As 2009 begins, it is an appropriate time to review certain of the past year’s important legal developments that may affect your business and to remind you of issues to assure your compliance with applicable law, regulation and best practices. The summary that follows discusses legal and compliance issues affecting hedge funds, private equity funds, federally registered investment advisers, unregistered investment advisers and broker-dealers. For further guidance regarding any of the information discussed below, please contact a member of the Lowenstein Sandler Investment Management Group.
Significant Developments in 2008
Short Sales and Form SH Filing. On October 15, 2008, the Securities and Exchange Commission (the “SEC”) adopted an interim final rule (the “Interim Rule”) requiring institutional investment managers to file information on Form SH disclosing their short sales of and positions in Section 13(f) securities, other than options. The rule extension became effective on October 18, 2008 and will expire on August 1, 2009, unless the SEC acts to amend or continue the rule beyond that date.
The Interim Rule requires that institutional investment managers that exercise investment discretion with respect to accounts holding securities described in Rule 13f-1(c) under the Securities Exchange Act of 1934 as amended (the “Exchange Act”), must file weekly reports of short sale activity for any account having an aggregate fair market value of $100,000,000 or more. The Interim Rule contains the following key provisions:
- Form SH filers must file the Form SH on a weekly basis on the last business day of the calendar week (i.e., generally, Friday);
- Filers are not required to disclose the value of the securities sold short;
- The Interim Rule requires the reporting of all short positions. This means that the start-of-day position and end-of-day position will need to include all prior short positions to the extent those positions remain open on the relevant reporting date;
- The threshold for reporting short sales or positions in a security is a fair market value of $10 million. The value is based on the market price of the security as of the close of trading on the New York Stock Exchange for the day in question. It is important to note that this threshold is calculated on a security-by-security basis and is not calculated based on the aggregate short positions that the filer holds in all securities;
- In order to facilitate the SEC’s ability to review the data, Form SH filers are required to submit an XML tagged data file to the SEC providing the requested data;
- Whether an institutional investment manager is subject to the Interim Rule depends on whether it filed, or was required to file, a Form 13F for the most recent calendar quarter; and
- All Form SH filings are non-public.
An institutional investment manager is not required to file a Form SH if it has not engaged in any short sales during the reporting period, even if the manager closes a short position during that period. In addition, there is no need to file a Form SH if on each calendar day of the reporting period, the following two conditions are met: (i) the start-of-day short position, the gross number of securities sold short during the day and the end-of-day short position in each security sold short constitute less than one-quarter of one percent of the issued and outstanding shares of that security as reported on the issuer’s most recent annual, quarterly or current report filed with the SEC, and (ii) the fair market value of the start-of-day short position, the gross number of shares of such security sold short during the day and the end-of-day short position is less than $10,000,000 (the “De Minimis Exemption”). In order to rely on the De Minimis Exemption to avoid the filing of a Form SH entirely, these conditions must be true for each security sold short during the entire reporting period (the full week). The investment manager may also rely on the De Minimis Exemption to exclude data from Form SH.
Customer Claims against Lehman Brothers Inc. January 30, 2009 is the deadline for customers of Lehman Brothers Inc. to file customer claims in the Securities Investor Protection Act (“SIPA”) liquidation proceeding. The January 30, 2009 deadline is applicable only for customer claims against Lehman Brothers Inc. and not against any other Lehman Brothers entity. The deadline for all other types of claims in the SIPA liquidation proceeding is June 1, 2009. No deadlines have been set for filing proofs of claim in the Chapter 11 proceedings of the other Lehman Brothers entities.
Customer Claims against Bernard L. Madoff Investment Securities LLC. March 4, 2009 is the deadline for customers of Bernard L. Madoff Investment Securities LLC (“Madoff Securities”) to file customer claims in the SIPA liquidation proceeding. The March 4, 2009 deadline is applicable only for customer claims, while the deadline for all other types of claims in the Madoff Securities liquidation proceeding is July 2, 2009.
Investment Adviser Examinations: Core Initial Request for Information. In November 2008, the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) released its Core Initial Request for Information list, which SEC examiners will present to investment advisors at audit. This request for information list details the information required from investment advisers to ensure the effectiveness of an investment adviser’s compliance program, which prevents violations of the Investment Advisers Act of 1940.
The requested information includes general information about the investment adviser, such as information about the firm’s organizational structure. In addition, the Core Initial Request solicits information regarding the firm’s compliance program, risk management procedures, and internal controls, as well as information needed to facilitate testing with respect to advisory trading activities and compliance in various areas, such as performance advertising, marketing, and anti-money laundering.
