Hedge Funds and State Securities
by Jay Fishman
Senior Writer Analyst
CCH Incorporated
Hedge funds are mentioned by state securities regulators (and appear in the CCH Blue Sky Law Reporter) primarily in no-action letters. There are, however, two Blue Sky regulations that refer to them but these provisions involve hedge fund advisers. One of them, a regulation from the District of Columbia at Section 1850, is entitled “notice filing for federal covered advisers and hedge fund advisers,” and goes on to provide the requirements for these advisers. The other, a Texas regulation at Section 109 entitled “investment adviser registration exemption for investment advice to financial institutions and certain institutional investors,” declares that there is no exemption under this Section for an investment adviser providing advisory services to a natural person or to a private fund such as a hedge fund composed partially or entirely of natural persons. This regulation then goes on to define “private fund.”
The no-action letters in the Blue Sky Law Reporter that mention hedge funds are from six states. A 2004 no-action letter from Arizona, declined to grant an investment adviser registration exemption for a Kansas privately held company proposing to create a fund to invest in a variety of instruments to be sold to accredited investors under rule 506 of federal Regulation D. The term “private fund” is used in place of “hedge fund.” An Idaho no-action letter from 1996 granted a general partner of a number of limited partnerships that invest and trade in commodity pools the right to give investment advice about commodities without registering as an investment adviser in the state. The limited partnerships that were managed (and provided with investment advice) by the general partner were referred to as first tier [commodity] pools or hedge funds that were privately placed.
Two no-action letters on hedge funds were issued from Kansas. In the first of these, from 1991, in answer to the requester’s hypothetical question regarding whether an exemption could be claimed for hedge funds, the Kansas Securities Commissioner defined a hedge fund as “a pooled fund of money engaged in some risk-managed investment hedging involving the purchase of index futures or options,” and determined that the Kansas “sales to institutional investor” exemption would apply only if the purchaser of the securities in the particular transactions qualified as an institutional investor. Also, that the term “institutional investor” being broad and ambiguous would be subject to interpretation on a case-by-case basis, and that qualification as an accredited investor under Section 2(15) of the Securities Act of 1933 would not necessarily qualify a purchaser as an institutional investor for purposes of claiming the institutional investor exemption in Kansas. The second no-action letter from 2002 granted an exemption from broker-dealer, agent and investment adviser registration for a Kansas limited liability company that managed the day-to-day operations of a hedge fund.
The Pennsylvania Securities Commission in a 1999 no-action letter declared that two limited liability companies proposing to trade securities in Pennsylvania exclusively with brokers or dealers registered under the Securities Act of 1934 fell within an exemption for persons registered as broker-dealers under the 1934 Act who do not maintain their principal place of business in Pennsylvania. The LLCs were formed under the laws of Delaware to trade a private investment fund organized under the laws of the Cayman Islands in which redeemable participating shares would be offered and sold to high net worth, financially sophisticated investors under Section 4(2) and Rule 506 of the Securities Act of 1933. A Texas no-action letter from 1997 required investment adviser registration for a private investment company, structured as a hedge fund, to provide advice to its newly formed partnership composed exclusively of individual accredited investors. The private company was a Texas limited partnership whose general partner was also a Texas limited partnership. The private company’s goal was to achieve capital appreciation through investments traded on organized domestic and international securities markets.
Lastly, a Utah no-action letter from 2001 granted an exclusion from its “broker-dealer” definition for an out-of-state securities firm whose transactions were restricted to Utah foundations and university endowments. The firm, in pushing for this exclusion, reiterated that in a no-action letter from 1995 the Utah Securities Division wrote that the intent of its “financial institution/institutional investor” exemption was to cover sophisticated buyers the Division could apply higher standards of knowledge and experience to. The firm contended that its qualification standards would be consistent with the Division’s intent for this exemption because the solicitation for investment in the types of products it would offer, including hedge funds and emerging markets private equity, would be limited to institutional buyers.