THE NATIONAL SECURITIES MARKETS IMPROVEMENT ACT OF 1996 -- DEFINING MOMENT FOR THE HEDGE FUND INDUSTRY?

Charles J. Gradante and E. Lee Hennessee May 1996

On October 11, 1996, President Clinton signed the National Securities Markets Improvement Act of 1996 ("NSMIA"). NSMIA has been modestly described by its sponsors as the "first major overhaul of securities law in 60 years". Its goals are: (a) to keep U.S. securities markets efficient and competitive with foreign markets; (b) to reduce the costs of capital formation by eliminating duplicative regulation; (c) to reallocate regulatory responsibility between federal and state "blue sky" regulators; and (d) to improve mutual fund regulation.

However, perhaps the most interesting aspect of NSMIA is that it provides a number of crucial amendments to the Investment Company Act of 1940 (the "Act"), the result of which could and should provide sweeping reform to the hedge fund industry (the "Industry"). Among its most significant consequences are that: (1) it removes the "100 person" limit for certain investment funds; (2) it introduces a non-integration safe-harbor permitting two funds run by the same management to operate side by side even if the two have identical investment programs; and (3) it includes a "grandfather" clause which enables funds which were established before these new laws to convert and be covered by the expanded exemptions.

Clearly, the intent of Section 3(c)(7) is to enable previously denied "high quality" institutions and investors due to legal restraints, access into the hedge fund community. Given that institutions currently comprise less than $3 billion of hedge fund capital, and given that the institutional capital exceeds $16 billion, the notion of this new "investor" into the hedge fund universe is indeed encouraging to the growth of the hedge fund industry.

The ultimate historical importance of this reform, however, may be its unintended consequences -- the first step towards "de-mystifying" the "murky" world of hedge funds via greater investor participation. Although hedge fund investing is still limited to, at a minimum, "Accredited Investors", NSMIA should indirectly trigger lower minimums by managers, since they could establish a 3(c)(1) fund with low minimums, and then when their investor limit hits 99, simply create a parallel (3)(c)(7) fund without fear of integration by the SEC. Lower minimums will encourage more "Accredited Investors" to invest and to be accepted. Ultimately, although quite a bit away, as more and more "Accredited Investors" become hedge fund investors, it is logical that a new class of "acceptable investors" lower than "Accredited" may, with proper regulation, be permitted to invest in hedge funds, the result of which would vastly expand the Industry's capital base. And, it is quite possible that the "99 Limit" may be dropped to enable widespread hedge fund investing.

Whatever the outcome, it is clear that this legislation may be as historic as it claims to be.

LEGAL BACKGROUND

Section 3(c)(1) of the 1940 Act

Investment companies are governed by The Investment Company Act of 1940 (the "1940 Act"). The 1940 Act was promulgated to protect investors by requiring such companies to go through a significant registration and disclosure process. However, recognizing that certain investors did not need these protections, Section 3(c)(1) was established to except investment companies whose outstanding securities are beneficially owned by no more than 100 persons, and which are not and do not presently intend to make a public offering of their securities. Many of these private investment vehicles which qualify as a 3(c)(1) exemption are organized as hedge funds, which are investment pools that invest on a hedged or non-hedged basis in domestic and foreign securities, commodities and other investments.

The practical application of the 3(c)(1) exception has been burdensome to both regulators and sponsors of private investment companies alike. From a practical perspective, Section 3(c)(1) frustrated the development of the Industry. To place an arbitrary limit on investor participation has not only been bad policy, but has also encouraged funds and investors to circumvent the law, through cleverly developed technicalities. Although the statute foresaw these problems and the Securities and Exchange Commission ("SEC") developed tests to prevent such actions, due to the inherent complexities of the 3(c)(1) exception, the statute has not only failed in its objective, but has been costly and time consuming to regulate.

As a result of these frustrations, but most importantly due to the recognition that large scale capital participation by sophisticated investors in private investment companies were frustrated by the requirement of 3(c)(1), NSMIA with its Section 3(c)(7) was enacted.

