Global asset management quarterly - North America

Developments and market trends in North America

Publication February 2018

Quarterly SEC developments roundup

Author: Steven Howard

Two New SEC Commissioners are Approved and the SEC Commissioners are Complete

Robert Jackson and Hester Peirce were sworn into office as Securities and Exchange Commission (SEC) Commissioners on January 11, 2018 joining Chairman Jay Clayton and Commissioners Stein and Piwowar. Robert Jackson was most recently a New York University Law Professor, and Hester Peirce was a Senior Research Fellow at George Mason University. With their installations, the SEC which has five Commissioners is now complete.

SEC Halts Initial Coin Offerings and Creates a Cyber Unit

On December 11, 2017, the SEC announced that it issued an order to Munchee Inc., a block-chain based food review service, halting its $15 million initial coin offering (ICO) before any tokens were delivered to investors. The SEC found that Munchee’s conduct constituted an offering of unregistered securities.

The SEC halted an ICO on December 4, 2017 by PlexCorps for claiming investment returns of 1,354% in less than 29 days. To date, the SEC has not promulgated or adopted any regulations concerning ICOs or distributed ledger technologies (DLT). The SEC issued an Investor Bulletin in July 2017 that discussed potential investor risks that may arise from participating in initial coin offerings.

The SEC organized a Cyber Unit in September 2017 that focuses on misconduct involving distributed ledger technology and ICOs, the spread of false information through electronic and social media, brokerage account takeovers, hacking to obtain non-public information and threats to trading platforms. The SEC has also formed a DLT Working Group that focuses on emerging applications of DLT in financial services.

$16 Million Whistleblower Award

On November 30, 2017, the SEC announced awards of more than $16 million to two whistleblowers. The SEC has issued a total of $175 million in whistleblower awards since its first award in 2012, and more than $1 billion in financial remedies since the start of the program.

SEC Ratifies the Appointment of Administrative Law Judges

On November 30, 2017, the SEC ratified its prior appointments of its administrative law judges, reversing its many-decades long position that its judges did not require approval by the Commissioners. The SEC approval of its administrative law judges is important because it now throws into doubt thousands of decisions made by its judges prior to their ratification by the Commissioners.

The US Supreme Court Will Review an SEC Case Concerning the Constitutionality of its Administrative Law Judges

On January 16, 2018, the US Supreme Court agreed to resolve a circuit split over whether the hiring of SEC administrative law judges violates the US Constitution’s appointments clause. The SEC has reversed its historical position and now takes the position that its judges are “officers of the United States,” not mere employees, and, therefore, must be approved by the SEC Commissioners under delegated executive authority from the US President.

An appellate case in the Tenth Circuit agrees with the SEC’s new position that its judges are officers, and the D.C. Circuit disagrees with that position in Lucia v. SEC. The Supreme Court will resolve the ‘split in the Circuit Courts.’

There is a likelihood that the Supreme Court will resolve the case in the SEC’s favor, and in doing so, throw into doubt the legitimacy of thousands of decisions made by hundreds of administrative law judges who, like the SEC judges, have not been approved by the US President or a government official who was appointed by the President.

SEC Announces Measures to Facilitate Cross-Border Implementation of the European Union’s MiFID II Research Provisions

On October 26, 2017, the SEC issued three no-action letters designed to provide market participants with greater certainty regarding their US regulated activities as they engage in efforts to comply with the European Union’s Markets in Financial Instruments Directive (MiFID II). The no-action letters provide a path for market participants to comply with the research requirements of MiFID II in a manner that is consistent with the US securities laws.  More specifically and subject to certain conditions, broker-dealers may receive research payments from money managers in hard dollars or from advisory clients’ research payment accounts; money managers may continue to aggregate orders for mutual funds and other clients; and, money managers may continue to rely on an existing safe harbor when paying broker-dealers for research and brokerage.

The temporary no-action relief facilitates compliance with the new MiFID II research provisions while respecting the existing U.S. regulatory structure.

