Admitting U.S. investors into your fund structure comes with costs and other burdens, but is certainly manageable if the manager and its operations and compliance teams are willing to dedicate the time and resources to understanding the relevant rules and the manager has legal and tax advisors with sufficient expertise to guide the process. FundsLawyer PLLC frequently discusses with non-U.S. fund managers and with non-U.S. counsel the requirements for admitting U.S. investors into a fund structure. These discussions typically touch upon common themes and a good deal of technical information is typically conveyed. This guide is meant to streamline those discussions. This guide is not meant to be fully comprehensive on any specific topic, but it attempts to provide an overview of what may be required of a non-U.S. fund manager to a fund with U.S. investors without getting lost in the weeds. The footnotes include links to sources of more detailed information. It is not a substitute for seeking your own legal and tax advice. The guide assumes that the reader is already managing an investment fund with non-U.S. investors and is therefore generally familiar with private funds, including how they operate and the role of the investment manager.[1] FundsLawyer PLLC hopes that this guide can serve as a resource for non-U.S. counsel in their preliminary discussion with clients who are considering admitting U.S. person investors for the first time.
U.S. Legal, Regulatory and Tax-Related 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[2] vehicles that private funds are not subject to), they are certainly not unregulated, and some may even characterize private funds 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 admit U.S. person investors. This guide does not touch on all of the applicable categories of U.S. law (such as U.S. privacy laws, insider trading rules, position reporting, foreign corrupt practices restrictions or anti-money laundering rules) that a fund manager may encounter in the course of its ongoing operations and investment activities, but provides an overview of the investment adviser/investment company regulations that are typically most relevant to a manager seeking to admit U.S. person investors into its fund structure.[3]
Non-U.S. managers who are considering opening an office within the U.S. should understand that opening that office or hiring personnel regularly located in the U.S. may impact the regulatory status of the manager. In addition, to the extent that the manager will have U.S.-based personnel, then the fund manager will need to ensure that the U.S. immigration status of its personnel allows them to perform the intended activities in the U.S. Proper immigration status is required for both employees and owners of the manager, and non-compliance can result in substantial penalties to both the manager and the persons performing services within the U.S.
The first part of the guide is divided into four sections, which correspond to the primary items that we often discuss on initial calls with non-U.S. managers interested in admitting U.S. persons (which typically last about an hour). These categories are:
- Investment manager regulatory registration and exemptions (i.e., regulation of the manager and its ability to conduct an investment advisory business);
- Investment Company Act exemptions that private funds often rely upon to avoid registration as an investment company (i.e., regulation of the fund itself in its capacity as an issuer that primarily trades securities);
- Rules for conducting a private placement, allowing the fund as an issuer of securities to avoid registration of the offering under the Securities Act of 1933 (i.e., regulation of the fund in its capacity as an issuer of securities generally); [4] and
- U.S. tax and ERISA (i.e., employee benefit plan rules) considerations.
Depending upon the investment strategy and the other factors that may be relevant to a specific fund or manager, items 1-4 may be supplemented with extensive discussions of additional topics.
- U.S. Regulatory Registrations and Exemptions for Private Fund Managers
In the U.S., the regulation of investment advisers (i.e., meaning persons who for a fee provide advice on securities) is divided between the U.S. federal government and the individual U.S. states. In general, and subject to exceptions, 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 (the “SEC”). However, an adviser only to private funds (i.e., no managed accounts) with no place of business in the U.S. likely would not be required to register with any U.S. state, but may be required to register with the SEC unless an exemption is relied upon.
As discussed more fully below, persons who advise on (or manage funds that only invest in) asset classes that are not deemed securities are typically not required to be registered as investment advisers and are outside of the investment adviser regulatory regime. [5] They may be required to be licensed under other regulatory regimes.[6] For example, a lending license may be required to engage in lending activities in certain jurisdictions. Managers investing in “commodity interests”[7] (including derivatives based upon cryptocurrencies or index futures) would also fall under the regulatory framework of a second agency of the federal government, the Commodity Futures Trading Commission (the “CFTC”).
