- Recommended Annual Review for Hedge Funds and Other Private Fund Managers
- December 14, 2009 | Authors: Stephen C. Tirrell; Neal E. Sullivan; Michael F. Mavrides; Robert G. Leonard; Thomas John Holton; Richard A. Goldman; Steven M. Giordano
- Law Firms: Bingham McCutchen LLP - Boston Office; Bingham McCutchen LLP - Washington Office; Bingham McCutchen LLP - Office; Bingham McCutchen LLP - New York Office; Bingham McCutchen LLP - Office
As 2009 begins, Bingham would like to remind our hedge fund clients, clients that manage other private funds (including private equity and venture capital funds), and our friends of certain “best practices” that they should consider and of certain regulatory changes that they should be aware of. The following summary is general in nature and does not constitute legal advice for your specific situation.
Compliance Policies and Procedures
Investment managers that are not currently registered with the SEC and do not currently have formal internal compliance guidelines in place should consider adopting compliance policies and procedures that reflect “best practices.”1 Investment managers that already maintain compliance policies and procedures should review them to determine their effectiveness. SEC-registered investment managers are required to review their written compliance policies and procedures on an annual basis. SEC-registered investment managers should also consider their obligations under Rule 206(4)-7 of the Advisers Act, including, but not limited to, considering the effectiveness of their code of ethics and conducting any necessary trainings that may be associated therewith, as well as the effectiveness of any disaster recovery contingency plans and systems that they have in place. SEC-registered investment managers, among other things, should also be sure that their access persons2 provide to the investment manager’s chief compliance officer a report listing such access person’s personal security holdings.
In a 2008 release,3 the SEC stressed the importance of having comprehensive compliance policies and procedures in place. According to the SEC, compliance policies and procedures can provide an investment manager’s personnel with adequate knowledge of the federal securities laws and help prevent violations of such laws.
In connection with any review, investment managers should consider any circumstances that have changed or may change in the future that could affect their requirements and obligations pursuant to their policies and procedures, and any information which may need to be updated in light of such changed circumstances. Investment managers should retain written evidence of their review.
There have been several regulatory developments during the past year that investment managers should consider as they review their compliance policies and procedures. A summary of some of these developments can be found in an alert posted on Bingham.com, “Compliance Reviews of an Extraordinary Year.”
Form ADV Part 1 and Form ADV Part II
SEC-registered investment managers must update Part 1 of their Form ADV and file it with the SEC on an annual basis within ninety (90) days after the end of their fiscal year. For most SEC-registered investment managers, this means by March 31, 2009. In addition, certain Form ADV information must be amended promptly if it has become inaccurate. Investment managers should refer to the Form ADV instructions (which can be found on the SEC’s Web site) or contact counsel to determine whether any of their Form ADV information must be updated promptly.
Part II of Form ADV must also be updated annually, and either Part II or an equivalent “brochure” containing the information required by Part II must be delivered, or offered in writing to be delivered upon request, to all of an investment manager’s “clients” (i.e., funds, managed accounts and other parties to which the investment manager charges a fee) sometime during the upcoming fiscal year. If a client requests a copy of Part II or the brochure, it must be mailed or delivered to such client within seven (7) days of receipt of the request.
On March 3, 2008, the SEC proposed amending Part II of the Form ADV to require SEC-registered investment managers to deliver a “plain English” brochure to clients and prospective clients. The proposed brochure would be composed of nineteen (19) items, including descriptions of the manager’s advisory business, fee arrangements, investment strategies, ethics policies and brokerage practices. The proposal would also require investment managers to file the amended brochure online as well as deliver it to clients. Comments on the proposal were due on May 16, 2008. A final rule has not yet been issued.
In addition, certain states also require that investment managers file their Form ADV with state regulatory authorities, and some states require a paper filing. State-registered investment managers should also consider any other requirements in the states in which they are registered.
On September 18, 2008, the SEC, pursuant to Section 12(k)(2) of the 1934 Act, issued an emergency order requiring institutional investment managers to file a newly created Form SH. The order was amended on September 21, 2008 and further amended on October 15, 2008 by the adoption of an “interim final temporary” rule. The new temporary rule will be in effect through August 1, 2009 unless it is sooner terminated or extended. The new rules require all institutional investment managers that exercise investment discretion with respect to accounts holding Section 13(f) securities (an official list is published every quarter by the SEC that can be found on the SEC’s Web site) having an aggregate fair market value on the last trading day of any month of any calendar year of at least $100,000,000 to disclose the number of securities sold short for each Section 13(f) security. The Form SH weekly filing deadline is the last business day of the next calendar week following a calendar week in which short sales are effect.
