Kirkpatrick & Lockhart LLP
Offshore Fund Bulletin
MAY 2003
In This Issue
Top Ten Legal Issues in Drafting Offshore Fund Distribution Agreements
Confidentiality and Investment Funds: The Cayman Islands Perspective
1
3
Legislative Proposals Could Impact Offshore Deferred Compensation Arrangements of Managers
5
CTFC Proposes Major Relief from the CFTC Registration Requirements for CPOs and CTAs
7
Kirkpatrick & Lockhart LLP is pleased to present its Offshore Fund Bulletin. Each issue of the Bulletin features
K&L’s analysis of developments in U.S. law affecting offshore funds, as well as articles contributed by other law
firms representing other jurisdictions. Kirkpatrick & Lockhart LLP is not admitted in any jurisdiction outside of
the U.S.
Top Ten Legal Issues in Drafting Offshore Fund
Distribution Agreements
by Benjamin J. Haskin and R. Charles Miller
As offshore funds managed by U.S. advisers look for
additional sources of distribution, they are increasingly
entering into distribution agreements with many
different entities in a variety of jurisdictions. This
article is intended to identify some key legal issues for
negotiating distribution agreements for mutual funds or
hedge funds organized outside the U.S. (“Offshore
Funds”) with unaffiliated selling agents (“Third-Party
Distributors”). Many of the issues identified below also
apply to privately offered funds organized in the U.S.,
but sold abroad. (We have not tried to discuss those
non-legal, but still important, issues that also arise in
negotiating distribution agreements (e.g., compensation
arrangements)).
COMPLIANCE WITH PRIVATE OFFERING
EXEMPTIONS
Many Offshore Funds are organized to comply with the
exemptions provided by Regulation S under the
Securities Act of 1933 (“Securities Act”). Pursuant to a
series of no-action letters issued by the Securities and
Exchange Commission staff, Offshore Funds organized
under Regulation S are exempt from registration under
the Investment Company Act of 1940 (“ICA”).
Alternatively, some Offshore Funds are organized to
comply with the exemptions provided by Section
3(c)(1) or 3(c)(7) under the ICA and Regulation D
under the Securities Act.
The continued availability of the relevant exemptions
from registration is critical to the operation of most
Offshore Funds. As a result, contracts with Third-Party
Distributors almost always specifically require the
Distributor to comply with the offering limitations set
forth in the prospectus or offering memorandum or
otherwise comply with the relevant offering exemptions
in the jurisdictions in which they are offered by the
Third-Party Distributor. As reliance on these
exemptions limits the marketing or sales activities that
can be conducted in the U.S., many such contracts
specifically address these limitations by simply
prohibiting any offering or sales to U.S. persons. As a
reciprocal matter, Third-Party Distributors often insist
that the Offshore Funds represent and warrant that their
exemptions from registration are, and will continue to
be, validly maintained.
SALES PRACTICES AND COMPLIANCE WITH
FOREIGN SECURITIES LAW
Different jurisdictions apply very different rules as to
whether registration is required of the offering. There
Kirkpatrick & Lockhart LLP
Offshore Fund Bulletin
MAY 2003
are different standards for what would constitute an
exemption for a private offering, for example. As fund
offerings or the agents for fund offerings may need to be
registered, an agreement should contemplate the party
responsible for assuring compliance with the applicable
securities laws. Contacts with a foreign jurisdiction
may subject an Offshore Fund or its service providers to
regulatory action or liability in a given jurisdiction.
Depending on the level of comfort with the distributing
party, the Offshore Fund may want certifications or
notice of compliance with foreign securities law. Some
Offshore Fund distribution agreements require the
distributing party to be registered, or exempt from
broker-dealer registration, in the jurisdictions offered.
COMPLIANCE WITH ANTI-MONEY
LAUNDERING LAW
Offshore Distribution contracts should clearly delineate
the responsibilities for compliance with anti-money
laundering (“AML”) law and regulation. In 2001, the
U.S. adopted the USA PATRIOT Act, which includes
Offshore Funds as “investment companies,” whether
registered or not. To implement the USA PATRIOT Act
for offshore funds, proposed Treasury Department rules
would make parts of the USA PATRIOT Act applicable
to many Offshore Funds, including the establishment of
a program to detect and prevent money laundering and
the appointment of an AML compliance officer. The
Treasury Department has already implemented much of
the USA PATRIOT Act for broker-dealers and banks. In
addition to USA PATRIOT Act concerns, sales
involving U.S. entities should not be made to any
persons or entities that are banned by the Treasury
Department’s Office of Foreign Assets Control. In
addition, the Bank Secrecy Act obligates U.S. entities to
make certain reports of currency transactions.