Registration of an investment adviser with a U.S. state’s securities regulatory agency and (especially) with the SEC[8] 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 and the possible need to hire additional dedicated compliance personnel). There may also be defense costs and amounts paid as fines or restitution if there is a regulatory violation. An SEC registered investment adviser is required to appoint a chief compliance officer and adopt a code of ethics with certain specified requirements. The SEC registered adviser will also need to put in place a longer set of compliance policies and procedures and actively monitor for violations. The registered adviser will need to conduct an annual compliance review and ensure that all of its marketing materials comply with the SEC’s marketing rules. Compliance with custody rules often involves having each private fund audited by a specified date each year. These are just a few examples of the burdens on registered investment advisers that are set out in the Investment Advisers Act and the rules promulgated by the SEC under that Act. Compliance with these obligations may require training existing employees, hiring someone with expertise or outsourcing the role to a compliance consulting firm. A state or federally registered investment adviser is subject to examination by the relevant regulatory agency. During the exam, the agency may request large lists of documents and interview members of the manager’s personnel. The agency’s findings often result in a deficiency letter detailing the deficiencies found and more material violations can result in an enforcement action (which may be a civil matter or be referred for criminal enforcement). There are similar costs and burdens (including those related to regulatory examinations) associated with registering as a commodity pool operator and/or a commodity trading advisor with the CFTC. As a result, many managers try hard to avoid registration, or at least avoid it for as long as they can.[9] Conversely, some managers may desire to be registered to bolster their legitimacy for marketing purposes.
There are various exemptions from SEC, CFTC and U.S. state level regulatory registrations that advisors may be able to rely upon to avoid registration. The availability of these exemptions will depend upon a number of factors related to the investment manager and the fund. Even if a manager is exempt from SEC registration as an investment adviser, an analysis should be conducted on a state by state level (where the manager does business or has clients) to ensure that registration with a U.S. 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.[10]
It should be noted that managers whose funds do not invest in securities or commodity interests, such as funds that only invest in artwork, real property or digital currencies that are not securities, may be outside of these regulatory regimes. An analysis as to whether a real estate investment is a security may be nuanced where holding companies or joint ventures are involved.[11] Digital assets (such as coins and tokens) are especially difficult to categorize, and there is great uncertainty as to whether specific digital assets are (or may in the future be) classified as securities. The categorization of certain digital assets is being fought over in U.S. courts, and it is likely that there will soon be U.S. legislation that establishes regulation for various categories of digital assets. Assets within the area of DeFi are especially tricky to categorize, and practitioners may not be able to provide assurances as to how specific assets are classified.[12] In these cases, a risk analysis is typically performed and a defensive registration may be the preferable outcome. U.S. and non-U.S. Managers that invest in these asset classes should continue to monitor for developments in this area on an ongoing basis. The U.S. securities regulators also heavily regulate exchanges, and therefore non-U.S. exchanges, including in the digital asset space, may prohibit participation by U.S. investors or entities with U.S. investors. For example, non-U.S. crypto exchanges may prohibit participation by U.S. persons or entities with U.S. person managers or beneficial owners. Any potential impact upon the fund’s trading program should be considered before admitting U.S. person investors.
- Certain Common Exemptions from SEC Investment Adviser Registration:
There are various exemptions from registration that non-U.S. managers may be able to rely upon to avoid registration. With very limited exceptions, U.S.-based investment advisers with less than $25 million in “regulatory assets under management” are prohibited from registering with the SEC.[13] Smaller managers are potentially subject to state-level registration. Foreign-based advisers are not subject to this prohibition on registration, and in fact must register with the SEC unless an exemption is found.[14]
Under the Foreign Private Adviser exemption, a non-U.S. manager would not need to register with the SEC if it: (i) has no place of business in the United States; (ii) has, in total, fewer than 15 clients in the United States and investors in the United States in private funds advised by the adviser; (iii) has aggregate “regulatory assets under management” attributable to these clients and investors of less than $25 million; and (iv) does not hold itself out generally to the public in the United States as an investment adviser.[15] This exemption requires the investment adviser to meet all four prongs, and this is not a 15 investor or $25 million test. This exemption is often useful to smaller managers whose assets under management and client base allow for it. There is no filing required to take advantage of this exemption. Regulatory assets under management is determined in accordance with the instructions to Form ADV, which is the form used to register investment advisers and file certain notices by unregistered investment advisers. For purposes of including a “private fund” in the regulatory assets under management calculation, gross assets of the fund (i.e., assets not minus unpaid liabilities, such as margin), including uncalled commitments, are included.[16] In this respect, regulatory assets under management will likely differ from the assets under management that the fund manager uses for marketing purposes. Note that for these purposes the term “private fund” has a specific definition as used in Form ADV and generally includes private investment funds that invest primarily in securities, not other asset classes.[17] For other types of funds or investment portfolios, the calculation can be more complicated.
