OFFSHORE FUNDS: CERTAIN STRUCTURAL AND SECURITIES ISSUES

Peter M. Rosenblum Foley, Hoag & Eliot LLP Boston, Massachusetts

Funds located outside the territory of the , so-called offshore funds, do not follow any fixed structural or organizational pattern. Rather, they vary widely in structure in accordance with the business aims of their participants. Because of their broad diversity of structures and objectives, ready categorization of the funds is difficult.

The easiest categorization focuses on the direction in which money flows to and from the fund. Direction can conveniently be determined with reference to United States jurisdictional boundaries. Thus, for purposes of these materials, an outbound will be considered to be a fund located offshore which invests its capital in offshore investments and obtains its capital from United States . An inbound offshore fund will be a fund located offshore which invests primarily in assets within the United States and obtains its capital from non-United States investors. In practice, many funds combine attributes of each of these categories, and considerable analytical and planning complexity can be created by such combinations. The most common combinations commingle capital from United States and non-United States investors or invest that capital both in the United States and abroad.

Three examples of these funds are considered in these materials. Two will be particular “pure” examples of each offshore fund type. The third is a more complex inbound offshore model designed to achieve specific goals.

1. Inbound Offshore Funds.

(a) Single company model. This inbound offshore fund is a company organized in an offshore jurisdiction with favorable tax laws. The fund invests money provided by non-United States institutional investors and wealthy individuals in United States securities. The company is organized under a specialized law governing international business companies or exempted companies (collectively “IBCs”). As such a company, it remains largely free from local taxes and charges as long as no nationals from the jurisdiction of organization are investors and local operations are limited primarily to administrative operations. Its investment decisions are directed by a United States entity registered under the Investment Advisers Act of 1940 (the “Advisers Act”), and it is not registered under the Investment Company Act of 1940 (the “Investment Company Act”). Despite the nature of its investments and the location of its advisor, this inbound entity is not treated as a United States taxpayer. Rather, it is taxed as a domiciliary of the jurisdiction of its organization. Ordinarily, tax will be withheld on dividends paid to the offshore fund, although there are several strategies which will minimize the burden of this withholding.

The structure of this type of inbound offshore fund has become familiar and was substantially dictated by principles of United States income tax law often referred to as the “Ten Commandments of .” See Treasury Regulations under Section 864 of the Internal Revenue Code of 1986, as amended (the “Code”). A full discussion of these principles is beyond the scope of these materials. Effective after December 31, 1997, the “Ten Commandments” are no longer a part of the tax analysis, and offshore funds which trade in United States securities will no longer need a principal office offshore in the old pattern to avoid federal taxation in the United States. State tax law in certain states may require retention of this approach in certain circumstances.

The focus of administration of this type of fund occurs offshore. An administrator, typically an offshore trust company or affiliate of one, among other things, communicates with shareholders, manages the share register and other books and records, accepts new subscriptions, supplies the statutory office and acts as resident agent. The administrator usually recommends nominees to constitute a majority of the directors. Directors will be elected by investors holding a majority of the shares or shares representing a majority of assets. The investment advisor has discretion to manage the assets of the fund. An affiliate of the investment advisor may have a seat on the board.

The principal custodian of the fund’s assets will be the offshore trust company or another or prime broker. However, subcustodians in the United States are often designated to handle actual trading. When the administrator is an affiliate of a United States commercial bank, broker or trust company which offers custodial services, the offshore and onshore affiliates will manage custody between them in the ordinary course.

Meetings of shareholders and directors occur offshore at periodic intervals. However, some of the offshore jurisdictions have modernized corporate statutes which permit meetings to be held by conference telephone or permit substitution of written consents for meetings.

This structure and format remains a preference of offshore investors. It permits them to participate in the United States securities markets without substantial involvement with United States tax or securities regulatory authorities. Certain funds in this structure have multiple classes of shares. A class of shares, usually non-voting, may be sold to United States tax exempt investors, which often are not regarded as problematical by offshore investors. When the inbound fund is operated in conjunction with a domestic partnership or limited liability company for United States investors, a key structural issue will be whether to employ a side-by-side, hub-and-spokes (master-feeder) or modified hub-and- spokes (mini-master-feeder) arrangement.

The investment advisor has an agreement with the inbound offshore fund under which the advisor’s fees are paid. This fund structure may permit the investment advisor to elect tax advantaged fee deferrals from the fund.

A diagram of this fund’s structure follows.

INBOUND OFFSHORE FUND

INVESTOR INVESTOR INVESTOR

$ SHARES $ SHARES SHARES $

SERVICES FUND ADMINISTRATOR

CONTRACT

CONTRACT OFFSHORE ONSHORE $ SECURITIES

ADVICE INVESTMENT ADVISOR UNITED STATES SECURITIES MARKETS

(b) Multi-tier model. A multi-tier model for an inbound fund, employing multiple entities, is sometimes desirable to achieve the goals of different classes of investors. The fund considered here adds capital from tax exempt United States institutional investors and taxable United States investors to the non-United States money invested in the single corporation example described above.

The basic fund entity remains an IBC, little different from the one discussed in the single corporation example. It is organized in an offshore jurisdiction with favorable tax laws and pays no substantial local taxes or charges. The IBC is not subject to taxation in the United States. Its administrator and principal custodian are located offshore.

This IBC differs from the ones in the prior example in two principal respects: unlike the previously-described IBC, tax exempt United States institutions also contribute funds to this one. Their participation draws the IBC more tightly into the United States securities regulatory network, and compliance under federal and state securities laws becomes a more significant concern.

The IBC does not invest directly in United States securities. Rather, its investment is through a second entity in which the IBC’s capital is commingled with other investors’ capital.

This second entity is also located offshore in the same favorable jurisdiction, but it is not an IBC. It is a limited duration company (“LDC”), an entity similar in many ways to a United States limited liability company. Investors in the LDC have liability limited to their investment and the centralized offshore management of the IBC. Taxable United States investors and the IBC pool their capital in the LDC.

For United States income tax purposes, the LDC is designed to be a “flow through” entity. Investors are taxed on all profits of the LDC, whether or not distributed, and no tax is paid at the entity level. Because of the “flow through” tax treatment, taxable United States investors will not be subject to the sometimes punitive effects of Code Sections 1296 and 1297 relating to passive foreign investment companies (PFICs), Code Section 951 et seq. relating to controlled foreign corporations (CFCs) or Code Sections 551-558 relating to foreign personal holding companies (FPHCs). These effects are ordinarily not a substantial concern for tax exempt United States investors, and for many investment strategies, they will prefer a corporate entity to shield them from unrelated business taxable income created by debt financing. However, for certain of the taxable investors investing through the LDC, avoidance of these punitive effects may be the difference between a profitable investment and one that makes little economic sense.

In this example, the LDC invests all of its capital in United States securities. Here, the investment is made through an offshore broker, which can provide access to greater leverage than would be possible through an onshore broker. Ordinarily, tax will be withheld on dividends paid to the LDC, although there are several strategies which will minimize the burden of that withholding. Profit and loss are allocated directly to all investors in the LDC, and they receive distributions which may differ in amount and character from the profits. The IBC receives allocations of profit and loss and distributions like any other investor in the LDC and then can pay the amount of these distributions to its shareholders as dividends.

A diagram of this structure follows. MULTI-TIER INBOUND OFFSHORE FUND

INVESTOR INVESTOR

$ $ SHARES

SHARES

SERVICES $ LIMITED SERVICES INTERNATIONAL DURATION ADMINISTRATOR BUSINESS ADMINISTRATOR COMPANY COMPANY CONTRACT INTEREST CONTRACT

SHARES $

$ INTERESTS ADVICE BROKER $

OFFSHORE CONTRACT ONSHORE $ SECURITIES TAX EXEMPT INVESTORS

TAXABLE INVESTORS INVESTMENT ADVISOR UNITED STATES SECURITIES MARKETS 2. Outbound Fund. The outbound offshore fund which is described here demonstrates a new approach to outbound offshore investing. It is designed to permit tax exempt United States institutional investors to participate in joint ventures with international operating companies to manage and operate assets in so-called “alternative asset classes.” Much of the structuring is designed to minimize taxes in non-United States jurisdictions. The investors, which are already tax exempt in the United States, anticipate a very low tax burden on cash flow. The particular example described here owns an interest in a large offshore forest, but there is no particular reason why the model cannot be extended to other asset classes and industries.

The joint venture consists of a contractual relationship between two special purpose corporations established to participate in the joint venture. In the United States, this type of arrangement might be styled a general partnership, but in the nation where the forest is located (the “Host Nation”) the distinction between partnership and joint venture has legal significance. The corporations own the forest as tenants in common and depend on the joint venture agreement to delineate their rights and obligations. Each of the participants agrees that the special purpose corporations will have no significant assets and no liabilities unrelated to the joint venture. The venturers do not wish to assume any credit risk external to the transaction.

