Avoiding Registration: Limits of the Lockup Loophole

By Maria Trombly | Securities Industry News | January 1, 2006

There are three ways for a fund to avoid the Securities and Exchange Commission's Feb. 1 registration requirement: having less than $25 million in assets under management or fewer than 15 U.S. investors, or by imposing a two-year minimum investment period for investors.

Deliberately staying small is not going to be an attractive option for legitimate hedge fund managers, experts say. "Nobody wants to go through life having under $25 million, because you want to make a living," says Chris Wells, a partner at Proskauer Rose and one of the country's top hedge fund attorneys. "It will make your life obnoxious, and you won't be able to achieve what you want to achieve."

Under SEC rules, advisers with less than $25 million in assets cannot register. Those with over $30 million must register. For advisers in between, registration is optional.

Even if a fund decides to go the small-is-beautiful route, it might run into regulation at the state level. "Under $25 million, you're subject to state registration," says Wells. "The SEC wanted to relieve itself of responsibility for smaller hedge funds and give it to the states. And, frankly, people would rather deal with the SEC because the state rules are worse."

Another attorney maintains that a hedge fund could avoid compliance for "a substantial amount of time" if there are no investor complaints or mentions in the press, because of the SEC's lack of staff. But Wells says that if a fund came to him and asked for advice about how to do this, he wouldn't help them: "If you're a hedge fund and you have 15 U.S. investors, you have to register."

An offshore fund that tries to duck SEC registration might find itself in trouble at home, adds John Langan, counsel at the London office of Bryan Cave LLP, an international law firm headquartered in St. Louis. "If the SEC found out that you were not registered with the SEC when you were obligated to be registered, they would probably get in touch with the FSA [the U.K.'s Financial Services Authority]," he says. The FSA has had rules in place for authorization of hedge fund managers since the late 1980s that are even stiffer in places than SEC requirements, notes Langan.

Since his clients already have to register with the FSA and submit to those requirements, the majority view is that they will go ahead and register with the SEC, he says.

The only break offshore funds get is that they're one step removed from U.S. investors where their direct client is an offshore hedge fund. Then, they only have to comply with "registration lite." This means that they still need to register and be subject to SEC inspections and investigation, but they do not have to comply with the "registration heavy" rules about archiving e-mails and monitoring trades that apply where there is a direct relationship with a U.S. person, Langan says.

But there is a fully legal way to avoid registration entirely. Wells says he's already helping fund managers to do this by requiring a two-year lockup of investors' money. The loophole came about, Wells explains, because the SEC doesn't want to have to oversee private equity funds such as venture capital funds. Investors usually put their money in these funds for periods of five years or more and promise not to touch it. The fund then invests directly in early-stage start-up companies, for example.

The assets that these funds trade in are not liquid. By comparison, most hedge funds trade in highly liquid assets such as stocks, bonds, commodities, derivatives and swaps.

The percentage of hedge funds going for the two-year lockup to avoid registration is not large, says Wells, and is limited mostly to large funds. "Some of the bigger hedge funds--especially those that are not looking for new clients anyway--are adopting the two-year lockup to avoid registration, including some of my clients," he says. "There's nothing wrong with what they're doing. It's just a factor of the way the rule is written."

The downside to the two-year lockup could be that potential investors might not want to do business with a hedge fund that's not registered. "I think it would possibly be a red flag," says George Lucaci, managing director of the capital markets group at New York-based Channel Capital, which raises money for hedge funds and also performs due diligence.

Bryan Cave's Langan also notes that the SEC might close the two-year lockup exemption if it finds that hedge funds are abusing it.

For fund advisers that do register, those that adopt tighter oversight practices than the minimums required by the SEC had best not spell them out in detail on paper, attorneys warn. Otherwise, they will be forced to comply with the written standards rather than the regulatory minimums. "While I typically see that companies may do more [than the SEC requires], you won't find it in writing in their internal procedures," says Cheryl Moore, a securities law partner at Dallas-based Patton Boggs who currently represents about a dozen hedge fund clients. "Frankly, that's because of the nature of the relationship with regulators. There's so little give, so little understanding of what it's like to do business."

(c) 2005 Compliance and SourceMedia, Inc. All Rights Reserved.

http://www.securitiesindustry.com/stp/ http://www.sourcemedia.com