DP&W Investment Management Regulatory Update


NYSE Regulation Fines 15 Firms a Total of $10.425 Million for Prospectus Delivery Failures

In a press release dated October 8, 2007, NYSE Regulation ("NYSE") announced that it has fined 15 firms that, in an industry-wide review by NYSE, were found to be in violation of various document delivery requirements under federal securities laws and NYSE rules. Among other things, NYSE found that, from July 1, 2004 to October 31, 2004, the firms failed to deliver prospectuses or product descriptions to certain customers who purchased shares of exchange traded funds ("ETFs"), in violation of NYSE Rule 1100(b).

Section 5(b)(2) of the Securities Act of 1933 (the "Securities Act") prohibits the delivery of certain securities without prior or simultaneous delivery of a prospectus meeting the requirements of the Securities Act. Under Section 4(3) of the Securities Act, dealers are exempt from the prospectus delivery requirement for certain secondary market transactions taking place on an exchange. Section 24(d) of the Investment Company Act of 1940 (the "1940 Act") makes the dealer exemption unavailable for transactions involving a redeemable security issued by an open-end mutual fund, which includes sales of ETF shares.

Most ETFs have obtained SEC exemptive relief from Section 24(d), allowing for the sale of ETF shares by dealers in the secondary market without a prospectus as long as purchasers of the shares are provided with a written description, also referred to as a "product description," of the securities. NYSE Rule 1100(b) requires that NYSE members provide a product description to purchasers of "Investment Company Units" exempted from Section 24(d), no later than the time the trade confirmation is delivered to the purchaser. For transactions involving ETFs that do not have an exemption from Section 24(d), the Section 5(b)(2) prospectus delivery requirement of the Securities Act applies.

During the relevant period, the 15 firms fined by NYSE failed to deliver product descriptions—or any other disclosure document, such as a prospectus—to purchasers of ETFs. This failure was attributed in part to systemic deficiencies in the document delivery procedures the firms had in place. Some firms relied on their own prospectus fulfillment facilities to deliver disclosure documents, while others relied on third-party vendors. In its press release, NYSE emphasized that regardless of how firms choose to fulfill prospectus and other delivery obligations, "compliance with the federal securities laws and NYSE rules is the sole responsibility of the firms and may not be assigned or delegated to others."

The fines, ranging from $375,000 to $2.25 million, are part of a settlement reached by NYSE with the 15 firms for violations that also included failure to deliver trade confirmations as required by Rule 10b-10 under the Securities Exchange Act of 1934 (the "Exchange Act"), failure to ensure the delivery of prospectuses in connection with certain sales and aftermarket trades of registered equity and debt securities and mutual fund transactions as required by Section 5(b)(2) of the Securities Act, and failure to establish and/or maintain adequate operational and supervisory policies and procedures to ensure the delivery of these documents to customers, as required by Section 17(a) of the Exchange Act, Rules 17a-3 and 17a-4 thereunder and NYSE Rules 342, 401, 440.

As part of the settlement, and without admitting or denying any of NYSE's allegations, the firms have agreed to pay the fines and certify to NYSE within 90 days that their current policies and procedures are sufficient to ensure compliance with regulatory requirements.

Industry Update

Proposed California Regulation Would Require Certain Investment Advisers to Register with State

The California Department of Corporations ("DOC") has proposed an amendment (the "proposed amendment") to Section 260.204.9 of the California Code of Regulations (the "current code"). If the proposed amendment is adopted, certain investment advisers that conduct business in California but are currently exempt from registration would be required to be licensed by the DOC.

The current code generally requires any investment adviser conducting business as such in the state of California to register with, and secure a certificate from, the DOC. Under the current code, investment advisers that are registered with the SEC pursuant to Section 203 of the Investment Advisers Act of 1940 (the "Advisers Act") are required only to make a notice filing with the state. In addition, an investment adviser that does not have a place of business in California and that, in the preceding 12-month period, has had fewer than 6 clients who are California residents, is not subject to the registration requirement. For purposes of this exemption, the definition of "client" conforms to Section 222(d) and Rules 203(b)(3)-2 and 222-2 under the Advisers Act, which permit an adviser to consider the funds it advises, rather than the investors in such funds, as its clients.

