Latham & Watkins Corporate Department

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1 Number 1260 November 22, 2011 Client Alert Latham & Watkins Corporate Department The Limits of Control: Private Funds and the Large Trader Rule... investment advisers to private funds should consider updating their internal compliance procedures to monitor both their own trading activities and those of their affiliates. Beginning December 1, 2011, so-called large traders will be subject to certain reporting and disclosure requirements under new Rule 13h-1 (the Rule) 1 under the Securities Exchange Act of 1934, as amended (the Exchange Act), to the extent they meet, or have met, the Activity Threshold specified below at any time on or after October 3, Large trader status applies to persons as well as their control persons, if any whose aggregate transactions in NMS securities 2 are at least: (1) two million shares or have a market value of $20 million during any calendar day, or (2) twenty million shares or have a market value of $200 million during any calendar month (the Activity Threshold). Under the Rule, large traders are required to file Form 13H with the US Securities and Exchange Commission (the SEC) to the extent that the filing requirements are not met by other entities in the hierarchy of corporate control, as further described below. In turn, the SEC will assign the large trader an identification number (a LTID), which the large trader must provide to any broker-dealer it uses in connection with its trading activity. Such broker-dealers are also subject to recordkeeping, reporting and monitoring duties under the Rule. This Client Alert focuses on the filing obligations of persons up the chain of ownership from the large trader. Investment Discretion and Control A large trader is any person that directly or indirectly, including through other persons controlled by such person, exercises investment discretion 3 over one or more accounts and effects transactions for the purchase or sale of any NMS security in an amount that meets the Activity Threshold. In the case of a private fund, 4 investment discretion is generally held by the fund s sponsor (whether as adviser, general partner or in another managing capacity), rather than the fund itself, so that the sponsor would be subject to the Rule. For purposes of this Client Alert, investment adviser refers to the person holding investment discretion over a given private fund. The Rule also applies to persons who control the investment adviser up the chain of ownership. For this purpose, control means the possession, direct or indirect, of the power to direct or cause the direction of the management and policies of a person, whether through the ownership of securities, by contract, or otherwise, in keeping with the uses of the term elsewhere under the Exchange Act. However, the SEC sought to provide further guidance in this area, such that for purposes of the Rule, any person that directly or indirectly has the right to vote or direct Latham & Watkins operates worldwide as a limited liability partnership organized under the laws of the State of Delaware (USA) with affiliated limited liability partnerships conducting the practice in the United Kingdom, France, Italy and Singapore and an affiliated partnership conducting the practice in Hong Kong and Japan. Latham & Watkins practices in Saudi Arabia in association with the Law Office of Mohammed A. Al-Sheikh. Under New York s Code of Professional Responsibility, portions of this communication contain attorney advertising. Prior results do not guarantee a similar outcome. Results depend upon a variety of factors unique to each representation. Please direct all inquiries regarding our conduct under New York s Disciplinary Rules to Latham & Watkins LLP, 885 Third Avenue, New York, NY , Phone: Copyright 2011 Latham & Watkins. All Rights Reserved.

2 the vote of 25 percent or more of a class of voting securities of an entity or has the power to sell or direct the sale of 25 percent or more of a class of voting securities of such entity, or in the case of a partnership, has the right to receive, upon dissolution, or has contributed, 25 percent or more of the capital, is presumed to control that entity. 5 In other contexts under the Exchange Act, shareholders have successfully rebutted the presumption of control where, despite their significant ownership stake in a given company, there was clear evidence that another shareholder exercised effective control over such company. The SEC has indicated informally that such analysis will continue to apply in the context of the Rule. However, the precise parameters of control, and the ability to rebut the presumption of control, are somewhat unclear. Notably, the SEC asserted in connection with adopting the Rule that (i) even a minority stakeholder holding at least 25 percent of the ownership interests of an entity would be in a position to (A) exercise the influence necessary to secure such entity s cooperation in facilitating a large trader s compliance with the Rule, and (B) materially influence the investment decisions made by such entity, 6 and (ii) the 25 percent threshold is already among the least expansive definitions of control referenced in SEC rules. 7 The Rule notes that control may be evidenced by ownership of securities, by contract, or otherwise. 8 The inclusion of the reference to contractual control rights, by inverse implication, suggests that contractual limitations on control may be helpful in seeking to rebut a presumption of control. For example, a parent entity could enter into contractual arrangements that seek to block investment discretion over trading activities and other indicia of control up the chain of ownership of an underlying company. While the SEC has indicated informally that such contractual arrangements may indeed prove helpful in rebutting the presumption of control, their efficacy will be quite fact-specific and would need to be carefully tailored. Application of the Rule to Certain Ownership Scenarios The following examples are designed to illustrate the application of the Rule in certain ownership scenarios. For these examples, we assume that each entity satisfies the investment discretion prong of the Rule, so that the analysis focuses on the control prong. As in other Exchange Act settings, it should be borne in mind that determinations of control can be complex and must in all events be made on a case-bycase basis after a careful review of the relevant facts. Example 1 Aggregation Requirement. Holdco owns 100 percent of both an investment adviser and a broker-dealer. Those entities each trade 15 million shares with an aggregate market value of $150 million of NMS securities in a calendar month (with the trades being evenly distributed over the course of the month). Neither the investment adviser nor the broker-dealer, taken alone, would meet the Activity Threshold. However, Holdco would in the aggregate exceed the Activity Threshold and would be required to file a Form 13H to register as a large trader. Notably, Item 4(d) of Form 13H would permit Holdco to assign LTID suffixes to both the investment adviser and the broker-dealer. The SEC encourages any large trader to utilize LTID suffixes for divisions, groups and entities under its control in order to facilitate such large trader s ability to (i) accurately and efficiently track with more particularity the trading for which it exercises investment discretion, and (ii) respond to any SEC request to further identify accounts or disaggregate trading data. 9 The Rule is intended to push the filing requirements up the hierarchy of corporate control to the ultimate parent company. 10 However, if both the 2 Number 1260 November 22, 2011

