Articles Posted in Private Funds

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In the summer the European Securities and Markets Authority (ESMA) published its advice and opinion on the proposal to extend the marketing passport to non-EU alternative investment fund managers (AIFM) and non-EU funds.  The passport would enable non-EU AIFMs to market their funds across the EU under the single AIFMD regime, rather than seeking investors using the individual countries’ national private placement regimes (NPPR).

As part of the review, ESMA assessed six countries’ regulatory regimes in the context of investor protection, market disruption, competition and monitoring systemic risk.  The outcome of the investigations was mixed.  Whilst Guernsey, Jersey and Switzerland were identified as jurisdictions to which the passport could be extended, it was not such good news for Hong Kong, Singapore and the United States.

For the US, ESMA identified obstacles to the extension.  Chief among these are the absence of remuneration rules for US investment managers and the “unlevel playing field” of the restrictions on EU funds to access US retail investors.  At present, in order for the passport to be extended to the US substantive changes would need to be made to US federal securities laws and regulations regarding the marketing of private funds in the US.  Whilst the SEC does focus on inadequate disclosures of fees, costs and expenses (see our posts here and here), it is highly unlikely that the legislative changes necessary to satisfy ESMA will be forthcoming in the near future.  Consequently US managers will need to continue accessing European investors either by way of the NPPR or reverse solicitation for the foreseeable future.  Each of those approaches continue to bring their own challenges, especially in the absence of guidance regarding the reverse solicitation exemption.

And what of the Cayman Islands?  As you may have noted from the list above, the Cayman Islands was not included as part of ESMA’s first assessments.  This a further blow to US investment managers and the inclusion of the territory on ESMA’s list of relevant jurisdictions will offer little comfort given the time required to conduct an assessment.

All in all, not a great deal has changed for the US firms.

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Strategy shifts now the focus, the SEC extracts another pound of flesh from a fund adviser. In a recently settled administrative proceeding, UBS agreed to return $8.2 million of advisory fees to investors, compensate investors for $4.9 million of investment losses and pay $4.4 million in interest and penalties to the SEC for allegedly failing to disclose an investment strategy shift and failing to supervise disclosures. UBS neither admitted nor denied culpability.

Investment advisers are advised to periodically review the description of their strategy and adjust the disclosure if their practices materially diverge from the described strategy over time. In addition, advisers should consider what manner of disclosure is appropriate in light of the facts and circumstances of a major strategy shift – whether, for example, to disclose promptly in an investor letter, prior to the strategy shift with an opportunity to redeem, and whether and when to involve the board of directors and/or outside counsel.

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The SEC, again, makes it clear:  all aspects of fee, expense and other arrangements must be disclosed accurately and in detail before commitments are accepted.

The SEC recently announced a settlement with three investment advisor affiliates of The Blackstone Group (the Advisors) that were accused of breaching their fiduciary duty to funds they manage or managed, failing to make necessary disclosure to the funds’ investors and failing to adopt and implement policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. The charges leveled against the Advisors centered on conflicts of interest involving monitoring fees and legal fee discounts. At the time the alleged violations occurred, each of the Advisors was an SEC-registered investment advisor. Although the Advisors neither admitted nor denied the SEC’s findings, they made several changes to existing business practices, agreed to pay the SEC a $10 million penalty and agreed to remit to their funds fees and interest approximating $29 million in response to allegations of violations of Section 206(2) and Section 206(4) of the Investment Advisers Act and Rules 206(4)-8 and 206(4)-7 thereunder.

Accelerated Monitoring Fees

According to the SEC, the Advisors entered into monitoring agreements with each portfolio company owned by their funds and received, in addition to the annual management fees paid by their funds, monitoring fees from the portfolio companies. In accordance with the funds’ limited partnership agreements, fifty percent of the Advisors’ monitoring fees was used to offset the annual management fee otherwise payable by the funds. Under certain of the monitoring agreements, in the event of a private sale or initial public offering of a portfolio company, monitoring fees could be accelerated for the remaining years of the agreements’ terms (including extension periods), discounted to present value and paid in advance upon termination of the agreements. Notwithstanding that fifty percent of the accelerated monitoring fees inured to the benefit of the funds and their limited partners, the SEC found the arrangements problematic because the value of the funds’ assets was reduced by the net amount of the accelerated monitoring fee payments when the portfolio companies were sold or taken public, thereby reducing amounts available for distribution to the limited partners.

