION: SECTIONS 3(c)(1) and 3(c)(7)
3(c)(1) Fund
Section 3(c)(7)

7
7
9

MARKETING THE FUND TO CLAIM THE EXEMPTION FROM SECURITIES REGISTRATION:

REGULATION D
9
Rule 501: Accredited Investors
10
Rule 502: Limitation on the Manner of Offering
10
Rule 506(b): The Traditional Private Placement of Fund Interests
11
Rule 506(c): JOBS Act Rule Permitting General Advertising
11
Rule 506(d): The Bad Actor Disqualification
12
Form D Notices
14
Rule 508: Non-Compliance
14
BROKER-DEALER ISSUES
Use of Finders and Broker-Dealers

14
14

COMMODITY INVESTMENT: WHAT IT MEANS FOR INVESTMENT

ADVISERS AND PRIVATE FUNDS
Commodity Interests: The Investment Portfolio
The Commodity Pool: The Fund
The Commodity Pool Operator (CPO): The Entity that Sponsors the Fund

16
17
17
18

The Commodity Trading Advisor (CTA): The Investment Adviser to the Fund
The Associated Person (AP)
Registration Requirements

18
18
19

EXEMPTIONS FROM REGISTRATION

Exemption for CPOs: Rule 4.13(a)(3)
Exemptions for CTAs: Section 4m
Exemption for CTAs: Rule 4.14
Registration Lite: Rule 4.7
Claiming the Exemptions

19
19
20
20
20
21

FIDUCIARY ISSUES: OPERATING THE FUND

Disclosure Obligations
Due Diligence
Performance Fees
Side Letters
Side-By-Side Management
Side Pockets
Side Pocket Policies to Consider

21
22
23
24
24
26
27
29

FUND OPERATIONAL ISSUES

Custody
Lock-Up Periods
Holdbacks
Gates
Unrelated Business Income Tax
Form PF Reporting Obligations
Avoiding Publicly Traded Partnership Status

29
29
30
30
30
31
31
32

ERISA ISSUES

33

ERISA EXEMPTIONS
Venture Capital Operating Company
Real Estate Operating Company
Alternative Investment Fund Manager Directive (AIFMD)

34
34
34
35

CONCLUSION

36

ABBREVIATIONS, ACRONYMS, and INITIALISMS

37

HEDGE FUND PRIMER

FOR INVESTMENT ADVISERS
Charles H. Field

INTRODUCTION
There is no universally accepted definition of a hedge fund, either legal or industry-wide. Some
funds pursue very aggressive investment practices, such as borrowing and speculating in commodities.
Others resemble single-strategy mutual funds and very often do not hedge their portfolios against
market movements or pursue leverage. The funds might be pools of illiquid assets whose gains will take
years to realize, if at all. Given the different variations on the investment theme, it is much more useful to
understand a hedge fund as synonymous with a private fund: a fund that is not registered as an investment
company with the US Securities and Exchange Commission. The investment policies and strategies of the
fund can be as constrained or as unconstrained as the portfolio manager desires. But structurally speaking,
hedge funds generally have the following characteristics:

They consist of a pool of assets from multiple investors meeting the legal requirements for
investing in an unregistered fund;
They are organized as a limited partnership or limited liability company;
They are less expensive to operate than mutual funds that are constrained by regulation;
They require a high minimum investment;
They generally impose a performance fee on investment gains;
Marketing of the fund is either prohibited or highly restricted; and
Investor access to their capital is restricted, in some cases up to two years or more.

There are a multitude of other features that are market and regulatory driven, based on the type of
investor the investment adviser seeks to attract. Investment advisers catering to the institutional market
will structure their funds to appeal to a more sophisticated investor, while those catering to an individual
investor market will structure something entirely different. Tax-exempt investors may require a structure
that is wholly inappropriate for taxable investors.
Operating a private fund involves, at a minimum, the Securities Act of 1933, the Investment
Company Act of 1940, the Investment Advisers Act of 1940, the Blue Sky Laws of the states where the
investment adviser attracts investors, and a host of federal tax regulations. It could also involve the
Securities Exchange Act of 1934 and the Commodity Exchange Act, not to mention the Employee
Retirement Income Security Act of 1974 and the European Alternative Investment Fund Managers
Directive. Operating a private fund is a complex business, and issues appear from all different directions..
It is our hope that this Primer will assist you in identifying the various private fund issues and formulating
a plan of action that will lead to an efficiently managed fund that generates outstanding returns for
investors.

TYPES OF FUNDS
Section 3(a)(1)(A) of the Investment Company Act of 1940 (Investment Company Act) defines
an investment company as any issuer that is or holds itself out as being engaged primarily in the
business of investing, reinvesting, or trading in securities. A private fund whose purpose is to trade in
anything that is a security (e.g., stocks, bonds, notes, options, warrants, and other securities derivatives),
whether publicly traded or privately held, will fit the definition of an investment company.
Traditional Private Fund
Traditional private funds are designed to generate returns by trading both long and short in the
securities of publicly traded operating companies across the globe, with micro, small, mid, and large
capitalizations. Other private funds may focus on particular industries or sectors, while yet others are
designed to produce alpha by managing market volatility though various well-defined hedging
mechanisms, such as the VIX and other index futures. The funds are free to borrow money to purchase
securities and, in fact, do so to leverage the gains of the portfolio.
While many of these traditional private funds are focused primarily on a narrow strategy, other
private funds have a less defined investment strategy that authorizes the portfolio manager to exercise
broad investment discretion over the portfolio and invest in whatever the manager believes will generate
the best return. The liquid nature of the portfolio allows traditional private funds to offer quarterly, even
monthly, liquidity to its shareholders.
Private Equity/Venture Capital Funds
Other private funds will trade primarily in illiquid securities, including private equity and debt.
The funds even may be designed to provide venture capital to start-up entities. In either case, these types
of funds pursue a much longer-term strategy and restrict shareholders ability to redeem their investments.
The private equity or debt fund may invest in Private Investments in Public Equity (PIPEs) or distressed
debt.
A venture capital fund invests primarily in start-ups and may take a role in the management of the
company. The venture capital fund is defined generally as one that invests in a venture capital strategy,
limits its borrowings to 15% on a relative short-term basis, and does not provide shareholders with
redemption rights except in extraordinary circumstances. The investment adviser to a venture capital fund
is exempt from the registration requirements under the Investment Advisers Act of 1940 (Investment
Advisers Act) and the fund itself is exempt from the Employee Retirement Income Security Act (ERISA),
as discussed later.
Hybrid Funds
It is not uncommon to see a fund that invests in both liquid and illiquid securities. These hybrid

funds are appealing to investment advisers and investors alike. Investment advisers can maintain a
partially liquid portfolio while pursuing more attractive, lesser-known opportunities in privately held
companies. Shareholders are drawn to these funds for the same reasons.
Despite their appeal, hybrid funds pose significant legal, operational, and marketing challenges
for investment advisers relative to valuing illiquid assets, calculating the performance fees on illiquid
assets, and maintaining liquidity in a falling market for investors seeking to redeem. When the capital
markets seized up in 2008, many hybrid funds were either not able or not willing to honor substantial
redemption requests, because their portfolios had become illiquid. As a result, shareholders gained
awareness of fund features such as lock-ups, gates, suspensions, and side pockets, as investment advisers
took defensive measures to protect their funds from collapse.
In the cases of the traditional fund, the private equity/venture capital fund, and the hybrid fund, an
investment adviser monitors individual holdings and makes investment decisions on individual securities.
Aside from the securities held in the portfolio, the major difference among these funds is the ability of the
investors to liquidate their investments for cash.
Funds that invest in liquid securities tend to be open-end funds whose interests are continuously
offered, and they tend to provide monthly or quarterly redemption rights for investors. Private equity and
venture capital funds, on the other hand, are generally of the closed-end variety, raising a set amount up
front, making capital calls on investors as investments are made along the way, and distributing the profits
as they are realized.
Fund of Funds
Another type of private fund is the fund of funds. Unlike a direct fund, where a portfolio manager
makes individual investment decisions, a fund of funds is a portfolio constructed by a portfolio manager
of interests issued by a number of other private funds. The fund can focus on a particular investment
strategy, such as investing in publicly traded stocks or private equity, or allocate among many different
strategies. Investment selections are based primarily on the skill, reputation, and expertise of the
underlying investment adviser.
The advantage of a fund of funds is that an investment adviser can add value by judiciously
selecting and monitoring other investment advisers. In addition, the fund of funds allows investors with
limited funds to gain access to more private fund investment advisers over which to diversify their assets.
For example, an investor with $250,000 can be efficiently exposed to a number of private fund advisers
instead of only one. One of the disadvantages is the layering of expensesthe expenses of the fund of
funds and the expenses of the underlying funds. The doubling of fees can have a significant adverse
impact on the total return an investor receives. Another disadvantage is the lack of transparency into the
underlying funds.
Whether a fund is a direct fund, a fund of funds, a fund that invests in liquid securities, a fund that
invests in private equity and start-ups, or a fund that invests in a variety of investments, the investment
adviser of each type of fund will look to structure the fund and attract investors based on a variety of

factors, including the types of investors they will seek, the types of investments they will make, and the
amount of resources they can commit to operating the fund.

STRUCTURING THE FUND

Limited Partnerships and Limited Liability Companies
The proper construction of a fund should ensure limited liability of the investor and efficient tax
treatment for both the fund and its shareholders. A fund organized as a corporation accomplishes the first
goal, but it is tax inefficient. For example, investment profits earned by the corporation are subject to
federal income tax when earned, and again when distributed to investors, thereby subjecting the
investment profits to double taxation. To avoid this drag on performance, investment advisers to private
funds organize their funds primarily as either limited partnerships or limited liability companies, which
afford flow-through tax treatment to investment gains and losses, and provide limitations on the liability
of investors.
Funds organized as limited partnerships and limited liability companies do not themselves pay
tax. Instead, the profits and losses attributable to a funds investments flow through to investors in
proportion to their investment in the fund. Each investor will be required to report on its Federal income
tax return its distributive share of the funds income or gain, whether or not it receives any actual
distribution of money or property from the fund during the taxable year.
The uniform limited partnership and uniform limited liability company acts adopted in one form
or another by the various states provide that the debts, obligations, and liabilities of these funds, whether
arising in contract, tort, or otherwise, are solely the debts, obligations, and liabilities of the fund and not
of the investors. In Delaware, for example, under 17-303 of the Revised Uniform Partnership Act, an
investor is not obligated personally for any such debt, obligation, or liability of the fund solely by reason
of being an investor. Investors do share the investment losses, but only to the extent of their respective
interests in the fund.
Limited partnerships and limited companies are generally organized by filing with the secretary
of state either a certificate of limited partnership or a certificate of formation. Limited partnerships and
limited liability companies are governed by the limited partnership agreement on the one hand and the
operating agreement on the other. Responsibility for the overall management of the fund will rest with the
General Partner for limited partnerships and with the Managing Member for limited liability companies.
The agreement generally will name the investment adviser or an affiliate as the general partner or
managing member, as the case may be, and grant the investment adviser a great deal of flexibility and
authority to manage the fund without interference from investors or other third parties, such as a board of
directors or a trustee. These agreements will also provide the investment adviser with the strongest
indemnification possible. They may provide for lock-up periods, holdbacks, redemption in-kinds, and
limit the investors rights to transfer their interests.

