The “Volcker Rule”

On January 21, 2010, President Obama, joined by Paul Volcker and others, proposed new measures calling for new restrictions on the size and scope of banks and other financial institutions to rein in excessive risk taking and to protect taxpayers. On March 3rd, President Obama sent a draft of the legislation to Congress entitled “Prohibitions on Proprietary Trading and Certain Relationships with Hedge Funds and Private Equity Funds.” Among other things, the proposal would prohibit banks from “sponsoring” (defined as serving as the general partner, managing member or trustee of a fund; in any manner selecting or controlling a majority of the directors or management of a fund; or sharing with a fund, for corporate, marketing, promotional or other purposes, the same name or a variation of the same name) and investing in hedge funds and private equity funds (defined as any entity exempt from registration as an investment company pursuant to either Section 3(c)(1) or 3(c)(7) of the Investment Company Act). Banks also would be prohibited from acting as a prime broker to funds they advise.  

On March 10th, Senators Jeff Merkley, Carl Levin, Ted Kaufman, Sherrod Brown and Jeanne Shaheen introduced their version of the “Volcker Rule” entitled the “Protect our Recovery Through Oversight of Proprietary Trading Act.” The bill, among other things, would bar banks, bank holding companies, and their affiliates and subsidiaries from taking or retaining any equity, partnership or other ownership interest in or sponsoring a hedge fund or a private equity fund. The defined terms “hedge fund,” “private equity fund” and “sponsoring” track the definitions set forth in President Obama’s proposal.  

On March 15th, Senate Banking Committee Chairman Christopher Dodd introduced his version of the “Volcker Rule” entitled “Restrictions on Capital Market Activity by Banks and Bank Holding Companies” as part of his financial overhaul bill. Senator Dodd’s version would, among other things: (i) prohibit banks, bank holding companies, and their affiliates and subsidiaries from “sponsoring or investing in a hedge fund or a private equity fund;” (ii) bar banks, bank holding companies, and their affiliates and subsidiaries, or companies that serve as the investment manager or investment adviser to a hedge fund or private equity fund from entering into a “covered transaction” (as defined in section 23A of the Federal Reserve Act to include loan-making, purchase or investment in securities, purchase of assets, guarantee, etc.) with such hedge fund or private equity fund; and (iii) impose additional capital requirements and additional quantitative limits on nonbank financial companies supervised by the Federal Reserve pursuant to its oversight authority under the bill (see Financial Stability Oversight Council below) that engage in proprietary trading or sponsoring and investing in hedge funds and private equity funds. Again, the defined terms “hedge fund,” “private equity fund” and “sponsoring” track the definitions set forth in President Obama’s proposal.  

Private Fund Investment Adviser Registration (House Version)

On December 11, 2009, the U.S. House of Representatives passed “The Wall Street Reform and Consumer Protection Act of 2009.” The bill sets forth a comprehensive set of financial regulatory reforms, including the “Private Fund Investment Advisers Registration Act of 2009,” which would eliminate the “private adviser exemption” from registration under Section 203(b)(3) of the Advisers Act, and, instead, require any investment adviser to a “private fund” to register with the SEC (subject to certain exemptions) and subject the private funds advised by such SEC-registered advisers to substantial regulatory reporting requirements. A “private fund” is defined as an issuer that would be an “investment company” under Section 3(a) of the Investment Company Act, but for the exception provided from that definition by either Section 3(c)(1) or Section 3(c)(7) of such Act.  

Importantly, the bill provides the following exemptions (among others) from registration as an investment adviser with the SEC:  

?? any private fund adviser that “acts solely as an adviser to private funds and has AUM in the United States of less than $150 million” (such an adviser would still be subject to certain recordkeeping and annual reporting requirements described below);  

  • any adviser to “venture capital funds” (which is to be defined by the SEC) (such an adviser would still be subject to certain recordkeeping and annual reporting requirements described below);  
  • any adviser that is a “foreign private fund adviser” defined as an investment adviser that: (a) has no place of business in the United States; (b) during the preceding 12 months has had (i) in total, fewer than 15 clients and investors in the United States in private funds advised by such investment adviser; and (ii) aggregate AUM attributable to clients and investors in the United States in private funds advised by such investment adviser of less than $25 million; and (c) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act; and  
  • any adviser to small business investment companies, which are regulated by the Small Business Administration.  

