Doug Cornelius

Joseph Bankman Testimony on Hedge Fund Tax Treatment

The House Committee on Oversight and Government Reform held a hearing on hedge funds and the financial market on November 13, 2008. Among those testifying was Professor Joseph Bankman, the Ralph M. Parsons Professor of Law and Business at Stanford Law School: Testimony of Joseph Bankman.

Professor Bankman points out that the carried interest of a private equity fund sponsor is typically taxed as capital gains (assuming the underlying assets are held long enough). professor Bankman points out his dislike of the tax advantages and proposes a legislative change:

The Alternative Minimum Tax Relief Act of 2008 contained a provision that would have taxed carry at ordinary income rates. That Act passed the House of Representatives in June, 2008, but died in the Senate. Thus, carry remains tax-favored. I recommend that Congress eliminate the tax advantage given to carry by again passing a measure similar to that contained in the Alternative Minimum Tax Relief Act of 2008. I recommend, though, that such a measure be amended to address the concerns expressed in the New York State Bar Association Report on Proposed Carried Interest and Deferred Fee Legislation.

Thanks to the Hedge Fund Law Blog for pointing out this resource: Hedge Fund Taxation – Law School Professor Perspective.

The SEC v. Mark Cuban Insider Trading Case

McDermott Will & Emery put together an excellent peice on insider trading: The SEC v. Mark Cuban Insider Trading Case (.pdf) by Stephen E. Older and Seth T. Goldsamt.

Insider trading under U.S. law has developed through a case-by-case interpretation of Section 10(b) and Rule 10b-5 of the Securities Exchange Act of 1934 in the federal courts. There are three basic elements to an insider trading claim. The elements include purchasing or selling a security after receiving information that is material, nonpublic, and obtained or used in breach of a fiduciary or similar duty.

There are two major theories of insider trading under federal law flowing from two different types of duties: the “classical” theory and the “misappropriation” theory. Under the classical theory of insider trading, the agents of an issuer of securities may be corporate insiders (e.g., directors, officers, employees or controlling shareholders) or they may be “temporary” insiders by virtue of a professional relationship giving the agent access to nonpublic information about the issuer. A temporary insider is typically a lawyer, banker, accountant or consultant. If someone falls into either category and receives material, nonpublic information, then that person must either disclose such information to his counterparty before trading or abstain from trading. Under the misappropriation theory, a person will be held liable if he or she traded on material, nonpublic information and owed a duty to maintain trust and confidence to the source of that information.

The authors take you through the elements of insider trading and how it relates to the public information about the Mark Cuban case.

They also take us through the industry practice for PIPE transactions.

In a typical PIPE transaction, the placement agent will contact an investment fund’s compliance officer or in-house counsel and disclose limited information about the PIPE issuer. The compliance officer then runs this information against the fund’s restricted list, which is a list of investments in which the fund currently has a position. This is done to ensure that the fund will be able to freely trade investments it has already made. If the compliance officer finds the issuer’s name on the fund’s restricted list, he generally will decline to learn anything further about the offering. If the issuer’s name is not on a restricted list and the potential investor is interested in participating in the PIPE transaction, currently, best practices call for the placement agent either to have such investor sign a confidentiality agreement or a securities purchase agreement that includes a confidentiality provision, or to read a detailed script regarding confidentiality and have the investor consent in the presence of witnesses. This procedure is meant to prevent the circumstances now being litigated between the SEC and Mr. Cuban.

Bingham Presentation on Massachusetts Data Security Law

bingham_logo Bingham McCuthen LLP put together a panel presentation on the Complying with Massachusetts New Data Security Regulations.

Mark Robinson, a partner at Bingham, started with an introduction of the law and panel. He called the law “perilous.”

Beth Boland, a partner at Bingham, went through the requirements of the new law. OCBR and the business community seem to be at a disconnect over the law. OCBR thinks that they are not a big deal. They cite a statistic that there were over 318 reported breaches that affects more than 500 Massachusetts residents during a 10 month period when they were considering the law. [See Report of M.G.L. Chapter 93h Notifications (.pdf)]

Beth highlighted the limitation that data should only be collected that is “reasonable necessary to accomplish the legitimate purpose for which it is collected” 201 CMR §17.03(g) is unique to Massachusetts.

Beth highlights one of the pitfalls being the cascading certifications. First, there is no standard for certification. She expects there will be some battle over acceptable forms. Second, you need to folow the certification process all the way down the chain of custody to your providers, the sub-providers, the sub-sub providers, etc.

Beth highlighted that May 1, 2009 is deadline for getting contractual agreement that service providers will comply and January 1, 2010 is the deadline for getting a compliance certification.

Doug Schwarz, a partner at Bingham, pointed out that in some organizations, the requirements will mostly affect Human resources and that HR may end up driving the process instead of IT.