The Master-Feeder Fund Structure

Investment advisers may seek to offer an investment strategy that appeals to a wide range of
investors, such as high net worth individuals, non-US investors, institutions, and tax-exempt investors.
Certain restrictions, however, present a host of challenges to organizing a fund that has broad appeal. For
example, a domestic fund organized as a limited partnership or limited liability company that utilizes
borrowing (also known as acquisition indebtedness) as an investment strategy may be unattractive to taxexempt investors. This is because earnings generated from borrowing would flow through to the investors
and possibly subject the tax-exempt investors to unrelated business income tax. The same fund also may
be unattractive to non-US investors, given that the tax rules require the fund to withhold tax at the source
on the profits of investors who do not have a tax identification number. A domestic fund would also put
the non-US investor under the jurisdiction of the Internal Revenue Service.
An offshore fund would likely be the more attractive option to US tax-exempt and non-US
investors because (a) the fund would be organized in a tax haven jurisdiction and not subject to local tax,
and (b) the unrelated business income from an offshore company would not receive flow-through tax
treatment. While the offshore fund would be attractive to tax-exempt US investors, it would be equally
unattractive to taxable US investors because of the unfavorable tax rules governing passive foreign
investment companies (PFICs).
To deal with these diversified needs, the investment adviser may consider either organizing two
separate side-by-side funds or creating a master-feeder fund structure. Under the master-feeder structure,
the investment adviser establishes a master fund that holds and invests the assets. Various feeder funds
are then organized in one or more jurisdictions to feed their assets into the master fund for investment in a
single strategy.
Each feeder fund is designed to accept contributions from different groups of investors based on
certain criteria driven primarily by tax status and place of domicile. In the case of a fund that employs
leverage, an offshore fund would be organized to accept tax-exempt and non-US investors. This is
because, unlike the profits of a limited partnership and a limited liability company, the profits earned by
an offshore company are recognized at the company level and do not flow through to the investor.
Accordingly, margin-financed profits do not flow through to the investors, thus eliminating the issue of
unrelated business income tax.
In addition, the profits of an offshore fund that invests in a non-US portfolio are not subject to US
withholding tax, and thus for non-US investors the offshore fund has a competitive advantage over
domestic funds. A domestic fund would be organized to accept US taxable investors seeking to avoid
PFIC issues. The assets of both feeder funds are combined into one master fund and invested according to
a single investment strategy. Each feeder fund is its own separate legal entity with its own fee structure
for investment advisory fees, performance fees, sales charges, and operating expenses.

In Chart 1, the investment adviser has established two side-by-side funds, and hence two separate
investment portfolios: one domiciled in the Cayman Islands and one domiciled in Delaware. For
investment advisers, side-by-side funds present some issues, with performance dispersion being at the top
of the list.
Many advisers seeking the efficiencies of managing one portfolio instead of two find the masterfeeder fund structure appealing. In Chart 2, the investment adviser establishes a master fund in the
Cayman Islands. Two feeder funds are also created: one in Delaware, the other in the Cayman Islands.
Contributions from tax-exempt investors come into the master fund by way of the Cayman Islands feeder
fund, and contributions from US taxable investors come into the master fund by way of the Delaware L.P.
While the portfolio efficiencies of the master-feeder structure may look appealing to investment
advisers, it is much more complex and expensive to operate. Instead of creating and operating two funds,
the investment adviser creates, operates, and pays for three. Absent sufficient assets that will generate
economies of scale, the expense of the master-feeder structure could offset any portfolio efficiencies.
Another consideration when evaluating the master-feeder structure is that its investment strategies
may not offer advantages to all investors at all times. For example, long-term capital gains treatment may
be preferred by US taxable investors, but taxes are not a concern for tax-exempt investors, so if the master
fund holds a security longer to receive favorable tax treatment, it may create conflicts of interest among
the different groups of investors.

Finally, there may be integration issues that could inadvertently lead to two funds being treated as
one, triggering fund registration under the Investment Company Act. While the master-feeder fund
structure has its place, careful consideration must be given before plunging headlong into its complexities.

MARKETING THE FUND TO CLAIM AN EXEMPTION FROM INVESTMENT COMPANY

REGISTRATION: SECTIONS 3(c)(1) and 3(c)(7)
Section 7(a) of the Investment Company Act prohibits an investment company from operating
unless it is registered pursuant to Section 8 or is excluded from registration. Registering a fund with the
US Securities and Exchange Commission (SEC) is a complicated and expensive process. Operating a
registered fund requires continuous compliance with a byzantine array of complex rules and regulations.
This includes the fund providing pricing and liquidity daily; empaneling a board of directors and holding
regular meetings; filing reports annually and semi-annually; updating prospectuses annually; and, through
the board, reviewing and approving the investment advisory agreement annually.
These annual fund operating expenses could run into the hundreds of thousands of dollars and,
unless they are picked up by the funds investment adviser, adversely affect the performance of the fund.
Because of the time, expense, and distraction associated with a registered fund, many investment advisers
that lack the business interest or the distribution resources to enter the retail fund space opt for the private
fund option.
Section 3(a)(1)(A) of the Investment Company Act defines an investment company as any issuer
that is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of
investing, reinvesting, or trading in securities. This definition would apply to anything from the billiondollar mutual fund with tens of thousands of shareholders to the smallest weekly investment club whose
members debate the merits of an odd-lot investment over coffee. Fortunately for the investment club and
other start-up funds, section 3(c) of the Investment Company Act of 1940 specifically excludes certain
entities from the definition of an investment company, and thus from the complicated registration process.
The two most commonly used provisions are sections 3(c)(1) and 3(c)(7).
3(c)(1) Fund
Section 3(c)(1) of the Investment Company Act excludes funds whose number of shareholders is
no more than 100 and whose capital raising does not involve a public offering.
But there are certain traps for the unwary when calculating the number of investors. One trap lies
in the look-through provisions. Generally, an entity that invests in a fund will be counted as one
shareholder unless that investor entity is itself an investment fund, the investor entity owns 10% or more
of the outstanding voting securities of the fund, and the aggregate amount of the investor entitys
investment in the fund represents 10% or more of the investor entitys total assets. In that instance, the
investor entitys ownership in the fund will be attributed to every owner of the investor entity.

For example, in the case of a $10 million fund with four investors, Investor A, which is organized
as a limited partnership with 99 partners and $10 million of its own in assets, and whose primary purpose
is investing, invests $2 million in another fund managed by an unaffiliated investment adviser. For
purposes of counting the number of shareholders in the fund, section 3(c)(1) and rule 3c-1 thereunder
require the fund to look through the limited partnership and include in the count all 99 partners. 99 + 3 =
102; and accordingly, under this scenario, the fund will fail to qualify for exclusion under section 3(c)(1).
To avoid this trap, the investment adviser must be diligent in adopting and adhering to a policy of
not accepting investments from any entity whose investment would exceed 10% of the fund. Since no
start-up entrepreneur desires to turn money away, another approach is to conduct due diligence on the
entity, which the investment adviser can and generally does accomplish through a questionnaire and other
investor representations and warranties contained in the funds Subscription Agreement.
The second trap lies in the concept of integration, or treating two or more like funds as one, and
counting the aggregate number of investors in the funds to determine whether they exceed 100. For
example, an investment adviser launches a second global macro fund after the number of investors in the
first fund reaches 100. Under certain circumstances, the SEC would treat both funds as one 3(c)(1) fund,
so that at the time the number of investors in both funds combined exceeded 100, neither fund would
qualify for the Section 3(c)(1) exemption.
There is no statute that addresses fund integration, and the SEC has not adopted any formal rules
that outline what may trigger integration. Guidance on integration, however, can be found in a number of
no-action letters, which lay out the following tests:

Are the different offerings a part of a single plan of financing?

Do the offerings involve issuance of the same class of security?
Are the offerings made at or about the same time?
Is the same type of consideration to be received?
Are the offerings made for the same general purpose?
Would an interest in one fund be considered materially different from an interest in a
second partnership by a reasonable investor qualified to purchase both?
Do the funds have the same investment objectives; the same types of portfolio securities;
and, particularly, similar portfolio risk return characteristics?

In Oppenheimer Arbitrage Partners LP (avail. Dec. 26, 1985), the SEC did not integrate two
funds where one fund was offered to tax-exempt investors and did not engage in short sales or write
uncovered calls, while the other fund was offered to taxable investors and engaged in short sales and other
leveraged transactions. In Shoreline Fund (avail. Apr. 11, 1994), the SEC did not integrate an offshore
fund with an onshore fund, both with almost identical investment strategies, on the grounds that the
offshore fund was created for non-US and US tax-exempt investors, while the onshore fund was created
for taxable investors.
Conversely, in Frontier Capital Management Company (avail. May 6, 1988), the SEC refused to
grant no-action relief to three funds where one invested in a portfolio of large cap stocks, the other in a
8

portfolio of small cap stocks, and the third in a balanced portfolio of stocks and bonds. The SEC noted
that the three funds were designed for one group of investors with similar investment profiles. Therefore,
it appears that to avoid integration, the investment adviser should design the fund for different groups of
investors: institutional, individual, taxable, or non-taxable.
Another consideration in counting the number of shareholders is Rule 3c-5, which allows the
fund to exclude from the count any person who at the time of purchase is a knowledgeable employee of
the investment adviser and any company owned exclusively by such knowledgeable employees. Rule
3c-5 generally defines a knowledgeable employee to include certain executive officers of the fund or
the investment adviser; heads of business units who perform a policy-making function; and non-executive
employees who, in connection with their regular duties or functions, participate in the investment
activities of a fund managed by the investment adviser. Traders, salespersons, staff lawyers, operations
and information technology staff, and junior analysts who do not regularly participate in the stock
selection process do not fit within the definition. In cases where a knowledgeable employee jointly
owns the fund with his or her spouse, the joint account would not count toward the funds 100-owner
limit (see American Bar Association Section of Business Law no-action letter [avail. April 22, 1999]).
Finally, Rule 3c-6 protects the fund from involuntary transfers accidentally triggering the 100beneficial-ownership test. The rule provides that beneficial ownership of a transferee who acquired the
interests by way of gift, bequest, or dissolution of marriage is deemed beneficially owned by the
transferor for purposes of counting the number of shareholders.
The second requirement is that the offering must be private. Provided the investment adviser
markets interests in the fund consistent with the requirements of Regulation D (as more fully explained in
the next section), then the offering will be considered private. Accordingly, careful adherence to Rule 506
of Regulation D is critically important, including a set of offering materials that include all appropriate
disclosure legends and restrictions on transfers required by Regulation D.
Section 3(c)(7)
Section 3(c)(7) excludes funds that are owned exclusively by qualified purchasers and whose
capital raising does not involve a public offering. A qualified purchaser is generally an individual or a
family-owned entity that owns at least $5 million in investments, or an institution that owns and invests at
least $25 million, or a knowledgeable employee. Identical to the Section 3(c)(1) prohibition on public
offerings, the 3(c)(7) offering must be private and consistent with the requirements of Regulation D, as
more fully explained in the next section.