Such SEC-registered advisers would be required to maintain such records of and file with the SEC such reports regarding the private funds that they advise as “are necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk as the SEC determines,” including for each private fund: the amount of AUM; the use of leverage (including off-balance sheet exposures); counterparty credit risk exposures; trading and investment positions; and other important information relevant to determining potential systemic risk. All records of a private fund maintained by a SEC-registered adviser would be subject at any time to such periodic, special and other examinations by the SEC.  

In addition, in prescribing regulations (including registration and examination procedures) relating to advisers of “mid-sized private funds,” the SEC must take into account the size, governance and investment strategy of such funds to determine whether they pose systemic risk; however, the bill does not provide a definition of “mid-sized private funds.”  

The SEC would be permitted to share copies of all reports and documents filed with or provided to it by an SEC-registered adviser with the Board of Governors of the Federal Reserve System and to Oversight Council as necessary for the purposes of assessing the systemic risk of a private fund. In addition, a registered adviser must provide reports to investors, prospective investors, counterparties and creditors of any private fund advised by such adviser. The SEC may not compel a private fund to disclose certain proprietary information to counterparties and creditors, including sensitive, nonpublic information regarding the investment adviser’s investment or trading strategies, analytical or research methodologies, trading data, computer hardware or software containing intellectual property.  

The bill gives the SEC broad authority to issue, amend and rescind such rules and regulations as are necessary or appropriate to carry out the intent of the bill, including the ability to: (i) classify persons and matters within its jurisdiction based upon, but not limited to, size, scope, business model, compensation scheme or potential to create or increase systemic risk; (ii) prescribe different requirements for different classes of persons or matters; and (iii) ascribe different meanings to terms (including the term “client,” except that the SEC cannot define the term “client” to include an investor in a private fund).  

Please see our December 16, 2009 client alert entitled “House Passes Bill Requiring Most Private Fund Investment Advisers to Register” for further information on this topic.  

Private Fund Investment Adviser Registration (Senate Version)

On March 15, 2010, Senate Banking Committee Chairman Christopher Dodd introduced a sweeping financial regulatory bill that included the “Private Fund Investment Advisers Registration Act of 2010.” The Senate Banking Committee had released an earlier discussion draft in November 2009. On March 22nd, following Committee discussions of these drafts, the Senate Banking Committee adopted an amended version of Senator Dodd's bill, which is substantially similar to the House bill, with the following key differences:  

  • provides an exemption from registration (but not from certain recordkeeping and reporting requirements) for any adviser to a “private equity fund” (which is to be defined by the SEC);  
  • provides an exclusion from the definition of “investment adviser” under the Advisers Act for any “family office” (which is to be defined by the SEC in a manner consistent with the SEC’s prior exemptive orders);  
  • does not contain a provision regarding regulation of “mid-sized private funds;”  
  • provides an aggregate AUM registration threshold of $100 million;  
  • requires disclosure to the SEC of any “side arrangements or side letters whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;”  
  • requires an investment adviser to take steps as the SEC may prescribe to safeguard client assets over which it has custody, including verification of such assets by an independent public accountant;  
  • generally requires investment advisers to maintain the same types of records as noted in the description of the House bill above; however, there is no requirement to file such records with the SEC; the SEC may issue rules requiring each investment adviser to a private fund to file such reports containing such information as the SEC “deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk;” and  
  • does not contain third-party disclosure requirements.  

Investor Protection; Broker Dealers (House Version)

Included in the passage by the House of the omnibus Wall Street Reform and Consumer Protection Act was the “Investor Protection Act of 2009.” Of significance to investment advisers, the bill provides that, with respect to a broker or dealer, when providing personalized investment advice about securities to a retail customer, the standard of conduct for such broker or dealer will be the same standard as applicable to an investment adviser under the Advisers Act.  

Investor Protection; Broker Dealers (Senate Version)

Senator Dodd’s financial overhaul bill included a version of the “Investor Protection Act of 2009,” which would require the SEC to conduct a study to evaluate (i) the effectiveness of existing legal or regulatory standards of care for broker dealers and investment advisers for providing personalized investment advice and recommendations about securities to retail customers; and (ii) whether there are legal or regulatory gaps or overlap in the legal or regulatory standards in the protection of retail customers relating to the standards of care for broker dealers and investment advisers.  

