Industry Update

SEC Chairman Outlines Priorities

As discussed in the February 18, 2009 Davis Polk Corporate Regulatory Report, SEC Chairman Mary Schapiro recently spoke at the annual “SEC Speaks” conference and indicated her priorities for the year ahead.  A summary of those priorities is provided below:

Policy and Rulemaking Agenda

Chairman Schapiro announced that the SEC will take action to (i) improve the credit rating system by addressing inherent conflicts of interest resulting from the compensation models of credit rating agencies, (ii) promote and appropriately regulate a centralized clearinghouse for credit default swaps, (iii) strengthen risk-based oversight of investment advisers and broker-dealers and (iv) promote the safe and sound custody of customer assets held by investment advisers and broker-dealers.  In addition, Chairman Schapiro announced that the SEC will form an “Investment Advisory Committee” in order to re-engage with investors and “ensure that the Commission hears firsthand about the issues most concerning to investors.”

Agenda to Enhance Enforcement Program

Chairman Schapiro announced that she has ended the two-year “penalty pilot” program which had required SEC enforcement staff to seek special approval from Commissioners in cases involving monetary penalties for public companies as punishment for securities fraud.  Chairman Schapiro stated that this program caused significant delays in corporate penalty cases and discouraged SEC staff from bringing such cases.  In addition, Chairman Schapiro has initiated a program to speed the approval process for formal orders of investigation, which are required for SEC staff to issue subpoenas to compel witness testimony and document production in an enforcement action.  Currently, many formal orders of investigation are made subject to review and approval at a meeting of all five Commissioners, which can cause a significant delay.  Chairman Schapiro has directed that going forward, approval may be obtained in writing by the Commissioners in seriatim or, where appropriate, by a single Commissioner acting as a “duty officer.”  Chairman Schapiro also stated that she is considering further measures to reinvigorate the SEC’s enforcement program, such as improving the handling of tips and whistleblower complaints.

President Proposes to Tax Carried Interest as Ordinary Income

President Obama’s budget proposal, released on February 26, 2009, contains, under the heading “Other revenue changes and loophole closers,” the following line item:  “Tax carried interest as ordinary income.”  The estimated impact of this provision on the federal deficit suggests that the change in the treatment of carried interest would not take effect prior to 2010.

Private equity funds and certain other investment partnerships typically grant an equity interest in the partnership – a “carried interest” or “incentive allocation” – that entitles the sponsor to a percentage of the partnership’s profits that is higher than the percentage of the capital contributed by the sponsor.  Because partnerships are transparent for tax purposes, the character of the underlying income out of which a carried interest allocation or incentive allocation is made (including long-term capital gain that may be taxed at the rate of 15%) flows through to the sponsor.  A change in law to treat carried interest as ordinary income would have a greater impact on sponsors of private equity, venture capital and real estate funds than it would on sponsors of hedge funds because the underlying income of many hedge funds consists, to a large extent, of short-term capital gains and ordinary income.

Although the proposed budget contains no details with respect to the provision that would change the taxation of carried interest, there have been several recent legislative proposals to tax carried interest at ordinary income rates.  In particular, proposed legislation originally introduced by House Ways and Means Committee Chairman Charles B. Rangel (D-N.Y.) would treat carried interest allocations as ordinary compensation income.  As a result, carried interest would not only be subject to income tax at the highest marginal rates, but would also be subject to self-employment tax.  This proposed legislation contains several provisions aimed at possible strategies that fund sponsors might adopt in response to changes in the tax treatment of carried income allocations, including loans made to a sponsor to enable it to make a capital contribution, loans made to the partnership, and options or other derivative instruments that reflect the increase in value of an investment fund.  In addition, the proposed legislation would treat gain derived from the disposition of a carried interest as ordinary compensation income, and would require the holder of a carried interest to recognize ordinary compensation income in connection with an in-kind distribution of partnership property.

We will continue to monitor developments in proposals to alter the taxation of carried interest.

