SEC Rules and Regulations
SEC Proposes Electronic Filing and Simplification of Form D; Recommends Broadening of Regulation D Exemption
At an SEC open meeting on May 23, 2007, the Division of Corporation Finance (the "Division") recommended that the SEC propose certain private offering reforms to improve the ability of smaller companies to raise capital and to modernize the reporting requirements applicable to them. Among the recommendations were amendments to Regulation D to broaden the exemptions from registration under the Securities Act of 1933 (the "Securities Act") and to restructure Form D, which is required to be filed in connection with an offering of securities made without registering under the Securities Act in reliance on a Regulation D exemption.
In a release issued on June 29, 2007, the SEC espoused the Division's Form D-related recommendations and proposed for comment rules to simplify Form D and mandate the electronic filing thereof (the "Proposed Form D Rules"). Under the Proposed Form D Rules, issuers would have to provide information on 14 items, including the issuer's industry group and revenue range, the applicable exemption from registration under Regulation D as well as the applicable exclusion from the definition of "investment company" under the Investment Company Act of 1940, the intended duration of the offering, the type(s) of securities offered and whether the offering is made in connection with a business combination transaction, among other things. As proposed, Form D would also be revised to require the identification of multiple issuers in multiple issuer offerings and to do away with the current requirement to identify owners of 10% or more of an issuer's equity securities, in light of privacy concerns.
In addition, Rule 503 under the Securities Act would be amended to specify when Form D amendments would need to be filed and specifically would require them in the following three instances: (i) to correct mistakes of fact (as soon as practicable after the mistake is discovered); (ii) to reflect a change in previously filed information (as soon as practicable after the change; the Proposed Form D Rules include some guidance on changes that would not trigger the need to file an amendment); and (iii) "in offerings that last more than a year, annually, between January 1 and February 14, to reflect information about the offering on or before its termination since the later of the filing of the Form D or the filing of the most recent amendment." Electronic filing of Form D on the SEC's EDGAR system would be mandatory and the information submitted would be accessible to the public as part of an interactive, fully searchable database. Comments on the Proposed Form D Rules are due by September 7, 2007.
With respect to the other amendments to Regulation D, the Division recommended a new exemption under Rule 507 of the Securities Act to allow issuers that sell only to "Rule 507 qualified purchasers" to engage in limited "tombstone" advertising (i.e., advertisements in the form permitted for registered offerings pursuant to Rule 134 under the Securities Act). According to the Division, "Rule 507 qualified purchasers" would include individuals with at least $2.5 million in "investments" or an annual income of $400,000 as an individual, or $600,000 with a spouse. Institutional investors would qualify with at least $10 million in "investments" or, if they are "accredited investors," without regard to a monetary threshold (e.g., banks, broker-dealers, insurance companies, registered investment companies, etc.). Finally, directors, officers and general partners of an issuer would also qualify irrespective of monetary thresholds.
A second recommendation would add another category of investors that would be exempt as "accredited investors" under Regulation D. The new category of "accredited investors" would consist of individuals owning at least $750,000, and institutions owning at least $5 million, in "investments." The Division also suggested "adding several new categories of entities to the list of approved accredited investors" (but did not elaborate on what those categories would be) and adjusting the thresholds for accredited investors and Rule 507 qualified purchasers to account for inflation on a going-forward basis.
In addition, the Division recommended (i) shortening the integration safe harbor under Rule 502(a) from six months (the rule currently provides that offers and sales made more than six months before or after a Regulation D offering will not be considered part of such offering) to 90 days and (ii) applying an updated "bad actor" disqualification standard to all Regulation D offerings (not only to Rule 505 offerings, i.e., offerings that do not exceed $5 million).
Although the SEC has published the Proposed Form D Rules, it has not yet issued a proposal based on the Division's recommendations to amend the other aspects of Regulation D but indicated in a press release that a detailed release will soon be posted on its website. We will monitor further developments regarding these amendments.