Further, AML laws and regulations of foreign
jurisdictions are likely to apply, including the
jurisdiction in which the Offshore Fund is organized, as
well as AML law and regulation of a jurisdiction in
which the Offshore Fund is distributed. The AML laws
of the country of organization typically include the
funds that are organized there (including such popular
jurisdictions for organizing Offshore Funds as Ireland or
the Cayman Islands). Finally, the AML law of the
country in which the purchaser is located may apply.
Most Offshore Fund distribution contracts allocate AML
responsibilities between the Third-Party Distributor and
the Offshore Fund and/or another agent. In cases with
2
specific jurisdictional concerns, periodic certifications
may be necessary to assure continued compliance by the
Third-Party Distributor.
REVIEW OF SUBSCRIPTION MATERIALS
Many Offshore Fund distribution agreements specify
whether the Offshore Fund’s service provider (an
administrator, for example) or the Third-Party
Distributor is responsible for receiving and reviewing an
investor’s subscription materials before accepting an
investment. (It may be beneficial to ascertain with
foreign counsel of the jurisdiction of organization
whether any particular party need review the
subscription agreements to meet anti-money laundering
requirements.) Review of the subscription materials is a
fundamental part of Offshore Fund distribution to make
certain both that an investor is qualified and that the
Offshore Fund is a suitable investment for that investor.
Accordingly, the determination of which party takes
responsibility for review or part of the review is an
important element of any Offshore Fund distribution
agreement. As a general matter, Third-Party
Distributors of large Offshore Funds assume
responsibility for both qualification and suitability.
ADVERTISING AND MARKETING MATERIALS
As noted above, advertising and marketing activities
must be in compliance with the offering exemptions
under the securities laws relied on by the Offshore
Fund. As many jurisdictions have anti-fraud rules that
may be triggered by misleading advertising materials,
Offshore Fund distribution agreements often
contemplate specific measures for allocating
responsibility for creation and dissemination of this type
of material. In addition, the anti-fraud protections of
the Investment Advisers Act of 1940 may apply to some
marketing activities involving Offshore Funds. Again,
as a general matter, most distribution agreements
attempt to place responsibility for advertising and sales
material with the party (Offshore Fund sponsor or
Distributor, for example) that drafted the material.
Some Offshore Fund distribution agreements prohibit
the creation of advertising and marketing materials
without the written consent of the Offshore Fund
sponsor or the sponsor’s approval of the materials.
PRIVACY/CONFIDENTIALITY
Offshore Funds and Third-Party Distributors should be
aware that different jurisdictions may have very
different standards for when information about
OFFSHORE FUND BULLETIN
Offshore Fund Bulletin
MAY 2003
beneficial owners may be provided to or shared with
third parties, including regulators. A U.S.-registered
investment adviser or broker-dealer, for example, may
well be subject to privacy and confidentiality standards
under the Gramm-Leach-Bliley Act for the adviser’s
client (which arguably may include the clients of the
Offshore Fund in some circumstances), while the
Offshore Fund may be subject to standards of its
jurisdiction of organization. The Third-Party
Distributor may be subject to the laws of its principal
jurisdiction(s). It is important, therefore, that contracts
contemplate the standards for information sharing that
may apply.
DELIVERY OF DOCUMENTS/INFORMATION
Offshore Funds typically want to ensure that the
prospectus or offering circular will be delivered to the
prospective investor or the party with investment
discretion over the investor’s account prior to
investment. The Offshore Fund will also want to be
assured that other communications with investors will
be provided to the investor or the party with investment
discretion over the investor’s account. Furthermore,
depending on the structure of the distribution
arrangements, the Offshore Fund or its sponsor may
need to assure itself that disclosure of the compensation
arrangements with the Distributor is provided to
investors. The most appropriate party for delivery of
documents or information will typically be the ThirdParty Distributor that has the information about the
beneficial owner of the account.
STANDARD OF CARE
As with any contract for performance of a service, the
standard of care for the parties is an important element
of the Offshore Fund distribution agreement. It is worth
noting, however, that many foreign jurisdictions do not
recognize some standards of U.S. law (gross negligence,
for example). Therefore, it is important that the
standard of care is appropriate for the choice of law
provisions of the contract.
