Download To: Clients and Friends June 30, 2004 The articles below contain

To: Clients and Friends
June 30, 2004
The articles below contain information about recent developments in the hedge fund industry. We
believe that knowledge of these recent developments will be beneficial to you and will allow us to
better serve your needs. We welcome any feedback or questions.
Update on SEC Rule Proposal Requiring Hedge Fund Managers to Register
as Investment Advisers
The Securities and Exchange Commission (“SEC”) is still considering whether to propose a rule that
would require all hedge fund managers to register with the SEC. Sources indicate that the SEC may
schedule a meeting to discuss proposals on regulating hedge fund managers as soon as mid-July (one
source has identified July 14 as the date of the meeting). The rule proposal stems from an SEC staff
report, published on September 29, 2003, recommending that the SEC require hedge fund managers
to register.
In various speeches and public statements, including testimony before the U.S. Senate Committee
on Banking, Housing and Urban Affairs on April 8, 2004, SEC Chairman William Donaldson
asserted the need for the registration of hedge fund managers with the SEC, citing the rapid growth
of the hedge fund industry, the amount of assets being managed by hedge funds and the
involvement of hedge fund managers in recent mutual fund scandals.
Chairman Donaldson has stated that the SEC is evaluating a form of registration and oversight
specifically tailored to the hedge fund industry. The proposal’s intent would be to provide the SEC
with more information about the hedge fund industry so as to allow the SEC to improve its
discovery and preemption of federal securities laws violations. Chairman Donaldson has stated,
however, that the purpose of any proposed rule would not be to regulate how hedge funds make
their investments or to prevent the expansion of the hedge fund industry.
On June 15, 2004, Reuters reported many in the hedge fund industry expect that the rule would be
proposed within the next several weeks, leaving enough time for public comment and SEC final
action before Federal elections in November.
The proposed rule has been met with both praise and criticism. SEC Commissioner Harvey
Goldschmid and Paul Stevens, president of the Investment Company Institute, have endorsed the
rule, citing, among other things, the need for more information on the hedge fund industry and the
role hedge funds played in the recent market timing scandal.
This Client Bulletin is published for the clients and friends of Bryan Cave LLP. Information contained herein is not to be considered as legal advice.
This Client Bulletin may be construed as an advertisement or solicitation. © 2004 Bryan Cave LLP. All Rights Reserved.
Opposition comes from SEC Commissioners Cynthia Glassman and Paul Atkins, Federal Reserve
Chairman Alan Greenspan, Treasury Secretary John Snow and Commodity Futures Trading
Commission Chairman James Newsome, who assert that the regulation of hedge funds would be
inefficient given that the high net worth individuals and institutions investing in hedge funds can
conduct their own appropriate due diligence and the SEC's normal enforcement powers are available
in the case of fraud.
The Bryan Cave Hedge Fund Team will continue to update you as more information becomes
available.
SEC Final Rule Regarding Code of Ethics for all Registered Investment Advisers
On May 26, 2004, the SEC voted to adopt new Rule 204A-1 (the “Ethics Rule”) under the
Investment Advisers Act of 1940 (the “Advisers Act”), as well as related amendments to Rule 204-2
and Form ADV under the Advisers Act and Rule 17j-1 under the Investment Company Act of 1940
(the “Company Act”). The Ethics Rule requires that all registered investment advisers adopt and
enforce a written code of ethics (“Ethics Code”) applicable to their supervised persons. All
registered investment advisers are required to comply with the Ethics Rule by January 1, 2005.
Each Ethics Code must include provisions establishing standards of conduct for all of the adviser’s
supervised persons, requiring compliance with all applicable federal securities laws and requiring
each supervised person to report all violations of the Ethics Code to the adviser’s chief compliance
officer or other designated persons.
In addition, the Ethics Rule provides that each Ethics Code require “access persons” to pre-clear
any personal investments in IPOs and limited offerings and report their personal transactions and
holdings, including transactions and holdings in mutual funds managed by the adviser.
Although approved, the final Ethics Rule has not yet been published. Upon publication, the Bryan
Cave Hedge Fund Team will update you with further details.