3 investment adviser and the brokerdealer were to make their own voluntary filings on Form 13H, and the resulting LTID numbers covered all of the indirect trading of Holdco, there would be no further need or requirement for Holdco to file. 11 On the other hand, to the extent Holdco engages in any separate trading subject to the Rule, it would also have to file its own Form 13H. Example 1 Aggregation Requirement Holdco 100% 100% Investment Adviser (trades 15 million shares with market value of $150 million per month) Broker-Dealer (trades 15 million shares with market value of $150 million per month) Example 2 A More Complex Organization. 12 Holdco owns 100 percent of both an investment adviser and a broker-dealer. Unlike Example 1, however, neither the broker-dealer nor the investment adviser directly engages in any trading subject to the Rule. The broker-dealer holds a 33 percent ownership stake in a proprietary trading firm, which in turn trades $500 million of NMS securities in a calendar month. No other owner of the proprietary trading firm holds an ownership interest of at least 25 percent in that firm. The investment adviser, on the other hand, owns 100 percent ownership interests in both (A) sub-adviser #1, which trades $500 million of NMS securities in a calendar month, and (B) sub-adviser #2, which trades 15 million shares of NMS securities with an aggregate market value of $100 million in a calendar month (in each case, with the trades being evenly distributed over the course of the month). Each of these entities, except subadviser #2 taken alone, would qualify as large traders under the Rule. A filing by Holdco would obviate the need for any of the others to also register as large traders. Alternatively, if the investment adviser and the broker-dealer were to separately register as large traders, and those entities capture all transactions and accounts controlled by Holdco, then Holdco would not itself be required to file. 13 The investment adviser and the broker-dealer would each identify the other as an affiliate filing separately, and identify Holdco as their parent company, on their respective Form 13H filings. The SEC would then assign LTIDs to the investment adviser and the broker-dealer that reference their common parent. In the event of a Form 13H filing by each of the entities directly engaged in trading activities, i.e. each of sub-adviser #1, sub-adviser #2 (filing voluntarily even though it would not meet the Activity Threshold on a standalone basis) and the proprietary trading firm, none of Holdco, the investment adviser or the broker-dealer would be required to register as a large trader. 3 Number 1260 November 22, 2011

4 Example 2 A More Complex Organization Holdco 100% 100% Investment Adviser Broker-Dealer 100% 100% 33% Various Small Stakeholders (<25% each) Sub-Adviser #1 ($500 million in trades per month) Sub-Adviser #2 (trades 15 million shares with market value of $100 million per month) Proprietary Trading Firm ($500 million in trades per month) Example 3 Presence of Controlling Stakeholder. An investment adviser holds a 25 percent ownership stake in an underlying company that meets the Activity Threshold. The investment adviser does not have any designated seats on the board of directors of the company, nor does it have any other indicia of control. Another stakeholder owns 75 percent of the company and controls its board of directors. Under the Rule, the investment adviser would initially be presumed to control the company based on its 25 percent ownership stake. However, given the presence of a clearly controlling stakeholder, the presumption of control by the investment adviser may well be properly rebutted based on the actual indicia of control in the example. Where effective control is less obvious for example, where a company is owned by a number of minority stakeholders, each of which holds at least a 25 percent ownership interest in the company it will become more difficult to predict whether the SEC would conclude that any or all of the stakeholders have control of the company. Importantly, the SEC contemplates that in some cases involving multiple control persons, multiple LTIDs may be disclosed to a registered broker-dealer for a single account. 14 Example 3 Presence of Controlling Stakeholder Investment Adviser Stakeholder #2 25% 75% Company (Meets Activity Threshold) 4 Number 1260 November 22, 2011

