Private Equity Fund Formation in 2013 Navigating JOBS Act, State Adviser Registration, SEC "Bad Actor" and "Red Flag" Rules, and the EU's AIFM Directive Today’s faculty features: 1pm Eastern | 12pm Central | 11am Mountain | 10am Pacific The audio portion of the conference may be accessed via the telephone or by using your computer's speakers. Please refer to the instructions emailed to registrants for additional information. If you have any questions, please contact Customer Service at 1-800-926-7926 ext. 10. TUESDAY, NOVEMBER 5, 2013 Presenting a live 90-minute webinar with interactive Q&A Scott W. Naidech, Partner, Chadbourne & Parke, New York Adam D. Gale, Partner, Mintz Levin Cohn Ferris Glovsky and Popeo, New York Jonathan R. Talansky, Partner, Mintz Levin Cohn Ferris Glovsky and Popeo, New York Edouard S. Markson, Partner, Chadbourne & Parke, New York
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Private Equity Fund Formation in 2013 Navigating JOBS Act, State Adviser Registration, SEC "Bad Actor" and "Red Flag" Rules, and the EU's AIFM Directive
Following unprecedented highs, fundraising fell materially through the global economic downturn
($ in billions)
Capital committed to private investment funds by year of final close
Gradual stabilization since 2010 … the “new normal”
- 54%
Data and graphics compiled by Credit Suisse Private Fund Group. Source: Preqin, as of Jul-2013. Includes all Buyout, Distressed, Fund of Funds,
Infrastructure, Mezzanine, Real Estate, Secondaries, Venture and Other (excludes Hedge Funds). Total fund size is accounted for in the year of a fund’s final
closing. Interim closings for funds that have not held their final closing are accounted for in the year of each closing, and amounts are rolled forward to the
quarter in which the final closing occurs. Capital committed in 2003-2007 is provided annually in the year of final closing. Data are continuously updated and
• Fund managers who are exempt from SEC registration still need to
check the investment adviser registration requirements of the state of
their principal office and place of business
• For most states (but not NY), solely under state rules if AUM under
$100 million
• Some states have recently added additional requirements to meet the
state exemption
• For example, California and Massachusetts:
o For 3(c)(1) funds, can only charge carried interest to investors that are
Qualified Clients under Adviser Act definition
o Must file Form ADV as Exempt Reporting Adviser
2. State Investment Adviser Registration Exemptions
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• April 2013 – SEC Div. of Trading & Markets speech – new approach
• Investment Banking/Acquisition/Disposition Fees
o Fund manager (or affiliate) charges success fee to portfolio co. or to fund
for identifying sellers or purchasers , or structuring transactions
o Unless 100% of that success fee is offset against fund management fees,
then SEC suggesting that fund manager must register as a B-D
• Personnel in Marketing Department
o Dedicated sales force, regardless of how compensated, "may strongly
indicate" B-D registration required
• Paying Commissions to "Finders"
o Beware of potential consequences – Ranieri matter; rescission
3. Broker-Dealer ("B-D") Registration
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• Under prior rules, PE funds could not engage in any general
solicitation or general advertising when raising a fund
• JOBS Act eliminated this prohibition, provided that:
o Everyone who ends up investing in the fund is an “accredited investor”
(though "reasonable belief" standard still applies)
o Fund takes “reasonable steps” to verify accredited investor status
o Fund relies on Rule 506 – called Rule 506(c)
• Reasonable Steps:
o Fund determines what steps are reasonable
o But just relying on investor reps or checking boxes is insufficient
o Safe harbor (non-exclusive list) included in rules
4. JOBS Act – General Advertising
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• Safe Harbor – Applies Only to Natural Person Investors:
o (A) Income – IRS Forms and rep as to future income
o (B) Net Worth – Bank/brokerage statements; credit report; rep as to liabs.