The special purpose corporation organized by the outbound investors is domiciled in an offshore jurisdiction with favorable tax laws (the “Organization Jurisdiction”), and, like the inbound fund, maintains its principal office outside the United States. It pays no income or capital gains taxes to the Organization Jurisdiction, and there is no tax on its dividends levied by that Jurisdiction. It is taxed on forest income by the Host Nation under a separate tax regime applicable to non-resident taxpayers, but benefits from deductions available under the Host Nation’s tax laws. The most important of such deductions is the Host Nation’s version of a depletion allowance.

The special purpose joint venture corporation formed by the investor group is owned by another corporation domiciled in the Organization Jurisdiction. This corporation (the “Investor Corporation”) is owned directly by the institutional investors in proportion to their committed capital. The investors contribute equity to the special purpose joint venture corporation by a purchase of shares in the Investor Corporation which, in turn, makes a contribution to the capital of the special purpose joint venture corporation. Like the special purpose joint venture corporation, the Investor Corporation will not be taxed in the Organization Jurisdiction on its earnings or gains, and there will be no withholding with respect to its dividends to the investors. The two-tier ownership structure facilitates a tax efficient exit from the joint venture by the investors: in certain exit transactions, the Investor Corporation will be able to sell the stock of the special purpose corporation to the joint venture partner or another buyer. Since the Investor Corporation has no direct contact with the Host Nation, its exit likely would not be taxed there, and the gain would not be taxed in the Organization Jurisdiction. The second corporation also provides a further shield against forest-related liabilities for the institutional investors.

The investment by the institutional investors has two components: an equity investment and a debt investment. The equity investment has already been described. The investment structured as debt is a direct investment by institutional investors in zero coupon notes of the special purpose joint venture corporation. The notes pay no current interest, but accretion on the notes is deductible currently in the Host Nation by the special purpose joint venture corporation. The accretion deduction, together with deductions for depletion, shelter from tax virtually all of the cash flow of the corporation in the Host Nation. The Host Nation does not tax the accretion on the notes to the holders until the accretion is paid to them. The notes may not be transferred by any to anyone who has not purchased a corresponding percentage of the shares of the Investor Corporation.

The advisor to the investors is a United States entity registered under the Advisers Act. Neither the Investor Corporation nor its subsidiary is registered under the Investment Company Act. The advisor maintains an advisory relationship with both the Investor Corporation and the institutional investors. A comprehensive investment management agreement defines each of the advisor’s roles: the advisor provides advice to the Investor Corporation, management services to the Investor Corporation and its subsidiary and assistance to the Investor Corporation and its subsidiary in managing the joint venture, in each case to the extent requested. To the extent feasible under relevant tax laws, employees of the investment advisor ordinarily serve as officers and directors of the Investor Corporation and its subsidiary. The advisor monitors the investment on behalf of the investors and reports to them on a mutually agreed schedule.

The joint venture, itself, is managed by a management committee appointed by the joint venture corporations. Two members of the management committee are appointed by each venturer. An independent fifth member is appointed by the venturers acting jointly. Certain major decisions concerning the joint venture require the concurrence of all members of the management committee appointed by the two venturers. A diagram of this outbound structure follows. OUTBOUND OFFSHORE FUND

ADVICE INVESTMENT ADVISOR INVESTOR INVESTOR CONTACT

ADVICE SHARES CONTACT $ $ SHARES ONSHORE OFFSHORE

$ OPERATING ZERO COUPON DEBT $ COMPANY INVESTOR ZERO COUPON DEBT CORPORATION SERVICES ADMINISTRATOR

CONTRACT

SPECIAL JOINT JOINT PURPOSE VENTURE VENTURE SUBSIDIARY CORPORATION

FOREST THE LEGAL BACKGROUND

These offshore funds, particularly the outbound fund, operate at the intersection of a broad cross-section of securities and other laws. To the uninitiated client, these laws can seem to create a thicket of regulation from which only the fortunate, or particularly well-advised, can emerge. In fact, many of the structural and compliance issues are commonly encountered in other contexts and have been fully explored. Others are considerably more esoteric and require specialized expertise.

In summary form, the matrix of applicable securities laws can be described as follows:

1. Securities Act of 1933 (“Securities Act”). Interests in the funds will ordinarily constitute securities for purposes of the Securities Act. If the offering of interests in the funds is within the jurisdictional scope of the Securities Act, the offering must either be registered under Section 5 of the Securities Act or exempt from such registration. Transactions with “true institutional investors” will ordinarily be exempt from registration under Section 4(2) of the Securities Act or Regulation D promulgated under the Securities Act. Following adoption of a new Section 18 of the Securities Act in the National Securities Markets Improvements Act of 1996 (“NSMIA”), securities issued in transactions that fall within the safe harbor provided by Rule 506 of Regulation D or that are otherwise exempt under SEC rules or regulations under Section 4(2) are “covered securities,” which are exempt from substantive state regulation. Under Section 18, states may still impose notice filing requirements that are “substantially similar” to those required by rule or regulation under Section 4(2) on September 1, 1996. Regulation S promulgated under the Securities Act usually is available for sales of securities to offshore investors by an inbound fund and may shelter offers and sales to offshore investors in outbound funds which cater primarily to United States investors. Each of these approaches to exemption from registration limits the freedom to market a fund since they preclude general solicitation and advertising in the United States. In essence, this freedom of action is exchanged for lower cost in the organization and operation of the fund.

2. Securities Exchange Act of 1934 (the “Exchange Act”). Offerings of securities in funds which are within the jurisdictional scope of the Exchange Act will be subject to the anti-fraud provisions of the Exchange Act and may require attention to the broker-dealer registration provisions of that Act. The offshore funds considered in these materials likely will fall within such jurisdictional scope. See, e.g., Zoelsch v. Arthur Andersen & Co., 824 F.2d 27 (D.C. Cir. 1987); IIT, an Int’l Inv. Trust v. Cornfeld, 619 F.2d 909 (2d Cir. 1980); CL - Alexanders Laing & Cruickshank v. Goldfeld, 709 F. Supp. 472 (S.D.N.Y. 1989). The familiar prohibitions against misstatements and omissions of material facts embodied in Section 10(b) of the Exchange Act and Rule 10b-5 promulgated thereunder govern such fund offerings. The approach taken to disclosure will depend on the nature of the offering and the relationship of the parties. A confidential memorandum (a “private placement memorandum” under Section 4(2) or Regulation D) describing the fund, its advisor and the offering is usually employed, but its scope and the additional documentation, due diligence and other information which accompany or elaborate on it depend on the judgment of counsel and the practices of the fund.

3. Investment Company Act of 1940. Most funds organized for institutional investors in the United States seek to remain outside the comprehensive regulatory framework established by the Investment Company Act as “private investment companies.” Registration under the Investment Company Act is a significant expense, and subsequent compliance issues under the Act increase costs and limit flexibility. Institutional investors located in the United States usually see such registration as unnecessary and burdensome. They have the capacity to protect themselves through fund documentation, enforcement of other common law and statutory fiduciary obligations and, when applicable, the very comprehensive regulation provided by the Employee Retirement Income Security Act of 1974, as amended (“ERISA”), and the regulations promulgated by both the Department of Labor and the Department of the Treasury under ERISA.

By contrast, funds which are organized offshore essentially do not have the option of registration under the Investment Company Act. Section 7(d) of the Investment Company Act appears to create a route for registration of investment companies organized under the laws of foreign countries, and a release issued by the Securities and Exchange Commission (“SEC”) Staff in 1975 (Investment Co. Act Rel. No. 8959) appeared to set forth guidelines for obtaining the necessary order permitting registration. However, in practice, very few registrations of foreign funds under Section 7(d) have even been attempted, and the processing of the attempts has not been easy. In 1983, the SEC Staff issued a new release (Investment Co. Act Rel. No. 13691) which recognized the impracticability of Section 7(d) applications and specifically recommended that a foreign investment company which wants to sell shares in the United States consider forming a “mirror fund” under United States law to register under the Investment Company Act. This advice is echoed in the 1992 report of the SEC’s Division of Investment Management, Protecting Investors: A Half-Century of Investment Company Regulation (May 1992), Fed. Sec. L. Rep. (CCH) Extra Edition, Report 1504 (hereinafter the “Report”) at 188-189.

Inbound funds frequently seek to remain entirely outside the Investment Company Act’s regulatory framework by declining to accept investments from any United States residents. When they accept investments from United States residents, they may still make a private offering in the United States (even one occurring simultaneously with a public offering abroad) if they satisfy the two- part test established by the SEC Staff in Touche Remnant & Co. (U.K.), [1984- 1985 Transfer Binder] SEC No-Action Letter, Fed. Sec. L. Rep. (CCH) ¶77,810 (July 27, 1984). Under Touche, Remnant, the offering to United States investors must be both a private offering under Rule 506 of Regulation D and result in the relevant fund having no more than one hundred beneficial owners resident in the United States. Under Touche Remnant the number of beneficial owners was to be calculated using the approach taken under Section 3(c)(1) of the Investment Company Act, which is described more fully below. The SEC Staff has stated that a private investment company will not violate Section 7(d) if it privately offers and sells its securities in the United States to an unlimited number of qualified purchasers in accordance with Section 3(c)(7). Goodwin, Procter & Hoar, SEC No-Action Letter (February 28, 1997). Under this no-action letter, a foreign private investment company which previously had sold its securities to 100 or fewer United States residents in reliance on Touche Remnant may rely on the grandfathering provisions of Section 3(c)(7)(B) to offer and sell securities to United States residents who are qualified purchasers.