In addition to the foregoing exceptions to the registration requirements of Section 25230, Section 260.204.9 currently exempts from registration any adviser that

  1. does not hold itself out generally to the public as an investment adviser;
  2. has fewer than 15 clients;
  3. is exempt from registration under the Advisers Act by virtue of Section 203(b)(3) thereunder; and
  4. either (i) has "assets under management" of not less than $25 million or (ii) provides investment advice only to "venture capital companies."

The proposed amendment to the current code would eliminate conditions (2) and (4)(i) above. Thus, if the proposed amendment becomes effective, hedge fund and other investment advisers with an office in California, that do not limit their advice to "venture capital companies," have more than five California "clients" and are not registered under the Advisers Act, will be required to register with the DOC. An investment adviser registered and licensed with the DOC must, among other things, comply with various financial and other reporting and record-keeping requirements, and is subject to periodic inspections by the DOC. As defined in the current code, a company is a venture capital company if at least 50% of its assets have on at least one occasion in each year since the company's initial capitalization consisted of venture capital investments.

In the release accompanying the proposed rule amendment, the DOC cited the SEC's 2003 report, Implications of the Growth of Hedge Funds, which asserted a need for greater regulatory oversight of hedge funds. The DOC noted three factors cited by the SEC in the 2003 report—growth of the hedge fund industry, increased fraud and broader availability of hedge funds to investors. The DOC further noted the SEC's attempt at increasing regulatory oversight of hedge fund advisers by promulgating Rule 203(b)(3)-2 under the Advisers Act, which required the registration of certain hedge fund advisers who were previously exempt from registration under Section 203(b)(3) of the Advisers Act. However, Rule 203(b)(3)-2 was vacated in June 2006 by the U.S. Court of Appeals for the D.C. Circuit in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). Citing "concerns with the lack of oversight of [the hedge fund] industry" and the exemption from federal registration provided by Section 203(a)(3) of the Advisers Act, the DOC concluded that "state oversight is proper." No mention was made in the DOC's release of more recent authorities, such as the President's Working Group on Financial Markets, that have encouraged other approaches to oversight of the hedge fund industry.

The written comment period for the proposed amendment ends on November 26, 2007.

SEC Continues its Scrutiny of PIPE Deals and Hedge Funds

The SEC is continuing to closely scrutinize hedge funds. Recently, staff from the Office of Compliance Inspections and Examinations raised concerns about the practice by some in the industry of entering into certain "pre-borrowing" arrangements for borrowing shares. Such arrangements have been used by hedge funds to facilitate short sales of an issuer's publicly traded shares within a short time after the issuer announces a PIPE transaction—sometimes within seconds of announcement—by ensuring that the stock loan department has shares available to borrow quickly and effect the short. It appears that the staff is focusing on whether such pre-borrowing arrangements, considered alone or in conjunction with a short sale executed after the public announcement of a PIPE transaction, amounts to insider trading based on material nonpublic information.

IRS to Increase Scrutiny of Private Fund Tax Compliance

On November 1, 2007, the IRS stated that it was undertaking a review of income tax compliance by private fund investors and managers. The IRS said it plans to investigate, among other things, whether tax withholding obligations have been met, whether offshore funds are in the business of originating loans, whether flows of funds between related onshore and offshore funds have been properly treated and whether income has been properly characterized as ordinary or capital. Although the IRS has not provided reasons for its decision to review these issues, the review may have been prompted by pending legislation in Congress regarding the taxation of private funds and/or by media reports of tax strategies used by those funds.

If you have any questions regarding this IRS initiative or other tax audit issues, please call your regular Davis Polk contact.

SEC's Donohue Discusses Mutual Fund Operational Risk Management; Regulatory Developments at the Division of Investment Management

On October 18, 2007, in a speech at the Investment Company Institute's 2007 Operations and Technology Conference, Andrew J. Donohue, director of the SEC's Division of Investment Management (the "Division"), discussed the importance of risk management for mutual fund complexes. He noted, in particular, the need for fund complexes to establish a robust operational risk management framework in order to adequately address the challenges posed by the increasingly complex, technological environment in which these firms operate. While noting that technological developments have had a largely positive impact, Donohue pointed out that the increased volume of transactions and interconnectedness of financial systems means that small "glitches" in these systems can have disproportionately large consequences.

