Sadis & Goldberg Hot Topics Investment Management Session

Transcription

1 Sadis & Goldberg Hot Topics Investment Management Session May 16, 2012

2 2 Overview Hedge Funds SEC s #1 Target? Regulatory Update New Changes for CPO Exemptions and The JOBS Act Why You Need To Worry About FATCA Side Letters and Seed Deals, Current Trends

3 Sadis & Goldberg LLP Hedge Funds SEC s #1 Target?

4 4 Douglas R. Hirsch, Partner Sadis & Goldberg LLP Douglas R. Hirsch is a founding member of the firm and heads the firm s Litigation Group. Mr. Hirsch focuses his practice on financial services litigation, including SEC and FINRA enforcement actions, securities class and derivative litigation, and disputes between investors and investment advisers. Mr. Hirsch also regularly counsels and advises investment advisers in connection with the drafting and litigation of employment and partnership/operating agreements, service provider agreements, third party marketing agreements, disclosure issues and ISDA issues.

5 5 Sam Lieberman, Partner Sadis & Goldberg LLP Sam Lieberman is a partner in the firm s Litigation Group. He has extensive experience handling all stages of high-profile securities class actions, complex commercial litigation and government investigations. Mr. Lieberman regularly serves as lead counsel presenting arguments on behalf of clients at the trial and appellate levels. In addition, he represents individuals and investment advisers in civil and criminal investigations by the SEC and the US Attorney s Office.

6 6 Overview SEC Enforcement Stats. Show Hedge Funds/Investment Advisers No. 1 Target Reasons Why SEC Focusing on Hedge Funds New, Specialized Enforcement Units with Focus on Hedge Fund Activity SEC using Compliance Exams to Build Enforcement Actions Aberrational Performance Inquiry: Targeting Outlier Returns Notable Cases Key Takeaways: Avoiding SEC Enforcement

7 7 SEC Increasingly Targets Hedge Funds and Other Investment Advisers Year-by-Year SEC Enforcement Actions Enforcement Actions by Fiscal Year Broker-Dealer Delinquent Filings FCPA n/a n/a n/a n/a *20 Financial Fraud/Issuer Disclosure **89 Insider Trading Investment Adviser/Investment Co Market Manipulation Securities Offering Other Total Enforcement Actions * Prior to FY 2011, FCPA was not a distinct category and FCPA actions were classified as Issuer Reporting and Disclosure. ** Prior to FY 2011, this category was reported as Issuer Reporting and Disclosure and included FCPA actions. In FY 2011, FCPA actions are tracked separately from financial fraud/issuer disclosure actions.

8 8 SEC Increasingly Targets Hedge Funds Actions against investment advisers are top category of SEC Enforcement Action Enforcement Actions against investment advisers jumped 92% from 2009 to % of Enforcement Actions in 2011 were against investment advisers Record total number of Enforcement Actions in 2011

9 9 Reasons Why SEC Is Targeting Hedge Funds Investment Advisers and other asset managers have grown to huge percentage of market wealth. (Some estimate as much as $40 trillion in asset management.) SEC (False?) perception that hedge funds had significant contribution to market collapse (market manipulation, deleveraging, etc.) Source: Jan. 23, 2010 Speech of Bruce Karpati, Head of SEC Asset Management Unit Madoff & Sanford Ponzi Schemes: highlight need for greater scrutiny of private managers Perceived effect of unique hedge trading strategies on major market events (e.g., Flash Crash linked to high-speed/algorithmic trading) Dodd-Frank registration requirement brings hedge funds under SEC scrutiny

10 10 SEC Creates New Specialized Units Focusing on Hedge Fund Activity Asset Management Unit: Focuses on investment advisers and hedge funds generally 1/13/10 press release notes focus on Valuation, Performance, Due Diligence, Diversification Market Abuse Unit: Focus on insider trading and market manipulation Press release suggests interest in high-speed, algorithmic, large volume and other system-based trading and manipulation Structured and New Products Unit: Focuses on CDO s, CDS and similar structured and exotic products often utilized by hedge funds Other Specialized Units (less likely to impact hedge funds): Foreign Corrupt Practice Act Unit Municipal Securities and Public Pension Speech by SEC Staff: Remarks at news conference announcing Enforcement Cooperation Initiative and new senior leaders, Khuzami Speech, January 13, 2010

11 11 Using Compliance Exams To Build Enforcement Cases Deceptive Marketing Materials/Practices Misrepresentations in Sales/Marketing Materials (e.g., performance/assets/strategy) Aggressive marketing of high-risk or exotic investments as safe or liquid Use of third-party marketers with success fees or non-cash compensation Fraudulent Valuation and Performance Asset Verification Deficiencies: Looking for red flags of Ponzi schemes, similar issues Market Manipulation (Insider Trading, Front-Running, etc.) Identifying Repeated Offenders as Problem Advisers Repeated compliance deficiencies lead to greater scrutiny, likely enforcement action SEC views this as a sign of larger fraudulent activity Source: SEC Report on Office of Compliance, Inspections & Examinations, 2/12