Although the Touche Remnant analysis has been strongly criticized for introducing Section 3(c)(1) beneficial ownership concepts to the Section 7(d) analysis (see, e.g., E. Greene, A. Beller, G. Cohen, M. Hudson and E. Rosen, U.S. Regulation of the International Securities Markets 624-630.2 (1993)), the SEC Staff adhered to it in the Report, and there seems to be no public indication of a change in approach other than the introduction of Section 3(c)(7) concepts into the Section 7(d) analysis. See the Report at 200-202. The Staff modified its Touche Remnant position in Investment Funds Institute of Canada, SEC No- Action Letter (March 4, 1996), to permit a fund organized outside the United States that is not registered under the Investment Company Act to have more than one hundred beneficial owners who are United States residents if, among other things, the fund has not publicly offered or sold securities in the United States, has not engaged in marketing activities that “could reasonably be expected, or are intended, to condition the U.S. market,” and exceeded the one hundred investor limit solely because non-United States residents holding its securities relocated to the United States. See also Fiduciary Trust Global Fund, SEC No-Action Letter (August 2, 1995) (sales under Regulation S to non-United States persons do not violate Section 7(d) solely because the securities sold are held in accounts by professional fiduciaries organized or resident in the United States); Indosuez Asia Limited, SEC No-Action Letter (February 14, 1997) (creation of United States depositary receipts program for foreign investment company does not raise concerns under Section 7(d), nor must depositary receipts, representing securities of the investment company purchased through offshore secondary markets by United States residents, be counted toward the one hundred beneficial owner limit); Goodwin, Procter & Hoar, SEC No-Action Letter (October 5, 1998) (exempt fund may conduct simultaneous private United States offering and offshore public offering and use United States jurisdictional means in connection with the offshore public offering); Investment Co. Act Rel. No. 24491 (June 23, 2000) (adopting Rule 7d-2, which exempts from Investment Company Act registration foreign investment companies that sell securities to Canadian tax- deferred retirement savings accounts of participants who, after the accounts’ creation, have become United States residents).

4. Investment Advisers Act of 1940. As a preliminary matter, each United States advisor to an inbound or outbound fund must determine whether to register under the Advisers Act. Subject to certain limitations in the Advisers Act and available exemptions, registration is required for any person or entity which, for compensation, advises others concerning the purchase, sale or value of securities.

Section 203A(a)(1) added by NSMIA, prohibits an investment advisor “that is regulated or required to be regulated as an investment adviser in the [s]tate in which it maintains its principal office and place of business” from registering under the Advisers Act unless that investment advisor has of at least $25,000,000 or is an advisor to a registered investment company. Rule 203A-1 increased this threshold amount to $30,000,000 but then added an exemption permitting registration by an investment advisor with $25,000,000 or more of assets under management. It is likely that the advisors to outbound offshore funds, assuming they have assets under management of not less than $30,000,000, would have to register under the Advisers Act absent a specific exemption. In certain circumstances, investors in an outbound fund which are ERISA-regulated pension funds may insist that the advisor register under the Advisers Act or state law to qualify to perform advisory activities under ERISA.

As described below in greater detail, an exemption from registration is available under Section 203(b)(3) of the Advisers Act for any investment advisor which has fewer than fifteen advisees and does not hold itself out generally to the public as an investment advisor or advise an investment company. Rule 203(b)(3)-1 provides a safe harbor under which certain entities would be counted as a single investor for purposes of Section 203(b)(3) of the Advisers Act.

If the advisor to the funds registers under the Advisers Act, subject to considerations described below relating to certain foreign advisors, it would be subject to the substantive and procedural requirements of the Advisers Act. These include limitations on performance fees, recordkeeping and custody or possession of client funds and securities.

Custody or possession can be a difficult issue for the unwary under Rule 206(4)-2 of the Advisers Act, particularly in the event of an audit by the SEC Staff. The Staff takes the position that an advisor which has the right to obtain possession of client funds, even by billing fees directly to a custodian, will be deemed to have custody of client funds. See Investment Advisers Act Rel. No. 1000 (Dec. 3, 1985) at II.C.5. The level of control exerted by the advisors to the outbound offshore fund and inbound offshore fund ordinarily is sufficient to give them custody or possession under this Release. To avoid a custody relationship, the advisor may want to adapt the procedures approved in John B. Kennedy, SEC No-Action Letter, [1996-1997 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶77,253 (June 5, 1996); Securities America Advisors, Inc., SEC No-Action Letter (April 4, 1997); PIMS, Inc., SEC No-Action Letter (October 21, 1991); Daniel H. Renberg & Associates, Inc., SEC No-Action Letter, [1982-1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶77,369 (Dec. 3, 1982) or Bennett Management Co., SEC No- Action Letter (Feb. 26, 1990), to the situations of their funds.

5. State Securities Regulation. Although amendments to the Securities Act and the Advisers Act made by NSMIA preempt much of the formerly applicable state law with respect to federally registered investment advisers and offerings of securities under rules or regulations issued under Section 4(2) of the Securities Act, state securities or blue sky laws may establish substantive and procedural requirements for a fund if either the advisor to an offshore fund or its investors are located in the United States and the federal preemption does not apply. Such state requirements relate both to the process of offering securities in the fund and to the advisory relationship. In particular, if securities in the fund are offered in a transaction other than one that is exempt under rules or regulations issued under Section 4(2) of the Securities Act or that does not otherwise result in the securities being deemed to be “covered securities,” as that term is defined in Section 18(b) of the Securities Act, the securities will be subject to such securities and blue sky laws, absent an exemption in each relevant state. In addition, if the advisor to the fund is not registered under the Advisers Act or excluded from the definition of “investment adviser” pursuant to Section 202 (a)(11) of the Advisers Act, the advisor will be subject to such securities and blue sky laws in any state in which the advisor has a place of business or has had six or more clients within the prior twelve months. Requirements vary widely from state to state, and inconsistent results are common.

(a) Offering. If offers or sales of interests in a fund are made in a state and such interests are not “covered securities”, the interests must ordinarily either be registered with the state or have the benefit of a specific exemption from regulation. Sales to investors in funds of the type considered in these materials are frequently exempt under an exemption for sales to institutional investors or an exemption for sales to a small number of investors in the state. Offers and sales may also invoke the broker-dealer and agent registration requirements in some states.

(b) Advisor Registration. The federal preemption of Section 203A is not complete even in the case of investment advisors registered under the Advisers Act. Under Section 307 of NSMIA, a state may require a federally registered advisor to file with the state any documents which are filed with the SEC, together with a consent to service of process, and to pay any required fees. Payment of the fees is an express condition to the federal preemption provided by NSMIA with respect to each state for a period of three years after enactment of NSMIA. If the advisor to the fund is not federally registered or excluded from the definition of investment advisor by Section 202(a)(11) of the Advisers Act, the advisor to the fund may also be required to register as an investment advisor in various states. The newest group of state statutes governing investment advisor registration generally lacks any de minimis exclusion from the definition of investment advisor, and the treatment of institutional investors is inconsistent among the states. However, Section 222(d) of the Advisers Act, added by NSMIA, supplies a national de minimis standard: a state may not require registration, or compliance with a registration statute, by an investment advisor that does not have a place of business in the state and during the preceding 12- month period had fewer than 6 clients who are residents of the state. Some states assert that an advisor has clients in the state when state residents invest in a fund organized and operated in another state. In that connection, at least one state securities administrator has observed privately that he would rather regulate offerings by funds under the investment advisor registration provisions of his state statute than under the securities registration provisions. Other states treat funds with only institutional investors as a single client located in the state where the fund operates.

Registered advisors in the various states must comply with a variety of substantive and procedural regulations. In addition to anti-fraud and record- keeping requirements, most states also have examination requirements applicable to senior officers of the advisor. “Grandfathering”, while common, is not uniform, and veteran securities industry professionals may find that they must pass new examinations to continue practicing their profession. Many states require that advisors maintain at least a minimum net worth.

Perhaps the most burdensome state regulations specify the basis on which registered advisors may charge fees. The criteria applied do not always follow federal standards, and certain common measures are prohibited in certain states. In those states, the fact that investors in an offshore fund are institutional investors which are fully capable of negotiating, and have negotiated, fee schedules is often not dispositive. SPECIFIC LEGAL ISSUES UNDER THE INVESTMENT COMPANY ACT AND THE ADVISERS ACT

The following sections consider in more detail certain of the legal issues which commonly arise under the Investment Company Act and Advisers Act in connection with offshore funds.

A. Section 3(c)(1) of the Investment Company Act of 1940.

Section 3(a) of the Investment Company Act defines the term “investment company” to include any issuer engaged primarily in the business of investing, reinvesting or trading in securities. Sections 3(c)(1) and 3(c)(7) of the Investment Company Act establish exclusions from the definition of “investment company” under that Act. As noted above, funds which avail themselves of those exclusions are often referred to as “private investment companies.”

