Structured Alternatives to Structured Notes

Masterclass: Structured Alternatives to Structured Notes

Tuesday, February 23, 2016

8:30 AM – 9:30 AM EST

Seminar

Presenter:

Anna T. Pinedo, Partner, Morrison & Foerster LLP

1. Presentation

2. Morrison & Foerster FAQ Guide: “Frequently Asked Questions about Unit Investment Trusts”

3. Morrison & Foerster FAQ Guide: “Frequently Asked Questions about Closed-End Funds”

4. Morrison & Foerster Newsletter: “Structured Thoughts – Volume 7, Issue 2”

5. Morrison & Foerster Newsletter: “MoFo Tax Talk – January 2016”

NY2 766600 NY2 - 657166

 Addressing TLAC through finance sub issuances  Basic repackaging concepts  Repackaging through a trust on an exempt basis  Repackaging in reliance on Reg ABII  40 Act vehicles

This is MoFo. | 2 TLAC and New Issuance Programs

This is MoFo. | 3 TLAC and new issuance programs

 US G-SIB issuers of structured notes already are making plans to prepare to comply with the requirements of the Federal Reserve Board’s proposed long-term debt (LTD), total loss-absorbing capacity (TLAC), and clean holding company rules  For structured products that reference asset classes other than rates, and without addressing the 5% excluded liabilities provision, it is likely that US G-SIB issuers of structured notes will establish finance company subsidiaries that will be the issuers of structured products.  If the G-SIB issuer establishes a new subsidiary that is a finance company, the issuer’s SEC disclosure obligations are reduced (as opposed to issuing through a subsidiary that is an operating company

This is MoFo. | 4 TLAC and new issuance programs (cont’d)

 Likely, the structure will take the following form:

BHC guarantee BHC

Direct or indirect wholly owned sub Structured Notes Investors Finance Co

This is MoFo. | 5 TLAC and new issuance programs (cont’d)

 The parent BHC guarantee enables the securities of the finance company to be registered on a Form S-3 (shelf)  The guarantee must comply with the guidance in the FRB’s proposal, which requires that a failure of the BHC will not trigger a payment acceleration on the finance company’s notes

This is MoFo. | 6 Basic Trust Structure

This is MoFo. | 7 Basic structure

 Institutional investor seeks structured product-like exposure and has, on a reverse inquiry basis, identified a basic pay out  Institutional investor may want to diversify issuer concentration  A structured note equivalent can be issued through a trust the assets of which will be a plain vanilla bond and a derivative or option

This is MoFo. | 8 Using a trust

 A trust is a common vehicle for repackaging debt (or other) securities as well as accompanying derivatives or options. However, there are a number of structuring concerns associated with a trust vehicle.  A trust usually is a passive vehicle (neither the trustee nor other parties actively manage the investment).  With a trust, often there is a concern that the trust will be an investment company under the Investment Company Act of 1940 (1940 Act). It will be necessary to structure the vehicle so that it is exempt from the 1940 Act.

This is MoFo. | 9 1940 Act

 Why avoid investment company status?  If a trust is determined to be an investment company, it must register as such under the 1940 Act.  Subject to regulatory scheme of the 1940 Act – reporting and other filing obligations.  Limits on ability to transact with affiliates (sponsor/depositor may not be able to engage in business with the trust - for example, an affiliate that “underwrites” offerings of an investment company is subject to restrictions).  Restrictions on the issuance of debt.  Must satisfy asset coverage test – 300% immediately following issuance of debt and 200% immediately following issuance of preferred securities.

This is MoFo. | 10 1940 Act (cont’d)

 An investment company is defined as an issuer that:  Is or holds itself out as being engaged primarily in the business of investing, reinvesting or trading in securities;  Is engaged in the business of issuing face-amount certificates of the installment type; or  Is engaged in the business of investing, reinvesting, owning, holding or trading in securities, and owns or proposes to acquire investment securities having a value exceeding 40% of its assets.

This is MoFo. | 11 1940 Act exemptions

 There are a number of exemptions from the 1940 Act; however, most would not be suitable.  Some exemptions require limiting the number of investors:  For example, Section 3(c)(1) exempts from the definition of investment company any issuer whose outstanding securities are owned by not more than 100 persons and is not making a public offering.  Some exemptions limit the scope of the business activities:  Section 3(c)(5) exempts from the definition any issuer not engaged in investment company activities but that is engaged in purchasing or acquiring notes, making loans or purchasing or acquiring mortgages, among other activities.

This is MoFo. | 12 1940 Act exemptions (cont’d)

 Other exemptions limit ownership to certain classes of investors.  For example, Section 3(c)(7) exempts from the definition of investment company any issuer whose securities are owned by “qualified purchasers” and is not making a public offering.  A “qualified purchaser” is:  Any person that owns not less than $5,000,000 in investments;  Any company that owns not less than $5,000,000 in investments and that is owned, directly or indirectly, by or for two or more related natural persons;  Any trust not covered by the preceding clause that was not formed for the specific purpose of investing in the securities offered whose trustee and each settlor are qualified purchasers; or  Any person acting for its own account or the account of other qualified purchasers, who owns and invests not less than $25,000,000 in investments.

This is MoFo. | 13 Preliminary concerns

 Assuming the trust approach:  The trust may be consolidated with and into the “issuer” or with and into the entity that is the “principal beneficiary”  The trust securities will be issued in a private placement and will be restricted securities  The “sponsor” of the trust if it is a Banking Entity (as understood under the Volcker Rule) may not be able to proceed with this approach as the trust is likely a “covered fund”  The institutional investor (if affiliated with a Banking Entity) may not be able to proceed with this approach because holding the trust securities may constitute holding an “ownership interest” in a covered fund

This is MoFo. | 14 Repackaging Structure and Analysis

This is MoFo. | 15 Public alternative

 A trust that sells its securities pursuant to Regulation ABII (similar to a securitization) and is exempt from the 1940 Act.

This is MoFo. | 16 Overall repackaging structure

Structured Note 1 Deposited Structured Note 2 or Trust sold securities Structured Note 3 Trust Depositor Investors Issuer Structured Note 4 $ $

Etc.

Swap Counterparty

This is MoFo. | 17 Basic structure Intermediate subs Issuer B/D Affiliated Swap Equity Counterparty ownership (51% or greater)

Trust Trust securities Issuer Investors $

Issues to consider: • Trust likely will be consolidated for accounting purposes (on balance sheet) • Accounting for: (1) swap; (2) trust securities; (3) equity interest in trust • Disclosure/reporting issues

This is MoFo. | 18 Third-party (rent-a-shelf) issuer Intermediate subs Issuer B/D Swap Contractual Counterparty relationship

Portfolio of plain vanilla Trust Third notes $ Trust securities Party Investors Issuer Sponsor $ Equity interests Issues to consider: • Ratings agency analysis: will ratings agencies “look through” or rely on swap counterparty rating? • The only “swaps” or “options” allowed in an SEC-registered vehicle are: rate-linked or currency-linked. No equity-linked or credit-linked exposure is possible through the swap or option.

This is MoFo. | 19 Repackagings or resecuritizations

 In a repackaging or resecuritization, assets (usually debt securities) are repackaged in a special purpose vehicle and the special purpose vehicle sells securities to the public.  The “repackaging” concept can be applied to any number of underlying assets— for example, a trust the assets of which are a diverse series of plain vanilla bonds issued by different issuers; a trust the assets of which are a series of CDs; etc.  Resecuritizations rely on the regulatory scheme established by Regulation ABII(for purposes of this presentation, we will refer to it as “Reg AB”).  Asset-backed issuers are exempt from the 1940 Act pursuant to Rule 3a-7.

This is MoFo. | 20 1940 Act considerations for ABS  Most ABS issuers are exempt from the 1940 Act pursuant to Rule 3a-7, which states:  Any issuer engaged in the business of purchasing, or otherwise acquiring and holding eligible assets and who does not issue redeemable securities will not be deemed an investment company.  Redeemable securities are defined in Section 2(a)(32) as “any security other than short-term paper, under the terms of which the holder upon its presentation to the issuer (or someone designated by the issuer) is entitled to receive approximately his proportionate share of the issuer’s current net assets, or the cash equivalent thereof.”

This is MoFo. | 21 1940 Act considerations for ABS (cont’d)  Rule 3a-7 contains a number of conditions:  The issuer must issue fixed income securities or other securities that entitle their holders to receive payments that depend on the cash flow from eligible assets;  Securities sold must be rated investment grade;  Acquisitions and dispositions of eligible assets may be made only in accordance with governing documents and may not trigger a downgrade in the issuer’s rating; and  Must appoint a non-affiliated trustee that has a perfected security interest in the assets.

This is MoFo. | 22 1940 Act considerations for ABS (cont’d)  Definition of “eligible assets” is similar to the definition under Reg AB.  Financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the distribution of proceeds.  “convert to cash” within a finite time period requirement may pose structuring challenges

This is MoFo. | 23 Reg AB

 Reg AB was amended and became effective in November 2015 to address disclosure differences between issuers of asset-backed securities (ABS) and operating companies.  Regulates:  1933 Act registration for these issuers;  Disclosure obligations;  Communications; and  Ongoing 1934 Act reporting obligations.

This is MoFo. | 24 Reg AB (cont’d)  Applies to any security that is “asset-backed.”  A security that is primarily serviced by the cash flows of a discrete pool of receivables or other financial assets, either fixed or revolving, that by their terms convert into cash within a finite time period, plus any rights or other assets designed to assure the servicing or timing distribution of proceeds to holders. . .”  Neither issuer nor depositor may be an investment company.  Issuer must passively own or hold the pool of assets.

This is MoFo. | 25 Reg AB (cont’d)  Reg AB imposes the following requirements: a requirement to file a preliminary prospectus at least three days prior to sales of any securities (this is referred to as the “speed bump” provision); a requirement to appoint an unaffiliated reviewer to review assets for compliance with representations and warranties; a requirement to provide in machine readable form asset-level information for securitizations involving residential mortgage loans, commercial mortgage loans, auto loans and leases, debt securities, and resecuritizations of these assets (effective after November 23, 2016); a requirement to report periodically demands by the trustee to repurchase assets for breach of representations and warranties, and any such assets not repurchased; for each offering, a certification is required by the CEO or executive officer in charge of securitization of the depositor stating that the securitization as described in the prospectus is designed to produce cash flows from the assets in amounts sufficient to service expected payments on the securities; and new Forms SF-1 and SF-3 for the registration of asset-backed securities.

This is MoFo. | 26 Reg AB (cont’d)  Risk retention requirement: For any registered issuance of asset-backed securities, such as an issuance off of the shelf registration statement, as well as for any issuance of asset-backed securities offered pursuant to an exemption, such as 144A, a risk retention requirement would apply. The 5% risk retention requirement was adopted recently as a result of the Dodd-Frank Act. The effective date of the Rule for assets other than residential mortgage loans is December 24, 2016. The required retained interest can be satisfied by holding either a “vertical interest” or an “eligible horizontal residual interest” or a combination of the two. A vertical interest would be the same percentage interest in each class of securities issued. An eligible horizontal residual interest would be the most subordinated class or classes representing the required percentage of the “fair value” of all ABS interests to be issued.

This is MoFo. | 27 Reg AB (cont’d)  Risk retention requirement: The retained interest must be held by the “sponsor” or a “majority-owned affiliate.” Majority-owned affiliate is defined as an entity in which a person has ownership of more than 50% of the equity or ownership of any other controlling financial interest. The Rule generally prohibits a sponsor from selling or otherwise transferring any retained interest other than to majority-owned or wholly owned affiliates of the sponsor. Moreover, a sponsor and its affiliates may not hedge their required risk retention positions or pledge those positions as collateral for any obligation (including a loan, repurchase agreement, or other financing transaction), unless the obligation is with full recourse to the pledging entity.

This is MoFo. | 28 Reg AB (cont’d)  Certain hedging activities are not prohibited. Sponsors and their affiliates are permitted to: hedge interest rate or foreign exchange risk, or hedge based on an index of instruments that includes ABS, subject to certain limitations. The retention period for retained interests for all assets other the residential mortgage loans is the period ending on or after the date that is the latest of (1) the date on which the total unpaid principal balance of the securitized assets that collateralize the securitization are reduced to 33 percent of the original unpaid principal balance as of the closing date, (2) the date on which the total unpaid principal obligations under the ABS interests issued in the securitization are reduced to 33 percent of the original unpaid principal obligations as of the closing date, or (3) two years after the closing date.

This is MoFo. | 29 Reg AB (cont’d)

 Eligibility for SF-3  Registrant requirements  If issuer previously was subject to 1934 Act requirements for ABS of the same class, must have been current for prior 12 months;  The issuer must otherwise satisfy the Form S-3 registrant requirements  Transaction requirements  Four transactions requirements that replaced the prior “investment grade” requirement: certification of the depositor’s CEO, an asset review provision, a dispute resolution provision for resolution of repurchase requests, and an investor communication provision  Reg AB requires disclosure about the sponsor, depositor, asset pool, and servicers, among other items.

This is MoFo. | 30 Reg AB (cont’d)

 Ease of establishing a “program” and doing takedowns: this approach permits an issuer to set up a program and do takedowns.  Liquidity  Securities issued in a repackaging structured under Reg AB may be listed on a national securities exchange, although this is rarely done.

This is MoFo. | 31 Reg AB for debt repackagings

 A number of debt repackaging products have been structured using Reg AB and Rule 3a-7.  Select Notes http://idea.sec.gov/Archives/edgar/data/1156877/000106880003000296/final.htm  SATURNS http://idea.sec.gov/Archives/edgar/data/1071246/000090342307000218/sat20071 -424b5_0222.htm  Fixed Income Client Solutions https://www.sec.gov/Archives/edgar/data/1509307/000106823811000099/fics_ll c-s3a.htm  Incapital Trust https://www.sec.gov/Archives/edgar/data/1536311/000121465915004538/s6115 0s3.htm

This is MoFo. | 32 Issues to consider  Diversification and concentration  Under Reg AB, if any issuer’s assets make up more than 10% of an asset pool, that issuer will be considered a significant obligor, and disclosure about that entity will be required in the registration statement.  Typically, to avoid this disclosure requirement, no issuer’s securities make up more than 10% of the pool (so each trust must contain the securities of at least 11 issuers).  Information regarding underlying issuer  Under the SEC’s guidance in the Morgan Stanley no-action letter, information about the issuer of the underlying securities may include a brief description of the issuer’s business in the prospectus and a reference to the availability to its 1934 Act filings.

