A Q&A guide to investment funds law in the United States.
This Q&A is part of the PLC multi-jurisdictional guide to investment funds. It provides a high level overview of investment funds in the United States, looking at both retail funds and hedge funds. Areas covered include a market overview, legislation and regulation, marketing, managers and operators, restrictions and requirements, tax and upcoming reform.
For a full list of recommended investment fund lawyers and law firms the United States, see PLC Which lawyer?
To compare answers across multiple jurisdictions, visit the Investment Funds Country Q&A tool. For a full list of jurisdictional Q&As visit www.practicallaw.com/investmentfunds-mjg.
Open-ended retail funds, commonly referred to as mutual funds, are pooled investment vehicles that generally offer shares to the public on a continuous basis. Open-ended retail funds issue redeemable securities, which means that except in extraordinary circumstances, on shareholder demand a mutual fund must:
Redeem its shares at net asset value (NAV).
Pay redemption proceeds within seven days.
Exchange-traded funds (ETFs) are an exception. Although typically organised as open-ended funds, their shares trade on an exchange.
The mutual fund market is well-developed and active. According to Investment Company Institute statistics:
As at 31 August 2011, there were over 7,500 United States (US) mutual funds with combined assets of over US$11.6 trillion (as at 1 November 2011, EUR1 was about US$1.4). Of this, over US$2.6 trillion was invested in money market funds.
Investor interest in ETFs remains strong. As of 31 August 2011, the combined assets of US ETFs were over US$1 trillion, a 29.9% increase from 2010.
Closed-ended retail funds, which are often sold in underwritten public offerings, do not offer redeemable securities. Investors generally buy and sell shares of closed-ended funds in the secondary market on exchanges.
The closed-ended fund market is also well-developed and active. As at 30 June 2011, there were 630 US closed-ended funds with over US$240 billion in assets under management (Investment Company Institute statistics).
Regulatory framework. The Investment Company Act of 1940 (ICA) is the primary source of applicable law. The ICA:
Imposes substantive requirements on funds' organisation and operation.
Empowers the Securities and Exchange Commission (SEC) to regulate their activities.
Mutual funds are also subject to other federal and state laws, including the:
Securities Act of 1933 (Securities Act), which governs the sale of shares and regulates the form and content of registration statements for sales to the public.
Securities Exchange Act of 1934 (Exchange Act), which governs the form and content of proxy statements.
Internal Revenue Code of 1986 (IRC), which imposes requirements on funds wishing to take advantage of the favourable tax treatment afforded to regulated investment companies.
Regulatory bodies. The SEC is the principal regulatory body for mutual funds. The Financial Industry Regulatory Authority (FINRA) is a self-regulatory organisation overseeing securities firms doing business in the US. Regulations promulgated by FINRA govern FINRA members' sales and marketing of fund shares.
Regulatory framework. Closed-ended funds are generally subject to the same regulatory regime as mutual funds. Closed-ended funds with shares listed on an exchange are also subject to the exchange's rules (as are ETFs).
Regulatory bodies. See above, Closed-ended retail funds: Regulatory framework.
A mutual fund must register as an investment company under the ICA and, if it offers its securities to the public, the offering must be registered under the Securities Act.
Form N-1A and Form N-8A. A mutual fund must file a notification of registration on Form N-8A and a registration statement on Form N-1A. Form N-1A requires disclosure regarding, among other things:
The fund's investment objective(s), strategies and related risks.
Fees and annual fund operating expenses.
Performance information.
The fund's adviser(s).
How to purchase shares.
SEC review. As part of the registration process, the SEC staff typically reviews and provides comments on a fund's registration statement. Responses to these comments can be incorporated into one or more pre-effective amendments (amendments made before the fund offers shares to the public). Once the SEC staff is satisfied with the form and content of the registration statement, the SEC will either:
Declare the registration statement to be effective.
Allow the fund to file an amendment that becomes effective in due course.
Mutual funds can only offer their securities to the public under an effective registration statement.
Registration statement updates. A mutual fund must annually update its registration statement by filing a post-effective amendment on Form N-1A. This updates performance, fee and expense information, as well as any other outdated information. Additionally, most states require mutual funds to make annual notice filings and to pay fees if the fund's shares are sold in that state.
Fees. A mutual fund does not pay any upfront fees to the SEC for filing or amending its registration statement, but typically pays fees annually after the fund's financial year-end. Fees are based on the value of shares sold.