12 12 Aberrational Performance Inquiry Use proprietary risk analytics to evaluate hedge fund returns for performance that appears inconsistent with the funds investment strategy or other benchmarks Anybody who is beating the market indexes by 3 percent and doing it on a steady basis, we are going to look for them. (SEC Deputy Dir. Enforcement Robert Khuzami, March 10, 2011 Testimony before House Fin. Serv. Committee) Purpose to identify fraudulent valuation of misrepresentation of funds assets SEC issues 12/1/11 press release identifying first cases resulting from inquiry: Balboa/Charsonville Millennium Global Emerging Credit Fund: Inflating performance and NAV through scheme to deceive fund s independent valuation agent with fictional prices of illiquid fund assets. Rooney/Solaris Mgmt.: Radical change in investment strategy from marketing materials. Went from long/short hedge to over weighted position in company in which portfolio manager held board position. LeadDog Capital Markets, et al., misrepresentation of professional background, compensation from fund investments, and conflicts of interests through investment in affiliates.

13 13 Notable Cases (cont.) In the Matter of Leaddog Capital Markets, LLC, F/K/A/ Leaddog Capital Partners, Inc., Chris Messalas, and Joseph Larocco, Esq., Admin. Proc. File. No (Dec. 1, 2011). SEC case focused entirely on marketing materials, s and individual statements to investors Fund invested 92% of assets in illiquid penny-stocks and micro-cap companies, but told investors 50% of assets were in liquid investments that could be marked to market each day. Falsely advertised background and performance on Hedgefund.net and Hedgeco.net, including hiding fact that Fund principal ran broker-dealer that FINRA had expelled. Conflicts of Interest: Fund invested in companies affiliated with Fund management

14 14 Notable Cases (cont.) In the Matter of Western Pacific Capital Mgmt., LLC and Kevin James O Rourke, Admin. Proc. File No (Nov. 1, 2011). SEC highlights five s from hedge fund adviser to investors misrepresenting liquidity Repeatedly stated Fund was very liquid and only had 25% invested in illiquid assets, when 90% of assets in illiquid investments Fund adviser failed to disclose to investors that he would be paid 10% success fee for investing Fund assets in Company A Misused Fund assets for preferential redemption of investor to resolve dispute

15 15 Key Takeaways: Avoiding SEC Enforcement Process to ensure accuracy of marketing materials and s: SEC focuses on these Process to ensure meeting due diligence standards & representations Disclose, Disclose, Disclose: Prevents lawsuits/liability with little effect on investment Be prepared for SEC s current focus at compliance exams Avoid repeated compliance violations: Commit resources to compliance/legal review Unscheduled compliance exams need extra care: SEC likely investigating alleged fraud Insurance coverage for defending against SEC investigation/lawsuit: Many E&O policies provide for payment of legal expenses even if the ultimate verdict is not covered

16 Sadis & Goldberg LLP Regulatory Update: New Changes for CPO Exemptions and The JOBS Act

17 17 Paul D. Fasciano, Partner Sadis & Goldberg LLP Paul D. Fasciano is a partner in the firm s Financial Services and Corporate Groups. Mr. Fasciano began his career as a general corporate attorney, and now focuses his practice on representing private fund managers, both in the formation phase and also in ongoing corporate and transactional matters, including mergers and acquisitions, activist investor representation, securities law compliance and derivatives. Mr. Fasciano regularly counsels clients on structuring and forming US and non-us private investment funds, including hedge funds, private equity funds and custom hybrid funds incorporating features of both. Funds advised by Mr. Fasciano cover a wide variety of strategies and asset classes, with varying liquidity characteristics, including more typical asset classes such as publicly traded equities, as well as less typical asset classes such as loans, consumer receivables and renewable energy credits. Mr. Fasciano also has extensive experience in drafting and negotiating agreements memorializing the relationship between the principals of a fund.

18 18 Daniel G. Viola, Partner Sadis & Goldberg LLP Daniel G. Viola oversees the Regulatory Defense and Compliance Group. He structures and organizes brokerdealers and investment advisers and regularly counsels investment professionals in connection with regulatory matters. Mr. Viola served as a Senior Compliance Examiner for the Northeast Region of the Securities and Exchange Commission ( SEC ), where he worked from 1992 through During his tenure at the SEC, Mr. Viola worked on several compliance inspection projects involving compliance examinations of registered investment advisers to ensure compliance with the Investment Advisers Act, the Investment Company Act, the Securities Act of 1933, and the Securities Exchange Act of Mr. Viola s examination experience includes financial statement, performance advertising, and disclosure document reviews, as well as analysis of investment adviser and hedge fund issues arising under ERISA and blue-sky laws.

