Understanding Securities Law
The business professional's guide to securities laws
 

A hedge fund is an investment company that is not currently required to register and report to the SEC.

So to understand what a hedge fund is, you must first understand what an Investment Company is.

What is an Investment Company?

The primary law that governs investment companies is the Investment Company Act of 1940.

The ‘40 Act, as it is called, defines an “investment company” as a company which is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting or trading in “securities.” Investment companies are classified as management companies, unit investment trusts, or face-amount certificate companies.

There are various types of Investment Companies:

• Mutual funds are called Open-end companies. Mutual funds generally offer an unlimited number of their redeemable shares to the public on a continuous basis.

Other types of Open-end companies that are mutual funds are:

• Closed-end companies usually offer to the public a fixed number of non-redeemable securities.
• Interval funds are a category of closed-end funds that differ from traditional closed-end funds because their securities are subject to periodic repurchase offers by the interval fund at net asset value. Interval funds also may differ from traditional closed-end funds by offering their shares continuously at net asset value.
• Business development companies, or BDC’s, are a category of closed-end funds that are operated for the purpose of making investments in small and developing businesses and financially troubled businesses.
• Exchange-traded fund or ETF’s are funds whose share value is based on specific domestic and foreign market indices. An "index-based ETF" seeks to track the performance of an index by holding in its portfolio either the contents of the index or a representative sample of the securities in the index.
• Unit investment trusts are investment companies that do not have a board of directors, corporate officers, or an investment adviser. They generally invest in a relatively fixed portfolio of securities.

• Face-amount certificate companies are investment companies that are engaged or propose to engage in the business of issuing face-amount certificates of the installment type. There are only a few face-amount certificate companies in existence today.

So again, what is a Hedge Fund?

Hedge Funds are Investment Companies that do not currently have to register with or report to the SEC. The principal characteristics of a hedge fund are:

• They have less than 100 shareholders or have shareholders that are all wealthy and sophisticated, called “qualified purchasers.”
• They are not making and do not at that time propose to make a public offering of their securities.
• Their shares are offered pursuant to an exemption from registration under the 1933 “Selling Stock” Act, generally under SEC Regulation D.

What is an Inadvertent Investment Company?

An investment company is a company 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, exclusive of government securities and cash items, on an unconsolidated basis.

This doesn’t seem like a big deal. Except – what if your operating business wants to by stock in other operating businesses as investments? Not to operate the other company as a subsidiary, but solely as an investment.

Look at your balance sheet. Look at the value of the stock in the other business you want to acquire for investment. When you record the value of the investment on your balance sheet, is it more than 40% of the value of your total assets, exclusive of government securities and cash items, on an unconsolidated basis?

If it is, you are an Investment Company, Inadvertently.

Because of the high cost of becoming and staying a registered investment company, and all the regulations you have to comply with, you don’t want that to happen.

Is my Investment Club required to register as an Investment Company?

Generally no, so don’t get too alarmed. You may be part of a group of people who pool their money and invest it in securities. Each person in the investment club holds an interest in the pool. If every member in an investment club actively participates in deciding what investments to make, the membership interests in the club may not be considered securities as defined in the Investment Company Act.

Investment Advisers

Generally, persons who manage the portfolios of registered investment companies must register with the Commission as investment advisers under the Investment Advisers Act of 1940. Persons who register are called Registered Investment advisers, or RIA’s.

In order to become an RIA you must complete a Form ADV and other forms and file them with the SEC and/or FINRA in the Central Records Depository, or CRD. You also must take and pass a FINRA qualifying examination called Series 65.

Under the laws an regulations governing Investment Advisors:

• Investment advisers are fiduciaries, meaning they have a high duty of loyalty to their clients.
• Investment advisers must have compliance programs.
• Investment advisers are required to prepare certain reports and to file certain reports with the sec.
• Investment advisers must provide clients and prospective clients with a written disclosure statement.
• Investment advisers must have a code of ethics governing their employees and enforce certain insider trading procedures.
• Investment advisers are required to maintain certain books and records.
• Investment advisers must seek to obtain the best price and execution for their clients’ securities transactions.

Investment advisers activities are subject to various requirements such as:

• Requirements for investment advisers’ contracts with clients.
• Requirements for investment advisers that advertise their services.
• Requirements for investment advisers that pay others cash to solicit new clients.
• Requirements for investment advisers that have custody or possession of clients' funds or securities.
• Requirements for investment advisers to disclose certain financial and disciplinary information.

Investment Advisers may be examined by the SEC staff.