MARKETING THE FUND TO CLAIM THE EXEMPTION FROM SECURITIES

REGISTRATION: REGULATION D
The role of raising assets is crucial to a funds success. The investment adviser needs adequate
assets to invest and diversify so it can generate fees and cover expenses. Investment advisers know all too
well the tough competitive challenges in raising assets, but there are legal challenges as well.

Section 5 of the Securities Act of 1933 (Securities Act) makes it unlawful to offer or sell a
security unless the issuer has filed its prospectus with the SEC and the SEC has deemed it effective.
Registration under the Securities Act is a complicated and expensive process, requiring, in most cases,
extensive negotiations with the SEC staff over disclosure issues. Because of the time, expense, and
distraction associated with registering securities and updating the registration annually, investment
advisers of funds tend to seek an exemption from registration.
Section 4(2) of the Securities Act exempts transactions that do not involve a public offering from
the registration process. Nowhere in the statute is public offering defined. To bring clarity to this
matter, the SEC adopted Regulation D, and related Rules 501508, in which it established safe harbor
provisions. Compliance with these provisions will conclusively bring the fund within the Section 4(2)
exemption. A discussion of exemptions in Rules 501508 follows.
Rule 501: Accredited Investors
Investment advisers to private funds that seek to rely on the safe harbor provisions of Regulation
D will require, with few exceptions, that all of the funds investors meet the definition of an accredited
investor. This includes banks, pensions, insurance companies, and individuals whose net worth exceeds
$1,000,000, or whose individual income exceeds $200,000 or joint income exceeds $300,000. In addition,
all offerees who purchase must possess the requisite level of sophistication that allows them to evaluate
the merits and the risk of the investment.
Although Rule 506(b) under Regulation D permits up to 35 non-accredited investors and an
unlimited number of accredited investors, most private funds will limit its investors to accredited
investors, due in large part to the requirement that non-accredited investors must receive two years of
additional financial and other information similar to what would be furnished in a registration statement.
Rule 502: Limitation on the Manner of Offering
Unless the investment adviser intends to sell interests in the fund solely to accredited investors
pursuant to Rule 506(c) (as discussed below), Rule 502(c) prohibits the fund and the investment adviser
from using any form of general solicitation or general advertising in the capital raising process. While
there is no definition of general solicitation or general advertising" in the statute, Regulation D broadly
defines this to include advertisements, articles, notices, and other communications published in
newspapers, magazines, and the internet, as well as general invitations to participate in promotional
seminars and meetings. For investment advisers, the issue will most likely arise when dealing with
client newsletters, client seminars, email blasts to clients, and investment adviser web sites.
By far the most difficult and pervasive questions concerning Rule 502(c) under Regulation D
have concerned the determination of what will be deemed a general solicitation." The SEC has tended to
focus on whether the investment adviser has a preexisting substantive relationship with the investor.

10

In H.B. Shaine & Co. (avail. May 1, 1987), a broker-dealer proposed using questionnaires to
identify investors who would be accredited under Rule 501(a)(1). The broker-dealer would update the
questionnaires annually, and the questionnaires would serve as the basis for an established list of
accredited investors. The firm then intended to offer private placements to the persons on the list. In
agreeing that the questionnaires provided sufficient detail to establish a substantive relationship, the SEC
stated that a satisfactory response by a prospective offeree to a questionnaire that provides a brokerdealer with sufficient information to evaluate the respondents sophistication and financial situation will
establish a substantive relationship. Because this relationship would be established prior to any offering,
the staff also agreed that the relationship was preexisting.
In Lamp Technologies, Inc. No-Action Letter (avail. May 29, 1997, http://www.sec.gov/
divisions/investment/noaction/1997/lamptechnologies052997.pdf; follow-up letter, May 1998), the SEC
issued guidance on how private funds could post information about themselves on a web site operated by
a third party and still comply with the prohibition on general solicitation and advertising under Regulation
D and the prohibition on a public offering in sections 3(c)(1) and 3(c)(7).
Lamp proposed to establish and administer a web site that contained information concerning
privately offered, exempt funds. An interested investor could gain access to the information within the
password-protected site only after (1) he or she had completed a questionnaire designed to allow Lamp to
form a reasonable basis for determining that the investor was an accredited investor, and (2) Lamp had
issued the investor a password to access the site. To prevent an investor from joining the service and
immediately investing in a particular fund, Lamp set a 30-day cooling-off period before an investor could
invest. By using a questionnaire that provided Lamp with sufficiently detailed information to evaluate the
potential investors sophistication, requiring the use of a password, and imposing a 30-day cooling-off
period, Lamp was able to establish a substantive relationship with a potential investor.
Rule 506(b): The Traditional Private Placement of Fund Interests
Rule 506(b) exempts the fund from registering its securities regardless of the size of the offering.
To qualify for the exemption, the securities may only be offered and sold to accredited investors, as
defined in Rule 501, and up to 35 non-accredited investors.
As a practical matter, however, most investment advisers to private funds will not want to accept
non-accredited investors into the fund, except under the most limited circumstances, because of Rule
505(b). This rule requires that the fund must provide non-accredited investors with the same information
that it would provide in a securities registration statement. Under Rule 506(b), the issuer may not engage
in general solicitation or general advertising of the offer, as defined in Rule 502, and the issuer must have
a reasonable belief that the purchasers are accredited investors or sophisticated, non-accredited investors.
Rule 506(c): JOBS Act Rule Permitting General Advertising
As required by the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (DoddFrank), provisions under Rule 506(c) have given investment advisers of private funds more latitude in
how they market and promote their fund. Effective September 23, 2013, the final Jumpstart Our Business

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Startups Act (JOBS Act) rules removed the 80-year-old ban under Rule 502 on general solicitation and
advertising, under certain conditions. Advisers of private funds now may promote funds through public
web sites and other forms of social media, provided that each investor in the fund meets the Rule 501
definition of an accredited investor and the investment adviser has taken reasonable steps to verify that
the investors in fact meet the definition. Accordingly, Rule 506(c) necessitates that investment advisers
adopt policies and procedures reasonably designed to ensure that each investor in the fund is an
accredited investor.
Rule 506(c) requires investment advisers to take reasonable steps to verify that the investors in
the fund are accredited investors, which is a higher standard than Rule 506(b)s reasonable belief
standard. In a Rule 506(b) offering, investment advisers generally rely on investor representations made
in the subscription agreement, without independently verifying the financial status of the investor. But if
the fund uses Rule 506(c) to promote its interests, the SEC will expect the adviser to exercise greater
diligence than before in ascertaining accredited investor status.
The SEC has indicated the more likely it appears that a purchaser qualifies as an accredited
investor, the fewer steps the issuer would have to take to verify accredited investor status, and vice versa.
In other words, the principles-based method allows the investment adviser to follow the rule of reason in
determining whether an investor is or is not accredited. For example, the risk of noncompliance is very
low in the case of an investor who invests $1 million or more into the fund.
The adopting release lists several nonexclusive and nonmandatory methods that it considers
reasonable steps to verify accredited investor status. These include:
a. For income verification: Form W-2, Form 1099, Schedule K-1 to Form 1065, and Form 1040;
b. For net worth verification: bank statements, brokerage statements and other statements of
securities holdings, certificates of deposit, tax assessments, and appraisal reports issued by
independent third parties; and for liabilities, a consumer report from at least one of the
nationwide consumer reporting agencies; and
c. Independent verification from (1) a registered broker-dealer, (2) an investment adviser
registered with the SEC, (3) a licensed attorney who is in good standing under the laws of the
Jurisdictions in which he or she is admitted to practice law, or (4) a certified public
accountant who is duly registered and in good standing.
Given that investment advisers may be reluctant to assume this reasonable step burden,
investment advisers increasingly may look to third parties (e.g., lawyers, accountants, and established
angel investor groups) to review and verify the investor information, in order to certify the accuracy and
legal qualification for which the third party must bear responsibility.
Rule 506(d): The Bad Actor Disqualification
As another consequence of Dodd-Frank, the SEC has adopted Rule 506(d) under the Securities
Act to disqualify certain bad actors from relying on the exemption from registration in Rule 506. As a
result, companies are now prohibited from relying on Regulation D in connection with a private offering

12

pursuant to Rule 506 if certain persons related to the fund participate in bad acts on or after September
23, 2013.
Investment advisers will need to collect this information in the form of a questionnaire from all
persons and entities connected to the fund, to ensure compliance with these new requirements. These
persons and entities will include the Issuer (the company issuing the securities); any predecessor to the
Issuer; any affiliated companies; beneficial owners of 20% or more the Issuers outstanding voting equity,
calculated on the basis of voting power; promoters under Rule 405 who are currently connected to the
Issuer in any capacity; investment advisers of the funds; broker-dealers and solicitors of the fund; and, as
applicable, directors, executive officers, and other officers of any of the above. Membership in any of
these categories is to be determined at the time of sale; thus, additional people might need to complete the
questionnaire as the offering progresses if the membership of any of the above categories changes.
Investment advisers must conclude a person will fit the definition of a bad actor if they
affirmatively answer any question in the questionnaire related to the following after September 23, 2013:
a. Certain criminal convictions for felonies or misdemeanors and certain court injunctions in
connection with certain securities activities and making false statements to the SEC;
b. Final orders of certain state and federal regulators of securities, commodities, insurance,
banking, savings associations, or credit unions constituting a bar from engaging in certain
activities; or final orders based upon fraudulent, manipulative, or deceptive conduct;
c. Certain SEC disciplinary orders, cease and desist orders, and stop orders;
d. Suspension or expulsion from membership in a self-regulatory organization (SRO), such as
the Financial Industry Regulatory Authority (FINRA), or from association with an SRO
member; or
e. US Postal Service false representation orders.
Even though September 23, 2013 was the trigger date, bad actor disqualifying events that existed
before that date are required to be disclosed in writing to investors. Issuers must furnish this written
description to purchasers within a reasonable time before the Rule 506 sale. Even though disqualification
will not arise as a result of disqualifying events that occurred before September 23, 2013, Rule 506 is
unavailable to a fund that fails to provide the required disclosure, unless the issuer is able to demonstrate
that it did not know, and, in the exercise of reasonable care, could not have known that a disqualifying
event was required to be disclosed.
Failure to qualify for exemption under Rule 506(b), (c), and (d) can have serious consequences.
Given that advisers potentially face strict liability under the Securities Act Section 12(a)(1) for selling
unregistered securities that otherwise should have been registered, advisers must exercise great care in
designing a program and the proper forms that demonstrate they have taken reasonable steps to comply
with Rule 506(b), (c), and (d).