For issuers whose securities are owned exclusively by sophisticated investors, the public offering prohibition and 100 investor limit are unnecessary constraints not supported by sufficient public policy concerns. Therefore, the Division recommends an amendment to the Investment Company Act of 1940 to create new exceptions for funds whose securities are held exclusively by qualified purchasers as defined by the rule.

Section 3(c)7: A New Exception For Private Pool Investing

There are four basic components of new Section 3(c)(7). First, in stark contrast to 3(c)(1), 3(c)(7) allow for the creation of hedge funds with unlimited partners, so long as each partner is a "Qualified Purchaser". While yet to be finalized, conceptually, a "Qualified Investor" is simply a super-rich "Accredited Investor". Specifically, it is:

(a) A natural person who owns at least $5 million in investments. (The SEC has 180 days to define "investments"). (b) A family controlled company which owns at least $5 million in investments. (c) A trust fund managed by "Qualified Investors" that was not expressly formed for the purpose of satisfying 3(c)(7).

Second, the new laws allow for those hedge funds established under 3(c)(1) to also exceed the "99 Investor" limit and convert to 3(c)(7) funds so long as all new investors after September 1, 1996 are "Qualified Purchasers", and that certain procedural matters have been satisfied. In effect, those previously closed funds will be able to convert and re-open.

Third, the new laws eliminate the 3(c)(1) concept of integration as it pertains to parallel 3(c)(1) and 3(c)(7) funds. Although the SEC will still apply the integration test with respect to parallel 3(c)(1) funds, it will not apply the test if one of the parallel funds is a 3(c)(7). Thus, a manager may set up funds with identical investment objectives so long as one is a 3(c)(7).

Fourth, the new laws amend the first "look through" test of 3(c)(1) thereby permitting non- registered investment companies that are not 3(c)(1) or 3(c)(7) funds to acquire more than 10% of a 3(c)(1) or 3(c)(7) fund without being subject to the "look-through" test, and thus being counted as multiple investors. It also eliminates the second test-- that an investor may invest only up to 10% of its assets in 3(c)(1) funds. Thus, for entities such as pensions and endowments, this represents a significant opportunity to get involved with 3(c)(1) funds, since they will now only represent 1 investor. However, the "look-through" test remains in effect for 3(c)(1) or 3(c)(7) funds.

As a smaller consequence, the new rules will permit the SEC to establish guidelines which would permit "knowledgeable employees" of the hedge fund, or an affiliated person of the hedge fund to invest in the 3(c)(1) fund without increasing the investor count and in the 3(c)(1) without violation of the 3(c)(7) fund.

Tax Issue Alert

While the tax implications have yet to be finalized, it is clear that the intent is not to afford Section 3(c)(7) funds with the same tax protections of Section 3(c)(1) partnerships. However, what is unclear is what the tax consequences will be. It is contemplated that converted 3(c)(1) and newly established 3(c)(7) funds will be considered by the Internal Revenue Service as "Publicly Traded Partnerships" ("PTP") and be taxable as a corporation. However, it is also clear that "carve-outs" for 3(c)(7) funds with only once a year redemption rights as well as other exceptions are being contemplated as ways the PTP may still gain certain tax advantages. Stay tuned.

IMPLICATIONS FOR HEDGE FUNDS

Big Winner: Institutional Investors

New Act Enables Full-Scale Invasion by Institutions into the Hedge Fund Arena

The expressed intent makes it clear that these reforms are to enable highly qualified investors, such as institutions, which have been previously unable to invest in hedge funds due to the "look-through", the "ten-percent rule" or because funds were closed, to gain investing access to hedge funds. If the institution wants to invest with a hot, but closed manager, that manager may open a new 3(c)(7) or convert its 3(c)(1). Either way, previously frustrated institutions will now be able to dive into hedge fund investing.

