Canada: Focus on climate change disclosure continues with LEEFF
Companies that receive LEEFF funding will be required to complete annual climate change reporting and should consider utilizing the TCFD standards to inform reporting strategies.
On January 6, 2016, the U.S. Securities and Exchange Commission (“SEC”) published a Guidance Update (the “Guidance”) concerning payments made by mutual funds to financial intermediaries that provide shareholder and recordkeeping services for investors in such funds. The Guidance is a product of a three-year sweep exam conducted by the SEC that studied these payments, which are typically classified as sub-transfer agent, administrative, sub-accounting and other shareholder servicing fees (collectively, “sub-accounting fees”).
The use by broker-dealers and other intermediaries of omnibus accounts to hold shares of a mutual fund that are owned by a large number of beneficial owners has increased significantly in recent years. These omnibus accounts reduce the recordkeeping burden imposed on the mutual fund’s transfer agent because the financial intermediary performs many of the typical transfer agent services for the beneficial owners who hold their shares through the omnibus accounts. Mutual funds compensate these intermediaries for the services they render through sub-transfer agency or sub-accounting agreements.
A number of offices and divisions at the SEC have raised questions as to whether a portion of payments in respect of sub-accounting fees may have actually been used to pay for activities that are primarily intended to result in the sale of mutual fund shares and to pay for other distribution activities by the mutual fund. Under Rule 12b-1 of the Investment Company Act (the “1940 Act”), fees paid by a mutual fund for distribution activities must only be paid pursuant to Rule 12b-1, which requires that such fees be paid pursuant to a plan (a “Rule 12b-1 plan”) that has been approved by the fund. Payments of sub-accounting fees that could be re-characterized as fees for distribution activities that are paid outside of a Rule 12b-1 plan would be improper under the 1940 Act.
Given the concerns noted above, the staff of the SEC’s Division of Investment Management (the “Staff”) made the following key recommendations in the Guidance:
The Guidance identifies certain activities and arrangements that were observed during the recent sweep examinations that may raise concerns that a payment, though ostensibly not for distribution-related activities, may in fact be (or at least in part) a payment for such services:
Given the Guidance and the continued growth in the use of omnibus accounts held by financial intermediaries, mutual fund boards should revisit, and if necessary, update their processes for evaluating the payment of sub-accounting fees, especially fees paid to intermediaries that provide distribution-related services for such fund.
On July 22, 2015, the United States Treasury Department and Internal Revenue Service (“IRS”) released proposed regulations under Section 707(a)(2)(A) of the Internal Revenue Code (the “Code”) regarding disguised payments from partnerships to its partners for services (the “Proposed Regulations”). The Proposed Regulations apply to any arrangement between a partnership (e.g., limited liability companies and limited partnerships that are often used as investment fund vehicles) and a partner that provides services to the fund in exchange for a partnership interest, including management fee waiver provisions found in many private equity and other investment fund agreements.
Although there are many different types of management fee waiver arrangements, they generally involve a waiver by the fund manager of all or a portion of its management fee in exchange for a “profits interest” granted to the manager, the general partner or another affiliated partner. In some arrangements, the amount received from the profits interest is equal to the waived management fee (if the fund has sufficient profits). In other arrangements, each reduction in the management fee is treated as if it were contributed to the fund, and the amount received from the fund in respect of a contribution will be more or less than the waived management fee depending on whether the investment is sold at a gain or a loss (i.e., the proceeds could be more or less than the amount waived). As part of the arrangement, the capital contribution obligation of the general partner (or another affiliated partner) may be reduced on a dollar-for-dollar basis in an amount equal to the waived fee, and limited partner contributions that would have been used to pay the waived fees would be available to the fund as if the general partner (or another affiliated partner) had made its full contribution.
Management fees are typically taxed to the fund manager as ordinary income, and carried interest is generally taxed as long-term capital gains (since carried interest retains the character of the income earned by the fund, which is typically long-term capital gains). Thus, management fee waivers typically result in the conversion of ordinary income taxed at federal income tax rates up to 39.6 per cent to long-term capital gains or qualified dividend income taxed at federal income tax rates up to 23.8 per cent (including the 3.8 per cent tax on net investment income.)
Management fees may be waived in different ways. For example, in some funds management fees may be “waived” prior to the beginning of the period for which those fees would otherwise be earned (e.g., annually or quarterly), and in others the management fee waiver and the recipient’s entitlement to allocations and distributions are determined by formulas set out in the fund agreement (often referred to as “hardwired”).
Section 707(a)(2)(A) of the Code grants the Treasury Department authority to issue regulations under which a purported allocation and distribution to a service partner are recharacterized as a “disguised” payment for services and consequently treated as ordinary income. The Proposed Regulations generally adopt a facts and circumstances test and provide a non-exclusive list of six factors to consider when making the determination. However, the Proposed Regulations provide that an arrangement that lacks “significant entrepreneurial risk” (determined at the time the arrangement is entered into and at the time of any subsequent modification) will in all cases be recharacterized as a payment for services. The Proposed Regulations describe certain facts and circumstances that create a presumption that an arrangement lacks significant entrepreneurial risk and will be treated as a disguised payment for services, unless other facts and circumstances establish by clear and convincing evidence that significant entrepreneurial risk is present. The facts and circumstances that create a presumption that significant entrepreneurial risk is lacking are:
Although only one example is in the Proposed Regulations is reasonably close to market practice for management fee waivers, the examples suggest that a waiver containing the following elements should be respected:
An arrangement that is characterized as a disguised payment for services will be treated as a payment for services for all federal tax purposes. Accordingly, the deferred compensation rules of Sections 409A and 457A of the Code and employment and withholding tax rules could be implicated.
