Joshua Stone – Principal
Allowing U.S. Persons to Invest in Your Fund
A Guide for Non-U.S. Fund Managers
Updated as of July 3, 2020
Marketing a fund to U.S. investors can present lucrative business opportunities to fund managers from around the world. Admitting U.S. investors into your fund structure for the first time comes with costs and other burdens, but they can be overcome if the manager and its operations and compliance teams are willing to dedicate the time and resources to understanding the relevant rules and engage legal and tax advisors with sufficient expertise to structure the fund and guide the process. FundsLawyer PLLC often discusses the requirements for admitting U.S. investors into a fund structure with non-U.S. fund managers who have not previously allowed U.S. investors in their funds. These discussions typically touch upon the same themes, and therefore the firm decided to prepare this guide as a primer for non-U.S. managers and their existing advisors. This guide is not meant to be comprehensive, but it attempts to provide an overview of what may be required without getting lost in the weeds. It is not a substitute for seeking your own legal and tax advice.
U.S. Legal and Regulatory Factors to Consider:
Although hedge funds, private equity funds, real estate funds and other private investment vehicles are sometimes referred to as “unregulated” in the U.S. (possibly due to the additional regulations placed on mutual funds and other registered vehicles, which private funds are not subject to), they are certainly not unregulated and some may even characterize them as being heavily regulated in the U.S. There is a wide range of U.S. laws that impact (i) fund managers with offices in the United States or whose managed funds include U.S. person investors, and (ii) investment funds that include U.S. person investors. The first part of the guide sets out the primary legal/regulatory items that we discuss on initial calls with non-U.S. managers looking to admit U.S. investors for the first time. These categories are 1. investment adviser regulatory registrations and exemptions; 2. investment company act exemptions that private funds (not their managers) may rely upon to avoid registration as an investment company; and 3. rules for conducting a private placement of securities by the fund, so as to avoid registration of the offering. Each is discussed briefly below:
- S. Regulatory Registrations and Exemptions for Private Fund Managers
In the U.S., the regulation of investment advisers is divided between the U.S. federal government and the individual U.S. states. Smaller investment advisers are typically regulated by the individual states, while larger investment advisers are regulated by the federal government under the supervision of the U.S. Securities and Exchange Commission (or “SEC”). Managers investing in commodities may also fall under the regulatory framework of a second agency of the U.S. federal government, the U.S. Commodity Futures Trading Commission (or “CFTC”).
Registration of an investment adviser with a U.S. state’s securities regulatory agency or (especially) with the SEC can be costly both initially (e.g., for paying outside advisers to complete the registration paperwork and set up a compliance program) and over time (e.g., due to the additional ongoing burdens, the possible need to hire additional dedicated compliance personnel and expenses that may arise out of regulatory examinations). An SEC registered investment adviser is required to appoint a chief compliance officer and have a code of ethics with certain specified provisions. It will also need to put in place a longer set of compliance policies and procedures and actively monitor for violations. Federally registered investment advisers also need to conduct an annual compliance review and meet certain custody requirements with respect to their clients’ assets, and registered fund managers are subject to additional lengthy reporting. Investment advisers registered with the SEC are prohibited from receiving performance-based compensation unless clients and fund investors are “qualified clients.” The SEC enforces a complex set of advertising requirements, established by rule and no-action letter guidance, which can be tricky to implement, especially in the area of performance advertising. Each of the 50 states may also impose significant obligations on its state registered advisers. A state or federally registered investment adviser is subject to examination by the relevant regulatory agency. During the exam, the agency will likely request large lists of documents and interview members of the manager’s personnel. The agency’s findings typically result in a deficiency letter detailing the deficiencies found and can result in an enforcement action (which may lead to civil or even criminal penalties).
Meeting the substantial obligations of state or federal investment adviser registration may require training existing employees, hiring personnel with expertise in U.S. investment adviser compliance or engaging a consulting firm to manage these aspects of the business. There are similar costs and burdens associated with registering as a commodity pool operator and/or a commodity trading advisor with the CFTC (which becomes relevant if the fund invests in commodity interests). CFTC registrants are typically required to be members of the National Futures Association, a self-regulatory agency, which has its own rules. As a result of all of these obligations and costs, many managers try hard to avoid registration, or at least avoid it for as long as they can.
