The landmark opportunity zone incentive marries tremendous tax benefits with economic development. Experienced and first time fund ‘sponsors’ alike are learning the intricacies of organizing a qualified opportunity fund (QOF) to gather investments, improve communities, and hopefully reap the rewards of investing in startups, growing and established businesses, and real estate-centric projects. Many have raised capital for other initiatives and know the definition of ‘accredited investor’ by heart. But with all of the attention to the Section 1400Z-1 and -2 of the Internal Revenue Code (OZ Incentive) and several rounds of Department of Treasury guidance, all QOF sponsors and managers should reacquaint themselves with the securities laws. [1]
Being mindful of what constitutes a ‘security’ is fundamental to understanding how the securities laws apply to a QOF and its management. This is especially true since the OZ Incentive encourages the use of a dual-tier structure for purposes of the working capital safe harbor. Under the dual-tier structure, substantially all of the QOF’s assets consist of interests in one or more lower-tier qualified opportunity zone business entities, namely opportunity zone stock (OZ Stock) and qualified opportunity zone partnership interests (OZ Partnership Interests). With this dual-tier structure, the QOF regulatory position more closely resembles a hedge fund than a traditional operating company or real estate investment vehicle.
THE REGULATORY LANDSCAPE
Four primary acts embody the core of the federal securities laws. Funds and their managers must comply with each of them. First, and most famous, is the Securities Act of 1933 (Securities Act), which regulates the offer and sale of securities, including interests in the QOF. Regulation D, which provides the “accredited investor” exemption utilized by most QOFs and operating companies, stems from the Securities Act. Next, the Securities Exchange Act of 1934 governs secondary trading of securities (like in the stock market, for example). It is less relevant to most QOFs. The Investment Company Act of 1940 (Company Act), however, regulates “investment companies,” including more broadly-held QOFs, potentially. Lastly, and perhaps of greatest need for attention, is the Investment Advisers Act of 1940 (Advisers Act). The Advisers Act regulates “investment advisers” and requires Securities and Exchange Commission (SEC) reporting and registration, or compliance with state-specific requirements, depending on the total amount of its regulatory assets under management (RAUM). Without careful planning and analysis, a QOF manager and/or others could easily and inadvertently be an “investment adviser,” and be subject to rules governing management fees, performance compensation (e.g., a ‘carried interest’), custody of funds, recordkeeping, and mandatory disclosures.
Fund sponsors and managers should carefully scrutinize their operational plans, business structures, and organizational structures to determine if, and to what extent, these securities laws apply and the compliance implications. For example, a fund manager that is an “investment adviser” may be prohibited from earning a ‘carried interest’ based on the performance of the QOF to the extent that QOF investors are not “qualified clients” under the Advisers Act. Learning that after the fact would probably be a blow to any hardworking and successful QOF manager. Thus, structuring the transaction to help assure the fund manager is exempt from these restrictions is often a critical objective.
WHAT IS A “SECURITY”?
Understanding what is, and is not a “security” is central to determining the application of these laws to the QOF and/or its manager. The term “security,” as defined in the securities laws, includes “any note, stock [and] investment contract,” among a seemingly all-encompassing list of other instruments or financial arrangements. OZ Stock, like all other corporate stock, is always a security. A partnership interest, like an OZ Partnership Interest, is a security if it is an “investment contract,” which common law says consists of four principal elements – (1) an investment of money; (2) in a common enterprise; (3) with the expectation of profits; (4) derived primarily from the efforts of people other than the investor.[2] That last element is usually where the action is – is the interest owner passive or meaningfully active in the underlying business?
Since a limited partner of a limited partnership is, by definition, not active in its management or operations, a limited partnership interest is always a security. Similarly, the interest of a limited liability company non-managing member is also generally a security. In the OZ context, the QOF interest offered to a passive investor is a security. In turn, the interest of the QOF in any lower-tier entity or portfolio assets is a security if (a) it is stock (e.g., OZ Stock), or (b) the QOF itself is not a substantially active partner. For example, a money-only joint venture partner’s interest in the joint venture entity is probably a security.
THE SECURITIES FRAMEWORK
The Securities Act: The Securities Act generally requires that all offers of a security be registered with the SEC, unless an exemption applies. Among other exemptions, Regulation D under the Securities Act permits an issuer (e.g., a QOF) to offer and sell a security (e.g., an interest in a QOF) to any number of “accredited investors” without registration, subject to certain solicitation limitations and notice filings. There is a laundry list of who qualifies as an accredited investor. It includes a natural person who has a net worth exceeding $1 million, exclusive of the value of his or her home (calculated with a little nuance) and entities owned exclusively by accredited investors. Most QOF offerings are structured to comply with this exemption.
Notably, the Securities Act also imposes prohibitions on the making of misstatements of material facts or the making of material omissions necessary to make any statements of fact that are made not misleading. These restrictions apply regardless of whether or not the offering is exempt from registration (e.g., offered in compliance with Regulation D). Most importantly for fund sponsors, any person engaged in the offer or sale of a security is jointly and severally liable for those material misstatements or omissions. Thus, it is crucial to prepare appropriate offering materials and use care in verbal statements during that process.
