AN ACCOUNTANT'S GUIDE TO THE MAJOR LEGAL ISSUES AFFECTING HEDGE FUNDS
By Steven B. Nadel
ccording to a recent survey, there currently exist over 3,000 hedge funds managing in excess of $200 billion of investors' capital (seeExhibit). As such, many accountants, both in the public sector and at private companies, are being exposed to this growing practice area and are being asked to provide guidance to hedge fund investors and hedge fund managers. Since today's accountants are often expected to give more than just accounting advice, they may be required to be conversant in the relevant hedge fund legal issues.
Hedge Fund Investors:
Major Legal Issues
What are hedge funds and how do they differ from mutual funds? While there is no precise definition, a hedge fund can best be described as an investment vehicle (typically in the form of a limited partnership or an offshore corporation), privately offered to a limited number of qualified investors, that is permitted to engage in virtually all types of securities-related investments, as well as utilize leverage and hedging techniques. Hedge funds are not registered with the Securities and Exchange Commission (SEC) as investment companies (because they either restrict their ownership to no more than 100 beneficial owners or are offered exclusively to certain qualified purchasers), nor are their managers usually required to be registered as investment advisers with the SEC. Furthermore, because hedge funds are often limited in both the number and types of investors they permit, the minimum initial subscription set by the hedge fund manager will frequently be at least $250,000 (subject to the manager's discretion).
Unlike mutual funds, which are heavily marketed to the general public and restricted in their investment methods by SEC regulations, hedge funds are not publicly traded, cannot publicly advertise, and are not subject to the same level of regulatory constraint. Moreover, hedge funds generally limit the frequency of capital contributions and withdrawals (usually no more frequently than quarterly), whereas mutual funds must permit transactions on a daily basis (with relatively low minimum initial contributions). Finally, hedge fund managers are typically paid a fee based upon assets under management, as well as an incentive fee or allocation in the form of a percentage (usually 20%) of actual net profits generated (generally after recouping all losses that have been carried forward from prior fiscal periods); by contrast, mutual fund managers generally do not receive any form of compensation tied to the return they generate for investors but rather receive a management fee based solely upon assets under management.
Hedge Fund Managers:
Major Legal Issues
Concerns about investors, structure, locale, and strategy. Hedge fund managers may seek to raise capital from U.S. taxable and tax-exempt investors, as well as non-U.S. investors. Factors that may affect this mix include the fund's investment strategy and its suitability for potential investors; the regulatory implications of admitting certain investors into the fund; and, in the case of an offshore fund, whether the fund is to be listed on an exchange. Hedge funds are free to engage in a myriad of investment strategies, some of which may not be well suited to certain categories of investors. For example, the fund's investment strategy may entail too much risk for a given investor, involve an area in which a prospective investor is not permitted or authorized to invest, (e.g., hot issues of securities may not be allocated to certain restricted persons under the rules of the National Association of Securities Dealers), or create negative tax consequences for the investor, e.g., U.S. tax-exempt investors may incur unrelated business taxable income (UBTI) if a U.S. hedge fund employs leverage, and non-U.S. investors in a U.S. hedge fund may be subject to certain U.S. withholding and possible U.S. estate tax requirements. Besides investor suitability, the admission of certain investors may result in undue regulatory burdens for the fund and its manager, e.g., the fund's assets will be considered ERISA plan assets if the capital contributions by ERISA plans and certain other benefit plan investors makes up 25% or more of the fund. Moreover, there are various classes of investors (particularly, certain institutional non-U.S. investors) that may require a hedge fund to be listed on an exchange (such as the Irish Stock Exchange), because the regulations governing such investors may prohibit or restrict their investment in unlisted securities or require them to have the ability to refer to a quoted market price with respect to their investment.
A threshold issue that all hedge fund managers will have to address is the fund's structure and locale. As a general rule, most hedge fund managers seeking to organize simultaneously a U.S. fund and an offshore fund would likely set up a U.S. flow-through vehicle such as a limited partnership or limited liability company for U.S. taxable investors, along with an offshore corporation (with an offshore administrator) in a tax haven jurisdiction (e.g., Cayman Islands, British Virgin Islands or Bermuda) for non-U.S. and U.S. tax-exempt investors (thereby virtually eliminating all UBTI concerns). The manager of the offshore fund would often be able to defer the receipt of the management and performance fees owing to it, thus delaying the payment of taxes. In addition, if the manager were seeking to avoid splitting brokerage tickets between the two funds (and quickly reach a certain financial critical mass), the manager could consider establishing a master-feeder structure, whereby the two funds described above would invest all of their assets in an offshore limited partnership that would act as a trading entity. However, such a structure could reduce the number of U.S. investors permitted to invest in the integrated funds.