The Private Fund Adviser exemption is available to an investment adviser with its principal office and place of business outside of the United States if (i) the investment adviser has no client that is a United States person except for one or more qualifying private funds, and (ii) assets managed by the investment adviser at a place of business in the United States are solely attributable to private fund assets, the total value of which is less than $150 million.[18] A non-U.S. adviser with managed accounts for U.S. clients is not able to rely upon this exemption. For purposes of the $150 million calculation, an adviser with a principal office and place of business outside the U.S. can exclude the assets managed at a place of business outside of the U.S., potentially giving it the ability to manage an unlimited amount of private fund assets from outside of the U.S., regardless of the number of U.S. investors in the private fund or the amount of capital they represent.
Advisers solely to qualifying venture capital funds may also rely upon the Venture Capital Adviser exemption. There are strict requirements for the types of funds that will qualify as venture capital funds. For these purposes, venture capital funds are defined as funds that primarily hold specified qualifying assets (generally, portfolio companies with certain attributes). There are also restrictions under this exemption on the fund’s use of leverage and investor redemption rights.[19]
The Private Fund Adviser exemption and the Venture Capital Adviser exemption result in the adviser having the status of an “exempt reporting adviser”. Exempt reporting advisers must complete and file certain sections of Form ADV and update the filing from time to time. Exempt reporting advisers are subject to only a few of the regulatory burdens that are applicable to registered investment advisers but, at least in theory, exempt reporting advisers may be examined by the SEC.[20] Filing to be an exempt reporting adviser puts a non-U.S. adviser on the radar screen of the regulators. The filing is publicly available on the internet.
Managers of qualifying family offices are also exempt from registration under the Investment Advisers Act. There are many investment advisers marketing themselves as family offices, including some referred to as multi-family offices, that fall outside of the definition of “family office” for these purposes. A family office is defined as a company (including its directors, partners, members, managers, trustees, and employees acting within the scope of their position or employment) that: (1) has no clients other than family clients; (2) is wholly owned by family clients and is exclusively controlled (directly or indirectly) by one or more family members and/or family entities; and (3) does not hold itself out to the public as an investment adviser.[21]
- Certain Common Requirements for State-Level Investment Adviser Registration:
State-level registration is also effected by filing a Form ADV. The rules regarding U.S. state-level investment adviser registration vary on a state by state basis. Registration in a specific state is relevant for advisers that have a place of business in the state and/or have a certain minimum number of clients in that state.
U.S. federal law preempts state law in certain respects. An SEC-registered investment adviser would not also register as an investment adviser with individual states. Exempt reporting advisers may need to register with one or more states, since the federal preemption only applies to managers who are actually registered. In addition, under federal law, state-level investment adviser registration is not required, under the federal de-minimis standard, for an adviser with (i) no place of business in that state and (ii) fewer than six clients who are resident in the state.[22] Funds, not their underlying investors, are typically considered the “client” for these purposes, and therefore state-level registration is not likely to be required for non-U.S. managers that only have a small number of funds as clients. Certain states, such as Florida, have more expansive exemptions. Certain states have exemptions that require an exempt reporting adviser filing and some of those states condition the exemption on the manager only managing funds with investors who meet specific qualifications. Advisers who are subject to potential state-level registration (or exemptions) should become familiar with the applicable state law and ensure that their policies and procedures match the obligations imposed by the applicable state or states.