An institutional investment manager is not required to report short sales or short positions of Section 13(f) securities in certain instances, including on any day where (a) the start of day short position, the gross number of securities sold short during the day [and] the end of day short position in a Section 13(f) security constitutes less than one-quarter of one percent (0.25%) of that class of the issuer’s Section 13(f) securities issued and outstanding and (b) the fair market value of the start of day short position, the gross number of securities sold short during the day [and]4 the end of day short position is less than $10 million.
Anti-Fraud Rule Adopted by the SEC for Naked Short Sales
Effective as of October 17, 2008, the SEC adopted Rule 10b-21 under the 1934 Act. Intended to address abusive “naked” short selling, Rule 10b-21 prohibits the submission of an order “to sell an equity security if such person deceives a broker or dealer, participant of a registered clearing agency, or a purchaser about its intention or ability to deliver the security on or before the settlement date, and such person fails to deliver the security on or before the settlement date.” The SEC stated in a preliminary note that the new rule is “not intended to limit, or restrict, the applicability of the general antifraud provisions of the federal securities laws.” The SEC takes the position that “naked” short selling as part of a manipulative scheme is always illegal under the general anti-fraud restrictions and that the new Rule 10b-21 is intended to further evidence the liability of persons who engage in such a scheme. The SEC noted in the release adopting Rule 10b-21 that “the courts have held that a private right of action exists with respect to Rule 10b-5 provided the essential elements constituting a violation of the rule are met.” The SEC also stated in the release that a private plaintiff able to prove all the elements of a Rule 10b-5 claim “in a situation covered by Rule 10b-21 would be able to assert a claim under Section 10(b) of the Exchange Act and Rule 10b-5 thereunder.”
Blue Sky Filings and Amendments to Form D
The blue sky laws of many states require that a Form D be filed with the relevant state authority within fifteen (15) days following the initial sale of interests or shares in a state. In addition, the blue sky laws generally require that filings previously made be updated from time to time to reflect certain changes, and some states require filings on a periodic basis. In considering blue sky filings, investment managers should pay special attention to: (i) new states where they intend to sell (or recently sold) interests or shares; (ii) states where they have sold interests or shares but did not file a Form D; and (iii) states from which investors have made additional investments.
On February 6, 2008, the SEC adopted proposed rule amendments to Rule 503 (among other rules) mandating, among other things, electronic filing of Form D. The amendments provide for a transition to electronic filing of Form D during a voluntary transition period that began as of September 15, 2008. Effective March 15, 2009, the old version of Form D will be eliminated, and electronic filing and amending of the new version of Form D will become mandatory.
The adopted amendments have reorganized Form D from five (5) sections into sixteen (16) informational items. The revised Form D requires disclosure of much of the same information previously required to be disclosed, but in a more simplified fashion. Some of the changes to Form D include:
- A requirement that certain private investment funds rely on an exemption from registration as an investment company based on Section 3(c) of the Investment Company Act disclose the specific exemption on which they are relying;
- Inclusion of an undertaking to provide offering materials to the SEC upon request;
- Addition of the date of first sale (“sale date” will be determined by the date on which the investor is irrevocably contractually committed to invest); and
- Addition of disclosure of the amount of proceeds from the offering used to pay “related persons”.
Other Regulatory Filings
There are several regulatory filings that investment managers (whether SEC-registered or not) may be required to make in light of certain activities, which may include:
- Form 13F. Investment managers are required to file a Form 13F with the SEC if they exercised investment discretion over $100 million or more in Section 13(f) securities on the last trading day of any month in the prior calendar year. Form 13F must be filed within forty-five (45) days after the last day of the calendar year (i.e., before February 14, 2009) and again within forty-five (45) days after the last day of each of the three (3) calendar quarters thereafter.