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Form D Notices
Form D is a form the fund files to perfect its exemption under Rule 504, 505, or 506 of
Regulation D. SEC rules further require the notice to be filed online within 15 days after the first sale of
securities in an offering. For this purpose, the date of first sale is the date on which the first investor is
irrevocably contractually committed to invest. The SEC does not charge any filing fee for a Form D
notice or amendment. If the fund is continuing to offer its interests, it will need to file an amendment
annually, on or before the first anniversary of the most recent previously filed notice.
Many states also require the filing of Form D notices and amendments, and most of them charge a
filing fee. For information on state Form D filing requirements, visit http://www.nasaa.org/ to get links to
the proper state web sites. State web sites contain bulletins providing details on filing requirements and a
contact person for specific questions. At the present time, all states that require Form D filings accept
paper filings only; none permit online filings.
Rule 508: Non-Compliance
Rule 508 offers a defense to a fund that has failed to comply in all respects with Rules 506. The
defense cannot be raised in an SEC enforcement action. To avail itself of the defense, the fund must show
three things: (1) the provision with which it failed to comply was not intended to protect the investor who
seeks rescission, (2) the failure to comply was not significant, and (3) the fund made a good faith effort to
comply. So for example, a fund may raise a 508 defense if it fails to file a Form D, or if it fails to give
investors an opportunity to ask questions. There are two activities that will always be significant and
therefore excluded from the 508 defense: (1) general solicitation (except Rule 506[c] offerings), and (2)
the numerical purchaser limit.

BROKER-DEALER ISSUES
Use of Finders and Broker-Dealers
Investment advisers may choose among several options to distribute interests in their private
funds to investors. They can utilize external groups such as broker-dealers, finders, and internet sites.
They can also utilize an internal sales force, or hope to rely on word of mouth. In 2013, the SEC began
focusing its attention on this area through no-action letters, an enforcement action, and speeches. The
SEC has distinguished those activities that it would consider finder activities and those it would
consider broker-dealer activities that require a broker-dealer license.
In doing so, the SEC has called into question the long-standing practice of investment advisers
using internal salespersons as agents of the fund and relying on the issuer exemption from broker-dealer
registration. Investment advisers who are not careful in this area are vulnerable to a regulatory
enforcement action and, even worse, rescission claims by investors.

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Section 3(4) of the Securities Exchange Act defines a broker as any person engaged in the
business of effecting transactions in securities for the account of others. Believing that the presence of a
transaction-based success fee, or the so-called salesmans stake, can lead to high-pressure tactics, the
SEC places heavy emphasis on transaction-based fees when evaluating whether a person is in the brokerdealer business.
Section 15(a)(1) of the Securities Exchange Act makes it unlawful for any broker or dealer to
effect any transaction in the purchase or sale of any security unless the broker or dealer is registered
pursuant to Section 15(b). For the person who should have been registered but isnt, then every investor
who has purchased from such unregistered person may rescind the purchase pursuant to Section 29(b) of
the Act.
As the SEC enforcement action against Ranieri Partners (http://www.sec.gov/litigation/admin/
2013/34-69091.pdf) exemplifies, investment advisers can be subject to SEC enforcement action under
Section 20(e) of the Securities Exchange Act for assisting non-registered third parties in soliciting sales of
fund shares without a broker-dealer license. Ranieri Partners illustrates that the SEC will pursue
investment advisers who turn a blind eye to third parties who solicit potential investors for the investment
advisers funds.
In this particular case, Ranieri Partners hired an unregistered individual to introduce investors to
the investment adviser and its funds in exchange for a 1% finders fee. However, the business relationship
evolved into something more. Ranieri furnished the individual with private placement memoranda
(PPMs), subscription documents, and marketing materials. The individual then furnished them to
prospective investors. Ranieri knew or should have known that the individual actively met with potential
investors to discuss the funds investment strategy, investment performance, and asset allocation. It is not
surprising that the SEC found that the individual had engaged in unregistered, and thus illegal, brokerdealer activities; however, it was surprising to see the SEC pursue Ranieri on an aiding and abetting
charge, as well.
Although Ranieri involved an external third party, the same issue can arise for investment
advisers that use an internal sales force to market their fund. In the past, investment advisers tended to
rely on the issuer exemption under Rule 3a41 promulgated under the Securities Exchange Act (17
CFR Part 240.3a41) to avoid registering as a broker-dealer, claiming that the fund was the issuer selling
for its own account, and not the account of others, and their employees were associated persons carrying
out that function.
Rule 3a41 is a non-exclusive safe harbor. Rule 3a41 provides that an associated person (or
employee) of an issuer who participates in the sale of the issuers securities would not have to register as
a broker-dealer if that person, at the time of participation: (1) is not subject to a statutory
disqualification, as defined in Section 3(a)(39) of the Act; (2) is not compensated by payment of
commissions or other remuneration based directly or indirectly on securities transactions; (3) is not an
associated person of a broker or dealer; and (4) limits its sales activities as set forth in the rule. However,
the SEC has suggested that a narrow reading of Rule 3a41 raises broker-dealer compliance issues for the
activities of internal sales staff paid on commission.

15

Following up on the Ranieri Partners case, David Blass, the Chief Counsel of the SEC Division
of Markets and Trading, gave a speech before the American Bar Associations Trading and Markets
Subcommittee. He put investment advisers on notice that their internal sales activities may involve
broker-dealer activities as a result of the methods of compensating their sales personnel and, in the case of
private equity fund managers, the receipt of investment banking fees with respect to their portfolio
companies (April 13, 2013, http://www.sec.gov/news/speech/2013/spch040513dwg.htm).
In evaluating whether the internal sales efforts of an investment adviser give rise to broker-dealer
activity and registration as a broker-dealer, the investment adviser should analyze the following:

How does the adviser solicit and retain investors?

Do employees who solicit investors have other responsibilities?
How are personnel who solicit investors for a private fund compensated? Do those
individuals receive bonuses or other types of compensation that are linked to successful
investments?

A critical element to determining whether one is required to register as a broker-dealer is the

existence of transaction-based compensation. This implies that bonuses tied to capital raising success
would likely give rise to a requirement for the individuals receiving such bonuses to register as brokerdealers.
In the Funders Club No-Action Letter (avail. Mar. 26, 2013, http://www.sec.gov/divisions/
marketreg/mr-noaction/2013/funders-club-032613-15a1.pdf), and Angel List LLC No-Action Letter
(avail. Mar. 28, 2013, http://www.sec.gov/divisions/marketreg/mr-/2013/angellist-15a1.pdf) the SEC
granted no-action relief to investment advisers that operated an internet-based platform exclusively for
accredited investors. When the investment advisers identified prospects in which to invest, it posted
investment information on the web site that could only be accessed by members who were accredited
investors and who may or may not reply with an indication of interest. Once indications of interest
reached certain levels, the investment adviser would close the transactions with the prospects. Investors
paid administrative fees to defray actual out-of-pocket expenses; the investment manager received a
performance fee based on the profits of the fund.
Key factors in the decision to grant relief were: (a) the Investment advisers received
compensation for their advisory service and not transaction-based compensation; (b) employees of the
investment adviser did not receive transaction-based compensation; and (c) none of the administrative
fees were paid to the investment adviser for selling activities.

COMMODITY INVESTMENT: WHAT IT MEANS FOR INVESTMENT ADVISERS AND

PRIVATE FUNDS
Historically, the Commodity Exchange Act (CEA) had limited application to investment advisers
and sponsors of private funds because of the sophisticated investor exemption. Funds that traded in

16

futures, options on futures, and hard commodities were exempt from the definition of a commodity
pool, their sponsors were exempt from the definition of a commodity pool operator (CPO), and their
advisers were exempt from the definition of a commodity trading advisor (CTA), as long as all of their
investors were accredited investors.
Dodd-Frank, however, has changed that. Dodd-Frank eliminated the long-standing sophisticated
investor exemption and expanded the definition of commodity pool, with the overall effect of
capturing trading in security futures products and swaps. As a result, a large number of investment
advisers that were not CTAs and CPOs under prior regulations must consider whether they need to
register as CTAs or CPOs, or both, and fulfill other regulatory requirements, or need to take action to
claim exemption. As investment advisers to private funds continue to rely more and more on derivative
instruments to hedge their portfolios (e.g., currency, interest rates, index futures, and options) knowledge
of and compliance with the CEA becomes increasingly important.
Commodity Interests: The Investment Portfolio
Determining what constitutes a commodity is not always straightforward. Originally, a
commodity was any item included on an enumerated list of agricultural goods, grain, sugar, and other
tangible goods. However, in 1974 the administration of the CEA was transferred from the US
Department of Agriculture to The Commodity Futures Trading Commission (CFTC), which subsequently
expanded the definition of a commodity to include all services, rights, and interests in which contracts
for future delivery are presently or in the future dealt in. Ensuing judicial cases and Congressional
legislation further pushed the boundaries of what could be included as a commodity.
Today, a commodity is considered to be any homogenous good, traded in bulk, on an exchange
that is standardized, usable upon delivery, and whose price varies enough to justify the creation of a
market. Thus, the expanded definition now encompasses intangible items as wellincluding financial
products such as foreign currencies and indexes, futures contracts, options, and swapswhere contracts
for a commodity do not necessarily involve settlement through delivery of a tangible underlying asset.
In July 2012, the CFTC and SEC finalized their definition of swaps and security-based swaps
to include foreign exchange forwards, foreign exchange swaps, foreign currency options (not traded on a
national securities exchange), non-deliverable forward contracts involving foreign exchange, currency
swaps, cross-currency swaps, forward rate agreements, contracts for differences, and certain combinations
and permutations of (or options on) swaps and security-based swaps, among others. (See 17 CFR Part 1;
17 CFR Part 240)
The Commodity Pool: The Fund
CEA section 1a(10) defines a commodity pool as an enterprise in which funds contributed by a
number of persons are combined for the purpose of trading futures contracts, options on futures, retail offexchange foreign currency exchange (forex) contracts or swaps, or to invest in another commodity pool.
Many investment advisers of equity funds that occasionally use derivatives to hedge their portfolios are
under the false impression that their funds are not commodity pools. Many take the position that the

17

purpose of their funds is to trade securities and not commodities. However, the CFTC interprets very
broadly the term for the purpose of, so that a single commodity position within the funds portfolio
would be enough for the fund to fall within the definition of a commodity pool.
The Commodity Pool Operator (CPO): The Entity that Sponsors the Fund
CEA section 1a(11) defines a CPO as any person engaged in a business that is of the nature of
an investment trust, syndicate, or similar form of enterprise, and who, in connection therewith, solicits,
accepts, or receives from others, funds, securities, or property, either directly or through capital
contributions, the sale of stock or other forms of securities, or otherwise, for the purpose of trading in any
commodity for future delivery on or subject to the rules of any contract market or derivatives transaction
execution facility. In the private fund context, and depending how the fund is structured, this could
include the general partner or managing member, or the investment adviser.
The Commodity Trading Advisor (CTA): The Investment Adviser to the Fund
Section 1a(12) defines a CTA as any person who for compensation or profit:
(i)

Engages in the business of advising others, either directly or through publications,

writings, or electronic media, as to the value of or the advisability of trading in:
(a) Any contract of sale of a commodity for future delivery made or to be made on or
subject to the rules of a contract market or derivatives transaction execution facility;
(b) Any commodity option authorized under Section 6c of the CEA; or
(c) Any leverage transaction authorized under section 23 of the CEA;

(ii)

And as part of a regular business, issues or promulgates analyses or reports concerning

any of the activities referred to above.

