Volkswagen Emissions Fallout Presents Claims Trading Opportunity for Fund Managers News that Volkswagen AG sold millions of diesel cars with software designed to evade emission-standards testing continues to have enormous ramifications beyond the automobile industry — investment funds are among those keenly interested in the ongoing fallout as the German manufacturer could become the next target for widespread claims trading activity. The long-term consequences for Volkswagen remain uncertain at this relatively early stage; however, significant regulatory penalties and class-action lawsuits are both strong possibilities, as is increased claims trading related to reduced used car values. Any of these outcomes are likely to become the target of substantial activity as investors, including hedge funds, seek to monetize the repayment process and capitalize on a short-term decline in securities. The company indicated in its Q3 2015 financial update it had set aside more than $7 billion to deal with the costs. However, investors, led by the litigation funding group Bentham, were quick to announce plans for a $45 billion lawsuit in Germany. In the U.S., the Department of Justice, on behalf of the Environmental Protection Agency filed a civil action against Volkswagen in January that could seek up to $48 billion in damages. Although it seems unlikely they will seek the maximum penalty, U.S. officials previously indicated Volkswagen’s violation of the federal Clean Air Act could result in financial penalties of up to $37,500 per car, or more than $18 billion in total. By comparison, in November 2014 the Environmental Protection Agency imposed a record $100 million penalty on Hyundai Motor Co. and Kia Motors Corp. for exaggerating fuel-economy claims and revoked another $200 million worth of regulatory credits. General Motors, meanwhile, recently agreed to pay $900 million to settle criminal charges Attorney Advertising In This Issue Volkswagen Emissions Fallout Presents Claims Trading Opportunity for Fund Managers ........................................... 1 Regulators Outline Examination and Rule-making Priorities for 2016 ............................................................................. 2 New Legislation Affects the Taxation of REITs....................... 4 SEC Report Examines Potential Changes to the ‘Accredited Investor’ Definition............................................................... 7 Editorial Team February 2016 Kramer Levin’s Funds Talk provides legal commentary on the news and events that matter most to alternative asset managers and funds. © 2016 Kramer Levin Naftalis & Frankel LLP Funds Talk The contents of this publication are intended for general informational purposes only, and individualized advice should be obtained to address any specific situation. Robert N. Holtzman email@example.com | 212.715.9513 Gilbert K.S. Liu firstname.lastname@example.org | 212.715.9460 Ernest S. Wechsler email@example.com | 212.715.9211 Mergers and Acquisitions Securitization Bankruptcy Thomas T. Janover firstname.lastname@example.org | 212.715.9186 Derivatives and Structured Products Fabien Carruzzo email@example.com | 212.715.9203 Insurance and Reinsurance Daniel A. Rabinowitz firstname.lastname@example.org | 212.715.9378 Employment Barry Herzog email@example.com | 212.715.9130 Tax Robin Wilcox firstname.lastname@example.org | 212.715.3224 White Collar Defense and Investigations Mark F. Parise email@example.com | 212.715.9276 Regulatory Kevin P. Scanlan firstname.lastname@example.org | 212.715.9374 Fund Formation www.kramerlevin.com Funds Talk 2 stemming from the poorly handled recall of vehicles with dangerous ignition defects. Ratings agency Moody’s confirmed the threat facing Volkswagen when it dropped its outlook for the company and its subsidiaries from stable to negative in September. It then downgraded the company’s credit ratings in November. In addition to the direct cost resulting from any vehicle recall, loss of future sales and reputational damage, Moody’s cited the potential for action from regulatory authorities — specifically those outside the U.S. — as justification for the diminished outlook and ratings. Europe could become the epicenter of claims activity. Approximately 11 million vehicles globally are believed to be affected, the vast majority of which Moody’s expects to be in Europe, where diesel engines are significantly more common than in the U.S. In 2015, only about 6% of Volkswagen’s sales were in the U.S., meaning international regulators will be highly influential as the company attempts to work its way through the aftermath of these revelations. The agency noted that “further negative rating action is likely if Moody’s reaches a view that fines and legal costs are likely to be well in excess of Volkswagen’s EUR6.5-billion ($7.1-billion) provision, or that there will be significant damage to the company’s market share or pricing position, with sustained negative impact on revenues or