- Certain Common Exemptions from CFTC Commodity Pool Operator/Commodity Trading Advisor Registration:
As noted above, the CFTC also imposes registration obligations upon managers who manage funds that trade in any “commodity interests,” which include futures, options on futures and certain swaps. There are two categories of CFTC registration that are of primary interest to fund managers. A commodity pool operator (“CPO”) is essentially the person who sponsors the fund (i.e., operates a commodity pool and solicits funds for the commodity pool).[23] The most common exemption from CPO registration is the 4.13(a)(3) exemption, which requires the fund (i.e., “pool”) to meet certain portfolio limitations. One of the following two limitations must be met at all times: (A) The aggregate initial margin and premiums required to establish such positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the pool’s portfolio, after taking into account unrealized profits and unrealized losses on any such positions it has entered into; 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 on any such positions.[24] The 4.13(a)(3) exemption requires the commodity pool operator to make an advance notice filing on an electronic portal, and the filing needs to be affirmed each year. There are specific steps that must be followed by fund of funds managers and others that invest in commodity interests indirectly through another vehicle, such as an ETF,[25] if the fund desires to rely upon the 4.13(a)(3) exemption. Advisers who cannot rely upon the 4.13(a)(3) exemption or any other exemption, including those that exceed the 4.13(a)(3) limitations on a look-through basis by investing in ETFs or other collective investment vehicles that hold commodity interests, may need to register but can be exempt from certain onerous provisions of the CFTC rules under a “registration lite” status.[26]
An investment manager who trades a pool’s[27] portfolio that includes commodity interests would also need to register as a commodity trading advisor, unless an exemption is available. It is often easier to find and comply with commodity trading advisor exemptions than commodity pool operator exemptions. Two common exemptions are the 4.14(a)(8) exemption (available where the advisor only serves as a commodity trading advisor to pools for which it is the commodity pool operator, the trading is incidental to securities trading and the advisor doesn’t hold itself out to the public as a commodity trading advisor) and the 4.14(a)(10) exemption (available where the advisor has provided advice to 15 or fewer persons during the last 12 months and does not hold itself out to the public as a commodity trading advisor).
CFTC registration, exemptions and compliance are a highly specialized area of the law, and those seeking to register may need to engage a consultant who specializes in the CFTC rules to ensure that the advisor remains in compliance.
- Additional Take-Aways.
Managing assets in the U.S. or for U.S. investors is a highly regulated activity, and fund managers seeking to enter the U.S. market should spend the required time to understand the applicable regulatory regimes, as well as their fiduciary obligations more generally. When conducting a securities offering in the U.S., disclosures are key. The issuer and its related parties must ensure that the disclosures are not untrue or materially misleading. Fund managers should work with their counsel to ensure that their disclosure documents are up to U.S. industry standards generally and, specifically, that they disclose the material risks and conflicts of interest associated with an investment in the fund. U.S. regulators are very much focused on hidden fees and expense reimbursements, as well as conflicts of interest arising from the use of the manager or its affiliates for ancillary services to the fund or its investments. These services may include property management, consulting services or other services for which affiliates of the manager are compensated at the investment level. This analysis is not just a one-time exercise, and the manager should plan to update the disclosure documents periodically as circumstances change.
Even if a manager is not required to register as an investment adviser, the manager should strongly consider engaging a compliance consulting firm to put in place basic compliance policies and procedures. Policies and procedures may focus on securities trading maters, such as procedures for handling non-public information, or on conduct more generally, such as a code of ethics. It is important to check in from time to time with your professional advisors to discuss changes to the business that may impact regulatory status.[28]
- 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 (or holds itself out as being engaged) primarily in the business of investing, reinvesting or trading in securities typically would need to register with the SEC as an investment company, unless there is an exemption available. In addition, a vehicle that is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of the value of its total assets would need to register with the SEC as an investment company, unless there is an exemption available.[29] This 40% test is a crucial factor to consider when a fund proposes to primarily invest in an asset class other than securities but may also invest in securities. 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 that trade in securities need to find an exemption from Investment Company Act registration to the extent that they would otherwise fall within the definition of an investment company.
Private funds that primarily trade in securities (or exceed the 40% test noted above) typically rely upon one of the following two exemptions from Investment Company Act registration. The first exemption, the 3(c)(1) exemption, is available if the fund privately places its securities and has no more than 100 beneficial owners (or 250 in the case of a qualifying venture capital fund). This exemption 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 (or 250) investor limit.[30] Funds domiciled in jurisdictions outside of the U.S. do not need to count non-U.S. investors toward these limits. The second exemption, the 3(c)(7) exemption, requires all U.S. person investors in the fund structure to be “qualified purchasers”[31] within the meaning of the U.S. securities laws, but does not have any numerical investor limit. 3(c)(7) funds domiciled in the U.S. need all investors to be qualified purchasers. The qualified purchaser requirement is a higher standard than the accredited investor standard, which is discussed below. The decision as to which Investment Company Act exemption is best will, in part, be a marketing decision, and the qualified purchaser test is sufficiently stringent so as to eliminate U.S. persons who are not truly high net worth individuals and organizations. Managers of funds of funds should also consider whether the portfolio funds will require their investors to be qualified purchasers and, if so, how this requirement will be met. There is an additional exemption, the 3(c)(5) exemption, available for private funds who are primarily engaged in one or more of the following businesses: (A) purchasing or otherwise acquiring notes, drafts, acceptances, open accounts receivable, and other obligations representing part or all of the sales price of merchandise, insurance, and services; (B) making loans to manufacturers, wholesalers, and retailers of, and to prospective purchasers of, specified merchandise, insurance, and services; and (C) purchasing or otherwise acquiring mortgages and other liens on and interests in real estate. Two similar 3(c)(1) offerings might be deemed integrated with respect to their numerical investor limit. 3(c)(1) and 3(c)(7) offerings are not combined for these purposes.