This is MoFo. | 33 Issues to consider (cont’d)

 Primary versus secondary distributions  If the broker-dealer purchases securities as part of their initial offering (a primary distribution) for inclusion in the trust, the offering of trust certificates may be viewed as a continuation of the initial offering.  In this case, the issuer of the underlying securities would be viewed as participating in the distribution of the trust certificates;  The trust would be required to distribute to the purchasers of the trust certificates a copy of the prospectus for each underlying security; and  The issuer of the underlying security would have Section 11 liability with respect to the trust certificates.  If the broker-dealer purchases the securities in the secondary market (a secondary distribution), these issues do not exist.

This is MoFo. | 34 Issues to consider (cont’d)  Ongoing reporting obligations  Reg AB requires that the issuer file ongoing and periodic reports  Tax treatment (assuming that the trust’s assets are “locked down,” i.e., there is not substitution of assets or reinvestment)  The trust is not a separate entity.  Likely it will be a grantor trust for U.S. federal income tax purposes (so not subject to federal income tax).  Each certificateholder will be subject to taxation as if it owned directly a pro rata share of the trust assets.

This is MoFo. | 35 Registered investment company alternative

This is MoFo. | 36 Alternative approach  Instead of choosing an approach that entails an exemption from 1940 Act registration, you may consider a 1940 Act registered vehicle.  There are several basic types of 1940 Act registered entities: open- end funds (mutual funds) and closed-end funds (or variations of these, like UITs and ETFs).  These can be sold to retail investors and can be customized.

This is MoFo. | 37 Unit investment trust

 A type of investment company regulated by the 1940 Act. The unit investment trust (UIT) must:  Be organized as a trust;  Not have a board of directors, and  Issue only redeemable securities, each of which represents an undivided interest in a unit of specified securities;  But does not include a voting trust.  Unit investment trusts (UITs) buy and hold a fixed portfolio of stocks, bonds or other securities – in this case, structured products or bonds and derivative instruments.  Portfolio may consist of a wide range of securities.  Do not have an investment adviser.

This is MoFo. | 38 UITs (cont’d)  A UIT makes a one-time public offering of only a specific, fixed number of redeemable securities called “units.”  Investors receive a share of the principal and dividends (or interest).  Payments can occur monthly, quarterly, semi-annually or at termination.  Usually permissible to reinvest dividends or interest.  A UIT must have a stated date for termination.  Investors receive a proportionate share of the UIT’s net assets.  Term may vary from one year to 30 years depending on the underlying portfolio.  Liquidity.  A UIT may be listed on a national securities exchange.  Investors can redeem outstanding units at their net asset value.  Some UITs permit investors to exchange their units for units of another UIT.

This is MoFo. | 39 1940 Act considerations  Under the 1940 Act, a UIT must disclose in a prospectus information about the trust, including:  Investment objectives;  Portfolio securities;  Sales charges and expenses; and  Terms for buying and selling units.  A UIT must file ongoing reports with the SEC under the 1940 Act, including:  An annual report containing audited financial statements, management’s discussion of fund operations, investments results and strategies.

This is MoFo. | 40 Issues to consider  The “buy and hold” strategy of a UIT does not permit substitution of assets in the portfolio  If questions arise regarding the issuer’s financial viability or the security’s creditworthiness, it may be possible to sell or replace a security.  Must register under the 1940 Act  1940 Act issuers may not rely on access equals delivery.  No “shelf” form for 1940 Act issuers – issuances on a continuous or delayed basis rely only on SEC no-action guidance.

This is MoFo. | 41 Issues to consider (cont’d)

 Tax treatment  Pass-through tax treatment (i.e., no tax at the entity level) as either:  A grantor trust for U.S. federal income tax purposes  Each unitholder would be subject to taxation as if it owned directly a pro rata share of the trust assets.  A “regulated investment company”  The UIT must distribute substantially all of its income and capital gain on an annual basis.  Tax treatment like most ETFs.

This is MoFo. | 42 Summary-Advantages/Disadvantages

Repackaging Custodial Unit Investment Trust Closed End Fund (Grantor Trust) Arrangement/Receipt Assets “Securities” as defined under “Securities” as defined under “A discrete pool of receivables Usually equity securities but the 1940 Act. the 1940 Act. or other financial assets . . . can be any assets. that by their terms convert to cash in a finite period.” Accounting Not consolidated Not consolidated Generally consolidated. Not consolidated Time to register Approx. 2 months, requires Approx. 2 months, requires Approx. 2 months, requires Approx. 2 months; would be initially SEC review SEC review SEC review. considered “novel” product. Time for subsequent Up to 2 weeks (each deal must Up to 1 week. Up to 1 week. Approx. 2 months. deals be submitted to SEC, though not reviewed) Ongoing cost Front-ended Ongoing administrative costs Minimal ongoing cost Minimal ongoing cost Who reviews at SEC? Investment Management Investment Management Corporation Finance Corporation Finance (40 Act) (40 Act) Disclosure More flexible More flexible Morgan Stanley letter-type Morgan Stanley letter-type requirements disclosure disclosure Rating Not required Not required Required Not required Familiar to investors? Yes Yes Yes Yes Investor perception Viewed as 1940 Act product Viewed as 1940 Act product More akin to a “securitization” Novel product “Suitability” Need to consider Need to consider Need to consider Need to consider Desirable tax If a grantor trust, yes No, because RIC requires Yes Yes treatment? diversification Flexibility in Only as part of initial set-up. Subject to prohibition on Yes Yes contracting with third affiliated transactions parties Redemption/like kind Must be redeemable Not required Not required Yes, for underlying assets Secondary market Yes Yes Yes Yes

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt Summary/Overview Entity Type Trust with fixed life Corporation. Trust with infinite life (may be Trust with fixed life structured as separate trusts, or as a master trust. Securities law Yes. Yes. No, exempt from 1940 Act No, exempt from 1940 Act purposes: 1940 Act (3a-7). (no-action letter relief) Registered Tax classification May be a RIC for tax, or a RIC Grantor trust/pass through Agency grantor trust Publicly Offered Units that represent an Common stock, preferred Equity/debt. If equity, then Custodial or trust receipts Security “undivided interest in a unit of stock and debt. pass-through trust certificates representing a 100% interest in specified securities.” representing an interest in the one or more underlying trust. securities Minimum Publicly registered. None Publicly registered. None. Publicly registered. None. Publicly registered. None, Investment/Purchaser required for investors provided none exists for Qualification purchasing in the open market. underlying securities. Fixed or Managed A UIT must have a fixed A closed-end fund may have a The trust will have fixed The trust must have a fixed Investment investment portfolio for the managed portfolio. Changes investments, though provisions investment portfolio, though duration to investment policy may may exist for weightings may change over require shareholder approval, removal/substitution under time, and corporate events may or disclosure. certain limited circumstances. necessitate removal. Ability to Withdraw Section 4(2) of the 1940 Act A closed-end fund is not Trust certificates generally are SEC relief focused on holders’ Underlying Assets requires that a UIT issue only required to issue redeemable not redeemable. ability to withdraw the redeemable securities. securities. underlying securities at any time, subject to only a Securities can be redeemed for moderate fee. NAV less applicable expenses. Receiptholders possess all indicia of ownership. Distribution of Income Required Required Required. Required.

 May be a RIC or a grantor trust for tax purposes.

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt Diversification Not required. Required. Not required. Not required. Tax Treatment Tax at Entity Level If grantor trust, no. No, so long as it distributes No. No. 100% of taxable income If RIC, no, so long as it annually. distributes 100% of taxable income annually. Flow Through of Tax If grantor trust, yes. No. Yes. Yes. Character of If RIC, no. Underlying If entity enters into If grantor trust, no. Yes. No. No. straddle and therefore If RIC, yes. has only short-term capital gains, can investor get long-term capital gains on sale? Long-term capital gain If grantor trust, no. Yes. No. No. on liquidation at If RIC, yes. maturity? Sales Issues Registration Rule 487 permits each series No shelf form for 1940 Act May register on Form S-3. Must register on Form S-1. of UIT (with different registered issuers. Form SF-3 is for use in underlying securities) to be connection with continuous or No action relief (Pilgrim, declared effective delayed offerings of Nuveen) permits registration automatically. Must establish investment grade asset-backed on Form N-2 and takedowns that SEC has reviewed original securities. using a prospectus supplement. series, that the underlying securities do not differ materially and disclosure in the new series does not differ materially. Rule 487 requires a new registration statement each time.

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt No shelf form for 1940 Act registered issuers. Distribution Single, firm commitment Single, firm commitment Single, firm commitment Single, firm commitment offering of a fixed size (not offering of a fixed size (not offering of a fixed size (not offering of a fixed size (not ongoing). Depositor receives ongoing). Fund sells securities ongoing). Trust sells trust ongoing). Trust sells receipts the units after making initial directly to the public in an securities directly to the directly to the public, in an deposit and then distributes to underwritten offering. public, in an underwritten underwritten offering. the public. offering. Secondary Sales Unitholders may sell their Common stock is listed and Holders may sell their Receiptholders may sell their securities at any time. can be sold at any time on the securities at any time. securities at any time. Sponsors generally maintain secondary market. Prospectus delivery not secondary market (at market Underwriters may maintain a required, but registration prices). secondary market for preferred statement must be kept current. stock and debt. Must deliver a prospectus with secondary sales. Must deliver a prospectus with secondary sales. Must keep registration statement current. Must keep registration statement current. Prospectus Delivery Not able to rely on access Not able to rely on access Access equals delivery. Access equals delivery. equals delivery. equals delivery. Sales Includes an initial sales charge Underwriters, placement Underwriters, placement Underwriters, placement Charge/Compensation and minimal ongoing trustee’s agents and sub-dealers and agents and sub-dealers and agents and sub-dealers and and sponsor’s fees. sub-agents usually receive sub-agents usually receive sub-agents usually receive commissions (or reallowances) commissions (or reallowances) commissions (or reallowances) Brokerage fees and in connection with initial in connection with initial in connection with initial commissions apply to issuance. issuance. issuance. purchases in the secondary market. Limits on front-end, back-end Brokerage fees and Brokerage fees and and asset based sales charges commissions apply to commissions apply to under FINRA rules. purchases in the secondary purchases in the secondary market. market. Must engage an investment adviser. Advisory contract requires specific content, approval and annual renewal.

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt Performance fees are permissible under tight limits. Securities Law Issues Disclosure A UIT must register using A closed end fund must A depositor/sponsor must A sponsor must comply with Form N-8B-2, which requires register on Form N-2, which comply with Reg AB II the disclosure requirements of extensive disclosure about the requires extensive disclosure disclosure requirements, Form S-1, including risk description of the securities, about the description of the including risk factors, factors, description of the sales loads and fees, securities, sales load and fees, description of the certificates, receipts, plan of distribution, information regarding the information regarding the plan of distribution, information regarding the sponsor, distribution and sponsor, investment adviser, information regarding underlying securities, the redemption arrangements, tax distribution and redemption underlying assets, servicers, trustee and tax consequences. consequences and audited arrangements, tax trustees and others, and tax financials. consequences and audited consequences. financials. Each series of a UIT must If any one issuer’s securities register on Form S-6 that A statement of additional make up 10% or more of the contains the information that information also with pool, issuer is a significant would be required in a Form extensive and specific obligor and subject to N8-B2 and financial disclosure requirements also is disclosure requirements, statements. required. among other things. Initial S-6 is treated like the initial offering of an investment company, including SEC review. Reporting Required to provide annual Required to file annual and Required to file annual reports Trust is required to register reports to unitholders. semi-annual shareholder on Form 10-K and reports on receipts with the SEC and to reports. Also required to file Form 10-D (in connection with file periodic reports upon a quarterly reports on holdings. a distribution) as well as change in the underlying asset periodic reports on Form 8-K. (such as stock split, if stock). Sarbanes-Oxley Not applicable. Closed-end funds are required Section 302 certifications Not applicable. Requirements to file an N-CSR twice yearly required (signed by person with annual and semi-annual signing Form 10-K) shareholder reports. Includes certain certifications and disclosures. Performance FINRA requires Requirements for calculation, Computational material may Not applicable

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt Advertising communications about format and disclosure of include statistical information performance based on NAV to performance are spelled out in such as the yield, average life, give equal prominence to Form N-2 and related SEC expected maturity, interest rate performance based on closing rules and FINRA rules. sensitivity, cash flows, etc. for market price. a class of securities Subject also to detailed UITs may not rely on guidance in no-action letters estimated current return; applying general anti-fraud instead should also rely on provisions. estimated long-term return. Anti-fraud Subject to the anti-fraud Subject to the anti-fraud Subject to the anti-fraud Subject to the anti-fraud Requirements provisions of the 1940 Act, provisions of the 1940 Act, provisions of the 1933 Act and provisions of the 1933 Act and 1933 Act and 1934 Act. 1933 Act and 1934 Act. 1934 Act. 1934 Act. Compliance Issues Affiliated Transactions Principal transactions (sales of Principal transactions (sales of Not subject to Section 17 of Not subject to Section 17 of securities or other property or securities or other property or the 1940 Act. the 1940 Act. loans from the UIT to the loans from the fund to the

Sponsor or other affiliates or adviser or other affiliates or vice versa) are flatly vice versa) are flatly Must describe how the prohibited. prohibited. sponsor, depositor or issuing entity is an affiliated of: the Sponsor permitted to act as Agency transactions with servicer, trustee, a significant underwriter (purchases and affiliates are permitted subject obligor or the provider of holds the securities making up to board review and limits on credit enhancement, as well as the portfolio) and to maintain the level of commissions. a description of any material unitholder records. Sponsor Cross transactions (between business may receive a fee for funds or between fund and relationship/arrangement providing portfolio supervisory another account managed by outside the ordinary course. services. Section 26 of the the adviser) mostly are treated 1940 Act limits fees payable. as principal trades but generally are treated under SEC rules. Pricing/Valuation UITs calculate NAV once a Pricing determined by Pricing determined by Pricing determined by day. For listed UITs, investors secondary market. secondary market. secondary market. can buy and sell on an

exchange at the prevailing market price, which may be at

Repackaging (through Custodial Unit Investment Trust Closed End Fund Grantor Trust) Arrangement/Receipt a premium or discount to NAV, but which generally tracks the approximate value. Performance disclosed based on NAV and market price. Board or Other A UIT is defined under Must have a board of directors Not required to have a board of Not required to have a board of Independent Oversight Section 4(2) of the 1940 Act as satisfying statutory directors. Minimal supervision directors. not having a board of directors. independence requirements (a by sponsor and trustee to Requires only minimal majority independent). administer the assets. supervision by the sponsor and a trustee to administer the assets. Code of Ethics Under the 1940 Act, must Under the 1940 Act, must Not required. Not required. adopt a code of ethics adopt a code of ethics and (provisions reasonably reporting by covered persons. necessary to prevent unlawful conduct). Must be approved by principal underwriter. Fiduciary Duty As specified by the regulations Express duty with respect to As specified by the regulations As specified by the regulations applicable to the trustee, receipt of compensation from applicable to the trustee, applicable to the trustee, usually a banking institution. the fund, and fees are subject usually a banking institution. usually a banking institution. to board oversight. Other duties as required by the Investment Advisers Act. Management Passive Active Passive Passive

FREQUENTLY ASKED QUE STIONS A B O U T UNIT INVESTMENT TRUS TS

directors, and (C) issues only redeemable securities, Understanding Unit Investment Trusts each of which represents an undivided interest in a unit

What is a “unit investment trust”? of specified securities. . . .”

