SEC Rules and Regulations
SEC Unanimously Adopts New Anti-Fraud Rule Under Investment Advisers Act
According to an SEC press release, on July 11, 2007, the SEC unanimously voted to adopt new Rule 206(4)-8 under the Investment Advisers Act of 1940 (the "Advisers Act"), a new anti-fraud rule designed to protect investors in pooled investment vehicles (the "Antifraud Rule"). The rule was reportedly adopted substantially as proposed in December 2006 and is intended to clarify the SEC's authority to bring enforcement actions against investment advisers after the U.S. Court of Appeals for the District of Columbia vacated the SEC's controversial rule requiring the registration of many hedge fund advisers in Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006). The Antifraud Rule will take effect 30 days following its publication in the Federal Register.
According to the press release, the Antifraud Rule, which is promulgated pursuant to Section 206(4) of the Advisers Act, "will make it a fraudulent, deceptive, or manipulative act, practice or course of business for an investment adviser to a pooled investment vehicle to make false or misleading statements to . . . investors or prospective investors in that pool." In addition, the Antifraud Rule will prohibit any other fraudulent, deceptive or manipulative act, practice or course of business with respect to investors or prospective investors, regardless of whether such conduct involves statements or other courses of action.
As discussed in the January 2007 Investment Management Regulatory Update, according to the rule proposal, the Antifraud Rule will apply to both registered and unregistered advisers that advise "pooled investment vehicles," which include registered investment companies as well as investment vehicles that would be investment companies but for their reliance on the exemptions under Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940. However, the text of the final rule has not yet been published. We will monitor further developments regarding the new rule.
CFTC Rules and Regulations
CFTC Regulation 3.10 Is Amended to Require Certain Registered Intermediaries to Complete Annual Online Review of Registration Information
On August 1, 2007, an amendment to Commodity Futures Trading Commission Regulation 3.10 became effective requiring futures commission merchants, introducing brokers, commodity trading advisers, commodity pool operators and leveraged transaction merchants that are registered with the National Futures Association ("NFA") to complete an annual online review of their registration information maintained with the NFA. If any such registrant fails to complete the review within 30 days following the date established by the NFA, such failure will be deemed to be a request for withdrawal from registration (which will become effective on the 30th day after the date on which the review should have been completed).
SEC Interpretations
SEC No-Action Letter Provides Guidance on Joint Investments by Spouses in the Context of Section 2(a)(52)(A)(iv) of the Investment Company Act
On July 26, 2007, the SEC issued a no-action letter in response to a request submitted by the law firm McDermott, Will & Emery regarding joint investments by spouses in private investment funds that are exempt from registration pursuant to Section 3(c)(7) of the Investment Company Act of 1940 (the "40 Act") (each such fund, a "3(c)(7) Fund") where one spouse is a "qualified purchaser" pursuant to Section 2(a)(51)(A)(iv) of the 40 Act, but the other is not a qualified purchaser. Under the facts presented to the SEC, one spouse serves as trustee (the "Trustee") to several large family trusts and meets the definition of "qualified purchaser" solely by virtue of being a trustee (i.e., not on an individual basis) pursuant to Section 2(a)(51)(A)(iv). The spouse of the Trustee (the "Spouse") is not a qualified purchaser under any definition. In granting no-action relief, the SEC took the position that the Trustee and the Spouse could invest in 3(c)(7) Funds as joint individual investors in reliance on the Trustee's qualified purchaser status.
Under Section 2(a)(51)(A)(i) of the 40 Act, a natural person who owns, either individually or together with such person's spouse, at least $5 million in investments is a qualified purchaser. Under Section 2(a)(51)(A)(iv) of the 40 Act, persons who own and invest, for their own account or for the account of other qualified purchasers, on a discretionary basis at least $25 million in investments are also qualified purchasers. However, Section 2(a)(51)(A)(iv) is silent as to whether the spouse of a Section 2(a)(51)(A)(iv) qualified purchaser can invest in a 3(c)(7) Fund jointly with such a qualified purchaser.
