Escrow Arrangements in Hedge Fund Offerings

Introduction

McCarthy Fingar’s Corporate and Business lawyers represent clients on hedge fund offerings. Hedge fund offerings are made in different ways. Often a hedge fund will make an offering to prospective investors in which a minimum amount of capital has to be raised for the offering to become effective. In such circumstances, a minimum offering will invariably make use of a third party escrow agent to hold the funds of the subscribers until the minimum in paid subscriptions is raised and accepted by the issuer. But, as illustrated below, sometimes escrow arrangements can be desirable even where there are no set minimums.

Business Advantages of Minimum Capital Requirements

Although an escrow arrangement is essentially mandatory in a minimum offering, hedge fund issuers sometimes forget the important business advantages of connecting the effectiveness of a hedge fund offering to a minimum capital requirement. For example, a hypothetical new hedge fund, Hedge Fund XYZ, elects to establish an initial $5 million minimum offering to investors. Thus, unless at least $5 million is received in paid subscriptions to Hedge Fund XYZ by a specific predetermined date, the offering will be ineffective and the money paid by the subscribers will be refunded to them. Establishing a minimum for an offering is useful for a number of crucial business reasons. For one, it simply may not be practical to run Hedge Fund XYZ on anything less than the minimum. For another, it is a rare investor who is willing to risk his or her capital without knowing that others are doing the same, up to at least a minimum amount of aggregate investments in the fund.

Escrow Arrangements Can Provide Legal Safeguards to Hedge Fund Offerings with No Minimums

While not a legal necessity, an escrow arrangement can be very useful to a hedge fund issuer, even in an offering where there is no minimum.  Typically, the subscription documents that come in from subscribers to an offering are not in “apple pie” order. Without the escrow arrangement the temptation is for the issuer (especially a newly formed one such as our hypothetical Hedge Fund XYZ) to cash subscribers’ checks as soon as possible (which is what happens where there is no minimum) without an adequate review of the subscription documents. This can be fatal to the legal validity of the offering. The general problem: in a garden-variety, Rule 506 Regulation D Private Placement Offering to Accredited Investors only, if the subscription paperwork is not properly filled out to establish the credentials for Accredited Investor status of each subscriber, the subscription of  each non-credentialed subscriber will not meet the safe-harbor standards of Regulation D under the U.S. Securities Act of 1933. It may also fail to satisfy comparable safe harbor standards in the state(s) of residence of the non-credentialed subscriber(s). The result for our hypothetical Hedge Fund XYZ: the non-credentialed subscription(s) may be subject to rescission and Hedge Fund XYZ may be susceptible to a variety of claims and penalties under federal and state securities laws. Indeed, a very common problem with a joint subscription to an all Accredited Investor offering is that each of the joint subscribers is typically required to be an Accredited Investor (the principal exception to the need for each joint subscriber to be credentialed typically being a husband and wife), but subscription documents submitted to the issuer (e.g., Hedge Fund XYZ) may only establish the Accredited Investor status of one of them. An escrow arrangement will give time for a professional review of the subscription documents before a subscription is accepted. This will save a lot of problems down the road for the issuer. Such a professional review is especially important to a new, relatively inexperienced issuer (like our hypothetical Hedge Fund XYZ) who is typically not knowledgeable about all the pitfalls in subscription documents and, understandably, anxious about putting the proceeds of the offering to work as soon as possible.

The McCarthy Fingar Approach in Advising as to Hedge Fund Offerings

When a client desires to establish a hedge fund, the lawyers in McCarthy Fingar’s Corporate and General Business group will advise the client as to the best way to proceed with the hedge fund offering, including whether it makes business or legal sense to use a third party escrow agent in establishing the legal effectiveness of the offering.

Contact Us

McCarthy Fingar’s Corporate and General Business lawyers are dedicated to our clients’ success. If you think you may require our assistance or have any questions regarding hedge fund offerings, please contact Howell Bramson by email (hbramson@mccarthyfingar.com) or by phone (914-385-1017).