By David Mainzer

April 2012

Managers of hedge funds and other private funds that buy and sell commodity futures and options on commodity futures are generally required to register as “commodity pool operators” (“CPOs”) with the National Futures Association (the “NFA”) unless they qualify for an exemption from this registration requirement.  

The Commodity Futures Trading Commission (the “CFTC”) currently provides an exemption from the requirement to register as a CPO under CFTC Rule 4.13(a)(4) (the “Sophisticated Investor Exemption”), for managers of hedge funds and other private funds where (a) each natural person investor in the fund is a “qualified eligible person” under CFTC Rule 4.7(a)(2) and (b) each non-natural person investor in the fund is either a qualified eligible person under CFTC Rule 4.7 or an “accredited investor” under Securities and Exchange Commission (“SEC”) Rule 501(a)(1), (2), (3), (7) or (8).  In order to claim the Sophisticated Investor Exemption, fund managers are required to file a “Notice of Exemption pursuant to Regulation 4.13(a)(4)” (an “Exemption Notice”) with the NFA.  

Effective on April 24, 2012, the CFTC has eliminated the Sophisticated Investor Exemption for fund managers that have not yet filed an Exemption Notice.  Fund managers that have filed an Exemption Notice prior to April 24, 2012 will be required to register as CPOs on or before December 31, 2012, unless they qualify for another exemption from the requirement to register.  For example, CFTC Rule 4.13(a)(3) (the “Limited Trading Exemption”) exempts managers of hedge funds that, among other things, either (a) limit the margin and premiums required to establish commodity futures, commodity option and swap positions to 5% or less of the fund’s net asset value or (b) limit the notional value of commodity futures, commodity option and swap positions to 100% or less of the fund’s net asset value.  The Limited Trading Exemption has not been affected by the recent CFTC rulemaking.

The Sophisticated Investor Exemption has been widely used by fund managers.  Accordingly, it is now anticipated that a significant number of private fund managers will soon be required either to register with the NFA as a CPO or else cease, or significantly reduce, their commodities trading activities.  


©2012 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

By David Mainzer

March 2012

Effective on May 22, 2012, the Securities and Exchange Commission (the “SEC”) has amended Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to adjust criteria necessary for a person to qualify as a “qualified client.”  Rule 205-3 is an SEC rule that allows investment advisers to charge their clients performance based fees, which are otherwise prohibited by Section 205(a)(1) of the Advisers Act.  For hedge funds and other funds, investors in the fund must be qualified clients in order for the fund to be able to pay performance fees to the investment adviser.

Since September 19, 2011, SEC Rule 205-3(d) has provided that individuals and companies are qualified clients if either (a) they have $1,000,000 under the management of the investment adviser (including capital contributions and bona fide capital commitments of private fund investors) immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that, immediately prior to entering into the investment management agreement providing for the performance fees, either (i) they have a net worth (for natural person, this includes assets jointly held with a spouse) of more than $2,000,000 or (ii) they are a “qualified purchaser” as defined in the Investment Company Act of 1940.

The latest rulemaking by the SEC will make three changes to the qualified client definition as of May 22, 2012.

First, in calculating the client’s net worth, the client will be required to exclude the value of the client’s primary residence from their net worth.  Client’s are generally also entitled to exclude the amount of any mortgage or other indebtedness secured by their primary residence, but the value of such indebtedness must be deducted from their net worth to the extent that (a) the indebtedness exceeds the fair market value of the client’s primary residence or (b) the indebtedness exceeds the amount of indebtedness that was secured by the client’s primary residence 60 days before the date on which the client’s net worth is calculated.  This change is similar to the change the SEC made to the net worth calculations in the “accredited investor” definition under the Securities Act of 1933.

Second, the new SEC rules provide that the foregoing amounts (i.e. $1,000,000 under management of the adviser or $2,000,000 of net worth) will be adjusted on or about May 1, 2016, and approximately every 5 years thereafter, to account for inflation.

Third, the SEC has amended the transition rules in Rule 205-3(c) to provide for certain arrangements that are already in place.  This means that clients and private fund investors who validly entered into contracts providing for performance fees prior to May 22, 2012 will generally be entitled to continue to pay performance fees under such existing contracts.

Investment advisers will need to update their compliance policies and procedures, by May 22, 2012, to ensure compliance with the changed rule.  For managers of hedge funds and other private funds, this will generally also require updates to the funds’ offering documents, including subscription documents and private placement memoranda.


©2012 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.

By David Mainzer

January 2012

Section 413(a) of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”), which was passed in July, 2010, required the Securities and Exchange Commission (the “SEC”) to change the definition of who is an “accredited investor” for the purposes of Regulation D (“Reg. D”) under the Securities Act of 1933 (the “Securities Act”).  Within the investment management industry, the primary effect of this provision was to require hedge funds, private equity funds and venture capital funds (collectively, “Private Funds”) to change their fund offering process to ensure that new investors satisfy the changed definition.

Prior to the passage of the Dodd-Frank Act, the accredited investor definition included as accredited investors “any natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of his purchase exceeds $1,000,000.”  Section 413(a) of the Dodd-Frank Act effectively changed this definition to exclude the value of a person’s primary residence from their net worth in making the determination of whether their net worth exceeds $1 million.  Shortly thereafter, the SEC issued guidance to allow investors to disregard any mortgage debt secured by their primary residence, unless the amount of the mortgage debt exceeds the fair market value of the primary residence.  If the amount of the mortgage debt exceeds the fair market value of the primary residence, then the prospective investor is required to deduct the amount of such excess from their net worth in determining whether they are an accredited investor.

