Author: Doug Cornelius

You can find out more about Doug on the About Doug page

Counting Clients under the Investment Advisers Act

With the demise of The Hedge Fund Rule, you can look to Rule 203(b)(3)-1 to help you figure out how to count clients.  The key part of the rule from a private investment fund perspective is (a)(2)(i):

A corporation, general partnership,limited partnership, limited liability company, trust (other than a trust referred to in paragraph (a)(1)(iv) of this section), or other legal organization (any of which are referred to hereinafter as a “legal organization”) to which you provide investment advice based on its investment objectives rather than the individual investment objectives of its shareholders, partners, limited partners, members, or beneficiaries (any of which are referred to hereinafter as an “owner”)

This rule is the opposite of The Hedge Fund Rule. Here the entity is the client, not the individuals or organizations in the entity.

For a private investment fund, the limited partnership is the client, not the invidiual limited partners.

Counting Clients under the Investment Advisers Act – The Demise of the Hedge Fund Rule

Section 203(b) lays out the exceptions to registration under the Investment Advisers Act. Section 203(b)(3) exempts you if during the previous 12 months (i) you have fewer than 15 clients and (ii) you do not hold yourself out as an investment adviser.

For private investment funds, the general partner is generally considered an investment adviser [See: Abrahamson v. Fleschner, 568 F.2d 862 (2d Cir. 1977) , overruled in part on other grounds by Transamerica Mortgage Advisors, Inc. v. Lewis, 444 U.S. 11 (1979)]

In the private investment world, as long as you had fewer than 15 funds and did not hold yourself out as an investment adviser you did not have to register.  The question is what was a fund/client for the purposes of the Investment Company Act?

With the demise of Long Term Capital, the SEC was interested in regulating hedge funds. In 2004 the SEC passed the Hedge Fund Rule which tried to expand the scope of the Investment Advisers Act by defining “client” under Section 203(b)(3). The rule specified that for “[f]or purposes of section 203(b)(3) of the [Advisers] Act (15 U.S.C. § 80b-3(b)(3)), you must count as clients the shareholders, limited partners, members, or beneficiaries . . . of [the] fund.” § 275.203(b)(3)-2(a). Effectively, the SEC tried to shift the definition from the fund up to the investors in the fund.

This Hedge Fund Rule was overturned by the United States Court of Appeals for the District of Columbia Circuit in the appelate case of Goldstein v. SEC, 451 F.3d 873 (D.C. Cir. 2006).

“An investor in a private fund may benefit from the adviser’s advice (or he may suffer from it) but he does not receive the advice directly. He invests a portion of his assets in the fund. The fund manager – the adviser – controls the disposition of the pool of capital in the fund. The adviser does not tell the investor how to spend his money; the investor made that decision when he  invested in the fund. Having bought into the fund, the investor fades into the background; his role is completely passive. If the person or entity controlling the fund is not an “investment adviser” to each individual investor, then a fortiori each investor cannot be a “client” of that person or entity.”

Siemens Reserves $1.3 Billion to Settle Corruption Charges

The German conglomerate Siemens has set aside $1.3 billion to settle an ongoing corruption investigation according to CFO.com: Siemens Reserves $1.3 Billion for Probe.

Back in April, international law firm Debevoise & Plimpton LLP, hired by Siemens to investigate bribery and corruption charges dating back to the late 1990s, found evidence of violations of domestic and foreign compliance regulations. Its report said many of the violations were due both to corruption and violations of regulations that govern internal controls and the accuracy of documentation.That report, delivered to the German conglomerate’s compliance committee, covered business transactions between 1999 and 2006, and management conduct related to those practices

FATF on Money Laundering and Terrorist Financing Through the Real Estate Sector

The Financial Action Task Force published their report on Money Laundering & Terrorist Financing Thorugh the Real Estate Sector (June 29, 2007).

I was disappointed in the report. I have a history of structuring complex real estate transactions. The report did little to help distinguish between legitimate and illegitimate structures. All of the structures and most of the transactions described in the report have completely legitimate uses. There are lots of tax and regulatory reasons for use of structured loan, trusts and many entities.