Donohue offered two suggestions for improving firms' operational risk profiles. First, Donohue suggested correcting technological imbalances that often exist between a firm's front and back offices. Typically traders and portfolio managers have access to very sophisticated systems for analyzing and executing trades, whereas back-office workers often settle and confirm trades using considerably less sophisticated systems, leading to backlogs and errors in data entry. Second, Donohue urged firms to resist the temptation to outsource critical back-office operations to third-parties. By focusing on increasing the sophistication of its internal back-office operations, both in terms of systems technology and personnel, a fund complex will likely find mitigating operational risk easier and more effective, predicts Donohue, because lines of responsibility will be clearer and coordination among the various operating units of a firm more likely to occur.

After addressing operational risk management, Donohue gave an overview of the Division's current regulatory initiatives.

12b-1 fees. Donohue noted his concern that 12b-1 fees "are now used primarily as a substitute for sales loads and for servicing" contrary to the regulation's original purpose, namely, reducing problems with net redemptions, spurring fund growth and reducing expenses for shareholders. The SEC began to address the issue of 12b-1 fees by hosting discussions that focus on the original purpose of, and the historical background to, rule 12b-1. Donohue characterized these discussions as fruitful. Promising ideas that arose from these discussions included: (i) creating new guidelines for fund directors to consider in accordance with their annual 12b-1 plan reviews; (ii) improving disclosure to shareholders in order to increase their awareness of the actual amount of distribution-related expenses they paid and (iii) ceasing to assess 12b-1 fees at the fund level in favor of assessing the fees directly to each investor. Donohue reported that, after placing a request for comments on the issue, the SEC received 1,400 responses, which it is in the process of reviewing.

Streamlining disclosure. Concerned that mutual fund investors are "overwhelmed with paper," the Division is in the process of formulating a streamlined disclosure regime for mutual funds, according to Donohue. Its recommendation would allow funds to give streamlined disclosure documents directly to investors and allow the investor to choose to view more detailed disclosures on the Internet or on paper, upon request. Donohue envisions the contents of the streamlined disclosure documents to include "investment objectives and strategies, costs, risks, and historical returns."

Soft dollars. On the issue of soft dollars, Donohue noted that the Division is working on providing guidance to the boards of mutual funds with respect to their responsibility to oversee the use of soft dollars at their funds. Due to improvements in technology, the cost of "best execution" is increasingly transparent, and this development, according to Donohue, allows advisers "to more accurately determine the cost of research and brokerage services obtained with soft dollars." He noted with approval overall decreases in commission rates and increased reporting of relevant information to fund boards. Donohue expected that the Division would issue a formal recommendation shortly regarding the issue of soft dollars.

Exchange traded funds. Exchange traded funds ("ETFs") have become increasingly important and now represent over $485 billion in assets. Donohue mentioned that the Division is in the process of recommending that the exemptive relief currently relied on by ETFs be codified. Currently, ETFs must apply for an exemptive order to begin operation, because, according to Donohue, they "were not envisioned when the Investment Company Act was enacted" and "do not fall neatly within the traditional categories of investment companies."

Books and records. Finally, Donohue commented on the Division's efforts to consider the books and records requirements of the Investment Advisers Act and the Investment Company Act in light of advances in technology. Donohue suggested that the Division is particularly focused on the "extent of obligations to retain electronic communications."

Congress Considering Tax Reforms Affecting Investment Managers

On October 25, 2007, House Ways and Means Committee Chairman Charles B. Rangel (D-N.Y.) introduced the Tax Reduction and Reform Act of 2007 (the "Rangel Bill"), which would have wide-ranging implications for investment funds and their managers. In particular, the Rangel Bill contains provisions that would treat fund sponsors' "carried interest" as ordinary income and eliminate the ability of investment managers to defer the recognition of incentive fees and management fees payable by offshore hedge funds. The Rangel Bill also contains a provision that would be beneficial to tax-exempt partners in investment partnerships. Under this provision, tax-exempt partners would no longer recognize "unrelated business taxable income" ("UBTI") as a consequence of certain borrowings by the partnership to finance investments.

On November 9, 2007, the House narrowly passed a version of the Rangel Bill, which included the reforms described above. According to an article published on November 10, 2007, in The Washington Post, however, the bill is unlikely to be passed by the Senate and would be subject to a veto threat by the White House. The Senate Finance Committee held extensive hearings on these issues in July and September, but as of November 12, 2007, it had not begun to consider any formal proposal regarding them. Following the House vote, Senate Majority Leader Harry Reid (D-Nev.) pledged that the Senate will approve tax reform legislation this term, but he did not express support for the carried interest proposal. According to an article that was published in The Washington Post on October 9, 2007, Senator Reid has communicated to lobbyists and industry executives that the Senate has no plans this year to change the tax treatment of "carried interest." Senate Finance Committee Chairman Max Baucus (D-Mont.) echoed this sentiment in an article published in The Wall Street Journal on November 6, 2007. Although Senator Baucus believes that the deferred compensation proposal has more support, he predicted that the measure was also not likely to be passed during this term.