As noted above, investment companies include entities that hold securities. 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. Digital assets may be especially tricky to classify, presenting risks to managers who invest in these asset classes, notwithstanding their best efforts to comply with applicable law.[32]
- Private Placement Rules
The sale of a securities to the public 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.[33] This is true even where the issuer is offering securities in a fund (i.e., shares or partnership interests), but the fund itself does not hold securities (e.g., real estate funds). Both U.S. domiciled issuers and issuers domiciled outside of the U.S. can rely upon the exemptions discussed below. The analysis as to whether a transaction represents a public offering can be uncertain, and therefore there were more specific safe harbors established that issuers may 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[34], which requires that all investors in the fund are accredited investors.[35] Issuers using Rule 506(b) must avoid engaging in general solicitation or advertising when marketing the securities (e.g., it can’t advertise on the internet or discuss the fund on television). The Rule 506 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, which are codified in Rule 506(d) of Regulation D. Bad actors are generally people who have been found to have committed specific crimes or regulatory violations. Determining whether a general solicitation or advertisement has taken place can be more complex in the Internet age (especially were managers may express their thoughts over social media or distribute information through databases or other information providers) and therefore use of the enhanced due diligence route (see the discussion of Rule 506(c) below) may be considered, even though this is a newer option and has not been widely adopted by the larger U.S. managers.[36] There are severe consequences that may arise from failing to meet the private placement rules, including both civil and criminal liability.
Rule 506 offerings are divided into two categories, which are 506(b) and 506(c) offerings.[37] Rule 506(c) allows general solicitation, but requires the issuer to take reasonable steps to verify that purchasers of securities sold in any offering under 506(c) are accredited investors. The rule sets out certain safe harbors for determining whether reasonable steps have been taken to verify the status of natural persons, but there is no similar safe harbor for entities. As a result of this additional work for the fund manager and its prospective investors and due to the uncertainty as to whether reasonable steps have been taken for the verification of entities, Rule 506(c) has been slow to catch on in the funds industry. As a result, it is much more common to encounter Rule 506(b) offerings. Managers and other marketing personnel must be very careful to avoid general solicitation when conducting an offering under Rule 506(b), given that the downside for violations is high. Practitioners typically advise that avoiding general solicitation can be done by offering securities only to those with whom the issuer has a preexisting substantive relationship. The relationship should be substantive enough for the issuer to evaluate the sophistication of the prospective investor and confirm that the investor is an accredited investor. Checking a box on a survey is not typically thought to be enough, and advisers often follow up with a phone call once they receive an accredited investor questionnaire completed by the prospective investor. Issuers often provide prospects with a preliminary questionnaire whereby they certify whether they are accredited investors, and do not provide offering materials about the fund until some time has passed. Historically, practitioners often advised waiting 30 days, but no specific time limit is required. The relationship may be established directly or through a broker, investment adviser or other agent. Accredited investor status may also be established through an accredited investor portal or other pre-screening process.
Offerings completed outside of the United States are typically made under Regulation S, which is a safe harbor from registration under the Securities Act for non-U.S. offers and sales.
When an issuer proposes to do two separate offerings simultaneously or within a short period of time, there are complex rules, which have been relaxed a bit recently, that determine whether the two offerings will be integrated for purposes of the U.S. securities rules (e.g., determining whether an issue can lawfully conduct simultaneous 506(b) and 506(c) offerings).[38]
Following a Regulation D private placement, a Form D is required to be filed with the SEC, using its EDGAR system, and state-level blue sky filings also need to be made using the NAASA portal (with few exceptions). These filings need to be completed within 15 days of the first sale (or first sale to an in-state resident).[39] The states charge fees for these notice filings, and therefore it may not be cost effective to allow U.S. investors to make very small investments in a fund. The Regulation D filing needs to be amended each year. Additional blue sky filings may need to be made when you have investors resident in new states.
