Financial Services Quarterly Report

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Financial Services Quarterly Report

  1. 1. Third Quarter 2009 In this issue Financial Services Quarterly Report Greater China and Asian Developments Greater China and Asian have promulgated new rules that permit fund management companies (including foreign Chinese Regulators Expand the Onshore Segregated Account Management Developments asset management joint ventures1) to provide Business; Cross-Border Fund segregated account management services to Raising Within ASEAN; Chinese Regulators Expand the multiple clients on a “collective account” basis The Minibond Saga p.1 Onshore Segregated Account (“Collective Investment Accounts”). Through Collective Investment Accounts, fund manage- The Shape of U.S. Financial Management Business ment companies may offer non-retail, alternative Regulatory Reform: Early Indications Based on the investment strategies to a limited number of Obama Administration’s qualified PRC investors. This development Proposals p.8 has been hailed by the PRC fund management industry as a means by which managers may Dechert Responds to Call for Evidence Regarding Draft EU expand and diversify their businesses to provide Directive on AIFM sophisticated strategies to the PRC’s burgeoning p.12 institutional and high net worth investor com- Extended Powers of the by Keith T. Robinson, Henry Wang and munities. German Regulator p.15 Derek B. Newman Background FAS 167: New Balance Sheet Until very recently, fund management Consolidation Requirements for Private Equity Fund and companies in the People’s Republic of China In November 2007, the China Securities Regula- Hedge Fund Managers (“PRC”) had not been permitted to offer tory Commission (“CSRC”) promulgated the Trial p.18 discretionary investment management services Measures for Fund Management Companies to to PRC investors other than through authorized Provide Asset Management Services for Specific retail mutual funds. However, PRC regulators Clients (“Account Management Measures”). d
  2. 2. D The Account Management Measures, which became ment Accounts pursuant to a written asset manage- effective on 1 January 2008, allow fund management ment contract, the contents of which are prescribed companies to provide wealth management services by the Contract Rules. With respect to fees, the to certain qualified investors through segregated Account Management Measures prescribe minimum account platforms. In addition to Collective Invest- management fees and maximum performance fees. ment Accounts, accounts may also be established for For example, management fees for Collective Invest- individual clients. To facilitate the establishment of ment Accounts cannot be lower than 60% of the corre- Collective Investment Accounts, the CSRC released the sponding fee rate for similar retail funds offered by the Rules on Relevant Issues in Relation to Fund Manage- same manager, while performance fees cannot exceed ment Companies Conducting Specific Multiple Client 20% of net profits. Asset Management Business (“Management Rules”) on Collective Investment Accounts may invest in a broad 5 May 2009, and the Standards Concerning the Con- array of securities and instruments (i.e., stocks, tent and Format of Multiple Client Asset Management bonds, investment funds, asset-backed securities and Contracts (“Contract Rules”) on 4 August 2009. financial derivatives) and have the same permitted investment scope as public QDII funds. While Col- Requirements for Establishing lective Investment Accounts will not be subject to the Collective Investment Accounts diversification and concentration limitations applicable In order to provide Collective Investment Account to public QDII funds, the Management Rules impose services, a fund management company must apply general diversification requirements.2 In addition, the to the CSRC for approval and meet certain quantita- CSRC has recently permitted fund management com- tive and qualitative standards. Currently, the CSRC panies to use their excess or unused QDII quotas for only permits fund management companies that are segregated account overseas investment.3 qualified under the Qualified Domestic Institutional The Account Management Measures and the Manage- Investor (“QDII”) program to provide Collective Invest- ment Rules also contain several provisions with respect ment Account services. In addition to meeting the to the operations of Collective Investment Accounts. QDII requirements for assets under management, fund For example, fund management companies must management companies generally must have at least take steps to mitigate conflicts of interest, including two years of experience managing investment funds, conflicts inherent in side-by-side management of retail properly qualified personnel, appropriate compliance and non-retail products. Furthermore, in order to policies and risk management procedures and a clean ensure adequate transparency, the Collective Invest- record. ment Accounts and their managers must observe vari- Once approved by the CSRC, a fund management com- ous record-keeping and reporting requirements (e.g., pany may establish Collective Investment Accounts. the fund management company must file quarterly Although CSRC approval is not required on an account- reports, and must calculate and disclose to investors by-account basis, the fund management company the net asset value at least monthly). must file various account documents with the CSRC Distribution of Collective Investment for record-keeping purposes. Each account may have Account Interests up to 200 investors, who are “qualified clients.” Pur- suant to the Management Rules, a client is “qualified” Collective Investment Accounts are prohibited from if it is able to invest not less than renminbi (“RMB”) conducting public marketing activity. Accordingly, 1 million in the Collective Investment Account, and is investors should be solicited strictly on a traditional able to identify, judge and accept the investment risks. private placement basis (e.g., fund management Collective Investment Accounts must also have initial companies and their sales agents should refrain from assets of at least RMB 50 million before they can marketing interests via newspaper, television, radio, begin operations. internet or any other public medium). In addition, subscription materials and know-your-client proce- Management of Collective Investment dures should be used to properly screen investors. Accounts The Management Rules also permit fund management companies to engage properly licensed third-party Fund management companies must provide asset distributors to market Collective Investment Account management and other services to Collective Invest- interests. 2 Third Quarter 2009
  3. 3. D Conclusion Cross-Border Fund Raising Through Collective Investment Accounts, fund man- Within ASEAN agement companies (including foreign asset manage- ment joint ventures) may offer sophisticated PRC by Angelyn Lim and investors exposure to various alternative investment Kher Sheng Lee strategies and asset classes, while the regulations seek to ensure that fund management companies Background implement appropriate procedures with respect to the offering and operation of these products. These In October 2008, the developments provide a welcome opportunity for the ASEAN Capital Mar- continued expansion of the onshore asset manage- kets Forum (“ACMF”)1 adopted the ASEAN and Plus ment business in the PRC. Standards Scheme (the “Scheme”), applicable to cross-border offerings of securities within the ASEAN2 _____________________ nations. The Scheme seeks to facilitate multi-juris- 1 Foreign asset managers may establish a presence in China dictional share or debt offerings across the different by setting up a foreign asset management joint venture. ASEAN nations. According to industry reports, there are approximately 32 such joint ventures, and the number is expected to The timeframe for the adoption of the Scheme allows increase. Dechert LLP is preparing and will publish an each member nation to opt-in on a when-ready basis. OnPoint that provides detailed information with respect to In June 2009, Malaysia, Singapore and Thailand foreign asset management joint ventures. (being three out of four of the region’s largest econo- 2 According to industry reports, the CSRC issued the Reply mies, with Indonesia yet to opt-in) became the first for Opening Offshore Asset Management Business for Seg- three member nations to opt into the Scheme. This regated Accounts by Fund Management Companies (the article highlights salient features of the Scheme and “Reply”) on 9 March 2009, which provides guidelines with respect to overseas investments by Collective Investment what this may mean for global investors and asset Accounts. The Reply is a non-public letter that was issued managers. to the Bank of Communications Schroder Fund Manage- ment in response to its queries. Drive Toward Economic Integration 3 QDII funds sponsored by fund management companies are permitted to invest in a wide range of offshore investment The Scheme has been introduced against the politi- products. However, such QDII funds are subject to restric- cal backdrop of ASEAN’s stated vision to achieve tions on “investment proportions” (e.g., no more than 10% European-style economic integration. ASEAN leaders of a QDII fund’s assets may be invested in the securities approved a roadmap for an integrated ASEAN market of a single issuer, or in illiquid securities). at the 40th-anniversary summit of ASEAN in 2007, Keith T. Robinson targeting the creation of an ASEAN Economic Commu- Hong Kong nity (“AEC”) by 2015. The aim of the AEC is to allow +852 3518 4705 the free movement of goods, services, investment and keith.robinson@dechert.com skilled labour, and freer flow of capital by the target- date. Henry Wang Beijing +8610 5829 1318 henry.wang@dechert.com Derek B. Newman Hong Kong +852 3518 4713 derek.newman@dechert.com Third Quarter 2009 3