The complete information request list is available at http://www.sec.gov/info/cco/requestlistcore1108.htm.
OCIE examinations that reveal serious deficiencies may be referred to the SEC for enforcement.
Deductibility of Management Fees. The Internal Revenue Service (“IRS”) recently released Revenue Ruling 2008-39, which addresses the tax treatment of management fees paid by upper-tier partnerships (“UTP”) and lower-tier partnerships (“LTP”). Specifically, Revenue Ruling 2008-39 involves an individual who owns a limited partnership interest in a UTP. A UTP owns limited partnership interests in LTPs. For tax purposes, each LTP is a “trader,” which is considered to be engaged in the business of trading in securities. On the other hand, the UTP is deemed to be an “investor,” as its activities consist solely of acquiring, holding and disposing of interests in the LTPs, which the ruling states does not rise to the level of a “trade or business” for tax purposes.
The management fees paid by the LTP are a trade or business expense under section 162 of the Internal Revenue Code (the “Code”), and an individual partner of the LTP can deduct his or her allocable share (passed through the UTP) of such expense, without limitation, in computing his or her allocable share (passed through the UTP) of an LTP’s income or loss. However, because the UTP is not itself a trader, and because the management fee is not paid on behalf of any LTP in connection with the LTP’s trade or business, the UTP’s management fee is not deductible under section 162 of the Code. Instead, it can be deducted under section 212 of the Code, which permits deductions for expenses incurred in the production of income. Such expenses are treated as miscellaneous itemized deductions, however, and thus generally are deductible only to the extent that such expenses exceed two percent (2%) of the individual taxpayer’s adjusted gross income. Consequently, individual UTP limited partners are likely to be prevented from deducting their full shares of the UTP management fee.
If the IRS were to extend the reasoning in Revenue Ruling 2008-39 to hedge funds using a master-feeder structure, management fees paid at the domestic feeder fund level could be treated as miscellaneous itemized deductions, even if the master fund were engaged in sufficient trading to be classified as a trader.
Red Flag Rules. As of May 1, 2009, businesses in the financial industry, including SEC-registered brokerdealers and investment advisers, are required to be in compliance with the “Red Flag Rules,” which require certain financial institutions and creditors to develop and implement written Identity Theft Prevention Programs to detect, prevent, and mitigate identity theft and other fraudulent activity in relation to customer accounts.
The Red Flag Rules apply to “financial institutions” and “creditors” that maintain “covered accounts.” A covered account includes any account that a financial institution or creditor offers or maintains, primarily for personal, family, or household purposes, that involves or is designed to permit multiple payments or transactions (i.e., consumer accounts). The definition also encompasses, however, “any other account” that a “financial institution or creditor offers or maintains for which there is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation, or litigation risks.” This second element of the definition of “covered accounts” targets small business and sole proprietorship accounts, which are presumably more vulnerable to identity theft and other fraudulent activity than accounts carried on behalf of large businesses or sophisticated parties. SEC-registered broker-dealers carrying customer accounts are subject to the Red Flag Rules.
Although the Red Flag Rules do not specify the contents of a regulated entity’s Identity Theft Prevention Program, the Federal Trade Commission (“FTC”) has issued “Guidelines” to assist in its design. The Guidelines identify twenty-six possible Red Flags, falling into five categories: (i) alerts, notifications, or warnings from a consumer reporting agency; (ii) suspicious documents; (iii) suspicious personally identifiable information (e.g., a social security number that does not match the Social Security Administration’s Death Master File); (iv) unusual use of—or suspicious activity relating to—a covered account; and (v) notice from customers, victims of identity theft, law enforcement, or other persons regarding possible identity theft in connection with covered accounts held by a financial institution or creditor.
Failure to comply with the Red Flag Rules may result in enforcement action by the FTC, including civil liability for nominal, actual or punitive damages, and attorneys' fees.
Regulation of Covered Credit Default Swaps as Insurance. On September 22, 2008, the New York State Insurance Department (the “Insurance Department”) announced that it would begin regulating covered credit default swaps (“Covered CDS”) on the basis that they are insurance contracts. A Covered CDS would be any credit default swap contract where, at the time the contract is entered into, the buyer holds, or reasonably expects to hold, a “material interest in the referenced obligation.” The effect of this regulation by the Insurance Department would have meant that only companies licensed as financial guarantee insurers would be able to write Covered CDS contracts in New York.
On November 20, 2008, the Insurance Department stated it would defer indefinitely its application of New York insurance law to Covered CDSs. However, the Insurance Department stood by its determination that Covered CDSs constituted insurance contracts. This determination may have ramifications that may include similar determinations from other jurisdictions, or further regulation of Covered CDSs by the Commodities Futures Trading Commission (“CFTC”). The Commodity Futures Modernization Act of 2000, however, currently exempts from CFTC regulation credit default swaps between two eligible contract participants as long as the swaps are not entered into on a trading facility.