Non-US funds. It is difficult and uncommon for a fund organised outside the US to register as a mutual fund. The ICA prohibits a foreign fund from offering shares in the US except under an exemptive order. The SEC (in special circumstances or arrangements) can grant an exemptive order, provided that:
It is both legally and practically feasible to enforce effectively the provisions of the ICA against the foreign fund.
The issuance of the order is otherwise consistent with the public interest and the protection of investors.
The SEC has issued exemptive rules that make it easier for Canadian funds to register under the ICA, subject to conditions. Foreign funds offered in the US may have unfavourable tax consequences for US investors.
The registration process for closed-ended funds is generally the same as for mutual funds, except that a closed-ended fund:
Files its registration statement on Form N-2.
Is exempt from the requirement to update its registration statement annually if it includes certain information in its annual shareholder reports.
Must pay upfront filing fees based on the amount of the offering.
FINRA typically must review in advance and raise no objections to the underwriting compensation and related arrangements for the distribution of closed-ended funds' shares. Closed-ended funds that list their shares on an exchange are also subject to the exchanges' registration requirements.
Mutual funds typically offer their shares to the public through a distributor registered with the SEC as a broker-dealer under the Exchange Act. Distributors are also members of FINRA and subject to FINRA's rules and regulations. The distributor purchases shares from the fund and then sells the shares to the public directly or indirectly through financial intermediaries.
The ICA limits the use of fund assets to pay for the distribution of its shares. Generally, a fund cannot use fund assets to finance distribution unless the fund has adopted a written plan under Rule 12b-1 of the ICA. In 2010, the SEC proposed significant changes to Rule 12b-1, but the timing of their enactment remains uncertain. Due to the difficulties in registering a foreign fund with the SEC (see above,Question 3), foreign funds are limited to making a private placement in the US.
Closed-ended funds typically offer shares through a broker-dealer in a single underwritten public offering. After the public offering, the shares of most closed-ended funds are traded on exchanges. (The shares of most ETFs are also traded on exchanges.) As is the case for open-ended funds (see above,Open-ended retail funds), foreign funds are limited to making a private placement in the US.
Generally, mutual funds that have registered a public offering of their shares can offer and sell their shares to any investor. However, mutual funds can restrict sales to certain investors, for example to comply with or to avoid the application of certain anti-money laundering laws.
Mutual funds can also adopt policies, such as frequent trading policies, that can result in sales restrictions on certain investors. Additionally, broker-dealers selling the fund's shares can be subject to FINRA requirements regarding the suitability of the fund's shares for a particular investor.
Mutual funds that have not registered a public offering of their shares (including foreign funds, see Question 3) may be offered to US persons under a private placement exemption under the Securities Act (seeQuestion 18).
See above, Open-ended retail funds.
Mutual fund advisers, including foreign advisers, are subject to the Investment Advisers Act of 1940 (Advisers Act) and the ICA. Among other things, these Acts require a mutual fund adviser to:
Register as an investment adviser with the SEC.
Adopt written compliance policies and procedures.
Act in the best interests of its clients.
File periodic reports with the SEC and maintain certain records.
Seek the best execution for portfolio transactions.
Obtain board and shareholder approval of advisory contacts with the fund.
Advisers to closed-ended funds are subject to the same requirements as advisers to open-ended funds.
A mutual fund must place and maintain its assets with a qualified custodian (ICA), typically either a:
US bank meeting certain capital requirements.
Broker-dealer.
If certain conditions are met, the fund can act as its own custodian. Rules under the ICA also permit the use of:
Securities depositaries.
Futures commission merchants.
Commodity clearing organisations.
For foreign assets:
government-regulated foreign banks;
subsidiaries of US banks or bank holding companies;
foreign securities depositaries.
Closed-ended funds are subject to the same requirements as open-ended funds.
Legal vehicles. A mutual fund or ETF can be organised as:
A business or statutory trust.
A corporation.
A limited partnership.
A limited liability company (LLC).
Another entity under the laws of any US state.
Participants' interests in a fund are commonly referred to as shares. A mutual fund can offer multiple classes of shares, subject to different expenses and offering different services, such as different shareholder servicing or distribution arrangements.
Advantages. In practice, most mutual funds are set up as one of the following:
Massachusetts business trusts.