There are various exemptions from SEC, CFTC and U.S. state level regulatory registrations that advisors may fall under to avoid registration. The availability of federal level exemptions will depend primarily upon whether the non-U.S. manager has a place of business in the U.S., the amount of assets managed by the non-U.S. fund manager from offices in the U.S., the number of clients and investors in the managed funds that are located in the U.S. (and the amount of assets attributable to those investors), and with respect to CFTC registration, the levels each fund has invested in commodity interests. Certain non-U.S. investment managers who are exempt from SEC registration may be categorized as an Exempt Reporting Adviser, and would therefore be subject to certain filing obligations, a limited number of ongoing compliance obligations and, at least in theory, the possibility of being examined by the SEC. Even if a manager is exempt from SEC registration, an analysis should be conducted on a state by state level to ensure that registration with a state is not required. Certain of these exemptions may be lost if, in addition to managing funds with U.S. person investors, the manager also advises managed accounts owned by U.S. persons.
It should be noted that managers whose funds do not invest in securities or commodity interests, such as funds that only invest in real property or digital currencies, may be outside of these regulatory regimes. The analysis as to whether a real estate-related investment is a security can be nuanced, including where joint ventures are involved.
- Exemptions from Registration Under the Investment Company Act of 1940
Under the Investment Company Act of 1940, as amended, and the related rules promulgated by the SEC, a vehicle that is engaged in the business of investing, reinvesting, owning, holding, or trading in securities typically would need to register with the SEC as an investment company, unless there is an exemption available. Publicly traded funds, such as mutual funds and ETF’s, register as investment companies, but the burdens of Investment Company Act registration would typically be far too restrictive for a private fund. The costs of registration and ongoing compliance are especially high. Private funds (other than real estate funds, for which an additional exemption is often available, and vehicles not formed to hold securities, which may not need an exemption) typically rely upon one of the following two exemptions from Investment Company Act registration. The first (i.e., the “3(c)(1)” exemption) requires all U.S. investors in the fund structure to be “accredited investors” within the meaning of the U.S. securities laws. The rule has a 100 investor limit, which is subject to certain look-though rules under which you may need to count the underlying beneficial owners of certain entity investors toward your 100 investor limit. The second (i.e., the “3(c)(7)” exemption) requires all U.S. person investors in the fund structure to be “qualified purchasers” within the meaning of the U.S. securities laws, but does not have any numerical investor limit. The qualified purchaser requirement is a higher standard than the accredited investor standard. The decision as to which Investment Company Act exemption is best will, in part, be subject to the expected qualifications of the targeted investor base. There are advantages to using the 3(c)(7) exemption if you can, including the fact that courts and regulators may, at the margins, assume that investors in a 3(c)(7) fund are more sophisticated, as reflected in the SEC’s proposed amendments to its investment adviser advertising rules.
Vehicles formed to hold asset classes other than securities, such as real property or digital currencies, may be outside of the Investment Company Act’s regulatory regime.
- Private Placement Rules
The sale of a securities to persons in the U.S. generally must be registered under the U.S. Securities Act of 1933, as amended, and related rules, unless the transaction does not involve any public offering. A fund offering shares or interests to U.S. persons would be subject to these rules even where the fund itself does not hold securities (e.g., cryptocurrency and real estate funds that do not hold securities). The analysis as to whether a transaction is a public offering can be uncertain, and therefore specific safe harbors were established for issuers to rely upon when conducting a private placement. The most common safe harbor that funds rely upon to avoid registration is Rule 506 of Regulation D, which requires that all investors in the fund are accredited investors (see above regarding this definition). In addition to the investor
qualification standards, the issuer must either (i) avoid engaging in general solicitation or advertising in marketing the securities (e.g., it can’t advertise on the internet or discuss the fund on television) or (ii) perform enhanced due diligence on investors to confirm that they are in fact accredited investors. Investors often prefer to simply certify that they are accredited investors, rather than providing due diligence documentation to prove it. This safe harbor may not be available if the issuer, large investors, the manager or other promotors of the offering are “bad actors,” as defined under the applicable rules. Bad actors are generally people who have been found to have committed specific crimes or regulatory violations. Failure to register or meet the private placement requirements can have significantly adverse consequences. Following the closing of a Regulation D private placement, a Form D is filed with the SEC, and specific state level “blue sky” filings may also be required.
