On July 21, 2010, President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (the "Dodd-Frank Act")1 into law, almost two years after the collapse of Lehman Brothers, which marked the beginning of a period of extreme stress and volatility in the global capital markets. The Dodd-Frank Act is comprehensive and affects almost all participants in our financial services and banking industries, including banks, depository institutions, holding companies, mortgage lenders, insurance companies, industrial loan companies, broker-dealers, investment advisers, hedge funds and other private investment funds, consumers and numerous federal agencies. Since the Dodd- Frank Act was passed, the Securities and Exchange Commission (the "SEC") and various other agencies, including the Commodity Futures Trading Commission (the "CFTC"), the Federal Reserve Board (the "Federal Reserve"), and the Department of the Treasury, have been busy proposing rules to implement provisions of the Dodd-Frank Act. Meanwhile, private litigants and the SEC continue to sort through the aftermath of the financial disruption as evidenced by recent enforcement and private actions.

This Report provides an update since our last Hedge Fund Report in October 2010 and highlights recent developments, including the Dodd-Frank rulemaking, as well as recent civil and enforcement actions as they relate to the hedge fund industry. Paul Hastings attorneys are available to answer your questions on these and any other developments affecting hedge funds and their investors and advisers.

I. SECURITIES-RELATED LEGISLATION AND REGULATION

A. The Dodd-Frank Rulemaking

In the wake of the unprecedented financial crisis that caused a significant downturn in the global economy in 2008 and 2009, President Obama on July 21, 2010 signed the Dodd-Frank Act into law, in the hope to "restore responsibility and accountability in our financial system to give Americans confidence that there is a system in place that works for and protects them." Since then, various agencies have been focusing on the rulemaking process to implement provisions of the Dodd-Frank Act. Despite the issuance of numerous proposed rules, no final rules implementing the Dodd-Frank Act have been adopted as of the date of this Report. Accordingly, although the Dodd-Frank Act is expected to have significant impact on the financial system in the United States and beyond, the precise impact of Dodd-Frank Act on the investment climate remains uncertain. The following summarizes various proposed rules implementing the Dodd-Frank Act that are most relevant to the hedge fund industry.

1. SEC's Proposed Rules on Private Investment Funds and Their Advisers

On November 19, 2010, the SEC issued a series of proposed rules to implement various provisions of Title IV of the Dodd-Frank Act, including those related to the new exemptions from the registration requirement of the Investment Advisers Act of 1940, as amended (the "Advisers Act"), for certain advisers (the "Proposed Exemption Rules") and those related to various registration and reporting requirements under the Advisers Act (the "Proposed Registration Rules").

New Sections 203(l), 203(m) and 203(b)(3) of the Advisers Act as enacted by the Dodd-Frank Act create new exemptions from registration under the Advisers Act for investment advisers who solely advise "venture capital funds" (the "venture capital fund exemption"), who solely advise "private funds"2 that have less than $150 million in assets under management in the United States (the "private fund exemption"), and who are "foreign private advisers" (the "foreign private adviser exemption"), respectively. Under the Proposed Exemption Rules, the SEC proposed the adoption of Rule 203(l), which would define the term "venture capital fund" for purposes of the venture capital fund exemption; Rule 203(m), which would address several interpretive questions raised by the private fund exemption, including how the private fund exemption should apply to non-U.S. advisers and the method of calculating assets under management; and Rule 202(a)(3), which would define certain terms used in the foreign private adviser exemption, including "client," "investor," "in the United States," "place of business," and "assets under management."

The Proposed Registration Rules address, among others, the reallocation of responsibility for oversight of investment advisers by requiring certain mid-sized advisers (i.e., those that have between $25 and $100 million of assets under management) to register with the states instead of the SEC, as well as the registration of many advisers to hedge funds, private equity funds, and venture capital funds as a result of the repeal of the "private adviser exemption" formerly contained in Section 203(b)(3) of the Advisers Act.