- Schedule 13D/13G. If an investment manager directly or indirectly “beneficially owns” (through fund(s), client account(s) or proprietary account(s)) more than 5% of a class of publicly traded securities, the investment manager (and possibly others) is required to file either a Schedule 13D or Schedule 13G with the SEC. “Beneficial ownership” generally means the direct or indirect power to vote and/or dispose of such securities. Unless qualified to file a Schedule 13G, an investment manager (and possibly others) must file a Schedule 13D within ten (10) days of the acquisition of more than 5% of such securities, which must be amended promptly to reflect material changes, including, but not limited to, an acquisition or disposition equal to 1% or more of such securities. Schedule 13G may generally be filed by investment managers that hold such securities in the ordinary course of business and not for the purpose of changing or controlling the management of the issuer of such securities. SEC-registered investment managers must file a Schedule 13G within forty-five (45) days after the end of the calendar year in which more than 5% of such securities were obtained. Non-SEC registered investment managers must file Schedule 13G within ten (10) days of the acquisition of more than 5% of such securities, and Schedule 13G must be amended: (i) if beneficial ownership of such securities exceeds 10% of the class of securities, and thereafter where beneficial ownership has increased or decreased by more than 5% of the class of securities; and (ii) within forty-five (45) days after the calendar year ends. In addition, all investment managers that have previously filed a Schedule 13G must file a Schedule 13D within ten (10) calendar days if their passive investment purpose changes and non-SEC registered investment managers that have previously filed a Schedule 13G must file a Schedule 13D within ten (10) calendar days upon acquiring more than 20% of the class of such securities. The statutes, rules, and SEC and court interpretations regarding Schedule 13D and Schedule 13G are very complicated, and we urge investment managers to seek guidance from counsel with respect to compliance with applicable laws, rules and interpretations. Investment managers should also note that in some cases one may need to consider non-equity investments in evaluating your filing requirements.5
- Forms 3, 4 and 5. Investment managers (and possibly others) may be required to file certain forms if they directly or indirectly beneficially own more than 10% of a public company’s equity securities, or if they serve as an officer or director of the issuer. Form 3 must be filed within ten (10) days after exceeding the 10% threshold or becoming an officer or director of the issuer; Form 4 must be filed by the end of the second day after executing a non-exempt transaction in such securities; and Form 5 must be filed within forty-five (45) days after the end of the issuer’s fiscal year to report exempt and other transactions that were not previously reported. Securities held by certain specified types of institutions in the ordinary course of business, and not for the purpose of changing or influencing control of an issuer, need not be counted in determining if an investment manager has reached the 10% threshold and, accordingly, certain investment managers may not be required to file these forms.
- Other Forms. Investment managers should consider whether other regulatory filings are required based on their operations and investments, including, but not limited to, annual filings that may be required under federal, state or Cayman Islands/BVI law, as applicable. For example, investment managers may be required to file a large position report with the Department of Treasury if they hold a significant amount of certain U.S. Treasury securities. Investment managers that are considering acquiring a large amount of voting securities of an issuer should take into account Hart-Scott-Rodino requirements that may apply, depending on the value of the acquisition and/or the size of the parties involved. Also, investment managers that invest in securities in foreign jurisdictions should consider the filing requirements in each jurisdiction in which they invest.
Audited Financial Statements
SEC-registered investment managers that maintain custody of client securities or assets are subject to Rule 206(4)-2 under the Advisers Act. For the purposes of Rule 206(4)-2, “custody” is defined as holding, directly or indirectly, client funds or securities, or having any authority to obtain possession of them. For example, an investment manager that has the power to instruct a custodian to pay the investment manager’s fee would normally be deemed to have custody. Unless such investment managers are having account statements delivered to their fund’s investors on a regular quarterly basis from qualified custodians or are sending out such quarterly account statements themselves and meet certain other requirements,6 the rule requires that a copy of the fund’s audited financial statements, prepared in accordance with generally accepted accounting principles, be delivered to fund investors within one hundred twenty (120) days (or one hundred eighty (180) days for funds of funds) after the end of the fund’s fiscal year.
Certain Tax Considerations
- Management Fees in FOF Context. The Internal Revenue Service recently issued Revenue Ruling 2008-39, which advised on the characterization of management fees paid to respective investment managers by an upper tier investment partnership (“UTP”) in a fund-of-funds structure. The ruling requires that the management fees an individual limited partner (“LP”) pays to the manager of the UTP generally will be treated as miscellaneous itemized deductions by the LP, deductible (along with other miscellaneous itemized deductions) only to the extent that such expense exceeds two percent (2%) of the individual partner’s adjusted gross income, and not deductible at all, for purposes of computing the individual partner’s alternative minimum tax liability.
- Schedule K-1. If an investment manager’s fund is organized as a partnership or limited liability company, the investment manager must provide the fund’s investors with their respective Schedule K-1s so that they can prepare their individual tax returns. Investment managers should begin the process of preparing their funds’ K-1s so that they can be delivered to investors in a timely manner. If an investment manager does not anticipate being able to provide K-1s to investors in time for their tax return filings, the investment manager should notify investors as soon as possible and consider providing them with an estimate. In addition, there may be other tax-related filings and/or elections that an investment manager should consider, and we urge investment managers to seek guidance from their counsel with respect to compliance with applicable tax laws, rules and regulations.