A unit investment trust (“UIT”) is a type of registered Who organizes UITs? investment company under the Investment Company Most often, UITs are organized by investment banks or Act of 1940, as amended (the “1940 Act”). Generally, broker-dealers registered with the SEC. These Section 3 of the 1940 Act defines an investment “sponsors” create a marketable portfolio of securities. company as an issuer that holds itself out as being On a certain date, the sponsor deposits the securities (or engaged primarily, or proposes to engage primarily, in contracts to purchase the securities) with a trustee the business of investing, reinvesting or trading in pursuant to the terms of the trust indenture or securities. Because UITs issue securities, and use the agreement. In exchange for the deposit of securities (or issuance proceeds to invest in securities, they fall within contracts), the sponsor receives unit certificates the definition of an “investment company” under the representing shares of ownership.2 An evaluator then 1940 Act. values the securities held, and this valuation is used to The most significant distinguishing characteristic of a establish the unit offering price. UIT compared to other investment companies is that it Once the UIT and its units are registered for public has “virtually no management.”1 That is, UITs employ sale, units are sold to the public in an underwritten a “buy and hold” strategy, and once the portfolio public offering. securities are selected, they generally do not change.

Section 4(2) of the 1940 Act defines a UIT as an What does “unit of specified securities” mean? investment company “which (A) is organized under a By definition, UITs issue units, each of which represents trust indenture, contract, custodianship or agency, or an undivided interest in a “basket” of specified similar instrument, (B) does not have a board of

2 While the deposit of the securities (or contracts) with 1 Hearings on S. 3580 Before Subcomm. Of Sen. Comm. the trustee in exchange for units constitutes a prohibited On Banking and Commerce, 76th Cong., 3d Sess. 300 affiliate transaction under Section 17(a)(1) of the 1940 (1940) (statement of John H. Hollands, SEC staff Act, Section 17(a)(1)(c) explicitly permits this attorney). transaction.

securities that has been determined in advance of the series trust, with each series constituting a different offering. In the SEC Staff’s view, because the structure portfolio. By creating several series, a UIT can sell units of a UIT does not include investment advisory of numerous portfolios without having to register an management or safeguards against abuses of entirely new trust under the 1940 Act. management discretion, UITs may not contemplate The trust indenture, or similar governing agreement, trading of securities. The Staff has stated that sales and governs both the trust and the activities of those purchases of portfolio securities, also referred to as associated with the UIT, such as the trustee, eliminations and substitutions, should take place only sponsor/depositor and evaluator. under unusual circumstances, i.e., circumstances indicating that the creditworthiness or economic What are the requirements for a UIT trustee? viability of the issuer of a portfolio security is seriously The trust indenture or agreement is of central in doubt.3 Only in extraordinary circumstances are UIT importance to UIT operations, and Section 26 of the 1940 sponsors permitted to sell portfolio securities to Act prescribes its minimum requirements. Section purchase new securities.4 26(a)(1) provides that a UIT’s trust indenture or agreement must designate a trustee that is a bank How many UITs are in the market already? having a specified minimum amount of capital (not less

According to statistics published by the Investment than $500,000). Company Institute (“ICI”), as of year-end 2014, there were a total of 5,381 UITs with a value of $101.14 billion. How does a UIT’s trustee earn and pay fees?

At year-end 2014; there were: 2,287 tax-free bond UITs, Section 26(a)(2) provides that the trustee may receive with a market value of $12.11 billion; 591 taxable bond fees and expenses from the income earned by a UIT, or

UITs, with a market value of $3.06 billion; and 2,503 the UIT’s corpus if there is no income, only if the trust equity UITs, with a market value of $85.96 billion. In indenture so provides and the trustee is not otherwise

May 2015 alone, 119 new UITs issued units.5 compensated. Section 26(a)(2) also limits the ability of the trustee to treat payments to a UIT’s sponsor or How are UITs organized? principal underwriter as an expense subject to

Although the 1940 Act allows UITs three forms of reimbursement by the UIT and requires that the trust organization (trust, custodian or agency), as a practical indenture give the responsibility for possession of the matter, nearly all UITs elect to organize as a trust under UIT’s assets to the trustee. state law. A UIT may be organized as a single trust, or a Can a UIT’s trustee resign? 3 Nike Securities L.P., SEC No-Action Letter (Nov. 20, Section 26(a)(3) requires that the trust indenture provide 1992). 4 Prudential Unit Trusts, SEC No-Action Letter (Dec. 21, that the trustee may not resign until the trust has been 1987); Growth Stock Series, PaineWebber Equity Trust, completely liquidated and the proceeds distributed to SEC No-Action Letter (Sept. 24, 1986). 5 Investment Company Institute, Monthly UIT Deposits investors, or a successor has been appointed. This May 2015, available at section, rooted in the origins of UITs, ensures that the https://www.ici.org/research/stats/uit/uits_05_15.

2 trustee may not abandon the UIT should fees become What differentiates a UIT from other investment unsatisfactory. companies?

Unlike other types of investment companies, such as What are a UIT’s recordkeeping obligations? mutual funds, UITs are passive and are not managed. Section 26(a)(4) requires the sponsor to keep records UITs do not have an investment adviser that determines and notify unitholders of substitutions of portfolio an investment strategy or manages portfolio holdings. securities. If the trust indenture does not meet these Instead, fixed portfolio securities are deposited with the requirements, Section 26(d) allows the trustee and trustee and remain in the trust with little change for the sponsor to execute a separate agreement in compliance duration of the UIT’s existence. UITs also do not have a with Section 26(a) and file it with the SEC. board of directors to oversee the operation of the trust,

nor do they have officers, and have a fixed termination What are the initial funding requirements for a UIT? date. While termination dates vary and depend on the Once the trust is formed, Section 14(a) of the 1940 Act nature of the underlying portfolio, a UIT may terminate requires that the UIT be funded with at least $100,000 in at any time from as little as one year to many years after seed capital before distributing its units. This capital is its creation. The nature of the UIT’s portfolio securities most often provided by a UIT’s sponsor. and its investment objective typically determine its

What are the benefits of a UIT? longevity.

UITs may offer investors diversification, liquidity and Are there any sections of the 1940 Act that do not apply access to otherwise inaccessible investments at a to UITs? reasonable price. They also offer investors some degree Since UITs differ in many ways from other types of of predictability, since the UIT’s portfolio securities investment companies, certain sections of the 1940 Act change very little, if at all. do not apply to UITs. For example, Section 15 Since UITs are unmanaged, they may offer liquid (investment advisory and underwriting contracts), investments at lower costs than more common Section 10 (affiliations of directors) and Section 16 investment companies, such as mutual funds.6 (changes in board of directors) are inapplicable to UITs.

What types of securities do UITs issue? What is the tax treatment of UITs? Like other investment companies, a UIT invests in UITs are typically structured as pass-through entities securities and issues fractional undivided interests, for U.S. federal income tax purposes. Generally, this is called “units,” in the securities portfolio. accomplished in one of two ways: as a “regulated

investment company” (“RIC”) under Subchapter M of 6 Mutual funds are open-end investment companies that the Internal Revenue Code of 1986 (the “Code”) or as a provide daily liquidity. A mutual fund’s investment adviser receives a contractual fee (typically a percentage grantor trust under Section 671 of the Code. of the assets in the portfolio) to manage the day-to-day investment decisions and strategic direction of the portfolio.

In order to qualify as a RIC, a UIT must generally earn What is the trustee’s role? sufficient qualifying income, hold a diversified portfolio The trustee’s role is analogous to that of a custodian. It of qualifying assets, and make periodic distributions to maintains the UIT’s assets, records ownership and shareholders of its taxable income, among other ensures that any advances received are credited and requirements. The diversification requirement under that the UIT’s expenses are paid. The trustee may also

Subchapter M of the Code could be difficult for a UIT to be responsible for reporting to the unitholders. In meet, since the UIT may hold only a limited amount of exchange for these services, the trustee receives a fee, securities. Furthermore, a UIT may plan to invest in which is typically based upon the total value of the UIT. assets that prohibit the UIT from qualifying as a RIC. To protect unitholders, Section 26 of the 1940 Act sets

In some cases, taxation as a grantor trust under forth certain minimum requirements of a trustee to

Section 671 of the Code may be a better means for a UIT ensure, for example, its solvency and its ongoing ability to obtain the benefit of pass-through tax treatment. to meet its responsibilities.

Investors in a UIT are generally treated as owning the What is the sponsor’s role? assets of the UIT directly. In order to qualify as a grantor trust, the UIT is generally not permitted to alter A UIT’s sponsor is usually its principal underwriter, its investment portfolio. and it is responsible for organizing the trust and establishing its investment objective. It is also Accordingly, careful consideration should be given to responsible for bearing the initial costs of establishing a the tax structure of a UIT. The best choice will depend UIT, but it can be reimbursed by the UIT for many of upon the composition of the UIT’s assets, the ability of these costs.7 the UIT to alter its portfolio, and the UIT’s planned liquidity. In most UITs, the sponsor is responsible for purchasing the portfolio securities and for instructing

the trustee on the disposition of securities should they

Mechanics and Participants need to be sold to meet redemption needs. For its

services, the sponsor is compensated by the sales charge

Who provides services to the UIT? (load) attached to unit sales, and it may also be

While UITs do not have directors or investment compensated for providing portfolio supervisory advisers, other service providers are responsible for its services, subject to certain limitations. day-to-day functions. These include the trustee, To ensure the sponsor’s integrity, Section 9 of the 1940 sponsor (or depositor) and evaluator. Each role is Act prohibits a person from serving as a sponsor if that defined in the trust indenture, as are the responsibilities person has committed certain offenses or has been entailed in carrying out each role. found guilty of certain securities-related misconduct.

7 Letter to Pierre de St. Phalle, Re: Unit Investment Trust Organization Expenses (May 9, 1995), available at https://www.sec.gov/divisions/investment/noaction/199 5/uit050995.pdf.

What is the evaluator’s role? may designate which is to be responsible for approving

The evaluator is typically responsible for valuing the the code and any material changes to it. securities held by the UIT. The evaluator may also Are transactions with affiliates prohibited? perform other supervisory services as well. Section 17 of the 1940 Act regulates all investment For its services, the evaluator typically receives a companies and prohibits certain affiliated transactions. fixed annual fee. While the evaluator may be Generally, Section 17(a)(1) prohibits an affiliated person independent from the sponsor/depositor, it does not of an investment company from knowingly selling any have to be, and may often be an affiliate. security or other property to the investment company.

What are the governance and code of ethics Section 2(a)(3) of the 1940 Act generally defines an requirements for a UIT? affiliated person of an investment company to include, among others, any person owning 5% or more of the While the central governance sections of the 1940 Act company’s voting securities, any person in which the are, generally, inapplicable to UITs, which do not have a investment company owns 5% or more of the voting board of trustees or an investment adviser, UITs are still securities, any person directly or indirectly controlling, subject to Rule 38a-1 under the 1940 Act. Generally, controlled by or under common control with the Rule 38a-1 requires UITs to adopt and implement company, and if the company is an unincorporated written policies and procedures reasonably designed to investment company without a board of directors, the prevent violations of the federal securities laws. depositor. Moreover, UITs are required to review these policies and procedures at least annually, and they must An affiliated transaction with a UIT would, therefore, designate a chief compliance officer (“CCO”) include a transaction between a UIT and its responsible for administering such policies and sponsor/depositor or principal underwriter. Section procedures. A UIT’s principal underwriter or depositor 17(a)(1)(C), however, excepts from the prohibition must approve its compliance policies and procedures securities deposited with the trustee of a UIT by the and its CCO, and will receive reports related to the depositor. Since a UIT can eliminate or substitute its

CCO’s annual review of the UIT’s compliance policies portfolio securities only under rare circumstances, and procedures. under most circumstances the prohibition imposed by Section 17(a) would be inapplicable. UITs are also required to adopt a written code of ethics. Generally, Rule 17j-1 under the 1940 Act requires Under certain circumstances, however, a UIT may, as that the code contain provisions “reasonably necessary an investment strategy, choose to invest in certain other to prevent” unlawful conduct. In addition to adopting series of the same UIT or a different UIT within the its own code, a UIT’s code of ethics must also be same investment complex. If such series are under the approved by its principal underwriter or depositor. If control of the same depositor, they could be affiliates, the UIT has more than one principal underwriter or and the sale or redemption of their units could be depositor, the principal underwriters and depositors deemed to be a principal transaction prohibited under

Section 17(a). To permit a strategy of this type, UITs Registration and Disclosure Under the often seek and receive exemptive relief from the SEC Securities Laws and Sale of Units under Sections 6(c) and 17(b) of the 1940 Act.

