Sadis & Goldberg LLP

FINRA Rule 5131(b) "Spinning Prohibition Rules" - New Effective Date - September 26, 2011


   

All hedge fund managers that invest in "new issues" will need to update their funds' Subscription Documents for new investors and recertify their existing investors in order to continue to be eligible to purchase "new issues" under the "Spinning Prohibition Rules" adopted by the Financial Industry Regulatory Authority, Inc. ("FINRA"). The Spinning Prohibition Rules generally prohibit a FINRA-member broker-dealer from allocating "new issues" to accounts (including hedge funds) in which a beneficial interest is held by executive officers and directors of certain current, former or prospective investment banking clients of such broker-dealer ("Restricted Investors").   The original effective date for the Spinning Prohibition Rules was May 27, 2011 and such date was recently extended by the Securities and Exchange Commission until September 26, 2011.  

 

To ensure compliance with the Spinning Prohibition Rules, FINRA-member broker-dealers will need to confirm whether any investor in a fund is a Restricted Investor. Similar to the other "new issues" rules which generally prohibit a FINRA-member broker-dealer from allocating "new issues" to accounts (including hedge funds) in which a beneficial interest is held by any employee or affiliate of any FINRA-member broker-dealer, the Spinning Prohibition Rules contain a "carve out" whereby new issues may be allocated to accounts in which the beneficial interests of Restricted Investors do not exceed 25% (the carve out is 10% under the other "new issues" rules). Please note that the Spinning Prohibition Rules are in addition to the other "new issues" rules currently in effect, and therefore, even if an investor in your hedge fund is not considered a Restricted Investor under the Spinning Prohibition Rules, such investor may be considered a "restricted person" under the other "new issues" rules. For example, while an investor in your hedge fund may not be an executive officer or director of a current, former or prospective investment banking client of the broker-dealer from which your fund is allocated "new issues", such investor may still be an employee or affiliate of a FINRA-member broker-dealer. As a result, you need to ensure that all new and existing investors in your hedge funds that participate in the profits and losses from "new issues" meet the requirements of the Spinning Prohibition Rules and the other "new issues" rules.

 

Please contact your attorney at Sadis & Goldberg to discuss updating your hedge fund's subscription documents, as well as to obtain a copy of the Spinning Prohibition Questionnaire for your existing hedge fund investors. If you have any questions concerning this Alert or any related matters, please contact Lance Friedler, 212-573-8030 or lfriedler@sglawyers.com.                                 

 
The information contained herein was prepared by Sadis & Goldberg LLP for general informational purposes for clients and friends of Sadis & Goldberg LLP.  Its contents should not be construed as legal advice, and readers should not act upon the information in this Alert without consulting counsel.  This information is presented without any representation or warranty as to its accuracy, completeness or timeliness.  Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP.  Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.  

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Qualified Client Standard Raised - Effective September 19, 2011


An order approved by the Securities and Exchange Commission ("SEC") on July 12, 2011 will impact all SEC registered investment advisers (and certain state registered investment advisers) that provide advisory services to investment funds and/or separately managed accounts and receive performance-based compensation for such advisory services.  The SEC's order raises the financial thresholds necessary for an investor to qualify as a "qualified client" under the Investment Advisers Act of 1940 ("Advisers Act"). 

 

Rule 205-3 under the Advisers Act precludes an SEC registered investment adviser from charging a client a performance-based fee (such as an incentive allocation or fee) unless the client is a "qualified client". For the avoidance of doubt, the investors in an investment fund (rather than the investment fund itself) are considered clients for purposes of this analysis. Currently, under Rule 205-3 a "qualified client" is defined as an investor that has (i) at least $750,000 in assets under management with the investment adviser or (ii) has a net worth at the time of investment of at least $1.5 million, including the value the investor's primary residence. In calculating the $750,000 assets under management threshold, an investor can include the investment that is currently being made with the investment adviser through an investment fund or separately managed account. Effective September 19, 2011, the assets under management threshold is being raised from $750,000 to $1 million and the net worth threshold is being raised from $1.5 million to $2 million. In addition, an investor can no longer include the value of his or her primary residence in calculating whether he or she meets the $2 million net worth threshold. Many states (such as California) follow Rule 205-3 and, therefore, even if your investment advisory firm is state registered (versus SEC registered) these changes may be applicable to your advisory business.   

