Monthly Archives: December 2009

Qualified Eligible Person (QEP) Definition

The securities laws can be written obtusely and the definition of a qualified eligible person (QEP) may be one of the best examples of this. There is no quick and easy definition of a what a QEP is so we are trying to make it as easy as possible to understand. This post discusses the importance of the classification, provides the overview of the definition and then provides a link to the actual statutory language.

Why QEP Definition is Important for CPOs

The definition of QEP is important for commodity pool operators (CPOs) in a couple of situations. The first is the 4.13(a)(4) exemption from the registration provisions for a CPO that provides advice to a commodity pool with only QEPs. The second situation where a CPO will need to make sure the investors are QEPs is if they want to take advantage of the Rule 4.7 exemption. The Rule 4.7 exemption allows CPOs to follow less-strict reporting requirements with regard to the commodity pool they manage. These two exemptions essentially provide for reduced regulatory oversight of a CPO who provides advisory services to these class of investors.

Definition of QEP

A qualified eligible person is an investor who fits into one of two distinct groups: (1) investors who do not need to meet the portfolio requirement and (2) investors who need to meet the portfolio requirement.

1. Investors who do not need to meet the portfolio requirement:

The following are considered to be QEPs regardless of whether or not they meet the portfolio requirement:

registered futures commission merchants
registered broker or dealers
registered commodity pool operators (under certain conditions, see rule for more details)
registered commodity trading advisors (under certain conditions, see rule for more details)
state or SEC registered investment advisers (under certain conditions, see rule for more details)
qualified purchasers
knowledgeable employee of the CPOs
certain persons related to advisers to exempt from registration as a CPO or CTA
trusts (under certain conditions, see rule for more details)
501(c)(3) organizations (under certain conditions, see rule for more details)
non-United States persons
certain entities in which all of the owners/participants are QEPs

2. Investors who need to meet the portfolio requirement:

The following will be considered to be QEPs only if they meet the portfolio requirement described below:

investment companies registered under the Investment Company Act (i.e. mutual funds)
certain business development companies (defined under both the Investment Company Act and Investment Advisers Act)
banks, savings and loan associations, and other like institutions acting for their own accounts or for the account of a QEP
insurance companies acting for their own account or for the account of a qualified eligible person
plans established and maintained by various governments and related bodies for the benefit of their employees, if such plan has total assets in excess of $5,000,000
employee benefit plans within the meaning of the ERISA (under certain conditions, see rule for more details)
501(c)(3) organizations with total assets in excess of $5,000,000
corporations, business trusts, partnerships, LLCs or similar business ventures with total assets in excess of $5,000,000 and not formed for the specific purpose of participating in the exempt investment program
a natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of either his purchase in the exempt pool or his opening of an exempt account exceeds $1,000,000 [HFLB note: this is one part of the accredited investor definition]
a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year [HFLB note: this is one part of the accredited investor definition]
pools, trusts, insurance company separate accounts or bank collective trusts, with total assets in excess of $5,000,000 (under certain conditions, see below)
other entities authorized by law to engage in such transactions (under certain conditions, see rule for more details)

3. Portfolio Requirement

If an investor is one of the entities described in (2) above, it will also need to meet the portfolio requirement. The portfolio requirement can be met in one of three ways:

Owns securities and other investments with an aggregate market value of at least $2MM;
Has had on deposit with a FCM at least $200K in exchange-specified initial margin and option premiums for commodity interest transactions in the 6 months prior to the investment; or
Has a combination of the two above. For example, has $1MM in securities/investments and $100K in exchange-specified initial margin in the 6 months prior to the investment

The above definitions have been shortened for the purpose of providing a general overview. When determining whether an investor meets the qualified eligible person definition the CPO should take special care to make sure that the investor meets the full definition which can be found here. Generally the investor will make these representations in the subscription documents which are drafted by the hedge fund attorney.

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Other related Hedge Fund Law Blog articles include:

Bart Mallon, Esq. runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.

Fund Appreciation Rights

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Alternative Hedge Fund Compensation Structure

At the very beginning of this year there was much discussion about the hedge fund compensation structure in light of the horrible returns from 2008. Many funds lost money but managers aren’t typically subject to the same types of clawback provisions as private equity fund managers. Additionally some funds had to close shop because of talent retention issues or because the manager realized that reaching a previous high water mark would take too long. Generally investors who have lost money will prefer to stay in a fund (all else being equal) because of the high water mark – when investors go into a new fund, there high water mark is their initial investment which means they are going to be subject to hedge fund performance fees sooner than in a fund which has previously lost money.

FAR Alternative

As an alternative to the traditional performance fee/ allocation structure, some hedge funds are instituting a different compensation structure called fund appreciation rights (FARs). Generally this structure provides a more aligned incentive structure for the manager. Essentially the FARs provide an option like mechanism for the manager. This option also has the potential to allow the manager to defer recognition of income which may be an added tax benefit for the manager. [Note: a longer discussion on this issue will be forthcoming shortly.]

Issues with FARs

FARs are new. It is not known how many groups have implemented FARs or whether they will catch on (or become the next standard). It is likely that any movement in this area will be driven by the demand (if any) by institutional investors for such products. FARs are also untested and it is not clear how they will be viewed by the IRS. As we have recently seen, there has been a big push to disallow the tax advantages of the performance allocation to hedge fund managers and in the current political climate it is likely that the IRS will scrutinize such transactions.