SunTrust Settles Charges of Improperly Recommending Higher-Fee Mutual Funds

On September 14, 2017, the SEC issued an order in connection with the settlement of an enforcement proceeding against SunTrust Investment Services, Inc. (“Adviser”), a dually-registered investment adviser and broker-dealer, in connection with its alleged: (i) failure to seek best execution for client transactions in mutual fund shares; (ii) failure to fully and adequately disclose conflicts of interest related to the Adviser’s mutual fund share class selection process; and (iii) deficiencies in related compliance policies and procedures.

This order concerned clients who held either discretionary or non-discretionary wrap fee investment accounts managed by the Adviser. The order states that from December 2011 to June 2015, the Adviser, on behalf of these clients, purchased, recommended or held Class A or other mutual fund shares that charged a Rule 12b-1 fee, when less-expensive institutional class shares of the same mutual funds were available. Further, the order states that while the Adviser disclosed in its Form ADV Part 2A that it “may receive 12b-1 fees” as a result of investments in certain mutual funds in its advisory program and that such fees may present a conflict of interest, the Adviser failed to disclose that many of the Adviser’s recommended mutual funds offered a variety of share classes, including some that did not charge 12b-1 fees. In addition, the order states that the Adviser failed to disclose to affected clients that an Adviser representative could purchase, hold, or recommend - and in certain instances did purchase, hold, or recommend - mutual fund investments in share classes that paid 12b-1 fees to the Adviser. The order indicates that the Adviser ultimately shared these fees with its representatives as compensation, even though such clients were eligible to invest in share classes of the same mutual funds that did not charge such fees and were less expensive.

The order states that the Adviser’s failure to make “adequate disclosures concerning its [representatives’] share class selections was misleading to investors in light of [the Adviser] investing its clients in more expensive mutual fund share classes when lower-cost options of the same funds were available.” The order further states that the practice of investing clients in mutual fund share classes with 12b-1 fees rather than lower-fee share classes was also inconsistent with the Adviser’s duty to seek best execution for its clients.

Based on these findings, the SEC alleged that the Adviser violated various provisions of the Investment Advisers Act of 1940, including Section 206(2) (an antifraud provision), Section 206(4) and Rule 206(4)-7 thereunder (requiring written policies and procedures reasonably designed to prevent Advisers Act and rule violations), and Section 207 (making an untrue statement in SEC filings). Without admitting or denying the SEC’s findings, the Adviser agreed to pay a civil penalty of $1.1 million and about $40,000 in disgorgement and pre-judgment interest.

SEC Makes a Fiduciary Rule a Priority

On October 4, 2017, SEC Chairman Jay Clayton stated that it is a priority of the SEC to promulgate and adopt a rule that defines the fiduciary duty of broker-dealers for all investor assets, including assets under the Employee and Retirement Income Security Acts of 1975. With the effectiveness of the US Department of Labor’s Fiduciary Rule postponed until July 1, 2019, the SEC has 18 months to promulgate and adopt its version of a fiduciary standard.  How the SEC and Department of Labor will harmonize two different fiduciary standards, is an open question at this point.

US tax reform update: Impact on private investment funds

Authors: Michael Flamenbaum, Bill Bowers, Hersh Verma and Danielle Floyd


On December 22, 2017, President Trump signed the Tax Cuts and Jobs Act (the “Tax Act”). The Tax Act is the most extensive change to the Internal Revenue Code since the Tax Reform Act of 1986 and includes provisions that will significantly impact private investment funds. The following is a brief summary of some of the key provisions of the Tax Act that are relevant to private investment funds.

Carried interest

Although several legislative proposals had been introduced in prior years that would have eliminated any tax benefit to carried interest for fund managers, the Tax Act retains the treatment of carried interest but substitutes a three (rather than a one) year holding period requirement for fund managers to receive long-term capital gain on the sale of capital assets such as stock or partnership interests in portfolio companies. Additionally, the changes apply only to carried interest transferred in connection with the performance of substantial services in an applicable trade or business, which is defined as any activity performed on a substantial, regular and continual basis for raising and returning equity and investing, disposing or developing specified assets (which generally consists of securities, commodities and real estate held for investment or rental). The three-year holding period will be determined based on the holding period of the asset giving rise to the gain and will apply irrespective of whether a Section 83(b) election was made for the carried interest. The three-year holding period will also apply to any sale or disposition of the carried interest itself. The three-year holding period requirement, however, will not impact the favorable long-term capital gain rates applicable to “qualified dividend income” or the gain from the sale of depreciable property and real property used in a trade or business and held for more than one year.