Delaware statutory trusts.
Maryland corporations.
These forms of organisation are attractive to fund sponsors because they:
Offer significant governance flexibility.
Do not require annual shareholder meetings.
Liability and indemnification issues can also influence the fund sponsor's choice of vehicle.
Disadvantages. There are no material disadvantages to the use of these forms of organisation.
Legal vehicles. Closed-ended funds are typically organised in the same manner as open-ended funds. Unlike open-ended funds, closed-ended funds can issue preferred stock, subject to certain conditions.
Advantages. The same advantages apply as for open-ended funds (see above, Open-ended retail funds: Advantages).
Disadvantages. See above, Open-ended retail funds: Disadvantages.
Mutual funds are subject to many restrictions on investments under the ICA, including:
Limitations on the maximum investment in a single issuer for diversified funds:
in relation to 75% of its assets, a diversified fund cannot invest more than 5% of those assets in a single issuer and cannot acquire more than 10% of the outstanding voting securities of a single issuer;
the remaining 25% of the diversified fund's assets are not subject to this limitation and can be invested in a single issuer.
These limitations do not apply to US government securities and securities of other investment companies.
Restrictions on transactions with affiliates.
Limitations on investments in other investment companies, securities-related businesses and illiquid securities.
Money market funds have additional restrictions on portfolio quality, diversification, maturity and liquidity.
A fund must also disclose in its registration statement its investment policy in relation to certain matters, such as the purchase and sale of real estate and commodities. These investment policies cannot be changed without shareholder approval.
A mutual fund is limited in its ability to borrow money. A mutual fund cannot issue senior securities, which the ICA defines as any:
Bond, debenture, note or similar obligation constituting a security and evidencing indebtedness (although bank borrowings are permitted as described below).
Stock of a class having priority over any other class as to distribution of assets or payment of dividends.
A mutual fund can borrow money from a bank, but must maintain certain asset coverage in relation to these borrowings. The SEC is of the view that certain trading practices and derivative instruments must be covered either by asset segregation or offsetting transactions.
Closed-ended funds are generally subject to the same restrictions as mutual funds. However, a closed-ended fund can issue a senior debt security and a senior equity security, subject to asset coverage requirements.
A manager/operator can place restrictions on the issue of interests in retail funds. For example, a fund can:
Close (or close a share class) to new purchasers.
Establish minimum investment amounts.
Impose front-end, level or deferred sales charges.
Limit the distribution channels through which shares are sold.
Limit the ability of frequent traders to purchase shares or otherwise limit the number of exchanges an investor can make within a specified period.
A mutual fund cannot suspend redemptions except under unusual circumstances (such as when the New York Stock Exchange is unexpectedly closed or trading is restricted, or the SEC has declared an emergency). However, it can impose a redemption fee of up to 2%.
Closed-ended fund shares are not redeemable at the shareholder's option. However, a closed-ended fund can:
Impose a sales charge on its initial sale of shares.
Repurchase its shares, including at a price other than NAV.
There are no statutory restrictions on mutual fund investors' rights to transfer or assign their rights to third parties. However, most investors seeking to dispose of their shares either:
Redeem them.
In the case of ETFs, sell them on an exchange.
There are no statutory restrictions on closed-ended fund investors' rights to transfer or assign their rights to third parties. However, most investors seeking to dispose of their shares sell them on an exchange.
Investors. Mutual funds must deliver the following reports to investors:
A prospectus or summary prospectus.
Supplements to the fund's prospectus.
Annual and semi-annual reports.
Annual privacy notices.
Certain tax information.
Regulators. Mutual funds must file the following reports, among others, with the SEC:
Annual updates to the fund's registration statement on Form N-1A.
Supplements to the fund's prospectus.
Annual and semi-annual reports on Form N-CSR, containing the fund's financial statements and certified by the fund's CEO and CFO.
Semi-annual reports on Form N-SAR, containing certain regulatory information.
Quarterly reports on Form N-Q, containing portfolio holdings information and certified by the fund's CEO and CFO.
Annual reports on Form N-PX regarding the fund's proxy voting record.
In relation to money market funds, Form N-MFP, containing information regarding a money market fund's portfolio holdings.
Mutual funds can be required to make periodic filings with state securities regulators.