In granting the relief requested, the SEC stated that "it is consistent with Congress's intent to apply the spousal joint interest position in Section 2(a)(51)(A)(i) to Section 2(a)(51)(A)(iv)." The SEC analogized the question to Rule 3c-5 under the 40 Act, which provides that "knowledgeable employees" of an investment fund are deemed to be qualified purchasers for purposes of Section 3(c)(7), and to its position that, although Rule 3c-5 does not expressly allow joint investment by the spouse of a knowledgeable employee, Congress intended to allow joint investments of this kind.
Donohue Defends SEC's Finding that Blackstone and Fortress Are Not Investment Companies
On July 11, 2007, in testimony before the Senate Finance Committee, Andrew Donohue, director of the SEC's Division of Investment Management, defended the SEC's decision not to deem The Blackstone Group L.P. ("Blackstone") and Fortress Investment Group LLC ("Fortress"), which manage hedge funds and private equity funds, to be investment companies under the Investment Company Act of 1940 (the "40 Act"). In response to questions regarding why Blackstone and Fortress, both of which recently had initial public offerings, were not required to register as investment companies, Donohue explained that the staff's review was "in the normal course and consistent with past review practice." According to Donohue, the staff applied both the "orthodox investment company" test pursuant to Section 3(a)(1)(A) of the 40 Act and the "inadvertent investment company" test pursuant to Section 3(a)(1)(C) of the 40 Act in determining that neither Blackstone nor Fortress qualifies as an investment company.
Under Section 3(a)(1)(A) of the 40 Act, an entity is an investment company if it "is or holds itself out as being engaged primarily, or proposes to engage primarily, in the business of investing, reinvesting, or trading in securities." According to Donohue, in this regard the staff typically focuses on whether an issuer invests its own assets rather than those of others and considers "the composition of [the issuer's] assets, sources of its income, the investment activities of its officers and employees, the company's public statements, and its historical development," with the nature of the issuer's assets and income being the most significant factors. Against this backdrop, according to Donohue, the staff determined that neither Blackstone nor Fortress is primarily engaged in the business of an investment company, because both are primarily engaged in (and hold themselves out as being primarily engaged in) the business of providing asset management and financial advisory services to others and both hold themselves out as asset managers (rather than as investment companies), among other factors.
Under Section 3(a)(1)(C) of the 1940 Act, an issuer is an investment company if it "is engaged or proposes to engage in the business of investing, reinvesting, owning, holding, or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40 per centum of the value of such issuer's total assets . . . ". Donohue stated that, in the case of alternative asset managers (such as Blackstone and Fortress), limited partner interests and general partner interests in the funds advised by such managers constitute the main assets to be considered in determining whether more than 40% of the manager's assets are investment securities. According to Donohue, generally limited partner interests are investment securities, whereas general partner interests "are not securities, if the profits relating to those interests generally come from the efforts of the general partners, as opposed to the efforts of others." Because Blackstone and Fortress manage the funds, the profits from their general partner interests in those funds result from their own efforts (rather than from the efforts of others), according to Donohue, and thus their general partner interests do not constitute securities within the meaning of Section 3(a)(1)(C). Donohue also explained that, after determining which assets are securities and which are not, the staff must assign a value to each security in order to determine whether the 40% threshold has been exceeded. According to Donohue, the value of the general partner interests of both Blackstone and Fortress exceeded 60% of the value of their overall assets (and the value of their investment securities—in the form of limited partner interests—was therefore less than 40%). As such, Donohue concluded that both Blackstone and Fortress have the asset composition of an operating company, not investment companies under Section 3(a)(1)(C).
Litigation
Claims That Offering Violated Minnesota Securities Laws Are Held to Be Preempted by Federal Law Where Offering Is Purported to be Made Under Regulation D
On July 3, 2007, the Minnesota Court of Appeals (the "Court of Appeals") held that federal law preempted claims that an offering did not comply with the registration requirements under Minnesota securities law because the securities offering in question was purported to be made pursuant to Regulation D under the Securities Act of 1933 (the "Securities Act") (Risdall v. Brown-Wilbert Inc., Minn. Ct. App., No. A06-1233, 7/3/07).
The case was based on the following facts. In March 2000, appellant funeral.com, a company that maintains a website for those with funeral needs ("Appellant"), sold shares of Appellant after having issued a private placement memorandum ("PPM1") stating, inter alia, that the shares were exempt from registration under the Securities Act pursuant to Rule 501(a) of Regulation D. In May 2000, Appellant posted a second private placement memorandum ("PPM2") on the Internet and mailed it to potential investors. When Appellant learned that general solicitation and general advertising prevent reliance on the exemptions under Regulation D, it removed the Internet postings and withdrew PPM2. No sales were made under PPM2.