19 19 Marketing private funds - the changing landscape JOBS Act Update - Regulatory Background Securities Act 1. Rule 506(d) of Regulation D under the Securities Act safe harbor for private placements to accredited investors 2. Rule 502(c) prohibits general solicitation/general advertising in connection with Reg D private placements (e.g., newsletters, non-password protected websites, media, television, etc.) Investment Company Act 1. 3(c)(1)/3(c)(7) of the Investment Company Act are the two most commonly used exemptions from registration as an investment company 2. Reliance on these exemptions also require that no public offering be made by the fund

20 20 JOBS ACT Key Points Related to Private Placements 1. Transaction conducted pursuant to safe harbor may utilize general advertising/solicitation if only sold to accredited investors 2. Offerings made pursuant to Reg D are not deemed public offerings for purpose of Investment Company Act 3. We expect SEC to have proposed rules disseminated prior to July 4 but final rules most likely not until some time later

21 21 Revisions to Section 12(g)(1) of 1934 Act 1. Current law -- 12(g)(1) of 1934 Act requires a company (e.g., investment fund) to become a SEC reporting company if any one class has more than 500 record holders 2. JOBS Act Registration only if (a) 2,000 or more record holders or (b) 500 or more record holders who are not all accredited investors

22 22 Other Areas of Law Which May Restrict Advertising/Solicitation SEC/FINRA anti-fraud provisions and restrictions on advertising, including Rule 206(4)-1 of Advisers Act be careful what you wish for CFTC/NFA Rules JOBS Act provides that Rule 506 offerings shall not be deemed public offerings under the federal securities laws 4.13(a)(3) exemption as a CPO requires that the fund s interests be offered and sold without marketing to the public in the United States CTA exemption for 15 or fewer clients in preceding 12 months requires the adviser to not hold itself out generally to the public as a CTA Advertising restrictions

23 23 Other Areas of Law Which May Restrict Advertising/Solicitation (cont.) State Laws Investment Adviser registration, e.g., Florida exemption for 15 or fewer clients in preceding 12 months requires the adviser to not hold itself out to the general public as an investment adviser Blue sky laws, e.g., Washington State exemption for sales not involving a public offering (fallback to the federal covered security exemption) Foreign Private Adviser exemption adviser must not hold itself out generally to the public in the United States as an investment adviser

24 24 Investment Advisers Act Rules Under the anti-fraud provisions of the Advisers Act, the SEC regulates the content of marketing materials and disclosure of performance results of both registered and unregistered investment advisers Under Rule 206(4)-1(a)(1), investment advisers generally may not use testimonials of any kind regarding the investment adviser or any advice or other services rendered by the adviser Under Rule 206(4)-1(a)(2), investment advisers generally may not use specific past recommendations, unless a list is provided of all recommendations made by that adviser within the immediate past period of at least one year; the list must include certain relevant information and cautionary language

25 25 Risk Assessment: Non-exclusive list of questions 1. Are all communications with clients (i.e., representations made and numbers used in advertisements, responses to requests for proposals, and in other marketing literature and on websites) truthful, representative, complete, and not misleading? 2. Are model and composite performance figures, formulas, and related disclosures contained in communications to clients consistent with industry standard and law? 3. Are advertisements that must be cleared by FINRA before use or filed with the FINRA after use done so on a timely basis? 4. Are all communications with clients and the press provided by advisory representatives reviewed and cleared as required by your policies and the law?

26 26 JOBS Act - What to Expect 1. We expect SEC to have proposed rules disseminated prior to July 4 but final rules most likely will not be in place until sometime later 2. Public comment period is currently ongoing so comments may very well impact SEC approach 3. Smaller/mid-size managers for the most part have welcomed the change 4. Mixed feedback from larger managers 5. Many lobbyist groups have been advocating stronger SEC supervision over advertising materials, fraud, etc. to protect investors who may be accredited but unsophisticated 6. Other groups point out that new rules will protect against fraud because smaller managers not otherwise on the SEC s radar screen will become targets if they use unlawfully 7. Expect the SEC rules to focus on (a) a balanced approach to verification of accredited investor standards; (b) advertising materials, including websites; (c) performance presentation; and (d) investor protection 8. Managers should maintain status quo until SEC publishes final rules

27 27 New CFTC Rules impact on private investment funds - Will you need to register as a commodity pool operator? Background Any fund trading even a penny of commodity interests is considered a commodity pool, and its operator must register as a CPO with the CFTC, unless an exemption is available commodity interests include futures contracts (including security futures), commodity options and retail off-exchange forex transactions Most commonly used exemptions for operators of private funds have been the 4.13(a)(3) and 4.13(a)(4) exemptions

28 28 New CFTC Rules impact on private investment funds (cont.) 4.13(a)(3) Exemption typically used by operators of 3(c)(1) funds permits a deminimis amount of trading of commodity interests either (i) the aggregate initial margin and premiums required to establish commodity interest positions, determined at the time the most recent position was established, will not exceed 5 percent of the liquidation value of the fund s portfolio (taking into account unrealized profits and losses) (the Margin Test ) or (ii) the aggregate net notional value of the fund s commodity interest positions does not exceed 100 percent of the portfolio s liquidation value (the Net Notional Test ) the fund may not be marketed to the public as a vehicle for trading in commodity interests this could limit the usefulness of the JOBS Act eventually allowing general solicitations in connection with Rule 506 offerings sold only to accredited investors

29 29 New CFTC Rules impact on private investment funds (cont.) 4.13(a)(4) Exemption typically used by operators of 3(c)(7) and offshore funds permits unlimited trading of commodity interests, but requires higher investor qualification standards generally, natural persons must be qualified purchasers; non-natural persons must be QEPs or accredited investors