INDEMNIFICATION
Another important issue in an Offshore Fund
distribution agreement is the scope of the
indemnifications between the parties. Related issues
include the selection of counsel, payment of counsel and
expenses, as well as notice of an indemnified claim.
There is no one right standard, but this is often a critical
issue in negotiations between Offshore Funds and
Distributors. Also, indemnification from another party
may not relieve regulatory standards imposed on the
Offshore Fund, an Offshore Fund sponsor or a ThirdParty Distributor.
ENFORCEABILITY
Fund groups should be aware that the enforceability of
any liability or indemnification clauses may be limited if
the distributing entity has no real U.S. operations. Thus,
reliance on such indemnification as a mechanism for
enforcing contractual obligations may be limited. This
factor may influence the level of control the Offshore
Fund sponsor may wish to take on a variety of
regulatory issues. It also may influence the choice of
law or forum for disputes in the contract.
Confidentiality and Investment Funds:
The Cayman Islands Perspective
by Sara Collins-Francis of Walkers
Investment funds incorporated in the Cayman Islands
may be subject to competing regulatory regimes
concerning protection of information relating to
investors. Careful drafting of an investment fund’s
offering materials and charter documents when the fund
is first established may avoid many of the difficulties
posed by this potential conflict.
The U.S. Securities and Exchange Commission (the
“SEC”) oversees U.S. registered investment advisers,
including U.S. registered advisers to offshore funds, in
its role of enforcing U.S. securities laws. The SEC’s
investigation or enforcement process can lead to
requests to U.S. advisers for information on investors in
a Cayman fund, including identification information.
Disclosure of such information (whether by the fund to
the adviser to enable it to comply with an SEC request
or by the adviser to the SEC) may contravene Cayman
Islands laws governing the privacy of offshore funds
unless the relevant fund documentation fully authorises
disclosure to the SEC. Other U.S. regulators may
similarly assert jurisdiction from time to time.
Kirkpatrick & Lockhart LLP
3
Offshore Fund Bulletin
MAY 2003
The Cayman Islands Confidential Relationships
(Preservation) Law (1995 Revision) (the “CRPL”) is the
main privacy protection statute in the Cayman Islands.
The CRPL provides that it is a criminal offence to
“disclose” or “attempt, threaten or offer” to disclose
confidential information, which is defined (somewhat
unhelpfully) as including information concerning any
property which the recipient is not authorised to
divulge, other than in the normal course of business.
The CRPL states, at section 3(1), that it applies to all
“…confidential information with respect to business of
a professional nature which arises in or is brought into
the Cayman Islands and to all persons coming into
possession of such information at any time thereafter
whether they be within or outside the Cayman Islands.”
The CRPL purports to have extra-territorial effect and
would theoretically apply to U.S. investment advisers
located in the United States in possession of
confidential information relating to investors in Cayman
Islands funds. This is usually the register of equity
interests of the relevant investment fund.
The CRPL provides an exception where information is
disclosed in the normal course of business or where the
investor’s consent to the disclosure has been obtained.
The “normal course of business” is defined as “the
ordinary and necessary routine involved in the efficient
carrying out of the instructions of a principal including
compliance with such laws and legal processes as
arises out of and in connection therewith and the
routine exchange of information between licensees”.
An interesting question is whether the exception to
section 3(1) allowing disclosure in the normal course of
business could be relied on by a U.S. adviser in
disclosing information or documentation to the SEC,
acting pursuant to applicable U.S. securities laws. In
Walkers’ view, the way section 3(1) has been drafted,
the answer is likely to be no. The exception has not,
however, been considered or interpreted by the courts of
the Cayman Islands in such circumstances so the
position is not free from doubt.
One way to ensure compliance with the CRPL would be
to obtain express waivers by investors of any rights
pertaining to the information regarding the affairs of the
fund and, in particular, an investor’s personal
4
information. This could be achieved by obtaining
express consent from each investor to disclosure of such
information by the fund (or its directors, administrator,
investment manager or adviser or broker-dealer acting
for or on behalf of the fund) where legally required to
do so. Ideally such consent would be obtained by
incorporating suitable wording into the fund
subscription documents and offering memorandum, so
that subscriptions are made on those terms. Consent
wording could also be incorporated into the Articles of
Association (or partnership agreement or trust deed in
the case of a limited partnership or unit trust).
