What is your fund acquiring?  Why does that matter? 

The first question that we ask in fund creation is, “What is your fund acquiring?” Real estate, mineral rights, stock, bonds, commodities, currencies, crypto assets, or interests in other funds (also known as “fund of funds”)? 

If your fund is holding itself out or is engaged in the business of investing, reinvesting, or trading of securities, then it falls within the definition of an “Investment Company” as defined Investment Company Act of 1940 and is subject to the registration requirements absent an exemption. 

 

Although many finance related words sound interchangeable, they’re not.  

  • An “investment company” invests other people’s money on their behalf.  
  • A “broker/dealer” is any institution that matches buyers with sellers of securities.  
  • An “investment adviser or advisor” gets an annual fee to make trading decisions.

When you see folks screaming about pork bellies and coffee in a commodities pit, they’re not trading securities but actual legal contracts that represent the underlying bacon or java for physical delivery.  Airlines buy fuel that way in advance. Hotels lock in coffee and orange juice prices that way too.  These examples don’t legally qualify as “securities,” because they represent an actual commodity to be delivered as opposed to being a derivative of an enterprise.  Same thing with some (but not all) crypto assets.

The SEC has decided that BTC or Bitcoin is not a security for now.  However, if a fund manager wraps Bitcoin into a larger investment vehicle, that potentially could be a security, because it bundles risk into a collective asset with the intention of hopefully turning a profit over time. Furthermore, the definition of what is a security would be looked at on a case-by-case basis under the Howey test. 

See, it all comes from this Florida orange grove owner (Howey), who sold plots of the orange grove to investors. The investors would then lease back to Howey’s company through a service contract which allowed for the company to have complete access to the land with no right of entry to the land.  In turn for access to the plots of orange grove, the investors shared profits with Howey.  This scheme soon attracted the attention of regulators, and after much litigation of whether there was an unregistered sale of securities by Howey, the Supreme Court ruled that it was in substance a security despite not fitting into the common understanding of what constitutes a security

In defining the term “security,” Congress, the SEC and U.S. Supreme Court have provided broad definitions including (but certainly not limited to): notes, stock, bonds, debentures, derivative contracts, fractional undivided interests in oil & gas mineral rights, etc. In the seminal case SEC v. Howey, the Supreme Court defined a “security” as any investment contract that involves: 

  1.  an investment, 
  2.  in a common enterprise, 
  3.  with a reasonable expectation of profit, 
  4.  derived solely from the efforts of others. 

The arduous registration process with the SEC involves filings, disclosures and audit requirements that could be burdensome and cost prohibitive for small, nascent funds that are in its infancy and are not backed by the legacy investment banks. 

 

There is hope!  Small funds have several options for raising capital. We turn to the available exemptions or exclusions from definitions: 

 

Exemptions and Exclusions

One way to define an “investment company” is by highlighting what it’s not.  An investment company does not:

  1. Have more than 100 direct or beneficial owners.
  2. Have more than 40% of total assets in the trading or investing of securities.
  3. Have unqualified owners (who are not qualified purchasers). 
  4. Include a bank, loan association, commercial lender, insurance company, broker/dealer, underwriter, or market intermediary.
  5. Fit the definition of an “oil and gas company.”
  6. Operate as a non-profit or religious organization.

 

The §3(c)(1) and §3(c)(7) exemptions are most popular among private equity funds. 

 

I call §3(c)(1), the small fund exemption. The fund can have 100 or fewer beneficial owners. 

 

Next, I call §3(c)(7) the “hedge fund exemption,” with no cap on how many investors you can have.  But it does require that 

  • All of your investors be qualified purchasers. That’s any natural person (legalese for “human being”) or family office, who owns at least $5 million in investments;
  • It can also be a trust, whose specific purpose is not to acquire the securities being offered and any fund’s settlor, grantor (check writer) also individually meets that definition of a qualified purchaser;  
  • Any $25 million person or entity acting on a discretionary basis on its own behalf or for other qualified purchasers; and 
  • A company whose beneficial owners are all themselves qualified purchasers. 

 

Once the requirements for the exemptions are met, the sponsors of the fund can seamlessly raise capital through the existing exemptions available under the Securities Act of 1933 and the rules promulgated thereunder.