EBITDA, and impact starting to extend to core markets outside the U.S.” Meanwhile, Fitch Ratings lowered its rating of the company to BBB+, the third-lowest investment grade, as a result of the heightened risk of legal proceedings involving regulators and customers alike. A drop in car values would also pose a risk to bonds tied to the company’s auto loans, leases and dealerships worldwide. In response to the initial revelations, the resale value of Volkswagen’s diesel cars decreased by an average of 13%, Volkswagen corporate debt bonds dropped while prices surged for the more liquid credit default swaps — which allow for the purchase of insurance against the risk of default, suggesting investors expect the company to face further volatility for some time to come as the compensation and regulatory processes unfold. n For more information, please contact: Thomas T. Janover email@example.com | 212.715.9186 Regulators Outline Examination and Rule-making Priorities for 2016 As the new year got underway, U.S. regulators gave the industry a glimpse into their plans for 2016. The Securities and Exchange Commission (“SEC”) released its 2016 investment adviser examination priorities and rule-making priorities, while the Financial Industry Regulatory Authority (“FINRA”) issued its own examination priorities for the year ahead. Many of the areas that face ongoing or additional scrutiny are directly linked to the alternative investment sector. As a result, private fund advisers and securities firms should be aware of which areas will be subject to regulators’ scrutiny so that they may review and/or update their policies and procedures in these areas to address the SEC’s and FINRA’s concerns in this regard. Regulatory penalties, class-action lawsuits and increased claims trading are all likely to become the target of substantial activity as investors, including hedge funds, seek to monetize the repayment process. www.kramerlevin.com Funds Talk 3 In its 2016 examination priorities, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) outlined two primary areas of interest that would impact private fund advisers: Assessing marketwide risks; and Using data analytics to identify potential illegal activity. As part of the SEC’s mandate to provide fair, orderly and efficient markets, OCIE’s inspections will seek to identify “structural risks and trends that may involve multiple firms or entire industries.” It further specified that its marketwide risks examinations will include the areas of cybersecurity and liquidity controls, among others. Cybersecurity became one of the SEC’s key compliance issues in 2015, and the regulator has provided notice that its focus on cybersecurity will continue in 2016. OCIE indicated that it will advance an examination of broker-dealers’ and investment advisers’ cybersecurity compliance and controls, previously launched in September 2015, to gather information, assess risks and test implementation at select firms. OCIE is now ready to begin more widespread testing and assessments of firms’ implementation of cybersecurity procedures and controls. The regulator’s emphasis on liquidity control comes amid recent turmoil in fixed-income markets and a rising interest rate environment. The examinations will focus on investment advisers to, among others, private funds with analysis of their exposure to illiquid securities. Accordingly, registered investment advisers should review their contractual obligations to their investors with respect to liquidity and ensure they are providing adequate disclosure to their investors regarding the risk or liquidity in a portfolio. With respect to the use of data analytics, OCIE stated that data and intelligence from regulatory filings and examinations alike will be used across all of its examination priorities in order to assist in the identification of higher risk restraints. This will include setting their sights on registrants that employ individuals that OCIE has identified, through their data analytics, as having a track record of misconduct. In addition, OCIE intends to utilize its data-driven analysis to identify firms engaged in excessive or otherwise potentially inappropriate trading, as well as the suitability of promotional practices for new, complex and highrisk products. Among its “Other Initiatives” for 2016, OCIE noted that it will review private placements to determine whether legal requirements are fulfilled regarding matters related to due diligence, disclosure and suitability under Regulation D of the Securities Act of 1933. Finally, select never-before-examined registered investment advisers will continue to be the subject of focused, risk-based examinations, while the SEC will continue its focus on private fund advisers’ fees and expense practices, along with the controls and disclosure associated with side-by-side management of performance-based and purely asset-based fee accounts. The SEC’s rule-making initiatives for 2016 also represent a continuation of its