  4. 4. D Tangible efforts have already been undertaken on  The second is a set of additional standards called some fronts to create a single integrated marketplace. the Plus Standards that may be prescribed by ASEAN member nations have been progressively re- the respective ASEAN jurisdictions to accommo- ducing intra-group trade barriers. On 1 January 2010, date local market practices, laws or regulations ASEAN will take a big step toward becoming a free that cannot yet be harmonised or reduced to the trade area, with zero tariffs on most products originat- ASEAN Standards. This will serve as the jurisdic- ing from Indonesia, Malaysia, the Philippines, Singa- tion-specific “wrapper” to accompany the baseline pore, Thailand and Brunei Darussalam3. disclosures in the ASEAN Standards. In the 1990s, the economies of South-east Asia – led An offer by an issuer in one ASEAN member country by the region’s five main “Asian Tiger” economies of which has adopted the Scheme, say Malaysia, and at Indonesia, Malaysia, the Philippines, Singapore and least one other ASEAN member country, say Singa- Thailand – were humming along as the world’s fastest- pore, which has adopted the same, will have to comply developing region. However, since the Asian financial with the baseline ASEAN Standards as the starting crisis of 1997-1998, and with the recent rise of China point. For the offer in Malaysia, the issuer must ad- and India, ASEAN has been perceived to be in a collec- ditionally comply with Malaysia’s Plus Standards in tive state of drift. respect of disclosures to investors in Malaysia. Simi- larly for the offer in Singapore, the issuer needs to also As such, the recent developments are perceived to comply with Singapore’s Plus Standards in respect of have been driven by the realisation amongst ASEAN disclosures to investors in Singapore. leaders that the region needs to repackage itself once again into an attractive financing and investment This is in contrast to the current situation where an destination, in order to stay economically relevant to issuer seeking to conduct multi-jurisdiction offerings global investors and asset managers, or risk trailing in ASEAN must separately comply with each jurisdic- further behind China and India. The Scheme has been tion’s full list of disclosure requirements. The ACMF promoted by the ACMF as one of the capital market envisages that the Scheme will improve efficiency and initiatives under a broader plan to drive the AEC vision bring about cost savings for such multi-jurisdiction forward. offerings. In implementing the Scheme, there are likely to be Brief Features of the Scheme early problems as overly cautious local regulators and The Scheme applies to multi-jurisdiction offerings securities exchanges may choose (taking into account within ASEAN that require the registration of prospec- the specific issuer profile and characteristics of the tuses or registration statements and applies to any offer) to impose disclosure requirements above and issuer (whether or not based in ASEAN) making such beyond the minimum which have been promulgated. offerings within ASEAN. It aims to facilitate cross- This may mean, depending on the additional require- border offerings of securities within the ASEAN region ments for which compliance is requested or directed by harmonising disclosure requirements. The Scheme by local regulatory authorities, that an issuer may have currently only applies to offers of equity and debt to contend with local specific disclosures in addition securities. to the relevant Plus Standards. The Scheme introduces two disclosure standards to be Further, while the Scheme appears to usher in a set complied with by issuers: of pan-ASEAN disclosure standards, the track record to date of ASEAN regulatory bodies in competing  The first is a baseline set of common require- against, rather than co-operating with, one another ments called the ASEAN Standards. The ASEAN may be an impediment to the success of the Scheme. Standards are based closely on standards of The ideal result would be to have a single set of global cross-border offerings set by the International Or- and comprehensive standards for pan-ASEAN applica- ganization of Securities Commissions (“IOSCO”).4 tion. But as this cannot yet be achieved, the Scheme It fully adopts the International Financial Report- may be an expedient step towards creating an over- ing Standards and the International Standards on arching framework for ASEAN regulatory bodies to Auditing. recognise each other’s regimes, so as to reduce the overall costs to issuers contemplating multi-jurisdic- tional offerings. 4 Third Quarter 2009
  5. 5. D A New Economic Era for ASEAN? It should also make ASEAN securities more attractive as an asset class to global investors and asset manag- Sandwiched geographically between the two prosper- ers, by harmonising and raising disclosure standards ing Asian giants of China and India, ASEAN is well amongst member nations to an international level as positioned to broaden and complement the trade and embodied by the IOSCO standards. investment flows in Asia. It is resource-rich, and has _____________________ abundant labour and plentiful land. If the AEC 2015 vision does take shape in one form or the other5, 1 The ACMF was established under the auspices of the the ten-nation-strong ASEAN bloc with a combined ASEAN Finance Ministers in 2004 to serve as a forum for market of more than half a billion people (larger than the heads of securities regulators in the ASEAN region to discuss policy issues relating to capital markets develop- Europe’s population) could become a force to reckon ment including the goal of harmonising differences in with on the global stage. securities law. The recent robust increase in domestic demand and 2 The Association of South-East Asian Nations, or ASEAN, the emergence of a larger middle class of consumers is a ten-member regional group of nations which currently are likely to create increased financing and investment comprises Indonesia, Malaysia, the Philippines, Singapore, Thailand, Brunei Darussalam, Vietnam, Lao PDR, Cambo- opportunities in the coming years. As such, ASEAN dia and Myanmar. can represent an outstanding source of growth and diversification for global investors and asset manag- 3 As another illustration of concrete measures toward ers. As ASEAN forges its own path to grow alongside closer integration, ASEAN has also pledged to introduce a full open-sky arrangement to the region by 2015. In China and India, global players may wish to adopt a the meantime, airspace and travel restrictions have been “prepare-and-decide” ASEAN strategy, by adopting eased to allow destinations to be serviced by more flights toehold positions, building positions where appropri- which, in turn, has spawned the arrival of low-cost air ate, anticipating strategic shifts, and being prepared travel, thereby boosting the tourism and leisure industries. to move early to implement investment policy. 4 International Disclosure Standards for Cross-Border Of- ferings and Initial Listings by Foreign Issuers (1998) in respect of offerings of equity securities, and International Disclosure Standards for Cross-border Offerings and If the AEC 2015 vision does take shape in Listings of Debt Securities by Foreign Issuers (2007) in respect of offerings of debt securities. one form or the other, the ten-nation-strong 5 ASEAN is seldom held up as a model of implementation ASEAN bloc with a combined market of due to its adherence to the principles of consensus and more than half a billion people (larger than non-intervention in member states’ affairs. Doubts have been expressed by some pundits as to whether the AEC Europe’s population) could become a force 2015 vision can be successfully realised by the ambitious to reckon with on the global stage. target-date or it will be a victim of political backsliding. 6 There have been suggestions to add Indonesia, which is the largest ASEAN nation by territory and population, to the term BRIC (first used in 2001 to refer to the new There are already signs that institutional investor wave of emerging markets of Brazil, Russia, India and interest may be returning to ASEAN. The recent re- China), or to coin a new term “Chindonesia”, grouping election of pro-business President Susilo Bambang China, India and Indonesia together, since they generate Yudhoyono has brought Indonesia into focus6. Eco- economic activity close to approximately 45% of the U.S. economy. nomic policy liberalisation and restructuring measures announced in Malaysia under the new reform-minded Angelyn Lim prime minister, Najib Razak (including dismantling Hong Kong of race-based investment quotas and opening up the +852 3518 4718 financial services sector to increased foreign partici- angelyn.lim@dechert.com pation) have also been welcomed in financial circles. Kher Sheng Lee In this context, the Scheme is an important Hong Kong milestone towards fulfilling the broader AEC 2015 +852 3518 4708 vision by deepening the combined ASEAN capital khersheng.lee@dechert.com markets, and making these markets more accessible to global issuers. Third Quarter 2009 5