Investors. Closed-ended funds must deliver the same periodic reports to investors as mutual funds (see above, Open-ended retail funds: Investors). A closed-ended fund's annual report typically includes the information that otherwise would be required in an updated Form N-2.
Regulators. Closed-ended funds must file the same periodic reports with the SEC as mutual funds (see above, Open-ended retail funds: Regulators). A closed-ended fund's annual report on Form N-CSR typically includes the information that otherwise would be required in an updated Form N-2.
Funds. Funds typically seek to qualify as regulated investment companies under the IRC. A regulated investment company is not subject to federal income tax at the fund level on income and gains from investments that are distributed in a timely manner to investors.
Resident investors. Generally, for federal income tax purposes, a fund's distribution of investment income and net short-term capital gains (that is, the excess of net short-term capital gains over net long-term capital losses) is taxable to resident investors as ordinary income. Distributions of net capital gain (that is, the excess of net long-term capital gains over net short-term capital losses) that are properly reported by the fund as capital gain dividends are taxable to resident investors as long-term capital gains.
Resident investors can also be subject to state and local taxes on these distributions. Any gain resulting from an exchange or redemption of fund shares is generally subject to tax as a long-term or short-term capital gain, depending on the period of time the investor held the shares. Top marginal federal income tax rates for individuals through 2012 are:
35% for ordinary income and short-term capital gains.
15% for long-term capital gains.
Tax rates for 2013 and beyond are currently the subject of much government debate in the US.
Non-resident investors. In general, dividends (other than capital gain and exempt-interest dividends) paid to an investor that is not a US person within the meaning of the IRC (non-US investor) are subject to withholding of US federal income tax at a rate of 30% (or any lower applicable treaty rate). Under a special IRC exemption, distributions paid to a non-US investor of US source interest income or net short-term capital gains generally are exempt from withholding, provided the fund reports them as such to investors. This special exemption will expire for taxable years of a fund beginning after 31 December 2011, unless the US Congress extends the effective date, as it has done in the past. Generally, non-US investors are not subject to US federal income tax on gains realised on the exchange or redemption of fund shares.
Funds. See above, Open-ended retail funds.
Resident investors. See above, Open-ended retail funds.
Non-resident investors. See above, Open-ended retail funds.
Recent legal changes potentially affecting retail funds include:
The adoption of amendments to the rules governing money market funds, which are meant to reduce the risks associated with a money market fund's portfolio. In addition, there is a continuing discussion regarding whether to impose floating NAVs or capital buffers for money market funds.
The SEC has issued a concept release (an SEC-approved document that poses ideas to the public to solicit their views) on the use of derivatives by investment companies, indicating interest in reconsidering the application of the ICA to funds' use of derivatives.
The proposal of a new rule and related amendments to replace Rule 12b-1 under the ICA, which would limit cumulative sales charges paid by an investor.
The Supreme Court's ruling in Jones v Harris Associates LP (130 S.Ct. 1418 (U.S. 2010)), which established the standard governing claims of excessive fees under the ICA.
The US hedge fund market is well developed and actively populated by many managers, funds and high net-worth and institutional investors. US hedge fund managers also manage significant assets of non-US investors. According to HedgeFund.Net, total industry assets reached an estimated US$2.459 trillion as of September 2011.
Hedge funds generally experienced rocky performance in 2011, although some new fund launches occurred. As of 31 October 2011, the year to date return of the AR Composite Index, a broad measure of hedge fund performance maintained by industry magazine AR, was estimated to be -0.25%.
The Advisers Act is the primary source of law applicable to hedge fund managers. The Advisers Act imposes substantive requirements on advisers and empowers the SEC to regulate advisers' activities. In addition to the statutes described in Question 2, hedge funds and their managers are subject to other federal and state laws, including the:
Employee Retirement Income Security Act 1974, which governs the management of pension money.
Commodity Exchange Act of 1974 (CEA), which regulates hedge funds and their managers if the fund invests in commodities, futures contracts and certain over-the-counter derivatives.
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank), which, among other things:
substantially alters the registration and reporting schemes under the Advisers Act;
places new restrictions on banks; and
imposes new requirements on over-the-counter derivatives markets and transactions.
See also Question 27.
Hedge funds are typically eligible for an exemption from certain federal securities laws, including the ICA and Securities Act (see Question 19).