efforts from the previous year. David Grim, director of the SEC’s Private fund advisers and securities firms should take note of the areas the SEC and FINRA will focus on in their inspections and rule-making efforts so that they can review and/or update their policies and procedures in these areas to address the SEC’s and FINRA’s concerns in this regard. www.kramerlevin.com Funds Talk 4 Division of Investment Management, announced that the SEC is developing recommendations on several issues relevant to registered investment advisers, including requiring transition planning to prepare for a major disruption in their business, stress testing by large investment advisers and a proposal to obligate registered investment advisers to establish a program of third-party compliance reviews. FINRA’s 2016 regulatory and examination priorities share many of OCIE’s examination areas, such as a focus on cybersecurity and liquidity. However, the 2016 priorities of the selfregulatory group demonstrate a greater focus on culture, conflicts of interest and ethics at securities firms. FINRA stated that, as part of the examination process, it will seek to understand how culture affects firms’ compliance and risk management practices. As such, its assessments will focus on the frameworks used to develop, communicate and evaluate conformance with a firm’s culture. In 2016, FINRA will focus its supervision, riskmanagement and controls efforts on four areas related to firms’ business conduct and the integrity of the markets. Two of the areas that are of particular interest are those governing the management of conflicts of interest and cybersecurity. With respect to conflicts of interest, FINRA will continue to focus on firms’ efforts to “identify, minimize and mitigate information leakage within or outside a firm,” and it stated that firms will be expected to manage such potential activities with targeted controls. In addition, FINRA stated that conflicts may also arise when proprietary traders are permitted to provide valuations for proprietary positions they establish. “This valuation can implicate both a firm’s risk management processes, as well as the trader’s performance assessment and compensation,” FINRA stated. As a result, another area of focus will be assessing firms’ supervision, control and validation of traders’ pricing of illiquid, level 3 assets to ensure that positions are fairly valued. Finally, FINRA will continue to focus on firms’ cybersecurity preparedness, given the ongoing threat environment and the continued need for firms to improve their defenses. FINRA will review firms’ approaches to cybersecurity risk management, including governance, risk assessment, technical controls, incident response, vendor management, data loss prevention and staff training. Although the areas discussed above will continue be part of the regulatory list of hot-button items for the coming year, regulators will also continue to take a risk-based approach to examinations, and adapt as information and market developments warrant. Accordingly, private fund advisers should stay alert to additional statements from these regulatory bodies as the year progresses. n For more information, please contact: Kevin P. Scanlan firstname.lastname@example.org | 212.715.9374 Mark F. Parise email@example.com | 212.715.9276 New Legislation Affects the Taxation of REITs The Protecting Americans from Tax Hikes Act of 2015 (the “Act”) became law on Dec. 18, 2015. The Act retroactively extended, either permanently or temporarily, various tax provisions that Congress had periodically been extending on a temporary basis. In addition, the Act made important changes affecting the taxation of investments, including several changes specifically affecting real estate investment trusts (“REITs”) and foreign investments in U.S. real estate. Summarized below are certain REIT-related provisions of the Act that may be of interest to funds with activities in that area, as well as other provisions of the Act. Our next issue will address changes affecting foreign investments in U.S. real estate. www.kramerlevin.com Funds Talk 5 REITs Restrictions on REIT spinoffs In several highly publicized transactions, operating businesses distributed their real estate assets in tax-free “spinoff” transactions, following which the real estate assets were held in tax-favored REITs. The Act restricts the ability to engage in such transactions in two ways. First, a spinoff involving a REIT will generally not qualify as tax-free if the distributing or the distributed corporation is a REIT, unless both corporations are REITs or, in certain circumstances, the distributed corporation is a taxable REIT subsidiary (a “TRS”). Second, neither the distributing nor the distributed corporation (nor any successor corporation) may elect to be treated as a REIT for 10 years following a tax-free spinoff. This provision applies to distributions on or after Dec. 7, 2015, unless a ruling request with respect to the