It should be noted that placement agents (i.e., brokers) who place shares or interests of a fund for a fee from the U.S. or into the U.S. are required to be registered as broker dealers. A summary of the rules, decisions and no action letters related to this point is beyond the scope of this publication, but using an unlicensed broker dealer can have severely adverse consequences upon both the unlicensed broker and the issuer. There is a risk that employees who do little more than solicit fund investors in the U.S. may be characterized as brokers, especially where the employee receives transaction-based compensation. As a result, a fund manager cannot avoid the broker-dealer rules by calling the unlicensed placement agent an employee, although employees who have other roles with the fund manager and happen to also market the fund (e.g., its chief investment officer) should be able to do so without registration. This is a complex area of the law and compensation arrangements should be analyzed on a case by case basis.
- Tax and ERISA Considerations
A fund 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. However, U.S. tax laws are complex. Tax regulations and their interpretations evolve, and therefore it is crucial that a U.S. tax adviser sign off on the proposed structure and a fund’s tax disclosures.
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 partnerships, most frequently formed under Delaware law. Non-U.S. entities, such as Cayman Islands limited companies, can also be used to 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 structure 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, although many sophisticated U.S. investors are also familiar with Cayman Islands, BVI and certain other non-U.S. structures and therefore may not have an aversion to investing in “offshore” vehicles.
The discussion above relates primarily to the preferences of and tax efficiency for investors. In addition, the manager will have its own tax-related 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.
Offshore fund managers should also be aware of additional burdens placed upon them under the “ERISA” rules, which pertain 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 would need to be included in the fund’s subscription documents and benefit plan investors must be tracked as the fund receives subscriptions and redemptions (if applicable). Additional exemptions may be available for venture capital and other specific types of funds. Funds subject to the ERISA rules are barred from engaging in certain prohibited transactions and their managers are likely subject to a higher standard of care (i.e., they would not be entitled to exculpation or indemnification in some cases where they would otherwise be entitled to exculpation and indemnification under the typical gross negligence/wilful misconduct standard).
For tax reasons, U.S. tax-exempt investors, such as foundations and retirement plans, often prefer to invest in the non-U.S. version of a private fund structure. Some managers or non-U.S. attorneys may mistakenly believe that these entities are permitted to invest in offshore structures as a result of being exempt from the rules described above (such as those that pertain to Securities Act of 1933 or Investment Company Act registration of the issuer or the rules that pertain to the registration status of the manager). This is a misconception. Non-U.S. funds offering their shares to U.S. residents need to consider the factors described above, even if they limit their U.S. investors to those who are tax-exempt. In this regard, U.S. counsel should advise on any offering made to U.S. persons, regardless of their tax status and regardless of the domicile of the issuer.
Additional Risks:
There may be substantial business 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. Class action litigation is a large and highly profitable industry within the U.S. Managers should take a cautious approach when engaging with investors, including by having the proper personnel review and approve investor communications and advertisements, eliminating selective disclosure to only some investors where conveying the information may adversely impact other investors and granting special rights through side letters to the extent that they may impact other investors. It is appropriate to re-consider your D&O/E&O insurance coverage before entering the U.S. market and to consider whether the fund documents should provide for arbitration or litigation and the specific venues where an action may be brought. Non-U.S. investors can also be insulated from exposure to U.S. investor disputes through entity 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, compliance with foreign sanctions, investor fraud, privacy,[40] etc. A firm’s compliance manual may need to include procedures designed to address these additional risks. Certain large institutional investment managers may also be required to file Form 13F on a quarterly basis.[41] These other categories of rules that impact persons doing business in the U.S. or investing in securities more generally are beyond the scope of this guide.
Recently, the SEC has been aggressively proposing new rules to regulate the private funds industry. Certain of these new rules may prohibit private funds and their managers from engaging in specific practices. For example, they may prohibit specific categories of private funds from indemnifying managers from losses arising out of ordinary negligence (as opposed to gross negligence), lending to the manager or its affiliates or engaging in certain refinancing transactions. Assuming the new rules are adopted in some form, it is impossible to predict with certainty the scope of the final rules or who will be subject to them (e.g., whether they will only apply to SEC registered investment advisers). Changes to the rules may require revisions to fund documents in the future.[42] The SEC has also been aggressive in enforcing existing rules, targeting private funds in its enforcement efforts. Some believe that the SEC even engages in regulation by enforcement, whereby enforcement actions are brough to punish industry participants for certain practices that are not prohibited with specificity in written regulations. This is especially true in the area of digital assets, where various regulators may contradict each other with respect to their treatment of an asset or asset class. Some of these views or decisions may be politically motivated, and private fund managers may be an attractive target for the regulators, especially where there is market disruption.