What are the registration requirements? What sales charges are typically assessed? Generally, Section 5 of the Securities Act of 1933 (the A typical unit is subject to a front-end sales charge, a “Securities Act”) requires that securities be registered, deferred charge or a combination of both. When sold and a registration deemed effective by the SEC, prior to with a front-end sales charge, the price per unit is equal their public offer or sale. Moreover, Section 8(b) of the to its net asset value (“NAV”) plus the sales charge 1940 Act requires investment companies to register with assessed. When sold with a deferred sales charge, the SEC. While mutual funds, for example, accomplish collection of the charge is deferred over a period of time both Securities Act and 1940 Act registrations on one after the initial purchase of the unit. Generally, the integrated form (Form N-1A), UITs must file two: Form deferred charge is deducted from the holder’s N-8B-2, registering the trust as an investment company distributions until the entire amount is paid. If a unit is under the 1940 Act; and Form S-6 registering the UIT’s redeemed before the entire charge has been paid, the units for sale under the Securities Act. Each subsequent balance of the charge is deducted from the redemption series of the UIT must also register separately on proceeds. Form S-6. The 1940 Act requires UIT units to be “redeemable,” which means that investors must have the ability to What is Form N-8B-2? redeem, or sell, their units back to the UIT at their Generally, Form N-8B-2 includes information such as: current value. Rule 22c-1 under the 1940 Act requires  a summary of the material terms of the trust that the price of a redeemable security be based on the indenture and other contracts into which the security’s NAV. Thus, charging a deferred sales charge trust has entered; raises issues with respect to the units’ redemption,  a description of the securities offered; because the investor will receive less than the units’ full  a description of sales loads, fees, charges and value upon redemption. In practice, however, UITs expenses; issuing units subject to a charge of this type seek and receive exemptive relief from the SEC that permits  information regarding the sponsor; deferred sales charges.  distribution arrangements;

 information regarding the trustee, custodian and other service providers;

 information regarding portfolio insurance, if

applicable;

 tax information; and

 audited financial statements.

The Form N-8B-2 is subject to review by the SEC’s  Rule 22c-1 (to permit purchases and redemptions of

Division of Investment Management. units at prices less than NAV as a result of a

deferred sales charge structure);8 What is Form S-6?  Section 22(d) (to permit waivers, deferrals or other To register units for a public offering, each series of the scheduled variations in the sales load);9 UIT must file a separate Form S-6. Each series must also  Section 26(a)(2)(C) (to permit a UIT’s trustee to prepare its own preliminary prospectus, which is used collect the sales charge deductions and disburse by the underwriter or underwriting syndicate to obtain them to the depositor); indications of interest in the units. Form S-6 generally  Section 14(a) (to exempt the UIT from the $100,000 requires disclosure, in a prospectus, of information net worth requirement, since the SEC interpretation similar to that required in Form N-8B-2. The filing for of the requirement is that the initial capital the initial series of a UIT on Form S-6 is subject to investment in the investment company be made review by the SEC’s Division of Corporate Finance. without the intention to dispose of the investment;

What are the typical regulatory requirements as to a UIT will deposit securities into the trust, and which exemptive relief is sought by UIT sponsors? distribute pro rata units to investors); and

Some UIT structures and the investment strategies  Section 19(b) and Rule 19b-1 (to permit the UIT to chosen require that the UIT seek exemptive relief from distribute long-term gains more than once every 12 the SEC from certain provisions of the 1940 Act. While months). the particulars of each application may vary, UITs often UITs may also seek exemptive relief from Sections seek exemptive relief to permit deferred sales charges 12(d)(1)(A), (B) and (C) of the 1940 Act to permit them and other transactions. To permit transactions of this to acquire shares of certain other investment companies type, UITs generally seek exemptions from the in excess of the limitations imposed by Section 12(d)(1). following sections of the 1940 Act: Can UITs permit holders to exchange their units for  Section 2(a)(32) (because the imposition of a units of another UIT or roll over their units? deferred sales charge may cause the UIT to fall

outside of the definition of “redeemable security” Generally, Section 11(c) of the 1940 Act prohibits an

as a unit could be redeemed at a price less than offer of exchange of a unit of one UIT for a unit of

NAV); another (or any other investment company security). However, UITs that are part of a complex or family of  Section 2(a)(35) (because the imposition of a other UITs or series often offer this as a privilege for deferred sales charge may fall outside of the

definition of “sales load”); 8 By rule, the SEC permits open-end investment companies to assess deferred sales charges. See Rule 6c 10 under the 1940 Act. 9 By rule, the SEC permits the sale of redeemable securities at prices that reflect sales loads, but UITs often seek this exemption for clarity. See Rule 22d-1.

7 unitholders. In addition, such exchanges may be This process has the effect of permitting frequent offered with reduced sales charges. To accomplish this, offers by series of the UIT on an expedited basis. exemptive relief from Section 11(c) may be available What are the requirements of Rule 24f-2? from the SEC upon application and request. Rule 24f-2 under the 1940 Act permits a UIT to register

How are subsequent series registered? an indefinite amount of units upon initial registration.

While there is no “shelf registration” process for UITs, After accounting for the number of units sold and

UITs organized as a series trust are afforded some redeemed during the UIT’s fiscal year, a UIT must file a flexibility for conducting subsequent series offerings by Rule 24f-2 notice 90 days after year-end, netting units

Rule 487 under the Securities Act. sold against units redeemed or repurchased and paying

To avail itself of this flexibility, the initial series of a any related registration fees.

UIT must file a Form S-6 registration statement that is What are the ongoing reporting obligations of a UIT? subject to review by the SEC. Once the SEC has Section 10(a)(3) of the Securities Act requires that a declared the Form S-6 for the initial series effective, the UIT’s prospectus be maintained and updated.10 In order UIT may rely on Rule 487 for offerings of units of future to accomplish this, sponsors typically file post-effective series. amendments to the UIT’s registration statement.

What are the conditions of Rule 487? In addition to maintaining a current registration

Rule 487 permits the Form S-6 registration statement statement, like many other issuers and investment relating to a subsequent series of a UIT to become companies, a UIT is subject to ongoing reporting effective automatically without affirmative action by the obligations under the Securities Exchange Act of 1934

SEC if it satisfies a number of conditions: (“Exchange Act”). A UIT may satisfy its periodic

 The UIT must identify one or more prior series reporting obligations under the Exchange Act by filing a

that the SEC has declared effective; Form N-SAR under Rule 30a-1 of the 1940 Act within 60 days after the close of each calendar year. The sponsor,  The UIT must represent that the securities in conjunction with the trustee, typically prepares this deposited in the new series being registered do annual report on behalf of the UIT. not differ materially in type or in quality from

those deposited in the prior series, and the What are the requirements for Form N-SAR? disclosure in the prospectus for the series being The Form N-SAR is required to disclose information registered may not differ materially from the regarding, among other things: disclosure in the prior series’ registration  information about the sponsor and trustee; statement; and  sales during the period;  The UIT must deliver a preliminary prospectus in compliance with Rule 460 (delivery to underwriters). 10 Information in the prospectus cannot be more than 16 months old.

 affiliated transactions; and Redemption and Secondary Markets  sales loads and other fees and expenses.

The Form N-SAR is not required to contain audited How are units redeemed? financial statements and UITs are not required to By definition, a UIT must issue redeemable securities. provide unitholders with annual reports containing A “redeemable security,” as defined in Section 2(a)(32) financial statements. As a result, UITs are exempt from of the 1940 Act, includes a security, other than short- the certification requirements of Section 302 of term paper, that by its terms entitles the holder to

Sarbanes-Oxley. In practice, however, the trustee present it to the issuer (or someone designated by the typically will provide an annual report to unitholders issuer) and to receive approximately the value of the detailing the activities of the trust. This report holder’s proportionate share of the issuer’s current net customarily contains audited financial statements and assets. Unless a secondary market is maintained, a UIT the trustee’s discussion of fund operations and and its sponsor, therefore, must be ready to redeem investment results. units. If units are redeemed for their cash value, the

1940 Act requires that they be redeemed at NAV, which, Are UITs subject to blue sky registration and review? like mutual funds, is calculated daily. For these

The National Securities Markets Improvement Act of purposes, the redemption price is the NAV per unit

1996 (“NSMIA”) preempts state law, and prohibits calculated on the date the trustee receives the states from imposing registration requirements or redemption notice. standards upon companies that are registered under the

1940 Act, among others. While a UIT is, therefore, not How do units trade on the secondary market? subject to substantive review by state securities officials, While not required, in practice, it is typical for a UIT it still must comply with each state’s blue sky sponsor to maintain a secondary market in and to act as requirements prior to offering the sale of units in that a market maker for the UIT’s units. In other words, the state. Requirements vary from state to state, but many sponsor may stand ready to purchase units from states require an initial notice filing, such as a filing on unitholders and sell them to interested purchasers. In

Form NF, or a state’s version of the notice filing, and addition to providing investors with enhanced liquidity, renewal notices. Other states require the filing of the this secondary trading also avoids depleting the UIT’s

UIT’s SEC-filed registration statement. States may also assets due to sales of portfolio securities to meet require that a UIT file a Form U-2, or similar form, redemptions. The SEC considers a sponsor making a consenting to the service of process in that state. market in a UIT’s securities to be the “issuer” of those

Moreover, UITs are subject to state registration and securities. As such, the sponsor is required to keep renewal fees, which vary from a flat registration fee to a current the registration statement in connection with percentage of the total aggregate offering price. any secondary market sales and must deliver a prospectus in connection with such sales.

Section 22(d) of the 1940 Act and Rule 22c-1 require that investment company redeemable securities be sold By Kelley A. Howes, Of Counsel, at NAV. Because of this requirement, it is not possible and Matthew J. Kutner, Associate, to list units of a UIT on a national securities exchange Investment Management Practice because the market price may not equal NAV. and However, the SEC frequently grants exemptive relief to Remmelt A. Reigersman, Partner, UITs to enable them to list their securities on a national and David J. Goett, Associate, securities exchange. Federal Tax Practice

What are the prospectus delivery requirements for Morrison & Foerster LLP sponsors that make a market in UITs?

Section 5(b)(2) of the Securities Act makes it unlawful for a person to deliver a security for sale, or for delivery © Morrison & Foerster LLP, 2016 after a sale, unless a prospectus that meets certain legal requirements accompanies or precedes the security.

Section 5(b)(1) of the Securities Act requires transmittal of a prospectus to investors following the filing of a registration statement. As an issuer of securities, UITs must comply with Section 5(b) of the Securities Act.

Accordingly, as units are offered for sale, a UIT’s sponsor must deliver a legally permissible prospectus.

If a sponsor purchases and sells units in a secondary market, these transactions are also subject to the prospectus delivery requirements.

In addition to the sponsor, any dealer in units must also provide investors with a current prospectus; dealers in units cannot utilize the “dealers’ exception” of Section 4(3) of the Securities Act, since Section 24(d) of the 1940 Act explicitly excludes UITs from the prospectus delivery exemptions of Section 4(3) of the

Securities Act.

The chart on the following page provides a comparison of

UITs and open-end mutual funds.

______

Comparison of Products

UITs Open-End Funds

Structure/Governance Trust/no directors; Business trust or minimal supervision by corporation/board of directors trustee

Unit (Share) Issuance IPO/ongoing Ongoing

Unit (Share) Redemption Every day at NAV, but Every day at NAV secondary market often maintained

Termination Date Yes No

Management Buy and hold; no ongoing Managed by a registered management investment adviser

Sales charges, and minimal Advisory, custody, transfer Fees ongoing fees for trustee, agency, distribution (12b-1) and sponsor or evaluator administration, among others

Ongoing Fees/Expenses Lower Higher

Initial Cost/Load Front-end/deferred sales Front-end/deferred sales charge charge/no-load

Fully Invested Yes No

Tax Structure Grantor trust/RIC RIC

Diversification Requirement RIC = Yes Yes Grantor trust = No

Integrated Registration No (Form N-8B-2 and Yes (Form N-1A) Form S-6)

FREQUENTLY ASKED QUE STIONS A B O U T CLOSED - E N D F U N D S

Most investors are familiar with mutual funds, or Closed-end funds are registered under the Investment

“open-end” registered investment companies. Closed- Company Act of 1940, as amended (the “1940 Act”) and end funds, however, may be less familiar to investors. their shares are typically registered under the Securities

Here we address some of the differences between open- Act of 1933, as amended (the “Securities Act”). Trading end and closed-end funds and answer frequently asked in listed shares of a closed-end fund is subject to the questions regarding the use and structure of closed-end Securities Exchange Act of 1934, as amended (the funds. “Exchange Act”), as well as the listing standards of the exchange.

Closed-End Funds What Are The Advantages Of Closed-End Funds?

What Is A Closed-End Fund? Closed-end funds can be attractive investments for

A closed-end fund is a management investment several reasons. company. Unlike an open-end mutual fund, however,  A closed-end fund raises a fixed amount of closed-end funds do not continuously offer their shares capital in a public offering and its shares are at a price based upon the current net asset value not redeemable directly by the fund, so it is not

(“NAV”). Rather, closed-end funds typically issue a subject to the fluctuations in asset size that can fixed number of shares that are listed on a stock result from day-to-day purchase and exchange. Shares of a closed-end fund trade at market redemption activity. As a result, the fund’s price (which may be at a discount or premium to the investment adviser manages a more stable

NAV) and they are not routinely redeemable directly by portfolio. the fund.1  Unlike open-end funds, closed-end funds do

not need to maintain liquidity to meet daily

1 Certain types of closed-end funds, including business development companies (“BDCs”) and interval funds, are beyond the scope of this article. For answers to common Development-Companies.pdf. Interval funds are subject to questions about BDCs, see Frequently Asked Questions About Rule 23c-3 under the 1940 Act and, unlike most closed-end Business Development Companies, at funds, adopt a policy of periodic redemption of shares and do http://www.mofo.com/files/Uploads/Images/FAQ-Business- not list their shares on an exchange.

redemptions. Thus, they have more flexibility Registration with the SEC subjects a fund to certain

to invest in less liquid securities. other filing requirements (see “Open-End and Closed-End

 Closed-end funds have more regulatory Funds at a Glance” below).

flexibility than open-end funds to leverage Post-Effective Amendments to Registration Statements

their investments. For example, they may issue Generally, closed-end funds amend their registration

preferred shares or debt, which open-end statements by filing a post-effective amendment as

funds may not do. (For more information on required by the rules under the Securities Act. These

the use and structure of leverage, see “Can rules require the SEC to review and declare effective

Closed-End Funds Use Leverage?” below.) any post-effective amendments, which can delay a

fund’s attempt to raise additional capital. (By contrast, How Does A Closed-End Fund Register With The SEC? the SEC’s rules allow open-end funds and interval Initial Registration funds to file post-effective amendments that become

Like any registered investment company, a closed-end immediately effective, provided that they contain only fund must file a notification of registration on Form updated financial information or certain other non-

N-8A. If the fund intends to publicly offer its shares, it material changes.)2 must then prepare and file a registration statement on Shelf Registration Statements Form N-2, a three-part registration statement consisting The SEC’s Staff has granted relief allowing closed-end of a prospectus, a statement of additional information funds to file Form N-2 to effect a shelf registration (“SAI”) and certain other information. statement for a delayed and continuous offering of  The prospectus is designed to provide shares.3 This relief, however, did not allow post- shareholders with essential information about effective amendments to Form N-2 to become effective the fund and should be written in clear, automatically upon filing. concise language (i.e., plain English). Subsequently, the Staff addressed the issue of  The SAI is designed to provide interested automatic effectiveness of post-effective amendments to shareholders with additional, more detailed Form N-2 on a case-by-case basis. In these individual information about a fund, its management and “no-action” letters, the Staff said that it would not service providers, and its policies. The SAI recommend enforcement action if certain closed-end must be available to shareholders on request

for free. 2 Interval funds may rely on Rule 486(b) and open-end funds  Other information included in the registration may rely on Rule 485(b), each of which enables a registrant to file an immediately effective post-effective amendment statement includes corporate organizational primarily for the purposes of updating financial information or making other non-material changes. documents and certain contracts and 3 See, e.g., Pilgrim America Prime Rate Trust (pub. avail. May 1, compliance policies. 1998); Nuveen Virginia Premium Income Municipal Fund (pub. avail. Oct. 6, 2006). The SEC’s Division of Investment Management generally allows third parties to rely on no-action letters if their facts and circumstances are substantially similar to those described in the previously granted no-action letter.