What the report missed was how the illegitimate funds got into the structures.

For those of you who are not familiar with real estate structures and transactions, the report does provide some interesting case studies. The red flag indicators in Annex B is a useful list.

Ignorance Is No Excuse When It Comes to the FCPA

Paul R. Berger, Bruce E. Yannett, Erin W. Sheehy, and Emily S. Pierce of Debevoise & Plimpton LLP wrote an article: Fair Warning: Ignorance Is No Excuse When it Comes to the FCPA (March 2008).

The article focused on some of the implications of Unites States V. Kay, 513 F.3d 432. [See Kay v. United States and Kay – Certiorari Denied]. The authors point out that one of the defendant defenses was that they did not have fair notice that bribes paid to reduce taxes and levies violated the FCPA.

The article also points out that there have been several prosecutions under the FCPA’s book and records requirement even when bribery could not be proven.

They also highlight the guidance from the DOJ about what are acceptable travel and entertainment expenses. They summarize FCPA Opinion Release 2007-01 and FCPA Opinion Release 2007-02 as providing these factors that made the proposed travel acceptable:

  • the foreign officials making the trip were not selected by the company and had no direct authority over decisions relating to potential contracts or licenses necessary to operate in the foreign country;
  • the expenses would be limited – no international airfare and economy class domestic airfare; no entertainment or leisure (although a “modest four-hour city sightseeing tour” was acceptable); no stipends; reimbursement for incidental expenses up to “a modest daily minimum, upon presentation of a written receipt”; no expenses for spouse, family or guests; and souvenirs limited to company-branded items of nominal value;
  • the company would pay all incurred expenses directly to the service providers (not to the officials) and properly record such payments in its books and records; and
  • the company received a written legal opinion that the trips did not violate the laws of the home country of the foreign official.

The authors point out that the best defense against FCPA is to have a robust compliance program in place that includes written policies, procedures, training and testing through internal audits.

Sovereign Wealth Funds That Are Part of the IWG and Santiago Principles

The following sovereign wealth funds are part of the Internal Working Group of Soverign Wealth Funds and the Santiago Principles:

Australia
The Future Fund

Azerbaijan
State Oil Fund of the Republic of Azerbaijan

Botswana
Pula Fund

Canada
Alberta Heritage Savings Trust Fund

Chile
Economic and Social Stabilization Fund / Pension Reserve Fund

China
China Investment Corporation

Ireland
National Pensions Reserve Fund

Korea
Korea Investment Corporation

Kuwait
Kuwait Investment Authority

Libya
Libyan Investment Authority

New Zealand
New Zealand Superannuation Fund

Norway
Government Pension Fund-Global

Qatar
Qatar Investment Authority

Russia
Reserve Fund
National Wealth Fund

Singapore
Temasek Holdings Pte. Ltd.
Government of Singapore Investment Corporation Pte. Ltd.

Timor Leste
Petroleum Fund of Timor-Leste

Trinidad and Tobago
Heritage and Stabilization Fund

The United Arab Emirates
Abu Dhabi Investment Authority

The United States
Alaska Permanent Fund

[IWG Member Sites]

The Santiago Principles

The International Working Group of Sovereign Wealth Funds created a set of 24 best practices called the Generally Accepted Principles and Practices (GAPP) or the Santiago Principles:

  • GAPP 1. Principle
    The legal framework for the SWF should be sound and support its effective operation and the achievement of its stated objective(s).