transaction was initially submitted to the IRS on or before that date, provided that the request was not withdrawn, issued or denied as of that date. Taxable REIT subsidiaries Among the requirements that an entity must satisfy to be taxed as a REIT, at least 75% of its assets must be real estate assets (including obligations secured by real property), cash and cash items and government securities (the 75% asset test); at least 75% of its gross income must consist of real estate-related income (the 75% income test); and at least 95% of its gross income must consist of income that satisfies the 75% income test or other qualifying passive income, such as interest or dividends (the 95% income test). REITs often hold nonqualifying assets, or assets that will generate non-qualifying income, in TRSs, which are taxed as corporations. Under existing law, the securities of one or more TRSs cannot represent more than 25% of the value of a REIT’s assets. The Act reduces that limit to 20% of the value of a REIT’s assets, effective for taxable years beginning after 2017. The Act provides that a TRS is permitted to provide certain services to the REIT, such as marketing, that typically are done by a third party. In addition, a TRS is permitted to develop and market REIT real property without subjecting the REIT to the 100% prohibited transactions tax. However, payments for services provided by the TRS to its parent REIT are subject to a 100% excise tax to the extent they are not at arm’s length. This provision is effective for taxable years beginning after 2015. Preferential dividends A REIT is entitled to a deduction for the dividends it pays, which generally results in the REIT’s not being subject to tax on its income to the extent it distributes that income to its shareholders. The REIT must distribute at least 90% of its income (other than net capital gains) to its shareholders in order to be taxed as a REIT. A “preferential dividend” — that is, one that is not pro rata and favors some shares of stock over other shares of the same class — does not give rise to the deduction for dividends paid, resulting in tax at the REIT level and possible loss of REIT status. The Act repeals the preferential dividend rule for “publicly offered REITs,” which are REITs that are required to file annual and periodic reports with the SEC. (Publicly offered regulated investment companies (“RICs”) were already exempt from the preferential dividend rule.) This provision is retroactively effective and applies to distributions in taxable years beginning after 2014. For REITs that are not publicly offered, the Act gives the secretary of the Treasury the authority to provide an appropriate alternative remedy (instead of disallowing the deduction for dividends paid) if the REIT’s payment of a preferential dividend is inadvertent or due to reasonable cause and not willful neglect. This provision applies to distributions in taxable years beginning after 2015. Treatment of ancillary personal property For purposes of the 75% income test, rent attributable to personal property that is leased www.kramerlevin.com Funds Talk 6 under or in connection with a lease of real property is treated as “good” income if the fair market value of the personal property does not exceed 15% of the total fair market value of the combined real and personal property. The Act makes clear that such personal property is treated as real property for purposes of the 75% asset test. In addition, an obligation secured by a mortgage on such property is treated as real property for purposes of the 75% asset test. This provision is effective for taxable years beginning after 2015. Debt instruments of publicly offered REITs and interests in mortgages on interests in real property The Act provides that debt instruments issued by publicly offered REITs (as well as interests in mortgages on interests in real property, such as an interest in a mortgage on a leasehold interest) are treated as real estate assets for purposes of the 75% asset test. (Equity interests in REITs were already treated as real estate assets.) Income from such debt instruments is not treated as “good” income for purposes of the 75% income test (unless the income would have so qualified under pre-Act law), but such income is “good” income for purposes of the 95% income test. No more than 25% of a REIT’s assets may consist of such debt instruments. This change is effective for taxable years beginning after 2015. Hedging provisions Income from certain hedging transactions is excluded in computing the 75% and 95% income tests. The Act extends that exclusion to income from hedges of previously acquired hedges that a REIT entered into to manage risk associated with liabilities or property that have been extinguished or disposed of, effective for taxable years beginning after 2015. Other Provisions Exclusion of 100% of gain on certain smallbusiness stock Noncorporate taxpayers may exclude a specified percentage of their gain from the sale of “smallbusiness stock” acquired at original issue and held for at least five years. Seven percent of such excluded gain was treated as an item of tax preference for alternative minimum tax purposes. The specified percentage has been increased on a temporary basis several times in the past, and was 100% for stock acquired after September 27, 2010, and before January 1, 2015; the minimum tax preference did not apply to gain excluded with respect to such stock. Effective for stock acquired after 2014, the Act makes the post-September 27, 2010, 100% exclusion permanent, and also permanently exempts such excluded gain from alternative minimum tax preference. Reduction in S corporation recognition period for built-in gains tax to five years S corporations generally are not subject to entity-level tax. However, if a C corporation has built-in gains at the time it converts to an S corporation, the S corporation is subject to tax at the highest corporate rate on any such built-in gain recognized during the applicable “recognition period.” The same treatment generally applies to RICs and REITs that were formerly C corporations. The recognition period was initially 10 years, but was reduced to seven years (for 2009, 2010 and 2011) and then to five years (for 2012, 2013 and 2014). The Act permanently reduces the recognition period to five years, retroactively effective for taxable years beginning after 2014. Interest-related and short-term capital gain dividends of regulated investment companies Foreign persons are generally not subject to U.S. income or withholding tax on their capital gains The legislation retroactively extended, either permanently or temporarily, various investmentrelated tax provisions that Congress had periodically extended on a temporary basis. www.kramerlevin.com Funds Talk 7 or portfolio interest income. However, dividends from RICs to foreign investors were subject to withholding even if attributable to such interest income or short-term capital gains. The previous exemption of such dividends from withholding had expired effective December 31, 2014. The Act retroactively reinstates and makes permanent that exemption, so that properly reported interestrelated and capital gain dividends from RICs will not be subject to withholding, effective for dividends paid with respect to any taxable year of a RIC beginning after 2014. Extension and modification of research credit The Act retroactively reinstates and permanently extends the research and development tax credit, which had expired at the end of 2014. In addition, beginning in 2016, an eligible small business ($50 million or less in gross receipts) may claim the credit against its alternative minimum tax liability, and the credit can be utilized by certain small businesses against their employer payroll tax liability. Extension of subpart F exception for active financing income A 10% U.S. shareholder of a controlled foreign corporation is required to include in income, on a current basis, its share of the “subpart F” income of the controlled foreign corporation. Under an “active financing” exception, which most recently expired as of the end of 2014, subpart F income did not include income derived in the active conduct of a banking, financing or similar business, or in the conduct of an insurance business. The Act retroactively reinstates that exception to 2015 and makes it permanent. Temporary extension of bonus depreciation The Act extends bonus depreciation for property acquired and placed in service during 2015 through 2019 (with an additional year for certain property with a longer production period). The bonus depreciation percentage is 50% for property placed in service during 2015, 2016 and 2017, and it phases down to 40% in 2018 and 30% in 2019. n For more information, please contact: Helayne Stoopack firstname.lastname@example.org | 212.715.9214 SEC Report Examines Potential Changes to the ‘Accredited Investor’ Definition On Dec. 18, 2015, the Securities and Exchange Commission (the “SEC”) released a staff report on its review of the definition of “accredited investor” as set forth under Regulation D of the Securities Act of 1933, as amended (the “Securities Act”). The staff issued the report in accordance with a Dodd-Frank Wall Street Reform and Consumer Protection Act requirement to determine whether the definition — as it applies to natural persons — should be modified or adjusted for the protection of investors, in the public interest and in light of the economy. In the interest of providing a comprehensive analysis, the staff report also addresses the use of the “accredited investor” definition as it applies to entities. The “accredited investor” definition is central to the transactional exemptions set forth under Regulation D of the Securities Act. The Regulation D exemptions allow issuers to offer securities to certain sophisticated investors without having to register such securities with the SEC as is generally required under the Securities