Top Ten Things Every Fund Formation Attorney Should Know in the Current Legal Market

Whether working in-house at a fund manager or in private practice advising those fund managers, fund formation attorneys play a pivotal role in the financial industry, navigating complex regulatory landscapes, structuring funds, and ensuring compliance with numerous legal requirements. Fund formation is an intricate, nuanced, and dynamic field, requiring that attorneys have a deep understanding of various legal, regulatory, and market considerations. Discussed briefly here are the top ten things every fund formation attorney should know, providing relevant legal citations and comprehensive explanations as a gateway for the practicing attorney’s further study.

1. ????? Regulatory Compliance and the SEC

Regulatory compliance is the cornerstone of fund formation. Attorneys must navigate the requirements set by the Securities and Exchange Commission (SEC) to ensure funds operate within legal boundaries. The Securities Act of 1933 governs the initial offering and sale of securities to the public, requiring registration or exemption from registration (15 U.S.C. § 77a et seq.). This Act ensures that investors receive significant information about securities being offered for public sale and aims to prevent fraud in securities transactions. The Securities Exchange Act of 1934, on the other hand, regulates secondary trading of these securities (15 U.S.C. § 78a et seq.), ensuring market transparency and fairness. Furthermore, the Investment Company Act of 1940 and the Investment Advisers Act of 1940 impose additional regulations on investment companies and advisers (15 U.S.C. §§ 80a-1, 80b-1 et seq.).

Fund attorneys must guide clients through the registration process or advise on available exemptions, ensuring proper disclosure of material information to investors, adherence to antifraud provisions, and compliance with specific rules related to advertising and communications. This involves understanding the nuances of SEC rules and interpretative guidance, which are crucial for maintaining compliance and avoiding legal pitfalls.

2. ????? Private Placement Exemptions

Private placement exemptions under Regulation D are essential for raising capital without undergoing the full SEC registration process. Regulation D offers several exemptions, including Rule 504, Rule 506(b), and Rule 506(c) (17 C.F.R. § 230.501 et seq.). Rule 506(b) allows issuers to raise unlimited capital from accredited investors and up to 35 non-accredited investors without general solicitation (17 C.F.R. § 230.506(b)). In contrast, Rule 506(c) permits general solicitation but requires all investors to be accredited, with reasonable verification steps (17 C.F.R. § 230.506(c)).

Understanding these rules helps in structuring compliant private offerings. For instance, under Rule 506(b), the absence of general solicitation means that fund offerings cannot be publicly advertised. Verification of accredited investor status under Rule 506(c) involves specific steps such as reviewing tax documents or bank statements. Attorneys must navigate these nuances to ensure successful fund formation and capital raising.

3. ????? Fund Structuring and Tax Considerations

Effective fund structuring optimizes tax efficiency and aligns with investor needs and regulatory requirements. This often involves forming limited partnerships (LPs) or limited liability companies (LLCs). The Internal Revenue Code governs federal taxation, including partnership tax rules and provisions affecting investment funds (26 U.S.C. §§ 701-777).

Key considerations include pass-through taxation, where income is taxed at the partner level rather than the entity level, avoiding double taxation. The allocation of profits and losses must comply with IRS regulations and meet the economic interests of investors. Structuring decisions also impact state tax obligations and potential international tax implications, requiring coordination with tax advisors to minimize the tax burden on the fund and its investors.

4. ????? Anti-Money Laundering (AML) Requirements

Funds must implement robust AML programs to detect and prevent money laundering activities, complying with federal regulations and international standards. The Bank Secrecy Act (31 U.S.C. § 5311 et seq.) requires financial institutions, including investment funds, to maintain AML programs. The USA PATRIOT Act expands AML obligations, including customer identification and due diligence requirements (Pub. L. No. 107-56, 115 Stat. 272).

AML compliance involves establishing policies and procedures for customer due diligence, suspicious activity monitoring, and reporting to the Financial Crimes Enforcement Network (FinCEN). Attorneys must ensure that funds have appropriate AML controls and training programs in place to mitigate risks. This includes conducting risk assessments, implementing record-keeping requirements, and staying updated with evolving AML regulations and guidelines.

5. ????? International Considerations

Global fund managers must navigate regulatory environments across multiple jurisdictions, necessitating familiarity with international laws and treaties. The Alternative Investment Fund Managers Directive (AIFMD) regulates hedge funds, private equity funds, and other alternative investment funds in the EU (Directive 2011/61/EU). The Markets in Financial Instruments Directive (MiFID II) enhances transparency and investor protection in the EU financial markets (Directive 2014/65/EU).

Additionally, the Foreign Account Tax Compliance Act (FATCA) requires foreign financial institutions to report on the holdings of U.S. taxpayers (26 U.S.C. §§ 1471-1474), while the OECD Common Reporting Standard (CRS) facilitates the automatic exchange of financial account information between participating jurisdictions.

Attorneys must advise on cross-border fundraising, including passporting rights under AIFMD and compliance with MiFID II's stringent disclosure and reporting requirements. Understanding the implications of local laws on fund operations and investor relations is essential, as is staying abreast of international regulatory developments.