YEAR END CHECKLISTS
Private Investment Funds
Compliance Policies. As we have noted in prior Investment Management Alerts, the requirements pertaining to registered investment advisers and to unregistered advisers have continued to merge, and more and more unregistered managers are adopting best practices and improving their existing compliance policies. Whether your firm is currently federally registered or will be required to register in the near future, you should review your compliance policies periodically to verify that they are adequate and that your firm is adhering to them.
New Issues Certifications. If you purchase “new issues” (defined by NASD Rule 2790 as adopted by FINRA to mean equity securities issued in an initial public offering), your broker (or, if you are a fund-of-funds that invests indirectly in new issues, the underlying funds) will require that you certify each year as to whether the fund is a “restricted person” within the meaning of the rule. To do so, you must re-certify the status of investors in your fund as restricted persons or unrestricted persons. Please contact us if you require documentation to obtain such re-certifications from your investors.
Updating Offering Documents. Offering documents should be reviewed from time to time to verify that they contain a current, complete and accurate description of your fund’s strategy, management, soft dollar and brokerage practices; that they comply with current law and regulation; and that they reflect current disclosure trends. We would be happy to assist you in reviewing and, if necessary, updating your offering documents to reflect changes in law, regulation and disclosure practices.
Blue Sky and Local Securities Matters. You should continue to inform us of all offers or sales of fund interests. Offers to U.S. persons may trigger filing obligations in a given offeree’s state of residence. Offers to foreign persons may require filings in the country of a given offeree’s residence.
Privacy Notices. Investment advisers and investment funds must have privacy policies in place. In addition to being distributed at the time of subscription, privacy notices must be distributed at least once per year and more often if there are any changes to the policy/notice. We believe that the best time for the annual distribution of the notice is with your annual financial statements and/or tax reports.
Beneficial Ownership Reporting Requirements. If your fund (including, for this purpose, affiliated investment funds) acquires more than five percent (5%) of a class of equity securities registered under the Securities Exchange Act of 1934, as amended (the “1934 Act”) (i.e., the equity securities of most publicly traded companies), you must monitor and comply with the reporting requirements of the Williams Act by filing a Schedule 13D or a Schedule 13G. A Schedule 13D must be amended upon any material change in the facts contained therein, including the acquisition or disposition of securities in an amount equal to one percent or more of the class being reported. If, on the other hand, you have filed a short-form Schedule 13G, and the information reflected in the schedule is different at December 31 than that previously reported, you are generally required to amend the schedule by February 14 of the following year.
In addition, if the fund (again, including affiliated funds) acquires a greater than ten percent (10%) interest in a class of equity securities registered under the 1934 Act, the fund has an obligation to file reports of beneficial ownership on Forms 3, 4 and 5, as well as corresponding potential liability for short-swing profits under Section 16 of the 1934 Act.
Furthermore, quarterly reports of equity holdings by institutional investment managers are required on Form 13F where certain equity assets under management total $100,000,000 or more. If the fund (together with all affiliated investment funds) reaches this threshold, please let us know, and we will provide information regarding how and when to file Form 13F and the required weekly reports of short sale activity on Form SH.
Registered Commodity Pool Operators. If your fund is a commodity pool, you must prepare an annual report for each pool in accordance with the rules of the Commodity Futures Trading Commission (“CFTC”) and file such report with the CFTC and the National Futures Association. In addition, unless your fund qualifies for an exemption, you must update your disclosure documents periodically, as you may not use any document dated more than nine (9) months prior to the date of its intended use. Furthermore, documents that are materially inaccurate or incomplete must be corrected and the correction must be distributed to pool participants within twenty-one (21) days of discovering the defect.
Investment Company Act Compliance. If your fund is a 3(c)(1) fund—that is, it relies on the exemption from registration as an investment company because it has one hundred (100) or fewer investors—you must continually monitor the number of investors and the attribution rules under the Investment Company Act of 1940, as amended. The attribution rules provide that if an investor that is itself relying upon Section 3(c)(1) or Section 3(c)(7) (for example, a “fund of funds”) holds more than ten percent (10%) of the equity interests in the fund, the fund must “look through” this investor and count as the hedge fund’s own investors each of the partners or shareholders of the fund investor. Therefore, potential investments greater than ten percent (10%) of the fund’s equity made by entities must be analyzed to verify that they will not subject the fund to regulation as an investment company by exceeding the one hundred (100) investor limit. In addition, if an entity not relying on Sections 3(c)(1) or 3(c)(7) invests more than forty percent (40%) of its total assets in the fund, regulators will “look through” such entity for purposes of counting beneficial owners. Furthermore, if an entity is created for the purpose of investing in a 3(c)(1) fund, then the regulators also will “look through” the entity, regardless of its percentage ownership.