In the private fund context, this will include the investment adviser, general partner, or managing
member, unless the general partner or managing member has elected to retain the services of an outside
investment adviser to manage the portfolio.
The Associated Person (AP)
An Associated Person (AP) is an individual who solicits orders, customers, or customer funds;
who supervises salespersons for any of these categories of individuals or firms; and any person in the
supervisory chain of command. The CFTC has indicated that not only should immediate supervisors be
registered as APs, but everyone in the line of supervisory authority, regardless of how senior their
positionincluding the president of the firmshould be registered as an AP, as well. The analysis of
who should register in small firms that sell interests in commodity pools appears straightforward:
everyone should register. In larger organizations with layers of assistants, sales personnel, and
supervisors, the analysis becomes more complex.

18

Registration Requirements
In general, registration is required unless the CPO or CTA qualifies for one of the exemptions
from registration outlined in CFTC Regulations 4.13 and 4.14. CTAs and CPOs are regulated by
government entities and an industry-wide SRO. The CFTC is the government entity responsible for
regulating commodity trading. The National Futures Association (NFA) is the SRO responsible for
regulating futures markets. Membership in NFA is mandatory, and the association is financed exclusively
from membership dues and assessment fees paid by the users of the futures markets. NFA has the
authority to take disciplinary actions against any firm or individual that violates its rules.
Full registration as a CPO and CTA is a relatively involved process and typically takes from six
to eight weeks to complete. Registration involves submission of Form 7-R for the CPO and a Form 8-R
for all natural person Principals and for all APs, along with fingerprints for such Principals and APs, as
well as proof that each AP passed the required proficiency exams (generally the Series 3 or 31). At least
one Principal will be required to be registered as an AP. Fully registered CPOs will also be subject to
CFTC and NFA regulation. Such regulation includes providing disclosure documents to pool participants
that are subject to review by NFA; recordkeeping; and periodic and annual reporting requirements,
including delivery of audited annual financial statements. In addition, APs of a registered CPO or CTA
must satisfy proficiency requirements, generally by taking and passing the Series 3 Examination.

EXEMPTIONS FROM REGISTRATION

Below are some of the most notable exemptions from registration.
Exemption for CPOs: Rule 4.13(a)(3)
Rule 4.13(a)(3), also referred to as the private fund de minimis exemption, exempts persons
who are operators of funds for which: interests in the pool are exempt from registration under the
Securities Act; the pool engages in a limited amount of trading in commodity interests (e.g., futures,
swaps, and options); participation in the pool is limited to certain types of qualified investors; and the
pool is not marketed as a vehicle for trading in commodity interests. There are two tests used to determine
whether there is limited trading.
The first is a five percent (5%) test, which compares the amount of margin, premiums, and
minimum-security deposits used to establish the positions in commodity interests to the funds liquidation
value. The second is the alternative net notional test, which looks at whether the net notional value of
the commodity interest positions, measured at the time the most recent position is put on, is more than
100% of the funds liquidation value.
Accordingly, to satisfy the limited trading test, the private fund will have to limit the aggregate
initial margin it posts for its speculative commodities-related trading to 5% of the liquidating value of its
portfolio, after taking into account unrealized profits and losses. Alternatively, a private fund may limit
the aggregate net notional value of its speculative commodities-related trading positions to 100% of the

19

liquidation value of its portfolio, after taking into account unrealized profits and losses (excluding the inthe-money amount of an option at the time of purchase).
In November 2012, the CFTC issued a time-limited no-action letter providing relief from CPO
registration for sponsors of funds of funds. Historically, funds of funds could rely on the de minimis
exemption, along with guidance provided in Appendix A to Part 4 of the CFTC regulations used to
calculate whether a fund was within the de minimis threshold. Since Appendix A was rescinded as a part
of Dodd-Frank the CFTC informally indicated that Appendix A may continue to be relied upon until
revised guidance is issued (see CFTC Letter to Investment Adviser Association and Managed Fund
Association, No. 12-38 (November 29, 2012)) .
This no-action letter is the CFTCs formal indication that funds of funds may continue to rely on
the guidance in the rescinded Appendix A until the later of June 30, 2013, or six months from the date the
CFTC issues revised guidance on the methods for calculating the de minimis thresholds under CFTC
Regulations 4.5 and 4.13(a)(3). In order to claim this relief, a fund of funds must comply with the
eligibility requirements stated in the no-action letter and must file a claim of exemption.
Exemptions for CTAs: Section 4m
Section 4m(1) of the CEA provides an exemption from registration as a CTA for a person
who, in the preceding 12 months, has not furnished commodity trading advice to more than 15 persons
and who does not hold himself out generally to the public as a commodity trading advisor (CTA).
Section 4m(3) of the CEA provides an exemption from CTA registration for a person:

Who is registered with the SEC as an investment adviser;

Whose business does not consist primarily of acting as a CTA; and
Who does not act as a CTA to any investment trust, syndicate, or similar form of enterprise
that is engaged primarily in trading in any commodity for future delivery on or subject to the
rules of any contract market or registered derivatives transaction execution facility.

Exemption for CTAs: Rule 4.14

Rule 4.14 is the registered investment adviser exemption from registration as a CTA. In order to
rely on Rule 4.14: (a) the adviser must be registered under the Investment Advisers Act of 1940 or with
the applicable securities regulator of any state; (b) their trading in commodity interests must be (i) solely
for qualified entities, and (ii) solely incidental to its business of providing securities and other
investment advice; and (c) the entity must not hold itself out as a CTA.
Registration Lite: Rule 4.7
CPOs of funds whose investors are qualified eligible purchasers must still register with the NFA;
however, they may be able to take advantage of the scaled-back disclosure, recordkeeping, and periodic
reporting requirements applicable to other registered CPOs.

20

Investment advisers that qualify for the exemption described above are still generally subject to
the following requirements under either CFTC or SEC rules:

Investment advisers must file a publicly available notice disclosing the exempt status that
may be reviewed on the CFTC or NFA web site;
Investment advisers must provide investors with an offering memorandum containing
information such as fees, transferability of fund interests, conflicts of interest, and other
matters; and
Investment advisers must provide investors with quarterly account statements and an annual
report.

Claiming the Exemptions

The exemptions described above are not self-executing. To claim an exemption, the adviser must
electronically file a notice of eligibility with the NFA. In addition, private funds must make certain
disclosures to each prospective investor regarding the funds exempt status. In order to retain ongoing
eligibility for the exemption, advisers that are still eligible for relief must affirm the accuracy of their
original notice of exemption on an annual basis.

FIDUCIARY ISSUES: OPERATING THE FUND

Nowhere does the Investment Advisers Act expressly create a fiduciary duty for investment
advisers. However, the courts and the SEC have established a fiduciary standard governing the conduct of
an investment advisers entire relationship with clients and prospective clients. Accordingly, there was
never a need by Congress to codify it. As a fiduciary, the investment adviser must avoid conflicts of
interest with clients, disclose all material facts to clients and prospective clients, and avoid overreaching
or taking unfair advantage of a clients trust. A fiduciary owes its clients more than mere honesty and
good faith alone.
This position is well supported by the courts. In the 1963 landmark decision, the United States
Supreme Court in SEC v. Capital Gains Research Bureau, Inc., 375 U.S. 180 (1963) created a federal
fiduciary duty that all investment advisers, registered and unregistered, must fulfill. In its decision, the
Court neither stated nor implied that the Investment Advisers Act created a fiduciary duty governing
advisers, but it did hold that inherent in the Investment Advisers Act was a recognition that a fiduciary
duty existed between investment advisers and their clients.
This position was later upheld by the Supreme Court in Santa Fe Industries v. Green, 430 U.S.
462 (1977), in which Justice White wrote in the now-famous footnote 11 that Congress intended the
Investment Advisers Act to establish federal fiduciary standards for investment advisers.

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Disclosure Obligations
Encouraging disclosure of information is a fundamental principle of the securities laws. Under the
federal fiduciary standard, a core duty of all investment advisers of private funds is to disclose the
material facts relating to the investment to the investors in the fund. The SEC has codified this duty in
Rule 206(4)-8 under the Investment Advisers Act, which states:
(a) It shall constitute a fraudulent, deceptive, or manipulative act, practice, or course of business
within the meaning of section 206(4) of the Act (15 U.S.C. 80b-6(4)) for any investment adviser
to a pooled investment vehicle to: (1) Make any untrue statement of a material fact or to omit to
state a material fact necessary to make the statements made, in the light of the circumstances
under which they were made, not misleading, to any investor or prospective investor in the
pooled investment vehicle.
On top of Rule 206(4)-8 is Rule 10b-5 of the Securities Exchange Act of 1934, which states:
It shall be unlawful for any person, directly or indirectly, by the use of any means or
instrumentality of interstate commerce, or of the mails or of any facility of any national securities
exchange,
(a) To employ any device, scheme, or artifice to defraud;
(b) To make any untrue statement of a material fact or to omit to state a material fact necessary in
order to make the statements made, in the light of the circumstances under which they were made,
not misleading; or
(c) To engage in any act, practice, or course of business which operates or would operate as a
fraud or deceit upon any person in connection with the purchase or sale of any security.
In addition, many state securities laws impose similar duties. For example, California
Corporations Code Section 25401 makes it unlawful:
For any person to offer or sell a security in this state or buy or offer to buy a security in this state
by means of any written or oral communication which includes an untrue statement of a material
fact or omits to state a material fact necessary in order to make the statements made, in the light
of the circumstances under which they were made, not misleading.
It is important to note that when an investor subscribes to interests in a fund, that investor is
buying a security and bringing Rule 10b-5 and the various states Blue Sky Laws into play. Avoiding the
liability imposed by these rules and Blue Sky Laws makes it imperative that the investment adviser
refrain from misrepresenting or concealing facts that a prospective investor may deem important.
Accordingly, even though each investor in the fund may be a sophisticated, high net worth investor, great
care still must be taken when drafting PPM to include meaningful disclosure that includes at a minimum
the following items:

Investment objectives, policies, and processes;

22

Background of the investment adviser and the portfolio managers;

Terms of the offering;
Investment advisory fees, performance fees, and other expenses;
Conflicts of interest;
Risks of investing in the fund;
Redemptions;
Allocations of profit and loss; and
Tax considerations.