SEC Issues No-Action Letter Regarding the Independence of Third-Party
Proxy Research Firms
On May 27, 2004, in response to a no-action letter submitted by Egan-Jones Proxy Services, the
SEC’s Division of Investment Management provided guidance as to when a proxy voting firm that
provides proxy research and recommendations regarding an issuer’s securities to a registered
investment adviser would be considered an independent third-party despite receiving compensation
from the issuer of such securities for providing advice on corporate governance issues.
Pursuant to Rule 206(4)-6 (the “Proxy Rule”) under the Advisers Act, a registered investment
adviser must adopt and implement policies and procedures governing the voting of proxies by the
adviser on behalf of its advisory clients. The Proxy Rule requires that the adviser’s policy be
designed to ensure that proxies are voted in the client’s best interests, material conflicts are avoided
and the adviser fulfills its fiduciary duties.
In the release adopting the Proxy Rule in January 2003, the SEC indicated that an adviser could
satisfy the Proxy Rule’s requirements by voting proxies in accordance with a pre-determined policy
based on the recommendations of an independent third-party. To be considered independent from
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the registered investment adviser, the third-party must be free from any influence or incentive to
recommend that the proxy be voted in anyone’s interest other than the adviser’s clients.
In response to the no-action letter, the SEC stated that a registered investment adviser should be
cautious in deciding to follow the recommendations of an independent proxy voting firm. Prior to
relying on the recommendations, the adviser should determine if the proxy voting firm has the
capacity and competency to adequately analyze proxy issues and can make such recommendations
impartially and in the best interest of the adviser’s clients. Further, a registered investment adviser
could be in breach of its duty of care if it voted proxies on the basis of a proxy voting firm’s
recommendation if the recommendation was in the proxy voting firm’s interest rather than in the
interests of the adviser’s clients.
Therefore, registered investment advisers should obtain information from all third-party proxy
voting firms to determine if the proxy voting firm truly is independent, including facts related to the
firm’s relationship with an issuer, and should establish procedures to identify and address conflicts
that arise with respect to the proxy voting firm. This will allow the registered investment adviser to
determine whether to follow the recommendation of a third-party proxy voting firm or whether
other steps must be taken by the adviser to vote a particular proxy.
SEC, CFTC and Department of Treasury Publish Semi-Annual Regulatory Agenda
On June 28, 2004, the semi-annual regulatory agendas of the SEC, the Commodity Futures Trading
Commission (“CFTC”) and the U.S. Treasury Department (“DOT”) were published in the Federal
Register. The agendas detail the regulatory actions that each agency expects to undertake in the near
future. Each agenda is only prospective and does not limit the activity that a particular agency can
undertake.
The SEC’s agenda details various actions that the SEC intends to take affecting the hedge fund
industry. The SEC intends to propose two rules by the end of the year. The first would be
proposed in July and would require all hedge fund managers register with the SEC (as explained in
more detail in the first article above). The second is scheduled for December 2004 and would
update the book and recordkeeping requirements for registered investment advisers. In addition,
the SEC intends to issue final rules amending Part II of Form ADV in the near future.
The agenda published by the CFTC indicates possible changes to the regulation of hybrid
instruments (i.e., financial instruments that possess, in varying combinations, characteristics of
forward contracts, futures contracts, option contracts, debt instruments, bank depository interests
and other interests) and the investment of customer funds by entities registered with the CFTC.
The CFTC has not set a timetable for these actions.
The DOT’s agenda indicates that the Financial Crimes Enforcement Network (“FinCEN”), a
division of the DOT, intends to publish final rules regarding anti-money laundering requirements
for mutual funds, investment advisers, commodity trading advisors and unregistered investment
companies, as each term is defined in the Bank Secrecy Act. FinCEN intends to take such action by
December 2004.
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More Hedge Funds Register with the SEC
A recent survey conducted by the Investment Counsel Association of America and the National
Regulatory Services shows an increase in the registration with the SEC by hedge fund advisers. The
survey defined a hedge fund adviser as an advisory firm in which hedge funds represent 75% or
more of the firm’s advisory clients.
According to the survey, the number of registered hedge fund advisers rose from 508 a year ago to
601 this year, an increase of 18%. The registered hedge fund advisers managed approximately $540
billion in client assets in 2004, up from $479 billion in 2003. Additionally, 431 of the hedge fund
advisers were technically exempt from SEC registration because they had 10 or fewer clients.