Consent should be express and sufficiently wide to
enable disclosure to the SEC or other U.S. regulators
and should cover the type of information which can be
disclosed and the circumstances in which it can be
disclosed. For example, suitable clauses would
authorise disclosure by the fund (or other entities related
to or concerned with the fund, such as investment
advisers) where required to do so under the laws of any
jurisdiction to which it (or they) are subject and would
extend to any information regarding the affairs of the
fund or documents relating to the fund but in particular
the types of information or documentation in which the
SEC or other regulators would be interested, such as the
Register of Members or transfer books.
The Cayman Islands Monetary Authority Law (2002
Revision) (the “Monetary Authority Law”) provides
another avenue for the SEC or other regulators to
attempt to gain information about a Cayman fund.
Section 30 of the Monetary Authority Law enables the
Cayman Islands Monetary Authority (“CIMA”) to
provide assistance to an overseas regulatory authority in
response to a request from that authority. Where CIMA
is satisfied that such assistance should be provided, it
may direct a Cayman fund (or any person reasonably
believed to have information relevant to the enquiries to
which the request relates) to provide specified
information or documents to CIMA within three days of
the request or such longer period as CIMA may allow.
Disclosure by a fund of information or documents to
CIMA following such a request would not constitute a
breach of the CRPL.
OFFSHORE FUND BULLETIN
Offshore Fund Bulletin
MAY 2003
LEGISLATIVE PROPOSALS COULD IMPACT OFFSHORE
DEFERRED COMPENSATION ARRANGEMENTS OF MANAGERS
by Joel Almquist and Christina Lim
On April 8, 2003, the Senate Finance Committee began
hearings on Enron’s executive compensation practices.
Among the practices being examined is Enron’s nonqualified deferred compensation program. Over
$150,000,000 of Enron executive compensation was
deferred during the years 1998 through 2001. In the
weeks leading up to Enron’s bankruptcy filing, more
than $53 million of the deferred compensation was
accelerated for payment to Enron employees. This
event is drawing close scrutiny from members of the
committee and proposed legislation could impact
managers of offshore funds.
Deferred compensation arrangements are commonly
established in connection with the management of
offshore investment funds. Although management fees
are not generally deferred, managers of offshore funds
often enter into arrangements that defer payment of all
or some portion of their incentive fees in order to defer
receipt, and income taxation, of such fees. Under
current law, where a deferred compensation
arrangement is properly established and the investment
manager uses the cash receipts and disbursements
method of accounting, incentive fees may be deferred
until the year in which the amounts are received.
Although it is not clear how and to what extent the
current regulatory scheme of deferred compensation
will change, there is a significant likelihood that
legislation in this area will be introduced in 2003.
CURRENT DEFERRED COMPENSATION RULES
The determination of when non-qualified deferred
compensation is includible in the gross income of the
individual earning the compensation currently depends
on whether the arrangement is unfunded or funded. If
the deferred compensation arrangement is unfunded, the
compensation is includible in income when it is actually
or constructively received by the employee. Deferred
amounts that are subject to the claims of the employer’s
creditors are considered unfunded, and are merely
unsecured promises to pay money or property in the
future. Such unfunded obligations are generally not
includible in the employee’s income at the time of
deferral.
If the deferred compensation arrangement is funded,
then it is generally treated as a transfer of property
under Section 83 of the Internal Revenue Code of 1986,
as amended (“Section 83”). As such, the deferred
amounts are includible in the year in which the
recipient’s right to the property is transferable or not
subject to a substantial risk of forfeiture.
Rabbi Trusts
One type of non-qualified deferred compensation
structure is called the “rabbi trust.” A rabbi trust is a
fund that is created by an employer for the purpose of
holding assets from which non-qualified deferred
compensation payments will be made. Generally, the
trust is irrevocable and is structured so that the
employer is prohibited from using the assets for
purposes other than to provide non-qualified deferred
compensation. The trust arrangement includes
provisions that subject the assets of the rabbi trust to the
claims of the employer’s creditors in the event of
bankruptcy, thereby preventing the arrangement from
being deemed “funded” for income tax purposes. The
compensation deferred in such arrangements becomes
includible in the income of the recipient when payments
are actually or constructively received from the trust.
