By Hansi Men
A fund, as defined in Merriam Webster, is “a sum of money or other resources whose principal or interest is set apart for a specific objective.” Many clients, especially those with a Chinese legal background, would disagree that pooling money from three people has anything to do with “fund.” In fact, “fund” in not a clearly defined term under the U.S. laws. The U.S. government and plaintiff lawyers make the fund business almost dangerous to people with no prior experience.
MAKING A FUND PRIVATE
Private funds is a colloquial term for unregistered investment funds. Investment funds are subject to federal and state registration requirements unless certain exemptions apply. At the federal level, the Investment Company Act (“ICA”), the Investment Advisors Act (“IAA”), and the Securities Exchange Act (“SEA”) are the most relevant. As the monetary and opportunity costs associated with registration is considerable, fund management tends to rely on certain exemptions to delay or avoid registration as long as possible. Sections 3(c)(1) and 3(c)(7) of the ICA provide categories of entities exempted from the registration requirement, such as: Companies who are not and will not go public and whose outstanding shares are not owned by 100 persons. Note that “beneficial ownership” (i.e. indirect ownership) matters, too.; Securities brokers, regulated under other laws; and nonprofit organizations.
Under the ICA exemptions, funds with investment in registered investment companies may also need to be registered. Therefore, funds that intend to stay “private” must also need to be careful with the type of investments they engage in.
In addition, management of a fund (typically organized as the general partner of a limited partnership) may be subject to investment advisor registration requirement under the IAA given that the management could be offering investment advice to the fund’s investors. Registration is typically triggered when the asset under management exceeds certain threshold. Indeed, advisors with less than $25 million of assets under management are actually prohibited from SEC registration. Even for advisors generally subject to SEC registration, certain exemptions may apply, like VC fund advisors.
Fund management may also be subject to broker/dealer registration under the SEA if it is involved in the business of brokering or dealing securities. Whether the management engages in broker dealer activities is a fact-sensitive question requiring thoughtful analysis. In practice, the most probative factor is whether the management receives “transaction-based” fees such as a percentage commission. This approach has been criticized by many lawyers and professionals as referring clients without being involved in the transaction does not appear to be broker/dealer activity. However, the SEC has taken the position that any activity which results in transaction-based fees being collected is presumed to be broker/dealer activity unless otherwise exempted. One typical mistake in the Chinese investment community is that “finders” are exempted from SEC registration. This has resulted in hefty fines in the EB-5 immigration industry where unregistered “finders” of immigrant investors found themselves being sued by the SEC. Moreover, both acting as a broker/dealer and using unregistered broker/dealer have legal ramifications. Fund management must carefully examine its marketing practices and fee structure to avoid violations of broker dealer rules.
State-level registration must also be considered. For example, advisor with more than six New York clients are subject to registration or notice filing through New York’s Investment Adviser Registration Depository system even though the advisor may not need to register with the SEC.
In the legal world, exceptions exist to general rules. When analyzing whether registration is required, we must carefully examine the facts against the statutory exemptions and industry practices so as not to run afoul of the fine prints.
STRUCTURING A PRIVATE FUND
While numerous funds are organized as limited partnership, it is not always the best option. Since different funds need to weather different risks and may be subject to different taxes, no structure, no matter how carefully designed, is universally applicable.
Limited partnership generally works for funds in which the investors do not have much control over the investment. This is why most large investment funds are organized as limited partnership because the management does not want investors’ interference. In the U.S., a limited partnership, organized under the laws of a state, consists of a “general partner” and one or more “limited partners.” The limited partners are subject to limited liabilities. The general partner technically does not enjoy limited liability protection, but most general partners are organized as limited liability companies to limit the risk exposures of the natural persons operating the fund. The general partner has the ultimate authority to bind the partnership into any investment deals, but the fund’s Limited Partnership Agreement may limit the authority to a certain extent.
Limited partnerships do not work where investors want to get actively involved in the investment. As stated, “fund” is not a clearly defined term. You do not need a “fund manager” that wears pocket square to start a fund. In some situations, even though the person starting the fund is running the day-to-day operations, there are only a limited amount of investors and they demand active control over all the investments. This is a good example where the fund probably should not be organized as a limited partnership.