30 30 New CFTC Rules impact on private investment funds (cont.) 4.13(a)(4) Exemption Repealed Exemption no longer available as of April 25, 2012 Those claiming the exemption prior to such date have until December 31, 2012 to either claim another exemption (which would in all likelihood be the 4.13(a)(3) exemption in the case of private funds) or register as a CPO If required to register, may not be eligible for Section 4.7 lite registration, because it is possible that some investors are not QEPs

31 31 New CFTC Rules impact on private investment funds (cont.) 4.13(a)(3) Exemption Modified Claiming this exemption had required a one-time filing, but now the filing must be made annually within 60 days after every calendar year end swaps will be included as commodity interests 60 days after the final rules defining swap have become effective (expected to occur later this year) swaps are expected to exclude swaps on single securities or a narrow index of securities, but are expected to include swaps on a broad-based security index

32 32 New CFTC Rules impact on private investment funds (cont.) CPO Registration Process The CPO Itself Must File Form 7-R through the NFA s Online Registration System (ORS), and concurrently will become a member of the NFA Application fee of $200; NFA annual membership dues of $750 Associated Persons of the CPO Generally, any person that solicits investors (and supervisors thereof) Must register with the CTFC on Form 8-R, and become an associate member of the NFA $85 application fee; must submit a fingerprint card for an FBI background check Must obtain Series 3 license, subject to exemptions

33 33 New CFTC Rules impact on private investment funds (cont.) CPO Registration Process (cont.) Principals of the CPO Generally, any general partner, managing member, director, executive officer and 10% owner Must file a Form 8-R with the CFTC $85 application fee Must submit a fingerprint card for an FBI background check (except for outside directors ) Not considered to be registered with the CFTC or members of the NFA; rather, they are listed as Principals of the registered CPO

34 34 New CFTC Rules impact on private investment funds (cont.) CPO Registration Ongoing Obligations Disclosure A Disclosure Document for pool participants must be prepared in accordance with Rules 4.24 and 4.25 and must accompany subscription documents The Disclosure Document must be accepted by the NFA prior to use Reporting Distribute to investors unaudited monthly Account Statements within 30 days of each month end Distribute to investors and file with the NFA audited Annual Reports within 90 days after each year end (subject to extension requests) Annual CFTC registration update Annual NFA questionnaire

35 35 New CFTC Rules impact on private investment funds (cont.) CPO Registration Ongoing Obligations (cont.) Reporting (cont.) File Form CPO-PQR CPOs divided into small (less than $150 million), medium (between $150 million and $1.5 billion) and large (greater than $1.5 billion) Small CPOs: file Schedule A only, annually, within 90 days after each year end Medium CPOs: file Schedules A and B, annually, within 90 days after each year end Large CPOs: files Schedules A, B and C, quarterly, within 60 days after each quarter end Recordkeeping Must make and keep prescribed records in an accurate, current and orderly manner at main business office Keep for 5 years; must be readily accessible for 2 years Open to inspection by DOJ and CFTC

36 36 New CFTC Rules impact on private investment funds (cont.) CPO Registration Lite A Section 4.7 exemption provides relief from many of the requirements of a registered CPO, effectively substituting significantly less onerous requirements Requires that every investor in the fund be a qualified eligible person (QEP) A QEP includes an entity with total assets in excess of $5 million or an individual that is an accredited investor, provided, in each case, that the person owns securities of issuers not affiliated with such person and other investments with an aggregate market value of at least $2 million

37 37 New CFTC Rules impact on private investment funds (cont.) Considerations for Fund of Funds Generally, to claim the 4.13(a)(3) exemption, a manager of a fund of funds must either (1) allocate no more than 50% of the fund s assets to investee funds that trade any level of commodity interests or (2) allocate all of its assets only to investee funds that trade within the 4.13(a)(3) limits CFTC guidance in Appendix A to Part 4 of the CFTC rules has been deleted; CFTC intends to revise guidance and has informally indicated that prior guidance may be relied upon until then

38 38 New CFTC Rules impact on private investment funds (cont.) CTA Exemptions CPOs that provide commodity trading advice only to the pools for which they are registered or exempt CTAs that have rendered commodity trading advice to no more than 15 persons during the previous 12 months, and do not hold themselves out generally to the public as CTAs CTAs that provide commodity trading advice only to specified pools (including 4.13(a)(3) and 4.13(a)(4) exempt pools) and solely incidental to securities advice, and that do not hold themselves out generally to the public as CTAs (requires a filing) A CTA: (1) who is registered with the SEC as an investment adviser; (2) whose business does not consist primarily of acting as a CTA; and (3) who does not act as a CTA to any pool that is engaged primarily in trading commodity interests

39 Sadis & Goldberg LLP Why You Need To Worry About FATCA

40 40 Alex Gelinas, Partner Sadis & Goldberg LLP Alex Gelinas is a partner in the firm s Tax Group. Mr. Gelinas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compensation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to US pension funds, sovereign wealth funds and other US and foreign institutional investors in connection with their investments in private equity funds, hedge funds and US joint ventures. He also has extensive experience in providing tax planning advice to highnet-worth individuals and families.