Although comments to both the Proposed Exemption Rules and the Proposed Registration Rules were due on January 24, 2011, the SEC continues to receive comments, and no final rules have yet been adopted. On April 8, 2011, in a letter to North American Securities Administrators Association ("NASAA"), the Associate Director of the SEC, Robert E. Plaze, indicated that the SEC expects to complete rulemaking related to the registration of mid-sized advisers with states and the newly created exemptions noted above by July 21, 2011 in accordance with the Dodd-Frank Act. In addition, the letter indicated that the SEC will also consider extending the compliance date under such rulemaking to first quarter of 2012. Note that as of the date of this Report the SEC has not confirmed such an extension.

On March 15, 2011, Representative Robert Hurt introduced the "Small Business Capital Access and Job Preservation Act" ("H.R. 1082"), which would amend the Advisers Act to provide an exemption from the registration requirement imposed on certain private equity fund advisers by the Dodd-Frank Act. H.R. 1082 was referred to the House Committee on Financial Services on March 15, 2011 and to the Subcommittee on Capital Markets and Government Sponsored Enterprises on April 4, 2011.

Additional information on the Proposed Exemptions Rules and the Proposed Registration Rules is available here.

2. SEC's Recently Released Study on Investment Adviser Examination

n January 19, 2011, the SEC released its "Study on Enhancing Investment Adviser Examination" (the "Study") as mandated by Section 914 of the Dodd-Frank Act. The SEC was required to conduct a study to review and analyze the need for enhanced examination and enforcement resources for investment advisers. The Study was organized in five parts: (1) the SEC's examinations of registered investment advisers' books, records and activities; (2) the number and frequency of examinations of registered investment advisers over the past six years; (3) the impact of the Dodd-Frank Act on the number and examinations of registered investment advisers; (4) options that Congress should consider in order to strengthen the SEC's investment adviser examination program; and (5) the SEC staff's recommendations respecting the examination capacity concerns identified earlier in the Study.

The SEC staff reported that over the past six years, the number of registered investment advisers had increased 38.5%, from 8,581 advisers to 11,888 advisers, and assets managed by registered investment advisers grew 58.9%, from $24.1 trillion to $38.3 trillion, while the number of SEC staff dedicated to examining registered investment advisers decreased 3.6%, from 477 staff members to 460 staff members. As a result, the number of adviser examinations conducted each year over the past six years decreased 29.8%, from 1,543 examinations in 2004 to 1,083 examinations in 2010, and only 9% of registered investment advisers were examined in 2010, a decrease from 18% in 2004. While the SEC staff expects a significant near-term decrease in the number of registered investment advisers because of the increased threshold of $25 million to $100 million for registration with the SEC, the staff also believes that the SEC will still face "significant capacity challenges." To address these challenges, the SEC staff proposed three options: (1) the imposition of "user fees" on SECregistered investment advisers to fund the investment adviser examination program; (2) the authorization of one or more self-regulatory organizations to examine, subject to SEC supervision, all SEC-registered investment advisers; or (3) the authorization of Financial Industry Regulatory Authority, Inc. ("FINRA") to examine dual registrants for compliance with the Advisers Act. Commissioner Elisse Walter released a statement expressing her disappointment with the results of the study.

Additional information on the Study is available here.

3. SEC's and CFTC's Joint Proposal to Adopt Form PF for Private Fund Advisers

On January 25, 2011 and January 26, 2011, the SEC and the CFTC jointly proposed the adoption of Form PF to implement certain provisions of Title IV of the Dodd-Frank Act. The SEC proposed Rule 204(b)-1 under the Advisers Act, under which SEC-registered investment advisers that advise one or more private funds ("Private Fund Advisers") would be required to report certain risk, leverage and financial information regarding those private funds on the newly created Form PF. Similarly, the CFTC proposed Regulation 4.27, under which Private Fund Advisers that are also registered with the CFTC as commodity pool operators ("CPOs") and/or commodity trading advisors ("CTAs") with the CFTC would be required to file Form PF in respect of any private funds advised by such dual registrants.

The amount of information required to be reported and the frequency of the reporting by an adviser are dependent on the assets under management and the types of private funds managed by the adviser. It is anticipated that most Private Fund Advisers would be subject to the lower reporting requirements. The information to be collected on Form PF is intended to assist the Financial Stability Oversight Council ("FSOC") in monitoring the potential systemic risks posed by private funds.

Additional information on proposed Form PF is available here.