  6. 6. D The Minibond Saga: The Final Terms of the Settlement/Repurchase Installment? Scheme The terms of this latest settlement are as follows: by Angelyn Lim and Kher Sheng Lee  The 16 banks will repurchase from investors all outstanding Lehman Brothers Minibonds at 60 Background to 70% of their original value – Minibond holders under the age of 65 years will receive 60%, and The sale to retail inves- those over 65 years of age will receive 70%, of the tors in Asia (primarily, in value of their initial investment, and all will be en- Hong Kong, Taiwan and Singapore) of structured credit titled to retain any coupon payments made to date. derivatives linked to Lehman Brothers and the ensu- ing events have been described in our previous client  In the event that the banks/distributors eventually bulletins and quarterly reports.1 Briefly, the collapse recover any of the underlying collateral, they must of Lehman Brothers in September 2008 resulted in the pay up to an additional 10% of the nominal value Minibonds losing almost all of their value, investors of Minibonds to eligible customers. taking to the streets in protest and regulators being brought to task.  Commissions earned by the banks from the sale of the Minibonds (reportedly amounting to approxi- In Hong Kong, the matter was further politicised by the mately HK$200 million) will be paid to a fund to Legislative Council exercising its special investigative be utilised to assist in the recovery of the underly- powers to focus on the role played by regulators in ing collateral. allowing the products to be made available on the retail market. In turn, the relevant regulators, the Securities  The banks will implement “special enhanced and Futures Commission (“SFC”) and the Hong Kong complaints handling procedures” regarding other Monetary Authority (“HKMA”) – the latter being the structured products. primary regulator of banks that had been the main dis- tributors of the Minibonds – swung into action to begin  Each bank is to appoint an independent reviewer investigations into the distribution processes, internal (to be approved by the SFC and HKMA) and quali- control measures and other operational issues within fied third parties to review the bank’s systems the banks and other intermediaries that had distrib- and processes relating to the sale of structured uted the Minibonds. products, issue a report to the SFC and the HKMA and commit to the implementation of all recom- The investigations were high-profile and resulted, mendations by the independent reviewer. beginning in January 2009, in the first of a series of intermediaries and banks that had distributed these Lessons Learnt? products to retail customers, agreeing with the regula- tors to provide complete or substantial restitution to Since the events unfolded in Hong Kong in September the aggrieved investors and improving their internal of last year, the regulators have sought to scrutinize control measures in order to reach a “settlement” of the distribution and internal processes of all known sorts in relation to the investigations. distributors of the Minibonds in light of investor complaints of unacceptable selling techniques and In July of this year, the SFC and the HKMA reached an alleged misrepresentation by banking staff as to the agreement with a group of 16 banks in Hong Kong un- true nature of the Minibonds. The investigations der which the banks would make partial compensation revealed that there was some truth in many of the to those of their customers who had invested in the allegations, exposing lapses in compliance with regu- Minibonds, in an aggregate amount of HK$6.3 billion latory requirements already imposed (under existing (approximately US$ 808 million). This is the first time SFC practice codes and guidelines) on distributors of a mass settlement of this nature has been reached in investment products to ensure appropriate investor Asia and is also significant given the amount of com- and product vetting, and, by extension, product suit- pensation agreed to. ability for each relevant investor. 6 Third Quarter 2009
  7. 7. D Given the details of the compensation package agreed regime on all authorized retail funds that is widely to by the 16 banks (with each investor receiving at regarded as a reaction to the Minibond crisis. least 60% of his initial investment), it would be rea- sonable to assume that the allegations had exposed a weak spot in the banks. With the distribution of retail products generally coming under public scrutiny, and This is the first designated regulation of given the extent of losses incurred by retail investors unlisted structured products in Hong Kong. in the Minibonds, many banks (including unaffected ones) had already commenced their own investigations into their internal processes in anticipation of more Going forward, it is now accepted that the regulation formal regulatory probes. There have been murmur- of financial intermediaries and retail products will ings that the practices that led to the mis-selling of only increase. A long overdue initiative by the SFC to the products scandal resulted from somewhat less regulate structured products that commenced this stringent requirements being imposed by the HKMA year was most likely also, at least in part, a reaction to on banks than by the SFC directly on SFC-licensed the events surrounding the Minibond scandal. A con- distributor intermediaries. sultative draft of a new Code on Unlisted Structured With the settlement, some of the pressure should ease Products was issued at the end of September. This is off the banks from both the investors and regulators the first designated regulation of unlisted structured (although some investors are holding out for greater products in Hong Kong. or full compensation). Executive man-hours previously The SFC has also, at the same time, issued for public spent managing the investigation and related issues consultation, drafts of proposed revisions to the exist- can now be more productively spent on business ing Code on Unit Trusts and Mutual Funds and Code needs. The share price of most listed distributors rose on Investment-Linked Assurance Schemes. The SFC after the settlement was announced since the SFC had has announced an intention to align all three codes not only ended its inquiry into Minibonds at the 16 such that standards required of players across these banks, but had also suspended investigation of other products will be consistent, with a view to ensuring products from those banks. The investigations of that no retail products fall between the cracks.2 three other banks, which were not part of the payout settlement because they sold Lehman-related products In addition to the increased focus on staff training and other than Minibonds, continue. internal risk and compliance controls, there has been commentary suggesting that there should be a super- regulator in Hong Kong to ensure a level playing field for all financial services intermediaries. The general Going forward, it is now accepted that the sense in the industry, however, is that this is unlikely to regulation of financial intermediaries and materialize in the near future. retail products will only increase. _____________________ 1 Please refer to http://www.dechert.com/library/Finan- cial%20Services%20Report%20-%2003_09.pdf and The mass settlement sets a precedent for the regula- http://www.dechert.com/library/FS%20_1_01_09_Hong_ Kong_Securities.pdf. tors, raising the prospect of similar settlements with distributors of similar products such as equity-linked 2 Dechert LLP is preparing and will publish an OnPoint that notes and accumulators where retail investors have provides detailed information with respect to these draft also suffered losses following alleged mis-selling by Codes. distributors. Angelyn Lim There is certainly more caution in the air now in Hong Hong Kong Kong as regards retail product distribution, and bonds +852 3518 4718 in particular. A recent proposed offering of Renminbi- angelyn.lim@dechert.com denominated bonds did not prove as popular as had Kher Sheng Lee been anticipated. As far as mutual funds are con- Hong Kong cerned, the SFC imposed an enhanced disclosure +852 3518 4708 khersheng.lee@dechert.com Third Quarter 2009 7