- See the full text of the SEC's press release relating to the recommendations made by the Division
- See the full text of the SEC staff statement at the May 23 open meeting
Mutual Funds May Use Interactive Data to Submit Risk/Return Information
At a June 20, 2007, open meeting, the SEC agreed to expand its two-year-old voluntary interactive data reporting program to allow mutual funds to use interactive data to submit tagged risk/return summary information in their prospectuses (in addition to the version of the information officially filed with the SEC). As such, mutual funds will be the first entities to be able to use interactive data to file non-financial information. The risk/return data would be tagged using eXtensible Business Reporting Language, which enables the information to be searched through automated means.
According to remarks made by Commissioner Roel C. Campos at the open meeting, "with more than 91 million individual investors of all ages, incomes, and educational backgrounds invested in a mutual fund industry that exceeds $10 trillion in assets under management, the need for comprehensive, interactive data that is searchable and analyzable has never been more acute."
The new rule, which was proposed in February 2007, as is discussed in greater detail in the March 2007 Investment Management Regulatory Update, will take effect on August 20, 2007.
Enforcement Actions
SEC Fines Barclays for Insider Trading Despite Use of "Big Boy Letters"
On May 30, 2007, the SEC announced the settlement of insider trading charges against Barclays Bank PLC and a former trader for Barclays' distressed debt desk, who allegedly traded large amounts of debt securities of at least six bankrupt issuers while in possession of material inside information which was acquired while serving on creditors' committees for these issuers. The SEC's complaint and litigation release in the matter suggest that so-called "Big Boy letters" do not protect against SEC charges of insider trading liability. Big Boy letters are used to put one party to a securities transaction (typically the buyer) on notice that the other (the seller) may be in possession of material non-public information. The buyer acknowledges that it is a "Big Boy" and agrees not to sue the seller under the securities laws. For a more detailed description of this matter, see the June 15, 2007 Corporate Regulatory Report.
Industry Update
Proposed Legislation to Tax Certain Publicly Traded Partnerships as Corporations
On June 14, 2007, Senate Finance Committee Chairman Max Baucus (D-Mont.) and committee member Senator Charles Grassley (R-Iowa) introduced legislation (the "Baucus-Grassley Bill") that would tax as a corporation any publicly traded partnership that derived income, directly or indirectly, from investment advisory or asset management services. Under current law, a publicly traded partnership will generally be treated as a corporation for U.S. federal income tax purposes unless at least 90% of its gross income for each taxable year consists of "qualifying income," including dividends, passive investment interest, real property rents and gain from the sale of real property or the sale of capital assets that are held for the production of other types of "qualifying income." Under the proposed legislation, this "qualifying income" exception would not apply to any publicly traded partnership that, directly or indirectly, had any income the rights to which were derived from investment advisory or asset management services provided by any person, regardless of whether that person was required to register as an investment adviser under the Investment Advisers Act of 1940. The Baucus-Grassley Bill would thus treat as a corporation any publicly traded partnership that held a "carried interest" in an investment partnership, in respect of which it received a disproportionate allocation of the investment partnership's profits for advisory or management services provided to the partnership. According to the technical explanation that accompanied the Baucus-Grassley Bill, the proposed legislation would also apply to any publicly traded partnership that received a dividend from a corporation if the corporation received or accrued income the rights to which were derived from investment advisory or asset management services provided by any person.
The Baucus-Grassley Bill is a response to the recent initial public offerings by Fortress Investment Group and Blackstone Group, as well as the various proposed public offerings by other similar investment management partnerships. Treasury Secretary Henry Paulson has expressed skepticism about the proposed legislation because it singles out the investment management industry and has stated that the current tax regime for publicly traded partnerships is "a great structure to promote risk-taking and entrepreneurial spirit and I really do think we need to be careful."
The Baucus-Grassley Bill would generally be effective for partnership taxable years beginning on or after June 14, 2007. In the case of any partnership that was publicly traded on June 14, 2007, or that had filed a registration statement with the SEC with respect to an initial public offering on or before June 14, 2007, however, the legislation would apply for taxable years beginning on or after June 14, 2012. (This five-year grace period would apply to both Fortress and Blackstone.) A House bill, introduced on June 20, 2007, by Representative Peter Welch (D-Vt.), is identical to the Senate bill except that it would be effective for partnership taxable years beginning after June 20, 2007, and it does not provide a transition period for existing partnerships.