Executive Compensation (House Version)

The omnibus Wall Street Reform and Consumer Protection Act also included the “Corporate and Financial Institution Compensation Fairness Act of 2009,” which would, among other things, require certain “covered financial institutions” - including investment advisers and broker-dealers - with assets of at least $1 billion to disclose to the appropriate Federal regulator the structures of all incentive-based compensation arrangements. The disclosures must allow regulators to determine whether such structures are aligned with sound risk management and their potential to have serious adverse effects on economic conditions or financial stability. Federal regulators would have the authority to prescribe rules preventing incentive- based compensation arrangements that regulators determine pose “serious adverse effects on economic conditions or financial stability.”  

Executive Compensation (Senate Version)

Senator Dodd’s financial overhaul bill contains a modified version of regulatory requirements on incentive-based compensation arrangements; however, this provision only applies to companies with securities listed on a national securities exchange.  

Financial Stability Oversight Council (House Version)

The Wall Street Reform and Consumer Protection Act passed by the House also included the “Financial Stability Improvement Act of 2009,” which would create an inter-agency Financial Stability Oversight Council that would be responsible for identifying financial companies that are so large, interconnected or risky that their collapse would put the U.S. economy at risk. These systemically risky firms would be subject to heightened oversight, standards and regulation. The bill also establishes an orderly process for shutting down large, failing financial firms. Any costs associated with dismantling a failed firm would be paid first from the company’s assets at the expense of shareholders and creditors. Any additional costs will then be covered by a $150 billion dollar “Systemic Dissolution Fund,” which would be capitalized by fees assessed on financial companies with more than $50 billion in assets, on a consolidated basis, and by “financial companies that manage hedge funds” with $10 billion or more of assets under management on a consolidated basis. Such fee assessments would be based upon individual risk assessments as determined by the Council.  

Financial Stability Oversight Council (Senate Version)

Senator Dodd’s financial overhaul bill would similarly create an inter-agency Financial Stability Oversight Council. Significantly, in addition to collecting information from various agencies to identify and assess risk to the U.S. economy, the Financial Stability Oversight Council would have the authority, following certain procedures, to require certain U.S. and foreign nonbank financial companies to register with and be supervised by the Federal Reserve. “Nonbank financial company” is defined as a company other than a bank holding company or a subsidiary thereof that is substantially engaged in activities that “are financial in nature.” This definition may include hedge funds and private equity funds. Senator Dodd’s bill would also establish an Orderly Liquidation Authority Panel that supervises the liquidation of large, failing financial firms. An “Orderly Liquidation Fund” would be established to cover relevant costs, which would be capitalized by fees assessed on certain bank holding companies, nonbank financial companies supervised by the Federal Reserve and potentially other financial companies with more than $50 billion in assets on a consolidated basis.  

Taxation of Carried Interest

On February 1, 2010, the White House released President Obama’s FY 2011 Budget proposal. Among the many proposals contained in the budget were proposals to tax carried interest received in connection with a “service partnership interest” and any gain recognized on the sale of the SPI (i.e., sale of the business) as ordinary income.  

On December 9, 2009, the U.S. House of Representatives approved the “Tax Extenders Act of 2009.” The primary purpose of the legislation is to extend for one year (through 2010) more than 40 tax relief provisions that were scheduled to expire at year-end. The legislation also contained several revenue provisions, including a provision that would tax certain carried interest income at ordinary income rates rather than at capital gains rates. The bill, which would be effective for taxable years beginning after December 31, 2009, would apply to carried interests in partnerships where the partner holds an “investment services partnership interest.” An investment services partnership interest is an interest held by a person who provides advisory, management, financing and other supporting services with respect to the acquisition, holding or disposing of securities, rental real estate, interests in partnerships, commodities, or options or derivatives with respect to any of the foregoing.  

In related news, on March 10, 2010, the Senate passed a tax extenders package; however, the Senate’s version does not use carried interest as its main revenue offset. Instead, the Senate’s version replaced carried interest with “black liquor” and “codification of economic substance doctrine” offsets.  

Amendment to the Bank Secrecy Act Regulations; Reports of Foreign Financial Accounts

On February 26, 2010, the Internal Revenue Service (the “IRS”) and the Financial Crimes Enforcement Network of the Department of the Treasury issued current guidance and Proposed Regulations covering a number of important issues with respect to the requirement to file Form TD F 90-22.1, Report of Foreign Bank and Financial Accounts (“FBAR”). Most significantly for private investment funds, the IRS guidance provides that an FBAR filing is not required with respect to interests in offshore private equity and hedge funds for 2009 and earlier calendar years. Please see our March 1, 2010 client alert entitled “FBAR Filing Not Required for Interests in Offshore Private Equity and Hedge Funds for Calendar Years 2009 and Earlier” for further information on this topic.  

