PrintEvolutionary theory includes a vacant-niche hypothesis that new species sometimes arise when evolution fills a niche that had sufficient available resources but was not already been occupied by another organism. Darwin’s observation of the evolution of finches to fill different available niches distributed among the Galapagos Islands was an example, as was the evolution of a number of Australian marsupials to resemble species that evolved elsewhere to fill comparable vacant-niches.
Similarly, the gap created by the combination of exemptions from registration under the 33 Act, the 34 Act, the Advisers Act, the Commodity Exchange Act (CEA), and the 40 Act created a opportunity rich vacant-niche that played a key role in the development of hedge funds. This article will analyze the substance of those exemptions, the application of each to hedge funds, and the ways in which they have determined some of the more distinctive structures and practices adopted as standard practice by the industry. Other articles (or, more likely, a series of articles) will analyze the changes in such standard practices, as legislation limits or removes one or more of the exemptions. To date, there are proposals by Congress and the Administration to close or limit the Advisers Act and 40 Act exemptions.
Without exemptions, a hedge fund and its adviser would be required to register under four or five statutes, depending on whether it invested in commodities. Hedge funds are usually limited partnerships; ownership interests in LPs are classified as securities under the 33 Act, and so that Act would require registering the funds’ shares with the SEC before any sales or offers to sell, and the 34 Act would impose a registration requirement while the shares were outstanding.
As companies primarily engaged in the business of investing the pooled assets of investors in securities, hedge funds are investment companies as defined in the 40 Act and as such would be required to register under that Act, and as Commodity Pool Operators (CPOs) under the CEA if they trade instruments regulated by the CFTC. And finally, the management company directing investment of the funds is a business compensated for advising others concerning investments in securities, making it an investment adviser under the Advisers Act, and potentially a commodity trading adviser (CTA) under the CEA, each of which would require registration under the respective Act.
A simplified view of the general structure typically used to issue and manage hedge funds, and the corresponding exemptions from SEC registrations, is shown in the diagram below and in greater detail in the table at the end of this article.
Each of the five statutes, however, includes one or more exemptions from registration that were originally designed to limit their impact on firms presenting limited risk either because they were too small, or because they served clients who needed less protection. Each exemption was adopted independently, at different times and in statutes designed to address different issues. The hedge fund industry has used them in combination to create a business niche that has enabled them to invest differently, and arguably more successfully, than registered firms while restricting the ability of registered firms to compete – in short, they’ve used them to create a fertile vacant-niche.
The relevant exemptions under the five Acts, and their application to hedge funds, are analyzed below.
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