Some clients might prefer setting up an LLC mostly because it seems to be the simplest. LLC is a flexible form of incorporation, but the flexibility also comes at a price. The laws are not exactly clear about how certain corporate governance issues need to be resolved for LLCs so state courts generally rely on the LLC’s operating agreement (also known as limited liability company agreement). Therefore, the operating agreement is an instrument that must be carefully drafted, reviewed and negotiated by the LLC’s members, as opposed to filling out a form obtained online. Nationals of certain countries, such as Canada, may suffer inequitable tax consequences as members of a U.S. LLC. Tax professionals should thus be consulted before decision is made.
The structure of the fund is further complicated by how the investment itself is structured. Sometimes, because the investment is highly speculative, to attract investors with lesser risk tolerance, fund sponsors may structure a guarantor to back the investment. While nothing is absolutely “guaranteed,” having a guarantor with ample assets boosts investors’ confidence. The guarantor may provide a certain type of guaranty or allow the limited partnership or its wholly owned special purpose entity to create certain lien interest on the guarantor’s assets. In this type of situations, understanding and disclosing the guaranty or lien interest’s priority in the event of bankruptcy would be crucial to both the investors and management.
Sometimes, investment trusts can also be set up to provide for tax benefits. Spendthrift trust may be used to protect the trust’s beneficiaries because creditors generally cannot reach the funds in the trust. However, setting up a trust may limit the fund’s leverage activities such as asset-backed borrowing.
CONSIDERATIONS IN ADVISING A STARTUP FUND
The legal issues in starting a private fund cannot be exhaustively enumerated. Clients must work closely with attorneys and tax professionals in order to achieve the best results. On the other hand, the life cycle of a fund can be rather simple: collect money, make money (hopefully) and get out. Perhaps the best way to organize our thoughts is to think about the three steps. For example, we can list out the issues that need to be addressed in the following manner: Offering: basic terms of the investment, marketing compliance, using broker/dealer/foreign finder, anti-money laundering and investor accreditation; Invest: due diligence, management rights/obligations, management fees
profit/loss allocation, record keeping and access management; Exit: exit timeline and strategy, priority, carried interest, noncash distribution, if any reinvestment options.
By examining these phases, we may spot issues that need to be either addressed in the documents and/or discussed with clients. Often a private placement memorandum (“PPM”) will need to be drafted to summarize the investment’s terms and disclose risks. Sometimes PPM is statutorily required (for example Rule 502(b)(2) of Regulation D). Otherwise it’s a good idea to make full and necessary disclosure. Truth be told, except lawyers, no one enjoys reading lengthy and obscure PPMs. From time to time, PPMs inhibit transactions or even break deals. Even so, one must understand that a well-drafted PPM protects against regulatory and general fraud claims, which may result in hefty fines or even punitive damages. Note that “fraud” in the securities context does not require proof of “intent,” as may be required under other contexts. Simply put, whether the fund’s management intended to commit fraud is almost irrelevant when the court examines fraud. The key is to avoid “untrue statement of a material fact” in any offering documents such as the PPM. Fund sponsors must conduct a line-by-line review of the PPM in order to avoid mistakes in the documents.
Although unregistered private funds are not heavily regulated in the U.S., management can’t turn a blind eye to the fund’s operational and compliance risks. On the operational side, real-time monitoring of the funds’ investment and operational activities is crucial to the fund’s success. On the compliance side, marketing, disclosure of conflicts and allocation of fees and expenses should be conducted under the guidance of counsel. Even though the SEC may not be actively monitoring an unregistered fund’s activity, once the investment falls apart, investors may resort to or be solicited by plaintiff attorneys to file lawsuits against the management.
As stated above, in the securities context, “intent” often does not matter, and carelessness is often punished as fraud. This is why “just do whatever is standard” is never a good approach. Interested parties must come together to review their strategies, business plans and documents to minimize the risks of regulatory violation or legal actions.
(Editor’s Note: May vary slightly as published.)