The recent repeal of the principal office requirement may, however, to some degree, alter the hedge fund landscape. Until recently, the IRC provided a statutory safe harbor that allowed a foreign investment fund to trade stocks or securities for its own account without being subject to U.S. Federal income taxation on its gains, provided that the fund did not maintain its principal office within the United States at any time during the taxable year. Under the safe harbor, an offshore fund was considered to have an offshore principal office if all or a substantial portion of 10 specified administrative and marketing functions (known as the 10 commandments) took place offshore. These functions consisted of (i) communicating with shareholders, (ii) communicating with the general public, (iii) soliciting sales of its own stock, (iv) accepting new subscriptions, (v) maintaining principal corporate records, (vi) auditing its books of account, (vii) disbursing certain payments, (viii) publishing or furnishing the offering and redemption price of shares, (ix) conducting director and shareholder meetings, and (x) making redemptions of its own stock.
Effective for taxable years beginning after December 31, 1997, an offshore fund trading stocks or securities for its own account is no longer required to maintain its principal office offshore in order to avail itself of the safe harbor. While some professionals believe that the repeal of the principal office requirement should permit the shifting of most or all of the 10 commandments onshore (thus obviating the need for an offshore administrator), and encourage the creation of new U.S.-based hedge fund structures in which foreigners can invest, this conclusion may be premature. For a variety of reasons (including local and state tax issues, securities and commodities law issues, and concerns about confidentiality and U.S. regulatory scrutiny raised by foreign investors), hedge fund managers should carefully consider this decision with their advisers before completely abandoning their old methods of doing business.
A hedge fund manager will also have to determine the fund's investment strategy. Some of the more commonly utilized strategies include market-neutral (investing in a balanced long and short portfolio), value (investing in undervalued situations), emerging markets (investing in developing countries), event-driven arbitrage (investing in companies undergoing major fundamental changes), distressed situations (investing in companies experiencing financial difficulties), and fund of funds (investing in other hedge funds for diversification purposes). When formulating the fund's investment strategy, the manager will focus upon its past performance; the type of investor it is expecting or seeking to attract; the marketplace's receptiveness to the proposed strategy; the accounting, valuation, and liquidity issues that may be associated with the strategy; the time and cost required to implement the strategy; and the regulatory issues concerning the specific strategy.
There are numerous regulatory issues that could arise, depending upon the particular investment strategy to be employed, including, for example, those related to trading commodities and utilizing leverage. A hedge fund manager seeking to engage in commodities trading will, as a general rule, have to be registered as a commodity pool operator with the Commodity Futures Trading Commission (CFTC). Such a registration will impose substantial disclosure, recordkeeping, and financial reporting obligations; however, there are certain exceptions which may allow for the avoidance of many, if not all, of the CFTC's requirements. Moreover, a hedge fund manager desiring to utilize leverage, besides prompting certain UBTI concerns, may also cause the fund to be regulated by the Federal Reserve's credit regulations, primarily Regulation T. Regulation T regulates the extension of credit by and to brokers and dealers and imposes certain margin requirements, depending on the type of security (generally, 50% of market value).
Understand Before Advising
While the hedge fund industry is an area that affords the accounting profession tremendous new business opportunities, accountants must remember that hedge funds are complex investment vehicles. Accordingly, before giving advice to prospective hedge fund investors or hedge fund managers, accountants should thoroughly understand their clients' objectives, as well as the interrelated legal issues affecting them. [Editor's note: They are also advised to consult with a knowledgeable attorney when appropriate.] *
Steven B. Nadel, Esq., is an associate with the law firm of Seward & Kissel, where he specializes in investment management and securities matters.
Milton Miller, CPA
William Bregman, CPA/PFS
Alan J. Straus, CPA
David R. Marcus, JD, CPA
Paneth, Haber & Zimmerman LLP
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