CFTC's Proposal to Adopt Amendments to Compliance Obligations of CPOs and CTAs

On January 26, 2011, the CFTC proposed amendments to the compliance obligations of CPOs and CTAs that, among others, would rescind or modify several CFTC registration exemptions and exclusions commonly relied upon by private investment fund sponsors (the "CPO/CTA Amendments"). Specifically, the CPO/CTA Amendments would rescind the exemption from CPO registration for operators of commodity pools that have limited futures activity as set forth in CFTC Regulation 4.13(a)(3), and the exemption for operators of commodity pools that restrict participation to certain sophisticated investors as set forth in CFTC Regulation 4.13(a)(4). Many sponsors of private investment funds currently rely on these exemptions.

The CPO/CTA Amendments would also reinstate trading criteria for registered investment companies claiming an exclusion under CFTC Regulation 4.5 such that such investment companies could neither be marketed as vehicles for gaining commodity exposure, nor engage in more than a de minimis amount of futures and options activity (other than for bona fide hedging purposes) without first registering as CPOs with the CFTC. This could also have the consequence of requiring advisers to such registered investment companies to register as CTAs with the CFTC.

The CFTC separately proposed the CPO/CTA Amendments shortly after the announcement of the joint proposal on Form PF with the SEC as discussed above. The CFTC believes that the CPO/CTA Amendments are necessary in order to oversee participants in the commodity futures and derivatives markets effectively better in light of the recent economic turmoil and that they are consistent with the spirit of the Dodd-Frank Act.

Additional information on the CPO/CTA Amendments is available here.

5. SEC's Approval of Interagency Proposal on Inventive-Based Compensation Arrangements

On March 2, 2011, as part of a joint rulemaking effort with various other agencies, the SEC proposed rules to implement Section 956 of the Dodd-Frank Act with respect to incentive-based compensation practices at "covered financial institutions"3 with assets of no less than $1 billion (the "Proposed Incentive-Based Compensation Rules").

Under the Proposed Incentive-Based Compensation Rules, a "covered financial institution" would include, in the case of the SEC, a broker-dealer registered under Section 15 of the Securities Exchange Act of 1934, as amended (the "Exchange Act"), and an "investment adviser," as such term is defined in Section 202(a)(11) of the Advisers Act, whether or not the investment adviser is registered under the Advisers Act.

The Proposed Incentive-Based Compensation Rules have four major components: (1) the prohibition against incentive-based compensation arrangements at a covered financial institution that encourage executive officers4, employees, directors5, or principal shareholders (collectively, "covered persons") to expose the institution to inappropriate risk by providing the covered persons with excessive compensation; (2) the prohibition against a covered financial institution establishing or maintaining any incentive-based compensation arrangements for covered persons that encourage inappropriate risks by the covered financial institution that could lead to material financial loss; (3) the requirement that a covered financial institution adopt policies and procedures appropriate to its size, complexity, and use of incentive-based compensation to help ensure compliance with the requirements and prohibitions contained in the Proposed Incentive-Based Compensation Rules; and (4) the requirement that a covered financial institution report annually certain information to its appropriate federal regulator(s) concerning its incentive-based compensation arrangements for covered persons.

In addition, the Proposed Incentive-Based Compensation Rules would also establish a deferral requirement applicable to larger covered financial institutions (i.e., generally those with $50 billion or more in total consolidated assets) mandating that at least 50 percent of the incentive-based compensation of an executive officer be deferred over a period of at least three years. Since the SEC approved the Proposed Incentive-Based Compensation Rules, all remaining participating agencies have also approved the proposed rule release, and comments are to be received by the respective participating agencies by May 31, 2011.

Additional information on the Proposed Incentive-Based Compensation Rules is available here.

6. Federal Reserve's Proposed Rule Relating to Nonbanking Financial Companies

On February 8, 2011, the Federal Reserve requested comments to a proposed rule, which would establish the requirements for determining if a company is "predominantly engaged in financial activities" for purposes of Title I of the Dodd-Frank Act and would define the terms "significant nonbank financial company" and "significant bank holding company." The proposed rule is relevant to provisions of the Dodd-Frank Act, including Section 113, which authorizes FSOC to require a "nonbank financial company" to be subject to consolidated, prudential supervision by the Federal Reserve if FSOC determines that material financial distress at or activities of the company could pose a threat to the financial stability of the United States.

