Both in terms of tax reform (yet to be determined) and financial markets reform, alternative investment firms will face a new set of standards that will have a major impact on the firms, their principals and the investors in such funds. Hedge funds and private equity funds will be impacted by the Dodd-Frank Wall Street Reform and Consumer Protection Act, which includes the Private Fund Investment Advisers Registration Act of 2010. This legislation requires many investment advisers and hedge fund managers to register as investment advisers with the SEC. It may also result in some investment advisers and hedge fund managers that are now registered with the SEC to register at the state level.
This bill also revised one of the definitions of an "accredited investor" by excluding the value of a person's primary residence from the $1 million net worth calculation. The SEC will now be required to review the definition of "accredited investor" in order to determine whether adjustments should be made after four years, and at least once every four years thereafter.This is effective immediately.A person is considered an accredited investor if he or she: (1) has $200,000 in annual income (or $300,000 jointly with a spouse); or (2) has a net worth of at least $1M.
This new definition of "accredited investor" can be subject to further interpretation and will not result in excluding those currently invested, but, rather, will limit new investors or additional subscriptions from existing investors.
Private equity firms and hedge funds will need to amend their offering agreements so as to comply with the new definition of an accredited investor each time it is updated by the SEC.
As part of this legislation, the Government Accountability Office (GAO) is going to be required to complete a feasibility study to possibly form a self-regulatory organization to oversee alternative investment funds.It is clear from the Act that there will be certain systemic changes which will directly impact hedge funds, including:
• tighter leverage requirements on banks;
• expected higher capital charges for banks;
• SEC registration requirements (as mentioned earlier); and
• central clearing requirement on derivatives.
As noted previously, under the Reform Act, an investment adviser will no longer be exempt from registration under the Advisers' Act of 1940 on the basis that the investment adviser advised fifteen or fewer funds or clients over a 12 month period. Although the Reform Act provides several new exemptions from registration, including an exemption for advisers solely to venture capital funds and an exemption for advisers with assets under management in the United States of less than $150 million, the Reform Act will subject numerous investment advisers, previously exempt, to registration with the SEC. The registration requirements will be effective one year after enactment of the Reform Act.
The requirements based on fiduciary, compliance and reporting standards for currently registered advisers is extensive. Presumably, most alternative investment firms will now face similar standards and be burdened with a new set of operational requirements, which includes:
• Fiduciary Obligations
• Creation of a Code of Ethics
• Adoption of a Compliance Program
• Reporting Obligations (via Form ADV)
• Maintenance of Books and Records
• As a fiduciary , a registered investment adviser must provide its clients with an affirmation of operating in good faith to act in the best interests of the client and to make full disclosure of all material facts, particularly in cases where the adviser's interests may conflict with the clients' interests.
• Registered investment advisers must have a code of ethics governing their employees and monitor insider trading procedures. The code of ethics must, at least, include (1) standards of business conduct for "supervised persons" that require them to comply with applicable federal securities laws; (2) provisions that require "access persons" to report personal securities transactions periodically and which require the adviser to review these reports; (3) provisions requiring supervised persons to report violations of the code of ethics to the adviser's chief compliance officer and (4) provisions that require each supervised person to be provided with the code of ethics and acknowledge receipt thereof.
• Registered investment advisers must adopt and implement written policies and procedures that are designed to prevent violations of the Advisers' Act. These policies and procedures must address at a minimum portfolio management processes, including allocation of investment opportunities, accuracy of disclosures made to investors, clients and regulators, proprietary trading, safeguarding of client assets, the creation of required records and their maintenance, privacy standards for client records and data, trading practices, marketing advisory services, procedures for valuation ofclient holdings and address fees, and business continuity plans.
• Registered investment advisers are required to file a Form ADV with the SEC and to file an annual update of Part 1A of the Form ADV.This needs to be completed within 90 days after the end of each fiscal year or more frequently if the information in the ADV needs to be updated.Registered investment advisers are required to provide prospective clients a written disclosure statement (which may be Part II of their Form ADV or a brochure that contains at least the information required to be included in Part II).This information must be provided, or at least offered, to each client on an annual basis.
• Registered investment advisers must keep accurate and current books and records including advisory business financial and accounting records, records that pertain to providing investment advice and transactions.They must also document the adviser's authority to conduct business, provide advertising and performance records, and records relating to the code of ethics.
• The various compliance requirements that were not previously part of most alternative investment firms' operations will require the hiring of either an internal compliance officer, or use of outside advisors.
Besides the impact on firms from the Dodd-Frank Act, it is expected that some form of tax legislation will be passed that will also impact alternative investment firms and their principals.While the most recent efforts did not pass the Senate, they may offer some insight into what should be expected.
Due to the projected revenue raising results and political landscape, we would anticipate some form of legislation particularly with regard to "carried interest."By way of summary, the following gives an overview of the recent proposed legislation, and may be a good indication of what might be expected in future legislative offerings.The American Jobs and Closing Tax Loophole Act of 2010 which was shot down in the Senate included the following:
• All partnership interests granted in connection with the rendering of services to a partnership will be subject to Section 83.
• By default, the recipient partner will be deemed to have made a Section 83(b) election and will have to affirmatively elect out of Section 83(b) treatment, if desired.
• All (or in the case of an individual partner, a specified portion) of the distributive share of certain partners' will be taxed at ordinary income rates, regardless of the actual character of the partnership's income.
• Partners subject to this rule include any partner providing management services to an "Investment Services Partnership," and the interest held by such a partner is defined as an "Investment Services Partnership Interest" or "ISPI."
• The prior proposal stated that for tax years in 2011 and 2012, the applicable portion that will be treated as ordinary income will be 50 percent of such an individual partner's income; beginning in 2013, the percentage increases to 75 percent.
• Distributions of assets attributable to an ISPI will result in tax recognition at the partnership level, allocable to the partner.
The investment funds that would be subject to these provisions include, generally:
• Hedge,
• Private Equity,
• Venture Capital,
• Commodity, and
• Rental or Investment Real Estate (not active development).
In anticipation of any future tax legislation dealing with the issue of "carried interest," certain alternative investment funds may consider:
1. Distributing appreciated assets of the partnership to the partners in advance of the (to be determined) effective date of the proposed legislation.
2. Accelerating gains on investment assets, if the 2010 applicable tax rate is expected to be less than that of future years.
3. Analyze the tax deduction value of "built in losses" existing in the assets if tax losses are recognized in 2010, versus recognition in a future year.
Published August 2, 2010.