Compliance with the investor qualification standards required by Rule 506 is pretty straightforward, however, determining whether a general solicitation or advertisement has taken place can be more complex in the Internet age (especially were managers express their thoughts over social media or distribute information through databases or other information providers) and therefore use of the enhanced due diligence route should be considered, even though this is a newer option and has not been widely adopted by the larger U.S. managers.
A manager that intends to take in U.S. person investors needs to seek U.S. tax advice and properly structure the fund to make it tax efficient for different categories U.S. person investors. It is typically more tax efficient for U.S. taxable investors to invest in funds that are structured as partnerships (vs. corporations) for U.S. federal tax purposes. It is generally more tax efficient for U.S. tax-exempt investors (such as foundations and pension plans), and preferable for non-U.S. persons, to invest in entities that are structured as corporations for U.S. federal tax purposes. U.S. tax laws are complex and tax regulations and their interpretations evolve, and therefore it is crucial that a U.S. tax adviser sign off on the proposed structure. U.S. investors will also need to receive specific tax reports, which results in an additional ongoing expense.
Due to the disparate preferences of U.S. taxable investors vs. U.S. tax-exempt investors and non-U.S. investors, it is usually necessary to use multiple entities within the fund structure to accommodate these different types of investors. Fund structures can be simple (such as two stand-alone entities) or complex (such as a real estate fund that includes a portfolio debt structure, REITS and blocker entities). The master-feeder structure (where multiple “feeder” entities established for different categories of investors invest in one “master” trading vehicle) is popular for hedge funds, but, like all structures, has advantages and disadvantages. Additional entities may require additional audits, additional fund administration and accounting costs, additional director fees and additional governmental fees to file and maintain the entities. U.S. domiciled fund entities are typically limited liability companies or limited partnerships, most frequently formed under Delaware law. Non-U.S. entities, such as Cayman Islands limited companies, can also admit U.S. investors, and a “check the box” filing can be made by the issuer to determine the U.S. tax treatment of such entities (e.g., a Cayman Islands limited company may elect to be taxed as a partnership for U.S. tax purposes). The choice of entity type and domicile is as much a marketing decision as a legal and tax decision, and U.S. investors may have a preference for U.S. domiciled entities for various reasons, such as perceptions that certain jurisdiction are less corrupt than others or the desire to be in a U.S. court in the event of a dispute, although sophisticated U.S. investors are often familiar and comfortable with Cayman Islands, BVI and certain other non-U.S. structures and therefore may not have an aversion to investing in these “offshore” vehicles.
The discussion above relates primarily to the preferences of different categories of fund investors. In addition, the manager will have its own tax considerations, primarily related to the receipt of its management fee and its performance allocation or “carry.” Different owners within the manager may be domiciled in different locations and therefore additional structuring may be needed to ensure that the manager and its underlying owners are taxed in an efficient manner.
Employee Benefit Plan Matters:
Offshore fund managers should also be aware of potential burdens placed upon them under the “ERISA” rules, which are applicable to funds with U.S. benefit plan investors. These burdens can largely be avoided if the fund limits the percentage of each class of the fund that may be held by U.S. benefit plan investors. Employee benefit plan questions are typically included in the fund’s subscription documents and benefit plan investors must be tracked as the fund receives subscriptions and redemptions (if permitted under the fund’s terms). Additional exemptions may be available for venture capital and other specific types of funds.
There may be substantial business-related reasons to enter the U.S. market, however, in addition to the risks of regulatory examination and enforcement actions noted above, U.S. investors may be seen as more litigious on balance than investors in other jurisdictions. Litigation in the U.S. may be drawn out, costly and all consuming. It is appropriate to re-consider your D&O/E&O insurance coverage before entering this market and to consider whether the fund documents should provide for arbitration or litigation only in certain venues. Non-U.S. investors can also be insulated from exposure to U.S. investor disputes through fund structuring decision.