Due Diligence
Investment advisers to private funds have a duty to ensure they have a reasonable basis for
making investment decisions for the fund. Accordingly, it is important for investment advisers to have a
rigorous investment process for selecting portfolio investments. An area that has begun to attract
increasing attention is the process employed by investment advisers in evaluating other third-party
investment advisers selected by funds of funds.
Private fund advisers will choose to engage third-party service providers to perform a number of
critical services for the fund, such as investment management, custody, valuation, client intake and
service, account reconciliations, and corporate action processing. However, when the investment adviser
hires a third-party investment adviser, the investment adviser still retains its fiduciary responsibilities for
formulating a reasonable basis for selecting the underlying investment adviser, just as it has when
selecting an individual security. As a result, fiduciary duty dictates that investment advisers develop and
implement strong due diligence process when selecting and retaining third-party investment advisers, so
they can demonstrate the level of judgment and care a reasonable person would take in formulating a
reasonable basis for entering into an agreement or transaction.
In 2003, then-Office of Compliance Inspections and Examinations (OCIE) Director Lori Richards
reminded investment advisers they have an affirmative duty to supervise under the Investment Advisers
Act (Remarks at Investment Counsel Association/IA Week Investment Adviser Compliance Summit,
April 28, 2003). Ms. Richards noted that the SEC believed that investment advisers had devoted lessthan-meticulous care in the area of supervision, particularly sub-advisers. Ms. Richards made it clear that
the track record alone was not enough; investment advisers need to satisfy themselves that the subadviser has on an ongoing basis all the necessary controls in place to evaluate the operational,
compliance, and investment risks of third party investment advisers.
In 2011, the SEC filed a complaint against an investment adviser to a private fund of funds for,
among other things, misstating the scope and quality of their due diligence checks on certain managers
and funds selected for inclusion in the funds portfolio (see SEC v Chetan Kapur; Lilaboc, LLC, d/b/a
Think Strategy Capital Management, LLC; Civil Action No. 11-CIV-8094 [S.D.N.Y.]). Although Kapur
told investors that all the funds in the portfolio would be selected using a vigorous due diligence process,
he instead selected funds that later were revealed to be Ponzi schemes. In 2013, final judgments were
entered against Kapur for $3,988,196 in disgorgement and $1,000,000 in civil penalties. In addition,
Kapur was ordered barred from the securities industry.
23

In another case, In the Matter of Hennessee Group and Charles J. Gradante (Investment Advisers
Act Release No. 2871, April 22, 2009), the SEC charged the investment adviser and its principal with a
breach of their fiduciary duties for failing to perform the services they represented they would provide
and failing to disclose all material departures from the representations they made to clients. The SEC
alleged that the Hennessee Group failed to perform two of the five elements of the due diligence
evaluation that they had represented to their clients they would undertake. The SEC also alleged that
Hennessee Group had failed to verify a funds relationship with its independent auditor, disregarded red
flags, and failed to investigate rumors relating to a conflict of interest between the fund and its
independent auditor. Hennessee Group and Gradante received censures, cease and desist orders, paid
disgorgement in excess of $700,000, and paid civil penalties of $100,000.
These cases illustrate that in a fund of funds context, it is critical for an investment adviser to
adopt and follow a formal due diligence process beyond that of reviewing investment performance.
Necessary due diligence includes conducting a general background check into the reputation of the
investment adviser and its management, checking disciplinary histories, verifying credentials, and
checking the references provided by the private fund into which the fund of funds intends to invest.
It would also be beneficial for the fund of funds investment adviser to evaluate the depth of
management of the underlying investment adviser, and understand where investment responsibilities lie.
This will normally entail meeting with management to become familiar with the individuals involved,
their capabilities, their business judgment, and their experience in managing and constructing a portfolio.
A deeper dive will include analysis of accounting and valuation principles and controls utilized by the
investment adviser, a review of the underlying funds audited financials, the auditors report, and any
management letters.
Performance Fees
Another core duty under the federal fiduciary standard is to not be overreaching with clients,
particularly in the area of fees. Many investment advisers to private funds enter into investment advisory
agreements that pay the investment adviser a set advisory fee and a share of capital gains upon or capital
appreciation of the fund, commonly known as a performance fee.
To prevent overreaching of clients, Section 205(a)(1) of the Investment Advisers Act generally
prohibits a registered investment adviser from entering into, extending, renewing, or performing any
investment advisory agreement that has a performance fee. Under current Rule 205-3, however, an
investment adviser may charge performance fees to the following types of clients, because the Rule
presumes these types of investors do not need the protections provided by the Investment Advisers Act
due to their wealth, financial knowledge, and experience:

Qualified Client: A natural person or a company who has at least $1,000,000 under
management with the adviser; or who has a net worth of more than $2,000,000;
Qualified Purchasers; or
Knowledgeable Employees (see Section 3(c)(1) Fund above).

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Side Letters
A side letter is an agreement between the investment adviser and the investor that outlines
different terms that will apply to the investors investment into the fund. Typically the letter will be used
to entice early investors to invest in the fund; it can also be used to attract investors who will contribute a
large amount of assets to the fund. The side letter can also be used to incentivize a current investor to
contribute more assets to the fund. Although the side letter can be an important tool for raising assets, it
nevertheless creates a conflict of interest in that it treats investors in the fund differently from each other.
Some of the more common terms in the side letter include:

Reduced Fees: the investment adviser will reduce or waive the management fees or
performance fees for the investor;
Lock-up and liquidity: the investment adviser may reduce or waive the lock-up for a specific
investor. The investment adviser may also allow for greater liquidity (i.e., monthly
withdrawals instead of quarterly withdrawals);
Information: the investment adviser may agree to provide an investor with greater
informational rights, such as the ability to request a description of the exact positions of the
fund at any given time; and
Most favored nations clause: this allows an investor to get the best deal that the investment
adviser gives to any other investor. This clause is usually reserved for very large or very early
investors.

In testimony concerning hedge funds before the US Senate Banking, Housing and Urban Affairs
Subcommittee on Securities and Investment, Susan Wyderko, SEC Director of Investment Education and
Assistance, indicated that some side letters address matters that raise few concerns, such as the ability to
make additional investments, receive treatment as favorable as other investors, or limit management fees
and incentives (May 16, 2006 http://www.sec.gov/news/testimony/ ts051606sfw.htm).
Other side letters, however, are more troubling, because they may involve material conflicts of
interest that can harm the interests of other investors. Chief among these types of side letter agreements
are those that give certain investors liquidity preferences or provide them with more access to portfolio
information. It should be expected that an examination staff will review side letter agreements and
evaluate whether appropriate disclosure of the side letters and relevant conflicts has been made to the
other investors.
Use of side letters is not without responsibility and risk. Dodd-Frank imposes certain new specific
recordkeeping obligations on investment advisers of private funds. Specifically, Section 204-2(b)(3)(F) of
the Investment Advisers Act now requires an investment adviser to maintain records relating to the side
arrangements or side letters whereby certain investors in a fund obtain more favorable rights or
entitlements than other investors.

25

In SEC v Harbinger Capital Partners LLC, Civil Action 12-CV-5028 (SDNY), the SEC alleged,
among other things that Harbinger Capital and two principals, Phillip Falcone and Peter Jensen, had
participated in a preferential redemption scheme with certain investors in exchange for their vote to raise
the gates. During the market turmoil in 2008, the fund was experiencing sizable redemptions and the
principals wanted to impose a more restrictive redemption gate, but to do so required shareholder
approval. To get approval, they entered into side deals that granted preferential redemption rights to the
largest investors. Neither Falcone nor Jensen disclosed the existence of these side letters to the Board or
to the other shareholders. They also failed to disclose the existence of side letters in response to investors
annual questionnaires. Falcone ultimately reached a settlement with the SEC that barred him from the
industry for two years.
In a case arising in the Cayman Islands, Lansdowne Limited & Silex Trust Company Limited v.
Matador Investments Limited (In Liquidation) & Ors (23 August 2012), the side letter attempted to
eliminate the gating and suspension provisions in the Articles of Association on redemption requests by
certain investors. The Articles of Association authorized the directors of the fund to gate and suspend
redemptions, but did not empower them to treat investors in the same class differently. The Court failed to
enforce the agreement on technical grounds but found that, even if it could be said that there was an oral
side letter between the Matador fund and the investors concerned, the agreement would have been
inconsistent with the Articles and would not have been effective in changing the prescribed redemption
and suspension process for those investors.
For side letters to be valid and enforceable, the Articles must permit the fund to relax their gating
and suspension provisions. The terms and manner of redemption from a fund must be sufficiently set
out in the companys Articles. It is sufficient, for this purpose, for a funds Articles to set out the general
gating and suspension powers and to specifically cross-reference another document (most commonly, the
PPM) that lays out the mechanics of how the directors intend to exercise those powers.
These cases emphasize the importance of providing investors transparency in relation to key
investment terms. In particular, to the extent that investors in a fund receive preferred treatment, that
position needs to be ascertainable by both new and existing investors. This does not mean that the specific
details of side letters are required to be disclosed to all investors and potential investors. However, new
investors must be aware, from a plain reading of the PPM, that the fund is entitled to offer different terms
to different investors. Even if the specific terms are not disclosed, the new investor is nonetheless able to
undertake a risk analysis and make an informed decision whether or not to invest.
Side-By-Side Management
Side-by-side management refers to the practice of having the same portfolio manager
simultaneously managing accounts with substantially similar investment strategies and policies. Within
an investment adviser that advises private funds, mutual funds, and separate accounts, the investment
strategies and fee structures for each client will be different. The private fund may be shorting a security
that another client owns. The mutual fund or separate account may charge a flat fixed fee of 1% while a
private fund may charge a fixed fee of 1% plus a 20% performance fee on net profits.

26

Because most investment advisers compensate their investment personnel in part on revenue,
portfolio managers have an incentive to focus more attention on the fund that generates the highest
revenue. In addition, the 1% and 20% fee schedule of most private funds may tempt the portfolio manager
to allocate his or her best ideas to the private fund at the expense of the accounts that simply pay a flat
fixed fee. Accordingly, this practice of side-by-side management has come under increased scrutiny,
because of the inherent conflict of interest and actual abuse by investment advisers and portfolio
managers seeking to maximize their personal returns.
In testimony concerning hedge funds before the of the US Senate Banking, Housing and Urban
Affairs Subcommittee on Securities and Investment, Susan Wyderko, SEC Director of Investment
Education and Assistance, reported that almost 15% (379) of the private fund advisers registered with the
SEC also advise at least one mutual fund (May 16, 2006 http://www.sec.gov/news/testimony/
ts051606sfw.htm). Because the advisers fee from the private fund is based in large measure on the fund's
performance, and because the investment adviser typically invests heavily in the private fund itself, the
SEC believes this side-by-side management presents significant conflicts of interest that could lead the
investment adviser to favor the private fund over other clients. Accordingly, based on this belief,,
investment advisers can anticipate the SEC staff will focus their review on whether the investment adviser
has developed sufficient controls to prevent such bias and to determine whether, in fact, the adviser has
favored its hedge funds over other clients.
Item 6 of Form ADV Part 2A requires investment advisers to disclose to clients that performance
fees may give the investment adviser an incentive to favor performance fee accounts over nonperformance fee accounts. It also requires the investment adviser to disclose whether it has policies that
guide portfolio managers to base their investment decisions on the clients best interests and procedures to
monitor compliance. These could include:

Allocation policies that prohibit taking compensation into consideration;

A CIO approval process for shorting securities held long in other accounts;
Performance dispersion among accounts;
Analysis of allocations among accounts; and
Trading patterns.

