O n December 18, 2003, the National investment company, investment - - PDF document

Investment Management Alert

March 2004

Rule 2790 Dealing with New Issues: Deadline for Compliance is March 23, 2004

O

n December 18, 2003, the National Association of Securities Dealers, Inc. (the “NASD”) issued a Notice to Members adopting Rule 2790 (the “Rule”), which deals with the sale and purchase of new issues – initial public offerings of equity securities. Firms must be in compliance with the Rule by March 23,

• 2004. This alert summarizes the most important

issues arising from the adoption of the Rule. For more detailed guidance on the differences between Rule 2790 and the previous rule issued by the NASD, the “Free Riding and Withholding Interpretation,” see our Investment Management Alert, “SEC Adopts NASD Rule 2790 to Replace ‘Hot Issues’ Rule,” available at http://www.lowenstein.com/new/InvMngt12-03.pdf.

Collecting Information about Investors

Securities brokers selling new issues must determine before each sale whether the purchaser is a “Restricted Person” under the Rule. “Restricted Persons” include: NASD members and other broker-dealers; officers, directors, general partners, associated persons, employees, and certain owners and affiliates of members and broker-dealers; portfolio managers, i.e., persons or entities with the authority to buy or sell securities for a bank, savings and loan institution, insurance company, investment company, investment adviser, or collective investment account (including a hedge fund); and certain immediate family members (as defined in the Rule) of any of the aforementioned

• persons. Note that hedge fund investment

managers (“Fund Managers”), who were “conditionally restricted persons” under the Free Riding and Withholding Interpretation, are Restricted Persons under the Rule. To comply with the Rule, brokers will require their clients (the funds) to obtain information about the funds’ investors to determine if they are Restricted Persons under the Rule. Initially, this information must be obtained by a positive certification from each investor; it must be updated every 12 months. Based on these certifications, a Fund Manager will be able to certify to a broker selling new issues whether or not the fund is eligible to purchase new issues. Although funds may have certifications from their investors pertaining to the Free Riding and Withholding Interpretation, it is advisable for every fund to obtain a re-certification from existing investors who have not submitted a recent

• certification. Please contact Lowenstein Sandler

to obtain an updated form of questionnaire for investors.

G

This document is published by Lowenstein Sandler PC to keep clients and friends informed about current issues. It is intended to provide general information only. 65 Livingston Avenue www.lowenstein.com

L

Roseland, New Jersey 07068-1791 Telephone 973.597.2500 Fax 973.597.2400

Funds with Restricted Person Owners

Funds in which Restricted Persons, in the aggregate, own less than ten percent of the ownership are considered “unrestricted” and are eligible to purchase new issues. A fund that has entity investors will have to “look through” to determine aggregate Restricted Person ownership. The NASD Notice to Members adopting Rule 2790 illustrates the method by which a fund should look through to the underlying beneficial owners of the entity investor and multiply (i) the percentage of the entity investor

• wned by Restricted Persons, by (ii) the percentage of

the fund owned by the entity investor. If the fund cannot meet the ten-percent “de minimis” test, the Rule allows the fund to purchase new issues only if the fund “carves out” the Restricted Persons, as discussed in further detail below.

Applying Carve-Out Provisions

A complete carve-out of Restricted Persons from purchases of new issues, as was required under the Free Riding and Withholding Interpretation, may still be used under the Rule. Based upon informal guidance provided by the NASD, a partial carve-

• ut, which would allocate not more than ten

percent of any new issues purchase to Restricted Persons, would also be acceptable. The partial carve-out option would require a fund in which Restricted Persons owned more than ten percent of the equity to set aside ten percent or less of each new issues purchase and to allocate a pro rata portion of that amount, based on ownership of the fund, to each Restricted Person. This could be done with separate accounts for new issues or by adjusting the capital accounts of Restricted Persons

• accordingly. However, funds should consider

recordkeeping and accounting complications that would arise from using such partial carve-out methods. The Notice to Members also provides for a post- IPO re-allocation. Although not permitted to share in the gains and losses from new issues, Restricted Persons may participate in subsequent gains and losses from securities that originally were purchased as new issues. The fund’s accounting records must reflect a re-allocation of the securities that originally were purchased as new issues among the investors’ shares in the fund, at the prevailing market price. Any fund that wishes to utilize this re-allocation provision will need to disclose to investors the procedures to be followed by the fund when making such re-allocation. Those procedures should include details on how and at what time of day the market price will be determined.

Management Fees and Incentive Allocations

Fund Managers, or those with the authority to buy

• r sell securities for a collective investment account,

are restricted under the Rule. However, the Rule contains an exception for management fees or incentive allocations received by Fund Managers. The exception provides that such fees, although arising from the purchase of new issues, will not increase the fund’s Restricted Person ownership for purposes of the carve-out exception. However, if management fees and incentive allocations were to be reinvested in the fund on the Fund Manager’s behalf, such fees and/or allocations would then be designated an ownership interest and would be required to be included in the calculation of percentage of Restricted-Person ownership.

G

G

Changes to Fund Documents

Fund subscription documents should be revised to comply with the Rule. Specifically, a Fund Manager must be able to determine the percentage interests of Restricted Person owners in the fund. The information obtained from subscription documents will be needed to issue a sufficient statement to broker-dealers selling new issues to the fund to assure that the sale complies with the Rule. A fund’s Agreement of Limited Partnership, Limited Liability Company Agreement and/or Articles of Association should be amended to grant the general partner, managing member or directors, as applicable, the discretion to distribute and re-allocate new issues profits and losses.

Conclusion

Compliance with the Rule will require drafting and implementing new policies and procedures, as well as adopting amendments to each fund’s

• documents. To purchase new issues, Fund

Managers must determine the percentage of the fund owned by Restricted Persons and must be able to certify such information to a broker-dealer. Please contact Lowenstein Sandler for information on implementing the new policies required and on amending fund documents to comply with the Rule.

For Further Information

Lowenstein Sandler’s Investment Management Practice Group will continue to monitor and report

• n developments regarding the issues affecting

private investment funds and other matters of interest to our clients. If you have any questions regarding this, or any investment management issue, contact a member of the Investment Management Practice Group at 973.597.2500. Investment Management Practice Group Co-Chairs: Allen B. Levithan, alevithan@lowenstein.com Robert G. Minion, rminion@lowenstein.com Partners: John L. Berger, jberger@lowenstein.com Andrew E. Graw, agraw@lowenstein.com Michael N. Gooen, mgooen@lowenstein.com Steven J. Tsimbinos, stsimbinos@lowenstein.com Counsel: Thomas L. Fraser, tfraser@lowenstein.com Paul W. Hartzel, phartzel@lowenstein.com Brian A. Silikovitz, bsilikovitz@lowenstein.com Douglas N. Bernstein, dbernstein@lowenstein.com Associates: Carolene S. Eaddy, ceaddy@lowenstein.com Marie T. DeFalco, mdefalco@lowenstein.com Elaine M. Hughes, ehughes@lowenstein.com Mark A. Dorfman, mdorfman@lowenstein.com Scott H. Moss, smoss@lowenstein.com Benjamin B. Allensworth, ballensworth@lowenstein.com Javier Cuebas, jcuebas@lowenstein.com Erik W. Johnson, ejohnson@lowenstein.com