Act. Investors that qualify as “accredited investors” under Regulation D are eligible to participate in investment opportunities unavailable to other, less sophisticated investors. The “accredited investor” definition also plays an important role in other federal and state securities law contexts. Under the existing definition, a natural person is an accredited investor if his or her (i) income exceeds $200,000 (or $300,000 in joint income with a www.kramerlevin.com Funds Talk 8 spouse) in each of the two most recent years and is reasonably expected to do the same in the current year or (ii) net worth exceeds $1 million, either individually or jointly with a spouse (excluding the value of their primary residence). Banks, partnerships, corporations, nonprofits and trusts may also be eligible for accredited investor status if they fall into one or more category of investors as enumerated under Regulation D. The staff recommends that the SEC revise the definition of “accredited investor” to amend or modify (i) the financial thresholds requirements for natural persons in order to adjust for inflation since the dates on which the existing financial thresholds were established and (ii) the list-based qualification approach for entities in order to permit otherwise eligible entities that do not fall within an enumerated category of “accredited investor” to nonetheless qualify as accredited investors. In particular, the staff recommends that the SEC consider the following approaches: Leave the current income and net worth thresholds in place, subject to investment limitations; Establish new, inflation-adjusted income and net worth thresholds without investment limitations; Index all financial thresholds for inflation on a going-forward basis; Permit spousal equivalents to pool their finances for purposes of qualifying as accredited investors; Revise the definition as it applies to entities by replacing the $5 million assets test with a $5 million investments test and including all entities, rather than specifically enumerated types of entities; and Grandfather issuers’ existing investors that are accredited investors under the current definition with respect to future offerings of their securities. The staff also recommends that the SEC revise the “accredited investor” definition to establish measures of sophistication outside of the brightline income and net worth tests currently in place that would (i) permit certain knowledgeable investors that do not meet existing financial thresholds requirements to participate in investments available only to accredited investors and (ii) preclude wealthy investors unable to understand certain risks associated with an investment from participating in such investment. The staff recommends that the SEC consider the following approaches to address what it calls the “under- and over-inclusive” nature of the existing quantitative criteria: Permit individuals with a minimum amount of investments to qualify as accredited investors; Permit individuals with certain professional credentials to qualify as accredited investors; Permit individuals with experience investing in exempt offerings to qualify as accredited investors; Permit knowledgeable employees of private funds to qualify as accredited investors for investments in their employer’s funds; and Permit individuals who pass an accredited investor examination to qualify as accredited investors. The possible effects of these proposed changes are as varied as the recommendations themselves. For example, should the SEC raise the existing income and/or net worth thresholds, the number of qualifying households would “shrink considerably.” Alternatively, should the SEC permit individuals with a minimum amount of investments to qualify Should they be adopted, certain of the SEC staff’s recommendations would augment the number of eligible investors, while others could cause the pool of accredited investors to shrink. www.kramerlevin.com Funds Talk 9 as accredited investors, the number of eligible households would increase. The SEC has requested public comment on the staff report, but did not stipulate a deadline for those interested in providing feedback. n For more information, please contact: Kevin P. Scanlan email@example.com | 212.715.9374 Mark F. Parise firstname.lastname@example.org | 212.715.9276 Caroline A. Levin email@example.com | 212.715.9518 NEW YORK 1177 Avenue of the Americas New York, NY 10036 212.715.9100 PARIS 47 avenue Hoche Paris 75008 +33 (0)1 44 09 46 00 SILICON VALLEY 990 Marsh Road Menlo Park, CA 94025 650.752.1700 www.kramerlevin.com This memorandum provides general information on legal issues and developments of interest to our clients and friends. It is not intended to provide legal advice. Readers should seek specific legal advice before taking any action with respect to the matters we discuss here. Should you have any questions or wish to discuss any of the issues raised in this memorandum, please call your Kramer Levin contact.