  8. 8. D The Shape of U.S. Financial The clearest picture of the likely reforms is found in the Obama administration’s financial reform propos- Regulatory Reform: Early als. These proposals were previewed in a Treasury Indications Based on the white paper “Financial Regulatory Reform, A New Foundation: Rebuilding Financial Supervision and Obama Administration’s Regulation” released in mid-June, and fleshed out in Proposals more than 600 pages of legislative text, comprising 13 separate titles, that were released over the ensuing by David J. Harris* weeks. This article provides a brief summary of those 13 titles, while highlighting those provisions most Many would say that the financial likely to be of interest and relevance to the investment crisis reached its high point (or management industry. depending upon your perspective, low point) more than a year ago with the failure of Lehman Brothers, which Not surprisingly, given both the severity was quickly followed by The Reserve’s Primary Fund “breaking the buck” and the U.S. Government’s of the financial crisis and the billions of acquisition/bailout of AIG. Not surprisingly, given tax dollars spent in an effort to prevent the both the severity of the financial crisis and the billions crisis from worsening, calls for substantial of tax dollars spent in an effort to prevent the crisis from worsening, calls for substantial regulatory reform regulatory reform have been heard from have been heard from virtually all sides of the political virtually all sides of the political spectrum. spectrum. While it is still too early to predict with pre- cision the final shape of the financial services regula- tory structure that will be in place following these reforms, especially in the current political environ- Title I, the “Financial Services Oversight Council Act ment, there has been enough legislative activity that of 2009,” would establish a Financial Services Over- one can discern the basic outline of the reforms and sight Council (the “Council”), whose members consist where the major battle lines are likely to be drawn. of the Secretary of the Treasury (who would also chair 8 Third Quarter 2009
  9. 9. D the Council); the Chairman of the Board of Governors Title II, the “Bank Holding Company Moderniza- of the Federal Reserve System (the “Federal Reserve”); tion Act of 2009,” would address the failures in the the Comptroller of the Currency (“Comptroller”) until supervision and regulation of large, highly leveraged, the Comptroller’s functions are transferred to the and substantially interconnected financial companies Director of the new National Bank Supervisor (the that many considered to have been a significant factor “NBS”) (see Title III below), at which time the Director in the financial crisis. Currently, many of these firms of the NBS would succeed to the Comptroller’s mem- are regulated by various agencies, and many facets bership; the Director of the Office of Thrift Supervi- of their operations are essentially unregulated. The sion (“OTS”) until the OTS Director’s functions are proposal would seek to implement a comprehensive, transferred to the NBS Director; the Director of the consolidated supervision and examination regime for new Consumer Financial Protection Agency (“CFPA”) these companies, with the hope of avoiding or miti- (see Title X below); the Chair of the Securities and gating similar crises in the future. Exchange Commission (“SEC”); the Chair of the Com- Title II would create a “United States financial com- modity Futures Trading Commission (“CFTC”); the pany” designation that would apply to any company, Chair of the Federal Deposit Insurance Commission including a bank holding company (“BHC”), that is (“FDIC”); and the Director of the Federal Housing organized in the United States or its territories and is Finance Agency (“FHFA”). “in whole or in part engaged in, directly or indirectly, The Council is in many respects a broader, more activities in the United States that are financial in na- formalized version of the currently functioning Presi- ture.” One primary purpose of this designation would dent’s Working Group on Financial Markets (“PWG”). be to address gaps in regulation and supervision with The Council would advise, and make recommenda- respect to many complicated financial institutions that tions to, Congress on financial markets, monitor the have avoided “bank holding company” status by either financial services marketplace to identify potential not owning an insured depository institution or by threats to the stability of the U.S. financial system, owning so called “non-bank banks” – insured deposi- facilitate information sharing among members of the tory institutions that are not considered “banks” un- Council, advise the Federal Reserve on the designation der the Bank Holding Company Act of 1956 (“BHCA”). of Tier 1 financial holding companies (“FHCs”) (see Under Title II, the Federal Reserve would be granted Title II below), and provide a forum for discussion of the authority to designate any United States financial emerging market developments and regulatory and company as a “Tier 1 financial holding company” jurisdictional issues. upon its determination “that material financial dis- Importantly, the Council would not be the so-called tress at the company could pose a threat to global or “systemic risk regulator,” as that role and responsi- United States financial stability or the global or United bility would be assigned to the Federal Reserve. The Council, however, would play an important advisory role to the Federal Reserve, which would be required to consult with the Council before implementing mate- rial rules and regulations regarding the designation and regulation of Tier 1 FHCs, financial market utili- ties and systemically important clearing, settlement and payment activities (see Title VIII below). The identity and scope of authority of the “systemic risk regulator” is likely to be an area of significant debate, as many have questioned whether the Federal Reserve should be granted significant additional au- thority over the financial system in light of perceived supervisory failures leading up to the financial crisis. The alternative most often suggested is to provide the Council with this systemic risk responsibility and authority, although that approach has been criticized as well on the grounds that arguably no single agency would have ultimate responsibility. Third Quarter 2009 9
  10. 10. D States economy during times of economic stress” be passed to the FDIC. Title III would also eliminate based on the amount and nature of the company’s as- the federal thrift charter, and each savings associa- sets and liabilities, or other factors the Federal Reserve tion under the authority of the OTS would be required, may determine to be appropriate. The Federal Reserve within six months after the date of enactment, to elect would have similar power over foreign FHCs under to become a national bank, mutual national bank, the proposal. From the perspective of the investment state bank, or state savings association. If the savings management industry, one of the concerns is that the association fails to do so, it would become a national Federal Reserve’s authority to designate Tier 1 FHCs is bank or mutual national bank by operation of law ef- broad enough to encompass large investment funds. fective at the end of the one-year period beginning on the date of enactment. Each Tier 1 FHC would be required to register with the Federal Reserve and meet certain prudential stan- dards that would be designed by the Federal Reserve to mitigate risks to the financial system, including: (1) While similar proposals in the past have risk-based capital requirements; (2) leverage limits; met strong opposition from the banking and (3) overall risk management requirements. With respect to foreign Tier 1 FHCs, the Federal Reserve industry, the expectation is that this limited would be required to take into account principles of consolidation of banking supervisors will be national treatment and equality of competitive oppor- included in the final reform legislation. tunity when devising these standards. Those compa- nies deemed to be Tier 1 FHCs by the Federal Reserve that had avoided designation as BHCs (and the related limitations on activities) by holding so-called “non- The powers of the OCC and OTS would be transferred bank banks” would have five years from the date of to the NBS one year after the date of the enactment their designation as a Tier 1 FHC to conform their of Title III, during which time the Director of the NBS activities to those permitted for an FHC. would have certain interim powers, while the Comp- troller and the Director of the OTS would continue Under the proposal, the Federal Reserve would be to have certain interim powers as well. All orders, granted broad examination authority over Tier 1 FHCs resolutions, determinations, agreements, regulations, and the authority to require such companies to sub- interpretive rules, other interpretations, guidelines, mit reports regarding their operations and financial procedures, and other advisory materials of the OCC conditions. In addition, the Federal Reserve would and the OTS would continue to be effective, although be granted the same broad enforcement authority the NBS would have the authority to identify which that federal banking regulators currently have over regulations it would