Effective on February 27, 2012, the SEC has made a further refinement to this set of rules.  The change creates a second level of inquiry regarding mortgage debt secured by a potential investor’s primary residence.  The effect of this is that any increase in primary residence mortgage debt incurred within 60 days prior to the determination of whether someone is an accredited investor (e.g. within 60 days prior to their completion of the subscription documents for a private fund) will also now be deducted from a person’s net worth for the purposes of the accredited investor definition, unless the increase was in connection with the acquisition of the primary residence.  This is the case regardless of whether the then increased amount of debt exceeds the value of the residence.

One interesting effect of these provisions is that a person may be able to invest in a private fund one day, but then not able to invest in a private fund the next day simply because they bought a new house or refinanced their mortgage.  In the adopting release, SEC notes the concern that, without this new rule, investors “…may be incentivized (or urged by unscrupulous sales people) to take on debt secured by their homes for the purpose of qualifying as accredited investors and participating in investments without the protection to which they are entitled.”  Implicit in this line of regulation seems to be the assumption that people who have equity in their home are less able look after their own interests than people of equal means who pay rent.

The SEC has also adopted a grandfathering provision for certain investors that had existing rights to purchase securities on July 20, 2010.

Private Funds relying on Reg. D will generally need to ensure that investors that are natural persons meet the accredited investor definition as it has been changed.  This will typically require updating the investor questionnaire portion of the fund’s subscription documents and the permitted investors section of the fund’s private placement memorandum.

As the accredited investor definition is only relevant at the time an investor invests in a fund, Private Funds will generally not need to determine if their existing investors remain accredited investors after the change.  However, as it is possible that an existing investor will no longer be an accredited investor, Private Funds should ensure that existing investors complete a new investor questionnaire before accepting additional investments in the fund.  Private Funds that rely on Securities Act exemptions other than Reg. D (for example, offshore funds relying on Regulation S under the Securities Act) should not be affected by this change.


©2012 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.

By David Mainzer

August 2011

On July 12, 2011, the Securities and Exchange Commission (the “SEC”) adjusted Rule 205-3 under the Investment Advisers Act of 1940 (the “Advisers Act”) to increase the dollar amount thresholds necessary for a person to qualify as a “qualified client.”  These adjustments will become effective on September 19, 2011.  Rule 205-3 is an SEC rule that allows investment advisers to charge their clients performance based fees, which are otherwise prohibited by Section 205(a)(1) of the Advisers Act.  For hedge funds and other funds, investors in the fund must be qualified clients in order for the fund to be able to pay performance fees to the investment adviser.

Currently, SEC Rule 205-3(d)(1)(i) and (ii) provides that individuals and companies are qualified clients if either (a) they have $750,000 under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $1.5 million immediately prior to entering into the investment management agreement providing for the performance fees.

The changes made by the SEC will increase these amounts, such that individuals and companies will be qualified clients if either (a) they have $1 million under the management of the investment adviser immediately after entering into the investment management agreement providing for the performance fees or (b) the investment adviser reasonably believes that they have a net worth (for a natural person, this includes assets jointly held with a spouse) of more than $2 million immediately prior to  entering into the investment management agreement providing for the performance fees.

The SEC has also proposed changes to the qualified client definition that, among other things, would (a) increase the foregoing dollar amounts every five years to reflect inflation and (b) exclude the value of a natural person’s primary residence in determining whether they meet these thresholds.  The SEC is still considering these further changes.

Investment advisers will be required to update their compliance policies and procedures, by September 19, 2011, to ensure compliance with the changed rule.  For managers of hedge funds and other private funds, this will generally require updates to the funds’ subscription documents and private placement memoranda.


©2011 Spolin Silverman Cohen & Bosserman LLP (“SSC&B”).  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and SSC&B makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and SSC&B.

By David Mainzer

July 2011

On September 26, 2011, the new FINRA Rule 5131(b) will come into effect.  FINRA Rule 5131(b) seeks to stop an underwriting practice called “spinning,” by generally prohibiting underwriters from allocating shares of an initial public offering of an equity securities (an “IPO”) to any hedge fund or other account in which executive officers or directors of certain public or non-public companies, or persons that are materially supported by these executive officers or directors, have a beneficial interest of greater than 25%.

Managers of hedge funds that intend to invest in IPOs will therefore be required to certify to the underwriters that their hedge funds are not prohibited accounts under FINRA Rule 5131(b).  This requirement is similar to the certifications that are currently required under FINRA Rule 5130.

In order to make the required certifications under FINRA Rule 5131(b), we expect that hedge funds will generally need to determine which of their investors are executive officers or directors of public or non-public companies, or persons that are materially supported by such executive officers or directors.   This will typically require (1) updating the investor questionnaire portion of the hedge fund’s subscription documents, to add a certification as to the investor’s status under FINRA Rule 5131(b), and (2) circulating an annual questionnaire to investors to update this certification.

With the September 26 deadline fast approaching, we recommend that hedge fund managers begin addressing these changes as soon as possible.


©2011 Cohen/Mainzer LLP.  All Rights Reserved.  Attorney Advertisement.  This document is not legal advice and you should not rely upon it as a substitute for legal advice based on your particular situation.  This document may not be accurate, complete or up to date, based on the facts applicable to you, and Cohen/Mainzer makes no representation or warranty that it is.  Receipt or use of this article does not create any attorney-client relationship between the user and Cohen/Mainzer.