Let Wall Street Pay for the Restoration of Main Street

On December 3, 2009, Representative Peter DeFazio, Chairman of the U.S. House of Representatives Subcommittee on Highways and Transit, introduced legislation entitled “Let Wall Street Pay for the Restoration of Main Street” that would assess a tax on certain securities transactions, including:  

  • stock transactions (tax rate = 0.25%);  
  • futures contracts to buy or sell a specified commodity of standardized quality at a certain date in the future, at a market determined price (tax rate = 0.02%);  
  • swaps between two firms on certain benefits of one party’s financial instrument for those of the other party’s financial instrument (tax rate = 0.02%);  
  • credit default swaps where a contract is swapped through a series of payments in exchange for a payoff if a credit instrument goes into default (tax rate = 0.02%); and  
  • options.  

To ensure the tax is appropriately targeted to speculators and has no impact on the average investor and pension funds, the tax would be refunded for tax-favored retirement accounts, mutual funds, education savings accounts, health savings accounts and the first $100,000 of transactions annually that are not already exempted.  

California: An Act to Amend the Political Reform Act of 1974: Placement Agents

On February 8, 2010, California Assemblyman Ed Hernandez introduced a bill requiring placement agents to register as lobbyists before pitching investment ideas to public pension plans in California. The legislation, AB 1743, would define placement agents as lobbyists in accordance with the state’s Political Reform Act. Placement agents would be subject to strict gift limits, campaign contribution prohibitions, and be prohibited from receiving compensation contingent upon any investment decision by the California Public Employees’ Retirement System (“CalPERS”). The placement agents, their firms and employers would be required to report quarterly on their fees and compensation and on any honoraria or gifts. The bill is sponsored by CalPERS, state Controller John Chiang and Treasurer Bill Lockyer.  

Connecticut: An Act Concerning Transparency and Disclosure  

On March 11, 2010, the Connecticut State Senate Banks Committee approved CT State Bill No. 5053 entitled “An Act Concerning Transparency and Disclosure.” The bill would require any investment adviser to a hedge fund to “disclose to each investor or prospective investor in such hedge fund, not later than thirty days before any such investment, any financial or other interests the investment adviser may have that conflict with or are likely to impair the investment adviser’s duties and responsibilities to the fund or its investors.” Although the bill is intended to target hedge funds, as currently drafted, the language of the bill potentially picks up all private funds, including private equity funds and venture capital funds. According to the bill, a hedge fund is located in CT if such fund has an office in CT where employees regularly conduct business on behalf of the hedge fund.  

New York: Taxpayers’ Reform for Upholding Security and Transparency

On October 8, 2009, New York State Attorney General Andrew Cuomo proposed legislation entitled, “Taxpayers’ Reform for Upholding Security and Transparency” (“T.R.U.S.T”), which would institutionalize Mr. Cuomo’s Public Pension Fund Reform Code of Conduct, announced earlier this year, and provide additional civil, criminal and administrative penalties and sanctions to ensure firms and individuals are held accountable for violations of the new law. The legislation would:  