continue to enforce before the the banks they supervise. This enforcement authority date of the transfer. includes the ability to assess significant civil money penalties, to seek to impose cease and desist orders While similar proposals in the past have met strong against companies and their employees and officers, opposition from the banking industry, the expectation and to seek to prohibit employees and officers from is that this limited consolidation of banking supervi- further participation in the banking industry. Finally, sors will be included in the final reform legislation. the Federal Reserve would have “Prompt Corrective Title IV, the “Private Fund Investment Advisers Action” authority to address serious undercapitaliza- Registration Act of 2009,” would amend the Invest- tion of Tier 1 FHCs that is similar to the authority the ment Advisers Act of 1940 (the “Advisers Act”) to federal banking regulators currently have over deposi- require investment advisers to certain pooled invest- tory institutions. ment vehicles, including hedge funds, private equity Title III of the Obama administration proposals would funds and venture capital funds (“Private Funds”), to create a new National Bank Supervisor as a bureau register with the SEC. Title IV would define a “Private of the Department of the Treasury. The Office of the Fund” to include an investment fund that (a) would be Comptroller of the Currency (“OCC”) and the OTS an investment company as defined under Section 3 of would be abolished. All powers of the OCC would be the Investment Company Act of 1940 (the “Investment passed to the NBS, as would all powers of the OTS, Company Act”) but for the exclusions from the defini- except for functions relating to the supervision and tion of investment company provided in either Section regulation of state savings associations, which would 3(c)(1) or Section 3(c)(7) of the Investment Company 10 Third Quarter 2009
  11. 11. D ability of an investment adviser to a Private Fund to rely on either the Advisers Act’s current “intrastate” or commodity trading adviser exemptions, although these exemptions will remain available to investment advisers who do not advise any Private Funds. In addition to imposing registration requirements on investment advisers to Private Funds, Title IV would give the SEC a broad mandate to require any invest- ment adviser to a Private Fund to maintain such records and submit to the SEC such reports regarding Private Funds as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Federal Reserve and the Council. Specific infor- mation that an investment adviser to a Private Fund would be required to file with the SEC concern- Act, and (b) either (i) is organized or is otherwise cre- ing such Private Fund includes, but is not limited to: ated under the laws of the United States or of a state; or (ii) has 10% or more of its outstanding securities  amount of assets under management; owned by a U.S. person. Thus, most domestic, and many offshore, hedge funds, private equity funds, and  use of leverage (including off-balance sheet venture capital funds would fall under the definition of leverage); “Private Funds” as set forth in Title IV.  counterparty risk exposures; Three exemptions from the registration requirements  trading and investment positions; and of the Advisers Act that have historically been avail- able to investments advisers to Private Funds would  trading practices. be eliminated. Most notably, Title IV proposes to All records of a Private Fund maintained by an eliminate in its entirety the current exemption from investment adviser would be subject to review and registration for any investment adviser who during the examination by the SEC. Moreover, the SEC would prior 12 months has had fewer than 15 clients and be required to provide to the Federal Reserve and the who neither holds itself out generally to the public Council copies of all reports, documents, records, as an investment adviser nor acts as the investment and information filed with or provided to the SEC by adviser to a registered investment company or a an investment adviser to a Private Fund as the Federal business development company. The current exemp- Reserve or the Council may consider necessary to as- tion would be replaced by a blanket exemption from sess the systemic risk of a Private Fund or to deter- SEC registration for any investment adviser that is mine whether it should be treated as a Tier 1 FHC. a “foreign private adviser,” which is defined as any While Title IV specifically provides for the confidential investment adviser who (a) has no place of business treatment of information required to be filed with the in the United States; (b) during the preceding 12 SEC by investment advisers with respect to Private months has had (i) fewer than 15 clients in the United Funds, this provision would not (i) authorize the SEC States, and (ii) assets under management attributable to withhold information from Congress or (ii) prevent to clients in the United States of less than $25 million the SEC from complying with (a) a request from any (or such higher amount as the SEC may establish by other Federal department or agency or self-regulatory rule); and (c) neither holds itself out generally to the organization that makes a request for purposes within public in the United States as an investment adviser the scope of its jurisdiction, or (b) a court order of a nor acts as an investment adviser to any registered in- court of the United States in an action brought by the vestment company or business development company. United States or the SEC. Because each of the foregoing provisions must be sat- isfied in order to fall within the definition of a “foreign __________________________________________________ private adviser,” this exemption may have a relatively narrow application. Title IV would also eliminate the continued on page 24 Third Quarter 2009 11
  12. 12. D Dechert Responds to Call To what extent is there a need to create a single regulatory regime for Alternative for Evidence Regarding Draft Investment Fund Managers in the European EU Directive on AIFM Union? There is already a (recently implemented) pan-EU regulatory regime covering alternative investment fund managers (AIFM) in Europe in the form of the Markets in Financial Instruments Directive (2004/39/EC). Whilst we appreciate the drivers behind further regula- tion in the financial services industry following recent events, we do not consider that a case has been made by Gus Black, Jennifer Wood and to single out AIFMs for special regulatory attention. It Adam Levin* is widely acknowledged that the alternative investment fund (AIF) industry was not the cause of the recent The EU Commission Proposal for a Directive on Alter- financial crisis. Further, many of the risks that are native Investment Fund Managers (the “Directive”), perceived to be associated with AIFs as regards their which was published on 30 April 2009 following very activities are simply not applicable to many AIFs, or little consultation, has already achieved widespread are also found in other quarters of the investing com- notoriety for the wide-ranging impact that it will have munity that undertake those activities and which are on alternative investment fund managers (“AIFM”) and ignored by the Directive. other service providers. In its present form, it will af- fect all collective investment funds which do not come Financial services regulation generally seeks to regu- under the UCITS umbrella. late behaviour or outcomes that are thought to be problematic. If certain behaviour – be it directional shorting, ‘excessive’ leverage or opacity – is thought The EU Commission Proposal for a Directive on AIFM has already achieved widespread notoriety for the wide-ranging impact that it will have on alternative investment fund managers and other service providers. There has been a growing response and lobbying op- eration from funds, investors, trade bodies, and local and national governments, all of which are hoping to influence the Directive before its ultimate adoption by the European Council and Parliament and final imple- mentation by individual EU Member States. To this end, the Economic and Financial Affairs and International Trade Committee of the UK House of Lords (the “Committee”) published a call for evidence at the beginning of August 2009. A working group from Dechert’s London office prepared a submission for the Committee, parts of which follow. 12 Third Quarter 2009