2 funds relied on Rule 486(b) under the Securities Act to such as directors and certain executive employees. file immediately effective post-effective amendments to “Insiders” must report their ownership at the inception their Form N-2 registration statements to bring financial of the fund and at least annually thereafter. Section 16 statements up to date or make other non-material also imposes certain trading restrictions on insiders. For changes.4 The Staff granted several of these no-action example, insiders of a closed-end fund cannot benefit requests under substantially similar circumstances. from a sale and purchase (or purchase and sale) of fund

However, each letter specifically states that other shares made within six months of each other. Insiders registrants may not rely on the relief. Thus, a closed-end are required to disgorge any benefit of these “short- fund that wants to maintain a continuously effective swing” transactions. shelf registration statement and does not want to incur Why Does A Fund Trade At A Premium Or A Discount? the additional time, and possibly expense, of waiting for the Staff to review and declare effective amendments to When shares of closed-end funds trade on a stock its Form N-2 registration statement may consider exchange, their price will fluctuate like those of other seeking similar no-action relief. publicly traded stocks. That is, shares usually trade at a market price that is higher (at a premium) or lower (at a

What Are The Requirements For Listing Shares Of A discount) than a fund’s NAV. Closed-End Fund? Many factors may determine whether a fund trades at

Closed-end funds that list their shares on a stock a premium or a discount to its NAV. Sometimes public exchange are subject to the listing requirements of the perceptions can drive the market price of a closed-end relevant exchange. As described in more detail below, fund up or down in relation to its NAV. For example, if these requirements can include corporate governance the market perceives that a closed-end fund is one of the requirements (e.g., audit committee independence and only ways to invest directly or indirectly in a category required contents of the audit committee charter), of scarce securities, market interest may drive the price requirements for annual shareholder meetings, and of shares to a premium. On the other hand, a closed-end certain required reporting. In the case of a listing on the fund with a large unrealized capital gain may trade at a

NYSE, the chief executive officer of a listed closed-end discount if investors believe that they may be subject to fund must annually certify to the NYSE that she is not tax if the fund realizes a capital gain. aware of any violation by the fund of NYSE listing standards. How Can A Closed-End Fund Minimize A Discount?

A listed closed-end fund is subject to the reporting Historically, shares of closed-end funds tend to trade at requirements of Section 16 of the Exchange Act with a discount to NAV after the initial public offering. Fund respect to holdings of fund shares by certain insiders, management may take steps to minimize the size of the discount. For example, from time to time a closed-end

fund may make a tender offer for outstanding common 4 See, e.g., Aberdeen Asia-Pacific Income Fund, Inc. (pub. avail. June 26, 2013); Credit Suisse High Yield Bond Fund and Credit shares and allow shareholders to redeem shares at Suisse Asset Management Income Fund, Inc. (pub. avail. June 26, 2013); Eaton Vance, et al. (pub. avail. June 26, 2013). NAV. Some closed-end funds have adopted a stock

3 purchase plan pursuant to which the fund purchases voting securities, which sets forth, among other things, shares on the open market to reduce the total number of the periodic intervals at which repurchases will be common shares outstanding. A closed-end fund may made. also choose to address a discount by adopting a policy Can A Closed-End Fund Raise Capital Through An At- to convert to an interval fund or to an open-end fund.5 The-Market Offering? (See “Can a Closed-End Fund Repurchase its Shares?” below.) Yes. At-the-market offerings allow a closed-end fund to raise capital quickly by selling newly issued shares into

Can A Closed-End Fund Repurchase Its Shares? the natural trading flow of the market, without having

As previously noted, closed-end fund shares generally to announce the offering. As a result, shares “trickle” trade on the secondary market at a market price that into the market without meaningfully affecting the may be at a premium or at a discount to a fund’s NAV. market price of a fund’s shares. The distribution costs

If shares trade at a discount, a closed-end fund may for at-the-market offerings are typically less than those attempt to reduce the spread through a tender offer for for traditional follow-on offerings. Moreover, the its shares. A tender offer is subject to the rules under the absence of an issuer commitment to sell means that

Exchange Act and the rules of the exchange. there will be no sales below acceptable share prices.

Closed-end funds may also decide to convert to At-the-market offerings may raise issues, however,

“interval funds.” Rule 23c-3 under the 1940 Act because Section 17(a) of the 1940 Act prohibits principal provides that a closed-end fund can adopt a policy of transactions with certain affiliated persons of a fund, repurchasing between five percent and twenty-five including its principal underwriter. To the extent a percent of its outstanding common stock at periodic distribution agent in an at-the-market offering is intervals pursuant to repurchase offers made to all considered a “principal underwriter” during the entire holders of common stock. The purchase price must be term of an at-the-market offering, the distribution agent the fund’s NAV determined as of a specified date, may not be able to provide other services to the closed- which may be subject to a repurchase fee of up to two end fund during the term of the program, absent an percent of the repurchase proceeds. A closed-end fund exemption from the prohibitions of Section 17. To avoid that wishes to periodically tender for its shares must potential issues under Section 17(a), closed-end funds adopt a fundamental policy, which may only be may wish to structure such a program to provide for changed by a majority vote of the fund’s outstanding agency-only transactions or structure an arrangement

between the closed-end fund and the distribution agent

5 Irrespective of whether the board adopts such a policy, in such a way to ensure that the distribution agent is not shareholders of a closed-end fund may propose to convert the a “principal underwriter.”6 fund to open-end status by obtaining approval by shareholders. Including such a proposal in a proxy statement is subject to the proxy rules under the Exchange Act and the provisions of the fund’s articles of organization and by-laws. 6 For more information about at-the-market offerings, see Subject to SEC rules, management of a fund may exclude such Frequently Asked Questions About At-the-Market Offerings, at a shareholder proposal if shareholders do not have the power http://www.mofo.com/docs/pdf/FAQAtTheMarketOfferings.p to require inclusion under the laws of the state of organization. df.

What Types Of Investments Are Permissible For to all registered investment companies. Among other

Closed-End Funds? things, these include:

The board of directors of a closed-end fund is free to set  Affiliated transactions. Section 17 of the 1940 Act the fund’s investment objectives and policies, subject to prohibits an affiliated person, sponsor or many of the same rules and restrictions regarding distributor of a registered investment permissible investments as are applicable to mutual company, including a closed-end fund, from funds. Like all registered investment companies, a engaging in principal transactions with the closed-end fund must disclose in its prospectus its fund. Such prohibited transactions generally investment objectives, its principal investment strategies include selling or buying any security or other and any restrictions on the types of investments it may property or borrowing from or loaning money make. It must also disclose whether its portfolio will be to the fund. The SEC has adopted several rules

“diversified,” or “non-diversified” as required by that exempt funds from these prohibitions.

Section 5(b)(1) of the 1940 Act. Because a closed-end These include Rule 17a-7 (governing cross- fund doesn’t need to meet daily redemption requests, it trades between affiliated funds), Rule 17a-8 may be easier for a closed-end fund to invest a non- (governing mergers involving affiliated funds) diversified or concentrated portfolio. and Rule 17e-1 (governing the payment of

The lack of daily redemptions also gives closed-end “usual and customary” brokerage funds the flexibility to invest in securities that are commissions to an affiliated broker). relatively illiquid. These may include thinly traded  Pricing and valuation. Although the price at securities, securities traded in countries with less which the shares of a closed-end fund trade is developed exchange mechanisms or less liquid markets, determined by the secondary market, a closed- municipal bonds that are not widely traded, or end fund nevertheless must periodically securities issued by small companies. Closed-end funds calculate its net asset value. Closed-end funds may also have exposure to private startup companies must comply with the requirements that apply funded by venture capital. to all registered investment funds including,

The ability to invest in these types of securities, among other things, the requirement to price together with the ability to use leverage, means that portfolio securities for which market closed-end funds may be more volatile and more risky quotations are not readily available at fair than many open-end mutual funds. value as determined in good faith by the closed-end fund’s board of directors. Are Closed-End Funds Subject To The Same Compliance  Code of Ethics. Rule 17j-1 requires closed-end Restrictions As Open-End Mutual Funds? funds (other than those that invest solely in

In general, closed-end funds are subject to the same U.S. government securities, certain short-term rules and restrictions set forth in the 1940 Act that apply securities or shares of open-end funds) and

their investment advisers and distributors to

adopt a code of ethics designed to prevent Preferred Shares

their access persons from engaging in As with preferred shares of any company, holders of

fraudulent, deceptive or manipulative conduct. preferred shares have priority over any other class of

Among other things, the code of ethics must shares with respect to distribution of assets and

require certain “access persons” to periodically payment of dividends. In addition, Section 18 provides

disclose their personal securities holdings and that holders of preferred shares of a closed-end fund

transactions and, in some cases, to pre-clear have the right to elect two directors of the fund at all

securities trades in their personal accounts. times.9

 Investments in Other Investment Companies. If a closed-end fund issues preferred shares, then any

Section 12(d)(1)(A) limits the ability of proposed plan of reorganization or any investment

registered investment companies to invest in policy changes that require shareholder approval under

securities issued by other investment Section 13 of the 1940 Act must be approved by a

companies. Section 12(d)(1)(C) limits the majority of the holders of preferred shares.

ability of any investment company to purchase Notwithstanding the limitation as to the number of

or otherwise acquire shares issued by a closed- classes of preferred stock that may be issued, a closed-

end fund if, immediately after such purchase end fund may offer more than one series of that class, as

or acquisition, the acquiring investment long as no series has priority over any other with

company, together with other investment respect to distribution of assets or payment of

companies in its fund complex, own more than dividends. 10% of the total outstanding voting stock of the Debt Securities closed-end fund. If a closed-end fund has issued debt, then it must

Can Closed-End Funds Use Leverage? maintain the 300 percent asset coverage level in order to pay out dividends on common stock. If the fund Section 18 of the 1940 Act effectively limits the amount proposes to pay out dividends on preferred stock, it of direct leverage in which an investment company can must maintain an asset coverage level of at least 200 engage. This section limits a closed-end fund’s issuance percent on any issued senior debt. of an evidence of indebtedness, unless the fund has 300 percent asset coverage,7 and preferred stock, unless the Section 18 provides an impetus to maintain a fund has 200 percent asset coverage.8 minimum asset coverage level on debt at all times: if a fund fails to maintain 100 percent asset coverage for 12

consecutive months, debt holders will be entitled to 7 In the case of debt securities, asset coverage is calculated as the ratio of the value of total fund assets, less all liabilities and elect at least a majority of the members of the board of indebtedness not represented by senior securities, to the aggregate amount of debt securities. 8 Asset coverage on preferred shares is the ratio of the value of 9 Additionally, Rule 18(a)(2)(C) provides that holders of the fund’s total assets, less all liabilities and indebtedness not preferred shares may elect a majority of directors if, at any represented by senior securities, to the aggregate amount of time, dividends on preferred shares remain unpaid for two debt securities issued by a fund plus the aggregate of the years. Preferred shareholders will continue to have this right involuntary liquidation preference of the preferred shares. until all dividends in arrears are paid.

6 directors. If a fund fails to maintain 100 percent asset they comply with the requirements of Section 18 or the coverage for 24 consecutive months, an event of default alternative requirement to cover assets with a shall be deemed to have occurred.10 segregated account. They may also invest in

Auction Rate Preferred Stock instruments that involve “implied” or “economic” leverage, provided those investments are consistent Historically, some closed-end funds issued auction rate with their investment policies. preferred stock (“ARPS”). The dividend rate on ARPS is determined by an auction managed by an independent In general, these segregated accounts must be marked- third party. During the financial crisis, the auctions to-market daily.

“failed,” meaning that there were more buyers than Some closed-end funds may establish credit lines sellers for the ARPS. While closed-end funds continued directly with banks or bank syndicates. Others may to pay ARPS-holders dividends at established rates form special purpose vehicles that issue commercial determined by a pre-existing formula, they were unable paper backed by a fund’s note, which is in turn backed to sell their shares because they became illiquid. Some by the fund’s assets or other sources of credit. closed-end funds redeemed, or repurchased, ARPS from Do Closed-End Funds Distribute Income? their holders at par. When a fund repurchases ARPS, the cost of leverage to the fund may increase. Closed-end funds pay out investment income in the form of dividends.11 In many cases, access to this

income is attractive to income-seeking investors, so Other Forms of Leverage closed-end funds may adopt a managed distribution Certain investment transactions, for example, reverse policy designed to provide routine (e.g., quarterly) repurchase agreements, firm commitment agreements distributions and stable distribution amounts. Closed- and standby commitment agreements, may involve a end funds may also provide investors with the senior security, because a counterparty may have a opportunity to reinvest distributions automatically future claim to the fund’s assets that is superior to the through the operation of a dividend reinvestment plan. rights of fund shareholders. The SEC has said that if a Distributions of net investment income and net short- fund has “covered” its obligations under these types of term capital gains realized by a fund are taxable to transactions, the fund would not be deemed to have shareholders as ordinary income. Distributions of net issued a senior security. A fund could “cover” the capital gain (i.e., the excess of net long-term capital gain transaction by segregating liquid assets on its books that over net short-term capital loss) are taxable as long-term are sufficient to satisfy 100 percent of the fund’s capital gain, regardless of the length of time a obligations under the transactions, or entering into shareholder owns the shares with respect to which such transactions that offset the fund’s obligations. distributions are made. An additional 3.8 percent Closed-end funds may also use derivatives and similar portfolio techniques to create leverage, provided 11 See “How are Closed-End Funds Taxed?” Closed-end funds electing to be treated as regulated investment companies are required to distribute substantially all of their income and 10 Rule 18(a)(1). capital gains to shareholders annually.