The SEC was particularly offended by the fact that, in certain instances, fees were accelerated beyond the period during which a fund owned the relevant portfolio company or beyond the period during which services were performed by the Advisors. In addition, the SEC alleged that, although the Advisors disclosed their ability to collect monitoring fees to the funds and the funds’ limited partners before capital was committed to the funds, the Advisors did not disclose the practice of accelerating monitoring fees prior to the time the Advisors received the accelerated fees. The SEC conceded, however, that monitoring fee acceleration was disclosed in distribution notices, quarterly management fee reports and, where there were public offerings of portfolio companies, in SEC filings on Form S-1. The SEC further acknowledged that the funds’ limited partner advisory committees could have objected to acceleration and arbitrated the matter, but never took such action. The problem, according to the SEC, is that, because of the conflict of interest, the Advisors could not effectively consent to the acceleration.

Disparate Discounts on Legal Fees

The Advisors also negotiated a single agreement with legal counsel pursuant to which legal counsel provided services to the funds and the Advisors.  According to the SEC, although the funds generated significantly more work than the Advisors, the Advisors received substantially greater discounts than the funds. In addition, the difference in the discounts was not disclosed to the funds, the funds’ advisory committees or limited partners. Again, because of the conflict, the Advisors could not consent effectively.

Takeaways

The findings made and penalties imposed by the SEC in the Blackstone matter highlight the SEC’s disdain of conflicts of interest between advisors and the private funds they manage. More importantly, the matter makes clear the SEC’s intention to go after even the most common business practices in private equity, if the SEC determines that aspects of those practices are not disclosed fully prior to the time capital commitments are accepted. Nothing is sacrosanct.

As was the case with Blackstone, a fund’s private placement memorandum typically discloses that the fund’s management entities and affiliates of those entities may receive fees to which the fund will not be entitled. It also customarily discloses actual and potential conflicts involving fund counsel. The SEC has made clear that those disclosures will not be sufficient if they do not describe all aspects of the relevant conflicts clearly, accurately and completely. Broad and generalized disclosures, even where sophisticated and experienced fund investors are able to discern the nature of the conflict, will not protect against violations of Sections 206(2) and 206(4) of the Investment Advisers Act and the rules promulgated under those sections of the Act. Further, disclosures made after investors’ capital commitments are accepted may not be sufficient.

This case also highlights the fact that the SEC will push back against attempts by an SEC-registered investment advisor to limit its fiduciary duty to the funds it advises. In addition, it appears that the SEC will apply Section 206(2) and Section 206(4) of the Investment Advisers Act broadly and with a big stick.

As is always the case, cooperation with the SEC in connection with an examination or investigation is critical. In addition, as is evidenced in the Blackstone matter, taking remedial action to eliminate or ameliorate conflicts can be very helpful to an advisor that is under SEC scrutiny and seeking to minimize exposure to punitive action.

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U.S. Investment advisers, other financial services providers, and pooled investment vehicles – private and public funds – involved in certain cross-border transactions must file.

Background

The U.S. Department of Commerce’s Bureau of Economic Analysis (“BEA”) is conducting its next five-year “Benchmark Survey of U.S. Financial Services Providers and Foreign Persons” on Form BE-180. The survey is mandatory and collects data on cross-border trade and financial services transactions of U.S. financial services providers, including investment advisers and other asset managers, broker-dealers and banks. BE-180 covers cross-border purchase and sales transactions that occurred or were charged during the U.S. reporter’s 2014 fiscal year. BE-180 is one of a series of benchmark surveys[1] measuring international trade transactions and collecting data for use in various economic studies.

Who Is Required to Report

Each U.S. individual and entity that is a “financial services provider” and meets the reporting requirements must file form BE-180. Financial services providers include investment advisers and their pooled vehicles such as hedge funds, private equity funds, pension funds, mutual funds and real estate funds, and broker-dealers.[2]

Filing Thresholds

The reporting requirement applies to each U.S. individual or entity that is a financial services provider with (i) either[3] sales or purchases directly with non-U.S. individuals or entities in excess of $3 million or more on a consolidated basis during the 2014 fiscal year, or (ii) sales or purchases directly with non-U.S. individuals or entities of less than $3 million, that were notified by the BEA about the survey. Any U.S. individual or entity that is notified by the BEA about the survey but has no transactions of the types of services covered must complete pages 1-3 of the survey.