We will continue to research and report on this and other tax structures for hedge fund managers.

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Weekly Hedge Fund News Stories | November 30 – December 4

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Below are a list of some of the news stories which caught my attention this week.

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Hedge Fund Carried Interest Tax “Loophole” Repeal? – the hedge fund carried interest “loophole” is again being discussed as a potential issue to be addressed by Congress before the end of the year. One proposal introduced by Representative Levin (R) has reportedly passed the House twice but is meeting opposition in the Senate. Watch for a bill to be included as a last minute rider. For more background, see articles by Boston.com and Reuters.

Wall Street “Transaction Tax” Introduced in House – A group of Congressmen introduced legislation to tax Wall Street. According to a press release by Representative Peter DeFazio (D-OR), investment transactions (including stocks, futures, swaps, CDSs, and options) will be subject to “small” transaction taxes which could raise up to $150 billion a year. The tax would not apply to certain groups like IRAs, mutual funds, and HSAs. See also a SIFMA press release which discusses this issue.

Florida to Invest $500MM in Hedge Funds – managers who are looking for an allocation from a large pension plan should look toward Florida which is looking to get into hedge funds. According an article on Pension & Investments, Florida has hired Cambridge Associates as a consultant to help with the search.

Positive November for Hedge Funds – Hedge fund managers gained an average of 1.8% in November according to this Market Watch article.

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Hedge Funds, the Secondary Market and PTP Issues

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Secondary Hedge Fund Market Poses Issues for Fund Managers

Recently there have been a number of groups springing up to provide a secondary hedge fund market. While such platforms provide investors with a potential avenue to get out of their illiquid investment (the investment in the fund may be illiquid for a number of reasons including the imposition of a gate provision), they pose problems for the hedge fund manager who will have to deal with the mechanical issues involved in a transfer of the fund interests. Additionally, as noted in the article below, the manager may have to worry about the PTP issues involved with such potential transfer.

The following article was written by Doug Cornelius of the Compliance Building blog and is reprinted with permission. All links in the article are from the original.

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Classification of Private Funds as Publicly Traded Partnerships

Due to the increasing incidence of fund investors who want to transfer their investment fund interests, private investment funds face a risk of being classified as publicly traded partnerships. That would mean the fund would become taxable as a corporation.

A bad result.

Under Internal Revenue Code § 7704, a partnership will be classified as a publicly traded partnership if (1) the fund interests are traded on an established securities market or (2) the fund interests are readily tradable on a secondary market or its substantial equivalent.

The big problem is determining when you have a “substantial equivalent” of a secondary market. Under the regulations, the IRS uses a facts and circumstances test to determine if “partners are readily able to buy, sell, or exchange their partnership interests in a manner that is comparable, economically, to trading on an established securities market.” You hate to get into a facts and circumstances discussion with the IRS.

Fortunately there are some safeguards in the implementing regulations at 26 C.F.R. § 1.7704-1.

Involvement of the Partnership

For purposes of section 7704(b), interests in a partnership are not readily tradable on a secondary market or the substantial equivalent unless (1) The partnership participates in the establishment of the market or (2) The partnership recognizes any transfers made on the market by (i) redeeming the transferor partner or (ii) admitting the transferee as a partner.

Since most fund partnerships require the general partner to approve the the transferee and then admit the transferee, they are unlikely to be able to take advantage of this safe harbor.

De Minimis Trading Safeharbor

The focus of a fund should be on the 2% de minimis safe harbor. 26 C.F.R. § 1.7704-1(j) provides for interests in a partnership to be deemed not readily tradable on a secondary market or the substantial equivalent thereof if the sum of the percentage interests in partnership capital or profits transferred during the taxable year of the partnership does not exceed 2 percent of the total interests in partnership capital or profits.

You want avoid having more than 2 percent of the partnership interests changing hands each tax year.

If you get close to that number there are several transfers that are disregarded transfers for this safeharbor, including:

block transfers by a single partner of more than 2% of the total interests
intrafamily transfers
transfers at death
distributions from a qualified retirement plan
Transfers by one or more partners of interests representing 50 percent or more of the total interests in partnership

Private Placement Safeharbor

The regulations deem a transfer to not be a trade if it was a private placement. But the regulations have their own definition of a private placement: (1) the issuance of the partnership interests had to be exempt from registration under the Securities Act of 1933, and (2) the partnership does not have more than 100 partners at any time during the tax year of the partnership. 26 C.F.R. § 1.7704-1(h)

The first prong should be straight-forward for most private funds. The trickier part is the second prong. In some circumstances the IRS can look through the holder of a partnership interest to its beneficial owners and expand the number of partners to include the beneficial holders of that interest.

Passive Income Safeharbor

If a fund is determined to be a Publicly Traded Partnership, it will nonetheless not be taxed as a corporation if 90% or more of the fund’s gross income is passive-type income. [26 U.S.C. § 7704(c)] Passive-type income generally includes dividends, real property rents, gains from the sale of real property, income from mining and oil and gas properties, gains from the sale of capital assets held to produce income, and gains from commodities (not held primarily for sale in the ordinary course of business), futures, forwards, or options with respect to commodities. The income test is on a taxable year basis and must be have been met each prior year.

References:

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Please also see the post on hedge fund compliance and twitter which includes another reprint of a Compliance Building article.

Other related hedge fund law articles include:

Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.

Hedge Fund Events December 2009