o (C) Written Confirmation from: B-D, RIA, Licensed Attorney or CPA that
they have taken reasonable steps to verify within prior 3 months
o (D) Prior investors who invest in subsequent close – certification
• Otherwise – Facts and Circumstances Test as to Reasonable Steps:
o Type of Investor (e.g., plan, entity, natural person)
o Amount of information about investor
o Nature of offering – how investor solicited; terms of investment
JOBS Act – General Advertising (Con't)
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• SEC's Release – Tips on Reasonable Steps
o High investment amount may be sufficient, with confirmation of no loan
o Can rely on publicly available info (e.g., Form 990 for a tax-exempt)
o Third party verification okay – if reasonable basis to rely on it
• Potential Pitfalls
o CFTC Registration Exemptions unchanged (e.g. CPO) – no public offering
o State exemptions – may still have a restriction on general advertising
o Non-US laws – especially on website
o RIAs – must keep records of advertisements
o Use of track record in general advertisements
JOBS Act – General Advertising (Con't)
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• What Can Funds Do Under 506(c) Offering
o Freely advertise and market
o No restriction of website access – for US persons
o Fund manager personnel can speak more freely to press and conferences
o Freely use social media (but note RIA record-keeping)
o No need to number PPMs (but still good idea)
• Form D Amended – must indicate if relying on 506(c)
• Reg S Offering – can conduct concurrent with 506(c) offering
JOBS Act – General Advertising (Con't)
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• Cannot rely on Reg D of Rule 506 if fund manager and affiliates,
solicitors, fund investors with 20% voting power, or affiliated issuers
have been subject of certain criminal, regulatory or civil proceedings
o Persons covered go well beyond those under fund manager's control
o Bad actor events go beyond list in Form ADV Item 11
o Form D amended – must certify that have no disqualifications
• Exception if did not know and "exercised reasonable care" by making
"factual inquiry into whether any disqualifications exist"
• Waivers: can apply to SEC for "good cause"; regulator issuing order
determines disqualification not necessary
• Events Prior to Sept. 2013 – Do not disqualify, but must disclose
5. Bad Actor Rules
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• What Constitutes Exercise of Reasonable Care:
o Scope of inquiry depends on facts and circumstances
o SEC suggested reps and covenants sufficient for third parties, if have no
information to the contrary
o For fund and affiliates own officers – additional steps may be necessary
o For placement agents – may need to consult FINRA BrokerCheck
• Action Items
o Sub Docs – Incorporate Bad Actor reps for investors with 20% ownership
o Employees – Complete Bad Actor questionnaire, and background checks
o Placement Agent Agreements
o Offerings lasting over one year
Bad Actor Rules (Con't)
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• Who Is Covered
o Any managing member, GP, director, executive officer, or other officer
participating in the offering, of:
- Fund's investment manager
- The Fund
- Anyone paid remuneration for solicitation
o Any affiliated issuer and any predecessor to the issuer
o 20% Beneficial Owners of Total Outstanding Voting Equity Securities
- If some investors are non-voting, may affect 20%
- Total outstanding – not by class
Bad Actor Rules (Con't)
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• Now in effect and applies if meet any of the following:
o Market to European investors
o Fund vehicle is organized in Europe
o Fund manager based in Europe (including a branch office)
• Non-EU Fund Manager Marketing to European Investors
o Need to comply with National Private Placement Regimes (NPPRs) in
each country where market – unless meet exemption
o Or rely on "reverse solicitation"
- Marketing not at direct or indirect initiative of fund manager
o In 2015 – can become AIFMD authorized and rely on passport regime
6. AIFMD (Alternative Investment Fund Managers Directive)
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• Exemption for Smaller Fund Managers
o AIFMD not apply if manager has AUM below €100 million (~US$135M)
o If fund not employ leverage, then AUM below €500 million (~US$690M)
• NPPR Requirements
o Must register with relevant country's regulator
o Comply with rules on reporting to regulators and disclosure to investors
o If began marketing prior to July 2013, have until July 2014 to comply, but
need to check each country's rules
• AIFMD Authorized – may not be practical, as includes restrictions on
remuneration to fund managers
AIFMD (Con't)
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• Not apply to fund managers at all if not an RIA
• Not apply to fund manager if no authority to redirect investor's
proceeds to third parties or others upon instructions from the investor
o Need to check power of attorney if narrowly drafted
• Not apply to fund manager if no investors are individuals
• Does apply to fund manager if regularly lend money to permit investors
to make an investment in the fund, pending receipt or clearance of
investor's capital
o Not apply solely because fund itself borrows money pending receipt of
investor contributions
7. Red Flags Rule
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If Rule applies:
• Must develop a written program designed to detect, prevent and
mitigate identity theft in connection with the opening of "covered
accounts" (accounts for individuals)
• Need policies and procedures to:
o Identify relevant Red Flags indicating possible identity theft
o Detect Red Flags that the program incorporates
o Respond appropriately to any Red Flags detected
o Ensure program is updated periodically
• Continued administration, including obtaining approval from
CCO, training, oversight of service provider arrangements
Red Flags Rule (Con't)
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• Volcker Rule generally prohibits banking entities, including affiliates of
banks, from engaging in, sponsoring or investing in private equity funds
(and hedge funds), but the Rule is subject to a number of exceptions.