Reportable Transactions

Reportable financial transactions include investment management and advisory services, brokerage services, underwriting, custodial services, credit-related services, securities lending, and electronic funds transfer services – transactions involving cross-border payments, such as advisory or sub-advisory fees, brokerage commissions, custodial fees and securities lending fees.

Reportable data include the transactional counterparty’s location by country and the relationship between the U.S. reporter and its counterparty (i.e., foreign affiliates or unaffiliated foreign persons). You may have easy access to some of the required data (such as through your administrator or internal accounting systems). However, as with the other BE forms, obtaining some of the required information may involve additional legwork and cooperation with cross-border counterparties, which should be considered in meeting the deadlines.

Filing Deadline and Extensions

The BEA has granted automatic extensions to the original October 1 filing deadline, as follows:

File no later than November 1, 2015 if:

  • You were notified of the BE-180 survey by BEA and have a BE-180 identification number below 140012490.
  • You were NOT notified of the BE-180 survey by BEA and do NOT have a BE-180 identification number.

File no later than December 1, 2015 if:

  • You were notified of the BE-180 survey by BEA and have a BE-180 identification number above 140012490.

Additional extensions to each filing deadline will be granted by the BEA if a request is submitted by November 1, 2015 as instructed by the BEA.

Penalties

Failure to file a required report can lead to civil and criminal penalties.

Confidential Treatment

Like it is the case with the other BE forms, information reported on BE-180 is confidential and may be used for only analytical or statistical purposes.

Sources

Form BE-180 is available online here.

Instructions for new filers are available here.

Form instructions are available here.

FAQs regarding the BE-180 benchmark survey are available here.

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[1] See our alerts and articles on other BEA survey forms here.

[2] Additional entities included in the definition are commercial banking entities, bank holding companies, financial holding companies, savings institutions, check cashing and debit card issuing entities, underwriters, investment bankers, providers of securities custody services, insurance carriers, insurance agents, insurance brokers, and insurance services providers.

[3] The $3 million threshold applies to purchases and sales separately, and must be reported on separate schedules to the BE-180. Consequently, a U.S. reporter, for example, that only exceeds the threshold for sales but does not reach the threshold for purchases, is only required to complete the schedule relating to sales.

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The U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued a notice of proposed rulemaking on August 25, 2015 which, among other things, would add SEC-registered investment advisers to the “financial institutions” regulated under the Bank Secrecy Act (BSA). This represents another step by the U.S. government to expand the professions and industries deemed anti-money laundering (AML) gatekeepers. Covered investment advisers will face new AML program, reporting and record-keeping requirements, with implications for hedge, private equity and other funds; money managers; and public or private real estate funds.

FinCEN has long expressed an interest in regulating investment advisers, which it believes may be vulnerable to or may obscure money laundering and terrorist financing. Should the rule become final, SEC-registered investment advisers would be included in the regulatory definition of “financial institution” and, as a consequence, required to establish and implement appropriately comprehensive written AML programs and comply with a variety of reporting and recordkeeping requirements under the BSA. Investment advisers that already implemented AML programs would need to evaluate them to ensure they comply with BSA requirements.

Who are Covered “Investment Advisers”?

Investment advisers provide advisory services, such as portfolio management, financial planning, and pension consulting, to many different types of clients, including institutions, private funds and other pooled investment vehicles, pension plans, trusts, foundations and mutual funds. According to the proposed rule, an “investment adviser” would be defined as “[a]ny person who is registered or required to register with the SEC under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(a)).”

The definition would cover all investment advisers, including subadvisers, subject to Federal regulation which, generally speaking, would include advisers that have $100 million or more in assets under management. This includes investment advisers engaging in activities with publicly or privately offered real estate funds. Small- and medium-sized investment advisers that are state-registered and other investment advisers that are exempt from SEC registration requirements would not be captured by the proposed rule. FinCEN indicated, however, that future rulemaking may include those types of advisers.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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In a release issued today, the Financial Crimes Enforcement Network (FinCEN) has proposed anti-money laundering (AML) regulations for investment advisers. The proposed rule requires investment advisers registered or required to be registered with the Securities and Exchange Commission (SEC) to establish AML programs and report suspicious activity to FinCEN pursuant to the Bank Secrecy Act (BSA). The SEC would be delegated authority by FinCEN to examine investment advisers for compliance. The proposed rule also makes investment advisers fall under the definition of “financial institution,” requiring them to file Currency Transaction Reports (CTRs) and comply with record keeping obligations under the BSA.