NATIONAL EMPLOYEE SAVINGS AND TRUST
EQUITY GUARANTEE ACT
Repeal of Section 132
The Finance Committee’s new hearings underscore the
likelihood that the committee will reintroduce the
National Employee Savings and Trust Equity Guarantee
Act (“NESTEG”), or something like it. On July 11,
2002, the Finance Committee unanimously approved
NESTEG, post-Enron legislation that would
significantly impact non-qualified deferred
compensation arrangements. Although the bill was
never subject to full Senate consideration before the
107th Congress adjourned, Senator Charles Grassley of
Iowa, the chairman of the Finance Committee, recently
announced his plans to reintroduce the bill and “fight to
get it passed this year.”
Kirkpatrick & Lockhart LLP
5
Offshore Fund Bulletin
MAY 2003
Section 132 of the Revenue Act of 1978 (“Section
132”), enacted in response to proposed Treasury
Regulations on the taxation of deferred compensation,
provides that the year for inclusion of private deferred
compensation in taxable income is determined
according to the regulations, rulings, and judicial
decisions relating to deferred compensation which were
in effect on February 1, 1978. Section 132, therefore,
effectively limits the ability of the Department of
Treasury (“Treasury”) to issue new guidance with
respect to the tax treatment of non-qualified deferred
compensation arrangements. NESTEG would repeal
Section 132 and enable Treasury to issue new guidance
on such arrangements, focusing specifically on
arrangements that “improperly defer income.”
The Joint Committee on Taxation’s Description of the
Chairman’s Modifications to NESTEG stated that the
legislation intends that Treasury “would address what is
considered a substantial limitation under the
constructive receipt doctrine” including:
n
Situations in which an individual’s right to receive
compensation is, at least in form, subject to
substantial limitations, but in fact is not so
limited;
n
Arrangements that appear to be unfunded, but in
substance should be treated as funded;
n
Situations in which assets are in form subject to
the claims of the employer’s general creditors but
are, in substance, unable to be reached by
creditors;
n
An employee’s ability to receive funds on account
of financial hardship;
n
The use of trusts or other measures under which
the rights of general creditors to gain access to the
funds are limited;
n
The use of triggers and third-party guarantees to
fund arrangements; and
n
The ability to receive funds subject to a forfeiture
of some portion of the participant’s deferred
compensation.
6
Deferred Compensation Through Offshore Trusts
Offshore trusts are sometimes used in connection with
deferred compensation arrangements because such
trusts may be legally subject to the claims of an
employer’s creditors while, in practice, being very
difficult for creditors to reach. Under NESTEG, assets
that are designated or otherwise available for funding
non-qualified deferred compensation and are located
outside the United States (e.g., in a foreign trust,
arrangement or account) will not be considered subject
to the claims of general creditors for purposes of the
constructive receipt doctrine. The deferred amounts in
such cases will be treated as funded and will be
considered property received by the employees and
subject to taxation in accordance with Section 83. The
deferred amounts will be includible in income when the
right to compensation is not subject to a substantial risk
of forfeiture, irrespective of when the compensation is
actually paid.
Not all offshore deferred compensation arrangements
would be affected by the passage of NESTEG. It
appears that the legislation is intended only to address
certain funded arrangements, such as rabbi trusts, that
are located offshore and are sufficiently remote from the
reach of creditors to justify the current taxation of any
deferrals that are added to the trust.
EFFECTIVE DATES
As proposed in 2002, the effective date for NESTEG’s
provision repealing Section 132 would be the taxable
year beginning after the date of enactment; and the
proposal changing the treatment of offshore trust
arrangements would be effective for amounts deferred
after the date of enactment.
Any legislation introduced this year will not likely differ
from last year’s version of NESTEG; a spokesperson
for Senator Grassley recently indicated that the Senator
will reintroduce “every piece of tax legislation” that was
approved by the Finance Committee with the same
terms as the prior proposals.
OFFSHORE FUND BULLETIN
Offshore Fund Bulletin
MAY 2003
CFTC Proposes Major Relief from the CFTC Registration
Requirements for CPOs and CTAs
by Cary J. Meer, Charles R. Mills, Marc Mehrespand, Ronald A. Holinsky and David J. Michehl
On March 17, 2003, the Commodity Futures Trading
Commission (“CFTC”) proposed new rules that, if
adopted, would lessen the regulatory burden on offshore
fund operators. Generally, operators of offshore funds
that, for example, solicit U.S. investors or conduct fund
activities from locations within the United States can be
subject to CFTC regulation and registration
requirements.