  13. 13. D to present, for example, a systemic risk (an argument neither intended for, nor generally available to, “con- which is far from conclusively made out by the Direc- sumers” as the word is generally used in the industry: tive’s explanatory notes), there seems to us to be no i.e., retail customers. logical basis to single out only one specific group of Consumers do ultimately benefit from AIFMs indirect- market participants that could engage in such behav- ly (for example, through investment of their pension iour – i.e. AIFMs – for regulation. funds or other investment products). Crucially, how- ever, in such cases there is an interposed professional manager, who is best placed to take a view on the Whilst we appreciate the drivers behind risks involved and will often only invest in AIFs follow- ing sophisticated legal and operational due diligence further regulation in the financial services processes. industry following recent events, we do In our view the Directive as currently drafted will not consider that a case has been made restrict not only the choice of investment opportuni- to single out AIFMs for special regulatory ties available to such professional managers, but attention. also competition within the industry. These are not outcomes usually associated with a pro-consumer agenda. Further, to the extent that these outcomes diminish AIF returns, they will ultimately be felt by To the extent that further regulation in the sector is consumers via their individual pension plans and found to be necessary (following proper consideration savings products. Accordingly we consider that the and consultation), as a general matter we would agree Directive as it stands fails consumers rather than that it makes sense to have common standards across protects them. the EU as far as possible. Does the Directive achieve its objectives? Should the objectives of the Directive be The Directive appears to go well beyond modified? financial regulatory objectives, muddling The Directive appears to go well beyond financial these with a political agenda. regulatory objectives, muddling these with a political agenda. We comment on certain objectives – as we understand them from the Impact Assessment to the Directive (SEC (2009) 576) and the text of the draft Accountability of AIFM, etc. Directive – below. We understand them from the Impact Assessment to Risk monitoring and management the Directive that one of the Directive’s objectives is the greater public accountability of AIFMs investing We do not see how the Directive’s objectives of moni- in and managing companies. Again, it is not clear toring and/or managing macro and micro prudential why AIFMs should be singled out. Why, for example, risks in financial markets can be achieved by require- should investors who join together to make private ments that apply in respect of AIFMs and AIFs but investments be required to disclose onerous levels of which do not apply to other large sections of the information to regulators, shareholders, etc. – when investing community such as banks, insurance compa- investors acting alone, or other types of investors, are nies and occupational pension funds – which neverthe- not? less engage in exactly the same types of activity, often to a greater degree. Will the passport system help create a single market in investments funds within the EU? Consumer protection? How will the passport system established affect the EU and the UK industry and particularly The Directive states at point 29 of the preamble that their position in the global market? its objective is to ensure a high level of consumer and investor protection by laying down a common frame- In principle, a passport system would help to create a work for the authorisation and supervision of AIFMs. single market. Its potential to open up capital mar- We are surprised at the focus on consumers: AIFs are kets and to simplify what can be a significant and Third Quarter 2009 13
  14. 14. D costly compliance burden, dealing with the existing patchwork of regulatory approaches is, in theory, to be welcomed. The alternative fund industry, however, is a global in- dustry. Provided there is “equivalent” regulation in oth- er non-EU states it ought to be possible for managers in such states to access the EU market and vice-versa. Unfortunately, as the Directive currently stands it is not clear that any third country, including the United States, would meet the proposed standards for equiva- lence. Ultimately, the passport system will help neither the interests of the UK nor EU market if it effectively serves to deprive the market of access to third country managers and funds. Mutual market access should be negotiated at an EU level based on a minimum best practice acceptable to both the EU and elsewhere. We believe it is important to distinguish the perceived risks associated with AIFs and the real risks. What risks arise from Alternative Investment Funds? Is the Directive proportionate given the role of AIF in the financial crisis? Will the Directive introduce over–stringent regu- lations or does it not go far enough? The lack of causation between AIFs and the recent financial crisis is well documented by the major reports (see, for example The High-Level Group on Financial a specialist supervision team to focus explicitly on Supervision in the EU Report (chaired by Jacques de hedge fund managers, and began gathering com- Larosière) etc.) and we will not dwell on this. Similarly, prehensive data from the prime brokerage com- a number of industry representatives and trade bod- munity that lends to them, giving us a good grip ies have highlighted some of the costs likely to arise on their levels of leverage – which in recent years from the Directive, which go to proportionality (or lack – including the run up to the crisis – have very thereof). typically been modest, especially in comparison to banks.” We believe it is important to distinguish the perceived risks associated with AIFs and the real risks. In our  Insofar as private equity is concerned, the World view AIFs pose little systemic risk when compared Economic Forum on the Global Economic Impact with other industry players, specifically banks. For of Private Equity found, in 2008, that private example, evidence points to the fact that in overall equity-backed companies had a default rate of terms neither hedge funds’ nor private equity funds’ 1.2% per year, compared to an average default levels of leverage have been excessive: rate of 1.6% for US corporate bond issuers.  Dan Waters, FSA Asset Manager Sector Leader, __________________________________________________ said in a speech to the International Fund Forum on 24 June 2009, “Some four years ago we set up continued on page 21 14 Third Quarter 2009
  15. 15. D Extended Powers of the cided to broaden the controlling powers of the BaFin and has introduced new provisions into the KWG German Regulator Regarding regarding the approval and removal of members of Supervisory Board Members of a supervisory board of a bank or a financial services provider. These new provisions entered into force on a Bank or a Financial 1 August 2009. Services Provider Key features of the new provisions by Angelo Lercara and The main feature of the new provisions is the imposi- Nicole Alexander tion of the duty to provide the BaFin with informa- tion regarding the personal reliability and applicable Any person who wishes expert knowledge of members of an entity’s supervi- to conduct banking busi- sory board. This applies when an entity is applying for ness or render financial permission to conduct banking business or to render services in Germany financial services, as well as when any such board as a commercial business must apply for a written member is replaced. Further to this, the BaFin has licence from the Federal Financial Services Authority been granted the power to remove supervisory board (“BaFin”) under section 32 of the German Banking members from their position or even to revoke the Act (“KWG”). In order to obtain such a licence, the permission of the bank/financial services provider, if applicant must name at least two directors and must the supervisory board members prove not to be reli- provide information regarding such directors’ personal able or do not possess the applicable expert knowl- reliability (extending the meaning of “reliable” set edge. The new provisions also limit to two persons the out by law) and applicable expertise. Up until now, number of members of a supervisory board who were these requirements have only been applicable to the also former directors of the institution concerned. applicant entity itself and its directors. There were no regulatory requirements that would have required Background to the legislation members of the supervisory board to disclose any specified qualifications. The reasoning behind the creation of the new provi- sions was twofold. Firstly, the legislator wanted to Recent Changes to the German ensure that supervisory board members are appropri- ately qualified, so as to enhance investor protection Banking Act and the stability of the financial markets. Secondly, As a result of the experiences gained during the the legislator felt that by giving the BaFin the power to recent financial crisis, the German legislator has de- remove supervisory board members who do not meet Third Quarter 2009 15