Section 3(c)(1) has two basic components: a limitation on the number of beneficial owners of an issuer’s securities; and a prohibition against involvement in a public offering of those securities. To qualify for the exclusion, the issuer’s outstanding securities (“other than short term paper”) may not be beneficially owned by more than one hundred persons. The issuer also must not be “making” and must not “presently propose to make” a public offering of its securities. If both components of the Section are satisfied the private investment company will not be subject to registration under the Investment Company Act.

(1) Public Offering. The concept of “public offering” is generally understood in other contexts under the Securities Act and the Investment Company Act. Similarly, the concept of what is not a “public offering” has repeatedly been outlined under the Securities Act, and Rule 506 of Regulation D under the Securities Act provides a “private placement” safe harbor.

In its no action positions under Section 3(c)(1) of the Investment Company Act, the SEC Staff has adopted Securities Act public offering concepts. The SEC Staff has long accepted the concept that the “term `public offering’ in Section 3(c)(1) of the [Investment Company] Act has the same meaning it has under Section 4(2) of the Securities Act of 1933.” Continental Bank, SEC No- Action Letter, [1982 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶77,248 (Aug. 3, 1982) at 78,083. Offerings which comply with Rule 506 of Regulation D will therefore be exempt since Rule 506 establishes safe harbor conditions for offerings under Section 4(2). Id. See STARS & STRIPES GNMA Funding Corp., SEC No-Action Letter, [1986-1987 Transfer Binder] Fed. Sec L. Rep. (CCH) ¶78,303 (Dec. 19, 1985). By contrast, in the SEC Staff’s view, offerings under Rule 505 of Regulation D under the Securities Act would not necessarily “not involve” a public offering because Rule 505 does not require an issuer to satisfy all conditions for a non-public offering. San Jose Capital Corp., SEC No- Action Letter, [1982-1983 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶77,391 (Jan. 13, 1983). This analysis also has significant implications in offerings of unregistered offshore funds in the United States. As already noted, the SEC Staff has incorporated Section 3(c)(1) concepts into its analysis of the registration obligations of such companies under Section 7(d) of the Investment Company Act. This analysis has been extended to funds relying on Section 3(c)(7) as well. See Goodwin, Procter & Hoar, SEC No-Action Letter (February 28, 1997). A “private offering” pursuant to Rule 506 would not be integrated with a public offering abroad by an unregistered offshore fund for purposes of this analysis. If the fund making the offering does not have more than 100 beneficial owners of its securities who are United States residents, or falls within the exclusion set forth in Section 3(c)(7) with respect to its investors who are resident in the United States, it would not be subject to registration under Section 7(d) of the Investment Company Act and would be able essentially to claim “private investment company” status. Id.; Touche, Remnant & Co. (U.K.), SEC No-Action Letter, [1984-1985 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶77,810 (July 27, 1984). The Report notes that the release adopting Rule 144A under the Securities Act “endorsed” that approach. See the Report at p. 201. The more general position that a private placement under Regulation D need not be integrated with an offering abroad under Regulation S is set forth in Preliminary Note 7 to Regulation D.

The SEC Staff has confirmed that a foreign fund that conducts a private offering in the United States and an offshore public offering will not be making a public offering for purposes of Section 7(d) even if United States jurisdictional means are used in the offshore public offering and functions previously performed offshore for United States tax purposes are performed onshore. Goodwin, Procter & Hoar, SEC No-Action Letter (October 5, 1998). Moreover, in connection with a global private offering, private meetings by representatives of a fund with foreign investors who are “temporarily” in the United States will not cause the fund to be deemed to be making a public offering for purposes of Section 7(d) if the offer and sale of the securities “is consistent with the regulatory restrictions on non-public offerings.” Wilmer, Cutler & Pickering, SEC No-Action Letter (October 5, 1998). Any such foreign investor would also not be counted as a United States person under Section 3(c)(1) or 3(c)(7) as applied to Section 7(d). Ibid.

(2) Number of Beneficial Owners. The limitation of “private investment companies” formed under Section 3(c)(1) to 100 beneficial owners has raised numerous issues concerning how to count participants. The most substantial of these arise under the attribution rules of Section 3(c)(1)(A) of the Investment Company Act which will be discussed below. However, other issues will affect the outcome of the analysis and should not be neglected. Some examples:

(a) Husband and Wife. Securities held in the name of both spouses should be considered to be owned by one beneficial owner. See Investment Co. Act Rel. No. IC-22597, n.69. However, if the husband and wife own the securities in their own names, they should be counted as two beneficial owners. American Bar Association Section of Business Law, SEC No-Action Letter (April 22, 1999).

(b) Participant-Directed Investments by Benefit Plans. In The PanAgora Group Trust, SEC No-Action Letter (April 29, 1994) (“PanAgora”), the SEC Staff stated that for the purposes of the Section 3(c)(1) analysis it would treat each participant in a defined contribution plan who could direct investment of the participant’s own account to be a beneficial owner of securities of a fund in which the plan invested at the participant’s direction. The Staff’s position did not depend on the attribution rules in Section 3(c)(1)(A). Rather, it turned on the more general principle that when an entity that “is managed as a device for facilitating individual investment decisions” each security holder of the entity will be deemed the beneficial owner of an investment made by the entity in a fund which is seeking to be a “private investment company” under Section 3(c)(1).

The Staff position in PanAgora evidently generated widespread concern in certain parts of the securities bar. In response to a no-action letter request, the Staff delayed the effective date of PanAgora until January 1, 1995. The PanAgora Group Trust, SEC No-Action Letter, [1994-1995 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶76,902 (June 30, 1994). It permitted private investment companies to treat as one beneficial owner “participant-directed defined contribution plans” which had invested in such companies before April 29, 1994 until December 31, 1995 and permitted such plans to continue to invest in such companies until that date. Latham & Watkins, SEC No-Action Letter, [1994- 1195 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶76,959 (Dec. 28, 1994). In each of these two no-action letters following PanAgora, the Staff expressed a willingness to clarify PanAgora. Indeed, in the Latham & Watkins letter, the Staff seemed to suggest opportunities to distinguish PanAgora’s facts from other situations in order to limit the scope of PanAgora.

On the same date it issued the Latham & Watkins letter, the SEC Staff issued a letter purportedly distinguishing PanAgora, but in a puzzling manner. In Caxton Corp., SEC No-Action Letter (Dec. 28, 1994), the Staff said that it would not recommend enforcement action if an investment partnership treated a participant-directed defined contribution plan as a single beneficial owner, despite the ability of plan participants to direct investments. The Staff emphasized that the fund which was the subject of PanAgora was “an investment vehicle for a variety of plans unaffiliated with the sponsor.” The Staff distinguished the private investment company in Caxton as a partnership sponsored by the employer “with which Caxton employees have substantial contact and familiarity.” The Staff described representations by Caxton concerning “easy access” to plan trustees and “complete and accurate information” about the partnership. The Staff did not explain why access to trustees and information should alter the PanAgora analysis, but, in a footnote, emphasized that “[t]his letter should not be read as reversing the interpretive position expressed in PanAgora.” Id. at n.2. The SEC Staff took the opportunity to distinguish PanAgora once again in The Standish, Ayer & Wood, Inc. Stable Value Group Trust, SEC No-Action Letter (Dec. 28, 1995) (“Standish, Ayer & Wood”). In Standish, Ayer & Wood, the Staff said that it would not recommend enforcement action if a participant- directed defined contribution plan were treated as a single beneficial owner with respect to an investment in a fund even though the plan’s participants could choose investments from a variety of investment options. The Staff emphasized that the participants’ discretion would be limited to allocating assets to generic investment options and the decision to make any particular investment or to withdraw assets from that investment would be solely that of the fiduciary that managed the plan. The plan would limit investment in the fund to less than fifty percent (50%) of its assets invested in any investment option. No representation would be made to participants that any specific part of their contributions or any specific portion of the assets allocated to a generic investment option would be invested in the fund. In Investment Co. Act Rel. 22597, after a review and affirmation of PanAgora, the SEC asked the Staff “to consider whether the position taken in the Standish Ayer letter is appropriate in the context of section 3(c)(7) and to reconsider whether the position taken in the Standish Ayer letter is consistent with that reflected in the PanAgora letter for the purposes of section 3(c)(1).”

In H.E. Butt Grocery Company, SEC No-Action Letter (May 18, 2001) (“H.E. Butt”), the SEC Staff undertook both a consideration of the Standish, Ayer & Wood position in a Section 3(c)(7) context and a reconsideration of Standish, Ayer & Wood for purposes of Section 3(c)(1). In H.E. Butt, the Staff stated that “we continue to believe that Standish, Ayer is consistent with PanAgora, as well as consistent with the prior no-action position issued in the context of partnership investments in Section 3(c)(1) [f]unds.” Id. The Staff then found that the position taken in Standish, Ayer & Wood is appropriate in the context of Section 3(c)(7) because it is consistent with the SEC’s “statements regarding the treatment of defined benefit plans as qualified purchasers” and with the “purpose” of Section 3(c)(7).