Taxation of Carried Interest as Ordinary Income. The Rangel Bill proposes to tax income derived from a sponsor's "carried interest" or "incentive allocation" in an investment partnership as ordinary income for the performance of services. This provision is very similar to legislation that House Ways and Means Committee member Sander Levin (D-Mich.) introduced on June 22 (the "Levin Bill"), but contains certain additional features.

As discussed in our July Regulatory Update with respect to the Levin Bill, private equity funds and certain other investment partnerships typically grant to their sponsors (i.e., their general partners or managing members) an equity interest in the partnership 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 U.S. federal income tax purposes, the character of the income recognized by the partnership (e.g., long-term capital gain, short-term capital gain, ordinary income) flows through to the sponsor under existing law. The sponsor entity of an investment partnership is often itself a partnership, and the character of the profits allocations flows through, in turn, to the sponsor entity's partners or members.

Like the Levin Bill, the Rangel Bill would override this flow-through treatment in the case of an "investment services partnership interest," generally defined as an interest in a partnership that is held by a person that provides to the partnership, in the active conduct of a trade or business, substantial advisory or management services with respect to securities, real estate or commodities, or options or other derivative contracts with respect to securities, real estate or commodities. To the extent that a partnership interest is attributable to the sponsor's contribution of money or other property, however, the proposed legislation would not apply, and the sponsor's share of the partnership's profits would continue to be characterized under a flow-through approach.

In this regard, the Rangel Bill adds two features that were not contained in the Levin Bill. First, under the Rangel Bill, a partnership interest would not be treated as attributable to the contribution of money or other property to the extent that the contribution was funded by a loan or other advance made or guaranteed, directly or indirectly, by a partner or by the partnership. Thus, for example, a general partner could not receive flow-through treatment with respect to allocations made in respect of an interest in the partnership that it acquired with the proceeds of a non-recourse loan from the limited partners. Second, loans or other advances to the partnership that are made or guaranteed, directly or indirectly, by a partner that does not provide services to the partnership would be treated as invested capital of that partner for purposes of determining whether allocations are made in proportion to invested capital. For example, under this provision, a general partner that held 20% of the common equity in an investment partnership would be treated as deriving ordinary compensation income in respect of a portion of its partnership interest if the limited partners made loans to the partnership.

The Rangel Bill would treat as ordinary compensation income not only allocations of partnership profits made in respect of an "investment services partnership interest," but also gain derived from the disposition of an "investment services partnership interest" (including, for example, in connection with an initial public offering of the relevant partnership). In addition, if a partnership distributed appreciated property with respect to any "investment services partnership interest," the partnership would recognize gain in the same manner as if it had sold the property for fair market value and, to the extent that the gain was allocated to the holder of the "investment services partnership interest," the allocation would, under the rule described above, be treated as ordinary compensation income. The Rangel Bill would treat net loss allocated to the holder of an "investment services partnership interest," and loss derived from the disposition of an "investment services partnership interest," as ordinary loss to the extent of the cumulative amount of net income allocated in respect of the "investment services partnership interest." Amounts treated as ordinary compensation income under the proposed legislation would also be subject to self-employment tax.

While the Levin Bill covers only "investment services partnership interests," the Rangel Bill would apply similar rules to income or gain derived from certain other interests in, or related to, an entity for which a person performs investment management services. These "disqualified interests" include convertible or contingent debt, options and derivative instruments the value of which (or the payment stream on which) is substantially related to the amount of realized or unrealized income or gain from the managed assets. In the case of any underpayment of the tax imposed on income or gain derived from "disqualified interests," the taxpayer would be subject to a special penalty equal to 40% of the amount of such underpayment.

This provision contains no proposed effective date.