The survey found that the number of registered investment advisers who stated that they advised
hedge funds rose 8% in the past year, from 1,762 to 1,906. The total number of SEC-registered
investment advisers rose from 7,852 to 8,302.
CFTC Issues Interpretive Guidance on CPO Exemption
On April 14, 2004, the CFTC issued an interpretation stating that a commodity pool operator
(“CPO”) claiming an exemption from registration pursuant to Rule 4.13(a)(3) under the Commodity
Exchange Act may permit non-U.S. persons to participate in exempt pools regardless of whether
such non-U.S. persons meet the investor sophistication requirements of the rule.
Rule 4.13(a)(3) provides that a CPO is exempt from registration with the CFTC if the pool meets
certain trading restrictions and all investors in the pool meet certain sophistication requirements.
Under the terms of Rule 4.13(a)(3), it is unclear whether non-U.S. persons must meet the
sophistication requirements to be admitted into such an exempt pool.
The interpretation brings the exemption in line with Rule 4.13(a)(4), an exemption enacted
concurrently with Rule 4.13(a)(3) that has no trading limitation and higher sophistication
requirements.
The interpretation does not exempt a CPO from any other applicable requirements in the
Commodity Exchange Act or from the rules and regulations promulgated thereunder by the CFTC.
NASD Withdraws Marketing Rule
On April 26, 2004, the National Association of Securities Dealers, Inc. (“NASD”) withdrew a
proposed interpretation that would have allowed NASD members to use related performance
information in marketing mutual funds. It was anticipated that approval of this interpretation would
lead to NASD members being permitted to use related performance information in the marketing of
hedge funds.
On December 30, 2003, the NASD released an interpretive letter permitting the use of related
performance information for private equity funds, including hedge funds and funds of funds,
provided that (i) the interests in such funds are sold through private placements only to certain
sophisticated investors, (ii) the funds are exempt from registration as investment companies, (iii) the
interests are exempt from registration under the Securities Exchange Act and (iv) have liquidity
restrictions. In addition, investors would be required to invest at the time the fund is formed or
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shortly thereafter. This interpretive letter came in response to an interpretive letter issued on
October 2, 2003, pursuant to which the NASD prohibited the use of related performance
information in hedge fund sales materials.
Regardless, all sales material used by NASD members must meet the applicable standards of NASD
Rule 2210, including the requirements that such material be truthful, accurate, balanced and not
misleading, among other things.
IRS Issues Final Regulations on Marking-to-Market Marketable Stock in a PFIC
Effective May 3, 2004, the Internal Revenue Service (the “Service”) issued final regulations under
Section 1296 of the Internal Revenue Code of 1986 (the “Code”) pertaining to the procedures for
electing to mark-to-market marketable securities held in a passive foreign investment company
(“PFIC”). Many offshore hedge funds (if corporations) constitute PFICs, which result in the
application of onerous rules for the fund’s U.S. investors. The regulations, although designed to
ameliorate the harsh effects of the PFIC rules, may have limited application due to the definition of
marketable stock.
The election to mark-to-market marketable securities provided for in Treas. Regs. Section 1.12961(b) is available to any U.S. person and any controlled foreign corporation (“CFC”) that owns
marketable stock (as that term is defined in Treas. Reg. Section 1.1296-2)1 in a PFIC. A Section
1296 election is made on a foreign corporation by foreign corporation basis, but once an election is
made it applies to all marketable stock of the corporation that the U.S. person owns at the time of
the election or that is acquired subsequently.
The preamble to the final regulations provides that the stated intent of Congress for enacting
Section 1296 was to provide another alternative to the interest charge rules of Code Section 1291
that would be available in instances where taxpayers cannot obtain sufficient information to make a
qualified electing fund (“QEF”) election. A QEF election is automatically terminated when a U.S.
person makes a timely Section 1296 election with respect to its PFIC stock.