In addition to the U.S. rules related to the regulation of fund managers and securities offerings, the U.S. enforcement agencies are also active in other areas that affect private funds, including the areas of insider trading, market manipulation, bribery of foreign officials, money laundering, compliance with foreign sanctions, investor fraud, reporting of certain derivative transactions, consumer privacy, tax reporting, etc. A firm’s compliance manual may need to include procedures designed to address these additional risks. Using a placement agent who operates from the U.S. or contacts people in the U.S. to place shares or interests in a fund can violate applicable law if the placement is not registered in the U.S. as a broker-dealer. Whether a person can be compensated for introducing U.S. investors to a fund can be a fact sensitive analysis and therefore needs to be looked at on a case by case basis.
Under Delaware law, a general partner or manager may substantially eliminate its fiduciary duties (although it would still be subject to fiduciary duties under applicable laws governing investment advisers). A manager using a U.S. domiciled vehicle for the first time should understand the relevant governance mechanisms, its fiduciary and similar duties, liability for the entity’s debts, whether the public has access to governmental filings and rights of investors to inspect books and records. Rules vary on a state by state basis, and therefore the choice of domicile is important, especially when a decision is made to form a fund under the laws of a state other than Delaware.
The FundsLawyer PLLC Approach:
The principal of FundsLawyer PLLC has had over 15 years of experience working with private funds, including as the general counsel and chief compliance officer of a multi-billion USD family of private funds with offices in the U.S., Switzerland and Singapore. While working as in-house counsel, the managed funds (which were domiciled in Delaware, the Cayman Islands and BVI) focused on emerging and frontier markets investments, providing the principal with substantial experience working across borders and finding solutions to ensure compliance with different rules and regulations across jurisdictions. FundsLawyer is happy to be engaged as “local” U.S. counsel and supplement the client’s existing non-U.S. counsel, which would take the lead on drafting the fund documentation (i.e., FundsLawyer would not seek to take over the project or the client relationship, except where that is the preference of the client and its team). We seek to be cost effective and do not seek to “cross sell” additional legal work or other services outside of our primary area of expertise.
We look forward to working with you!
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 Generally defined as any person or firm that: for compensation is engaged in the business of providing advice, making recommendations, issuing reports, or furnishing analyses on securities, either directly or through publications.
 Generally defined as qualified purchasers (see below), people with $1.0 million or more under management with the adviser or people with a net worth of at least $2.1 million.
 Under the foreign private adviser exemption from federal investment adviser registration, a manager may be exempt if it has (A) no place of business in the United States; (B) fewer than 15 clients and investors in the United States in private funds advised by the adviser in the aggregate; and (C) less than $25 million in assets under management attributable to clients in the U.S. and investors in the U.S. in private funds advised by it. Under the private fund adviser exemption, a non-US investment advisers may be exempt from registration if (A) it has no client that is a U.S. person except for qualifying private funds and (B) all assets managed by the adviser at a U.S. place of business are solely attributable to private fund assets and have a value of less than $150 million. Assets managed outside of the U.S. do not count toward that $150 million limit, so managers with no place of business in the U.S. are able to fall under this exemption without any relevant asset cap. Advisors relying upon the private fund adviser exemption are required to file documentation with the SEC as “exempt reporting advisers.”
 The Section 4.13(a)(3) exemption from commodity pool operator registration is commonly used by fund managers that invest primarily in securities and not commodity interests. This exemption is available where the funds (or “pools”) managed by the manager meet the following test (summarized in broad terms): (A) The aggregate initial margin, premiums, and required minimum security deposit required to establish such positions, does not exceed 5% of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses; or (B) The aggregate net notional value of such positions, determined at the time the most recent position was established, does not exceed 100 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses.
 The most relevant categories of who is an “accredited investor” include” entities with total assets in excess of $5,000,000, natural persons whose individual net worth, or joint net worth with a person’s spouse, exceeds $1,000,000, natural persons who had an individual income in excess of $200,000 in each of the two most recent years or joint income with a person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year, and entities in which all of the equity owners are themselves accredited investors.
 Qualified purchasers generally include individuals with $5 million in investments and entities that own and invest at least $25 million or whose underlying beneficial owners are all themselves qualified purchasers.
 Obligations include higher fiduciary standards, subjecting the manager to additional risk.