Side Pockets
A side pocket is simply a separate account created by the fund to segregate illiquid or hard-tovalue securities. The remaining liquid securities remain in the funds portfolio, subject to the funds
investment advisory fee, performance fee, and liquidity needs. The side pocket, however, is typically
illiquid and can remain so for lengthy periods of time until the investment adviser can liquidate the assets
in an orderly fashion. Funds may continue to charge management fees but generally charge no
performance fees on side pockets, though they are typically paid, if at all, once the assets are liquidated.
Any investor that redeems their account in whole will still remain in the side pocket until the assets can be
sold and the proceeds distributed.

27

Side pockets can arise from a planned purpose of an illiquid security or the unplanned shift of
status for a position from liquid to illiquid. Upon the creation of the side pocket, new investors to the fund
do not share receive any allocation of profits or losses from an investment in the side pocket. Rather, their
purchased interest in the fund is solely the funds portfolio.
Thus, in the event of a side pocket, the ongoing, realized returns to old and new investors would
differ. When a side pocket is created, the fund segregates a portion of its assets into a separate illiquid
investment vehicle. These contractual restrictions ensure that, under normal market conditions, the funds
can invest in illiquid assets and have the flexibility to meet redemptions without resorting to selling
illiquid portfolio assets at knocked-down prices. The types of securities that are typical candidates for a
side pocket include:

Private Equity Investments;

Real Estate;
PIPES; and
Securities that lack a readily available market.

Given that investment advisers are paid on both realized and unrealized gains on their
investments, they may be tempted to overvalue an asset whose valuation is difficult to establish. The
purpose of the side pocket is to authorize the investment adviser to erect a barrier to guard against the
investment adviser collecting too much or too little on performance fees from an asset that is illiquid or
hard to value.
During the financial crisis of 2007-2009, market conditions were anything but normal. As market
liquidity dried up and performance suffered, many funds found themselves subject to substantial
withdrawal requests that overwhelmed ordinary redemption restrictions, creating a run on many funds. In
an effort to turn the tide on outflows, some hedge fund managers enacted side pockets, which stopped
investors from redeeming interest in what for many funds were illiquid portfolios. These restrictions were
imposed ex-post at the discretion of fund managers and were in addition to the ordinary withdrawal
restrictions (e.g., lockups and redemption notice periods) present ex-ante in the partnership agreements.
Side pockets had a negative impact on fund reputations that spilled over across the hedge fund
family. The continuing notoriety of side pockets is partly due to investor outrage over being unable to
access their capital during the crisis and partly due to investment managers abusing side pockets in order
to preserve fund capital and earn excess fees.
The SEC has brought two enforcement cases involving side pockets. In SEC v. Goldfarb, an
investment adviser allegedly concealed more than $12 million in investment proceeds that it owed fund
investors by using a side pocket to hide the profits. In SEC v. Mannion, the first side pocket case of its
kind, the SEC alleged that a hedge fund manager overvalued illiquid assets in a side pocket and extracted
excessive management fees, based on the asset values in the side pocket.

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Side Pocket Policies to Consider

Establish conditions under which the investment adviser may side pocket an investment and
procedures for side pocketing an asset;
Establish criteria for the investment adviser to follow when deciding that an investment is no
longer eligible for a side pocket;
Establish limits on the amount of assets that may be side pocketed at any one time;
Establish procedures for determining fair valuation of side pocketed assets; and
Establish policies for disclosing when a fund side pockets an asset.

FUND OPERATIONAL ISSUES

Custody
SEC-registered investment advisers with custody of client assets must comply with the Custody
Rule under the Investment Advisers Act (Custody Rule). An adviser has custody if it or a related person
holds, directly or indirectly, client funds or securities or has any authority to obtain possession of them.
One of the more commonly overlooked examples of custody is the adviser that serves as the general
partner of a private fund. The Custody Rule prescribes a number of requirements designed to enhance the
safety of client assets by insulating them from any possible unlawful activities or financial reverses of the
investment adviser, including insolvency. The Custody Rules key safeguards include:

Rule 206(4)-2(d)(2) requires qualified custodians to hold client assets. An adviser with
custody generally must maintain client funds and securities at a qualified custodian (e.g., a
bank or a broker-dealer), either in a separate account for the client under the clients name or
in an account under the advisers name as agent or trustee for the advisers clients but that
contains only client assets (i.e., client assets may not be commingled with the advisers
assets).
Rule 206(4)-2(a)(2) requires notices to be sent to clients detailing how their assets are being
held. An adviser that opens an account with a qualified custodian on the clients behalf must
notify the client in writing and provide the client with certain information. However, the
adviser who distributes audited financial statements to investors in the private fund does not
need to give notice.
Rule 206(4)-2(a)(3) requires the qualified custodian to send account statements quarterly to
clients detailing their holdings. An adviser must have a reasonable basis, after due inquiry, for
believing that the qualified custodian sends account statements to clients at least quarterly.
However, the adviser who distributes audited financial statements to investors in the private
fund does not need to send quarterly statements.
Rule 206(4)-2(a)(4) requires that advisers who have custody of client assets in many cases
must undergo an annual surprise examination by an independent public accountant that
verifies client funds and securities. The public accountant must also file a Form ADV-E to
document the surprise exam. However, the adviser who distributes audited financial
statements to investors in the private fund is deemed to have satisfied this requirement.
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In light of the 2008 Bernard Madoff scandal, where the former NASDAQ Chairman admitted that
the wealth management arm of his business was an elaborate $50 billion Ponzi scheme, custody has
moved to the forefront of the SECs attention. Previously, custody was considered a non-event. Despite
its seemingly straightforward requirements, complying with the custody rule has proven elusive. SECs
National Examination Program has observed widespread and varied noncompliance with elements of the
Custody Rule. Of the 140 advisers examined, one-third had custody-related issues.
One of the biggest issues was that many advisers werent even aware what custody actually
meant and the how the Custody Rule applied. The SEC also found instances investment advisers
commingling client money with their own. The SEC was so concerned with the deficiencies that it issued
a public risk alert on March 4, 2013, alerting investment advisers that OCIE inspectors had found
significant deficiencies involving advisor custody and safety of assets, and therefore investment advisers
should review their practices accordingly (see http://www.sec.gov/about/offices/ocie/custody-riskalert.pdf).
Lock-Up Periods
Private funds invest in complex and illiquid assets. Because they offer redeemable claims to
investors, however, their strategies and survival are constrained by their ability to retain outside financing.
Private funds, therefore, typically maintain withdrawal restrictions, such as lock-ups, to slow down the
flow of capital from their funds. These contractual restrictions ensure that, under normal market
conditions, the funds can invest in illiquid assets and have the flexibility to meet redemptions without
resorting to selling illiquid portfolio assets at fire-sale prices. Lock-up provisions restrict an investor's
ability to withdraw capital from a hedge fund for some stated period of time.
Traditionally, it was common for hedge funds to lock-up an investor's contribution for one or two
years. In the wake of the recent financial crisis, lock-up provisions received considerable negative
publicity as investors attempted to withdraw funds to meet liquidity needs, and were unable to do so. As
such, many hedge funds launched since the financial crisis have determined not to include a lock-up on
investor capital. These funds will generally restrict liquidity in other ways, for example, by decreasing the
frequency of periodic withdrawal dates and increasing notice periods to effect a withdrawal. Despite the
negative association of lock-up provisions, they are still relatively common and are often important for
funds that trade illiquid assets.
Lock-up periods longer than two years are rarer in the traditional private fund space. Generally,
most investors want to have some access to their capital, particularly in times of market turmoil and
downturns. However, some investors, such as pensions and endowments, are willing to lock money up
with a private fund for longer than a year if the investment adviser agrees to discount the fees.
Holdbacks
In the event that an investor withdraws any portion of its interest in a hedge fund, most funds
allow the general partner to withhold from the withdrawing investor a specified amount that would

30

otherwise be distributable to the withdrawing investor. This is done in order to create a reserve for the
investors share of the expenses, liabilities, management fees, and obligations with respect to the funds
general and side pocket investments, or to accommodate any adjustments required in connection with the
funds audit. Any holdback amounts are segregated from the investor's capital account or side pocket
account, become a general liability of the fund, and typically do not participate in the profits and losses of
the fund or accrue interest.
Gates
A gate is the funds right to limit withdrawals on any withdrawal date to a certain stated
percentage of the funds assets, often between 10% and 25%. If withdrawal requests exceed the gate, then
redemptions will be honored on a pro rata basis until the redemption amounts reach the gate. Gates are a
very common feature in many funds, particularly those with portfolios that hold thinly-traded or illiquid
securities. Without gates, an investment adviser, in order to satisfy redemption requests, might be forced
to sell positions in a falling market at unfavorable prices in order to gain necessary liquidity. This would
adversely affect the net asset value of the fund owned by remaining investors.
Unrelated Business Income Tax
Even though an investor in a private fund is recognized as tax-exempt (e.g., a pension or
foundation), it still may be liable for tax on unrelated business income generated by the fund. Generally,
the term unrelated business income means the gross income derived from any unrelated trade or
business regularly conducted by the exempt organization, less the deductions directly connected with
carrying on the trade or business. Incurring acquisition indebtedness in the purchase of securities is not
inherent in the performance of an exempt purpose (Alabama Central Credit Union v. United States, 646
F. Supp. 1199 [N.D. Ala. 1986]). Accordingly, an exempt organization that purchases securities on
margin with borrowed funds will generate unrelated business income subject to unrelated business
income tax (UBIT).
For domestic funds organized as limited partnerships or limited liability companies and treated as
flow-through entities for tax purposes, the UBIT issue arises when the fund makes profits on securities
that were purchased with borrowed funds. The income generated by the fund through borrowing will flow
through and be attributed to the tax-exempt investor, subjecting the investor to UBIT. Since most taxexempt investors will avoid any fund that has the potential of generating unrelated business income, the
investment adviser must create an offshore investment company organized either side-by-side with the
domestic fund or within a master-feeder fund structure.
Another thing to consider is that for there to be acquisition indebtedness, there must be a debt.
Acquisition indebtedness does not include the borrowing of stock from a broker to sell the stock short.
Although a short sale creates an obligation, it does not create debt. Acquisition indebtedness does not
include an obligation to return collateral security provided by the borrower of the exempt organization's
securities under a securities loan agreement. This transaction is not treated as the borrowing by the
exempt organization of the collateral furnished by the borrower (usually a broker) of the securities.

