SEC Votes to Propose Hedge Fund Adviser Registration

The SEC voted to propose new Rule 203(b)(3)-2 (the "Proposed Rule") under the Investment Advisers Act of 1940, as amended (the "Advisers Act"), which is designed to require advisers to certain unregistered funds to register under the Advisers Act. The Proposed Rule would narrow the current exemption from SEC registration generally available to advisers with fewer than 15 clients (the "Private Adviser Exemption"). Under the Proposed Rule, an adviser would have to look through each "private fund" it advises (and through any registered or unregistered fund-of-funds that holds an interest in that private fund) to count each of the private fund’s ultimate underlying investors as a client for purposes of the Private Adviser Exemption. A "private fund" would be defined as one that: (1) is not registered under the Investment Company Act of 1940, as amended (the "1940 Act"), in reliance on 1940 Act Section 3(c)(1) or 3(c)(7), (2) permits investors to redeem their interests within two years of purchase (not including certain extraordinary redemptions), and (3) is offered on the basis of the investment skills and expertise of the adviser. The Proposed Rule would not apply to offshore publicly offered funds; however, offshore advisers would be required to look through both offshore and US private funds to count US investors.

Although all advisers, whether registered or unregistered, are currently subject to the anti-fraud provisions of the Advisers Act, registration would impose a number of additional obligations on private fund advisers, most notably, the obligation to implement compliance policies and procedures and designate a chief compliance officer. Following registration, private fund advisers would also be subject to Advisers Act requirements regarding recordkeeping, custody and advertising activities, as well as limitations on when a registered adviser may charge its clients performance-based fees. The SEC has also proposed amendments to other rules under the Advisers Act to facilitate the transition of private fund advisers to registered status. These amendments would (a) grandfather existing performance-based fee arrangements that would not otherwise be permitted because of the adviser’s registered status, (b) limit recordkeeping obligations to the post-registration period, and (c) permit advertising of pre-registration performance. The SEC has also proposed to extend the deadline for delivering audited annual financial statements to investors under the Advisers Act self-custody rule from 120 days to 180 days following the end of a private fund’s fiscal year. Comments on the Proposed Rule must be submitted to the SEC by September 15, 2004. The proposing release, as well as a dissent of Commissioners Glassman and Atkins, is now available on the SEC’s website.

The IRS recently issued Rev. Rul. 2004-67. This new ruling amends Rev. Rul. 81-100, the ruling that established the requirements applicable to a tax-qualified group trust. As initially promulgated, Rev. Rul. 81-100 authorized pension and profit-sharing plans that are tax-qualified under Section 401(a) of the Internal Revenue Code (the "Code") and IRAs established under Section 408 of the Code to invest in such a group trust. Subsequently, Congress amended Section 401(a) to provide that investment by a "governmental plan" in a group trust would not cause the group trust to lose its tax-qualified status, regardless of whether the government plan was tax-qualified under Section 401(a). Rev. Rul. 2004-67 reflects the foregoing statutory change by amending Rev. Rul. 81-100 to include non-401(a) governmental plans, but only if they are eligible deferred compensation plans under Section 457(b). However, Rev. Rul. 2004-67 raises several issues regarding the conditions applicable to governmental plans and may require the amendment of existing group trusts. A model amendment is provided by the IRS for this purpose. Sponsors of all Rev. Rul. 81-100 group trusts should consider the impact of this new ruling on their group trusts.

The U.S. Court of Appeals for the D. C. Circuit (the "Appeals Court") upheld final OTS regulations that went into effect on January 1, 2003 amending earlier regulations promulgated in 1996 under the Alternative Mortgage Transaction Parity Act (the "AMT Parity Act"). The AMT Parity Act was enacted in 1982 to level the playing field for state-chartered housing lenders, including state-licensed mortgage lenders and state-chartered banks and credit unions, by authorizing them to make, purchase, and enforce alternative mortgage transactions (i.e., adjustable rate mortgage loans, balloon loans, loans in which the lender shares in any appreciation in value of the collateral, and certain other kinds of nontraditional home loans), notwithstanding state law to the contrary. The OTS, the OCC and the NCUA, respectively, were charged with determining which of their regulations governing "AMTs" should be given preemptive effect against contrary state laws for the benefit of state-licensed mortgage lenders ("Mortgage Lenders"), state-chartered banks, and state-chartered credit unions, respectively. In 1996, the OTS added its regulations on late fees and prepayment penalties to the list of regulations applicable to Mortgage Lenders, thereby preempting conflicting state laws. The change allowed the Mortgage Lenders to levy prepayment penalties and late fees on alternative mortgage loans without regard to state laws limiting or prohibiting such charges.