ERISA Compliance. If the aggregate amount invested in the fund by benefit plan investors (e.g., employee benefit plans, individual retirement accounts (IRAs) and entities the underlying assets of which include plan assets) were to equal or exceed twenty-five percent (25%) of the aggregate investments in the fund (excluding investments by the fund’s managers), the fund would be subject to various Employee Retirement Income Security Act of 1974 (“ERISA”) requirements. Prior federal legislation has modified the types of plans that are to be counted for the purposes of the twenty-five percent (25%) threshold (i.e., governmental plans, church plans and foreign plans are no longer counted for the purposes of the twenty-five percent (25%) threshold). You should monitor on an ongoing basis the level of investments by benefit plan investors, and, to the extent your fund approaches the twenty-five percent (25%) threshold, you should contact us to discuss the application of ERISA rules and the alternatives for compliance.
Annual VCOC Certification: As a condition to investment in a venture fund or a private equity fund, an ERISA plan investor may require the fund to provide an annual venture capital operating company (“VCOC”) certification stating that the fund qualifies as a VCOC and is deemed not to hold “plan assets” subject to ERISA. A fund will be a VCOC if (a) at least fifty percent of the fund’s portfolio investments (as determined on the fund’s annual valuation date) are venture capital investments in operating companies for which the fund has management rights, and (b) the fund has and exercises substantial management rights in at least one of its portfolio companies.
Registered Investment Advisers
Annual Updating Amendments to Form ADV. Any investment adviser who is registered with the SEC must amend its Form ADV at least annually, within ninety (90) days after the end of the adviser’s fiscal year. Your annual updating amendment must update all items on the form. Part 1A, however, must be updated electronically on the SEC’s electronic Investment Adviser Registration Depository (“IARD”) system and must specify that it is an annual updating amendment. In addition to providing the annual updating amendment, a registered adviser is required to amend (and, with respect to Part 1, file) certain parts of its form whenever the information on it becomes inaccurate.
State Filing Requirements. In addition, a given state’s laws may require a federally registered adviser to make notice filings and to pay fees in the state if it has clients or a place of business therein. Laws vary significantly from state to state. For example, New York requires that a federally registered investment adviser that has more than five clients residing in the state complete a notice filing by adding New York as a notice filing state on the IARD, and that the adviser submit to the Office of the Attorney General a copy of Part II, Schedule F and any other part of the Form ADV that is not on the IARD. There may also be certain licensing or qualification requirements for representatives of state-registered investment advisors. Please contact us with any state-specific questions.
Compliance Policies and Code of Ethics. Federally registered investment advisers must adopt and maintain detailed compliance policies and a code of ethics, and appoint a Chief Compliance Officer. If you have not already done so, please contact us immediately so that we may assist you in creating and/or documenting compliance procedures tailored to your business. In addition, compliance policies and procedures must be reviewed by the registered adviser at least annually. The first review is required to be conducted within eighteen (18) months after the adoption of the compliance policies. The compliance policies and procedures review should focus on an evaluation of the effectiveness of the policies and procedures and the need for revisions as a result of any compliance issues that arose during the prior year, any changes in the business activities of the investment adviser and/or any regulatory changes. We recommend that this review be conducted relatively early in the year so that it does not conflict with time periods when quarter-end or year-end matters are pressing. Policies that are materially changed as a result of such review should be redistributed to all appropriate personnel. In addition, Schedule F of Form ADV must contain a description of the code of ethics and a statement that the adviser will provide upon request the code of ethics to any current or prospective client.
Annual Delivery of Form ADV. Every year, a federally registered adviser must deliver (or offer in writing to deliver) to each advisory client a written disclosure statement containing the information required by Part II of Form ADV. The written offer to deliver the written disclosure statement may be included in other communications with the client, such as in an annual investor letter.
Custody. In order for federally registered investment advisers that are general partners or advisers to limited partnerships to avoid sending quarterly statements detailing the fund’s investments to all limited partners as a result of the Advisers Act’s custody rules, the fund must distribute annually audited financial statements in accordance with GAAP (without any exception to GAAP, including the amortization of offering expenses) to all limited partners within one hundred twenty (120) days after the end of its fiscal year (one hundred eighty (180) days for funds-of-funds). Please contact us if you have any question about what your practice should be.