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Form PF Reporting Obligations

Registered investment advisers (including advisers to hedge funds, private equity funds, and
liquidity funds) with at least $150 million in private fund assets under management must periodically file
a reporting form, Form PF. The information reported in Form PF will be used by the Financial Stability
Oversight Council (FSOC) to monitor risks to the US financial system and by the SEC to conduct risk
assessments of private fund advisers. The type of information that is required to be disclosed on Form PF
and the frequency of filing depends on whether the investment adviser is an adviser to private equity
funds, hedge funds, or liquidity funds or a large private fund adviser, which for a hedge fund adviser is
an adviser with at least $1.5 billion in hedge fund assets under management.
All investment advisers required to file a Form PF must provide basic information in Sections 1a
and 1b. Section 1a requires information about the adviser and all related persons whose data is included;
the large trader identification number, if any; the regulatory assets under management and net assets
under management broken out by types of funds advised; and any assumptions made in responses to any
question in Form PF. Section 1b requires information for each advised fund, including identifying
information, gross and net asset values, investor concentration, borrowing and liquidity, and performance.
There are also questions regarding a funds investment in other private funds and parallel managed
accounts. Hedge fund advisers must disclose information about investment strategies, identification of
significant credit risk, and trading and clearing practices in Section 1c.
Large private fund advisers must provide more detailed information than smaller advisers.
Section 2a of Form PF requires that large hedge fund advisers disclose aggregate information regarding
their hedge funds, including information regarding exposures by asset class, geographical concentration
of investments held by funds, and the monthly value of portfolio turnover by asset class.
Section 2b of Form PF concerns registered advisers that are large private fund advisers and that
advise at least one qualifying hedge fund, a hedge fund with a net asset value of at least $500 million.
Such advisers must disclose information for each qualifying hedge fund relating to fund exposures,
portfolio liquidity, unencumbered cash holdings, identification of the funds base currency, collateral
practices with significant counterparties, risk metrics, market risk, concentration of positions, and trading
and financing for each such hedge fund.
Avoiding Publicly Traded Partnership Status
Under certain circumstances, the fund, whether organized as a limited partnership or a limited
liability company, can forfeit its flow-through tax treatment. If the fund is considered a publicly traded
partnership (PTP) for US federal income tax purposes, and doesnt meet a qualifying income test, the
partnership will be treated as an association taxable as a corporation for US federal income tax purposes,
with various adverse tax consequences for the fund and its investors.
This includes (a) the imposition of US corporate income tax filing and payment obligations on the
fund with respect to the partnerships worldwide taxable income (in the case of a partnership organized
under US law); (b) possible treatment of the partnership as a passive foreign investment company

32

(PFIC), or as a controlled foreign corporation (CFC) (in the case of a partnership organized under nonUS law), resulting in additional tax filing and payment obligations for US taxable investors; and (c) the
inability of investors to benefit from the pass-through treatment of the partnerships items of income and
loss. The term publicly traded partnership means any partnership if:

Interests in such partnership are traded on an established securities market; or

Interests in such partnership are readily tradable on a secondary market (or the substantial
equivalent thereof).

There are three principal safe harbors most relevant to private equity and similar partnerships: (a)
private placements; (b) lack of actual trading; and (c) qualified matching services, all as set forth in
Treasury Regulations, 26 CFR 1.77041:
(g) Matching service: (1) In general. For purposes of section 7704(b) and this section, the
transfer of an interest in a partnership through a qualified matching service is disregarded in
determining whether interests in the partnership are readily tradable on a secondary market or the
substantial equivalent thereof. A matching service consists of a computerized or printed listing
system that lists customers' bid and/or ask quotes in order to match partners who want to sell their
interests in a partnership (the selling partner) with persons who want to buy those interests.
Matching occurs either by matching the list of interested buyers with the list of interested sellers
or through a bid and ask process that allows interested buyers to bid on the listed interest.
(h) Private placements: (1) In general. For purposes of section 7704(b) and this section, except as
otherwise provided in paragraph (h)(2) of this section, interests in a partnership are not readily
tradable on a secondary market or the substantial equivalent thereof if(i) All interests in the
partnership were issued in a transaction (or transactions) that was not required to be registered
under the Securities Act of 1933 (15 U.S.C. 77a et seq.); and (ii) The partnership does not have
more than 100 partners at any time during the taxable year of the partnership.
(j) Lack of Actual Trading interests in a partnership are not readily tradable on a secondary
market or the substantial equivalent thereof if the sum of the percentage interests in partnership
capital or profits transferred during the taxable year of the partnership (other than in transfers
described in paragraph (e), (f), or (g) of this section) does not exceed 2 percent of the total
interests in partnership capital or profits.
It is because of the Lack of Actual Trading safe harbor that most funds impose strict limitations
on the transferability of fund interests.
Funds can still avoid publicly traded partnership status for any taxable year if the fund can meet
the gross income test. The fund meets the gross income requirement for any taxable year if 90% or more
of its income comes from interest, dividends, real property rents, gains from the sale of real property,
gains from the sale of stock, securities, foreign currencies, and other income derived with respect to the
business of investing in stocks, securities, or currencies.

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ERISA ISSUES
The volume of ERISA issues is so great that most investment advisers elect to avoid its
application. Below is a summary of some of the more salient ERISA issues.
Pension plans are a vital source of capital for investment advisers that cater to institutional
investors, but at the same time they pose significant challenges. The investment adviser of a private fund
that accepts an investment from pensions will need to familiarize itself with the US Employee Retirement
Income Security Act of 1974 (ERISA). The fiduciary duties under ERISA are demanding and
unforgiving.
Depending on the composition of the shareholders in a private fund, the fiduciary provisions of
ERISA may impose limitations on investment by a private fund. Once Benefit Plan Investors cross the
25% threshold of equity ownership in the private fund, the assets of the fund will be considered ERISA
plan assets and the ERISA fiduciary standards will apply to the fund. The general partner and
investment adviser of the fund become fiduciaries, which then brings into play the prohibited
transaction and other restrictions under ERISA.
An ERISA fund manager must acknowledge its fiduciary responsibility under ERISA rules and
must be in compliance with ERISA requirements at all times. There are prohibitions on an ERISA
account entering into cross trades. Provisions in governing documents that require the fund to indemnify
and hold investment managers harmless for gross negligence are unenforceable. Then there is the
requirement that all ERISA fiduciaries maintain a 412 bond (named after Section 412 of ERISA).
ERISA fund managers must also consider prohibited transactions and parties in interest
transactions as defined under Section 4975 of the Internal Revenue Code. For example, performance fees
may be considered self-dealing prohibited transactions. However, performance fees would be allowed if
the following standards were met: (i) the fee arrangement were approved by the plan fiduciary; (ii) most
investments were readily marketable; and (iii) all other investments (not readily marketable) were
appraised by an independent appraiser chosen by the plan fiduciary.
Finally, ERISA requires additional disclosures at the plan level. ERISA compliance requires the
fund to file Form 5500 in addition to its income tax return. Further, Schedule C of Form 5500 requires
disclosure of direct compensation paid by the plan. This includes management fees and performance fees
paid by the ERISA plan to the fund manager, as well as other fees that might be paid in connection with
certain investments. In addition, regulations under Section 408(2)(b) require investment advisers to make
certain disclosures regarding their services and compensation prior to entering into, extending, or
renewing an advisory arrangement with the plan.
Rather than deal with the significant requirements and obligations of ERISA, many investment
advisers simply limit investment in the fund by benefit plan investors, so that participation is less than
25% of the equity ownership of the fund, the so-called 25% exception.

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ERISA EXEMPTIONS
Venture Capital Operating Company
Private equity funds and venture capital funds typically fall within one of two ERISA exceptions:
(1) the so-called 25% exception, which exempts a fund from ERISA if benefit plan investors do not
hold 25% or more of any class of equity interests in a fund; or (2) the Venture Capital Operating
Company (VCOC) exception, which exempts funds that make private equity investments and maintain
certain management rights with respect to a majority of their portfolio company investments.
Real Estate Operating Company
Real estate funds generally fall within one of three ERISA exceptions: (1) the 25% exception, (2)
the VCOC exception, or (3) the Real Estate Operating Company (REOC) exception, which exempts funds
with certain real estate investments in which the fund has the right to participate in management or
development decisions.
Alternative Investment Fund Manager Directive (AIFMD)
Investment advisers to private funds organized and/or marketed abroad should be aware of the
regulatory framework known as the Alternative Investment Fund Manager Directive (AIFMD), which
applies to alternative investment fund managers (AIF Managers) that conduct business in the European
Union. US investment advisers that manage European funds, have European shareholders in their
offshore funds, or market their offshore funds to European investors, will be subject to certain parts of the
AIFMD effective July 22, 2014.
Included in AIFMD are detailed provisions governing delegation, the calculation of assets under
management, leverage, reporting and disclosure obligations, conflicts of interest, risk and liquidity
management, and the safeguarding of assets by depositaries.
One of the key issues arising out of AIFMD is the ability of US investment advisers to market
their funds to investors in the European Union. Generally, in such circumstances, US investment advisers
may continue to make use of existing private placement regimes provided that: (i) they comply with
certain disclosure and transparency requirements, (ii) appropriate information sharing agreements are in
place between the relevant competent authority in each Member State and the relevant competent
authority in each of the jurisdictions of establishment of the US investment adviser, and (iii) the
jurisdictions of establishment of the US investment adviser are not on the Financial Action Task Force's
list of high-risk and non-cooperative jurisdictions. The ability to make use of member state private
placement regimes may be withdrawn in 2015, meaning that US investment advisers will, from 2015,
have to register and be EU authorized in order to do private fund business in the European Union.

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CONCLUSION
Although hedge funds are unregulated, they remain highly complex entities whose various
permutations are driven principally by the bargaining power of both investment advisers and investors,
alike. It is my hope that I have given readers an introduction into the issues of operating a hedge fund and
explanations of how to address them. Please do not hesitate to contact me for comments and questions.
Good luck and good investing.

Charles H. Field
Chapin Fitzgerald LLP
550 W C Street, Suite 2000
San Diego, California 92101
619.241.4810
cfield@cftriallawyers.com

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ABBREVIATIONS, ACRONYMS, and INITIALISMS

Alternative investment fund managers (AIF Managers)
Alternative Investment Fund Manager Directive (AIFMD)
Associated Person (AP)
Blue Sky Laws
Commodities Futures Trading Commission (CFTC)
Commodity Exchange Act (CEA)
Commodity Pool Operator (CPO)
Commodity Trading Advisor (CTA)
Controlled foreign corporation (CFC)
Custody Rule under the Investment Advisers Act of 1940 (Custody Rule).
Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 (Dodd-Frank)
Employee Retirement Income Security Act (ERISA)
Financial Industry Regulatory Authority (FINRA)
Financial Stability Oversight Council (FSOC)
Form PF
Investment Advisers Act of 1940 (Investment Advisers Act)
Investment Company Act of 1940 (Investment Company Act)
Jumpstart Our Business Startups Act (JOBS Act)
National Futures Association (NFA)
Office of Compliance Inspections and Examinations (OCIE)
Passive foreign investment companies (PFICs)
Private Investments in Public Equity (PIPEs)
Private Placement Memoranda (PPMs)
Publicly traded partnership (PTP)
Real Estate Operating Company (REOC)
Securities Exchange Act of 1934
Securities Act of 1933 (Securities Act)
Securities and Exchange Commission (SEC)
Self-Regulatory Organization (SRO)
Senate Banking, Housing and Urban Affairs Subcommittee on Securities and Investment
Unrelated business income tax (UBIT)
US Employee Retirement Income Security Act of 1974 (ERISA)
Venture Capital Operating Company (VCOC)

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