HEDGE FUNDS
LAWS FOR ADVISERS & FUNDS
REGISTERED INVESTMENT ADVISORS (RIAS)
CALIFORNIA RULES
The bad news is that there is no way for a California resident to set up a hedge fund without being a Registered Investment Advisor (RIA).
You can register as an RIA with the SEC, but only after you reach $25 million under management. You are required to register with the SEC when your assets under management reach $30 million.
Below the $25 million-under-management level, you must register as an
RIA in California.
Aren’t there any exemptions?
Forming your hedge fund entity in some other state, as long as you are
a resident, has no impact on the California regulations. You could move
to a different state, but that does not seem to be a reasonable option.
If you moved to a different state and ended up with more than five California
clients, you would still be affected by at least some of California's
regulations.
This analysis is based on the California Corporations Code and miscellaneous
references from the state of California Web site.
What are the Minimum Financial Requirements? And What Happened
to what were known as the Disbursement Procedures?
Investment advisers in California who have custody of client funds or
securities must maintain minimum net worth of $35,000. This is not a fee,
but it can be viewed as a type of a security deposit. The SEC is adopting
new amendments to the custody rule under the Investment Advisors Act of
1940. The amendments are effective November 15, 2003, and all SEC-registered
RIAs must be in compliance by April 1, 2004. Among other things, the amendments
define the term “custody”. An adviser has custody of client
assets when it holds , “directly or indirectly, client funds or
securities or (has) any authority to obtain possession of them.”
Our interpretation of the rule is that almost all hedge fund managers
will be considered to have custody of client assets.
See this web page for more details on the new amendments http://www.greencompany.com/HedgeFunds/Registration.shtml.
In the amendments to the rule the SEC has withdrawn the PIMS/Bennett no-action letters regarding disbursement procedures. While these amendments are currently effective for SEC-registered RIAs, we believe California may change the rules to follow SEC guidance. If you have specific questions – talk to us – we can help.
See this web page for more data on the new SEC rule regarding Custody:
http://www.sec.gov/rules/final/ia-2176.htm
How many investors can I have?
Under a typical Form D filing under Rule 506, you can have as many as
100 investors, of which as many as 35 can be non-accredited. California
wants to make it unpleasant for you to accept non-accredited investors.
One staff member from the California Department of Corporations that audits
California hedge funds indicated that the average hedge fund in California
has only one or two non-accredited investors and suggests that the number
of non-accredited investors not exceed 10. One of the ways the state makes
it hard on you to accept non-accredited investors is that you cannot charge
a performance allocation to your non-accredited investors. You can only
charge the same management fee that you charge to your accredited investors.
What makes someone accredited?
Here is another situation that makes California a bit challenging. Under
a Rule 506 filing under Regulation D of the Securities Act of 1933, accredited
investors are those with more than $1 million in assets or those with
income exceeding $200,000 for each of the two prior years (there are other
types of accredited investors, but these two are the most common for individuals).
California requires that accredited investors meet the more stringent
rules under the Investment Advisors Act of 1940. For California, accredited
investors must have more than $1.5 million of net worth (combined with
their spouse, if married). There is an additional provision that an investor
with $750,000 invested in the fund is an Accredited Investor. However,
California puts a restriction in that the investor's interest in the fund
should not exceed 10 percent of the investor's net worth.
What is the process to become an RIA?
This web
page is a publication that provides some basic information regarding
the process of applying for RIA status in California. There are two other
related web pages that supply additional information on the topic:
Information
To Assist Persons Apply For An Investment Adviser Certificate Post Effective
Requirements
The
Most Overlooked Items When Completing Investment Advisor Application
Basically, you need to pass the Series 65 NASD examination and need to
complete a Form ADV (it’s 73 pages on paper, but it is best completed
electronically at www.iard.com).
Completing the 73 pages of the Form ADV will be an arduous task. We can
help you get through the hassle with a minimum of pain on your part.
Can GreenTraderTax.com help?
Since most states are not requiring hedge fund managers to become RIAs
(yet), the process of helping you prepare the various applications is
not part of our hedge fund formation fee. If you want us to help in completing
the Form ADV, plan on about $1,500 for our time (the SEC estimates that
it will take a knowledgeable user more than nine hours to complete the
form).
Conclusion
California has put up some barriers to setting up a hedge fund. They are
not insurmountable, but they are a bit of a pain. We can help you minimize
the pain and set up your fund all at the same time.
Supporting Information:
You may be interested in reviewing some of the numerous sites from which
this information was derived:
California
Corporations Code Sections 25200-25209
California
Corporations Code Sections 25230-25238
California
Code of Regulations Section 260.234
California
Code of Regulations Section 260.236
California Department of Corporations http://www.corp.ca.gov/