Offering Document Updates
Investment managers should review their funds’ offering documents (e.g., private placement memoranda, subscription documents, marketing materials, etc.) to determine whether the investment managers’ and/or funds’ business has undergone any material changes (including, but not limited to, changes to investment objectives/strategies, current personnel and/or service provider relationships), or if there have been any regulatory changes, since the documents were last updated. If so, investment managers should consider updating the offering documents to reflect any such changes or developments. Given the events in the markets during 2008, investment managers should pay particular attention to whether or not their stated investment strategies and related risk factors are still accurate. Further, given the recent events involving several large financial institutions, investment managers should carefully review their statements on counterparty risk to ensure that they adequately reflect the new market environment.
ERISA Considerations and Fee Deferral Arrangements
- Ongoing ERISA Compliance. Investment managers who accept investments from employee benefit plans, IRAs and other benefit plan investors but do not want the funds they manage to become subject to ERISA should take the opportunity to confirm that their fund(s) satisfy the requirements of ERISA’s “significant participation” exemption. Under the exemption, funds are only subject to ERISA and to certain prohibited transaction provisions of the tax code if 25% or more of any class of their equity interests is held by “benefit plan investors” (“BPIs”). Only benefit plans subject to ERISA (primarily private domestic employer and union plans) or to the prohibited transaction provisions of the tax code (such as IRAs and Keogh plans) will count as BPIs for purposes of the 25% test. Governmental and foreign benefit plans are not counted. A pro-rata rule will apply where a fund (such as a fund of hedge funds or “FOF”) that fails the 25% test and therefore becomes a BPI invests in another fund. The lower-tier fund in which the FOF invests will consider the FOF to be a BPI only to the extent that the FOF’s equity interests are held by BPIs. The 25% test should be conducted each time there is a new investment or any transfer or redemption of interests in the fund.
- Section 457A. Section 457A was added to the Internal Revenue Code as part of the Emergency Economic Stabilization Act of 2008. This new provision effectively prevents investment managers from deferring the receipt - and the taxation - of fee income earned from funds established in tax havens by requiring the investment managers to include in gross income all compensation owing by a “nonqualified entity”7 under a nonqualified deferred compensation arrangement as soon as the right to the compensation “vests.” Although the new law primarily affects compensation that is earned after 2008, compensation deferred in 2008 and earlier years must now be taken into income by the investment manager by the end of 2017. Significantly, compensation that is based on the appreciation in the value of a specific number of equity units in an offshore hedge fund or other nonqualified entity - such as certain stock appreciation rights - will also be considered “nonqualified deferred compensation” under the new law. However, very limited short-term deferrals - of up to a year - are permitted. There is also a concern that, under the new statute, any incentive fee arising out of a side pocket investment may be considered earned and vested in the year the side pocket is established, with the result that an additional 20% penalty tax plus interest will be due by the investment manager on the incentive fee in the year in which the side pocket is realized (or becomes liquid), even if receipt of the incentive fee is not actually “deferred” by the investment manager. In response to Section 457A, investment managers should consider taking the following steps:
- Pre-2009 deferral arrangements must be amended by the end of 2011 to pay out all amounts by the last day of the last tax year of the fund starting before 2018 (or the date of vesting, if later).
- Investment managers with current deferral arrangements with an offshore fund with a non-calendar fiscal year spanning 2008 and 2009 will likely wish to limit their deferral elections to the fees earned in the 2008 period.
- Investment managers of funds that generate long-term capital gains may wish to change the form of their incentive for services performed after December 31, 2008 from a fee to a partnership allocation. Those funds currently structured as stand-alone offshore corporations should consider moving to a partnership “mini-master” fund structure in which an incentive allocation would be made at the new partnership level. Those funds that currently operate through a “master-feeder” structure should consider taking an incentive allocation from the master fund on the offshore fund’s assets.
- Section 409A. Despite the virtual elimination of fee deferrals starting in 2009, Internal Revenue Code Section 409A compliance is still important for hedge funds. Investment managers who retain a fee structure with their offshore fund(s) and wish to defer fees for up to one year, as permitted by Section 457A, must continue to comply with the Section 409A deferral election rules going forward. Further, December 31, 2008 was the deadline for all written deferred compensation arrangements - including any pre-2009 deferred fee arrangements between fund managers and the offshore funds they advise, as well as all deferred bonus, phantom carry and profit-pool arrangements for investment manager employees - to be amended to comply in form with Section 409A. Any deferred compensation arrangement that was not written must have been reflected in a Section 409A-compliant document by the end of 2008. Finally, investment managers and funds must administer all deferred compensation arrangements, including deferred bonus or phantom carry plans for their employees and any pre-2009 deferred fee arrangements with their offshore funds, in accordance with the final Section 409A regulations starting January 1, 2009.