  • Replace the sole trustee that currently manages the New York State Common Retirement Fund (“CRF”) with a Board of Trustees composed of 13 members. The Comptroller would chair the Board and serve alongside six members appointed by the Governor, Attorney General, Temporary President of the Senate, Speaker of the Assembly, the Senate Minority Leader and the Assembly Minority Leader. The Board’s other six members would be selected by the members of CRF.  
  • Prohibit investment firms from using placement agents, lobbyists, or any other thirdparty intermediaries to communicate or interact with New York public pension funds for any purpose. The prohibition would not apply to the use of consultants and investment banks to otherwise directly assist investment firms by, for example, preparing marketing materials or performing due diligence.  
  • Prohibit investment firms (and their principals, agents, employees and family members) from doing business with a public pension fund for two years after the firm makes a campaign contribution to any board member. The prohibition would also apply to candidates for such positions, but would not apply to contributions of $300 or less to elected officials or candidates for whom the person making the contribution can vote.  
  • Require rigorous, ongoing disclosure of information relating to the identities, responsibilities and qualifications of investment fund personnel and any payments by investment firms to third parties in connection with public pension fund matters. Investment firms would be required to promptly publish such information on their websites.  
  • Hold investment firms to a higher standard of conduct that avoids even the appearance of impropriety. The legislation would prohibit: (i) improper relationships between pension fund officials and an investment firm’s personnel or agents; (ii) “revolving door” employment by investment firms of former public pension fund officials and employees; and (iii) improper gifts by investment firms to public pension fund employees and officials.  
  • Require investment firms to promptly disclose and cure any actual, potential and apparent conflicts of interest to public pension fund officials or law enforcement authorities where appropriate.  
  • Require investment firms to certify annually that they are in compliance with key disclosure requirements.  
  • Institute comprehensive and tough enforcement provisions by creating tough new civil, criminal and disciplinary penalties and sanctions, and by requiring licensed professionals to report to law enforcement evidence of violations of the law. The legislation would also provide as a basis of criminal prosecution the theft of property and honest services from the retirement system, and would extend the statute of limitations for a person acting in concert with a public servant.  

New York City: Restrictions Regarding Placement Agents

On February 18, 2010, New York City (“NYC”) Comptroller John Liu proposed new rules regarding the use of placement agents in connection with investments by NYC pension funds. Mr. Liu seeks to make a distinction between “legitimate placement agents who provide value-added services” and those that seek to influence decision makers for a designated fee. These new restrictions must be approved by the various NYC pension boards. Here is a brief summary of the proposals taken from Mr. Liu’s press release:  

  • Comptroller Liu will decline any campaign contributions from investment managers and their agents doing business with, or seeking to do business with, the NYC pension systems.  
  • Fund managers must certify that they have not given any gifts to any employees of the Comptroller’s Office, nor to any employees or trustees of the NYC pension systems.  
  • Fund managers must disclose all contact with employees of the Comptroller’s Office regarding new investments, as well as all contact with pension trustees and other individuals involved in the investment decisionmaking process.  
  • Fund managers must disclose all fees and terms relating to any firm retained to provide marketing or placement services, and that any such fees are fully paid by the fund manager.  
  • Fund managers must agree that the pension system(s) may terminate or rescind a contract or commitment for investment and recoup all management and performance fees for violation of these requirements.  
  • The current ban on private equity placement agents will be expanded to include placement agents and third-party marketers for all types of funds, where such agents and marketers are exclusively providing “finder” or introduction services.  
  • The current ban on private equity placement agents will be relaxed to allow use of placement agents who provide legitimate valueadded services such as due diligence and similar professional services on behalf of prospective investors.  
  • Such agents and marketers must demonstrate the ability to raise capital outside NYC by establishing that they raised $500 million in at least two of the past three years from entities other than the NYC pension systems.  
  • A full description of value-added services provided as well as resumes of key professionals and employees who contact individuals involved in the decision-making process regarding a proposed investment will be required.  
  • Registration with either the SEC or the Financial Industry Regulatory Authority will be required.  

IOSCO Publishes Systemic Risk Data Requirements for Hedge Funds

On February 25, 2010, the International Organization of Securities Commissions’ (“IOSCO”) Technical Committee published details of an agreed template for the global collection of hedge fund information that it believes will assist in assessing possible systemic risks arising from the hedge fund sector. The purpose of the template is to enable the collection and exchange of consistent and comparable data amongst regulators and other competent authorities for the purpose of facilitating international supervisory cooperation in identifying possible systemic risks in this sector. The template is not a comprehensive list of all types of information and data that regulators might want; so, regulators are not restricted from requiring additional information at a domestic level. The 11 proposed categories are: general manager and adviser information; performance and investor information related to covered funds; assets under management; gross and net product exposure and asset class concentration; gross and net geographic exposure; trading and turnover issues; asset/liability issues; borrowing; risk issues; credit counterparty exposure; and other issues such as complexity, number of open positions and concentration. The SEC is a member of the Executive Committee of IOSCO. As a member, the SEC agrees to adopt the principles of IOSCO. The press release states specifically, “IOSCO is publishing the template now to help inform any planned legislative changes being considered in various jurisdictions, as well as providing securities regulators the type of information authorities could gather. The Task Force has recommended that the first data gathering exercise should be carried out on a best efforts basis (given pending legislation in many jurisdictions) in September 2010.”