Apr. 16, 2015

U.K. Disguised Fee Rules May Result in Increased U.K. Taxation of Investment Fees to Individuals Affiliated with Hedge Fund Managers (Part One of Two)

Whilst the U.K. tax treatment of management fees relating to, and performance fees arising from, fund arrangements has been the subject of debate for some time, the recent introduction of new U.K. legislation has brought the issue into sharper focus in the United Kingdom.  Accordingly, hedge fund personnel operating within the United Kingdom may be affected by the new legislation and thus subject to increased taxation on fees and compensation earned with respect to their investment management activities.  In a guest article, the first in a two-part series, Sidley Austin partner Will Smith discusses the background and enactment of the new legislation known as the “disguised fee rules” and provides a summary of their technical application.  The second article in the series will detail exceptions to the application of the disguised fee rules and discuss certain practical consequences which may arise under the new legislation.  For additional insight from Smith, see “Potential Impact on US Hedge Fund Managers of the Reform of the UK Tax Regime Relating to Partnerships and Limited Liability Partnerships,” Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).  For insight from Smith’s partner Leonard Ng, see “Sidley Austin, Ivaldi Capital and Advise Technologies Share Lessons for U.K. Hedge Fund Managers from the January 2015 AIFMD Annex IV Filing,” Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015).  For insight from Sidley more generally, see “Sidley Partners Discuss Evolving Hedge Fund Fee Structures, Seed Deal Terms, Single Investor Hedge Funds, Risk Aggregators, Expense Allocations, Co-Investments and Fund Liquidity (Part One of Two),” Hedge Fund Law Report, Vol. 7, No. 36 (Sep. 25, 2014).

How to Mitigate Conflicts Arising Out of Simultaneous Management of Hedge Funds and Alternative Mutual Funds Following the Same Strategy (Part Three of Three)

Despite the fiduciary duty that managers have to manage a fund in the best interests of that fund’s investors, as well as requirements under the Investment Company Act of 1940 that joint enterprises involving a mutual fund and certain affiliates be fair to the mutual fund, numerous potential conflicts nevertheless arise out of the simultaneous management of hedge funds and alternative mutual funds (or liquid alternative funds).  See “SEC and FSA Impose Heavy Fines on Investment Manager for Failing to Address Conflicts of Interest Associated with Side by Side Management of a Registered Fund and a Hedge Fund,” Hedge Fund Law Report, Vol. 5, No. 21 (May 24, 2012).  Along with those potential conflicts comes the corresponding risk that the manager or hedge fund investors can benefit at the expense of the mutual fund investors.  Investment allocation, operational, valuation and other conflicts all arise out of simultaneous management, and managers operating both hedge funds and mutual funds must try to mitigate such conflicts wherever possible.  This article, the third in a three-part series, discusses ways to mitigate conflicts arising out of simultaneous management of hedge and alternative mutual funds.  The first article provided an overall assessment of conflicts of interest in simultaneous management; outlined the conflicts inherent in allocation of investments between a hedge fund and an alternative mutual fund following the same strategy; and discussed leverage limits, liquidity issues and diversification requirements applicable to alternative mutual funds.  The second article detailed additional conflicts arising out of simultaneous management of hedge funds and alternative mutual funds, including operational conflicts, conflicts of fee-related investment decisions, cross trades, soft dollar allocations, valuation concerns, reporting conflicts and marketing conflicts.  See also “The First Steps to Take When Joining the Rush to Offer Registered Liquid Alternative Funds,” Hedge Fund Law Report, Vol. 7, No. 42 (Nov. 6, 2014).

Tax Proposals and Tax Reforms May Affect Rates and Impose Liabilities on Hedge Fund Managers

Hedge fund managers need to be constantly aware of new tax regulations or changes in the tax code that could affect the investments they make, the taxes they pay and any flow-through issues that could impact investors.  Under the Economic Growth and Family Fairness Tax Reform Plan (commonly known as the Rubio-Lee plan), taxation of capital income would cease; corporate tax would be based on income earned in the U.S. and interest would no longer be expensed; capital investments would be expensed with no depreciation schedules; and most itemized deductions would end.  The 2016 federal budget proposal would increase the capital gains and qualified dividend rate to 28%; the tax on accrued market discounts would be assessed as it accrues; and carried interest would be taxed as ordinary income.  Under California State law, Sales Sourcing rules may have an impact on the taxation of hedge fund investments from out-of-state managers.  Finally, peer-to-peer lending platforms raise questions regarding proper tax characterization.  During a roundtable discussion on March 24, 2015, Pepper Hamilton LLC partners Gregory Nowak and Steven Bortnick discussed the foregoing issues.  This article summarizes the key points raised during that roundtable.  For a discussion of other proposed tax regulations, see “Tax Practitioners Discuss Taxation of Options and Swaps and Impact of Proposed IRS Regulations,” Hedge Fund Law Report, Vol. 8, No. 7 (Feb. 19, 2015).  See also “Key Tax Issues Facing Offshore Hedge Funds: FDAPI, ECI, FIRPTA, the Portfolio Interest Exemption and ‘Season and Sell’ Techniques,” Hedge Fund Law Report, Vol. 8, No. 3 (Jan. 22, 2015).

ACA Compliance Group Clarifies Misconceptions Commonly Held by Fund Managers with Respect to Cybersecurity

In 2014, the SEC conducted a widely-publicized review of over 100 investment advisers and broker-dealers to learn more about their cybersecurity measures and preparedness.  See “Seven Cybersecurity Risks That SEC Examiners Will Look for in Examinations of Hedge Fund Managers,” Hedge Fund Law Report, Vol. 7, No. 17 (May 2, 2014).  A recent program presented by ACA Compliance Group surveyed the current cybersecurity landscape; offered insights into what advisers and fund managers may expect from regulators going forward; discussed common misperceptions about cybersecurity; and explored goals of cybersecurity and technology risk programs.  The program featured Raj Bakhru and Marc Lotti, both partners at ACA Aponix, the cybersecurity and risk arm of ACA Compliance Group.  This article summarizes the key takeaways from that program.