Nonqualified Deferred Compensation. Under the Rangel Bill, managers of offshore hedge funds, and other persons providing investment services to "nonqualified entities," would no longer be permitted to defer the inclusion of incentive fees and management fees in income for tax purposes. Under current law, a fund manager that uses a cash method of accounting for tax purposes can enter into a "nonqualified deferred compensation plan" with an offshore hedge fund, under which it can elect to defer the receipt of fees in respect of services to be provided during a period that begins after the election date.(1) The deferred compensation, increased or reduced to reflect the appreciation or depreciation in a designated asset or index (which is generally the hedge fund itself) is paid at a stated future date. Although the enactment in 2004 of Section 409A of the Internal Revenue Code of 1986, as amended, introduced certain restrictions and uncertainties with respect to these arrangements, that provision has not prevented their continued use.

The Rangel Bill provides that deferred compensation for investment services provided to a "nonqualified entity" must be taken into account for tax purposes when there is no substantial risk of forfeiture of the right to such compensation. For this purpose, a right to compensation would be treated as subject to a substantial risk of forfeiture only if the right were conditioned upon the future performance of substantial services by any individual. "Nonqualified entities" would generally include any foreign corporation that is not subject to a comprehensive income tax, as well as any partnership with partners that are either tax-exempt organizations or foreign persons who are not subject to a comprehensive income tax. If the amount of any deferred compensation were not ascertainable at the time that it would be required to be included in income under the Rangel Bill, the compensation would be taken into account when it became ascertainable, but the tax liability at that time would be increased by an amount equal to 20% of the compensation, as well as by an interest charge.

This deferred compensation provision would be effective for taxable years beginning after December 31, 2007, and would apply to amounts for which a deferral election had been made prior to that date.

Self-Employment Taxes of Limited Partners and Shareholders of S Corporations(2) Under current law, a limited partner's distributive share of partnership income, other than guaranteed payments to the partner that serve as compensation for services rendered to or on behalf of the partnership, are exempt from the U.S. federal self-employment tax. Regulations proposed in 1997 would subject a limited partner's distributive share of partnership income to the self-employment tax if the limited partner were actively involved in the partnership's trade or business or had authority to contract on behalf of the partnership, but these regulations have never been finalized. Under the Rangel Bill, if a partnership is engaged in a trade or business consisting primarily of the performance of services, income attributable to the trade or business that is allocated to any partner, including any limited partner, who provides substantial services with respect to the trade or business would be subject to the self-employment tax. Similarly, a shareholder of any S corporation that is engaged in such a trade or business, and who provides substantial services with respect to the trade or business, would be subject to self-employment taxes on his or her share of the corporation's income that is attributable to the trade or business.

This provision would be effective for taxable years beginning after December 21, 2007.

Modification of unrelated business income tax rules for certain investment partnerships. In general, a tax-exempt organization is subject to U.S. federal income tax with respect to UBTI, including any UBTI it derives through a partnership. UBTI generally does not include dividends, interest or gains from the sale, exchange or other disposition of property (other than inventory or property held primarily for sale to customers in the ordinary course of a trade or business). UBTI does, however, include "unrelated debt-financed income," which is generally defined as income derived from property in respect of which "acquisition indebtedness" is outstanding, even if that income would otherwise be excluded in computing UBTI.

The Rangel Bill would provide an exception to the "unrelated debt-financed income" rule for tax-exempt organizations that are partners with limited liability in investment partnerships. Under the proposed provision, a tax-exempt partner would no longer be required to treat as "acquisition indebtedness" any indebtedness incurred by the partnership to purchase or carry securities or commodities, or options or other derivative contracts in respect of securities or commodities. Similar rules would apply in the case of tiered partnerships and other pass-through entities.

Because hedge funds typically purchase securities on margin or otherwise borrow to fund investments, tax-exempt organizations generally invest in offshore hedge fund vehicles that are treated as corporations for U.S. tax purposes (rather than in onshore hedge fund partnerships) in order to avoid UBTI. By investing through an offshore corporation, however, a tax-exempt organization economically bears its share of the U.S. federal withholding taxes on U.S. source dividend income and certain other types of U.S. source income that are imposed on the fund vehicle. According to Representative Rangel, the purpose of the proposed provision is to eliminate the incentive for tax-exempt organizations to invest in hedge funds through these offshore "blocker" vehicles, as well as to improve the investment returns for tax-exempt organizations.

1 Managers generally do not enter into deferred compensation plans with onshore hedge funds, which are treated as partnerships for tax purposes, because the limited partners would not be entitled to a deduction in respect of the deferred fees until the payment date.

2 This provision is not included in the version of the Rangel bill that was approved by the House on November 9, 2007.