The result of the Section 1296 election is that a U.S. person will mark the marketable securities to
market on the last day of the U.S. person’s taxable year and any gain will be treated as ordinary
income. Correspondingly, if the adjusted basis of the marketable securities is greater than its fair
market value on the last day of the U.S. person’s taxable year, the U.S. person is allowed an ordinary
loss deduction equal to the lesser of the excess or the unreversed inclusions with respect to such
stock. (An unreversed inclusion is the excess, if any, of the amount of marked-to-market gain
previously included for prior years over the amount allowed as a deduction for prior years.)
Treas. Regs. Section 1.1296-1(d)(1) provides that a U.S. person’s adjusted basis in the marketable
securities will be increased or decreased, as the case may be, by the amount included in gross income
or allowed as a deduction. Where a U.S. person owns the marketable securities in a PFIC through
1
Generally, the term marketable stock means (a) PFIC stock that is regularly traded (as class of stock that is
traded on one or more qualified exchanges or other markets (i.e., a national securities exchange that is registered
with the Securities and Exchange Commission or a foreign securities exchange that is regulated or supervised
by a governmental authority of the country in which the market is located and which has characteristics
including trading volume, listing, financial disclosure, etc.), (b) and stock in certain PFICs meeting several
criteria and (c) options thereon.
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certain foreign entities (i.e., a U.S. corporation owns interest in a foreign partnership which holds an
interest in a PFIC), the basis adjustment applies to the stock in the hands of the foreign entity
actually holding the stock. Corresponding adjustments are then made to the adjusted basis of the
U.S. person’s interest in the foreign entity and any intermediary entity through which the U.S.
person holds the PFIC stock. PFIC stock owned, directly or indirectly, by or for a foreign
partnership, foreign trust (other than a foreign grantor trust) or a foreign estate is considered as
being owned proportionately by its partners or beneficiaries.
A U.S. person which wants to make a Section 1296 election for a taxable year must make it on or
before the due date of its U.S. Federal income tax return. The election must be made on Form
8621, “Return by a Shareholder of a Passive Foreign Investment Company or Qualified Electing
Fund,” and such form must be included with the U.S. person’s original tax return or an amended
return, provided the amended return is filed on or before the election due date. (A late Section 1296
election may be permitted only in accordance with relief granted by the Service.)
A Section 1296 election will be terminated if the stock ceases to be marketable, if the U.S. person
elects or is required under another provision of the Code to mark the stock to market, or if the
Commission consents to allow the U.S. person to revoke the Section 1296 election upon a finding
of a substantial change in circumstances. (A substantial change may include a foreign corporation
ceasing to be a PFIC.)
The final regulations also amended Treas. Regs. Section 1.6031(a)-1 to provide that a foreign
partnership will not be considered to have derived income from U.S. sources solely because a U.S.
partner marks to market its pro rata share of PFIC stock held by the foreign partnership pursuant to
a Section 1296 election.
European Union Turns its Attention to Hedge Funds
The European Union continues to work towards an integrated single market in financial services,
including the harmonization of investment fund registration and marketing requirements in the
different member states. Previously, the European Union has concerned itself only with retail
investment funds, dealt with under the so-called UCITS Directive (the acronym stands for
"undertakings for the collective investment in transferable securities"), originally passed in 1985 and
amended by two recent amending directives. Recently, however, its attention has turned to hedge
funds.
In January of this year, the European Parliament passed a resolution approving certain broad
proposals for "sophisticated alternative investment vehicles" (“SAIVs”). Those proposals were
originally set out in a report on hedge funds and derivatives made to the European Parliament by
Mr. John Purvis, a Scottish Member of the European Parliament.
The proposals are very broad in scope and, as of now, no definitive legislation has been drafted.
They propose, for instance, the establishment of a "light touch" regulatory regime for SAIVs
(intended to encourage them onshore), a "passport" to allow harmonized marketing of funds
qualifying under the proposed regime across member states, freedom to use innovative techniques
and instruments and to charge performance fees, and a requirement to run daily risk control.
Currently, it is not possible to assess the extent of the opportunity provided by any resulting
legislation. The result, one would hope, will be a rationalization and harmonization of what are
currently the very varied regulatory regimes applying to the management and marketing of hedge
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funds across the European Union. It is also to be hoped, however, that this does not come at the
price of burdensome regulation for hedge fund managers and promoters. It may be some time
before all becomes clear: the UCITS Directive, for instance, dates back to the mid-1980s, but the
legislation implementing the Directive in the various member states has still not completely achieved
the desired single market in retail funds. Furthermore, in the absence of harmonized tax regimes,
any such single market will always be difficult to achieve.