The proposed rules would relieve many offshore fund
operators from CFTC registration requirements by
expanding the current exemptions from the definition of
commodity pool operator (“CPO”) in CFTC Rule 4.13
and the exemption from commodity trading advisor
(“CTA”) registration in Rule 4.14. The CFTC release
also alters the no-action positions relating to CPOs and
CTAs previously issued on November 13, 2002.
EXEMPTION FROM CPO REGISTRATION FOR
POOLS WITH SOPHISTICATED INVESTORS
The Commodity Exchange Act (“CEA”) generally
defines a CPO to include any natural person or entity
that operates an investment vehicle that pools the assets
of two or more persons and trades any commodity
futures or commodity options contract. Unless
excluded from the definition of CPO or exempted from
registration, CPOs are required to register under the
CEA and are subject to a variety of disclosure, reporting
and recordkeeping requirements.
The proposed amendments to CFTC Rule 4.13 would
expand the types of pools that are exempt from CPO
registration.
Proposed Rule 4.13(a)(3) would exempt a CPO from
registration if, among other conditions, it (1) restricts
participation in the pool to “accredited investors” as
defined in Rule 501 of Regulation D under the
Securities Act of 1933 (“Securities Act”), (2) limits the
commodity interest positions (whether or not entered
into for bona fide hedging purposes) in each of its pools
such that either (i) the aggregate initial margin and
premiums required to establish such positions will not
exceed 2% of the liquidation value of the pool’s
portfolio or (ii) the aggregate net notional value of such
positions does not exceed 50% of the liquidation value
of the pool’s portfolio, and (3) does not market
participations in the pool to the public as a commodity
pool or otherwise as or in a vehicle for trading in futures
and commodity options markets.
Under Rule 4.13(a)(3) as currently proposed, all
investors must be accredited investors, even if they are
non-United States persons. This is not the case under
the CFTC’s current no-action position, which is
described below.
Proposed Rule 4.13(a)(4) would exempt a CPO from
registration if, among other conditions, (1) it restricts
participation in the pool to natural persons who are
“qualified eligible persons” (“QEPs”) as defined in
CFTC Rule 4.7 and non-natural persons who are either
QEPs or “accredited investors” and (2) interests in the
pool are exempt from registration under the Securities
Act and offered and sold without marketing to the
public in the United States. This proposed exemption,
unlike that proposed as Rule 4.13(a)(3), does not
impose any restrictions on options and futures trading
activities, ostensibly because the QEP sophistication
standard for natural persons in Rule 4.13(a)(4) is higher
than the “accredited investor” standard in Rule
4.13(a)(3).
Non-U.S. investors are typically QEPs by virtue of
being “Non-United States persons” under CFTC Rule
4.7. Accordingly, an offshore fund that does not have
any U.S. investors who are natural persons should be
able to qualify for the Rule 4.13(a)(4) exemption. The
CFTC release notes that pool operators could
simultaneously rely on the exemptions in Rule
4.13(a)(3) and Rule 4.13(a)(4).
The CFTC also announced that it was issuing no-action
relief that will allow CPOs to rely immediately on the
exemption in proposed Rule 4.13(a)(3) (but not on the
exemption in proposed Rule 4.13(a)(4)) if the CPO
makes certain disclosures to pool participants and
makes a notice filing with the CFTC and National
Futures Association (“NFA”).
Kirkpatrick & Lockhart LLP
7
Offshore Fund Bulletin
MAY 2003
EXEMPTIONS FROM CTA REGISTRATION
The CFTC release also proposes relief for CTAs from
registration, which corresponds to that for CPOs. The
CEA generally defines a CTA as any person that
provides trading advice regarding commodity futures
and commodity options to others for compensation.
Like CPOs, CTAs must register under the CEA unless
they are excluded or exempted from registration
requirements.
The Current Rule. CFTC Rule 4.14(a)(8) exempts
CTAs from registration that give trading advice solely to
Rule 4.5 qualifying entities, such as mutual funds, and
are registered as investment advisers with the SEC or
excluded from the definition of investment adviser under
the Investment Advisers Act of 1940 pursuant to Section
202(a)(2) or Section 202(a)(11) (certain banks, lawyers
and other professionals, brokers, dealers and publishers).
Currently, the Rule does not exempt smaller investment
advisers (those with under $25 million in assets under
management) that are registered with a state securities
regulator and not with the SEC.
The Proposed Rule. One of the proposed amendments
to Rule 4.14(a)(8) would expand the exemption to cover
U.S. state-registered investment advisers.