 

Please note that, absent further guidance from the SEC, we currently believe that the new "qualified client" definition only applies to (i) new investors in your hedge funds and/or separately managed accounts and (ii) existing investors in your hedge funds that make an additional capital contribution.  We do not currently believe that you need to recertify existing investors in your hedge funds or separately managed accounts that are not making additional capital contributions.  Likewise, with respect to private equity funds, if an investor has already made a capital commitment to the fund, we do not believe that subsequent draw-downs of capital by the fund from such investor will require you to recertify such investor.  However, as with hedge funds, any investor that is making a new capital commitment to the private equity fund would need to meet the new definition of "qualified client".    

 

We urge you to contact us as soon as possible in order to update the subscription documents for your investment funds, as well as any investment management agreements for separately managed accounts that you are contemplating in the future. If you have any questions concerning this Alert or any related matters, please contact your attorney at Sadis & Goldberg or the author of this Alert, Lance Friedler at 212-573-8030 or lfriedler@sglawyers.com.

 

 
The information contained herein was prepared by Sadis & Goldberg LLP for general informational purposes for clients and friends of Sadis & Goldberg LLP.  Its contents should not be construed as legal advice, and readers should not act upon the information in this Alert without consulting counsel.  This information is presented without any representation or warranty as to its accuracy, completeness or timeliness.  Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP.  Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.  

 

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President Obama Signs the Dodd-Frank Wall Street Reform and Consumer Protection Act


Note:  Change to the Definition of an Accredited Investor is Effective Immediately.   

On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Financial Bill") into law. Set forth below are certain aspects of the Financial Bill which impact investment managers to hedge funds and private equity funds.  

The Financial Bill revises one of the definitions of an "accredited investor" under the Securities Act of 1933 ("1933 Act").   Specifically, in determining if a natural person is an "accredited investor" who meets the $1 million net worth test, the value of such person's primary residence must now be excluded from the $1 million net worth calculation.  Previously, a natural person's primary residence (net of any mortgage) was included in calculating a natural person's net worth.  The other definitions of "accredited investor" under the 1933 Act are currently remaining the same.  This change in definition is effective immediately.  As a result, we urge you to contact us as soon as possible as the Confidential Private Placement Memorandum and Subscription Documents for any investment funds you manage will need to be revised for this new definition of "accredited investor".  Please note that, absent further guidance from the Securities and Exchange Commission ("SEC"), we currently believe that the new "accredited investor" definition only applies to (i) new investors in your hedge funds and (ii) existing investors in your hedge funds that make an additional capital contribution.  We do not currently believe that you need to recertify existing investors in your hedge funds that are not making additional capital contributions.  Likewise, with respect to private equity funds, if an investor has already made a capital commitment to the fund, we do not believe that subsequent draw-downs of capital by the fund from such investor will require you to recertify such investor.  However, as with hedge funds, any investor that is making a new capital commitment to the private equity fund would need to meet the new definition of "accredited investor".    

Under the Financial Bill, the Investment Advisers Act of 1940 ("Advisers Act") will also be amended to require many investment advisers that are currently exempt from registration with the SEC to register.  Generally, the Financial Bill requires all investment advisers to hedge funds and/or private equity funds that manage $150 million or more in assets to register with the SEC.  Importantly, the "private adviser" exemption which many hedge fund and private equity fund managers relied upon in the past is being eliminated.  The "private adviser" exemption enabled an investment adviser to avoid SEC registration if it: (i) did not act as an investment adviser to a registered investment company or business development company; (ii) had fewer than 15 clients (counting each fund as 1 client); and (iii) did not hold itself out to the public as an investment adviser.  Please note that the SEC will need to issue additional guidance on numerous aspects of the Financial Bill relating to investment adviser registration and coordinate their efforts with various State regulators.  Unlike the change in the "accredited investor" definition set forth above, the new rules under the Advisers Act will become effective on July 21, 2011.     