Fund managers should have an anti-money laundering (“AML”) program in place and, at a minimum, should ensure that investors are not on the OFAC list maintained by the U.S. Treasury. Typically, a fund would engage a fund administrator or other service provider to perform its anti-money laundering due diligence, since this is a complex area of the law and is facilitated by electronic databases, extensive training and formal procedures. A fund’s administrator often takes responsibility for the administration of a fund’s AML compliance.
Certain non-U.S. cryptocurrency exchanges, including derivatives exchanges, are not open to investment by U.S. persons. Managers should scrutinize the terms of service with these exchanges to ensure that their funds’ structures and categories of investors do not cause them to be ineligible to utilize their intended investment programs and exchanges. Although some offshore service providers may offer solutions to structure around this issue, those solutions are not free of risk.
Note on Drafting “U.S. Style” Documents:
In addition to adding lengthy disclosures on tax and regulatory matters, U.S. counsel may add lengthy disclosures to other sections of an offering memorandum that have been prepared by non-U.S. counsel. This is often the case when a U.S. counsel reviews and comments on the risk factors and conflicts of interest disclosures, which are typically lengthier in U.S. documents than in the documents of entities formed in other jurisdictions. Even where non-U.S. counsel serves as the lead counsel (or drafting counsel) on a project, U.S. counsel may bulk up those sections to bring them in line with what is customary in a U.S. offering. Many industry-leading law firms in the U.S. take a “kitchen sink” approach to these items, disclosing more rather than less under the theory that it can’t hurt to disclose more items than less, even though many items will likely never be relevant. U.S. counsel, and many U.S. legal consumers, also likely mistake the length of a document for its quality and protection, and therefore on average seek longer, more detailed documents. This may not be the case in other jurisdictions, where norms and client preferences are different. In this respect, receiving a heavier than expected markup of a set of non-U.S. fund documents may not indicate any deficiency on the part of the non-U.S. counsel. When collaborating on a set of fund documents, it is important that your U.S. and non-U.S. counsel take a cooperative approach and have a decent working relationship in order to avoid duplication, turf battles and conflict, all of which may be costly and cause delays.
FundsLawyer PLLC’s Approach:
The principal of FundsLawyer PLLC has 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. FundsLawyer PLLC works with a manager’s existing non-U.S. counsel and tax advisors to find the ideal fund structure, whether that is a stand-alone fund, a master-feeder or a more complex private equity or real estate fund structure. FundsLawyer is comfortable working as “local” U.S. counsel or as a sub-counsel to the fund’s existing non-U.S. counsel that takes the lead on drafting the fund documentation. We do not need to take over a project or the client relationship. FundsLawyer PLLC does have extensive experience serving a primary counsel, so it can expand its role based upon the client’s and existing counsel’s preferences. We seek to be cost effective and do not seek to “cross sell” additional areas of legal work or other services, and therefore we are happy to refer you to other cost-effective specialist boutique firms or solo practitioners as needed. We look forward to working with you!
This document is attorney advertising and not legal, tax or regulatory advice or a substitute for seeking your own legal, tax or regulatory advice.
[1] For example, this guide assumes that the reader understands the duties, including fiduciary duties, that are associated with managing an entity. Persons charged with the management of an entity may include an investment manager, sub-managers, directors, a general partner or others, depending upon the jurisdiction and type of entity.
[2] These vehicles are registered under the Investment Company Act of 1940 and related rules.
[3] Private funds often outsource anti-money laundering compliance and know your customer due diligence to fund administrators.
[4] This registration regime is set out in the Securities Act of 1933 and related regulations.
[5] These asset classes may include, among other things, real estate, commodities, artwork and certain cryptocurrencies.
[6] For example, certain funds that are lenders may require lending licenses to pursue their investment programs.
[7] Defined below.
[8] SEC registration is effected pursuant to the Investment Advisers Act of 1940 and related rules.