Medicare tax will be imposed on certain net investment tender offers, additional public offerings of shares or income, including ordinary dividends and capital gain conversion to open-end status. distributions, of certain U.S. shareholders for years Like all fund directors, directors of a closed-end fund beginning after December 31, 2012. Reinvestment of are subject to corporate governance standards imposed dividends will not change the tax treatment of by state law, the federal securities laws and regulations dividends for shareholders. adopted under such laws. Thus, directors of a closed-

end fund owe a fiduciary duty to the fund to act in a How Are Closed-End Funds Taxed? manner that protects its interests, taking into account To avoid the imposition of federal tax at the fund level, the interests of all shareholders. Under Section 16 of the a closed-end fund must elect to be treated as a regulated 1940 Act, a closed-end fund must elect a board of which investment company (RIC) under Subchapter M of the at least 40 percent are not “interested persons” of the Internal Revenue Code of 1986, as amended (the fund (as that term is defined in the 1940 Act). Practically “Code”). Among other things, Subchapter M imposes speaking, however, most closed-end funds elect a board requirements related to the sources of income and that consists of at least 75 percent non-interested diversification of portfolio holdings. Like open-end directors in order to avail themselves of certain funds, a closed-end fund electing to be treated as a RIC exemptive rules adopted under the 1940 Act. under Subchapter M must distribute substantially all of The 1940 Act also requires the directors to carefully its income and capital gains to shareholders annually. monitor the fund for conflicts of interest between the If a fund does not qualify as a RIC or fails to satisfy fund and its service providers. And, as with any the 90 percent distribution requirement in any taxable registered investment company, investment advisory year, it would be taxed in the same manner as an agreements are subject to annual board review and ordinary corporation on its taxable income. In addition, renewal under Section 15(c) of the 1940 Act. distributions to shareholders would not be deductible in Directors of a closed-end fund must oversee the fund’s computing a fund’s taxable income. compliance with federal securities laws. They are

Are There Special Corporate Governance Requirements required by Rule 38a-1 under the 1940 Act to approve,

For A Closed-End Fund? and annually review, written policies reasonably designed to prevent violation of the federal securities As noted previously, closed-end funds listed on an laws by the fund and certain of its service providers. exchange must hold annual shareholder meetings, and The directors must also designate a Chief Compliance must provide all shareholders of record with a proxy Officer, whose designation and compensation is subject statement in advance of such meetings. In addition, to the approval of the fund’s board and who can be rules of a listing exchange generally require prompt removed from his role only with the approval of the public disclosure of material information. From time to fund board. Closed-end funds must adopt a code of time, directors of a closed-end fund may be asked to ethics, anti-money laundering policies, trade allocation consider extraordinary corporate transactions such as policies, whistleblower policies, proxy voting policies

8 and policies related to handling shareholder complaints Are Closed-End Funds Subject To The Sarbanes-Oxley and maintaining full and fair disclosure, among others. Act?

Yes. Closed-end funds that are registered with the SEC Do Closed-End Fund Audit Committees Have Special are required to maintain internal controls over financial Rules? reporting as required by the Sarbanes-Oxley Act. They The board must appoint, from its members, an audit must also maintain and regularly evaluate the committee meeting the independence standards of the effectiveness of disclosure controls and procedures SEC and the exchange on which the fund is listed. The designed to ensure that information required in filings audit committee must have at least one “audit with the SEC is recorded, processed, summarized and committee financial expert” as that term is defined in reported in a timely manner. Item 407(d)(5)(ii) of Regulation S-K. This requirement is Closed-end funds are required to file Form N-CSR, the more stringent than the rule that applies to open-end certified shareholder report for registered investment funds, which must disclose whether or not their audit companies, on a semi-annual basis. Form N-CSR must committees have an audit committee financial expert, be accompanied by a certification of a fund’s principal and if not, why not. executive officer and principal financial officer(s) that, SEC rules require closed-end funds (as well as all among other things, they: public companies) to include in their annual report to  are responsible for establishing and shareholders a report from the audit committee stating maintaining disclosure controls and that the committee: procedures and internal controls over financial  reviewed and discussed the financial reporting and that such procedures have been statements with management; designed to ensure that material information

 discussed the audit with the fund’s regarding the fund is reported to such officers

independent auditors; and to provide reasonable assurances

 confirmed that the auditors met independence regarding the reliability of financial reporting;

standards; and  have disclosed to the fund’s auditors and its

 recommended to the board of directors that the audit committee all significant deficiencies,

audited financial statements be included in the any material weaknesses in the internal

annual report to shareholders. controls over financial reporting and any fraud

The fund must also disclose the names of each involving employees with a significant role in member of the audit committee, identify which the fund’s internal controls over financial member(s) of the audit committee are audit committee reporting. financial experts and state the fees paid to the Closed-end funds must file Form N-Q, the quarterly independent auditors. schedule of portfolio holdings, for their first and third

fiscal quarters. The filing must include a certification of

the fund’s principal executive officer and principal

9 financial officer(s) similar to that set forth above with  compliance with disclosure obligations; and respect to Form N-CSR.  compliance with other legal or regulatory

Form N-SAR requires closed-end funds to disclose obligations. whether they have adopted a code of ethics for their ______senior financial officers as required by Section 406 of the By Jay G. Baris, Partner, and Kelley A. Howes, Of Sarbanes-Oxley Act, and if not, why not. The code of Counsel, in the Investment Management Group of Morrison & Foerster LLP ethics required by the Sarbanes-Oxley Act should address: © Morrison & Foerster LLP, 2015  resolution of actual or apparent conflicts of

interest between personal and professional

relationships;

OPEN-END AND CLOSED-END FUNDS AT A GLANCE OPEN-END FUNDS CLOSED-END FUNDS A management company that offers Any management company other than an for sale or has outstanding any open-end company. Status under the 1940 Act redeemable security of which it is the issuer. A mutual fund issues or redeems its securities at a price based upon the net Closed-end fund shares trade in the asset value (NAV) next computed after Pricing of Securities secondary market and may be at a discount receipt of the order. Mutual funds or premium to the fund’s NAV. must compute NAV at least once daily.  Can issue a senior debt security and a  Senior debt is prohibited. senior equity security, subject to asset coverage requirements.  Senior equity (e.g., preferred stock) is prohibited.  Senior debt must maintain asset Leverage Restrictions coverage of at least 300 percent or  Must maintain asset coverage of at comply with alternative asset least 300 percent or comply with segregation requirements. alternative asset segregation requirements.  Senior equity must maintain asset coverage of 200 percent. The SEC has taken the position that Limits on Illiquid open-end funds should not invest No limit. Securities more than 15 percent of net assets in illiquid securities.  Closed-end funds sell a fixed number of shares in an IPO, after which investors generally buy shares of the fund in the Mutual funds continuously offer secondary market (on an exchange or shares to the public at a price based over the counter) at market price Sale of Shares upon the current NAV (may be subject (subject to brokerage commission costs). to sales loads and other distribution

fees).  Closed-end funds may also issue shares in follow-on offerings and at-the-market offerings.  Investors generally sell may sell shares of closed-end funds in the secondary market on an exchange at the market price. Open-end funds must be ready,

willing and able to redeem shares at Redemption of Shares  In order to reduce the discount at which the next-determined NAV (subject to shares may be trading, closed-end redemption fees, if any). funds may adopt stock repurchase programs or periodically tender for shares (subject to rules under the Exchange Act and proxy requirements).  Typically, mutual fundsoffer shares  Closed-end funds typically offer shares Marketing through a registered broker-dealer through a registered broker-dealer that that is a member of FINRA (broker- is a member of FINRA in a single

OPEN-END AND CLOSED-END FUNDS AT A GLANCE OPEN-END FUNDS CLOSED-END FUNDS dealers may charge distribution- underwritten public offering. related fees to investors).  After the public offering, the shares of  Rule 12b-1 governs the use of fund most closed-end funds are traded on assets primarily intended to finance exchanges. distribution. A closed-end fund must comply with rules Exchange Listing Not applicable. of the exchange on which its shares are listed.  Registration statement on Form N-2 is  Registration statement on Form not required to be updated annually. N-1A must be updated at least annually.  Annual shareholder meeting and proxy statement, consistent with the rules of  No requirement for an annual the listing exchange and the Exchange shareholder meeting and proxy Act. statement (unless required by state law where the fund is organized).  Closed-end funds that wish to make a repurchase offer must file notice of the  Annual notice of securities sold offer on Form N23c-3. pursuant to Rule 24f-2.  Semi-annual shareholder reports and Disclosure  Semi-annual shareholder reports filing certified reports on Form N-CSR. and filing certified reports on Form N-CSR.  Form N-PX annual report of proxy voting record.  Form N-PX annual report of proxy voting record.  Form N-Q quarterly schedule of portfolio holdings.  Form N-Q quarterly schedule of portfolio holdings.  Semi-annual reports on Form N-SAR.

 Semi-annual reports on Form  Insider holding reports required by N-SAR. Section 16 of the Exchange Act (Forms 3, 4 and 5).

Volume 7, Issue 2 February 10, 2016

IN THIS ISSUE: Is There a Standard Form of Rule 144A Representation Letter? ...... 1 Issuer Representations and Frequent Issuers ...... 2 Rule 15a-6 and Structured Note Sales Into the United States ...... 3 How Many Years?: Disclosing Historic Reference Asset Performance ...... 5 Tax Developments for Structured Products ...... 6 The Structured Products Association’s Comment Response Letter to the Federal Reserve Board Regarding TLAC and Structured Notes ...... 7

Is There a Standard Form of Rule 144A Representation Letter? My file of Rule 144A representation letters has been growing fatter, and I‘m not sure why. I would have hoped that by now there would be just one great form that I could point to, and recycle the rest of them. After all, it should be kind of simple – investor represents to broker-dealer that it’s a QIB. The broker-dealer files the letter in a safe spot, and the purchase price for the securities is wired. (Maybe there’s also a closing dinner?) So, why are so many forms floating around? Aside from many lawyers’ natural instinct to add text and make comments, there are a variety of reasons why some letters differ from one another. Additional Legal Qualifications. The representation letter may need to cover more ground than just QIB status. For example, the relevant securities that are being offered may be limited to “qualified purchasers” under the 1940 Act, “eligible contract participants” for commodities purposes, etc. FINRA Suitability Rules. By selling to an “institutional account” that is exercising independent judgment, a broker-dealer may have fewer obligations under FINRA’s suitability rules. For example, the broker-dealer may be selling to a registered investment adviser that is exercising investment discretion for one of its customers. The broker-dealer may wish to have the investor acknowledge this, in order to help document and record the broker-dealer’s process in making the sale. Are You Sure You Know What You’re Doing? A key notion behind Rule 144A is that QIBs are more likely to understand what they are buying. Still, in the event of a complex transaction, the broker-dealer may often want to memorialize this point. Similarly, in the case of a reverse inquiry transaction, it may be worthwhile to note that the terms were proposed by the investor, and not the issuer. In the case of an offering of a structured product with a complex underlier, such as the

Attorney Advertising Volume 7, Issue 2 February 10, 2016

broker-dealer’s own proprietary index, the broker-dealer would often like the investor to acknowledge that it understands that underlier, and that it had all the information it needed about the index prior to making an investment decision. Legal Obligations of the Investor. The investor, especially if it operates in a regulated industry, may be subject to a variety of legal and contractual obligations that may impact its ability to invest in different types of instruments. Accordingly, the broker-dealer may ask the investor to represent that it has done its homework, and confirm that the investment is permissible for it under the circumstances. Long-Term Relationship? The representation letter may be intended to last for a long time, and cover many years of offerings, as opposed to a single discrete offering. The broker may want the investor to have a “duty to update” the representations in the letter if its QIB (or other) status ever changes. Feeling Conflicted. In connection with a variety of transactions, the broker-dealer or its affiliates may wear multiple hats, and may (quite lawfully) have multiple interests. For example, the broker-dealer’s research division may have expressed a rating or recommendation as to an underlying asset that is the opposite of the view underlying a structured note. The broker-dealer may wish to memorialize the fact that the investor fully understood the situation, in order to avoid future claims from being made to the contrary. Informational Advantages. A broker-dealer, somewhere in its organization, may have material non-public information relating to the relevant issuer, or the relevant underlying asset. Notwithstanding the existence of appropriate ethical walls, the broker-dealer may wish to have the investor record the fact that it was aware of this possibility. Resale Restrictions. The offered security may be subject to a variety of resale restrictions under applicable securities, investment company, commodity or other laws. Violation of these transfer restrictions could, in some cases, involve the issuer or the broker-dealer in legal proceedings that they would obviously prefer to avoid. Accordingly, the letter may explicitly restate these restrictions, and/or obligate the investor to properly observe them. ERISA Concerns. The broker-dealer and the issuer wish to avoid any implication that they are acting as a fiduciary to an investor that is subject to ERISA. Accordingly, they may wish to have the investor represent that it is not an employee benefit plan that is subject to ERISA. Who Can Rely? The broker-dealer selling the instrument may have good reason to be looking out for the welfare of parties other than itself. Accordingly, the representation letter may include third party beneficiary provisions that entitle the issuer of the security and potentially other parties to rely on the representations that are set forth in the letter.