    • GAPP 1.1 Subprinciple The legal framework for the SWF should ensure the legal soundness of the SWF and its transactions.
    • GAPP 1.2 Subprinciple The key features of the SWF’s legal basis and structure, as well as the legal relationship between the SWF and the other state bodies, should be publicly disclosed.
  • GAPP 2. Principle
    The policy purpose of the SWF should be clearly defined and publicly disclosed.
  • GAPP 3. Principle
    Where the SWF’s activities have significant direct domestic macroeconomic implications, those activities should be closely coordinated with the domestic fiscal and monetary authorities, so as to ensure consistency with the overall macroeconomic policies.
  • GAPP 4. Principle There should be clear and publicly disclosed policies, rules, procedures, or arrangements in relation to the SWF’s general approach to funding, withdrawal, and spending operations.
    • GAPP 4.1 Subprinciple The source of SWF funding should be publicly disclosed.
    • GAPP 4.2 Subprinciple The general approach to withdrawals from the SWF and spending on behalf of the government should be publicly disclosed.
  • GAPP 5. Principle
    The relevant statistical data pertaining to the SWF should be reported on a timely basis to the owner, or as otherwise required, for inclusion where appropriate in macroeconomic data sets.
  • GAPP 6. Principle
    The governance framework for the SWF should be sound and establish a clear and effective division of roles and responsibilities in order to facilitate accountability and operational independence in the management of the SWF to pursue its objectives.
  • GAPP 7. Principle
    The owner should set the objectives of the SWF, appoint the members of its governing body(ies) in accordance with clearly defined procedures, and exercise oversight over the SWF’s operations.
  • GAPP 8. Principle
    The governing body(ies) should act in the best interests of the SWF, and have a clear mandate and adequate authority and competency to carry out its functions.
  • GAPP 9. Principle
    The operational management of the SWF should implement the SWF’s strategies in an independent manner and in accordance with clearly defined responsibilities.
  • GAPP 10. Principle
    The accountability framework for the SWF’s operations should be clearly defined in the relevant legislation, charter, other constitutive documents, or management agreement.
  • GAPP 11. Principle
    An annual report and accompanying financial statements on the SWF’s operations and performance should be prepared in a timely fashion and in accordance with recognized international or national accounting standards in a consistent manner.
  • GAPP 12. Principle
    The SWF’s operations and financial statements should be audited annually in accordance with recognized international or national auditing standards in a consistent manner.
  • GAPP 13. Principle
    Professional and ethical standards should be clearly defined and made known to the members of the SWF’s governing body(ies), management, and staff.
  • GAPP 14. Principle
    Dealing with third parties for the purpose of the SWF’s operational management should be based on economic and financial grounds, and follow clear rules and procedures.
  • GAPP 15. Principle
    SWF operations and activities in host countries should be conducted in compliance with all applicable regulatory and disclosure requirements of the countries in which they operate.
  • GAPP 16. Principle
    The governance framework and objectives, as well as the manner in which the SWF’s management is operationally independent from the owner, should be publicly disclosed.
  • GAPP 17. Principle
    Relevant financial information regarding the SWF should be publicly disclosed to demonstrate its economic and financial orientation, so as to contribute to stability in international financial markets and enhance trust in recipient countries.
  • GAPP 18. Principle
    The SWF’s investment policy should be clear and consistent with its defined objectives, risk tolerance, and investment strategy, as set by the owner or the governing body(ies), and be based on sound portfolio management principles.

    • GAPP 18.1 Subprinciple The investment policy should guide the SWF’s financial risk exposures and the possible use of leverage.
    • GAPP 18.2 Subprinciple The investment policy should address the extent to which internal and/or external investment managers are used, the range of their activities and authority, and the process by which they are selected and their performance monitored.
    • GAPP 18.3 Subprinciple A description of the investment policy of the SWF should be publicly disclosed.
  • GAPP 19. Principle
    The SWF’s investment decisions should aim to maximize risk-adjusted financial returns in a manner consistent with its investment policy, and based on economic and financial grounds.

    • GAPP 19.1 Subprinciple If investment decisions are subject to other than economic and financial considerations, these should be clearly set out in the investment policy and be publicly disclosed.
    • GAPP 19.2 Subprinciple The management of an SWF’s assets should be consistent with what is generally accepted as sound asset management principles.
  • GAPP 20. Principle
    The SWF should not seek or take advantage of privileged information or inappropriate influence by the broader government in competing with private entities.
  • GAPP 21. Principle
    SWFs view shareholder ownership rights as a fundamental element of their equity investments’ value. If an SWF chooses to exercise its ownership rights, it should do so in a manner that is consistent with its investment policy and protects the financial value of its investments. The SWF should publicly disclose its general approach to voting securities of listed entities, including the key factors guiding its exercise of ownership rights.
  • GAPP 22. Principle
    The SWF should have a framework that identifies, assesses, and manages the risks of its operations.