Section 113 also provides a number of criteria that FSOC must consider in determining whether a company poses systemic risks and should be subject to the supervision of the Federal Reserve. FSOC has also recently requested comments on a proposed rule implementing Section 113 of the Dodd- Frank Act. Because the Federal Reserve defines those terms broadly, the proposed rule may capture, among others, the largest hedge funds and private equity funds.

Additional information on the Federal Reserve's proposed rule relating to nonbanking financial companies is available here.

B. Other New and Proposed Securities-Related Legislation and Regulation

1. DOL's Proposal to Expand Definition of "Fiduciary"

On October 21, 2010, the Department of Labor (the "DOL") issued a proposed rule that would amend a 1975 regulation to define "fiduciary" more broadly as a person who provides investment advice to plans for a fee or other compensation for purposes of the Employee Retirement Income Security Act of 1974, as amended ("ERISA").

The existing 35-year-old regulation creates a five-part test that must be satisfied in order for a person to be treated as a fiduciary by reason of rendering investment advice. The proposed rule would replace the five-part test with one that is easier to satisfy as a result of, among others, the elimination of the requirement that the advice is provided on a regular basis and the broadening of the types of activities that would constitute investment advice. As a result of the expanded definition of "fiduciary," various hedge fund industry participants, including hedge fund investment advisers, placement agents, appraisers and valuation firms, and pension plan consultants, could be affected. The DOL proposed the change because it believes that the existing regulation may inappropriately limit the types of investment advice relationships that give rise to fiduciary duties on the part of the investment adviser in light of significant changes in the marketplace, the increased types and complexity of investment products and services available to plans, and the changes in the relationships between the advisers and their plan clients. Comments to the proposed rule were initially due on January 20, 2011, but due to the large number of comments received, the DOL has extended the comment period to April 12, 2011, 15 days after the official transcript of the March 1-2, 2011 hearing was posted on DOL's website on March 28, 2011.

Additional information on the DOL's proposal to expand the definition of fiduciary is available here.

2. Delayed Effective Date of DOL's ERISA Regulations on Fee Disclosure

On July 16, 2010, the DOL published an interim final regulation under Section 408(b)(2) of ERISA that requires improved disclosures by service providers to facilitate pension plan fiduciaries in assessing the reasonableness of the compensation to be paid to service providers and potential conflicts of interest that may affect the performance of services to be provided. The interim final regulation was to take effect on July 16, 2011. However, on February 11, 2011, the DOL announced that it intends to extend the effective date for the new disclosure rules to January 1, 2012 to ensure a careful review of comments received by the DOL as well as sufficient time for plans and service providers to engage in compliance efforts.

3. FINRA's New Rule 5131 on New Issue Allocation and Distribution

On September 29, 2010, the SEC approved the adoption of FINRA Rule 5131. The National Association of Securities Dealers, Inc. (NASD) initially proposed the rule on September 13, 2003, which was subsequently amended four times. On November 29, 2010, FINRA issued Regulatory Notice 10-60 setting the effective date of the new rule as May 27, 2011. The new rule establishes certain requirements with respect to the allocation, pricing and trading of new issues (i.e., an initial public offering ("IPO") of an equity security as defined in Section 3(a)(11) of the Exchange Act made pursuant to a registration statement or offering circular). The new rule does not replace, but rather supplements, existing FINRA Rule 5130. In particular, the new rule prohibits the allocation of new issues by a FINRA member in order to obtain a "kick back" in the form of executive compensation relative to other services offered by the FINRA member (the so-called quid pro quo allocation), as well as the allocation of new issues by a FINRA member to any prohibited account, i.e., an account in which an executive officer or director of a public company or a covered non-public company6, or a person materially supported by such executive officer or director, has a beneficial interest, if the company is a current or certain former or prospective investment banking client of such FINRA member (an activity known as "spinning"). The new rule also regulates the conduct of FINRA members in the IPO process, including the practice of "flipping," reports of indications of interest to an issuer's pricing committee, and the application of lock-up agreements. Additional information on the new FINRA Rule 5131 is available here .