Company Act: Like the Securities Act, the Company Act requires all “investment companies” to register with the SEC, absent an exemption or exclusion. The definition of “investment company” includes any company that “is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing . . . in securities.” The Company Act excludes “private funds” from the definition of “investment company.” Private funds are companies with fewer than 100 beneficial owners (so-called “§3(c)(1)” funds, after the exemption section of the Company Act) and companies owned exclusively by those with $5 million in investments and/or other “qualified purchasers” (“§3(c)(7)” funds). Therefore, if a QOF is structured to be a private fund, ideally by design but often by lucky happenstance, it usually need not be overly concerned with the registration requirements of the Company Act. But any QOF nearing the 100 beneficial owner mark, and has any owners who are not “qualified purchasers” as defined in the Act, needs to pay careful attention to whether or not the fund invests in securities and to its obligations under the Company Act. Funds may impose internal restrictions on transfer to help comply with these exceptions.
Advisers Act: Keeping with the theme of the other securities laws, the Advisers Act requires all investment advisers to register with the SEC, unless exempt or prohibited because of the adviser’s home state regulation. An “investment adviser” includes “any person who, for compensation, engages in the business of advising others . . . as to the value of securities or as to the advisability of investing in, purchasing, or selling securities . . ..”[3] Most states have similar definitions of investment adviser and often requires state registration without any exemption for limited assets under management. Investment advisers are subject to strict limitations on charging fees and performance compensation to the accounts of persons (in this context, the investors) who are not “qualified clients,” a threshold far higher than the traditional “accredited investor” bar.
Reduced to its main elements, an investment adviser is one who for compensation, engages in the business of advising others regarding securities. The compensation element is generally satisfied by the receipt of any economic benefit related to the services provided. [4] For example, a management fee, administrative services fee, or carried interest paid to a QOF manager are each likely “compensation.” A person is “in the business” if her activities occur on such a basis that it constitutes a business activity occurring with some regularity.” Unless the manager is neglecting her responsibilities to manage the affairs and investments of the QOF, she probably meets the business element as well. Again, the analysis often will turn on whether or not the QOF invests in “securities.”
Among others, QOFs that seek to benefit from the working capital safe harbor of the OZ Incentive probably have a dual-tier structure in which the QOF owns OZ Stock or OZ Partnership Interests, among other potential assets. If any of the QOF’s assets consist of securities (such as OZ Stock or passive OZ Partnership Interests), the third element is likely satisfied. Accordingly, a QOF manager is probably an investment adviser if the manager receives any fees, carried interest, or other compensation for its services and the QOF owns securities.
SO WHAT IF THE QOF MANAGER IS AN INVESTMENT ADVISER?
Advisers regulatory treatment under the Advisers Act depends, in part, on the extent of its RAUM, including the gross assets of any private fund for which it provides it supervises or manages, including uncalled commitments. [5] In this context, not just one QOF, but all that she manages count toward the RAUM calculation. Small advisers with less than $25 million RAUM generally look to the requirements of the regulatory authority in their home states. Mid-sized advisers with RAUM of $25 -$110 million must register with the SEC (or be eligible for an exemption) unless required to be registered as an investment adviser in its home state (e.g., because it qualifies for a state exemption). Advisors with RAUM exceeding $110 million must register with the SEC regardless of any state-registration, unless the advisor advises solely private funds (such as 3(c)(1) and 3(c)(7) funds). Private fund advisers, however, must register with the SEC upon having $150 million RAUM. Importantly, despite the above thresholds, advisors with at least $25 million in RAUM, and not state-registered are “exempt reporting advisers” and must file reports with the SEC under Rule 204-4. [6]
In addition to the registration requirements under the Advisers Act (and corollary state laws), investment advisers must comply with the Advisers Act’s compensation rules, disclosure obligations, record keeping, and funds custody requirements. Even more, to become registered as an investment adviser, an adviser or investment adviser representative may be required to pass the Series 65 exam. All of which is important to know before it’s too late.
If a QOF manager or potential manager is concerned about the possibility of being deemed an investment adviser before she is ready, the manager should analyze (with qualified legal counsel) the QOF’s proposed business and investment plans. A QOF may be able to organize its lower-tier investments in a way to reduce the risk that those investments are deemed a security in the hands of the QOF. QOF managers should also consider whether it makes sense to increase the threshold of eligible QOF investors above the “accredited investor” threshold and into the “qualified client” territory to diminish certain potential limitations on the performance compensation that the QOF manager may otherwise intend to receive.
The OZ Incentive engenders a lot of enthusiasm, both from potential investors and from entrepreneurial and experienced sponsors. But there is more to it than business plans, opportunity zone property tests, operating agreements, and tax compliance. A host of entrants into the QOF space who may never have had reason to think about the Company Act or Advisers Act before should get up to speed quickly. With a little planning and preparation with competent advisors, both new and experienced fund managers can ensure they and their QOFs meet all their respective securities compliance obligations. Plan, develop a compliance strategy, do good, and do well.
Notes:
[1] Authors Note: The securities laws are vast and technical. Their application is often nuanced and fact-intensive and. This article is not intended to, and cannot in the space provided, describe the laws, or even any of the issues touched on here, in any detail. This article is not, and should not be deemed legal advice. Every QOF sponsor or manager should meaningfully consult with securities counsel experienced with the laws described here.
[2] See, e.g., S.E.C. v. W.J. Howey Co. et. al., 328 U.S. 293 (1946); see also United Housing Federation v. Forman, 421 U.S. 837 (1975).
[3] Advisers Act of 1940, §202(a)(11); 15 U.S.C. §80b-2(a)(11).
[4] Advisers Act Rel. No. 1092 (1987).
[5] See Form ADV Part 1: Instructions for Part 1A, instr. 5.F, Calculating Your RAUM.
[6] 17 CFR §275.204-4.