Capital gains not satisfying the three-year holding period requirement will be treated as short-term capital gains, which are taxed at ordinary income rates but can be offset by long-term capital losses.

The three-year holding period requirement does not apply to a capital interest which provides for a right to share in partnership capital commensurate with the total amount of capital contributed or to the value of the carried interest subject to tax under Section 83 of the Tax Act upon receipt or vesting of the interest.

This new rule will apply for tax years beginning after December 31, 2017, without any grandfathering of carried interest issued prior to December 31, 2017.

Reduction in corporate tax rates and limitations on NOLs

Under the Tax Act, the corporate tax rate is reduced permanently from 35% to 21% for tax years beginning after December 31, 2017. This reduction in corporate tax rates may impact the decision by fund managers to structure portfolio companies as corporations rather than pass-through entities, such as limited liability companies (“LLCs”), and will have implications for the use of US “blocker” corporations often established by funds for investment by non-US and US tax-exempt investors.

A corporation’s ability to use net operating losses will be limited to 80% of its annual taxable income. The Tax Act disallows the carryback of losses but allows for an indefinite carryforward of losses.

Reduction of tax on income from pass-through entities

Many investments by buyout and venture funds are made in pass-through entities, in particular LLCs that are classified as partnerships for US federal income tax purposes. The Tax Act creates a new deduction for non-corporate taxpayers who have domestic “qualified business income” (“QBI”) from flow through entities (e.g., partnerships, S corporations or sole proprietorships) (a “Flow-Through Deduction”) engaged in qualifying trades or businesses (“QTB”). The Flow-Through Deduction applies to taxable years beginning after December 31, 2017 and before January 1, 2026. The Flow-Through Deduction is generally the lesser of: (i) 20% of the QBI for the taxable year; or (ii) the greater of: (a) 50% of the W-2 wages with respect to the QTB; or (b) 25% of the W-2 wages with respect to the QTB plus 2.5% of the unadjusted basis of qualified property.

In general, QBI is income from a US trade or business, and also includes certain dividends from REITs and cooperatives and qualified publicly traded partnership income. However, QBI does not include investment income such as capital gain, dividends, investment interest income, and commodity and foreign currency gains, and does not apply to reasonable compensation for services or guaranteed payments paid to a partner for services. Except for persons with income below a threshold, the Flow-Through Deduction also does not apply to taxpayers with pass-through income from specified service businesses including those in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, and brokerage services, or which involve investing, investment management, trading or dealing in securities, partnership interests or commodities.

This provision is very complex and there is uncertainty about the application of particular aspects of the new rule. However, it is expected that the Flow-Through Deduction should benefit US individuals and other non-corporate fund investors receiving allocations of taxable income from fund investments in pass-through entities such as LLCs.

Limit on business interest deductions

The Tax Act limits the deduction for the excess of business interest expenses over business interest income to 30% of the taxpayer’s adjusted taxable income, which is defined for years beginning before 2022 as the taxpayer’s taxable income computed without regard to any deduction for depreciation, amortization, or depletion. Beginning January 1, 2022, however, the 30% limit will be applied without any adjustment to adjusted taxable income for depreciation, amortization, or depletion. Any disallowed excess interest expense can be carried forward indefinitely.The new interest expense limitation applies to any form of business (e.g., a corporation or LLC), but does not apply to a business if its average annual gross receipts over three years do not exceed $25 million, and does not apply to electing real estate or farming businesses. The application of the 30% limitation is made at the partnership level.

The 30% limitation is expected to impact typical leveraged buyouts and may result in the increased use of preferred equity as a substitute for mezzanine debt in acquisitions, although caution should be exercised to avoid the preferred equity being characterized by the Internal Revenue Service as debt. In addition, this limitation is likely to have implications for leveraged blocker corporations.