If you have any questions concerning this Financial Services Alert or any related matters, please contact Lance Friedler, 212-573-8030.

                                       
 
The information contained herein was prepared by Sadis & Goldberg LLP for general informational purposes for clients and friends of Sadis & Goldberg LLP.  Its contents should not be construed as legal advice, and readers should not act upon the information in this Tax Alert without consulting counsel.  This information is presented without any representation or warranty as to its accuracy, completeness or timeliness.  Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP.  Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.  

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Attracting Retail and Institutional Investors in Europe - UCITS III


 

Entrepreneurial U.S. hedge fund managers should consider offering products under the European Union's Undertakings for Collective Investment in Transferable Securities ("UCITS III") framework.  UCITS III is the latest version of the Europe-wide regulation that allows for the creation and distribution of investment fund products throughout the European Union to retail and institutional investors.  The primary advantage to a UCITS III fund is that it may be offered to retail and institutional investors in all EU member states after its initial organization, which generally takes place in Dublin or Luxembourg.

 

According to HedgeFund Intelligence, half of all hedge fund managers are either planning or have already launched a UCITS III compliant vehicle.  UCITS III compliant vehicles are also becoming popular in Asian and Latin American countries as investors and regulators become more comfortable with the UCITS III framework.  According to JP Morgan Chase, over 40% of new UCITS sales are outside of the European Union.

 

Even though these figures appear to support a convergence between hedge funds and UCITS III vehicles, due to the UCITS III framework, not every hedge fund can be "reformatted" into a UCITS III compliant vehicle.  More liquid strategies such as absolute return, managed futures, trend followers and long-short equity can work well within a UCITS III structure; however, strategies (i) with an event driven focus, (ii) that invest in illiquid and difficult to value securities, and (iii) that rely heavily on leverage (like certain arbitrage funds) may have difficulties in operating under a UCITS III compliant structure.  Additionally, managers should be aware that under the UCITS III framework, they (i) may only invest in a prescribed list of eligible assets, (ii) are prohibited from shorting securities, (iii) are subject to limitations on the use of leverage, (iv) are subject to certain portfolio diversification mandates (e.g., no more than 10% of the fund's net asset value ("NAV") may be invested in any one transferable security), and (v) must provide investors with at least bi-monthly liquidity. 

 

However, through the use of financial derivative instruments ("FDIs") (one of the permitted assets), UCITS III compliant vehicles may employ synthetic leverage (up to 100% of NAV) and shorting, as long as the assets underlying the FDIs are considered as being eligible under the UCITS III framework.  Currently, nearly all derivatives (e.g., CFDs, repos, total return swaps and CDSs) can be used by "sophisticated" UCITS III compliant vehicles (i.e., those that employ FDIs for strategic/investment purposes) to replicate many hedge fund strategies.  All "sophisticated" UCITS III compliant vehicles are required to employ robust risk management procedures (e.g., managers must apply value-at-risk (VaR) analysis in order to assess the global exposure the UCITS compliant vehicle is undertaking and such analysis must be combined with portfolio stress-testing and back-testing).

 

The UCITS III framework will remain in place until July 2011 when the individual European Union member states are required to implement the UCITS IV Directive, adopted by the European Commission on January 13, 2009, which repeals the current UCITS III framework.  Our expectation is that the cross-border and operational benefits from UCITS IV will attract increased interest from fund managers over the coming years.

 

UCITS III compliant vehicles can offer U.S. hedge fund managers a vastly expanded pool of potential investors and distribution channels, specifically retail investors in Europe, who may not otherwise invest directly in a hedge fund, and institutional investors in Europe, who are attracted to the regulated risk management, liquidity and high transparency of UCITS III compliant vehicles. 

 

Please contact Lance Friedler at 212.573.8030 (or lfriedler@sglawyers.com) or Micah Nessan at 212.573.8034 (or mnessan@sglawyers.com) for more information on launching a UCITS III fund. 

 

 

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