The preamble to the Proposed Regulations states that the Treasury Department and IRS plan to amend the existing profits interest “safe harbor” guidance (Revenue Procedures 93-27 and 2001-43) when the Proposed Regulations are finalized, to exclude a profits interest issued in exchange for services in conjunction with foregoing a payment of a substantially fixed amount. Any issuance of a profits interest not within the safe harbor would be governed by the existing case law that does not provide clear guidelines regarding the valuation and treatment of a profits interest.
In addition, the preamble indicates that the Treasury Department and IRS are of the view that issuing a profits interest for services to a person other than the service provider (e.g., fee waiver arrangements where the manager waives the fee but an affiliate receives the profits interest) does not qualify for the existing profits interests “safe harbor.” Thus, profits interests should be granted to the party that waived the management fee.
The Proposed Regulations will apply only to arrangements entered into or modified on or after the date final regulations are published in the Federal Register. However, the Treasury Department and IRS have indicated that they believe that the Proposed Regulations generally reflect Congressional intent. Therefore, the IRS may challenge existing fee waiver arrangements prior to the Proposed Regulations being finalized. In addition, if an arrangement permits a service provider to waive its fee after the date the arrangement is entered into, then the arrangement would be considered to be modified on any date that the fee is waived. As a result, fee waivers that are made on a quarterly or annual basis rather than “hardwired” at inception of the fund would be treated as modifications upon each quarterly or annual election.
Since 2012, when many private fund advisers became required to register with the SEC as a result of the Dodd–Frank Wall Street Reform and Consumer Protection Act, the U.S. Securities and Exchange Commission (“SEC”) has begun to more closely investigate certain of the fee and expense allocation practices in the private equity industry. A number of recent SEC settlements illustrate that the SEC has become increasingly focused on combatting conflicts of interest that can arise from undisclosed expense and fee allocation practices, and that without robust disclosures and written compliance policies in place, private equity firms can be exposed to substantial disgorgement and penalties.
For example, in June 2015 the SEC settled administrative proceedings against Kohlberg Kravis Roberts & Co. (“KKR”), in which the SEC alleged that KKR misallocated over $17 million in broken-deal expenses to its private equity funds without allocating any of these expenses to the funds’ co-investors (including entities established for investment by KKR employees), thus breaching its fiduciary duty. Although KKR’s private placement memorandum and limited partnership agreement disclosed that broken-deal expenses would be borne by the fund, it did not disclose that committed co-investors would not be charged their pro rata share of broken-deal expenses. The SEC further alleged that KKR had failed to adopt and implement a written compliance policy or procedure governing broken deal expense allocation practices until five years after the misallocation of broken-deal expenses began. The Investment Advisers Act of 1940 (“Advisers Act”) requires registered investment advisers to adopt written policies and procedures reasonably designed to prevent violations of the Advisers Act. As part of its settlement with the SEC, KKR agreed to pay approximately $18 million in disgorgement and $10 million in penalties.
Several months later, the SEC settled administrative proceedings with the Blackstone Group, L.P. (“Blackstone”), in which Blackstone agreed to pay nearly $39 million, including $10 million in penalties. The SEC alleged that Blackstone had failed to adequately disclose the acceleration of monitoring fees paid by fund portfolio companies to Blackstone prior to the portfolio companies’ sale or initial public offering. The SEC acknowledged that the fund documents disclosed Blackstone’s potential receipt of monitoring fees, and that Blackstone did disclose the accelerated monitoring fees after they were paid, but the SEC asserted that Blackstone failed to disclose the fact that it had the right to accelerate the payment of future monitoring fees prior to the commitment of capital by investors. The SEC also alleged that Blackstone breached its fiduciary duty by not informing fund investors that it had negotiated a discounted fee for legal services provided to Blackstone by its outside law firm that was substantially greater than the discount received by Blackstone funds. The SEC stated that Blackstone had a conflict of interest with respect to these two practices and thus breached a fiduciary duty to its investors. In addition, the SEC alleged that Blackstone failed to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act.
Recently, the SEC settled an administrative action with Fenway Partners, LLC (“Fenway”) and certain of its executives for failing to disclose certain conflicts of interest relating to, among other things, monitoring fees paid by a Fenway fund to an entity affiliated with Fenway. The SEC stated that Fenway and the executives had failed to inform the fund and its investors that certain portfolio company fees were paid to a Fenway affiliate, and thus avoided providing the benefits of those fees to the investors through a management fee offset mechanism. In the SEC settlement, Fenway and the executives agreed to pay more than $10 million.
These recent enforcement actions brought by the SEC, as well as SEC actions brought against other private equity firms, highlight the SEC’s increased scrutiny of potential conflicts of interest in private equity. Private equity firms should carefully review and evaluate the disclosures contained in their funds’ offering documents, particularly with respect to expenses and fee allocations and any other practices that could pose a potential conflict of interest. In addition, private equity firms should ensure that they have written compliance policies and procedures in place that are designed to prevent any such conflicts of interest.
En France, plus de 900 000 tonnes d’hydrogène sont produites chaque année pour couvrir les besoins de l’industrie française.