(c) Integration. A trap for the unwary is the possible integration of otherwise separate entities for purposes of calculating the number of beneficial owners. Except in connection with funds excluded from the definition of “investment company” pursuant to Section 3(c)(7) (discussed below), the limitations on numbers of beneficial owners cannot be avoided simply by formation of new entities. When the interests in two funds would “not be considered materially different by a reasonable investor qualified to purchase them,” the two funds will be considered a single fund for purposes of calculating the number of beneficial owners under Section 3(c)(1). Rogers, Casey & Associates, Inc., SEC No-Action Letter, [1989-1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶79,320 (June 16, 1989). See Santa Barbara Securities, SEC No- Action Letter (March 8, 1983); PBT Covered Option Fund, SEC No-Action Letter, [1979-1980 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶82,407 (Jan. 18, 1979); Kenneth von Kohorn, Investment Advisers Act Rel. 1471 (February 22, 1995). In analyzing particular situations, the Staff will consider whether the funds have identical or nearly identical investment objectives, portfolios and profiles of risk and return. It may also be relevant that the funds are intended for the same group of investors. Id.

The Staff has issued a variety of no-action letters concerning integration issues, but has not established a clear approach to the integration analysis. Some examples of these no-action letters are the following:

• In Frontier Capital Management Company, Inc., SEC No-Action Letter (July 13, 1988), the Staff stated that it was unable to concur in the position of counsel that interests in three funds should not be integrated. The Staff believed that interests would not be considered materially different by a reasonable investor where one fund’s objective was “long-term capital appreciation, seeking a return greater than the return on the Standard & Poor’s 500 Stock Index (the “S&P 500”), one fund’s objective was “to outperform the Russell 2000 Index” and the third fund’s objective was to “earn a return greater than that achieved by a benchmark portfolio of securities of which 60% is comprised of the securities of companies included in the S&P 500 and 40% is comprised of the securities of companies included in the Shearson, Lehman Corporate Bond Index.” The Staff found that two of the funds have similar investment objectives and that all three funds may have “similar or overlapping portfolio securities and the...funds are designed...for one group of investors with similar investment profiles.”

• In Meadow Lane Associates, L.P., SEC No-Action Letter (May 24, 1989), the Staff stated that it would not recommend enforcement action if each of two funds sold limited partnership interests to up to 100 persons. Although the funds shared the same general partner, that fact was not dispositive. The Staff focused on the investment objectives, portfolio securities and portfolio risk/return of the two funds. One fund focused on securities selected for potential appreciation based on the “potential for financial growth or the historic financial strength of the issuer” while the other was “designed for investors seeking to achieve capital appreciation through investments in...[candidates for] mergers, exchange offers, tender offers or recapitalizations ... or [securities sold at] disparate prices ... in different ... markets.” One fund had a broadly diversified portfolio, and the other likely would not have a diversified portfolio.

• In Monument Capital Management, Inc., SEC No-Action Letter (July 12, 1990), the Staff stated that it was not persuaded that an investor would necessarily consider interests in two funds to be materially different where the owner of 96% of the general partner of one fund was the advisor with respect to up to eighty percent of another, one fund might use leverage and the other would not, and the equity component of each fund that was commonly managed would be comprised of similar securities. • In Pasadena , SEC No-Action Letter (Jan. 22, 1993), the Staff stated that it would not recommend any enforcement action where an offshore fund would invest substantially all of its assets in a domestic registered investment company and interests in the offshore fund would be beneficially owned by non-United States residents and up to 100 United States residents even though both entities would have direct or indirect interests in the same underlying securities. The Staff said that differing tax laws create different investment opportunities for foreign and United States investors. As a result, a “reasonable investor” would view investments in the two entities as materially different and therefore the Staff would not integrate the two entities for purposes of Section 7(d) of the Investment Company Act.

• In Welsh, Carson, Anderson & Stowe, SEC No-Action Letter (June 18, 1993), the Staff indicated that it would not recommend enforcement action if Welsh, Carson, Anderson & Stowe organized three investment funds, an institutional fund and two side-by-side investment funds designed for individuals, and the aggregate number of limited partners of the three funds exceeded one hundred. The Staff reviewed a variety of differences in the structure and operations of the funds, their portfolio composition and potential risks and returns. Among other things, unlike the individual funds, the institutional fund would not be able to use leverage or certain option and short-sale strategies, would seek management rights in a majority of its investments, would not be required to make distributions to offset tax liabilities, and would compensate its general partner with a 20% carried interest. In the individual funds, the general partner would be allocated gains and losses only in proportion to its capital contributions. There would be very little overlap in the portfolios of the two individual funds. The institutional fund would be less focused and more diversified, although there would be substantial overlap between its investments and those of the two individual funds.

• In Shoreline Fund, L.P., SEC No-Action Letter (April 11, 1994), the Staff stated that it would not recommend enforcement action where a domestic limited partnership that proposed to offer its interests exclusively to United States taxable investors and a corporation that proposed to offer its common stock in the United States exclusively to investors that are exempt from United States income taxation were not integrated for purposes of determining whether registration was necessary under the Investment Company Act. Even though the two entities shared investment advisors, investment strategies and securities portfolios the Staff was “satisfied that the tax treatment of investments in offshore corporations as compared to domestic limited partnerships creates materially different investments for taxable and exempt investors.” For the future, the Staff indicated that it would not “respond to letters in this area unless they present novel or unusual issues.” In analyzing whether funds will be integrated in any situation, the similarity of the funds will be a question of degree. Because the line of no-action letters does not suggest a single clear analytical approach, caution in this aspect of the calculation under Section 3(c)(1) seems warranted.

Section 3(c)(7)(E) of the Investment Company Act provides that “an issuer that is otherwise excepted [from the definition of “investment company”] under [Section 3(c)(7)] and an issuer that is otherwise excepted [from the definition of “investment company”] under [Section 3(c)(1)] shall not be treated by the Commission as being a single issuer for purposes of determining...” the number of beneficial owners of the issuer relying on Section 3(c)(1). Therefore, an advisor to a fund relying on Section 3(c)(1) may ordinarily form a similar fund under Section 3(c)(7) without concern that the two funds would be integrated in the analysis under Section 3(c)(1). Neither fund’s investors would be attributed to the other for purposes of determining compliance with Sections 3(c)(1) and 3(c)(7). However, this “Non-Integration Provision” would not prevent a Section 3(c)(7) fund created by conversion of a Section 3(c)(1) fund from being integrated with another Section 3(c)(1) fund created by the same sponsor. The SEC will not permit a fund to rely on Section 3(c)(7) when its conversion is designed to evade the 100 investor limitation in Section 3(c)(1)(A). See Investment Company Act Rel. No. 22597 (April 3, 1997), Fed. Sec. L. Rep. (CCH) ¶ 85,929 at 89,455.

(d) Concentration of Investment. The SEC Staff has also been concerned that partnerships or other entities which themselves invest in private investment companies claiming the Section 3(c)(1) exclusion might be formed solely to invest in the investment companies in order to avoid the Section 3(c)(1) limitation on beneficial owners. Reflecting this concern, the Staff has often applied a forty percent test: to treat a partnership or other entity as a single beneficial owner for purposes of the Section 3(c)(1) analysis, in addition to satisfying the statutory attribution rule described below, no more than forty percent of the committed capital of the partnership or entity may be invested in the private investment company relying on Section 3(c)(1). Merrill Lynch & Co., Inc., SEC No-Action Letter (April 23, 1992); Handy Place Investment Partnership, SEC No-Action Letter (July 9, 1989); CMS Communications Fund L.P., SEC No-Action Letter, [1987 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶78,427 (March 18, 1987). The Staff regularly notes that even those situations which satisfy the bright line percentage tests may be questioned under Section 48(a) of the Investment Company Act if an entity is formed to circumvent the Act’s limitations. See, e.g., CMS Communications Fund, L.P., supra at 77,391.

However, inability to satisfy the forty percent test does not automatically require that a private investment company “look through” an entity. Recently, the Staff agreed with an employer’s view that when it annually formed funds through which management employees could co-invest with the employer “as a way to encourage and reward long-term employment” each fund could be considered a single beneficial owner even though due to the small amounts of capital invested on an annual basis, the employer could not represent that each fund would not invest more than forty percent of its committed capital in a 3(c)(1) entity. Cornish & Carey Commercial, Inc., SEC No-Action Letter (June 21, 1996). The Staff agreed that the forty percent test is not mandatory and that all facts and circumstances should be considered:

“When an issuer can make the 40% representation, the staff generally has been able to conclude with a degree of certainty that the structure was not created to evade the [Investment Company] Act and the staff thus has granted no-action relief ... Because the 40% test is not a statutory requirement, however, failure to comply with it would not automatically place a private investment company in violation of the Act. Rather, whether a company that meets the express conditions of Section 3(c)(1) will be considered to have violated Section 48(a) will depend on an analysis of all of the surrounding facts and circumstances. While the percentage of an issuer’s assets invested in another 3(c)(1) company is relevant to this analysis, exceeding a specified percentage level, by itself, is not determinative.”