In March 2003, several investors who had purchased Appellant stock under PPM1 (the "Respondents") filed suit against Appellant claiming that the sale by Appellant of unregistered securities violated Minnesota's securities laws. Respondents' claim was based on the argument that PPM1 and PPM2 were integrated (i.e., part of the same offering) such that the irregularities regarding PPM2 also tainted PPM1 (and any sales of securities made thereunder). The lower court granted Respondents' motion for summary judgment holding that PPM1 and PPM2 were indeed integrated and that, as a result, the offering failed to meet the registration requirements under the Minnesota securities laws.
In reversing the lower court's grant of summary judgment, the Court of Appeals ruled that "an offering purporting to be exempt under Regulation D is governed exclusively by federal law, and any claim under state law relating to the offering is therefore preempted," irrespective of whether the offering actually complies with Regulation D. According to the Court of Appeals, federal courts are in a better position to apply and interpret federal law (including Regulation D) and should therefore decide whether a Regulation D exemption is available. In addition, the Court of Appeals noted that even if one were to take the conflicting view that the Minnesota securities laws are preempted only where an offering is actually exempt under Regulation D, the outcome would be the same—in other words, PPM1 and PPM2 would not be integrated under Regulation D because no securities were ever sold under PPM2 and therefore the sales under PPM1 actually complied with Regulation D, according to the Court of Appeals.
Industry Update
SEC Staff Publishes Welcome Letter Aimed at Assisting Newly Registered Investment Advisers
In a release dated July 24, 2007, the SEC staff announced that a "welcome letter" will be sent to all newly registered investment advisers along with an informational memorandum (together, the "Letter") summarizing in plain English the key provisions of the Investment Advisers Act of 1940 (the "Advisers Act"). The Letter is aimed at helping newly registered investment advisers better understand their compliance obligations under the Advisers Act and contains helpful information regarding the SEC's local offices, the resources available on the SEC's website and the CCOutreach Program (which was developed to assist chief compliance officers with implementing effective compliance programs).
According to the SEC release, over 1,000 advisers file initial registration filings each year and it is expected that the number of new registrations will increase. Of the roughly 10,500 registered advisers, approximately 30% have registered since January 2005. Andrew J. Donohue, Director of the SEC's Division of Investment Management, said that the Letter "will benefit advisers, and ultimately investors, because it provides important and helpful information to newly registered firms, early in their operations."
House Financial Services Committee Holds Hearing on Potential Systemic Risk Raised by Hedge Funds
On July 11, 2007, the House Financial Services Committee held a hearing on ways to mitigate the potential systemic risk raised by hedge fund activity. The panelists who were from the SEC, the CFTC, the Treasury and the Federal Reserve (representing the President's Working Group on Financial Services (the "PWG")) discussed the PWG's Principles and Guidelines regarding Private Pools of Capital published in February 2007. As discussed in greater detail in the March 2007 Investment Management Regulatory Update, in its Principles and Guidelines the PWG advocated disclosure, market discipline and transparency rather than hedge fund regulation or registration.
Committee Chairman Barney Frank expressed concern about the potential for systemic risk raised by hedge funds and the potential for excessive risk taking by pension fund investors. He added that there is "no obvious thing" Congress should be doing at this time. However, he asked whether a document retention program for unregistered hedge funds might be effective for anti-fraud purposes. Although the panelists were non-committal in their responses, Frank said that in a prior hearing, the heads of two hedge fund associations stated that they would not object to a mandatory document retention program aimed at combating insider trading. Frank reportedly told reporters after the July 11 hearing that he was in favor of such legislation and noted that the House Financial Services Committee and other committees are currently considering whether special rules should be developed for pension funds that invest in hedge funds in their capacity as fiduciaries.
Separately, there was discussion at the hearing regarding the lack of a rationale behind the current "patchwork" registration regime, with a large number of hedge fund advisers that are not registered with either the SEC or the CFTC and with others that are registered with either the CFTC or the SEC.