41 41 Lance S. Friedler, Partner Sadis & Goldberg LLP Lance S. Friedler practices in the firm s Corporate and Financial Services groups. Mr. Friedler regularly counsels clients on structuring and forming US and non-us private investment funds, including the investment manager and general partner entities to such funds. He also counsels investment managers on registration and ongoing compliance issues with the Securities and Exchange Commission, including the preparation of all written compliance policies and procedures. His investment management experience is broad in scope and includes the preparation and negotiation of seed capital arrangements and joint venture arrangements.

42 42 The Impact of the FATCA Provisions on Private Investment Funds History The tax law changes known as the Foreign Account Tax Compliance Act (FATCA) were added to the Internal Revenue Code in 2010 as a revenue raising measure to support certain tax cuts made in the Hiring incentives to Restore Employment (HIRE) Act. These provisions are designed to combat offshore tax evasion by US persons and are expected to raise around $8.5 billion in tax revenue over ten years. Certain of these FATCA tax provisions have already gone into effect, including: A. Reporting by US Taxpayers Holding Foreign Financial Assets Form 8938 FATCA requires certain US taxpayers holding foreign financial assets with an aggregate value exceeding $50,000 to report certain information about those assets on a new form (Form 8938) that must be attached to the taxpayer s federal income tax return. This requirement went into effect for tax returns filed with respect to Interests in offshore investment funds are classified as foreign financial assets for this purpose. Substantial penalties are provided for failure to file this form, and the statute of limitations with respect to the taxpayer tax return for a tax year will not start to run until the required filing of Form 8938 has been made with the IRS.

43 43 The Impact of the FATCA Provisions on Private Investment Funds (cont.) B. Enhanced Reporting by US Investors in PFICs- Form 8621 Another FATCA provision requires a US shareholder in a passive foreign investment company (PFIC) to file an annual report on Form 8621 for each taxable year. Under prior law, annual reporting on Form 8621 only applied if the US person received a distribution from, or disposed of an interest in, the PFIC, or made certain tax elections. These rules went into effect beginning March 18, Most offshore investment funds that are classified as foreign corporations are also classified as PFICs. C. US Withholding Tax on Dividend Equivalent Payments under Swaps and Certain Other Financial Transactions FATCA also closed a tax loophole that foreign funds have commonly used to avoid US withholding tax on US-source dividend payments. Hedge funds and other foreign investors have used total return swaps with respect to US dividend- paying stocks as a means of avoiding the withholding tax on the dividend which would apply if the foreign investor had direct ownership of the dividend-paying stock. New Treasury Regulations will now treat the imbedded dividend equivalent payment under a total return swap with respect to US stocks as US-source dividend income subject to the US withholding tax.

44 44 The Impact of the FATCA Provisions on Private Investment Funds (cont.) D. Elimination of Portfolio Interest Exemption from US Withholding Tax for Foreign Targeted Bearer Bonds Under prior law, the portfolio interest exemption from US withholding tax applied only to bonds issued in registered form. However, an obligation in bearer form could also qualify if the offering was structured to ensure that the bonds were being sold only outside the United States to non-us persons. Such bearer bonds could end up in the portfolios of offshore funds with US investors via secondary market transactions. FATCA eliminated the foreign targeted bearer bond exception for debt obligations issued by US persons after March 18, 2012.

45 45 On the Horizon New FATCA Withholding and Reporting Regime I. Overview FATCA mandates certain information reporting and withholding procedures in order to ensure that US persons invested in foreign entities are reported to the IRS. Generally, FATCA requires withholding agents to withhold 30 percent on withholdable payments and passthru payments made to foreign financial institutions (FFIs) or to non-financial foreign entities ( NFFEs ), unless certain information reporting requirements are met. These rules affect both offshore funds (which are generally classified as FFIs) and onshore funds (which are generally withholding agents). On February 8, 2012, the Internal Revenue Service issues 338 pages of proposed regulations. Such proposed regulations are expected to be revised and finalized later this year. Although the general effective date for these FATCA provisions is January 1, 2013, the proposed regulations have delayed the effective dates for FATCA withholding and reporting to 2014 and beyond and provided for a phase-in timetable for such obligations.

46 46 On the Horizon FATCA Withholding and Reporting (cont.) II. Key Definitions A. Offshore Funds are Foreign Financial Institutions Financial institutions, for FATCA purposes, include entities that are engaged primarily in the business of investing, reinvesting or trading in securities, commodities, partnership interests, swaps and derivatives thereon and certain other financial contracts. Therefore, investment funds would generally be treated as financial institutions under FATCA. Investment funds that are organized under non-us law (master funds, stand-alone offshore funds, and offshore feeder funds) will be classified as FFIs. B. Withholdable Payments Withholdable payments are currently defined as: payments of US source interest, dividends, rents, royalties, annuities and other fixed or determinable annual or periodic income (collectively FDAP income ), and any gross proceeds from the sale or other disposition of any property that can produce US-source interest or dividend income. Withholdable payments generally include FDAP income allocated to the partners of entities that are treated as partnerships for US tax purposes. For purposes of FATCA, it appears irrelevant whether the partnership physically distributes or pays such FDAP income to its partners. Withholdable payments also include certain receipts of gross proceeds by such entities.