In order to engage in the solicitation or accepting of funds for the purpose of trading commodity futures contracts or advising others with respect to trading commodity futures contracts, an investment manager must generally be registered with the CFTC as a commodity pool operator or a commodity trading adviser. However, CFTC rules provide exemptions from these registrations in various circumstances. Investment managers that are contemplating engaging in commodity futures trading or management activities should contact counsel to determine whether they qualify for the exemptions from registration or if they should register with the CFTC. Investment managers that are registered with the CFTC and/or are members of the National Futures Association (“NFA”) must comply with a number of annual compliance requirements including completing an annual compliance self-assessment and updating their registration information via the NFA’s online system. Failure to complete the online update within 30 days of the registration renewal date will be deemed as a request to withdraw the investment manager’s registration. Investment managers that hold a futures position exceeding a certain threshold may be required to file a Form 40 with the CFTC. The compliance requirements referenced above are only examples and due to the complicated nature of the CFTC and NFA compliance requirements, investment managers are urged to consult counsel for further details.
In light of the increasing number of investor lawsuits in recent years, as well as the increasing review and scrutiny by regulatory and governmental authorities of the hedge fund industry generally, investment managers may want to consider whether management liability insurance should be obtained, depending on their current business’s exposure. Management liability insurance generally includes coverage for directors’ and officers’ liability, fiduciary liability, errors and omissions liability, and employment practices liability.
In order to encourage a culture of compliance in the work environment, investment managers should consider instituting training and/or programs to promote a better understanding of the investment manager’s compliance policies and procedures. An investment manager’s fiduciary duties and obligations, avoiding potential conflicts of interest, and the prevention of insider trading and employee harassment are just a few topics for training that investment managers should consider.
Other Annual Requirements
SEC-registered and unregistered investment managers are subject to several other annual requirements and obligations, including the following. Although these obligations need not be completed immediately, investment managers should confirm that these activities are on their compliance calendar.
- New Issues. If an investment manager’s fund(s) invest in “new issues”8 (whether directly or through an investment in another fund), the investment manager must obtain an annual representation from all investors in its fund(s) as to their eligibility to participate in profits and losses from new issues. This can be accomplished by requesting that each investor inform the investment manager of any changes in the investor’s status from its representation in its subscription agreement with the fund. The investment manager must keep a record of all information relating to whether an investor is eligible to purchase new issues for at least three years.
1 The President’s Working Group on Financial Markets has recently released a report of its Asset Managers’ Committee detailing what the Committee feels are best practices for the hedge fund industry. We feel that the report is a good resource for investment managers and can provide a starting point for developing a robust compliance program. The full report of the Asset Managers' Committee can be found at http://www.amaicmte.org/.
2 “Access person” means any employee of the investment manager who has access to nonpublic information regarding any clients’ purchase or sale of securities, or nonpublic information regarding the portfolio holdings of any reportable fund, or who is involved in making securities recommendations to clients, or who has access to such recommendations that are nonpublic.
3 Release No. 5744, dated March 6, 2008: Report of Investigation Pursuant to Section 21(a) of the Securities Exchange Act of 1934: The Retirement Systems of Alabama.
4 The SEC release uses the word “or.” However, as a matter of practice, we think it would be prudent to treat this as an “and” test, especially on a day when a short position in a Section 13(f) security is first established.
5 Please see our alert summarizing the CSX decision (CSX Corporation v. The Children’s Investment Fund Management (UK) LLP et al. (S.D.N.Y. No. 08 Civ. 2764)) for further details.
6 Where an investment manager sends out its own quarterly account statements, an independent public accountant must do a surprise verification of all funds and securities in the account at least once each calendar year.
7 A “nonqualified entity” is in essence a tax-indifferent entity, and includes not only foreign corporations not subject to U.S. tax or a “comprehensive” foreign tax system, but also any partnerships, including domestic partnerships, in which U.S. tax-exempt organizations or low-taxed foreign persons are significant investors.
8 The term “new issue” is defined generally by the Financial Industry Regulatory Authority (“FINRA”) as initial public offerings of equity securities regardless of whether such securities trade at a premium. Please note that the “new issues” rule which was formerly designated as NASD Rule 2790 has been transferred into the FINRA Manual and is now designated as FINRA Rule 5130.