EU Group Releases Report on Regulatory Reform (Including Hedge Funds)

On February 25, 2009, the High-Level Group on Financial Supervision in the EU, a group established by the President of the European Commission and chaired by Jacques de Larosière, released an 86-page report (the “Report”) that includes 30 recommendations aimed at strengthening the financial regulatory system in the European Union (“EU”) and promoting global financial stability.  Of note to hedge funds and banks that do business with hedge funds, the Report recommends (i) extending appropriate regulation, in a proportionate manner, to all firms or entities conducting financial activities of a potentially systemic nature, even if they have no direct dealings with the public at large, (ii) improving transparency in all financial markets, and notably for systemically important hedge funds, by imposing, in all EU Member States and internationally, registration and information requirements on hedge fund managers concerning their strategies, methods and leverage, including their worldwide activities, and (iii) introducing appropriate capital requirements on banks that own or operate a hedge fund or are otherwise engaged in significant proprietary trading and closely monitoring them.  In addition, the Report recommends developing common rules for investment funds in the EU, including (i) developing a common EU definition of money market fund, (ii) restricting the assets in which money market funds can invest, (iii) instituting rules to restrict the delegation of investment management functions and (iv) instituting rules to tighten supervisory control over the independent role of depositories and custodians.  Although the Report is primarily intended to address a European audience, many of its recommendations extend to the international level, and we may see some of these concepts emerge as elements of U.S. regulatory reform expected to take shape later this year.

Connecticut Lawmakers Propose Stricter Private Fund Regulations

Connecticut legislators have proposed three bills that would impose additional restrictions on private funds that have an office in Connecticut where employees regularly conduct business on behalf of the fund.  Raised Bill No. 953 would prohibit individual investors with less than $2.5 million in investment assets and institutional investors with less than $5 million in investment assets from making investments in hedge funds.  While the bill is advertised as targeting hedge funds, it defines hedge funds in reference to funds that claim an exemption from registration with the SEC under Section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, which would capture hedge funds as well as private equity funds, venture capital funds and other private funds.  Raised Bill No. 953 would also require, among other things, annual independent financial audits and disclosure of fees, side letters and material changes in a fund’s investment strategy.  The second bill, Raised Bill No. 6477, would require “hedge funds” to purchase an annual $500 license from the Connecticut Banking Commissioner and subject such funds to regulations promulgated by the Banking Commission.  The third bill, Raised Bill No. 6480, calls for hedge funds receiving money from pension funds to provide detailed portfolio information to prospective pension investors.

It is uncertain whether the proposals will be enacted, but they could represent a starting point for future legislation.  Connecticut is estimated to be home to almost 10% of the world’s hedge fund assets, with only New York and London having a greater concentration.  Thus, a change of policy in Connecticut could affect a significant number of funds and even encourage some funds to relocate.  It could also inspire similar regulatory proposals in other states.  If the Banking Committee approves the proposals, lawmakers could vote on the bills before June.

SEC Rules and Regulations

SEC Releases Final Rules Requiring Mutual Funds to Provide Information in Interactive Data Format

On February 11, 2009, the SEC released final rule amendments that will require mutual funds to provide risk/return summary information to the SEC in an interactive data format using eXtensible Business Reporting Language (“XBRL”).  The amendments (which, as reported in the January 13, 2009 Investment Management Regulatory Update, were adopted in December 2008) will become effective July 15, 2009; and the deadline for mutual funds to begin complying with the requirements set forth in the amendments is January 1, 2011. 

The amendments will require mutual funds to provide the risk/return summary section of their prospectuses in XBRL interactive data format as an exhibit to their registration statements.  In addition, the amendments will require mutual funds filing a form of prospectus pursuant to rule 497(c) or (e) under the Securities Act of 1933 (“Securities Act”) that contains risk/return summary information varying from the fund’s registration statement to submit that information as an exhibit in interactive data format as well.  Mutual funds will also be required to provide document and entity identifier tags, such as form type and fund name, and to post interactive data to their websites the same day such data is provided to the SEC (or the day the data is required to be submitted to the SEC, if earlier).  Mutual funds failing to comply with the new interactive data requirements will lose the ability to file post-effective amendments to registration statements under rule 485(b) under the Securities Act until they submit and post the interactive data as required.

The amendments are not intended to change the substance of disclosure, but rather to require information to be provided in an additional format.  For purposes of Form N-1A filings (whether registration statements or post-effective amendments), the interactive data exhibit must be submitted as an amendment to the registration statement to which the interactive data relates and must be submitted after, but within 15 business days of, the effective date of such related filing.  For a form of prospectus filed pursuant to rule 497(c) or (e) under the Securities Act, the interactive data exhibits may be submitted concurrently with the rule 497 filing, or up to 15 business days subsequent thereto.