We shall monitor further developments on the proposed legislation.
Proposed Legislation to Tax Carried Interest as Ordinary Income
On June 22, 2007, House Ways and Means Committee member Sander Levin (D-Mich.) introduced legislation (the "Levin Bill") to tax income derived from a sponsor's "carried interest" or "incentive allocation" in an investment partnership as ordinary income from the performance of services. Private equity funds and certain other investment partnerships typically grant their general partners or managing members an equity interest in the partnership that entitles the holder to a percentage of the partnership's profits that is higher than the percentage of the capital contributed by the holder. Typically, the general partner or managing member receives, in respect of this interest, allocations of 20% of the profits that would have been allocated to the limited partners if allocations had been made in the same percentages as capital contributions. 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 holder of the profits interest. The general partner or managing member of an investment partnership is often itself a partnership, and the character of the profits allocations flows through, in turn, to its partners or members.
The proposed legislation 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, a substantial quantity of 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 holder's contribution of money or other property, however, the proposed legislation would not apply and the holder's share of the partnership's profits would continue to be characterized under a flow-through approach.
The Levin 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." 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 partnership allocated the gain to the holder of the "investment services partnership interest," the allocation would, under the rule described above, be treated as ordinary compensation income. The Levin 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 be subject to self-employment tax.
Unlike the Baucus-Grassley Bill introduced in the Senate, the Levin Bill would affect the tax treatment of the service partner or its members, rather than the tax treatment of an investment partnership itself. If enacted, the legislation would generally have a greater impact on private equity, venture capital and real estate funds than it would on hedge funds, because many hedge funds generate more short-term capital gains and ordinary income than long-term capital gains, and thus a substantial portion of the "incentive allocations" made to the general partner or managing member are taxed at ordinary income rates under current law. The bill contains no proposed effective date provision, but leaves the decision on the effective date to be made as part of the ongoing legislative process.
The Senate Finance Committee has scheduled a hearing on "carried interest" arrangements for Wednesday, July 11. We shall monitor further developments.
SEC's First "ComplianceAlert" Cites Compliance Deficiencies
On June 14, 2007, the SEC published its first "ComplianceAlert," which identifies various deficiencies in compliance and supervisory controls found during reviews of registered investment advisers and investment companies, among others. The stated intent of the ComplianceAlert is to encourage chief compliance officers (to whom it is addressed) to review and improve compliance in such areas.
With respect to closed-end funds, the SEC highlighted failures to comply with Section 19a of the Investment Company Act of 1940 (the "40 Act") and Rule 19a-1 thereunder, which provide that funds may only make distributions to shareholders from sources other than the funds' net investment income if, contemporaneously with such distributions, they provide a written statement (a "19a-1 Notice") to shareholders about the source of the distribution. According to the ComplianceAlert, many of the closed-end funds examined by the SEC that pay periodic, level distributions to their shareholders failed to send the requisite 19a-1 Notice to shareholders along with distributions that included a return of capital. Failure to do so, according to the SEC, may mislead investors by causing them to believe erroneously that their funds are yielding a high total return, while, in reality, the distributions consist largely of a return of capital. The ComplianceAlert also indicates that providing Internal Revenue Service Form 1099-DIV to shareholders at the end of a calendar year does not satisfy the requirements of a 19a-1 Notice.
The SEC also found that mutual funds had inadequate policies and procedures to prevent or detect violations of Rule 22c-1 under the 40 Act, which prohibits the sale, redemption or repurchase of securities of a registered investment company at a price other than the current net asset value ("NAV") except in limited circumstances. For instance, trades at a price other than the current NAV (so-called "as-of" transactions) are permitted under Rule 22c-1 to correct errors made in processing fund shares. According to the ComplianceAlert, some mutual funds lack appropriate policies and procedures to monitor as-of trades and to assess the cumulative impact of as-of transactions on a fund's NAV.
