Hedge Fund - Regulation - US Regulation

US Regulation

Hedge funds within the US are subject to various regulatory and trading reporting and record keeping requirements that also apply to other investors in publicly traded securities. Before the Dodd-Frank Act made registration mandatory for hedge fund advisers with more than US$150 million in assets under management, hedge funds were primarily regulated through their managers or advisers, under the anti-fraud provisions of the Investment Advisers Act of 1940. Hedge funds are privately-owned pools of investment capital with regulatory limits on the number and type of investor that each fund may have. Because of these regulatory restrictions on ownership, hedge funds have been exempted from mandatory registration with the US Securities and Exchange Commission (SEC) under the Investment Company Act of 1940, which is generally intended to regulate investment funds sold to retail investors. The two primary exemptions in the Investment Company Act of 1940 that hedge funds relied on were (a) Section 3(c)1 which restricts funds to 100 or fewer investors and (b) Section 3(c)7, which requires all investors to meet a "qualified purchaser" criterion. These sections also both prohibit hedge funds from selling their securities through public offerings. Under 3(c)7, a qualified purchaser is defined to include an individual with at least US$5 million in investment assets. Companies, including institutional investors, generally qualify as qualified purchasers if they have at least US$25 million in investment assets. Although under Section 3(c)7 a fund can have an unlimited number of investors, if a fund has any class of equity securities owned by more than 499 investors, it must register its securities with the SEC under the Securities Exchange Act of 1934.

Because Sections 3(c)1 and 3(c)7 of the Investment Company Act of 1940 prohibit hedge funds from making public offerings, funds must sell their securities in accordance with the private offering rules under the Securities Act of 1933. The 1933 Act generally requires companies to file a registration statement with the SEC if they want to sell their securities publicly, or comply with private placement rules under the Act. Though the securities of hedge funds are not registered under the 1933 Act, they remain subject to the anti-fraud provisions of the Act.

Hedge funds raise capital via private placement under Regulation D of the Securities Act of 1933, which means the shares are not registered. To comply with the private placement rules in Regulation D, hedge funds generally offer their securities solely to accredited investors. An accredited investor is an individual person with a minimum net worth of US$1 million or, alternatively, a minimum income of US$200,000 in each of the last two years and a reasonable expectation of reaching the same income level in the current year. For banks and corporate entities, the minimum net worth is US$5 million in invested assets.

For SEC registered hedge fund advisers to charge an incentive or performance fee, the investors in the funds must be "qualified clients" as defined in the Investment Advisers Act of 1940 Rule 205–3. To be a qualified client an individual must have US$750,000 in assets invested with the adviser or a net worth in excess of US$1.5 million, or be one of certain high-level employees of the investment adviser. Under the Dodd-Frank Act, the SEC is required to periodically adjust the qualified client standard for inflation.

Because hedge funds do not have publicly traded securities, they are not subject to all of the reporting requirements of the Securities Exchange Act of 1934. Hedge funds that have a class of equity securities owned by more than 499 investors do, however, have to register under Section 12(g) of the 1934 Act and are subject the quarterly reporting requirements of the Act. Similar to other institutional investors, hedge fund managers with at least US$100 million in assets under management are required to file publicly quarterly reports disclosing ownership of registered equity securities. Also similar to other investors, hedge fund managers are subject to public disclosure if they own more than 5% of the class of any registered equity security. Hedge fund managers are also subject to anti-fraud provisions.

Prior to the requirements of the Dodd-Frank Act, many hedge fund advisers voluntarily registered with the SEC. Advisers who do so are subject to the same requirements as all other registered investment advisers. Registered advisers must provide information about their business practices and disciplinary history to the SEC and investors. They are required to have written compliance policies and have a chief compliance officer to enforce those policies. In addition, they are required to maintain certain books and records and have their practices examined by SEC staff. As a result of the Dodd-Frank Wall Street Reform Act, hedge fund advisers with at least US$15 million in assets under management were required to register with the SEC by 30 March 2012; smaller advisers are subject to state registration.

In December 2004, the SEC issued a rule change that required most hedge fund advisers to register with the SEC by 1 February 2006, as investment advisers under the Investment Advisers Act. The requirement, with minor exceptions, applied to firms managing in excess of US$25 million with over 14 investors. The SEC stated that it was adopting a "risk-based approach" to monitoring hedge funds as part of its evolving regulatory regimen for the burgeoning industry. The new rule was controversial, with two commissioners dissenting, and was later challenged in court by a hedge fund manager. In June 2006, the U.S. Court of Appeals for the District of Columbia overturned the rule and sent it back to the agency to be reviewed. In response to the court decision, in 2007 the SEC adopted Rule 206(4)-8, which unlike the earlier challenged rule, "does not impose additional filing, reporting or disclosure obligations" but does potentially increase "the risk of enforcement action" for negligent or fraudulent activity.

Many hedge funds also fall under the jurisdiction of the Commodity Futures Trading Commission. Hedge fund advisers registered as Commodity Pool Operators (CPO) or Commodity Trading Advisors (CTA) would fall within this category, as would any manager of a hedge fund investing in markets under the CFTC's jurisdiction, even if they qualify for an exemption from CPO or CTA registration. Hedge fund managers who meet these criteria are subject to rules and provisions of the Commodity Exchange Act prohibiting fraud and manipulation.