The SEC regulates the activity of advisers to funds (see above, Regulatory framework). Also, the Commodity Futures and Trading Commission (CFTC) regulates advisers to (and operators of) funds that invest in commodities, futures and certain over-the-counter derivatives.
Several federal regulators, including the Financial Stability Oversight Council, the Federal Reserve Board of Governors, the CFTC and the SEC, monitor systemic risk of financial institutions including hedge funds (Dodd-Frank). Fund offering documents typically list risk factors related to an investment in the fund.
The SEC emphasises valuation and pricing. Funds generally value securities in accordance with US generally accepted accounting principles (GAAP).
All registered advisers must adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules (Advisers Act).
Hedge fund managers must not engage in market manipulation and insider trading (Securities Act, Exchange Act and Dodd-Frank). Registered advisers must adopt and implement written policies and procedures designed to prevent insider trading.
Limited reporting of public securities holdings is required (see Question 22). In addition, the SEC can require additional reporting, including rules for the assessment of systemic risk (Dodd-Frank) (see below, Short selling).
Most hedge fund managers maintain some sort of anti-money laundering programme, although they are not required to do so.
In addition, the anti-fraud rules of the Advisers Act apply to all US advisers, regardless of registration status (see Question 22).
The SEC must prescribe rules requiring monthly public disclosure of certain information relating to short sales (Dodd-Frank), although these rules have not yet been adopted.
Dodd-Frank prohibits "a manipulative short sale of any security". The SEC has also adopted a rule requiring stock exchanges to prevent short sales of certain stocks at a price that is lower than the current national best bid price if the price has decreased 10% or more from the closing price on the previous day.
Separately, issuer securities cannot be sold short within a restricted period before purchasing the same securities in the issuer's secondary public offering (Rule 105, Regulation M).
Persons who sell interests in any hedge funds must be registered as broker-dealers, subject to certain limited exemptions for issuers who market their own securities. Other jurisdictions may apply similar or different regulations with respect to marketing interests in hedge funds.
Interests in hedge funds are generally offered to US persons under a private placement exemption under the Securities Act.
An offering can be exempt from registration if sales are restricted to accredited investors, generally defined as:
Persons with a net worth of US$1 million (with spouse) or annual income of US$200,000 (US$300,000 with spouse).
Businesses and other entity investors with total assets of US$5 million.
The SEC has proposed an amendment that would exclude the value of an individual's primary residence from the calculation of net worth.
Interests in non-US hedge funds may be exempt from registration if offers and sales are made outside the US to non-US investors, even if those offers and sales are not made in a private placement.
Hedge funds typically operate under one of the following exemptions from ICA registration either:
Interests are privately offered to, and held by, fewer than 100 US beneficial owners.
Interests are only privately offered to qualified purchasers, generally:
persons with US$5 million in investments;
companies or other institutions with US$25 million in investments;
persons investing solely on behalf of qualified purchasers.
Managers to funds that engage in futures and commodities transactions can be required to register as commodity pool operators and commodity trading advisors with the Commodity Futures Trading Commission (CFTC), and become members of the National Futures Association (NFA). In addition, when certain changes enacted by Dodd-Frank become effective, managers that invest in interest rate derivatives, commodity derivatives, or most types of currency derivatives may be required to register. CFTC registrants and NFA members must comply with various disclosure, record keeping and reporting requirements, as well as with other regulations.
An SEC-registered investment adviser is generally prohibited from receiving compensation based on the performance of a client's account unless the client is a "qualified client". Hedge funds typically offer interests in hedge funds solely to such "qualified clients", defined as:
Persons or companies that have at least US$1 million under management with the adviser after making the investment.
Persons or companies that have a net worth of more than US$2 million prior to their investment.
The SEC's proposal to exclude the value of an individual's primary residence from the calculation of net worth is also relevant for the purposes of determining a potential investor's status as a "qualified client".
Local investors investing in a hedge fund must register both:
Funds under the ICA.
The offering of fund interests under the Securities Act.
To avoid this requirement, a fund offering interests to investors in the United States must comply with restrictions outlined in Question 19, Regulation D of the Securities Act and Question 19, Investment Company Act.
In general, a fund that is organised outside the United States must only count its US investors to determine if:
It has fewer than 100 beneficial owners.
All of its investors are qualified purchasers.
Registered advisers must engage a qualified custodian (such as a bank, registered broker-dealer or other financial institution) to hold client assets.