47 47 On the Horizon FATCA Withholding and Reporting (cont.) II. Key Definitions (cont.) C. Passthru Payments Passthru payments are defined as payments that are withholdable payments or foreign passthru payments. The IRS has not yet defined foreign passthru payments. D. Non-Financial Foreign Entity (NFFE) An NFFE is any foreign entity that is not a financial institution. E. Substantial US Owner A substantial US owner is generally a US person that owns more than ten percent of a foreign entity. F. High Value Account FATCA requires enhanced scrutiny by FFIs for pre-existing accounts if such account has a value in excess of $1 million at the end of the most recent preceding calendar year.

48 48 III. FATCA Effective Dates for Withholding and Reporting (cont.) The proposed FATCA regulations provide that US onshore funds and offshore funds that are Participating FFIs will be required to begin withholding on US-source dividends and interest and other FDAP income on January 1, Withholding with respect to gross proceeds from disposition of US stocks and debt instruments and all other withholdable payments will begin on January 1, Foreign Passthru Payments. Participating FFIs will not be required to withhold FATCA tax from foreign passthru payments before January 1, For an offshore corporate fund, such payments are expected to include distributions to the fund s shareholders that are attributable to withholdable payments. Reporting Requirements Phased In. Reporting requirements to the IRS are phased in during the time period. The first reporting, for calendar year 2013, currently has a due date of September 30, 2014.

49 49 IV. Summary of FATCA Requirements Imposed on Offshore Funds In order to avoid being subject to FATCA withholding in respect of payments by counterparties, FFIs must: (i) enter in an agreement with the IRS in which such FFI ( Participating FFI ) agrees to implement due diligence and verification procedures for determining whether any of its account holders are US persons or US-owned foreign entities; (ii) report certain information about such accounts to the IRS, and (iii) withhold on payments to accounts that fail to provide the necessary information and other FFIs that do not comply with FATCA. The IRS will offer FFIs seeking participating FFI status the opportunity to register online beginning no later than January 1, FFIs will be required to enter into the FFI Agreement by June 30, Such FFI Agreements will take effect on July 1, 2013.

50 50 A. Anticipated Terms of the FFI Agreement The proposed regulations identify the general provisions intended to be included in the FFI Agreement. The IRS intends to circulate a draft model FFI Agreement in the first half of The FFI Agreement will require the following provisions (among others): Withholding: Participating FFIs must agree to act as withholding agents and must withhold 30 percent on withholdable payments and foreign passthru payments made to Recalcitrant Account Holders ( investors that fail to provide the required tax information to the FFI ) and those FFIs that have not entered into FFI agreements with the IRS ( Non-participating FFIs ). Identification and Documentation Procedures: Participating FFIs must perform due diligence for identifying and documenting account holders. Determining an account holder s status requires the collection of an account holder s valid withholding certificate (W-8BEN, W-8ECI, W-8EXP, W-8IMY or W- 9). Recordkeeping: Participating FFIs must retain originals or photocopies of the documentation needed to determine an account holder s status generally for six calendar years (subject to extension by the IRS) for pre-existing accounts. The retention period for new accounts is unspecified.

51 51 A. Anticipated Terms of the FFI Agreement (cont.) Annual Reporting: Participating FFIs must annually report certain information to the IRS. The proposed regulations phase in the full reporting requirements set forth below: For Accounts Held by Specified US Persons : Participating FFIs must report the name, address and TIN of each specified US person account holder; the account number and account balance or value; the payments made with respect to the account during the calendar year; and such information required to be reported on the IRS form for this reporting. There is no minimum amount or percentage of the FFI that a specified US person account holder must own in order for such person to be subject to reporting. For Accounts Held by US-owned NFFEs : Participating FFIs must report the name, address and TIN (if any) of the US-owned foreign entity; the name, address and TIN of each Substantial US Owner of such entity (e.g., an owner of more than 10% of the company); the account number, and account balance or value; and the payments made with respect to the account during the calendar year. For Recalcitrant Account Holders : Participating FFIs must report separately the number of active accounts and aggregate values of such accounts belonging to Recalcitrant Account Holders for each of (i) those accounts with US Indicia and (ii) those accounts without US Indicia.

52 52 A. Anticipated Terms of the FFI Agreement (cont.) Foreign Law Waiver: When the law of the foreign jurisdiction in which the account is held prohibits (but for a waiver) the reporting required by the FFI Agreement, Participating FFIs must either obtain a valid waiver from its US account holders, or close the account if they do no obtain a waiver within a reasonable amount of time. Verification Procedures: As described above, participating FFIs must adopt written due diligence policies and procedures for identifying and documenting account holders, withholding and reporting as required under the FFI Agreement. The IRS may audit (through an external auditor) Participating FFIs to determine compliance.