5 Recommendations for Investment Advisers to Private Funds In order to support compliance with the Rule, investment advisers to private funds should consider updating their internal compliance procedures to monitor both their own trading activities and those of their affiliates. To that end, investment advisers should consider including a representation and/or covenant in their acquisition agreements to the effect that the target company will comply with the Rule and/or assist the investment adviser in complying either by filing Form 13H itself, or by providing the investment adviser with the information necessary for the investment adviser to determine whether it needs to register as a large trader based on its aggregate holdings. Also, as noted above, investment advisers may wish to reconsider their contractual arrangements and internal structures, such as ethics walls, in light of the Rule to determine whether they may be useful and effective limitations of control in connection with the trading activities of their affiliates. Endnotes 1 See SEC Exchange Act Release No (July 27, 2011), 76 Fed. Reg. 149 (August 3, 2011), currently available at: gov/rules/final/2011/ pdf (the Adopting Release). 2 An NMS security is any security or class of securities for which transaction reports are collected, processed, and made available pursuant to an effective transaction reporting plan, or an effective national market system plan for reporting transactions in listed options. See 17 CFR (b)(46). The term refers generally to exchange-listed securities, including equities and options. 3 A person exercises investment discretion with respect to an account if, directly or indirectly, such person (A) is authorized to determine what securities or other property shall be purchased or sold by or for the account, (B) makes decisions as to what securities or other property shall be purchased or sold by or for the account even though some other person may have responsibility for such investment decisions, or (C) otherwise exercises such influence with respect to the purchase and sale of securities or other property by or for the account as the [SEC], by rule, determines, in the public interest or for the protection of investors, should be subject to the operation of the provisions of this title and the rules and regulations thereunder. See Section 3(a)(35) of the Exchange Act. 4 A private fund includes any company that would be an investment company but for Sections 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, as amended, such as virtually all private equity, venture capital and hedge funds in which US persons or entities may invest. See Rule 203(b)(3)-1(d) under the Investment Advisers Act of 1940, as amended. 5 See Rule 13h-1(a)(3). 6 See Adopting Release at pages See Large Trader Reporting System SEC Exchange Act Release No (April 14, 2010), 75 Fed. Reg (April 23, 2010), currently available at: proposed/2010/ pdf (the Proposing Release), at page See Rule 13h-1(a)(3) (emphasis added). 9 See Adopting Release at pages See Adopting Release at page 17 and Rule 13h- 1(b)(3)(i). 11 See Rule 13h-1(b)(3)(ii). 12 This scenario is based on the example provided at pages 35-7 of the Adopting Release. 13 In this case, the investment adviser would be responsible for providing its LTID to each registered broker-dealer that effects transactions on its behalf, on behalf of sub-adviser #1 or on behalf of sub-adviser #2. In addition, the brokerdealer would be responsible for providing its LTID to each registered broker-dealer that effects transactions on its behalf or on behalf of the proprietary trading firm. Further, the investment adviser and the broker-dealer would be responsible for identifying each of the accounts to which their respective LTID applies, which would include the accounts of sub-adviser #1, sub-adviser #2 and the proprietary trading firm, as applicable. 14 According to the SEC, such a situation could arise where more than one large trader exercises investment discretion over an account (e.g., where two large trader investment managers co-manage an account), or where a parent company and one of its subsidiaries both identify themselves as large traders. Therefore, registered broker-dealers would need to develop systems capable of tracking multiple LTIDs. See Proposing Release at page Number 1260 November 22, 2011

6 If you have any questions about this Client Alert, please contact one of the authors listed below or the Latham attorney with whom you normally consult: Stephen P. Wink New York Stefan Paulovic New York Client Alert is published by Latham & Watkins as a news reporting service to clients and other friends. The information contained in this publication should not be construed as legal advice. Should further analysis or explanation of the subject matter be required, please contact the attorney with whom you normally consult. A complete list of our Client Alerts can be found on our website at If you wish to update your contact details or customize the information you receive from Latham & Watkins, please visit to subscribe to our global client mailings program. Abu Dhabi Barcelona Beijing Boston Brussels Chicago Doha Dubai Frankfurt Hamburg Hong Kong Houston London Los Angeles Madrid Milan Moscow Munich New Jersey New York Orange County Paris Riyadh* Rome San Diego San Francisco Shanghai Silicon Valley Singapore Tokyo Washington, D.C. * In association with the Law Office of Mohammed A. Al-Sheikh 6 Number 1260 November 22, 2011