[9] At the most basic level, under U.S. law, investment advisers are subject to a fiduciary duty to act in the best interest of their clients. See generally https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf
[10] Under a line of no action letters, managers that need to register as investment advisers with the SEC may not need to comply with substantive provisions of the Investment Advisers Act with respect to their non-U.S. clients.
[11] There have been longstanding tests, established by caselaw, as to whether certain types of assets represent securities, provided that these tests do not always provide a clear result that attorneys or their clients can rely upon. https://www.sec.gov/news/public-statement/statement-clayton-2017-12-11
[12] Managers may consider DeFi assets and other assets for which there is uncertainty as securities out of an abundance of caution.
[13] https://www.sec.gov/divisions/investment/iaregulation/memoia.htm
[14] https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf
[15] https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf
[16] https://www.sec.gov/rules/final/2016/ia-4509-appendix-b.pdf https://www.sec.gov/files/formadv.pdf
[17] https://www.sec.gov/about/forms/formadv-instructions.pdf
[18] https://www.sec.gov/about/offices/oia/oia_investman/rplaze-042012.pdf
[19] https://www.law.cornell.edu/cfr/text/17/275.203(l)-1
[20] https://www.americanbar.org/groups/business_law/publications/blt/2016/10/06_ross/
[21] https://www.law.cornell.edu/cfr/text/17/275.202(a)(11)(G)-1
[22] https://www.sec.gov/rules/final/ia-1633.txt
[23] https://www.nfa.futures.org/registration-membership/who-has-to-register/cpo.html
[24] https://www.nfa.futures.org/members/member-resources/files/exemptions-reference-guide.html
[25] A fund manager would need to find an exemption or register if it has just a single U.S. investor and invests in just a single ETF that holds a commodity interest. In this regard, a protective 4.13(a)(3) filing may be useful even where no futures trading is contemplated.
[26] See CFTC Regulation 4.7 https://www.nfa.futures.org/members/cpo/cpo-exemptions.html.
[27] The fund trading commodity interests would be a pool.
[28] Compliance consulting is its own industry in the U.S. There may be some overlap with the work performed by law firms, but compliance consultants are often less expensive than attorneys and are more familiar with the practical implementation of policies and procedures. Consider having counsel engage the compliance consulting firm on a fund’s (or the manager’s) behalf in an effort to have the relationship fall under an attorney client privilege.
[29] https://www.law.cornell.edu/uscode/text/15/80a-3
[30] The most common private placement exemption used by fund managers requires all U.S. investors in the fund structure to be “accredited investors” within the meaning of the U.S. securities laws. The exemption expands the 100 investor limit to 250 in the case of a qualifying venture capital fund. https://www.law.cornell.edu/uscode/text/15/80a-3
[31] For the definition, see item (a)(51) https://www.law.cornell.edu/uscode/text/15/80a-2 In general terms, it includes natural persons with $5 million of investments and companies with $25 million of investments.
[32] For example, various regulators in the U.S. have taken different views as to whether Ether is a security. https://www.coindesk.com/policy/2023/03/09/what-happens-if-ethereum-is-a-security/
[33] Offerings outside of the U.S. are typically exempt from registration under Regulation S.
[34] Promulgated under the Securities Act of 1933.
[35] Under Rule 506(b), a fund may admit up to 35 non-accredited investors, provided that admitting non-accredited investors results in a burdensome set of disclosure requirements. As a result, it is rare to see private funds admit non-accredited investors. The investment amount that they represent is typically far outweighed by the additional costs and risks associated with admitting these investors. See the additional requirement in Rule 502. https://www.law.cornell.edu/cfr/text/17/230.502
[36] https://www.law.cornell.edu/cfr/text/17/230.506 See rule 506(d).
[37] https://www.sec.gov/smallbusiness/exemptofferings/rule506c
[38] https://www.sec.gov/rules/final/2020/33-10884.pdf
[39] https://www.sec.gov/smallbusiness/exemptofferings/formd
[40] Funds marketing to U.S. investors should deliver a U.S. privacy notice. See https://www.sec.gov/files/OCIE%20Risk%20Alert%20-%20Regulation%20S-P.pdf
[41] An institutional investment manager that uses the U.S. mail (or other means or instrumentality of interstate commerce) in the course of its business, and exercises investment discretion over $100 million or more in Section 13(f) securities must report its holdings publicly to the SEC quarterly.
[42] https://www.sec.gov/rules/proposed/2022/ia-5955.pdf