Issuer Representations and Frequent Issuers Introduction In the prior article, we discussed the representations that sophisticated investors may provide to broker-dealers in connection with securities offerings. We now turn our attention to the representations made by the issuers. For most structured note programs, whether offered on a registered basis or a non-registered basis, the issuer makes a variety of representations about its business, finances and the offering documents. These are typically set forth in a program agreement or similar agreement with the distributors. These representations may be quite lengthy and detailed, or in the case of many seasoned issuers, may be more limited. This program agreement is executed at the commencement of the program, while the actual offerings may take place over a period of years. Accordingly, how do the underwriters receive the benefit of these representations in subsequent offerings? Automatic Representations The designers of today’s program agreements anticipated this question. Structurally, these agreements are typically constructed such that the issuer automatically repeats the representations to the underwriters as of specified dates following the initially signing date: typically, the pricing date of any offering, as well as its closing date. These automatic

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Volume 7, Issue 2 February 10, 2016

representations replicate in a sense the manner in which representations are given in a classic “bullet” underwriting, where there is no program: the issuer is required under the terms of the underwriting agreement to make its representations as of the pricing date (when the agreement is signed) and as of the closing date. As a result of these deemed representations in a program, the issuer effectively must monitor its business and affairs, particularly to ensure that it is not making statements in the offering documents (including any periodic reports that are incorporated by reference) that are no longer correct. Terms Agreements Many program agreements address the question of subsequent representations by having the issuer execute a short “terms agreement” at the time of each pricing. These agreements are often created in the form of an exhibit to the program agreement, with fairly simple blanks that can be filled at the time of each offering. Under these short agreements, the issuer may repeat the program agreement’s representations as of the pricing date. Practice varies as to terms agreements. Some structured note underwriters insist on receiving them in connection with each structured note takedown, whether the principal amount is large or small, and whether the offering is underwritten or agented. Some underwriters dispense with terms agreements, relying instead on the “automatic representations” in the program agreement, together with the ongoing due diligence performed by both the investment bank and designated underwriter’s counsel. In the view of the latter group, the time and expense involved in creating these terms agreements is not necessarily justified by the benefit provided. For example, under the analysis applied in the “Worldcom” case,1 an underwriter’s due diligence is judged by the adequacy of its investigation of the issuer’s business and affairs, and not necessarily the frequency of the written representations and other “due diligence” documents that it receives. Impact of Representations Whether the representations are being provided automatically, through the program agreement’s terms, or through a deal- specific terms agreement, the issuer is “on the hook” to the underwriters (and to potential investors) as to the accuracy of the offering documents, and as to the other representations. Accordingly, all issuers of structured notes maintain reporting mechanisms to ensure that they are effecting their offerings at appropriate times, when these representations can be appropriately relied upon.

Rule 15a-6 and Structured Note Sales Into the United States Introduction Rule 15a-6 under the Exchange Act sets forth the (limited) activities that foreign broker-dealers may undertake in the United States, and still remain outside the scope of the Act’s broker-dealer registration requirements. The rule mainly addresses four areas of activity:  Effecting unsolicited transactions.  Soliciting transactions with certain institutional investors (which are then coordinated with U.S. broker-dealers).  Conducting business with U.S. broker-dealers and banks acting as broker-dealers, and expatriates that are temporarily in the United States.  Distributing research reports to certain institutional investors. The first three types of activities at times involve sales of structured notes, and we describe them in this article. Non-U.S. broker-dealers carefully structure these activities around Rule 15a-6, in order to avoid becoming subject to U.S. broker-dealer regulation.2

1 In re WorldCom Inc. Sec. Litig., 346 F. Supp. 2d 628 (S.D.N.Y. Dec. 15, 2004). 2 For additional discussion of this rule, please see our “Frequently Asked Questions About Rule 15a-6”, available at: http://media.mofo.com/files/Uploads/Images/150710FrequentlyAskedQuestionsAboutRule15a_6.pdf

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Transactions with Retail Customers Rule 15a-6 permits non-U.S. broker-dealers to transact with retail customers in the United States only on a very limited basis. The rule permits these broker-dealers to engage in (a) unsolicited transactions with retail (or institutional) customers in the United States and (b) under certain circumstances, transactions with expatriates who reside in the United States. Unsolicited Transactions. The exception for unsolicited transactions applies only to a U.S. investor who has sought out the foreign broker-dealer entirely of the investor’s own accord, without any solicitation by the non-U.S. broker-dealer. For example, a U.S. investor may somehow be informed about a type of structured product that is traded outside of the United States, and contact the non-U.S. broker dealer to offer to purchase a quantity of that product. As is the case for a variety of items under the federal securities laws, the SEC interprets the term “solicitation” very broadly. As a result, if the non- U.S. broker agrees to such a transaction, or if it establishes an account with that U.S. investor to facilitate the sale of the investment, the broker must be very careful not to take any action that could be deemed to be a solicitation of any additional transactions. Accordingly, many non-U.S. broker-dealers generally refrain from establishing these types of accounts, in the absence of special circumstances. A note of caution as to the exemption for unsolicited purchases: Rule 15a-6 itself is only an exemption from registration as a broker-dealer. For any sale to a person in the United States, an exemption from registration under the 1933 Act will still be needed. Expatriates. In addition to unsolicited transactions, a non-U.S. broker-dealer may transact with certain expatriates who are in the United States. This part of the exception is designed to ensure that non-U.S. broker-dealers do not have to terminate a pre-existing existing business relationship with their non-U.S. customers who happen to travel to the United States, or work in the United States on a temporary basis. These considerations shaped the provisions of Rule 15a-6: to qualify for the exemption, the non-U.S. person must be in the United States on a “temporary basis,” and there must be a “pre-existing relationship” between the broker and that person before the move to the United States took place. If a relationship between a non-U.S. broker-dealer and an expatriate qualifies for the exemption, there are no significant limitations on the nature of the business that the broker-dealer can conduct with that person. For example, there is no need to retain a “U.S. chaperone” to act in connection with these transactions, as discussed below in the case of certain institutional sales. Transactions with Institutional Investors Rule 15a-6 enables non-U.S. broker-dealers to solicit transactions with “U.S. institutional investors” and “major U.S. institutional investors.” (These terms are defined in the rule.) Visits and telephone conversations with U.S. institutional investors” that are not “major U.S. institutional investors” must be “chaperoned” by a representative of a U.S. broker-dealer. The key limitation for the use of this exemption is that any transactions that result from the solicitation must be effected through a U.S. broker-dealer. As in the case above for retail investors, this exemption for institutional investors only relates to the broker-dealer registration requirements, and a separate exemption from Securities Act registration must be obtained for any resulting sale. In the case of structured notes, this will often be the Rule 144A functionality that is built into many EMTN and “Global MTN” programs. Obligations of the U.S. Broker-Dealer. A U.S. broker-dealer that facilitates a trade with a U.S. institutional investor has a variety of obligations, including the information required for “know your customer” purposes, and obtaining the information or documentation needed for the broker-dealer to satisfy its suitability obligations. The U.S. broker-dealer must ensure that the confirmations and statements that the U.S. institutional investor receives for the relevant offerings comply with applicable legal requirements. A U.S. broker that engages in this type of trade must satisfy a variety of additional obligations, including:  determining that the non-U.S. broker-dealer and its associated persons involved in the trade are not subject to a statutory disqualification under Section 3(a)(39) of the Exchange Act or any substantially equivalent non-U.S. provisions;

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 obtaining from the non-U.S. broker-dealer the basic background information required under Rule 17a-3(a)(12) under the Exchange Act with respect to each associated person of the non-U.S. broker-dealer who is involved in the trade;  obtaining from the non-U.S. broker-dealer and each involved non-US. associated person a written consent to service of process by the SEC or other securities regulators; and  making the information obtained in the second and third bullets above available to the SEC. (i) In short, the U.S. broker-dealer will essentially take full responsibility for the executed trade, treating the referred account in the same manner it would treat any of its other accounts. These requirements are sufficiently cumbersome that a U.S. broker-dealer will not typically enter into such an arrangement with a non-affiliated non-U.S. broker-dealer in the absence of a plan for multiple transactions and repeat business. However, in the case of affiliated entities that operate as part of a multinational financial institution, there is typically greater openness to an arrangement of this kind. Transactions with U.S. Broker Dealers The rule also permits a non-U.S. broker-dealer to engage in transactions with U.S. broker-dealers or with U.S. banks acting in a broker-dealer capacity. These transactions may be actively solicited by the foreign broker-dealer, and also provide a basis in which non-U.S. broker-dealers may purchase and sell structured notes with U.S. market participants.

How Many Years?: Disclosing Historic Reference Asset Performance Early in each calendar year, issuers of structured notes and structured CDs often revisit the question, “how many years of historical information for the reference asset should we set forth in our offering documents?” That is, with the recent completion of the prior year, and the ability to extend all “stub” performance information through December 31st of that year, should one or more older years be deleted from the offering document? “Black Letter Law” At least as to common stocks, the SEC’s 1996 “Morgan Stanley letter” 3 implicitly requires only two complete years of historical information, together with information for any competed quarters. This is because the letter refers to the requirement for a prospectus to include: “Information concerning the market price of the [Underlying Securities] similar to that called for by Item 201(a) of Regulation S-K.” In turn, Item 201(a) of Regulation S-K requires the presentation of historical stock information: “for the two most recent fiscal years and any subsequent interim period for which financial statements are included, or are required to be included by Article 3-01 through 3-04 of Regulation S-X ( § 210.3-01 through 3-04 of this chapter), or Article 8-02 through 8-03 of Regulation S-X (§ 210.8-02 through 8-03 of this chapter) in the case of smaller reporting companies, as reported in the consolidated transaction reporting system or, if not so reported, as reported on the principal exchange market for such equity.” Different Practices Of course, readers of structured note offering documents will quickly note that most documents show more than this minimum requirement. However, the specific number of years set forth often varies among different market participants. For example:  some will seek to show a fixed ten-year period;  some will seek to show performance since the beginning of 2008, in order to capture the negative impact (on many market measures, at least) of the 2008 fiscal crisis.  some will seek to show a specified number of years (greater than two full, and the current “stub” period).

3 Available at the following link: http://media.mofo.com/files/Uploads/Images/Morgan-Stanley-6-24-1996.pdf

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Some underlying assets, including some types of proprietary indices, will have more interesting performance histories in some periods, and in some market conditions, than in others. (They may have been designed for that purpose.) Accordingly, issuers that link to these market measures may be interested in showing a period of time that reflects the performance in these different market environments, and the number of years selected may be designed to reflect these differences. (Of course, “cherry picking” only the periods of positive performance would be problematic under all applicable regulatory standards.) All this being said, particularly for widely available, broad-based equity indices and ETFs, and for large-capitalization stocks, the specific number of years shown above the minimum is not mandated by any particular legal requirement. And we previously discussed,4 the Morgan Stanley letter’s requirements were imposed long before retail investors had easy access to historical index information through the Internet. Today’s issuers can have a modicum of confidence that investors who are interested in obtaining this form of information for periods beyond those presented in the prospectus will be able to find them without too much difficulty. Of course, the length of the period discussed in the Morgan Stanley letter should be satisfied or exceeded in all cases.

Tax Developments for Structured Products Of Q4’s federal tax developments, one is already appearing regularly on structured products, and another provides taxpayers with an idea of how the IRS thinks basket option contracts fitting within two October 2015 notices should be treated for federal income tax purposes.5 A brief summary of each follows. Extension of New Dividend Equivalent Rules In September 2015, the IRS issued new final and temporary Treasury regulations under Internal Revenue Code Section 871(m) that cover dividend equivalent payments to nonresident aliens.6 Generally, the rules treat “dividend equivalents” paid under certain notional principal contracts and equity-linked instruments as U.S. source dividends; accordingly, they are subject to U.S. withholding tax if paid to a non-U.S. person. The initial release of the rules had an effective date that was graduated over 2015, 2016 and 2017. Contracts entered into in 2015 were exempt from the rules, contracts issued in 2016 were only subject to the rules if the contracts made payments in 2018 or onwards, and all contracts issued in 2017 were captured. The concern among issuers of financial contracts was that the short period between September and January 1, 2016 was not enough time to put in place the needed infrastructure to comply with the recordkeeping, determination and withholding requirements under the regulations. On December 7, 2015, the Internal Revenue Service issued an amendment to the new dividend equivalent regulations to change this effective date.7 Now, the dividend equivalent regulations will only apply to any payment made on or after January 1, 2017, for any transaction issued on or after January 1, 2017. Thanks to the extension, issuers will have the full 2016 calendar year to develop the architecture that is needed to meet the requirements of the new regime. IRS Ruling Describes How to Account for Notice 2015-73 and Notice 2015-74 Basket Option Contracts On October 21, 2015, the IRS issued Notice 2015-73 and Notice 2015-74. These Notices revoked Notice 2015-47 and Notice 2015-48, respectively, and replaced them with new guidance.8 In addition to releasing the revised Notices, in November, the IRS released CCA 201547004, which elucidates the IRS’s view on how basket option contracts that fit within the Notices should be treated for federal income tax purposes.

4 See our June 25, 2014 edition of this publication, available at: http://www.mofo.com/~/media/Files/Newsletter/140625StructuredThoughts.pdf 5 For a more detailed discussion of these and other Q4 federal tax law developments, please see MoFo’s latest issue of Tax Talk, available at http://www.mofo.com/~/media/Files/Newsletter/2016/02/160201TaxTalk.pdf. 6 For a more detailed discussion of the new regulations, see our Client Alert, available at http://www.mofo.com/~/media/Files/ClientAlert/2015/09/150921DividendEquivalent.pdf. 7 The published amendment also makes some immaterial edits in other places in the rules. 8 For a more detailed discussion of the Notice 2015-73 and Notice 2015-74, see the November issue of Tax Talk, available at http://www.mofo.com/~/media/Files/Newsletter/2015/11/151103TaxTalk.pdf.

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There, the taxpayer purchased two options on a basket of hedge fund limited partnership interests from a bank, which the taxpayer’s designee could and did change over the life of the options. Consistent with the basket notices, the IRS concluded that the contracts did not constitute options because they did not function or have the economic characteristics of options. Since the contracts were not options, the IRS explained two different treatments for them. First, to the extent the bank held the referenced assets on the taxpayer’s behalf (including as a hedge for the options), the option contracts transferred ownership of the referenced assets to the taxpayer for tax purposes. Second, if the taxpayer could not be considered the owner of the referenced assets for tax purposes (for example, if the bank did not hold the limited partnership interests as a hedge) and the referenced asset was a passthrough entity, then the taxpayer would be subject to the constructive ownership provisions of Code Section 1260 with respect to the referenced asset. Additionally, the IRS stated that where the taxpayer has the discretion to change a basket and exercises that discretion, changes in the referenced basket could constitute a fundamental change in the option and result in a taxable deemed exchange for the taxpayer of the old options for new options. If taxpayers choose to file amended returns pursuant to the new Notices for basket option contracts they have already entered into, CCA 201547004 provides a roadmap on how to treat those transactions.