C. Other Updates

1. The Emergency Mortgage Relief and Neighborhood Stabilization Programs Cost Recoupment Act of 2011

On March 17, 2011, Representative Barney Frank introduced "The Emergency Mortgage Relief and Neighborhood Stabilization Programs Cost Recoupment Act of 2011" (the "Recoupment Act"), which was referred to the House Committee on Financial Services. The Recoupment Act would amend the Dodd-Frank Act to direct the Secretary of the Treasury, in order to recoup the amount of assistance made available under the Emergency Mortgage Relief and Neighborhood Stabilization Programs, to make risk-based assessments in the total amount of $2.5 billion on (1) financial companies that manage hedge funds with $10 billion or more in assets under management on a consolidated basis; and (2) other financial companies with $50 billion or more in total consolidated assets, subject to terms and conditions that the Secretary of Treasury may establish with the concurrence of certain other agencies. A similar proposal was introduced in the last Congress but did not receive enough support to become law. Additional information on the Recoupment Act is available here.

2. NASAA's Proposed Changes to Model Rules on Custody and Brochure Delivery Requirements for State Investment Advisers

On February 17, 2011, the comment period (14 days until March 2, 2011) began for the proposed changes to the NASAA Model Rules on investment adviser custody, financial requirements, recordkeeping and brochure delivery. The proposed changes to the NASAA Model Rules were prompted by the recent changes to the SEC custody rules and the SEC brochure rules applicable to SEC-registered advisers. Among other things, the proposed changes to the NASAA Model Rules would clarify or add certain definitions and clarify or modify certain requirements applicable to state investment advisers, all of which are intended to preserve the increased investment protection afforded by states while making the NASAA Model Rules more consistent with the current SEC custody to the NASAA Model Rules is available here.

3. EU AIFM Directive

In response to the world financial market meltdown in 2008, the European Commission first unveiled a draft Directive on Alternative Investment Fund Managers (the "AIFM Directive") on April 30, 2009. The AIFM Directive is aimed to create a comprehensive and effective regulatory and supervisory framework for alternative investment fund managers ("AIFM"), which encompass managers to hedge funds, private equity funds, real estate funds and a wide range of other types of institutional funds. On November 11, 2010, after months of difficult negotiations, the European Union ("EU") Parliament by a very large majority vote approved the final text of the AIFM Directive. Subject to the formal approval by the European Council, the AIFM Directive is expected to become effective in early 2011 and be applied to members of the EU by 2013.

One of the most important concepts introduced by the AIFM Directive is the "passport," or a "single market framework," concept, which allows AIFMs to manage and/or market funds throughout the EU with the authorization of only one single EU member state. Although the stated goal of the AIFM Directive is to regulate AIFMs within the EU, as suggested by the title of the directive, the AIFM Directive also provides for regulation of funds and will have significant impact on fund service providers, and the reach of the AIFM Directive goes beyond the territory of the EU. According to a recent poll conducted by PricewaterhouseCoopers, LLC, the vast majority of AIFMs did not have a plan to implement the mandates of the AIFM Directive. As the AIFM Directive draws closer to becoming effective, AIFMs should begin considering the impact of the AIFM Directive on their businesses and the actions they may need to take in response to this comprehensive regulatory framework. Additional information on the final rules on shareholder proxy access is available here.

II. TAXATION

One of the noteworthy tax developments since our last Report relates to President Obama signing into law the Tax Relief, Unemployment Insurance Reauthorization, and Jobs Creation Act of 2010 (the "Act"). The Act extends all Bush-era tax cuts for two additional tax years (through December 31, 2012), along with other important "tax extenders". Note that the Act does not include provisions addressing the taxation of "carried interests" or the S-Corporation self-employment ("SE") tax. With a new Republican-controlled House in 2011 and 2012, it seems unlikely that the "carried interest" or the S-Corporation SE tax provisions will be repealed during this session of Congress.

The Act and the shift in political power in Congress should translate to positive news for investment advisers. Managers can continue to structure private funds with profit allocation provisions that can take advantage of favorable long term capital gain tax rates.

To read this article in full please click here.

The content of this article does not constitute legal advice and should not be relied on in that way. Specific advice should be sought about your specific circumstances.