In Cornish & Carey Commercial, Inc., the Staff concurred that each fund could be considered a single beneficial owner provided that no fund would exceed the ten percent tests set forth in Section 3(c)(1)(A) and no fund or Section 3(c)(1) entity in which it invested would be structured or operated for the purpose of circumventing the provisions of the Investment Company Act. The Staff added that it would “continue to adhere to the positions taken in the prior no-action letters [relating to the 40% test], and issuers may continue to rely on them.” Id. at n.9.

(e) Section 3(c)(1)(A) Attribution. A gloss on the one hundred beneficial owner limitation in Section 3(c)(1) of the Investment Company Act is added by Section 3(c)(1)(A). Section 3(c)(1)(A) provides that ordinarily beneficial ownership by a “company” will constitute beneficial ownership of securities of an issuer by one person. However, if a company* owns ten percent or more of the “outstanding voting securities” of the issuer, and is or, but for the exceptions set forth in Section 3(c)(1) or Section 3(c)(7), would be an investment company, then each beneficial owner of the company’s securities (other than “short-term paper”) must be counted as a beneficial owner of the issuer being analyzed. The analysis must be made as of the date of the most recent acquisition of securities of the issuer by the company.

The analysis under Section 3(c)(1)(A) often radically changes the results of calculations under Section 3(c)(1). The significant consequences of Section 3(c)(1)(A) have led to attempts to limit and define it through the no-action letter

* The term “company” is defined in Section 2(a)(8) of the Investment Company Act and includes “a corporation, a partnership, an association, a joint- stock company, a trust [and] ... a fund.” process. Although the no-action letters referred to below were obtained prior to the effectiveness of NSMIA, they relate to aspects of Section 3(c)(1)(A) that likely were not affected by the enactment of NSMIA and the promulgation of rules thereunder.

As noted, only companies that hold “voting securities” of an issuer are subject to the attribution rules under Section 3(c)(1)(A) and may be counted as more than one person for purposes of the one hundred beneficial owner limit in Section 3(c)(1). Section 2(a)(42) of the Investment Company Act defines “voting security” to be “any security presently entitling the owner or holder thereof to vote for the election of directors of a company.” The definition suggests that interests in trusts and limited partnerships which do not explicitly confer the right to vote on their holders might not constitute voting securities. However, the analysis is not nearly that easy.

At a minimum, to obtain no-action treatment from the SEC Staff on the ground that limited partnership interests are not voting securities, the investing limited partnership must be able to represent that the limited partners lack the power to remove or replace any general partner. Many of the earlier no-action letters also required that, to avoid pyramiding and circumvention issues, an issuer be able to represent that no limited partner would itself be an investment company but for Section 3(c)(1). See, e.g., Cigna Corp., SEC No-Action Letter (Oct. 1, 1984). In Kohlberg Kravis Roberts & Co., [1985-1986 Transfer Binder] SEC No- Action Letter, Fed. Sec. L. Rep. (CCH) ¶78,143 (Aug. 9, 1985) at 76,637, the Staff also found analytically significant representations that no limited partner was formed for the purpose of making the investment in the relevant fund and that none would participate in the “conduct or control” of the fund’s business. Accord, MMC Fund L.P., SEC No-Action Letter (March 31, 1989) (cautioning about the Pierce, Lewis and Dolan control through economic power analysis described below); Horsley Keogh Venture Fund, SEC No-Action Letter (April 27, 1988) (representations concerning Section 3(c)(1) exception limited to ten percent holders); Robert N. Gordon, Thomas J. Herzfeld, SEC No-Action Letter, [1987- 1988 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶78,539 (Oct. 30, 1987) (collecting all of the factors as representations). The SEC Staff has recently altered this position and confirmed that reliance by an investor in a private investment company on Section 3(c)(1) is not a factor in determining whether the private investment company issues voting securities. Willkie Farr & Gallagher, SEC No-Action Letter (June 21, 1996). The Staff emphasized in its response that Section 48(a) of the Investment Company Act gives the SEC the authority to look through a transaction or a multi-tiered structure if the structure is a sham formed to circumvent Section 3(c)(1).

A variety of no-action letters involving investment trust beneficiaries agree that they do not hold voting securities for this purpose. E.g., Morgan Grenfell Investment Services International Trust, SEC No-Action Letter (March 11, 1985); Global Investment Trust, SEC No-Action Letter (June 14, 1984). In practice, however, care must be used in pursuing this approach. The Staff has found “voting securities” where no conventional right to vote was involved, and mere characterization of an interest as a limited partnership interest or beneficial interest in a trust does not automatically dictate a non-voting characterization. See Devonshire Capital Corp., SEC No-Action Letter (Feb. 15, 1976). Thus, in Pierce, Lewis & Dolan, SEC No-Action Letter (April 21, 1972), the Staff stated that a limited partner holding “an economic interest which gave it the power to exercise a controlling influence ... would then have the equivalent of a voting security.” In Rogers, Casey & Associates, Inc., SEC No-Action Letter [1989-1990 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶79,320 (June 16, 1989), the Staff indicated that if a partner cannot withdraw from a partnership, an ability to “amend or renew” a partnership agreement may be “analogous to the power of shareholders to vote for directors.” See also Real Estate Investment Trusts, SEC No-Action Letter (November 4, 1998).

(f) Certain Transferees. Under Rule 3c-6 promulgated under the Investment Company Act, beneficial ownership of any person who acquires beneficial ownership of securities in a Section 3(c)(1) fund as a gift or bequest or pursuant to an agreement of legal separation or divorce is deemed beneficial ownership by the transferor. A variety of questions concerning the application of Rule 3c-6 are answered in American Bar Association Section of Business Law, SEC No-Action Letter (April 22, 1999), Part E.

B. Section 3(c)(7) of the Investment Company Act of 1940.

This Section excepts an issuer from the definition of investment company if the holders of the outstanding securities of the issuer (measured, with respect to a particular holder, at the time of any acquisition of the issuer’s securities by such holder) are “qualified purchasers” (as defined) and the issuer was not making, and did not propose to make, a public offering of the securities. If an investor makes additional investments pursuant to a binding commitment to make such investments, the investor will be deemed a qualified purchaser if it was one at the time it made the commitment. See Investment Company Act Rel. No. 22597 (April 3, 1997), Fed. Sec. L. Rep. (CCH) ¶ 85,929 at 89,450. As noted above, funds that are described in the new Section 3(c)(7) ordinarily will not be integrated with funds excluded from the definition of investment company by virtue of Section 3(c)(1) of the Investment Company Act for purposes of determining the number of holders of voting securities of the 3(c)(1) funds or for purposes of determining whether all holders of voting securities of an issuer under Section 3(c)(7) are (or were) qualified purchasers. Under Rule 3c-5, certain employees, directors and general partners of an investment company or an affiliated person that manages it (and others holding similar positions) are excluded from consideration in the Section 3(c)(7) analysis and in counting the number of beneficial owners under Section 3(c)(1).

Section 2(a)(51)(A) of the Investment Company Act defines “qualified purchasers” to include: natural persons that own not less than $5 million in investments (as defined in SEC regulations); companies that own not less than $5 million in investments and that are themselves owned by natural persons of the same family (as defined); or trusts, the trustee(s) and settlor(s) of which are otherwise qualified purchasers; any person, acting for its own account or the accounts of other qualified purchasers, that owns and invests on a discretionary basis not less than $25 million in investments. Under Rule 3c-6, securities that are received from a qualified purchaser by gift or bequest or pursuant to an agreement of legal separation or divorce are deemed to be acquired by a qualified purchaser.

However, an entity formed “for the specific purpose of acquiring the securities offered” will not be a “qualified purchaser” unless each beneficial owner of the potential qualified purchaser’s securities is, itself, a qualified purchaser. See Section 2(a)(51)(A)(iii) of the Investment Company Act and Investment Company Act Rule 2a51-3(a). See also Section 48 of the Investment Company Act (as applied to prohibiting use of entity formed or operated for purpose of circumventing the Investment Company Act). The SEC Staff has indicated that in the Section 3(c)(7) context, it will apply its analysis from the Section 3(c)(1) context concerning whether an entity is formed for the specific purpose of acquiring securities. See American Bar Association Section of Business Law, SEC No-Action Letter (April 22, 1999), Part D.

The analysis of whether a 3(c)(7) fund is making, or proposing to make, a public offering is presumably the same as under Section 3(c)(1). See Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1997).

C. Investment Advisers Act of 1940

(1) Registration. As noted above, the first determination to be made under the Advisers Act by any advisor to a fund is whether to register. Subject to certain exemptions and the limitations set forth in Section 203A of the Advisers Act and the rules thereunder, Section 203(a) of the Advisers Act makes it “unlawful for any investment adviser, unless registered under this section to make use of the mails or any means or instrumentality of interstate commerce in connection with his or its business as an investment adviser.” Section 202(a)(11) of the Advisers Act defines an investment adviser, among other things, to be “any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to the value of securities or as to the advisability of investing in, purchasing or selling securities,” subject to certain exceptions for and others. The definition is quite broad, and applies to virtually any fund-related advisory activity as long as the activity is undertaken for compensation, constitutes part of a “business” and involves advice as to the value of securities or as to the advisability of investing in securities. The advisor to the inbound fund described above clearly fits this definition.