Enforce Your Email and Web Acceptable Usage Policies

MessageLabs (now part of Symantec) published a whitepaper Not Just Words: Enforce Your Email And Web Acceptable Usage Policies. The Whitepaper was written by Nancy Flynn, Executive Director of the ePolicy Institute.

Email & Web Rule #1:
Comply with Legal and Regulatory Rules
Email & Web Rule #2:
Enforce Acceptable Usage Policy with Training and Technology
Email & Web Rule #3:
Control Written Content to Control Risk
Email & Web Rule #4:
Protect Resources, Preserve Productivity and Prevent Lawsuits
Email & Web Rule #5:
Personal Use Heightens Risk
Email & Web Rule #6:
Exercise Your Legal Right to Monitor
Email & Web Rule #7:
No Reasonable Expectation of Privacy
Email & Web Rule #8:
Lock Out Malicious Intruders
Email & Web Rule #9:
Annual Review of Acceptable Usage Policies

Irrational Exuberance

In an essay in the Wall Street Journal, Stephen Greenspan explains some of the psychology behind the success of Ponzi schemes: Why We Keep Falling For Financial Scams.

The basic mechanism explaining the success of Ponzi schemes is the tendency of humans to model their actions — especially when dealing with matters they don’t fully understand — on the behavior of other humans. This mechanism has been termed “irrational exuberance,” a phrase often attributed to former Federal Reserve chairman Alan Greenspan (no relation), but actually coined by another economist, Robert J. Shiller, who later wrote a book with that title. Mr. Shiller employs a social psychological explanation that he terms the “feedback loop theory of investor bubbles.” Simply stated, the fact that so many people seem to be making big profits on the investment, and telling others about their good fortune, makes the investment seem safe and too good to pass up.

In Mr. Shiller’s view, all investment crazes, even ones that are not fraudulent, can be explained by this theory. Two modern examples of that phenomenon are the Japanese real-estate bubble of the 1980s and the American dot-com bubble of the 1990s. Two 18th-century predecessors were the Mississippi Mania in France and the South Sea Bubble in England (so much for the idea of human progress).

Mr. Greenspan has model of four explanatory factors for “foolish action.”

situation – a social challenge you need to solve
cognition – a deficiency in knowledge and/or clear thinking
personality – trust and niceness
emotion – greed or the desire to not lose

The Electronic Communications Privacy Act

The Electronic Communications Privacy Act (Pub. L. 99-508, Oct. 21, 1986, 100 Stat. 1848, 18 U.S.C. § 2510) prohibits unauthorized “intercepts” of electronic communications, such as email.

In Fraser v. Nationwide Mutual Insurance Co., 135 F. Supp. 2d 623 (E.D. Pa. 2001)) an employee had sent the e-mail, the recipient at the competitor company had received it, and so the employer had not intercepted the e-mail while it was being sent, which is the only thing protected by the ECPA. On December 10, 2003, the Third Circuit Court of Appeals affirmed that part of the federal district court’s judgment (352 F.3d 107).

An important note here: an employer can do anything with e-mail messages sent and received on company computers, even including intercepting them during the process of transmitting or receiving, as long as it has notified employees that they have no expectation of privacy in the use of the company e-mail system, that all use of the e-mail system may be monitored at any time with or without notice, and that any and all messages sent, relayed, or received with the company’s e-mail system are the property of the company and may be subject to company review at any time.

New York Social Security Number Protection Law

The New York Social Security Number Protection Law went into effect on January 3, 2009. Under New York Labor Law §203-d:

Employers may not, unless otherwise required by law:

1. Publicly post or display an employee’s SSN;
2. Visibly print a SSN on any ID badge or card, including time card;
3. Place a SSN in files with unrestricted access; or
4. Communicate an employee’s personal identifying information to the general public.

The statute broadly defines “personal identifying information” to include an employee’s SSN, home address or phone number, personal e-mail address, Internet ID or password, parent’s surname prior to marriage, or driver’s license number

Risk-Based Compliance

Certain customers, vendors, and intermediaries represent a higher compliance risk than others. Risk indicators include geography, relationships to government officials, business type, method of payment, and dollar volume.

In places where risks are very low, compliance burdens can be reduced. Where risks are not low, compliance is heightened . When there are more red flags, the proper response is more compliance.

The key to a risk-based approach is tracking and sorting the critical elements. Apply enhanced due diligence and heighten ongoing monitoring of high-risk parties proportionate to their risk profiles.

Avery Dennison and the Pitfalls in China

Don Lee of the Los Angeles Times has a great story about the pitfalls encountered by Avery Dennison when it was trying to build its road and traffic business in China: Avery Dennison case a window on the pitfalls U.S. firms face in China.

It highlights the gray area between building relationships and corrupt transactions, especially in an economy like China’s where corruption is more pervasive and accepted.

Avery Dennison ended up under a federal investigation for violations of the Foreign Corrupt Practices Act.