In early June, the Committee of European Securities Regulators (“CESR”), an advisory committee
which, amongst other things, assists the European Union on the preparation of implementing
measures in European Union securities legislation, announced proposals to establish a harmonized
framework of prudential rules and disclosure for so-called "non-harmonized collective investment
schemes". This term includes alternative investment vehicles such as hedge funds. As with the
proposals announced in January, no concrete details have as yet been published as to what the
CESR has in mind. However, these moves demonstrate an increasing awareness of hedge funds as a
product. Given sensibly drafted legislation in this area, without overly prescriptive legislation,
opportunities could open to managers for cross-border pan-European marketing to institutions and
high net-worth individuals.
FSA Announces Consultation on Implementation of European Union's
Market Abuse Directive
On January, 28 2003, the European Parliament and the Council of the European Union adopted the
Directive on Insider Dealing and Market Manipulation (“Market Abuse Directive”). The Market
Abuse Directive was proposed as part of the European Union's Financial Services Action Plan, a set
of 42 measures, initially proposed by the European Commission in 1999 and aimed at achieving
integration of the financial markets across the European Union. The Commission believed that
differences in the market abuse regimes across the various member states had led to competitive
distortions in European financial markets.
The UK's securities regulator, the Financial Services Authority (“FSA”), has now published a joint
consultation document with the UK Treasury on proposals to implement the Market Abuse
Directive in the UK. The Directive's provisions are similar, but not identical, to the UK's existing
market abuse regime, contained in the Financial Services and Markets Act 2000 (“FSMA”) and
related provisions in the FSA's Handbook of rules.
The consultation document proposes a number of draft changes to the FSMA and to the FSA's
Handbook, including changes in regulatory provisions contained in the Code of Market Conduct,
Price Stabilising Rules, the UK Listing Rules and certain provisions in the Conduct of Business
Sourcebook. Among the proposed changes are:
•
an extension of disclosure obligations to issuers whose securities are admitted to trading on
regulated markets in any member state (extending the current provisions, which apply only to
those issuers whose securities are traded on markets based in the UK);
•
a requirement for such issuers to keep lists of persons with access to inside information relating
to them and to require those discharging "managerial responsibilities" to disclose transactions
for their own account in shares of such issuers or derivatives relating to such shares; and
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•
a requirement of those involved in producing and disseminating research recommendations
(including journalists) to present their recommendations clearly and disclose any conflicts of
interest.
The Treasury and FSA aim to finalize the legislative and regulatory changes made necessary by the
Directive by the end of November, and it is expected that such changes will come into force within
three months of publication.
The new provisions mark a further stage in the implementation of the Financial Services Action
Plan, which is intended to be carried out by 2005.
European Institutions Demonstrate Growing Interest in Hedge Funds
The press has given much attention in recent months to the increasing interest shown by European
institutions in hedge funds. Recent reports suggest, for instance, a movement by UK pension funds
away from their traditionally high weightings in the equity markets and towards alternative
investments, although UK pension fund investment in hedge funds remains at a relatively low level.
Nevertheless, attitudes appear to be changing: preliminary results have just been announced in the
press of a survey of European investment consultants carried out by Prospera Research, a Swedish
market research firm, on behalf of IMP-First Quadrant, of Stockholm, and the Alternative
Investment Management Association, the London-based trade association for the alternative
investment industry. Those preliminary results suggest that European investment consultants are
increasingly confident of hedge fund managers' future returns and inclined to recommend hedge
fund investment to their institutional clients. The results (which are to be published in final form
later this year) further showed that, according to the consultants surveyed, the most important
criteria when selecting external managers for alternative investments are experienced and high
quality staff, a clear investment philosophy, a high quality risk management function and the ability
to generate good risk-adjusted returns.