Liability for the interactive data files required by the amendments will be governed by rule 406T of Regulation S-T, which generally provides that interactive data files are:

  • Subject to the anti-fraud provisions of Section 17(a)(1) of the Securities Act, Section 10(b) of and rule 10b-5 under the Securities Exchange Act of 1934 (“Exchange Act”) and Section 206(1) of the Investment Advisers Act of 1940 (“Advisers Act”);
  • Deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act; deemed not filed for purposes of Section 18 of the Exchange Act or Section 34(b) of the Investment Company Act and are otherwise not subject to liability under these sections;
  • Deemed filed for purposes of rule 103 of Regulation S-T; and
  • Subject to liability for a failure to comply with rule 405 of Regulation S-T, but deemed to have complied with rule 405 and not be subject to liability under the anti-fraud provisions set forth above or under any other liability provision if the electronic filer: (i) makes a good faith attempt to comply with rule 405 and (ii) after the electronic filer becomes aware that the interactive data file fails to comply with rule 405, promptly[1] amends the interactive data file to comply with rule 405.

The foregoing liability provisions will apply only until October 31, 2014; thereafter, interactive data files will be subject to the same liability provisions as the official filings to which they relate.

New Form D Filing Deadline Approaches on March 16, 2009

As discussed in greater detail in the February 9, 2009 Investment Management Regulatory Update, new changes to Form D and electronic filing requirements will go into effect on March 16, 2009.  In the case of an ongoing offering for which an old Form D (or the latest amendment thereto) was filed on or prior to March 16, 2008, an annual amendment on the new electronic Form D will have to be submitted no later than March 16, 2009.  If you have any questions on whether your fund must file a Form D prior to the March 16, 2009 deadline, or on the process of filing a Form D electronically, please contact your regular Davis Polk contact.


SEC Sends “Sweep Letters” Regarding Custodial Arrangements and Rumor-Mongering

On February 13, 2009, the SEC sent a “sweep letter” to various registered investment advisers and broker-dealers requesting information concerning custodial arrangements for the safekeeping of client assets.  The SEC also sent a “sweep letter” to registered investment advisers on February 10, 2009 requesting information regarding the manipulation of securities prices through the malicious use of false or misleading rumors.  The letters are consistent with recent statements by SEC Chairman Shapiro, as discussed in “SEC Chairman Outlines Priorities” above, indicating that the SEC would promote sound custodial practices and reinvigorate enforcement initiatives.

The custodial arrangements letter indicates that the SEC seeks to understand recipient custodial arrangements, client asset safekeeping controls and control implementation measures through on-site interviews with personnel responsible for safekeeping client assets.  In particular, the letter notes that the SEC wishes to interview middle- and back-office personnel involved with authorizing custodians to receive and disburse client assets, provide periodic statements to clients and reconcile client position records with those of custodians.  Additionally, the letter requests information on non-registrants, such as names and contact information of affiliated and unaffiliated service providers.

The rumor-mongering letter requests information from registered investment advisers regarding reviews by such advisers in relation to the malicious use of false or misleading rumors in connection with price manipulation.  Additionally, the letter asks advisers to provide information concerning changes to policies on, and employee training in connection with, rumor-mongering.  Notably, the letter requests information regarding how advisers monitor employee Internet use and adviser policies for monitoring the use of personal mobile communications devices by portfolio management and trading personnel. 

UBS to Pay $200 Million to Settle SEC Charges of Unregistered Investment Adviser and Broker-Dealer Activity

On February 18, 2009, the SEC charged UBS AG (“UBS”) with acting as an unregistered investment adviser and broker-dealer in violation of Section 203(a) of the Investment Advisers Act of 1940 (“Advisers Act”) and Section 15(a) of the Securities Exchange Act of 1934 (“Exchange Act”).  The SEC claims that UBS’s conduct enabled its U.S. clients to maintain undisclosed accounts in Switzerland and other foreign countries, thereby facilitating the avoidance by such clients of taxes on assets held in those accounts.  In settlement of the charges, UBS consented to the entry of a final judgment ordering it to disgorge $200 million in ill-gotten gains and permanently enjoining it from acting as an unregistered investment adviser or broker-dealer.