  16. 16. D the standards set out by the KWG, it would help facili- including such individual’s personal experience. In ad- tate the restructuring of banks and financial services dition to his résumé, the BaFin can obtain a certificate providers that is currently taking place in Germany. of good conduct from the police, information from the central trade bureau or information from the criminal The Criteria of “Personal Responsibility” records bureau. It is the responsibility of the regula- tory authority to verify this personal information and, and “Applicable Expertise” as the case may be, to determine a lack of reliability from the facts. Generally, one would assume that the criteria of “per- sonal responsibility” and “applicable expertise” will be interpreted by the BaFin in this context in a similar Applicable expertise way to its interpretation of such terms for the direc- A director must have the requisite applicable expertise tors of a bank or a financial services provider, and that to direct a bank or a financial services provider. Gener- such criteria will apply equally to members of a super- ally, it is the responsibility of the regulatory authority visory board to the extent that such application to ascertain whether a director’s qualifications are is appropriate. sufficient, based on legal, verifiable criteria, for the director to be appointed. Unlike the personal reliability The requirements of personal reliability and applicable criterion, applicable expertise is not presumed in the expertise are essential to the security and operational absence of any negative information. In fact, appli- function of an institution and to banking supervision. cable expertise must be positively identified on one’s These requirements apply not only in gaining authori- résumé, particularly with respect to training, previous sation, but also throughout a company’s entire exis- experience, current activities and examples of good tence, (including the appointment of a director or a stewardship. As a result, it is necessary to ensure that, member of a supervisory board). The special emphasis in every case, the qualifications meet the requirements placed upon personal reliability and applicable exper- necessary to carry out the functions of a director. This tise also indicates that directors and members of a su- depends heavily on the nature of the business and the pervisory board are the intended subjects of the duties size of the relevant institution. imposed by the KWG and regulatory measures, either directly or as the legal representative of an entity. The The specific requirements to meet the standard of ap- BaFin can reject an application if a director does not plicable expertise for directors are set out in § 33 para. fulfil the criteria of personal reliability and applicable 1 sen. 2 of the KWG, which provides that directors expertise. must possess a sufficient degree of theoretical and practical knowledge regarding their relevant business Given this background, one needs to take a closer look and management practice. For directors of a credit at the criteria of personal reliability and applicable ex- institution, the applicable expertise is regularly pre- pertise as they apply to directors, in order to see how sumed where a director can demonstrate that he has these criteria can be interpreted in relation to mem- served in a “leading position” at a credit institution of bers of a supervisory board. similar size and business type for a three-year period. Such a three-year leading position is considered by Personal reliability the regulatory authority, in its standard administrative practice, to be the equivalent of the management of There should be no facts that might cast doubt upon units within a credit institution in a position directly the personal reliability of a director. Facts that could beneath the board level. In order for candidates to raise such doubts include the perpetration of white provide evidence that they are qualified to lead a credit collar crimes (such as, for example, fraud), the in- institution in full measure and with complete respon- fringement of regulatory provisions, especially in the sibility, their leading position may not have been of an realms of business, trade, competition or tax laws, or essentially limited nature within the institution, must personal or professional behaviour that indicates that have involved a level of authority to outwardly repre- solid business management cannot be expected of the sent the bank, and must have demonstrated success individual. Such personal reliability does not have to (and, particularly, a high level of responsibility). The be positively demonstrated but it is presumed if no applicable expertise criterion will depend upon the facts are known that would suggest irresponsibility. specific nature of the credit institution involved. For Thus, the task of a potential director is simply to pro- directors that have been employed predominantly out- vide the BaFin with all requisite personal information, side the scope of the KWG (i.e. outside of Germany), 16 Third Quarter 2009
  17. 17. D the regulatory authority will make a presumption of area, so that the expertise of all board members applicable expertise where a director has demon- taken together ensures a smooth functioning of the strated that he held a three-year leading position at supervisory board. an institution (including an institution that operates in another country) of comparable size and business Outlook type, provided that such director has adequate com- mand of the German language or another commonly The changes brought about by the new provisions have used international language (i.e. English) that is re- been sought by market participants for some time. Al- quired for such person’s appointment as director, and though the additional controlling powers of the BaFin can demonstrate having held at least a one-year long, may impose higher regulatory burdens on banks and practice-related position within the scope of the KWG financial service providers, the improved investor (i.e. inside of Germany). In addition, at least one protection and the added stability of the financial sys- of the existing directors must have held a three-year tem potentially resulting from these changes should leading position at an institution within Germany. outweigh such burdens. Above all, the members of the supervisory boards that have been in place prior Application to members of the supervisory to the BaFin controls arguably should be able to meet board the personal reliability and applicable expert knowl- edge requirements now imposed. Supervisory boards The criteria outlined above for directors form the basis that do not currently fulfil these requirements will be for interpreting the criteria that apply to supervisory forced to do so going forward, since the BaFin’s power board members. However, in applying such criteria to to remove supervisory board members if they do not supervisory board members, the “controlling” func- meet the new criteria under the KWG will also apply tion of supervisory board members (rather than the to supervisory board members appointed before “leading” function of directors) must be taken into 1 August 2009. account. Personal reliability To conclude, it should be noted that the legislator was not consistent when drafting the new provisions: In respect of the requirements of personal reliabil- the law does not provide the BaFin with the power to ity, one can assume that such requirements should deny the grant of a licence to a bank or a financial not differ for supervisory board members from the services provider on the grounds that a supervisory requirements applied to directors, as personal reli- board member lacks personal responsibility and/or ability is not tied to a “leading” function and is equally applicable expertise; the BaFin may only remove a necessary for a “controlling” one. supervisory board member, and revoke a licence after it has been granted. Theoretically, such removal and/ Expert knowledge or revocation could take place immediately after the The German legislator decided to express the neces- licence has been granted, if the required standards sary expertise for a supervisory board member as for supervisory board members were not fulfilled “expert knowledge” (Sachkunde) to emphasize that in the first instance. This should be borne in mind a supervisory board member can have more lim- when selecting supervisory board members, and it is ited expertise than a director. Generally, the expert advisable to make a responsible choice even though knowledge of the supervisory board members has to the BaFin may not technically deny a permission on correspond to the kind of business being exercised the grounds that supervisory board members lack the by the relevant bank or financial services provider specified qualifications. and it is considered appropriate if the applicant can Angelo Lercara demonstrate that he has held a leading position at an Munich institution of comparable size and business type (or +49 89 21 21 63 22 even another business type). In this respect, it can be angelo.lercara@dechert.com assumed that the “leading position” requirement can be for a shorter period of time than the burdensome Nicole Alexander requirement of a three-year period for directors. In Munich addition, it is considered sufficient if a supervisory +49 89 21 21 63 41 board member has expert knowledge of a special nicole.alexander@dechert.com Third Quarter 2009 17