• Volcker Rule also prohibits a bank from engaging in "proprietary
trading," but those are less relevant to funds.
• Rule does not go into effect until July 21, 2014, and we are still waiting
for final rules to be promulgated.
• Grandfather Provision: Regulators may, upon application by any
banking entity, extend the period
o (i) for up to 5 years (until 2019)
o (ii) to the "extent necessary to fulfill a contractual obligation that was in
effect on May 1, 2010” if fund is an “illiquid fund”
8. Volcker Rule
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The 3% Exception to the General Prohibition:
• A banking entity may acquire or retain an ownership interest in a
covered fund if, among other things, it:
(i) owns not more than 3% of the total ownership interests in any single fund; and
(ii) invests an aggregate amount not exceeding 3% of the banking entity's Tier 1
capital (i.e., the bank's regulatory capital) in covered funds as a whole.
• Seed Investment Exception: There is an exception to the 3% rule to
allow the banking entity to make a seed investment in a fund (in
which case it can own 100% of the fund) - provided that within one
year of the covered fund's establishment, the banking entity must
reduce its ownership to no more than 3% of the total ownership
interests in the covered fund.
Volcker Rule (Con't)
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Sun Capital & Private Equity Funds
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• A PE Fund's portfolio company (SBI) was in bankruptcy and stopped its contributions to a multiemployer pension plan (TPF)
• TPF demanded payment of SBI's withdrawal liability under ERISA
• TPF also asserted that the PE Fund was jointly and severally liable for the withdrawal liability under ERISA, on the basis that it was a "trade or business" that is "under common control" with the primary ERISA obligor (29 U.S.C. § 1301)
Sun Capital – Basic Facts
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• No offices or employees
• Report only investment income
• Make investments with the aim of turning them around and selling them at a profit
• The Fund agreements vest the General Partner with authority to manage the Fund, which includes managing and supervising investments.
• GP receives a 2% management fee from the Fund, plus a share of profits
• Subsidiary management companies provide management services to the Fund's portfolio companies for a fee.
• This fee results in an offset to the management fee owed by the Fund
• The employees of the management companies are actively involved in the operations and management of the portfolio companies' businesses.
Key Features of Sun Funds
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• The Funds were in a "trade or business" under ERISA (and remanded for other issues) – but the business of SBI itself.
• Holding was based on the fact that the Funds were not merely passive investors (as mere investment is not a "trade or business"), but were, through agents, "actively," "extensively" and "intimately" involved in the management, operation and supervision of SBI.
• The court focused heavily on the management fee offset, characterizing it as the "economic benefit" that most clearly distinguished the Fund from an ordinary, passive investor.
– "It is one thing to manage one's investments in businesses. It is another to manage the businesses in which one invests"
– "Under Delaware law, it is clear that the GP of [the Fund], in providing management services to SBI, was acting as an agent of the Fund."
• The standard used by the court was not taken from tax precedent, but was held to be not inconsistent with such precedent, including the Supreme Court's decisions in Groetzinger (1987), Higgins (1941) and Whipple (1963).