In 2000, the OTS expressed concern that the application of its late fee and prepayment penalty regulations to the Mortgage Lenders, and their consequent preemption of state consumer protection laws, might be contributing to predatory lending practices in the subprime mortgage market. The OTS eventually adopted a final rule, effective on January 1, 2003, making the OTS’s late fee and prepayment penalty regulations inapplicable to Mortgage Lenders, thereby re-subjecting them to the governance of state laws on those topics. Shortly thereafter, the National Home Equity Mortgage Association ("NHEMA"), a trade association of non-prime mortgage lenders, challenged the new OTS rule in federal district court on behalf of the Mortgage Lenders, but its suit was rejected on motion for summary judgment in favor of the OTS. NHEMA appealed, arguing (as it had in the lower court) that the OTS had exceeded its statutory authority in designating certain OTS regulations as applicable and others as inapplicable to Mortgage Lenders making alternative mortgage loans. The Appeals Court disagreed, affirming the decision of the district court, validating the rule, and holding that the OTS did in fact have statutory authority to identify those portions of its AMT regulations that are inappropriate for application to state-licensed creditors. National Home Equity Mtg. Ass’n v. OTS, No. 03-5204, (DC Cir. Jul. 13, 2004).

The IRS issued long-awaited guidance on backup withholding and information reporting with respect to payment card transactions (e.g., transactions whereby a company provides a credit or debit card to an employee to purchase goods or services.). The guidance, consisting of final regulations plus two new revenue procedures, makes it less burdensome for cardholders and for payment card issuers, such as banks, to determine whether a transaction is subject to withholding and reporting requirements. In general, businesses making payments of $600 or more in the course of their trade or business must file information returns that include the payee’s name and taxpayer identification number ("TIN"). If a payee fails to provide a TIN, the payor must withhold backup withholding taxes unless the payee is an exempt recipient (such as a tax-exempt organization or a federal, state or foreign government). However, in transactions made using payment cards, the information-reporting requirement may be a problem, especially because the card users may not be aware of the need to request the name and TIN of the payee. The withholding requirement is also difficult, since merchants generally receive payment from a bank in full within a few days after the transactions are completed but the employers/payors do not remit payment to the bank until they receive their monthly billing statements.

Last year, the IRS proposed special treatment for card issuers (generally, banks) that become "qualified payment card agents" ("QPCAs"). Reportable payments made through a QPCA to a "qualified payee" – a payee verified by the QPCA through the IRS TIN matching program, or a payee which first furnished its TIN number to the QPCA within the prior six months – would be exempted from backup withholding. The final regulations retain this provision, while eliminating the proposal that QPCAs must report payee status to payors monthly as part of the billing process. Instead, QPCAs must report the status of each payee to a payor not later than four months from the date of payment. The information can be included as part of a quarterly (or other regular period) report of merchant data, and QPCAs may treat all payments made during a calendar quarter as made on the last day of the quarter. In addition, backup withholding is required for payment card purchases only if purchases from a nonqualified payee are made more than two months after the last date for the QPCA to furnish notification to the payor that the payee is nonqualified. The regulations also clarify that an individual to whom a payment card is issued is not treated as the cardholder if another person is responsible for paying the charges on the card. The regulations related to backup withholding apply to payments made after 2004; the regulations related to information reporting apply to returns due after 2005.

The accompanying revenue procedures, both effective as of July 14, provide a method for a payment card organization to request a determination from the IRS that it is a QPCA (good for five years from the date of the determination) and permit payors to rely on existing Merchant Category Codes ("MCCs") to determine whether payments are reportable (e.g., payments for services) or not (e.g., payments for goods).

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