  18. 18. D FAS 167: New Balance Sheet generally have recourse to the assets of the reporting enterprise. Consolidation Requirements for Notwithstanding such requirements for separate Private Equity Fund and Hedge presentation of a VIE’s assets and liabilities in the con- Fund Managers solidated financial statements of the primary benefi- ciary, many in the financial community have expressed by Cynthia J. Williams concern that such consolidation and related financial and Adam I. Gehrie disclosure obligations will substantially increase the costs of preparing statements, is not necessary or Introduction helpful to investors or creditors of the manager from a On June 12, 2009, the policy standpoint, and may create problems for man- Financial Accounting agers under existing financial covenants to which they Standards Board (“FASB”) issued a new standard that may be subject. will materially impact the extent to which the manag- ers of private funds (including private equity funds and Analysis of FAS 167 vs. FIN 46R hedge funds) will be required to consolidate the assets of the private funds that they manage onto their own The principal differences between the current consoli- balance sheets. The new standard – FASB Statement of dation regime under FIN 46R and the new require- Accounting Standards No. 167, Amendments to FASB In- ments pursuant to FAS 167 that are relevant to deter- terpretation No. 46R (“FAS 167”) amends FASB Interpre- mining whether the assets of a private fund tation No. 46R Consolidation of Variable Interest Entities must be consolidated with those of its manager are (“FIN 46R”). as follows: FAS 167 will be effective as of a private fund’s (or 1. Which entities are VIEs? any other reporting entity’s) first annual reporting Under FAS 167, a VIE is generally an entity in which period that begins after November 15, 2009 (which either: (1) the equity investors are not deemed to will be January 1, 2010 for calendar year-end funds). have sufficient equity at risk for the entity to finance It revises one of the tests to determine whether an its activities without additional subordinated financial enterprise is a “variable interest entity” (a “VIE”) so as support, or (2) the equity investors lack any one of the to treat almost all private funds as VIEs. FAS 167 also following three characteristics: (i) the power, through embraces a new control test for consolidation, such voting rights or similar rights, to direct the activities that most managers that receive customary private that most significantly impact the entity’s economic fund performance or incentive fees will be deemed to performance; (ii) the obligation to absorb the losses hold a variable interest in the fund, will be deemed the of the entity; and (iii) the right to receive the expected primary beneficiary of the fund and will be required residual returns of the entity (i.e., the equity investors to consolidate the fund into their own financial state- do not have a stipulated limit to their potential return ments. on investment). As elaborated below, FAS 167 will require many man- For many private funds, it is clear that investors pos- agers to consolidate onto their balance sheets the sess the qualities enumerated in (1) and (2)(ii) and assets and liabilities of the private funds they manage (2)(iii) above. It is not clear, however, that investors in even if the managers have no ownership interest in private funds possess the power described in Section such private funds and have no obligation to pay the 2(i) above because such investors do not typically have liabilities of such private funds. To increase transpar- any management rights with respect to the private ency and reduce potential confusion related to such funds in which they have invested. Therefore, under consolidation, FAS 167 modifies FIN 46R to require FAS 167, the analysis of whether the private fund may that a reporting enterprise which is required to con- avoid VIE status centers around the “power to direct” solidate a VIE separately present on its statement of criterion enumerated in 2(i) above. financial position (a) assets of a consolidated VIE that can be used only to settle obligations of the consoli- Prior to FAS 167, many private funds were not subject dated VIE and (b) liabilities of a consolidated VIE for to FIN 46R because there was sufficient equity in the which creditors (or beneficial interest holders) do not fund to permit it to finance its activities without addi- tional subordinated financial support, and the ability 18 Third Quarter 2009
  19. 19. D of a majority of the equity investors unaffiliated with liabilities in the normal course of the entity’s the manager to kick out and replace the manager activities; without cause was deemed to meet the FIN 46R re- (c) the decision maker or service provider and its quirement that the equity investors have the ability to related parties do not hold other interests in the make decisions about the entity that have a significant VIE that individually, or in the aggregate, absorb effect on the success of the entity that most signifi- or receive, as applicable, more than an insignifi- cantly impacts the entity’s economic performance. cant amount of the entity’s expected losses or Key to the FIN 46R analysis of the “power to direct” expected residual returns, respectively; criterion was the concept that these kick-out rights constituted power to direct the private fund’s activities (d) the service agreements contain only terms, con- as described in criterion 2(i). ditions or amounts that are customarily present in arrangements for similar services negotiated However, FAS 167 makes clear that the presence at arm’s length; of kick-out rights will not affect the determination of whether the holder of a variable interest has the (e) the total amount of anticipated fees is insig- power to direct the activities of a VIE unless a single nificant relative to the total amount of the VIE’s equity holder (including its related parties and de anticipated economic performance; and facto agents) has the unilateral ability to exercise those kick-out rights. This change means that unless (f) the anticipated fees are expected to absorb an a single equity investor unaffiliated with the manager insignificant amount of the variability associ- (together with its related parties and de facto agents) ated with the entity’s anticipated economic possesses kick-out rights, the private fund will be a performance. VIE and, as discussed in detail below, the manager Any manager or manager affiliate that receives an will likely be the primary beneficiary required to con- incentive or performance fee or allocation from a solidate the fund into its financial statements. If such private fund that is a VIE would be considered to have a single equity investor does possess kick-out rights, a “variable interest” in such private fund based on the then the fund will still be deemed to be a VIE but the criteria set forth in (b), (c), (e) and (f) above. A man- holder of the kick-out rights will likely be deemed the ager that takes only a senior fixed management fee primary beneficiary required to consolidate it. based on assets under management likely will not be 2. When does a fee paid to a service provider deemed a holder of a “variable interest,” although this (such as a manager or its affiliates) consti- analysis is not entirely free from doubt. For example, tute a “variable interest” in a VIE? it is not clear whether even a standard 2% senior management fee will be considered to be “commensu- A manager that is not an equity owner in a private rate with the services provided and the level of effort fund and does not otherwise hold a variable interest required to provide those services” by every finance in the private fund will not be the primary beneficiary, department or external auditor, and FASB has pro- no matter how much control or power it may have vided no “bright lines” for the quantitative thresholds and, hence, will not be required to consolidate it. contained in these criteria. Pursuant to the criterion However, fees received by the manager can constitute set forth in (b), a manager that takes a subordinate a variable interest. FAS 167 sets forth new, strict management fee or a subordinate incentive fee or per- parameters for when fees paid to a fund’s manager formance allocation will be deemed to hold a variable create a “variable interest” in the fund which, in turn, interest in the related private fund. may subject the manager to “primary beneficiary” status. Under the new standard, fees paid to an 3. Who is considered to be the “primary ben- entity’s decision maker(s) or service provider(s) are eficiary” of a VIE? not variable interests, provided that all of the following Under FIN 46R, the determination of whether a conditions are met: holder of a variable interest in a VIE must consolidate (a) the fees are commensurate with the services the assets and liabilities of the VIE was based on a provided and the level of effort required to pro- quantitative analysis that required an enterprise that vide those services; held a variable interest that (i) absorbed a majority of the entity’s expected losses, or (ii) received a majority (b) substantially all of the fees are at or above of the entity’s expected residual returns, or both, to the same level of seniority as other operating consolidate the assets and liabilities of the VIE on its Third Quarter 2009 19

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