A full copy of the proposed rule is available HERE.

A related article about the new AML regulations was posted in our blog last week.

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Kimberly Mann, co-head of Pillsbury’s Investment Funds and Investment Management Group, was interviewed and quoted at length in an article published in FundFire this week. The article explored whether regulators should permit asset managers to settle cases without admitting culpability. In response to that question, Ms. Mann, who has expertise in investment advisor regulatory and fund-related matters, commented “If you’re asking investors, they would likely say “yes”, there should be an admission required. But if you ask fund managers, the response might be a little different and it might be nuanced; it might depend on the severity of the charge and the impact of the charge.” Ms. Mann added “There’s a lot to consider when one is trying to decide whether to make an admission. So, I think most would want flexibility.” She further commented “Some investors might shy away from anyone who’s even been charged, but there are others who might not be as put off if there weren’t an admission.”  To the question of how a regulator would determine when to require an admission, Ms. Mann responded “The broader the effect, the more aggressive [the regulator] would be in pursuing an admission.”

Read the full article HERE.

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The U.S. Treasury Department’s Financial Crimes Enforcement Network will soon propose new rules that may require investment advisers to establish and implement written anti-money laundering programs designed to prevent advisory clients from using advisers to launder funds or perpetrate other criminal activities. The rules also may require advisers to report suspicious client activity.

The new rules may be similar in certain respects to rules proposed by Treasury in 2003, when the Department attempted to subject investment advisers to the AML provisions of the Bank Secrecy Act. The 2003 rules would have required advisers to (1) establish and implement policies, procedures and controls reasonably designed to prevent advisers from being used to launder money or finance terrorist activities, (2) provide independent testing of compliance by the advisory firms’ personnel, affiliates or third parties, (3) designate persons responsible for implementing and monitoring the operations and internal controls of the program and (4) provide ongoing training for appropriate persons who are involved with the program.

The new rules are likely to reflect comments received in response to the 2003 proposal and may be informed, in part, by certain practices followed by advisers in offshore jurisdictions. It is unclear whether the rules will require investment advisers to apply their anti-money laundering programs to their clients’ beneficial owners.

If the new rules are adopted, investment advisers will need to review and update their compliance manuals, as necessary, to incorporate anti-money laundering policies and procedures that are tailored to their business, clients and risks. In addition, private offering memoranda, fund governance documents, advisory agreements and other client communications should be updated to include information about the anti-money laundering program and suspicious activity reporting requirements.

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On August 6, 2015, the Treasury and the IRS issued Notice 2015-54, which implements a Clinton-era tax provision intended to prevent U.S. taxpayers from using the partnership provisions of the Code to shift built-in gain on property contributed to a partnership to non-U.S. affiliates of the transferor that are partners in the transferee partnership. These rules were announced in reaction to Treasury’s and the IRS’s belief that U.S. taxpayers have been using partnership structures that adopt Section 704(c) methods, special allocations under Section 704(b) and inappropriate valuation techniques with a view towards shifting income to their foreign affiliates.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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In the Federal Register for July 23, 2015, the Treasury Department published proposed regulations regarding the circumstances under which partnership allocations and distributions will be treated as disguised payments for services. These proposed regulations are aimed at attempts by investment fund managers to convert ordinary, management fee income into tax-favored long-term capital gains through the use of management fee waivers.

The proposed regulations draw heavily on the legislative history to Internal Revenue Code section 707(a)(2)(A), enacted as part of the Deficit Reduction Act of 1984 (P.L. 98-369), which provides that allocations and distributions to a partner by a partnership will be disregarded and instead treated as disguised payments for services if the performance of such services and the related direct or indirect allocation and distribution, taken together, are properly characterized as a transaction between the partnership and a partner acting other than in his capacity as a member of the partnership.

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Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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