Gain on the sale of partnership interests by a foreign person

Under the Tax Act, a non-US person that sells an interest in a partnership (including an LLC that is treated as a partnership for US federal income tax purposes) engaged in a US trade or business will recognize US effectively connected income (“ECI”) to the extent the foreign person would have had ECI had the partnership sold its assets for fair market value. This provision reverses the recent Tax Court decision in Grecian Magnesite Mining v. Commissioner and effectively codifies the IRS’ long standing position in Revenue Ruling 91-32.

In addition, to support the collection of tax from non-US sellers of interests in ECI partnerships, the Tax Act imposes a 10% withholding requirement on the amount realized from the disposition of the interest (much like the withholding requirement under the Foreign Investment in Real Property Tax Act of 1980 in the case of a sale of interest in US real estate). If the transferee fails to withhold, the partnership is required to withhold the amount (plus interest) from distributions to the transferee.

Many funds have established US corporate “blockers” to shield non-US investors from ECI and the resulting US tax filing and payment obligations. Following the Grecian Magnesite decision, there was hope that non-US investors could structure their investments through non-US blockers that would not incur US tax on the disposition of a partnership interest. However, under the Tax Act, non-US investors should continue to consider the use of US blockers. Moreover, the decrease in the corporate tax rate from 35% to 21% will reduce the tax cost of investing through US blockers.

Separate investment-by-investment computation of UBTI

The Tax Act requires that tax-exempt organizations compute “unrelated business taxable income” (“UBTI”) separately for each unrelated trade or business, which prevents a tax-exempt investor’s expenses or losses from one UBTI activity from offsetting UBTI from another activity, as had been permitted under prior law.

Tax-exempt investors are often provided the opportunity to choose whether to participate in a fund investment that is expected to generate UBTI directly or through a blocker. Because of the elimination of the ability to offset UBTI gains and losses, this change may encourage tax-exempt investors to invest through blocker corporations.

Excise tax on certain private colleges and universities

The Tax Act imposes a 1.4% excise tax on the net investment income of private colleges and universities with at least 500 full-time, tuition-paying students and with aggregate assets (other than assets used directly in carrying out the institution’s exempt purpose) of at least $500,000 per full-time student.

Capital expensing

The Tax Act permits the immediate write-off of 100% of the cost of property acquired and placed into service after September 27, 2017 through 2022. The available write-off will be reduced by 20% per year beginning in 2023 (and for certain property in 2024). This new rule allows write-offs for not only “new” property, but also for “used” property as well. Accordingly, fund managers may be incentivized to make asset acquisitions, including deemed asset acquisitions under Sections 336 and 338(h)(10) of the Tax Act, in order to reduce the effective tax rate of equipment-intensive businesses.

Controlled foreign corporations

A non-US corporation is a controlled foreign corporation (“CFC”) if “US shareholders” own directly or by attribution, more than 50% of the non-US corporation (by vote or value). Section 951(b) defined a US shareholder as a US person who owns, directly or by attribution, 10% or more of the total combined voting power of all classes of stock entitled to vote. The Tax Act expands the definition of US shareholder to include US persons who own 10% or more of the total value of shares of all classes of stock, voting or non-voting. The Tax Act also provides expanded downward attribution from a non-US person of its stock in a non-US corporation to a related US person for purposes of determining whether the US person is a US shareholder.

These changes are likely to result in more non-US portfolio companies being treated as CFCs, and consequently, US shareholders having greater “phantom income” inclusions and reporting obligations.

The Tax Act also imposes a one-time transition tax, under which US shareholders that own 10% or more of the voting stock of certain foreign corporations will generally include in income their pro rata share of the foreign corporation’s post-1986 accumulated earnings and profits that were not previously subject to US tax. The transition tax imposes a 15.5% rate applicable to cash and cash equivalents and an 8% rate for non-cash assets. A US shareholder may elect to pay the transition tax over eight years without an interest charge. This transition tax could affect US corporate portfolio companies or taxable US investors, depending on the investment structure.

Miscellaneous itemized deductions

Under prior law, individuals, trusts and estates could deduct miscellaneous itemized deductions (e.g., investment management fees) that exceeded 2% of the taxpayer’s adjusted gross income. The Tax Act eliminates all miscellaneous itemized deductions beginning after December 31, 2017 and before January 1, 2026.

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