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Red Oak Blog

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Thursday, February 25 2016

Hedge Funds- Should they be Registered?

Hedge funds are trendy, and therefore popular investment vehicles. Most hedge funds in the marketplace today are erroneously named and marketed. A hedge fund is a pooled investment where the manager of the pool of funds is utilizing some sort of hedge strategy; i.e. long/short positions or long with an option strategy.

Most of the “hedge funds” being sold and managed by smaller advisers (AUM under $100,000,000) are more of a non-regulated mutual fund or ETF; the adviser is pooling client funds to increase leverage power, take advantage of tax law and doing nothing more than buying and selling traditional products without any type of hedge strategy. I believe this is why that during a thirteen year stint as a financial examiner for a state financial services regulatory agency I saw quite a few investment advisers that were managing some sort of “hedge fund”, for which they had never submitted any type of filing with the state or SEC.

Many have a misconception that if they are only accepting accredited investors into the fund that the fund is not deemed to be a security. This is entirely untrue. The SEC and all state securities regulatory agencies have strict definitions for what is deemed to be a security. The Securities Act of 1933 defines a security as:
“any note, stock, treasury stock, security future, security-based swap, bond, debenture, evidence of indebtedness, certificate of interest or participation in any profit-sharing agreement, collateral-trust certificate, preorganization certificate or subscription, transferable share, investment contract, voting-trust certificate, certificate of deposit for a security, fractional undivided interest in oil, gas, or other mineral rights, any put, call, straddle, option, or privilege on any security, certificate of deposit, or group or index of securities (including any interest therein or based on the value thereof), or any put, call, straddle, option, or privilege entered into on a national securities exchange relating to foreign currency, or, in general, any interest or instrument commonly known as a ‘‘security’’, or any certificate of interest or participation in, temporary or interim certificate for, receipt for, guarantee of, or warrant or right to subscribe to or purchase, any of the foregoing.”

Each state will also have similar, if not the same, definition for a security. So for any offering issued by an investment adviser that is going to be sold across state lines, it should either be registered as a security with the state of residence of the Adviser and the SEC, or there should be some sort of filing for exemption from registering the fund as a security with the SEC and the state of residence of the adviser. Here is a link to a “Fast Answer” site published by the SEC regarding the Regulation D filings process. If the offering is just going to be sold within the state of residence of the adviser, the adviser should contact the state regulatory agency under which he/she is registered to determine what type of filing is required.

Filings for the product to be sold is not the only issue that should be taken into consideration when contemplating the issuance of one’s own offering. Another area of concern is the compensation which the adviser will receive. Please be advised that a registered investment adviser is NOT allowed to pay itself a commission for the sale of the offering. As a registered investment adviser you are only allowed to charge a management fee, and/or a performance fee. And if you are going to charge a performance fee, it can only be charged to qualified clients. Any registered investment adviser wishing to pay itself a commission for the sale of an offering should consult with the SEC and/or state(s) in which it is registered. In the state of Texas, it is a violation of the Securities Act to receive a commission unless registered as a broker dealer with the State. Please find the related article here.