Special from Jay B. Gould and David A. Goldstein, White & Case LLP

SAN FRANCISCO (www.hedgeco.net) – The Securities and Exchange Commission (the “SEC”) has historically taken an expansive view regarding the activities that would subject an individual or an organization to the broker dealer registration requirements under the Securities Exchange Act of 1934 (the “1934 Act”). Simply put, any promotional, introductory, or marketing activity with respect to a security is a “brokerage activity” in the SEC’s view; and any person who is conducting such activities may only do so after becoming an SEC registered broker dealer and, in most cases, a member of a self-regulatory organization, such as the National Association of Securities Dealers, Inc. (the “NASD”). The SEC has broad authority to seek injunctive relief, bring civil enforcement actions, or refer matters for criminal prosecution against any person alleged to be conducting brokerage activities without registration. Because the SEC’s view of what constitutes a brokerage activity is so broad, any unregistered individual or organization that is even peripherally involved with issuers of securities should conduct their activities in a manner that is consistent with SEC positions on such matters, or they should find an exemption from the definition of broker on which to rely.

Most hedge funds and their general partners and principals rely on Rule 3a4-1 under the 1934 Act to avoid registration as a broker dealer. Pursuant to Rule 3a4-1, an “associated person” of an issuer is not required to register as a broker dealer to engage in an offer and sale of the issuer’s securities if certain conditions are met. In this regard, the associated person must not be subject to a statutory disqualification, nor be compensated by the payment of commissions, directly or indirectly, based on the sale of the issuer’s (fund) shares. Additionally, the associated person must not be an associated person of a broker dealer.

For hedge fund purposes, the term “associated person” of an issuer means any natural person who is a partner, officer, director, or employee of the issuer, a corporate general partner of a limited partnership that is the issuer, or a company or partnership that controls, is controlled by, or is under common control with the issuer. This simply means that employees or owners of a general partner to a hedge fund, which is organized as a limited partnership, may rely on Rule 3a4-1 to engage in promotional and sales efforts on behalf of the hedge fund without registering as a broker dealer. But what about hedge funds that are not organized as limited partnerships? How does the exemption apply, if at all?

Specifically, may a hedge fund organized as a Cayman Islands unit trust – the vehicle of choice for many Asian and European hedge fund sponsors/advisers – rely on Rule 3a4-1? Unfortunately, it appears unlikely that certain individuals affiliated with the investment adviser of a unit trust may rely on Rule 3a4-1. Under Rule 3a4-1, an investment adviser who is a corporate general partner of a fund organized as a partnership, is a principal of the fund, and falls within the definition of an “associated person” of the fund. Conversely, a hedge fund organized as a unit trust typically has only a contractual arrangement with its investment adviser, thereby creating an agency (and not a principal) relationship. The principals of a unit trust are the trustees of the fund, not the third party agent with which the trustees contract for the provision of investment advice. Agents of a fund are not “associated persons” under Rule 3a4-1 and therefore neither they nor their employees may promote or sell fund units within the borders of the U.S. without the proper registration. Such promotional and sales activities on behalf of a unit trust in the U.S. must be conducted either by the trustees, a very unlikely scenario, or through a U.S. registered broker dealer.

The disparate treatment of limited partnerships and unit trusts seems like something that the SEC should be able to remedy with the wave of its no-action wand. Indeed, the adopting release for Rule 3a4-1 states that exemptions from registration as a broker dealer for other types of entities, persons, and affiliates may be available on a case by case basis. White & Case LLP recently spoke to the Office of Chief Counsel of the Division of Market Regulation at the SEC about this point and was told that the Division of Market Regulation will not provide industry interpretive guidance with respect to Rule 3a4-1, and would not view favorably a submission from an investment adviser of a hedge fund organized as a unit trust. Additionally, the Division continued, because Rule 3a4-1 is a safe harbor rule and cannot be interpreted beyond its content, any activity that does not fall squarely within the four corners of the Rule must be examined under Section 15 of the 1934 Act. It is the Division’s position that Section 15 would require registration of any investment adviser of a hedge fund organized as other than a limited partnership or a corporation.

“Common control” appears to be integral to the SEC in determining whether an entity will be an associated person of an issuer for purposes of the Rule. This presents an interesting dilemma for certain unit trusts that target Japanese investors where, as a result of Japanese tax considerations, the investment adviser must go to great lengths to demonstrate that it does not control the fund. Therefore, it would appear that an investment adviser would be required to argue inconsistent positions under U.S. and Japanese laws in order to obtain relief under Rule 3a4-1, a precarious undertaking in this age of international information sharing.

For hedge fund sponsors who intend to pursue distribution opportunities in the U.S., the choices are few. To the extent an investment adviser intends to promote or offer an investment program in the U.S., the fund adviser or sponsor should consider organizing a Delaware partnership as a feeder fund in a master-feeder arrangement, a side-by-side fund, the U.S. component of which is a partnership, or enter into a distribution agreement with a U.S. registered broker.

Note:

White & Case LLP represents hedge fund and private equity fund sponsors and advisers, prime brokers, and administrators through its 38 offices in 25 countries around the world. For further information on the White & Case investment funds practice, contact:

Jay B. Gould, Esq.
White & Case LLP
San Francisco, California 94111
415-544-1112 (O)
310-800-6500 (C)
Jgould@whitecase.com

David A. Goldstein
White & Case LLP
New York, New York 10036
212-819-8757 (O)
917-891-8900 (C)
dgoldstein@whitecase.com