    • GAPP 22.1 Subprinciple The risk management framework should include reliable information and timely reporting systems, which should enable the adequate monitoring and management of relevant risks within acceptable parameters and levels, control and incentive mechanisms, codes of conduct, business continuity planning, and an independent audit function.
    • GAPP 22.2 Subprinciple The general approach to the SWF’s risk management framework should be publicly disclosed.
  • GAPP 23. Principle
    The assets and investment performance (absolute and relative to benchmarks, if any) of the SWF should be measured and reported to the owner according to clearly defined principles or standards.
  • GAPP 24. Principle
    A process of regular review of the implementation of the GAPP should be engaged in by or on behalf of the SWF.

There is also a Full Report on the Santiago Principles (.pdf).

Committee on Foreign Investment in the United States

The Foreign Investment and National Security Act of 2007, Pub. L. 110-49, which amends section 721 of the Defense Production Act of 1950 (50 USC §2170) authorizes the President to review merger, acquisitions and takeovers by or with any foreign person which could result in foreign control of any person engaged in interstate commerce in the United States to determine the effects of such transaction on the national security of the United States.

FINSA codifies the structure, role, process and responsibilities of the Committee on Foreign Investment in the United States. Previously, CFIUS had existed only by executive order. FINSA establishes CFIUS in statute.

FINSA provides for a 30 day review period of a “covered transaction” to determine the effect of the transaction on national security.

The system is based on voluntary notices to CFIUS by parties to a transaction, although CFIUS can review a transaction regardless of whether it has been notified.

The term ‘control’ has the meaning given to such term in regulations which the Committee shall prescribe.

The term ‘covered transaction’ means any merger, acquisition, or takeover that is proposed or pending after August 23, 1988, by or with any foreign person which could result in foreign control of any person engaged in interstate commerce in the United States.

The term ‘foreign government-controlled transaction’ means any covered transaction that could result in the control of any person engaged in interstate commerce in the United States by a foreign government or an entity controlled by or acting on behalf of a foreign government.

The Department of the Treasury issued proposed regulations for the CFIUS on April 21, 2008. You can also get the comments on the proposed CFIUS regulations.

The key part of the proposed regulations is section 800.302(c) (on page 54) stating that a “transaction that results in a foreign person holding ten percent or less of the outstanding voting interests in a U.S. business (regardless of the dollar value of the interests so acquired), but only if the transaction is solely for the purpose of investment” is not a covered transaction.

Section 800.203 helps to clarify “control.” Even though an investor has some investor protection rights associated with their investment, that does not necessarily create “control” under section 800.203(c). Having the power to limit insider deals and selling the company’s assets do not in themselves confer control of the entity.

Section 800.224 expands the term transaction to include the acquisition of an ownership interest in an entity, the formation of a joint venture and certian types of long term leases.

Sovereign Wealth Funds Adopt Voluntary Best Practices

Adam O. Emmerich of Wachtell Lipton Rosen & Katz put together a summary published on The Harvard Law School Corporate Governance Blog on the Santiago Principles and the potential impact of these on investments by sovereign wealth funds: Sovereign Wealth Funds Adopt Voluntary Best Practices.

Intended to demonstrate that SWFs are soundly established and that investment decisions will be made on an economic and financial basis, the Santiago Principles address three broad areas of concern regarding SWFs: (i) their legal structure and relationship with the state, policy and investment objectives, and degree of coordination with their sovereign’s macroeconomic policies; (ii) their institutional structure and governance mechanisms; and (iii) their investment and risk management framework. While much will turn on how SWFs actually implement these aspirational guidelines (and it is worth noting that all of the principles are well caveated and subject to home country laws, regulations, requirements and obligations), the Santiago Principles may help reduce political influence in SWF investing and encourage the flow of sovereign wealth across borders.