The complaint, which was filed in the U.S. District Court for the District of Columbia, alleges that UBS acted as an unregistered investment adviser and broker-dealer between 1999 and 2008 to thousands of U.S. persons and offshore entities beneficially owned by U.S. citizens.  According to the SEC, UBS held billions of dollars of assets for these persons and entities, generating $120 to $140 million in revenues per year. 

The SEC claims that UBS conducted its U.S.-focused cross-border business predominantly through advisers in Switzerland who were not associated with a U.S.-registered investment adviser or broker-dealer.  According to the complaint, these advisers traveled to the U.S. approximately two to three times per year on trips ranging from one to three weeks in duration during which they attended various events—which were often sponsored by UBS—such as yachting events, art shows and sporting events in order to solicit and communicate with U.S. clients.

The complaint asserts that UBS was aware that it was required to register with the SEC and attempted to conceal its unregistered investment advisory and broker-dealer conduct.  For instance, client advisers allegedly used encrypted laptop computers when traveling in the U.S. in order to provide account-related information, show marketing materials for securities products and communicate securities transaction orders to UBS in Switzerland.  Moreover, the SEC asserts that client advisers received training in avoiding detection by U.S. authorities.

As noted above, UBS agreed to the issuance of a final judgment to settle the charges.  UBS has also entered into a deferred prosecution agreement with the Department of Justice in connection with a related criminal investigation, pursuant to which it will pay an additional $180 million in disgorgement and $400 million in tax-related payments.

Judge Denies Hedge Fund’s Motion to Dismiss in Investor Redemption Suit

On February 18, 2009, the U.S. District Court for the District of Connecticut denied a hedge fund’s motion to dismiss a variety of claims asserted by an investor who was blocked from withdrawing his investment in a case that could influence future disputes involving hedge fund redemption requests.

The plaintiff, Joseph Umbach, filed suit against defendants Carrington Investment Partners (US), L.P. (the “Fund”), Carrington Capital Management, LLC (the general partner of the Fund) and Bruce Rose (the sole member of the general partner) (collectively, the “Defendants”) claiming that he was improperly barred from withdrawing his $1 million investment in the Fund.  Umbach alleged, among other things, that he was assured through verbal communications and a side letter (the “Side Letter”), and as a condition to investing in the Fund, that any lock-up periods would be permanently waived and that his investments would always be redeemable.  Umbach claimed that he was not informed that the Side Letter only waived the initial 12-month lock-up period imposed under the limited partnership agreement of the Fund (the “Agreement”) and not any lock-up periods that subsequently could be imposed by amending the Agreement.

In July 2007, Umbach gave timely notice of withdrawal of his investment pursuant to the Agreement.  Several months later, the Fund amended the Agreement to impose an additional 12-month lock-up period for all investors and to freeze redemptions (the “Amendment”).  Umbach alleged that the Fund improperly coerced its limited partners to approve the Amendment by, among other things, misrepresenting to investors weeks prior to the voting deadline that a majority of the limited partners supported the Amendment.

The Defendants’ motion to dismiss rested largely upon their claim that the language in the Side Letter and the Agreement was unambiguous and only waived the initial 12-month lock-up period, not any subsequent lock-up periods.  The court rejected the Defendants’ argument, reasoning that “when taken in context with Plaintiff’s allegations, the language in the Agreement and Side Letter is not as clear as the Defendants allege in their motion.”  Accordingly, the court denied the Defendants’ motion to dismiss claims of securities fraud, common law fraud, negligent misrepresentation and breach of contract in connection with the alleged misrepresentations regarding the effect of the Side Letter.  In addition, the court denied the Defendants’ motion to dismiss the breach of fiduciary duty claim, reasoning that the complaint alleged facts sufficient to support a finding that the Defendants coerced the limited partners of the Fund to approve the Amendments with the incentive of collecting greater compensatory fees.


If you have any questions regarding the matters covered in this Regulatory Update, please contact any of our Investment Management Group lawyers listed below or your regular Davis Polk contact:

John Crowley, Partner
212-450-4550 |

Nora Jordan, Partner
212-450-4684 |

Yukako Kawata, Partner
212-450-4896 |

Leor Landa, Partner
212-450-6160 |

Danforth Townley, Partner
212-450-4240 |

Sophia Hudson, Associate
212-450-4762 |


To ensure compliance with requirements imposed by the IRS, we inform you that, unless explicitly provided otherwise, any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.