Most structured products and derivative securities are not registered with the Securities and Exchange Commission because they are targeted at sophisticated investors. For so-called accredited investors and qualified purchasers--the two more sophisticated categories of individual investors--structured products firms can rely on certain exemptions from the 1933 Securities Act and the 1940 Investment Company Act to to issue alternative investments and warrants.
This Learning Curve is a primer on the two main exemptions from the 1940 Act and how to comply with the requirements of each exemption.
Legal Overview
In the U.S. companies or funds that manage investments for public investors are subject to registration under the 1940 Investment Company Act. It is a requirement for mutual funds, for example, to be registered with the Securities and Exchange Commission to make a public offering of fund shares, units or securities to the public.
Being registered with the SEC imposes numerous requirements upon the investment company, including daily net-asset-value reporting, liquidity, marketing, transparency, disclosure and limits on leverage.
By making a non-public offering to certain kinds of investors, however, the investment vehicle will be exempt from registration requirements of both the Securities Act of 19331 and the 1940 Act, under the belief that certain classes of sophisticated and wealthy investors do not require the same levels of protection as public customers.
Accordingly, there are two significant exemptions from the 1940 Act for non-public funds:
3(c)1 (for accredited investors); and
3(c)7 (for qualified purchasers).
The Federal Securities Laws define the terms accredited investor and qualified purchaser in terms of minimum asset and income threshold that must be met before they qualify to be investors in the hedge fund.2 The thresholds are described in more detail below.
The 3(c)1 Exemption: 99 Accredited Investors Test
If an investment vehicle limits itself to 99 accredited investors and otherwise complies with the safe harbor provisions of Regulation D, it is exempt from the extensive regulation of the 1940 Act pursuant to the Section 3(c)1 exemption.
Under this exemption, only accredited investors can become limited partners in the underlying limited partnership. An individual accredited investor, generally speaking, must have a net worth of at least USD1 million or an annual income of at least $200,000 in each of the last two years and has a reasonable expectation of reaching the same income level in the current year.
The 3(c)7 Exemption: Unlimited Qualified Purchasers Test
In 1996 Congress changed the limits on investors by allowing a hedge fund to have an unlimited number of investors who are qualified purchasers. A qualified purchaser is generally accepted as one or more of the following:
an individual with $5 million or more in investments, including investments held jointly with a spouse;
* a family held business that owns $5 million or more in investments;
* a business that has discretion over $25 million or more in investments;
* or a trust sponsored by qualified purchasers.
Section 3(c)7 of The Investment Company Act offers a similar exemption to private investment companies with less than 500 qualified purchasers as investors. As an unregulated entity, the hedge fund investment manager is free to undertake greater risk on more volatile positions thereby exposing investors to potential substantial profit as well as substantial losses.
Consequences Of Failure To Comply With The Requirements Of The Exemptions
Insuring compliance with the exemptions is an important consideration, not only for the manager of the hedge fund who is the general partner of the limited partnership, but for the investors themselves.
For the manager of the fund relying upon the 3(c)1 exemption, if there are more than 99 investors in the vehicle, the SEC could declare the hedge fund is now a public fund and must register as a Registered Investment Company (RIC) with the Commission. This would have serious consequences for the vehicle, because it would be compelled to bring the investment policy in compliance with the limitations of the 1940 Act.
For an investor in a fund that loses its exempt status, there could be serious tax consequences. In order to avoid entity-level taxation, most qualified purchaser pools will be organized, like most hedge funds, as limited partnerships. Under Internal Revenue Service regulations, partnerships with more than 100 partners will be treated as a publicly traded partnership (PTP) and be taxable as a corporation.
To maintain its status as a non-public fund that can avail itself of the exemptions, a hedge fund is prohibited from making any public offerings through general advertising. Investors usually invest in hedge funds through word of mouth, consultants, registered representatives, brokers or investment advisors.
Conclusion
To be treated as a private fund that is exempt from the registration and regulatory requirements of the 1940 Investment Company Act, investment vehicles must limit themselves to accredited investors or qualified purchasers. The consequences of not properly complying with these exemptions are problematic both for the managers and the investors in the vehicle and must be strictly followed.
This week's Learning Curve was written by Keith Styrcula, an official in the structured solutions group at JPMorgan and chairman of the Structured Products Association in New York.