The Sun Capital Holding
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• The Sun Capital decision emphasized the fee offset arrangement as a key factor in its holding
• Practitioners have historically expressed concern that the offset arrangement gives rise to the characterization of the offending fees as having been received by the fund itself in respect of services performed "on behalf of" the fund
• For this reason, management fee offsets are commonly carved out of many LP covenants.
• But isn't this just an economic arrangement? How does it change the nature of the Fund's activities?
Management Fee Offset
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• A Private Equity Fund that invests in securities of portfolio companies treated as corporations for U.S. tax purposes is not engaged in a trade or business, notwithstanding the substantial managerial activities that the GP/Manager may conduct.
• This is based on the fact that a PE Fund acquires portfolio companies as investments with a view to long-term appreciation, doesn’t execute enough trades to be a "trader," and doesn’t have the customers that are necessary for "dealer" status.
Traditional View
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• Sponsor – Ordinary income on gains?
– §1221(a)(1)
– Investor vs. Trader vs. Dealer. "Promoter"?
• Tax-Exempt Investors – UBTI
– Statutory exemption (§512(b)(5))
• Significance of "customers" in both of these categories. Further guidance would likely be necessary
• Non-U.S. Investors – ECI
– Eligibility for trading safe harbor of §864?
• Management fee deductions?
– Possible pro-taxpayer overall result
What are the potential ramifications if a PE Fund is treated as engaged in a business for tax purposes?
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• ECI/UBTI covenants and "opt-outs," availability of blocker/AIV structures – Typically, the covenants and the definition of "ECI"
carve out the activities of the Fund itself, as well as the management fee offset, which is typically contained in the Investment Advisory Agreement
• LP waiver of unapplied balance of fee offset – Usually elected upfront
– Does it really help?
Common "Trade or Business" Provisions in Fund Documents
52
• Case decided under ERISA, not IRC
• Fund Sponsors should focus on covenants that go to this issue
• Courts can read PPMs and other marketing materials
• The court did not really address the "promoter"/"corporate developer" argument
– "Promoter" characterization would have a more significant impact on PE funds
– Possible change to taxation of carry without legislative action?
Key Takeaways
FOREIGN ACCOUNT TAX
COMPLIANCE ACT (FATCA)
Update
53
All Together Now: FATCA
• Who Are You? (Townsend)
• U.S. person
• FFI
• NFFE
• I Don’t Know if I’m Coming or Going (Wainer/Fien)
• U.S. person making payments
• FFI making payments
• FFI or NFFE receiving payments
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Y’all Ready For This?
• June 30, 2014
• Last day of grandfather period
• Accounts already open are “preexisting accounts”
• July 1, 2014
• Withholding begins on withholdable payments
• New account opening procedures required
• March 31, 2015
• Reports due with respect to calendar year 2014
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Sponsored Investment Entities
• In general – Treas. Reg. 1.1471-5(f)(1)(i)(F)
• “Registered deemed-compliant FFI”
• Sponsoring entity must:
• Register with IRS
• Register sponsored entity with IRS (GIIN)
• Be authorized to manage the FFI and enter into contracts on behalf of the
FFI (such as a fund manager, trustee, corporate director, or managing
partner)
• Agree to perform all participating-FFI requirements on behalf of the
sponsored FFI
• Sponsored, closely held investment vehicles – Treas. Reg.
1.1471-5(f)(2)(iii)
• “Certified deemed-compliant FFI”
• 20 or fewer individuals own all debt and equity in FFI (disregarding
debt owned by certain FFIs), or 100% of equity owned by such FFI
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Scott W. Naidech: Scott is a Partner at Chadbourne & Parke LLP. He
represents domestic and international sponsors (with a particular focus on Latin
America and other emerging markets) in the structuring, establishment and
operation of their private equity funds. He has formed buyout, growth capital,
real estate, energy, infrastructure, mezzanine and venture capital funds, among
others, ranging in size from $50 million to over $16 billion of committed capital.
He also advises clients on leveraged buyouts, acquisitions, recapitalizations and
divestitures, and general corporate matters. In 2013, he was recognized in Best
Lawyers in America and The Legal 500 for his work in private funds law. He can