With respect to registered investment advisers, the ComplianceAlert identified deficiencies related to performance advertising. In many cases, such advertising was misleading (e.g., advisory fees were not deducted from performance results; firms did not disclose whether results reflected dividends; differences with benchmark indices were not explained; past recommendations were only partially disclosed). In addition, many advisers reportedly had inadequate compliance policies and procedures regarding performance advertising. According to the ComplianceAlert, characteristics of the inadequate policies included failures to:
- "address the operations or practices of the adviser's business;
- ensure that third-party consultants used compliant presentations;
- address the methods the adviser used to treat cash (and equivalents) when 'carving out' separate equity and fixed income performance from balanced accounts;
- ensure the adviser was in compliance with all applicable requirements of the CFA Institute's performance presentation standards . . . prior to making a claim of such compliance;
- require a consistent comparison of composites to appropriate benchmarks; and
- ensure accurate composite descriptions."
The ComplianceAlert cites the following as policies and procedures maintained by firms with fewer deficiencies:
- "a multi-level review process among an adviser's performance group, portfolio managers, and marketing group for the accuracy of marketing materials prior to their use;
- the creation of 'tolerance reports' on a monthly basis to compare all composite accounts to their respective benchmarks, with any material discrepancies being investigated;
- a composite committee review of all accounts on at least a quarterly basis to ensure proper composite construction and maintenance; and
- the use of a second independent pricing service to periodically verify the accuracy of prices supplied by the primary pricing service, with any material discrepancies in prices being investigated."
Examiners also found numerous cases in which an adviser had inappropriately used "hypothetical return" numbers or falsely claimed to comply with the performance presentation standards of the CFA Institute.
SEC's Donohue Discusses Regulatory Developments Related to Hedge Funds
On May 23, 2007, in a speech to the 4th Annual Hedge Funds and Alternative Investments Conference, Andrew J. Donohue, director of the SEC's Division of Investment Management, discussed hedge fund-related regulatory developments. He noted, in particular, his belief that the regulatory gap left by the D.C. Court of Appeals' Goldstein decision in June 2006 has narrowed during the past 12 months.
As an initial matter, Donohue noted that, although approximately 350 hedge fund advisers withdrew their registration following Goldstein, a large number have voluntarily remained registered. In addition, he said that 83 advisers have registered since the decision. Of the approximately 10,000 investment advisers that are registered, approximately 2,000 advise at least one hedge fund, according to Donohue, and as such, many hedge fund advisers are being regulated through registration despite Goldstein.
Donohue also discussed the SEC's rulemaking efforts regarding private pooled investment vehicles as another means of overseeing the hedge fund industry. Specifically, Donohue highlighted the new rules proposed by the SEC in December 2006—Rule 206(4)-8 under the Investment Advisers Act of 1940 (the "Advisers Act") and Rules 509 and 216 under the Securities Act of 1933, which are discussed in more detail in the January 2007 Investment Management Regulatory Update. According to Donohue, the SEC is reviewing over 500 comments on the proposed rules. He also indicated that the SEC is monitoring regulatory developments in other countries, particularly in the UK, where he was struck by the similarity between the UK's "principle-based approach to regulation, as opposed to the use of detailed, prescriptive rules, and the approach taken here to regulating advisers . . . . " He noted that just over 100 hedge fund advisers from the UK are currently registered with the SEC, which is more than from any other country.
Donohue cited examination and enforcement as another way to oversee the hedge fund industry, and pointed to insider trading policies as an area in which deficiencies have been found among hedge funds' advisers. According to Donohue, the SEC considers whether such policies are "tailored to the specific facts and circumstances of the firm and considers factors such as the affiliations of investors in the hedge funds and the likelihood that those investors could be mined for non-public information, as well as the types of investment strategies a hedge fund follows, such as distressed debt and bank loan participations, as well as the use of long/short equities." In addition, with respect to policies on the use of non-public information, Donohue noted that it is important to use "insightful forensic tests to determine any interesting patterns of investment decisions that evidence a problem in this area."
Finally, Donohue mentioned the following trends as leading to better