Managers can be exempt from all of the following requirements to:
Deliver quarterly account statement.
Provide notice of the qualified custodian.
Arrange for surprise audits.
This exemption applies if they:
Engage an independent public accountant to perform an annual audit. The accountant must be registered with, and subject to regular inspection by, the Public Company Account Oversight Board.
Distribute financial statements prepared in accordance with GAAP within 120 days (or 180 days for funds of funds) of the end of the fund's fiscal year.
Additional rules apply when an affiliate acts as qualified custodian.
Hedge funds and their advisers must make public filings, including of the following, among other things:
Ownership in public companies above certain specified thresholds set out in the Exchange Act.
Certain exchange traded equity securities, equity options/warrants, shares of closed-ended funds and convertible debt securities (only for advisers qualifying as institutional investment managers with a discretion of over US$100 million in those securities).
Certain large positions.
Form D filings to disclose initial and annual sales of fund interests in the US.
Filings with states under Blue Sky laws.
Filings with the Internal Revenue Service.
Form ADV, the form used by investment advisers to register with the SEC, which requires certain disclosure about:
the types of services offered by an investment adviser;
the adviser's fee schedule;
disciplinary information relevant to the adviser or its employees;
conflicts of interest;
the educational and business background of management and key advisory personnel of the adviser.
In addition, the SEC has adopted substantial new reporting obligations with respect to hedge funds under Form PF. These rules have not yet been finalised (see Question 28). If adopted as proposed:
Hedge fund advisers will be required to file Form PF with the SEC annually.
Advisers managing hedge funds (including certain separately managed accounts) that collectively have over US$1.5 billion in assets under management will be required to file this form with the SEC quarterly. Advisers managing hedge funds with between US$150 million and US$1.5 billion under management will be required to file annually. Advisers with less than US$150 million under management attributable to private funds are not required to file Form PF but are subject to less comprehensive disclosure requirements.
Form PF will require disclosure of the following items, among other things, with respect to each hedge fund:
the fund's investment strategy;
gross and net assets;
percentage of assets managed using high-frequency, computer-driver trading algorithms;
largest creditors;
notional value of derivatives;
number of equity holders;
percentage of the fund owned by certain types of investors; and
monthly and quarterly performance information.
Funds of funds are permitted to provide only a subset of the Form PF disclosure required of other private funds.
Offering memoranda, marketing materials and side letters are not required to be filed with the SEC but are subject to review by the SEC on examination.
All hedge fund managers are subject to Advisers Act anti-fraud provisions. US private fund managers with assets under management above US$150 million generally must register with the SEC (Dodd-Frank) (see Question 27). Managers with separate account clients typically must register with the SEC if they have assets under management above US$100 million. Registration subjects an adviser to various requirements including those relating to custody, advertising, personal trading, record keeping and proxy voting.
Advisers not subject to registration under the Advisers Act can be subject to state registration requirements. Advisers to funds engaging in futures or certain other derivatives transactions can also be subject to registration under the CEA.
Non-US advisers can manage assets of US investors. However, depending on the nature and extent of their US activities, non-US advisers can be required to register with the SEC or otherwise be subject to the Advisers Act in certain respects. Non-US advisers to hedge funds are exempt from registration under the Adviser Act if they:
Have no place of business in the US.
Have, in total, fewer than 15 clients and investors in the US in private funds advised by the adviser.
Have less than US$25 million of aggregate assets under management attributable to such clients and investors.
Do not hold themselves out to the public in the US as an investment adviser or advise funds registered under the ICA.
US hedge funds are typically structured as Delaware limited partnerships or LLCs. These vehicles afford investors limited liability while providing the manager with broad authority (see Question 25). Typically, the fund also enters into a separate management agreement with the manager. Investor interests are referred to as limited partnership interests or membership interests.
The typical structures include a master-feeder structure and a parallel fund structure.
This is where both of the following invests in a master fund, which is typically treated as a partnership for US tax purposes as feeder funds:
A Delaware limited partnership or LLC.
A non-US corporation.
The non-US corporation and the master fund are generally organised in a tax-efficient jurisdiction, such as the Cayman Islands. US taxable investors typically invest in a US feeder fund, and non-US investors and US tax-exempt investors typically invest in a non-US feeder fund.
Advantages. The main advantage of a master-feeder structure is that the adviser can manage a single pool of assets.