The advisor to the outbound fund arguably is not involved in providing advice concerning investments in securities. Its advice relates to forests, property and operations. This outbound fund is not a classical securities fund. However, to try to avoid federal or state registration on this basis would require a reasonably aggressive approach. The definition of “security” in Section 202(a)(18) of the Advisers Act and in similar state statutes is very broad. The fund holds its investments through a corporation and a joint venture, and the fund’s advisor will give advice concerning disposition of those investments. In addition, the fund and its investors will be dependent on the day-to-day efforts of the other joint venturer for profits from the investments in tangible assets. Under the theory of S.E.C. v. W.J. Howey Co., 328 U.S. 293 (1946) and S.E.C. v. C.M. Joiner Leasing Corp., 320 U.S. 344 (1943) and their progeny under the Securities Act, these relatively passive investments in tangibles might well be held to be securities. The direct advisory relationship between the fund’s advisor and the investors further suggests a need to register absent a specific exemption.

(2) Exemptions. Section 203(b) of the Advisers Act exempts from registration under Section 203(a) investment advisors with an intrastate practice, investment advisors with only company clients and investment advisors with private practices restricted to a small number of clients. This last exemption, contained in Section 203(b)(3), exempts an investment advisor “who during the course of the preceding twelve months has had fewer than fifteen clients and who neither holds himself out generally to the public as an investment adviser nor acts as an investment adviser to any [registered] investment company.” To be exempt, the advisor must satisfy all three parts of the exemption: no more than fourteen clients; no public “holding out”; and no registered investment company clients.

Prior to the adoption of Rule 203(b)(3)-1 in 1985, it was not totally clear whether each limited partner of a limited partnership had to be counted as an investment advisory client of the general partner for purposes of Section 203(b)(3). The Rule established a safe harbor under which the limited partnership was to be counted as the client of the general partner and each of the limited partners was not to be so counted if the limited partnership interests were securities and advice was provided to the partnership based on its investment objectives.

The scope of Rule 203(b)(3)-1 was significantly expanded in July 1997. Rule 203(b)(3)-1 now provides that a “person” is a single client if it is (i) a natural person, certain of that person’s relatives and trusts and accounts with respect to which they are the only primary beneficiaries, (ii) a corporation, general partnership, limited partnership, limited liability company, trust or other legal organization that receives investment advice based on its investment objectives rather than the “individual investment objectives” of its beneficial owners or (iii) two or more such organizations with identical owners. A person that might otherwise only be a beneficial owner of a client and not a separate “client” for this purpose would still be a “client” of any advisor which provided investment advice to such person “separate and apart” from advice provided to a legal organization in which such person is a beneficial owner. Under the Rule, if the outbound fund were organized in the United States, it would constitute a single client, but any direct relationship between fund advisor and investors would likely render this safe harbor inapplicable. The inbound fund might be deemed a single client, but the analysis might be complicated by the use of offshore organizational forms similar, but not identical, to United States organizational forms.

The Rule also codifies the Staff’s previous position that a United States- based advisor must include United States and foreign clients in the exemption calculation but that foreign advisors need only consider United States residents. Compare Walter L. Stephens, SEC No-Action Letter (April 9, 1990) with Vocor International Holding S.A., SEC No-Action Letter (April 19, 1990) and Murray Johnstone Ltd., SEC No-Action Letter (April 17, 1987).

To have the benefit of the exemption provided by Section 203(b)(3), even if the investment advisor has fourteen or fewer clients, it still cannot be an entity that “holds [itself] out generally to the public as an investment adviser.” The SEC Staff has taken a very restrictive view of what constitutes “holding out to the public.” The Staff has stated that, letting it be known, “by word of mouth through existing clients, or otherwise” that an investment advisor is “willing to take on new clients” constitutes such holding out. Weiss, Barton Asset Management, SEC No-Action Letter, [1981 Transfer Binder] Fed. Sec. L. Rep. (CCH) ¶76,839 at 77,347. Even such relatively common actions as accepting a listing as an investment advisor in a telephone or building directory or using stationery indicating that the sender is an investment advisor or performs similar functions have previously prevented use of the exemption in the Staff’s view. See, e.g., Richard W. Blanz, SEC No-Action Letter (Dec. 28, 1984); Michael L. Miller, SEC No-Action Letter (Feb. 20, 1980).

However, the Rule does state that an investment advisor relying on the Rule will “not be deemed to be holding itself out . . . solely because such investment adviser participates in a non-public offering of interests in a limited partnership . . . .” Therefore, a private investment company that is a limited partnership may conduct an offering in compliance with Rule 506 of Regulation D without causing the investment advisor to such private investment company to lose its exemption under Section 203(b)(3). This portion of the Rule appears to apply solely to limited partnerships.

Unfortunately, because of the “inherently factual nature” of the determinations, the SEC Staff will ordinarily not provide interpretive advice by means of no-action letters under the Rule. See Investment Advisers Act Rel. No. 1633, n.139. Willkie Farr & Gallagher, SEC No-Action Letter (October 30, 1998).

(3) Prohibition from Registration. NSMIA added new Section 203A to the Advisers Act. Section 203A provides, in part, that no investment adviser regulated or required to be regulated as an investment adviser in the state in which it maintains its principal office and place of business shall register with the SEC unless it has at least $25,000,000 of assets under management or is an adviser to an investment company that is registered under the Investment Company Act. Rule 203A-1 increased this threshold amount to $30,000,000 but then added an exemption permitting registration by an investment adviser with $25,000,000 or more of assets under management. The SEC has exempted from the prohibition against federal registration nationally recognized statistical rating organizations, pension consultants that provide investment advice with respect to plans having an aggregate value of at least $50,000,000, investment advisers affiliated with registered investment advisers and investment advisers that expect to be eligible for federal registration within 120 days.

Investment advisors that are prohibited from registering federally, or exempt from registering federally pursuant to Section 203(b)(3), may well be subject to state regulation. Section 222(b) of the Advisors Act provides that the laws relating to the maintenance of books and records and maintenance of net capital or a bond in the state in which the investment advisor maintains its principal place of business will govern the advisor, and no other state may impose additional or higher standards. This should simplify compliance in such states.

(4) Performance-Based Fees. If the investment advisor to each of the offshore funds registers under the Advisers Act, it will become subject to regulation of compensation from the fund. Ordinarily, the advisor will seek some compensation linked to the performance of the fund. The investors may even prefer to pay compensation on this basis rather than pay higher fixed fees because performance-based fees align the interests of the advisor and the client more closely. Unfortunately, this form of compensation is expressly prohibited by the terms of the Advisers Act. Section 205(a)(1) prohibits registered investment advisors from entering into or performing any investment advisory contract which provides for “compensation to the investment adviser on the basis of a share of capital gains upon or capital appreciation of the funds or any portion of the funds of the client.” By its terms, this Section would preclude a registered investment advisor from charging most of the common forms of performance fees. NSMIA amended Section 205(b) to provide that the prohibition against charging performance fees does not extend to an investment advisory contract with a private investment company relying on Section 3(c)(7) or with a person who is not a resident of the United States.

In Rule 205-3, the SEC adopted in 1985 an exemption to this prohibition for investment arrangements with certain more affluent clients which comply with all of the conditions of the Rule. Rule 205-3 was amended effective August 20, 1998. The amendments raised the standard for determining which clients are eligible to enter into performance fee arrangements but eliminated certain required contractual terms and disclosures with respect to performance fees.

(a) Clients Qualifying. To qualify for exemption under Rule 205-3, an investment advisory contract must be with a client which is either a natural person or a company (as defined in the Rule) with at least $750,000 under management by the advisor or which the advisor reasonably believes prior to entering into the contract has a net worth that exceeds $1,500,000. A “company” will not qualify if it would be an investment company under Section 3(a) of the Investment Company Act but for the exception from the definition in Section 3(c)(1) unless each of the owners of the company (other than the investment advisor) would, itself, qualify as a client under Rule 205-3. Business development companies and registered investment companies are similarly treated. The amendments also added (i) qualified purchasers (as defined in Section 2(a)(51)(A) of the Investment Company Act, (ii) any natural person who is an executive officer, director, trustee, general partner, or person serving in a similar capacity of the investment adviser and (iii) an employee of the investment adviser (other than an employee performing solely clerical, secretarial or administrative functions with regard to the investment adviser) who, in connection with his or her regular functions or duties, participates in the investment activities of such investment adviser, provided that such employee has been performing such functions and duties for or on behalf of the investment adviser, or substantially similar functions or duties for or on behalf of another company, for 12 months, to the list of clients eligible to enter into performance fee arrangements.

(b) Additional Limitations. Prior to its recent amendment, Rule 205-3 required, among other things, that performance be measured over a 12 month period and that certain disclosures be made to clients about the risks associated with performance fees. These requirements no longer apply and, accordingly, advisors have more flexibility in the structuring of performance fee arrangements. The elimination of these requirements does not alter an advisor’s fiduciary obligation to deal fairly with its clients and to make full and fair disclosure of its compensation arrangements, however.