6. ????? Environmental, Social, and Governance (ESG) Criteria

ESG investing is gaining prominence, with regulators and investors demanding greater transparency and accountability regarding ESG factors. The Sustainable Finance Disclosure Regulation (SFDR) imposes disclosure requirements on financial market participants in the EU regarding sustainability risks and impacts (Regulation (EU) 2019/2088). The EU Taxonomy Regulation establishes criteria for environmentally sustainable economic activities (Regulation (EU) 2020/852).

Attorneys must guide funds in integrating ESG criteria into their investment processes and ensuring compliance with disclosure obligations. This involves developing policies for assessing and managing ESG risks, reporting on sustainability impacts, and meeting investor expectations for ethical and responsible investment practices. The SFDR requires detailed disclosures on how sustainability risks are integrated into investment decisions, while the EU Taxonomy provides a framework for determining the sustainability of investments.

7. ????? Cybersecurity and Data Privacy

Protecting sensitive investor information and ensuring data privacy is critical in the digital age. Compliance with data protection laws is mandatory. The General Data Protection Regulation (GDPR) sets stringent data protection standards for entities handling personal data of EU residents (Regulation (EU) 2016/679). The California Consumer Privacy Act (CCPA) provides California residents with rights regarding their personal information and imposes obligations on businesses handling such data (Cal. Civ. Code § 1798.100 et seq.).

Attorneys must ensure that funds implement robust cybersecurity measures and comply with data protection laws, including obtaining necessary consents, providing transparency about data usage, and responding to data breaches. This also involves drafting and reviewing privacy policies, data processing agreements, and conducting privacy impact assessments. GDPR, for example, mandates data protection by design and by default, requiring stringent measures to protect personal data. The CCPA grants consumers rights such as the right to know, the right to delete, and the right to opt-out of the sale of personal information.

8. ????? Fiduciary Duties and Governance

Fund managers owe fiduciary duties to their investors, including duties of care, loyalty, and good faith. Effective governance structures support compliance with these duties. The Investment Advisers Act of 1940 imposes fiduciary duties on investment advisers, including fund managers (15 U.S.C. § 80b-1 et seq.). The Delaware General Corporation Law (DGCL) governs the fiduciary duties of directors and officers in Delaware corporations (8 Del. C. § 141 et seq.). The Uniform Limited Partnership Act (ULPA) provides a framework for limited partnerships, including fiduciary duties of general partners.

Attorneys must advise on establishing governance frameworks that ensure fund managers act in the best interests of investors. This includes creating policies for conflict-of-interest management, ensuring transparency in decision-making, and maintaining accurate records. Fiduciary duties under the Investment Advisers Act require advisers to put clients' interests above their own, disclose conflicts of interest, and provide full and fair disclosure of material facts. The DGCL and ULPA provide additional governance standards for entities organized under these frameworks.

9. ????? Fundraising Strategies and Investor Relations

Effective fundraising strategies and strong investor relations are crucial for a fund's success. This involves navigating regulatory constraints and managing investor expectations. SEC no-action letters provide guidance on permissible fundraising activities and the use of side letters (SEC No-Action Letter, ABA Subcommittee on Private Investment Entities, 1996). Regulation A allows smaller companies to raise capital from the public with simplified reporting requirements (17 C.F.R. § 230.251 et seq.). Regulation Crowdfunding enables eligible companies to raise capital through crowdfunding (17 C.F.R. § 227.100 et seq.).

Attorneys must craft compliant fundraising strategies, including drafting private placement memoranda (PPMs), subscription agreements, and side letters. They must also advise on managing investor relations through clear communication, addressing investor inquiries, and ensuring adherence to representations made during the fundraising process. SEC no-action letters provide critical guidance on issues such as the permissible scope of side letters, which often include terms that modify the standard terms of the fund offering for specific investors.

10. ??? Technological Innovations and Fintech

The rise of fintech and blockchain technology presents new opportunities and regulatory challenges for fund formation. The Securities Exchange Act of 1934 applies to digital assets and securities trading on blockchain platforms (15 U.S.C. § 78a et seq.). The Howey Test determines whether an instrument qualifies as an investment contract under federal securities laws (SEC v. W.J. Howey Co., 328 U.S. 293, 1946). The SEC Framework for “Investment Contract” Analysis of Digital Assets provides guidance on applying the Howey test to digital assets (SEC Release No. 33-10649, April 3, 2019).

Attorneys must understand how to integrate fintech solutions into fund operations, such as using blockchain for efficient record-keeping and transactions, and navigating the regulatory landscape for digital assets. This includes advising on compliance with securities laws, ensuring proper disclosure of risks associated with digital assets, and staying updated on regulatory developments in the fintech space.

Conclusion

Staying abreast of these ten key areas is crucial for fund formation attorneys to navigate the complex and evolving legal landscape. Mastery of regulatory compliance, tax considerations, international laws, ESG criteria, data privacy, fiduciary duties, fundraising strategies, and technological innovations is essential for successfully guiding clients in the formation and operation of investment funds. By understanding and addressing these critical areas, attorneys can help their clients achieve regulatory compliance, optimize operations, and meet investor expectations in a dynamic market.

? Copyright Edward W. Little, Jr., Esq., Algin Consulting LLC, 2024.