EMIR Offers Three Models of Asset Segregation to Fund Managers That Trade OTC Derivatives

In August 2012, the European Commission adopted the Regulation on OTC Derivatives, Central Counterparties and Trade Repositories, also known as the European Market Infrastructure Regulation (EMIR).  One of its key risk mitigation measures is a central clearing regime for derivatives similar to that adopted in the U.S. under the Dodd-Frank Act.  See “Comparing and Contrasting EMIR and Dodd-Frank OTC Derivatives Reforms and Their Impact on Hedge Fund Managers,” Hedge Fund Law Report, Vol. 6, No. 36 (Sep. 19, 2013).  To protect counterparties in the event of the failure or default of a clearing member or central clearing party, EMIR requires a client’s collateral to be segregated, which can be achieved in a number of ways.  A recent program explored the three basic models of asset segregation, the risks and costs of each and how an asset manager’s own structure may affect the choice of segregation model.  The program was hosted by Julia Schieffer, founder of DerivSource Limited, and featured Jaki Walsh, a buy-side consultant at Derivati Consulting Limited.  This article summarizes the key points discussed during the program.  See also “Interest Rate Swap Compression for Hedge Fund Managers: Mechanics, Fee Savings, Risk Consequences and Regulatory Context,” Hedge Fund Law Report, Vol. 8, No. 8 (Feb. 26, 2015).

SEC Summary Judgment Emphasizes the Importance of Disclosure of and Client Consent to Cross Trades and Principal Transactions

A recent decision by the U.S. District Court for the Eastern District of New York granting the SEC’s motion for partial summary judgment against an affiliated registered investment adviser and broker-dealer and their principal emphasizes the importance the SEC places on obtaining client consent to cross trades among clients and principal transactions with client accounts in advance of such transactions.  For recent resolution of another case brought by the SEC against a manager involving inter-fund transactions, see “SEC Settlement Emphasizes the Importance – and Limits – of Fund and Transaction Disclosure,” Hedge Fund Law Report, Vol, 8, No. 13 (Apr. 2, 2015).  For more on transactions among hedge funds, see “Katten Forum Identifies Best Practices for Hedge Fund Managers Regarding Best Execution, Soft Dollars, Principal Trades, Agency Cross Trades, Cross Trades and Trade Errors,” Hedge Fund Law Report, Vol. 7, No. 10 (Mar. 13, 2014).  For more on transactions between hedge fund managers and funds, see “When and How Can Hedge Fund Managers Engage in Transactions with Their Hedge Funds?,” Hedge Fund Law Report, Vol. 4, No. 45 (Dec. 15, 2011).  This article provides a detailed discussion of the decision, then highlights the implications for the hedge fund industry arising out of the decision.

Andrew J. Dunbar Joins Bel Air Investment Advisors as GC and CCO

Wealth management advisory firm Bel Air Investment Advisors recently announced the addition of Andrew J. Dunbar as its general counsel and chief compliance officer.  Dunbar will oversee legal, advisory and compliance needs for the firm’s operations.  Prior to joining Bel Air, Dunbar was a partner at Sidley Austin LLP and previously was an enforcement attorney at the SEC in its Los Angeles Regional Office.  For insight from Dunbar, see “2014 Was a Series of ‘Firsts’ in the SEC’s Focus on Investment Advisers and Investment Companies,” Hedge Fund Law Report, Vol. 8, No. 4 (Jan. 29, 2015); and “How Can Hedge Fund Managers Understand Recent SEC Developments to Mitigate Enforcement Risk?,” Hedge Fund Law Report, Vol. 6, No. 8 (Feb. 21, 2013).

Gregory Weston Joins Winston & Strawn in New York

Winston & Strawn LLP recently announced that Gregory Weston has joined the firm as partner in New York.  For insight from Winston & Strawn LLP partners, see “Permanent Capital Structures Offer Managers Funding Stability and Access to Capital While Granting Investors Liquidity and Access to Managers,” Hedge Fund Law Report, Vol. 8, No. 14 (Apr. 9, 2015).  Weston was most recently senior counsel at Pillsbury Winthrop Shaw Pittman.  Weston advises emerging managers and other sponsors of private equity, real estate and debt funds regarding fund formation and transactional matters.  For more on emerging managers, see “Key Accounting and Legal Hurdles in Starting a Hedge Fund Management Business, and How to Surmount Them,” Hedge Fund Law Report, Vol. 7, No. 18 (May 8, 2014); and “How Can Emerging Managers Raise Institutional Capital While Avoiding Regulatory Pitfalls?,” Hedge Fund Law Report, Vol. 6, No. 33 (Aug. 22, 2013).  He also represents institutional investors in connection with their alternative investments.  For more on institutional investors, see “Credit Suisse Hedge Fund Survey Considers Factors in Institutional Investors’ Investment and Redemption Decisions, Appetite for Alternative UCITS and Anticipated 2015 Hedge Fund Investments by Strategy and Region,” Hedge Fund Law Report, Vol. 8, No. 12 (Mar. 27, 2015); and “Why and How Do Corporate and Government Pension Plans, Endowments and Foundations Invest in Hedge Funds?,” Hedge Fund Law Report, Vol. 6, No. 14 (Apr. 4, 2013).