The apparent increased willingness of consultants to contemplate the recommendation of hedge
fund investments may have a significant effect on the development of the industry, given the high
reliance placed on consultants by institutional investors. UK pension funds, for instance, are
required to take advice on their investments, and this has strengthened the role played by
consultants in the allocation of institutional portfolios. The survey's preliminary findings as to the
key selection criteria also serve as a useful indicator as to areas of focus for managers keen to access
institutional capital, as well as indicating key areas for due diligence for institutional and fund of
funds investors.
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Effective Dates of Hedge Fund Related Regulations
Custody Rule: Amended Rule 206(4)-2 under the Advisers Act (the “Custody Rule”) went into effect
on April 1, 2004. All registered investment advisers must be in compliance with the Custody Rule,
which essentially provides that registered investment advisers that have “custody” of the funds or
securities of a client must place the assets with a “qualified custodian” and provide the client, or
ensure that the client is provided with, periodic account statements regarding the assets held in
custody.
Compliance Programs: New Rule 206(4)-7 under the Advisers Act and new Rule 38a-1 under the
Investment Company Act become effective on October 5, 2004. The rules generally require all
registered investment advisers, registered investment companies and business holding companies to
adopt and implement written policies and procedures reasonably designed to prevent violation of
federal securities laws and to appoint a chief compliance officer responsible for developing,
administering and enforcing the program.
Ethics Rule: New Rule 204A-1, amended Rule 204-2 and the amended Form ADV under the
Advisers Act, and new Rule 17j-1 under the Investment Company Act, are scheduled to become
effective on January 1, 2005. Although approved, the final rules have not yet been published and are
subject to modification. The rules generally require all registered investment advisers and registered
investment companies to adopt and enforce a written code of ethics applicable to their supervised
persons.
If you have any questions about any of the above rules, please contact a member of Bryan Cave's
Hedge Fund Team at a number listed below.
Hedge Fund Team in the News
Robert G. Leonard and David S. Plutzer spoke at the 2nd Annual Hedge Fund Start-Up and Business
Development Forum, organized by Euromoney, held in New York on May 11-12, 2004. Michael F.
Mavrides also attended. Mr. Leonard discussed the marketing of hedge funds in the United States
and other current regulatory issues and Mr. Plutzer spoke on investment adviser regulation and the
new rules relating to commodity pool operators and commodity trading advisors.
Robert G. Leonard and John F. Langan spoke at the 10th Annual Global Alternative Investment
Manager Forum, held in Lausanne, Switzerland on June 8-10, 2004. Elizabeth A. Smith also
attended. Mr. Leonard again spoke on the marketing of hedge funds in the United States and other
current regulatory issues and Mr. Langan discussed attracting institutional investors into hedge
funds.
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For further information, please contact:
St. Louis Office:
New York Office:
London Office:
Denis P. McCusker
Tel: (314) 259-2455
E-mail: [email protected]
Robert G. Leonard (Team Leader)
Tel: (212) 541-2266
E-mail: [email protected]
Charles H. Attlee
Tel: +44-20-7246-5810
E-mail: [email protected]
Robert L. Newmark
Tel: (314) 259-2568
E-mail: [email protected]
Michael F. Mavrides
Tel: (212) 541-1263
E-mail: [email protected]
John F. Langan
Tel: +44-20-7246-5895
E-mail: [email protected]
David S. Plutzer
Tel: (212) 541-1133
E-mail: [email protected]
David M. Pfeiffer
Tel: +44-20-7246-5925
E-mail: [email protected]
Johnny C. Lee
Tel: (212) 541-1150
E-mail: [email protected]
Irvine Office:
John C. Richardson
Tel: (212) 541-1281
E-mail: [email protected]
Brett J. Souza
Tel: (949) 223-7119
E-mail: [email protected]
For ERISA information, please contact:
St. Louis Office:
Brian W. Berglund
Tel: (314) 259-2445
E-mail: [email protected]
Lisa A. Van Fleet
Tel: (314) 259-2326
E-mail: [email protected]
Ephraim D. Lemberger
Tel: (212) 541-1196
E-mail: [email protected]
For Tax information, please contact:
New York Office:
Elizabeth Ann Smith
Tel: (212) 541-1183
E-mail: [email protected]
Alan H. Solarz
Tel: (212) 541-2075
E-mail: [email protected]
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