Several possible fee analyses now should be made concerning performance-based fees under Section 205 and Rule 205-3. If a fund is a private investment company relying on Section 3(c)(7) or a non-United States resident it may be charged a performance-based fee without restriction. Although the outbound fund described above is technically covered by Section 7(d), because it has United States residents as investors and is excluded from the definition of an investment company under the Investment Company Act by virtue of Section 3(c)(1), Rule 205-3 would likely apply only if each of its investors were a qualifying client under Rule 205-3(b), and its documentation would have to be sufficient to demonstrate that fact.

As noted above, the inbound fund described above is likely covered by the Touche, Remnant no-action letter and Section 7(d) of the Investment Company Act. If it has no United States investors, it likely need not be treated as a fund exempted by Section 3(c)(1), and therefore no inquiry need be made concerning the nature of its investors under Rule 205-3(b). An informal conversation with the SEC Staff suggested this result in another situation. If, on the other hand, the inbound fund does have United States investors, a more searching examination of its investor group will be necessary. A conservative approach might suggest this inquiry in any event, as well as some concern about future transfers of beneficial interests. But one might well wonder at what point it can comfortably be deemed “a person who is not a resident of the United States” for purposes of Section 205(b) of the Advisers Act.

(e) Other Limits on Performance Fees. Further limitations on performance fees, particularly for the outbound fund may be created under applicable state securities laws and ERISA. A brief discussion of the state laws appears above.

Section 406 of ERISA contains a series of limitations on activities by a plan fiduciary with respect to assets of a plan covered by ERISA. Section 408(b)(2) of ERISA exempts from Section 406(a) certain contracts and arrangements for services if no more than reasonable compensation is paid. If the assets of a fund constitute “plan assets” of an ERISA-covered plan or if advisory services are provided directly to an ERISA-covered plan, then the requirements of ERISA embodied in these provisions must also be satisfied. Although a lengthy ERISA analysis is beyond the scope of these materials, it is worth noting that two advisory opinions from the Department of Labor provide guidance as to the ERISA approach to these issues. See Batterymarch Financial Management, DOL Opinion 86-21A (Aug. 29, 1986); Alliance Capital Management Corp., DOL Opinion 89-28A (Sept. 25, 1989). In view of the changes in the law governing performance fees under the Advisers Act, these opinions must be used with care.

FUND DATA ON THE WORLDWIDE WEB

The effect of the Internet and the worldwide web on fund investment approaches and offerings is becoming evident in requests to the SEC Staff for no-action letters. In Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1997), the SEC Staff considered one way in which information, including offering documents, concerning private investment companies may be posted on a web site. Lamp Technologies, Inc. (“Lamp”) requested assurance that posting such information (i) would not involve general solicitation or general advertising on behalf of a participating fund, (ii) would not constitute a public offering of the securities of a private investment company and (iii) would not cause the investment advisor to such a fund to be deemed to be holding itself out generally to the public as an investment advisor.

Among other things, Lamp represented that (i) it would allow access to the web site only to a subscriber to the web site that, based on a completed questionnaire, it had a reasonable belief was an accredited investor; (ii) it would charge subscribers a fee of approximately $500 a month; (iii) Lamp would not be an agent of any subscriber; (iv) publicly accessible portions of the web site would not contain any reference to a fund that had posted or would post information on the web site; and (v) neither Lamp nor any of its affiliates would operate or provide investment advisory services to any of the funds posting information on the web site. In addition, Lamp represented that funds that post information on the web site may only post information relating to such funds and may not post information that might be deemed to be an offer of other services or products provided by the managers of the funds. Finally, Lamp represented that subscribers to the web site must agree not to deliver information posted on the web site to anyone other than the subscriber’s authorized personnel (if the subscriber is an entity) and the subscriber’s professional advisers and, with limited exceptions, subscribers must agree not to invest in any fund that posts information on the web site until thirty days after such subscriber has become qualified as a subscriber.

Based on Lamp’s representations, the SEC Staff granted the no-action letter requested. Based on the “procedures designed to limit access to the web site information to a select group of accredited investors,” the Staff said that it did not believe that the posting of the fund information on the web site would constitute a public offering for purposes of Section 3(c)(1) or 3(c)(7) of the Investment Company Act. The Staff also said that it believed such limitations, together with the limitation on offerings of other products or services on the site, would not cause an investment advisor to be “holding itself out generally to the public” under Section 203(b) of the Advisers Act.

At the request of the Division of Corporation Finance, the no-action letter added that “qualification of accredited investors in the manner described and posting of a notice concerning a private fund on a web site that is password- protected and accessible only to subscribers who are predetermined by Lamp to be accredited” would not be a “general solicitation” or “general advertising” as such terms are used in Rule 502(c) promulgated under the Securities Act. The Division of Corporation Finance emphasized that its conclusion was based on the fact that (a) questionnaires and the invitation to complete questionnaires were “generic” and would not refer to any particular fund, (b) the subscriber will have access to the web site only after Lamp has determined it is accredited and (c) the subscriber could invest only after the described waiting period.

In reaching its conclusion, the Staff distinguished situations in which private offering materials or information about an investment advisor are publicly available without appropriate limitations on a web site or other electronic medium. It relied on the procedures designed to limit access to private information on Lamp’s web site and specifically cited IPONET, SEC No-Action Letter [1996-1997 Transfer Binder], Fed. Sec. L. Rep. (CCH) ¶ 77,252 (July 26, 1996), a no-action letter relating to a web site which appears to be designed for non- private placements. In Lamp, the Staff used a similar analysis in spite of the heightened risk that, due to continuous offerings by funds, the web site might constitute a continuing general solicitation or general advertising by participating funds.

The Lamp no-action letter does not resolve all questions about similar web sites. The SEC Staff specifically did not express an opinion concerning whether Lamp might be a broker-dealer under the Exchange Act. Further, the Staff did not describe the level of information about an investment advisor that may be posted on a web site which is to remain within the Lamp no-action letter. Information about the investment advisor and its strategies is usually material and included in offering materials relating to a fund managed by that advisor, but it is not clear at what point such a description becomes information that might be deemed to be a prohibited offer of other services or products provided by the advisor. Securities laws of the states, to the extent they are not pre-empted by federal securities laws, and of foreign jurisdictions still may apply to the web site.

The Lamp no-action letter was modified in Lamp Technologies, Inc., SEC No-Action Letter (May 29, 1998). In this second Lamp no-action letter, the Staff indicated that its position would not be affected by elimination of the requirement of a specific fee for Lamp’s HedgeScan service and elimination of the requirement that each subscriber be a “qualified eligible participant.” The Staff further agreed that private funds listed with the service could be structured as domestic or foreign partnerships, limited liability companies, trusts or other entities without a different analytical result.

Certain of the broader implications of the Lamp no-action letters continue to be reviewed by the SEC and the Staff. In Investment Co. Act Rel. No. 24426 (May 4, 2000), the SEC expressed concern that certain web sites, particularly those allowing for self-accreditation, might make “general solicitations” in connection with the offerings they facilitate. The SEC disagreed with an interpretation of the Lamp line of no-action letters that would extend the basis for satisfying the “pre-existing substantive relationship” test, one approach to demonstrating that a general solicitation has not occurred, to solicitations made by third parties other than registered broker-dealers. In the Release, the SEC was careful to limit Lamp as “a separate means to satisfy the no general solicitation requirement” in the context of a web site offering Section 3(c)(1) and 3(c)(7) hedge funds to screened accredited investors. Investment Co. Act Rel. 24426 at fn. 88.

In the same Release, but in a separate footnote, the SEC pointed out that in the IPONET no-action letter, IPONET was implicitly required to have its web site activities supervised by a registered broker-dealer (the no-action letter was issued in reliance upon this representation by IPONET). Raising a question not addressed in the Lamp no-action letters, the SEC asked the Division of Market Regulation “to consider whether the activities of a web site operator, such as described in the no-action letters to Lamp Technologies..., require the web site operator to register with the Commission as a broker-dealer. Id. at fn. 94. See also Progressive Technology Inc., SEC No-Action Letter (October 11, 2000).

Shortly before issuance of this Release, in OilOre.com, SEC No-Action Letter (April 21, 2000), the Staff declined to confirm that a web site purporting to match accredited investors with “screened junior” mining and oil and gas companies need not register as a broker-dealer under the Exchange Act. Building upon the OilOre.com letter in Oil-N-Gas, Inc., SEC No-Action Letter (June 8, 2000), the Staff indicated that based on Oil-N-Gas, Inc.’s description of a web site that would provide certain accredited investors with a directory of small company oil and gas offerings, it would view Oil-N-Gas, Inc. as a broker within the meaning of the Exchange Act. Citing IPONET, and relying particularly on Oil-N- Gas, Inc.’s active solicitation of investors, advice to issuers concerning the preparation of offering materials and collection of fees, the Staff said the company was to be “engaged in the business of effecting transactions in securities for the account of others.” The Staff did not respond to Oil-N-Gas, Inc.’s inquiry as to whether it needed to register as an investment advisor, pointing only to past no-action letters addressing “matching services” instead.