Big Winner: Previously Closed, But "Hot in Demand" 3(c)(1) Funds

New Act Permits 3(c)(1) Funds To Convert To a 3(c)(7) and Exceed "99 Investor" Rule

The previously closed "hot" 3(c)(1) fund will now be able to convert and "re-open" as a 3(c)(7) fund. It is currently estimated that around 200 funds are presently closed due to partnership limits. Coupled with the fact that it will now have access to billions of new investing dollars, the positive impact of this legislation can only be described as a major victory for marquee hedge funds. There are indications that some of the leaders have already begun to move on this notion. Julian Robertson's $7.5 billion Tiger fund, which has been closed for some time, is now expected by many to reopen sometime in 1997.

Winner: Start-Up Hedge Funds

New Act Allows Easier Access To Capital For Start-Up Hedge Funds

For once however, not only the "strong will get stronger". One of the major barriers to entry in the Industry, is that start up funds are often caught in the dilemma of when to accept capital. If it established too high a minimum it might not attract investors. If it was too low, it might close out due to the "99 Investor" limit with much less capital than its potential. No more fear, NSMIA is here. Now, a start-up could set up a 3(c)(1) fund with low minimums and then when it caps-out, to simply establish a 3(c)(7) fund without fear of integration, a concept which prohibited such parallel funds under 3(c)(1).

Winner: The 3(c)(1) Fund Desiring Big Investors, Yet Wishing to Remain a 3(c)(1): S

New Act Will Enable Certain Entities To Invest Without Being Counted as Multiple Investors

The new law benefits those 3(c)(1) funds wishing to retain their 3(c)(1) special status but yet eager to attract investors with large pools of capital, by permitting certain types of entities, such as endowments and foundations to be counted as one investor. Previously, such investors were subject to "look-through" tests, and if they owned more than 10% of the fund's assets, they would be counted as multiple investors.

Winner: "Accredited" But Not "Qualified Investors"

Under the old regime, only "Accredited Investors" could invest in hedge funds. However, due to the "99 Investor" rule, they were often unable to gain access due to either a fund's decision to have high minimums (since they were limited in number of investors), or because many were closed. After all, if given the choice between a $1,000,000 and $250,000 investor, and there was only one spot, it is fairly obvious who would be accepted. Now, many funds which may have been either unwilling or unlawfully able to accept these investor's might now find a place for them. However, it is not a major victory for this class of investor yet, because 3(c)(7) or converted 3(c)1 funds are only permitted to take "Qualified Investors". The one area that these investors will be able to gain access is to new start-up funds.

Mixed Verdict: Fund of Funds

As a by-product, the fund of funds stands to gain from increased institutional participation. Yet, it is conceivable, that many "Accredited Investors" who opted for the fund of funds because they were unable to get into a fund which was either closed or which had high minimums, might now be able to go straight to that fund. As a result, it is too early to tell what the outcome on the fund of funds might be.

Little Affect: Distressed and Value Managers

Not all investment styles will be affected the same. For example, small-cap players need to keep their assets under management down in order to stay nimble. Many believe that big does not necessarily mean better.

Loser: The Mid-Size Fund Hoping to Grow Into The "Mega-Fund"

If there is a losing participant, it will probably be the mid-size fund hoping to grow to a "mega-fund". By way of example, many "Qualified Investors" who may have wanted to get into a mega-fund but couldn't because it is closed, may now be able to. As a result, there may be a flight of capital from those near giants, to the giants.

CONCLUSION:

The trend is obvious, and the historical consequences are clear. The U.S. is the last G-7 nation whose investors do not culturally embrace the concept of "hedging". One day it is quite conceivable that the notion of "hedging" will be considered the prudent method to invest. With increased volatility, and the increased maturation of the Industry, hedge funds may prove safer bet than mutual funds in the years to come. After all, few would disagree that the U.S. equity market is frothy, so why not hedge while participating in a pricey market. It's simply prudent to have insurance against a market decline at the moment. Finally, with the improved sophistication of investors, many of the former safeguards to protect investors from hedge fund investing are obsolete.

Whether or not history takes this course, only time will tell. But one thing is for certain --this legislation will dramatically reshape the landscape of the hedge fund industry. Whether, due to new institutional or retail capital, it is quite possible that NSMIA has placed the Industry at a historical crossroads, and, it may never be the same.

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