In addition, the CFTC proposes to extend the Rule
4.14(a)(8) exemption to CTAs that (1) advise
“qualifying entities” (as defined in CFTC Rule 4.5(b))
for which notices of eligibility have been filed or that are
excluded from the definition of the term “commodity
pool” in CFTC Rule 4.5(b), (2) advise CPOs that have
claimed an exemption from registration under proposed
CFTC Rule 4.13(a)(3) or 4.13(a)(4) or (3) provide
commodity interest trading advice to commodity pools
organized and operated outside of the United States that
meet the following criteria:
n
The CPO has not organized and is not operating
the pool for the purpose of avoiding CPO
registration;
n
With the exception of the pool’s operator, advisor
and their principals, only “Non-United States
persons” may contribute funds or other capital to,
and own beneficial interests in, the pool;
8
n
No person affiliated with the pool may conduct
any marketing activity for the purpose of, or that
could reasonably have the effect of, soliciting
participation from other than Non-United States
persons; and
n
No person affiliated with the pool may conduct
any marketing activity from within the United
States, its territories or possessions.
To qualify for the exemption, a CTA also must limit its
commodity interest trading advice to only that which is
“solely incidental” to its business of providing
securities or other investment advice to the trading
vehicles specified in the Rule, and it must not hold
itself out as a CTA.
CHANGE TO NO-ACTION RELIEF
The CFTC release alters, in one respect, the existing
no-action relief that allows CPOs and CTAs to purchase
and sell futures contracts and commodity options for a
pool without first registering with the CFTC if they
restrict the pool’s participants to persons that are
accredited investors, knowledgeable employees, or
non-United States persons. Now, the CPO and CTA
may choose from among two limitations on their use of
futures and commodity options. They can limit (1) the
aggregate initial margin and premiums required to
establish a pool’s futures and commodity options
positions to 2% of the liquidation value of the pool’s
portfolio or (2) the pool’s futures and commodity
options activity to positions with notional values not
exceeding half the liquidation value of the pool’s
portfolio. To qualify for the no-action relief, a CPO or
CTA must file a notice with the NFA and the CFTC and
provide certain disclosure to pool participants.
TREATING AN ENTITY AS A SINGLE CLIENT
Section 4m of the CEA provides that the registration
requirements for CTAs do not apply to any CTA who,
during the course of the preceding 12 months, has not
furnished commodity interest trading advice to more
than 15 persons and who does not hold itself out
generally to the public as a CTA. For purposes of
determining the number of persons a CTA advises, the
CFTC staff has long interpreted the statute to require
OFFSHORE FUND BULLETIN
Offshore Fund Bulletin
MAY 2003
CTAs to “look through” any entities they advise (such
as partnerships or corporations) and to count each
limited partner, shareholder or other investor as a
“person” advised by the CTA.
Proposed Rule 4.14(a)(10) would eliminate this “look
through” position, such that any entity advised by a CTA
would count as only one “person” for purposes of
determining eligibility for the exclusion from
registration under Section 4m of the CEA.
The CFTC’s release discussing the proposed rules does
not discuss whether pools that are excluded or exempt
from CPO registration pursuant to Rule 4.5 or Rule 4.13
should be counted as “persons” advised for purposes of
determining compliance with the “15-person” limitation.
Proposed Rule 4.14(a)(10) does not alter the additional
statutory prerequisite of Section 4m—that a CTA not
hold itself out generally to the public as a CTA.
OTHER PROPOSED RULES
The proposals also would amend current rules to
(1) permit CTAs and CPOs to engage in certain types of
communications with investors prior to distribution of a
required disclosure document, (2) relieve CPOs from
duplicative disclosure and reporting requirements in the
“master/feeder fund” context, (3) establish criteria for
CPOs to distribute periodic account statements
electronically, and (4) harmonize the various signature
requirements of Part 4 of the CFTC rules.
Kirkpatrick & Lockhart LLP
9
Offshore Fund Bulletin
MAY 2003
KIRKPATRICK & LOCKHART LLP
Kirkpatrick & Lockhart LLP has over 700 lawyers in 10 offices around the United States. The firm maintains one of the
largest investment management practices in the United States.
The firm represents private funds, offshore funds, mutual funds, insurance companies, broker-dealers, investment advisers,
retirement plans, banks and trust companies, and other financial institutions. The firm works with these clients in
connection with the full range of investment management products and activities, including all types of private and
offshore investment funds, variable insurance products, funds of hedge funds, open-end and closed-end investment
companies, and unit investment trusts.