53 53 B. Compliance Procedures for Offshore Funds; Appointment of a Responsible Officer Written Due Diligence Policies and Procedures Under the proposed regulations, Participating FFIs must adopt written due diligence policies and procedures for identifying and documenting account holders, withholding and reporting as required under the FFI Agreement. Participating FFIs must periodically review their compliance with the provision of the FFI Agreement and appoint a Responsible Officer who must certify their compliance to the IRS. Responsible Officer s Obligations 1. A Responsible Officer of the Participating FFI must certify to the IRS within one year of the effective date of its FFI agreement that (i) the participating FFI has reviewed all of its High-Value Accounts (generally, accounts with a value exceeding $1 million at the end of the calendar year) that were in existence prior to the effective date of the FFI Agreement and (ii) to the best of the Responsible Officer s knowledge, the Participating FFI did not have any formal or informal practices or procedures in place from Aug. 6, 2011 through the date of the certification to assist account holders in the avoidance of FATCA withholding and reporting. 2. Additionally, the Responsible Officer must certify to the IRS within two years of the FFI Agreements' effective date that the FFI has completed the account identification procedures and documentation requirements for all financial accounts that are pre-existing obligations or, if it has not obtained the documentation required to be obtained with respect to an account, that it treats such account in accordance with the requirements of its FFI Agreement.

54 54 IV. Obligations of Onshore Funds as Withholding Agents Onshore funds are withholding agents for purposes of FATCA withholding in respect to foreign entities (e.g., investors and contractual counterparties) who do not comply with the applicable information reporting requirements. Compliance Procedures Must Be Established. Just like offshore funds, onshore funds must establish procedures by which they can identify the US or foreign status of their investors and counterparties to ascertain any potential withholding obligations. FATCA Withholding. Onshore funds must withhold FATCA tax on payments to foreign payees that do not provide the information necessary to avoid such withholding and must file information returns on withholdable payments and passthru payments.

55 55 IV. Preparing for FATCA Implementation A. Steps to be taken in 2012 All funds preparing or updating their legal documents should include FATCA language to put investors on notice of the additional reporting obligations imposed by FATCA and the risk of withholding tax for their failure to comply. Fund documents should be reviewed (and, if necessary, amended) to ensure the Fund has the legal authority to redeem the interests of those investors that fail to provide the Fund with the required tax information. Offshore funds that will become Participating FFIs need to appoint a Responsible Officer who will periodically certify that the FFI has complied with its FATCA obligations. The Responsible Officer should start dialogue with third-party service providers and begin to determine and assign roles and responsibilities for FATCA compliance. Prepare to request new FATCA-modified W-8 forms from investors as soon as these forms are available (within the next few months according to a senior IRS official).

56 56 IV. Preparing for FATCA Implementation A. Steps to be taken in 2012 (cont.) Review and become familiar with the draft model FFI agreement as soon as it is released (before June 30, 2012 according to a senior IRS official). Responsible Officer will need to certify that since August 6, 2011 management personnel did not engage in any activity, or have any policies and procedures in place, directing, encouraging, or assisting account holders with respect to strategies for avoiding identification of their accounts as US accounts (e.g., instructing account holders to split-up accounts to avoid classification as a High-Value Account).

57 57 IV. Preparing for FATCA Implementation B. Steps to be taken in 2013 Offshore funds that will seek to become Participating FFIs should prepare to submit their application to enter into an FFI Agreement with the IRS through an online system that will become available January 1, 2013 (preferably as early as possible but not later than June 30, 2013). Entities taxed as partnerships in particular should begin to determine which investor accounts, if any, may require FATCA withholding beginning January 1, ********************** Caveats The foregoing is a very general outline. It is not intended to constitute specific tax advice for any particular party and it should not be relied upon as such. In order to comply with US Treasury Regulations governing tax practice (known as Circular 230 ), you are hereby advised that any tax advice provided herein was not intended or written to be used, and cannot be used, by any taxpayer for the purpose of (i) avoiding US federal, state or local tax penalties, or (ii) promoting, marketing, or recommending to another party any transaction or matter addressed therein.

58 Sadis & Goldberg LLP Side Letters and Seed Deals: Current Trends

59 59 Ron S. Geffner, Partner Sadis & Goldberg LLP Ron S. Geffner is a member of Sadis & Goldberg LLP and oversees the Financial Services Group. He regularly structures, organizes and counsels private investment vehicles, investment advisory organizations, brokerdealers, commodity pool operators and other investment fiduciaries. Mr. Geffner also routinely counsels clients in connection with regulatory investigations and actions. Mr. Geffner's broad background with federal and state securities laws and the rules, regulations and customary practices of the Securities and Exchange Commission, Financial Industry Regulatory Authority, Commodities Futures Trading Commission and various other regulatory bodies, enables him to provide strategic guidance to a diverse clientele. He provides legal services to several hundred hedge funds, private equity funds and venture capital funds organized in the United States and offshore.

60 60 Yehuda M. Braunstein, Partner Sadis & Goldberg LLP Yehuda M. Braunstein practices in the firm s Financial Services and Corporate Groups. Mr. Braunstein s practice focuses on investment funds, securities, regulatory compliance and investment advisers. He regularly structures and organizes hedge funds, private equity funds (including real estate, distressed and lending funds), funds of funds, separately managed accounts and hybrid funds. Additionally, he advises private fund managers on structure, compensation, employment and investor issues, and other matters relating to management companies. He also structures and negotiates seed investments and provides ongoing advice to investment advisers on securities law issues and regulatory matters.