Disadvantages. Because the adviser manages a single pool of assets, the master/feeder structure may not permit the adviser to tailor its management of a pool of assets to address the specific tax considerations of the offshore fund and of the investors in the onshore fund.
This is where the manager manages a Delaware limited partnership or LLC, and a non-US corporation, side by side. The non-US corporation is generally organised in a tax-efficient jurisdiction, such as the Cayman Islands.
Managers can also provide advice to investors through separately managed accounts.
Advantages. The main advantage of a parallel fund structure is that the manager can make different investments for the US fund and the non-US fund based on tax or other considerations.
Disadvantages. A parallel fund structure may be more complex to operate due to the administrative burdens associated with allocating trades between different pools of assets pursuing a similar strategy and the problems that may arise where, for example, the securities being traded are in short supply.
Advantages. Onshore structures permit pass-through tax treatment for US taxable investors.
Disadvantages. Disadvantages include:
Taxation of income that can not have been actually received.
Potential adverse tax consequences for US tax-exempt investors and for non-US investors.
Advantages. Offshore structures permit avoidance of potentially adverse tax consequences for US tax-exempt investors and non-US investors (including avoidance of US tax filing requirements for non-US investors).
Disadvantages. Disadvantages include:
Potentially adverse passive foreign investment company and controlled foreign corporation tax treatment for US taxable investors.
Information reporting requirements.
There is no federal entity level tax on domestic/onshore funds, so long as they are treated as partnerships and not as publicly traded partnerships for US income tax purposes (which can be taxable as corporations in certain circumstances). An offshore fund formed as a non-US corporation or partnership that is taxed as a corporation for US income tax purposes is subject to:
Net-basis US tax and, in certain circumstances, an additional branch profits tax on the fund's share of income that is, or is treated as, effectively connected with a US trade or business (ECI) conducted by the fund.
US withholding tax on US corporate dividends and certain other US source income that is not ECI.
From 2014, a US withholding tax on a broad range of US-source withholdable payments. This will generally not apply if the fund enters into a withholding/reporting agreement with the US Treasury.
A taxable US investor reports on its own tax return its distributive share of the fund's annual taxable income or loss, regardless of whether distributions are received. The tax character of the income or loss also generally passes to the investor.
Non-US investors and US tax exempt entities typically invest through an offshore corporation, generally to avoid:
Direct US tax on ECI and, for non-US investors, the obligation to make tax filings in the US.
Unrelated business taxable income on the part of the US tax exempt entities.
For the relevant tax rates, see Question 13.
Investors can usually redeem periodically (that is, monthly or quarterly) with prior notice. Redemptions can be subject to:
Lock-up periods.
Fees.
Gates.
Suspensions.
Reserves.
Transfers are typically restricted and require prior approval by the general partner or manager.
Dodd-Frank was signed into law on 21 July 2010 for the purpose of preventing future financial crises. It effected sweeping changes to the overall US regulation of the financial services industry, including hedge funds. It:
Generally requires advisers with at least US$150 million under management to register as investment advisers with the SEC by 30 March 2012.
Places new restrictions on banks, known as the Volcker Rule, that limit a bank's ability to trade its own capital and invest in hedge funds and private equity funds.
Many other rules have been proposed under Dodd-Frank but have not yet been adopted. These rules include the Volcker Rule, which would limit the proprietary trading and private investment fund activities of US banks and their affiliates, and substantial new regulations on over-the-counter derivatives. Many industry participants have commented on these rules. It is likely that some of these rules will be revised substantially before they are issued in final form. As a result, the full impact of these new requirements remains unclear.
T +1 212 497 3636
F +1 646 728 1576
E bryan.chegwidden@ropesgray.com
W www.ropesgray.com
Qualified. US (Massachusetts), 1987; US (New York), 2004
Areas of practice. Co-head of the firm's investment management practice.
Recent transactions
T +1 617 951 7367
F +1 617 235 0483
E james.thomas@ropesgray.com
W www.ropesgray.com
Qualified. US (Massachusetts), 1997
Areas of practice. Investment funds and investment advisers.
Recent transactions
T +1 212 596 9017
F +1 646 728 6225
E sarah.davidoff@ropesgray.com
W www.ropesgray.com
Qualified. US (New York), 1997
Areas of practice. Private investment funds and investment advisers.
Recent transactions