If you have questions about the article on U.S. law in this bulletin, please contact any of the following members of
Kirkpatrick & Lockhart’s Hedge, Private and Offshore Funds Practice:
BOSTON
Joel D. Almquist
Michael S. Caccese
Philip J. Fina
Mark P. Goshko
Thomas Hickey III
Nicholas Hodge
617.261.3104
617.261.3133
617.261.3156
617.261.3163
617.261.3208
617.261.3210
LOS ANGELES
William P. Wade
310.552.5071
NEW YORK
Jeffrey M. Cole
Beth R. Kramer
Richard D. Marshall
Robert M. McLaughlin
Scott Newman
Loren Schechter
212.536.4823
212.536.4024
212.536.3941
212.536.3924
212.536.4054
212.536.4008
SAN FRANCISCO
Eilleen M. Clavere
Jonathan D. Joseph
David Mishel
Mark D. Perlow
Richard M. Phillips
415.249.1047
415.249.1012
415.249.1015
415.249.1070
415.249.1010
WASHINGTON
Clifford J. Alexander
Diane E. Ambler
Catherine S. Bardsley
Arthur J. Brown
Arthur C. Delibert
Robert C. Hacker
Benjamin J. Haskin
Kathy Kresch Ingber
wwade@kl.com
Rebecca H. Laird
Thomas M. Leahey
Cary J. Meer
jcole@kl.com
R. Charles Miller
bkramer@kl.com
Dean E. Miller
rmarshall@kl.com
rmclaughlin@kl.com Charles R. Mills
R. Darrell Mounts
snewman@kl.com
C. Dirk Peterson
lschechter@kl.com
Alan C. Porter
Theodore L. Press
eclavere@kl.com
Robert H. Rosenblum
jjoseph@kl.com
William A. Schmidt
dmishel@kl.com
Lynn A. Schweinfurth
mperlow@kl.com
Donald W. Smith
rphillips@kl.com
Robert A. Wittie
Robert J. Zutz
jalmquist@kl.com
mcaccese@kl.com
pfina@kl.com
mgoshko@kl.com
thickey@kl.com
nhodge@kl.com
202.778.9068
202.778.9886
202.778.9289
202.778.9046
202.778.9042
202.778.9016
202.778.9369
202.778.9015
202.778.9038
202.778.9082
202.778.9107
202.778.9372
202.778.9371
202.778.9096
202.778.9298
202.778.9324
202.778.9186
202.778.9025
202.778.9464
202.778.9373
202.778.9876
202.778.9079
202.778.9066
202.778.9059
calexander@kl.com
dambler@kl.com
cbardsley@kl.com
abrown@kl.com
adelibert@kl.com
rhacker@kl.com
bhaskin@kl.com
kingber@kl.com
rlaird@kl.com
tleahey@kl.com
cmeer@kl.com
cmiller@kl.com
dmiller@kl.com
cmills@kl.com
dmounts@kl.com
dpeterson@kl.com
aporter@kl.com
tpress@kl.com
rrosenblum@kl.com
william.schmidt@kl.com
lschweinfurth@kl.com
dsmith@kl.com
rwittie@kl.com
rzutz@kl.com
WALKERS
Walkers is one of the Cayman Islands’ largest law firms with a total staff of over 200 in the Cayman Islands, London and
the British Virgin Islands and an international reputation for quality and responsiveness. Walkers focuses principally on
corporate and international finance law with an emphasis on capital markets and structured finance, investment funds and
asset finance. Walkers is also a Listing Agent for the Cayman Islands Stock Exchange (CSX). The firm also has the largest
commercial litigation department in the Cayman Islands and an experienced private client and trust department as well as
specialist banking, e-commerce, insolvency, insurance and regulatory groups.
If you have questions about the article on Cayman Islands law in this bulletin, please contact any of the
following members of Walkers:
Mark Lewis
Jonathan Tonge
Iain McMurdo
345.914.4223 mlewis@walkers.com.ky
345.914.4225 jtonge@walkers.com.ky
345.914.4217 imcmurdo@walkers.com.ky
®
Kirkpatrick & Lockhart LLP
Challenge us.®
www.kl.com
.............................................................................................................................................................
This publication/newsletter is for informational purposes and does not contain or convey legal advice. The information herein
should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.
© 2003 KIRKPATRICK & LOCKHART LLP AND WALKERS.
ALL RIGHTS RESERVED.