61 61 A. Overall Trends/Themes: Trends in Seed Deals 1. Frequency of Deals increase of transactions over 24-month period and greater diversity of transaction structures (e.g, accelerated capital, first-loss, incubation, proprietary trading) 2. Primary Focus in Manager Selection strategy, capacity, investment team, track record - pedigree, strong operations 3. Supply versus Demand significant number of talented managers available (e.g., proprietary traders leaving banks for a variety of reasons (including Volcker Rule; reduced bonuses), departures of portfolio managers from recently closed down managers; and others who were waiting to leave their firms until markets turned) 4. Diligence in Both Directions seeders focusing on back office set up and service providers; managers want to evaluate track record of seeders to see performance of seeded managers and involvement of seeder with other managers 5. Focus on Fairness more deals are being structured with a fair balance in mind so although seeders may be more involved in governance, they are also balancing control/governance terms with terms more favorable to managers such as buy-out clauses, etc. 6. Timing while the majority of seed transactions occur at or prior to launch, many transactions have transpired at later stages in a manager s cycle

62 62 Trends in Seed Deals (cont.) B. Trends in Specific Terms: 1. Size o Portfolio Capital - Typically, seed deals are in the $50 million range but we are also seeing some larger deals in the $ million range, as well as some smaller deals, such as $10 25 million o Operating Capital In certain instances, managers are sharing economics with firms providing operating capital 2. Lock-ups o Most seeders are subject to a 2-2 1/2 year lock-up though some seeders are only subject to fund lock-up terms o Length of typical lock-up has gotten shorter over time (previously 3 years was more common) as seeders tend to have less patience waiting for performance o Most seed deal lock-ups still allow seeders to withdraw capital in the event of various special circumstances such as key man situations, significant drawdowns, regulatory issues, breach of agreement, (including portfolio construction), etc.

63 63 Trends in Seed Deals (cont.) B. Trends in Specific Terms (cont.): 3. Economics o 20-40% is the typical sharing percentages and would apply for management fees, incentive performance and capital transactions o Almost all deals are on a gross basis with certain exceptions o Most seeders receive economics as a special LP in investment vehicles (less common to see seeders admitted as LPs of management entities) and are not equity owners in an effort to decrease potential liability (this is a fine line) 4. Control o Seeders appear to be more involved in marketing, operations, back office functions and service providers o Access to all books and records o Major decisions (e.g., capital transactions, waiver of fees, promotional materials)

64 64 Trends in Seed Deals (cont.) B. Trends in Specific Terms (cont.): 5. Transparency o As is the case with many larger or institutional investors, seeders are receiving significant reporting such as: daily position reporting, customized weekly and monthly reports and requiring reports to be sent to third party service providers 6. Buy-Outs o A significant number of seed deals no longer provide for a manager buy-out right o Historically, large percentage of deals provide for buy-out rights after a fixed period of time (e.g., 4 7 years) or a minimum amount of assets are invested in the fund $700 million) o Many deals provide for tag-along and drag along rights o Buy-out price can be set on numerous measures such as AUM or multiple of the amount of revenue received by seeder during a fixed period

65 65 Trends in Seed Deals (cont.) C. Why Seed Deals Fall Apart and Practical Tips to Employ in Negotiations: 1. Manager may be negotiating with multiple parties at once If seeder pushes too hard, may lose opportunity t0 a competing party 2. Parties don t understand each other Like any business transaction, parties must appreciate each other s needs; seeder must appreciate the manager s desire for some level of autonomy and manager must appreciate the seeder s desire to protect its investment 3. Seeder employs heavy-handed tactics Although we are in a seeder s market, many managers will feel threatened if seeders become too demanding and will view heavy negotiations as a bad omen of seeder meddling and the well may become poisoned 4. Lack of Internal Resources at Manager - During diligence and negotiation phases, seeders come to the realization that although a manager may be talented, he lacks the back office operations and surrounding service providers to successfully run a business 5. Lack of Perspective In certain instances, managers need to trust counsel and relinquish primary contact in the negotiations. At times, managers allow anxiety or fear to enter into transactions that are too binding which limit future opportunities 6. Timing Managers are advised to involve their legal counsel early in the process. It is difficult to protect a client who has agreed to onerous or non-commercial terms prior or to legal counsel engagements

66 66 Side Letters A. General Legal Issues: 1. More focus on disclosure of terms to investors 2. Regulators here in the US, UK and Cayman Islands still focused very much on terms related to transparency and liquidity B. Trends in Specific Terms (sampling) 1. Many MFNs come with a take it all or leave it mandate 2. Institutional investors are looking for customized reporting 3. Focus on sponsor reps/warrantees (e.g., no litigation or regulatory issues) and conflicts of interest 4. Notice of material events 5. Indemnification Limitations/LP Clawback Limitations 6. Key man and commitment of time by key persons 7. Assignment to affiliates and no re-set of terms 8. Ability of institutional LPs to disclose data to underlying investors 9. Limitation related to ERISA

67 67 Sadis & Goldberg LLP If you have questions, please contact: Sadis & Goldberg LLP 551 Fifth Avenue, 21 st Floor New York, NY