The Structured Products Association’s Comment Response Letter to the Federal Reserve Board Regarding TLAC and Structured Notes As discussed in an earlier article in this publication, on October 30, 2015, the Federal Reserve Board (“FRB”) issued its notice of proposed rulemaking relating to U.S. bank holding companies which are G-SIBs and the intermediate holding companies of foreign banking organizations that are G-SIBs. Among other things, U.S. G-SIBs will be required to maintain a minimum amount of unsecured long-term debt and a minimum about of total loss-absorbing capital (“TLAC”).9 In response to the FRB’s invitation for comments on the proposed TLAC rule, the Structured Products Association (“SPA”) posted a comment response letter.10 The SPA letter responds to the following aspects of the proposed rule:  Clarification that certain rate-linked notes and non-USD denominated instruments are excluded from the definition of “structured note” (and, consequently, would be eligible debt securities);  Clarification that debt securities linked to readily ascertainable reference rates are eligible debt securities;  A proposal to add a “default amount” provision to structured notes, causing their value to be readily ascertainable upon an acceleration after an event of default; and  A discussion of the 5% cap on the value of a covered bank holding company’s eligible external TLAC for certain non-contingent liabilities to third parties that are not otherwise eligible debt securities. Structured notes that are not considered eligible long-term debt are subject to the 5% cap. The SPA letter questions the rationale behind this exclusion. The deadline for submitting comment response letters to the FRB was recently extended from February 1, 2016 to February 16, 2016.

9 Structured Thoughts, Vol. 6, Issue No. 7 (Nov. 4, 2015), available at http://www.mofo.com/~/media/Files/Newsletter/2015/11/151104StructuredThoughts.pdf. 10 The SPA letter is available at http://www.federalreserve.gov/SECRS/2016/February/20160208/R-1523/R- 1523_020516_130203_487725025622_1.pdf.

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Upcoming Events

Masterclass: Structured Alternatives to Structured Notes Tuesday, February 23, 2016 Morrison & Foerster Partner Anna T. Pinedo will discuss the issuance of structured notes from bank holding company subsidiaries that are finance companies, the issuance of structured notes through a repackaging vehicle and the disclosure and reporting requirements entailed in a bond repackaging, as well as potential Volcker Rule considerations, the issuance of custodial receipts, and the use of unit investment trusts.

For more information about this complementary CLE seminar, or to register, click here.

Current Practices and Issues for Foreign Broker-Dealers Under Rule 15a-6 in 2016 Wednesday, March 30, 2016 Morrison & Foerster Senior Of Counsel Hillel T. Cohn will present on current practices and issues for foreign broker- dealers under Rule 15a-6. This session will cover topics including: Summary of Rule 15a-6 requirements; Risks and responsibilities of acting as a chaperoning broker; Practical issues in intermediating Rule 144A and other transactions; Benefits of an intermediary agreement; and Dealing with retail customers under Rule 15a-6.

For more information about this complementary CLE teleconference, or to register, click here.

Announcing our Structured Thoughts LinkedIn Group Morrison & Foerster has created a LinkedIn group, StructuredThoughts. The group will serve as a central resource for all things Structured Thoughts. We have posted back issues of the newsletter and, from time to time, will be disseminating news updates through the group.

To join our LinkedIn group, please click here and request to join or simply e-mail Carlos Juarez at [email protected].

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Contacts

Lloyd S. Harmetz Anna T. Pinedo Bradley Berman New York New York New York (212) 468-8061 (212) 468-8179 (212) 336-4177 [email protected] [email protected] [email protected]

For more updates, follow Thinkingcapmarkets, our Twitter feed: www.twitter.com/Thinkingcapmkts.

Morrison & Foerster has been shortlisted for the 2016 Equity Derivatives Law Firm of the Year for the EQDerivatives Global Equity & Volatility Derivatives Awards. Morrison & Foerster was named Best Law Firm for Derivatives – US, 2015 by GlobalCapital at its US Derivatives Awards.

Morrison & Foerster has been named Structured Products Firm of the Year, Americas by Structured Products magazine six times in the last ten years. See the write-up at http://www.mofo.com/files/Uploads/Images/120530-Americas-Awards.pdf. Morrison & Foerster named Best Law Firm in the Americas, 2012, 2013, 2014 and 2015 by Structured Retail Products.com.

About Morrison & Foerster We are Morrison & Foerster—a global firm of exceptional credentials. Our clients include some of the largest financial institutions, investment banks, Fortune 100, technology, and life sciences companies. We’ve been included on The American Lawyer’s A-List for 12 straight years, and Fortune named us one of the “100 Best Companies to Work For.” Our lawyers are committed to achieving innovative and business-minded results for our clients, while preserving the differences that make us stronger. This is MoFo. Visit us at www.mofo.com. © 2016 Morrison & Foerster LLP. All rights reserved.

Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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MORRISON & FOERSTER QUARTERLY NEWS Volume 8, No. 4 January 2016 Authored and Edited By Thomas A. Humphreys Anna T. Pinedo Stephen L. Feldman Remmelt A. Reigersman Shiukay Hung David J. Goett Alexander I. Birkenfeld Nicole M. Humphrey TAXTALK Brennan W. Young IN THIS ISSUE IRS Provides RICs Alternatives to Account for Foreign Tax Refunds Page 2 Sixth Circuit Reverses Tax Court: A Foreign Currency Option Can Be a “Foreign Currency Contract” Page 2 Ruling Addresses Effects of Consent Payments on Contingent Debt Page 3 Extension of Dividend Equivalent Rules Page 4 Ruling Describes How to Account for Notice 2015-73 and Notice EDITOR’S NOTE 2015-74 Basket Option Contracts Page 5 Q4 2015 saw one of the biggest tax bills to come along in some time. By all accounts, the “Protecting Americans from Tax Hikes,” or PATH Act, was a rush Omnibus Appropriations Act Makes job. That means it will take years to find the goodies (and what paid for them). Changes to FIRPTA One clear winner even now: foreign investors in U.S. real estate. Congress Page 5 added some new provisions to the Foreign Investment in Real Property Tax Act (“FIRPTA”), which will make investment in U.S. real estate more attractive Tax Court Disallows Netting of (taxwise, at least), particularly for publicly traded foreign funds in certain Blocks of Stock in Reorganization jurisdictions and for foreign pension funds. Much of this change will also Page 6 encourage investment in U.S real estate investment trusts (“REITs”). Tax Talk explains it all. Supreme Court Grants Certiorari In REIT Citizenship Case Speaking of Subchapter M, right after the end of the quarter, the Internal Page 6 Revenue Service (“IRS”) provided some welcome relief for U.S. regulated investment companies (“RICs”) that have received or will receive refunds of Tax Court Rules “Monogamy foreign dividend withholding taxes. In 2012, the European Court of Justice Payment” is Income held that the imposition of withholding taxes on U.S. RICs violated the EU’s Page 6 nondiscrimination principles. Since then, RICs have been pursuing refunds from individual EU governmental tax authorities. The problem is that Internal Presidential Candidates’ Tax Revenue Code (“IRC”) section 905(c) requires an amended return when a Positions foreign tax refund is received. This is impossible for a widely held RIC because Page 7 its thousands of shareholders claimed the credit many years ago and there is MoFo in the News no mechanism to pass through a refund, let alone to find the shareholders that Page 7 were there at the time. The IRS guidance (which we discuss below) isn’t perfect, but will help funds work through these problems.

continued on page 2 In other Q4 news, Tax Talk reports on the Sixth Circuit to the RIC’s Refund Year shareholders, (2) the RIC reversing the Tax Court on what can be a “foreign was not held predominantly by insurance companies currency contract,” the extension of the effective date or fund managers in connection with the creation or of the dividend equivalent rules, a PLR on the effects management of the RIC, (3) the RIC makes a Section 853 of consent payments for contingent debt, the Supreme Election in the Refund Year, and (4) (as discussed above) Court granting certiorari in a case deciding a REIT’s foreign taxes paid by the RIC in the Refund Year equal or “citizenship,” and more. Finally, as we’ve done in prior exceed the amount of the foreign tax refund (including election cycles, Tax Talk summarizes the tax plans of interest received from the foreign taxing jurisdiction). If the various Republican and Democratic presidential a RIC takes advantage of the Netting Method, the RIC is candidates. required to file an information statement with the IRS.

The second method under the Notice allows RICs that IRS PROVIDES RICS receive a refund of foreign tax to request a closing ALTERNATIVES TO ACCOUNT agreement with the IRS addressing the treatment of the refund, which the IRS will grant where such FOR FOREIGN TAX REFUNDS agreement is found to be in the interest of sound tax Generally, when a U.S. taxpayer pays foreign tax, the administration. According to the Notice, a closing U.S. taxpayer is entitled to take a credit (a “Foreign agreement will generally be considered to be in the Tax Credit”) against the taxpayer’s U.S. tax liability. interest of sound tax administration where (1) the RIC The purpose is to avoid double taxation. When a RIC demonstrates that it is precluded from applying either pays foreign tax, it has two options: it can either claim the Default Method or the Netting Method, and (2) the foreign tax credit itself to offset any tax liability, or the RIC provides information sufficient to establish a under certain circumstances, it can make a “Section 853 reasonable estimate of the aggregate adjustments that Election” that allows the RIC to pass through the foreign would be due under the Default Method. tax credit to its shareholders. In other words, the RICs The Notice also states that the IRS intends to shareholders are entitled to claim the foreign tax credit promulgate regulations in the future that memorialize directly on their tax returns. Under existing rules (the these rules. Until that time, RICs may rely on the “Default Method”), a taxpayer that receives a refund Netting Method as described in the Notice to address of foreign taxes is required to notify the IRS, which refunds received in past tax years. redetermines the taxpayer’s U.S. tax liability in the year in which the credit was taken. Due to a recent ruling by the EU Court of Justice, many RICs have received SIXTH CIRCUIT REVERSES refunds of foreign taxes paid by the RIC in prior years. TAX COURT: A FOREIGN These refunds have caused RICs to question whether the existing rules regarding foreign tax credit refunds CURRENCY OPTION CAN are administrable when applied to RICs that have made Section 853 Elections. BE A “FOREIGN CURRENCY

Notice 2016-10 (the “Notice”), released on January 15, CONTRACT” 2016, by the IRS, gives RICs additional options when In Wright v. Commissioner,1 taxpayers, the Wrights, faced with refunds of foreign taxes paid in prior years. challenged a Tax Court decision upholding an IRS Generally, the Notice allows RICs to treat foreign tax deficiency claim. The Wrights had engaged in a major- credit refunds under two methods. The first method, the minor transaction detailed as follows: (i) the Wrights “Netting Method,” applies to a RIC that, in the same year were members in an investment company called Cyber in which it receives a refund of foreign taxes (the “Refund Advice, LLC, which was treated as a partnership for Year”), also pays an amount of foreign taxes equal to or federal income tax purposes; (ii) Cyber Advice paid greater than the refund (including interest received from premiums to purchase reciprocal offsetting put and the foreign taxing jurisdiction). Essentially, the RIC is call options (the purchased options) on a foreign permitted to use the foreign tax refund received to offset currency in which positions are traded through the foreign tax paid in the Refund Year. As a result, the regulated futures contracts (the “major currency”— RIC is not required to separately include the tax refund here, the euro); (iii) Cyber Advice received premiums in its gross income, and shareholders are able to take for writing reciprocal offsetting put and call options advantage of foreign taxes paid by the RIC that are not (the written options) on a different foreign currency offset by the refund. The Netting Method is available in which positions are not traded through regulated to RICs if (1) the economic benefit of the refund inures 1 117 AFTR 2d 2016, (6th Cir. 2016).

2 Morrison & Foerster Tax Talk, January 2016 continued on page 3 futures contracts (the “minor currency”—here, the Sixth Circuit explained that the use of the word “or” Danish krone); (iv) the net premiums paid and received between the delivery and settlement phrases indicated substantially offset one another and the values of the that the phrases described two ways in which a contract two currencies underlying the purchased and written may qualify as a foreign currency contract; either the options historically demonstrated a very high positive contract (1) could require delivery of a foreign currency correlation with one another; (v) Cyber Advice assigned or (2) could be a contract the settlement of which to a charity the purchased option that had a loss and the depends on the value of a foreign currency. Accordingly, charity also assumed Cyber Advice’s obligation under an option “could be” a foreign currency contract. the offsetting written option that had a gain; and (vi) the Wrights, as members of Cyber Advice, took the position In reversing the Tax Court’s decision, the Sixth Circuit that the purchased option assigned to the charity is a recognized that tax policy did not appear to support contract subject to Section 1256 of the Code, marked the allowance of the Wrights’ claimed losses; however, purchased option to market under Section 1256 of the this was not a reason sufficient to reform the statutory Code, and claimed a loss. language. The Sixth Circuit stated that there were two alternatives more appropriate for dealing with the type This transaction is similar to the transaction in Summitt of abuse observed in the transaction. First, it stated that v. Commissioner,2 a case discussed in an earlier edition Congress allows the secretary to prescribe regulations of Tax Talk,3 which held that foreign currency options to exclude any type of contract from the foreign are not foreign currency contracts within the meaning currency contract definition if the inclusion of the type of Section 1256 of the Code; therefore, the Summitt of contract would be inconsistent with the purposes of taxpayers were not allowed to claim the losses resulting Section 1256. Also, according to the Court, Congress from their major-minor transaction. In following allows the Commissioner to prevent taxpayers from Summitt, the Tax Court also rejected the Wrights’ claiming inappropriate tax losses by challenging specific argument that foreign currency options were foreign transactions under the economic substance doctrine. Tax currency contracts within the meaning of Section 1256 Talk will keep an eye on this case as it continues. because options are not contracts that “require delivery of, or the settlement of which depends on the value of, a RULING ADDRESSES EFFECTS foreign currency” as set forth in Section 1256(g)(2)(A)(i). OF CONSENT PAYMENTS ON On appeal, the Sixth Circuit reversed and remanded. The Sixth Circuit held the Tax Court’s ruling was incorrect CONTINGENT DEBT because it ignored the plain language of the statue. PLR 201546009 addresses the tax treatment of consent Section 1256(g)(2) defines a foreign currency contract as: payments to holders of an outstanding issuance of contingent payment debt instruments. (A) Foreign currency contract.—The term “foreign currency contract” means a contract— Taxpayer, a publicly traded corporation, issued a series of publicly traded debentures (the “Notes”) treated as (i) which requires delivery of, or the settlement of contingent payment debt instruments (“CPDIs”). As which depends on the value of, a foreign curren- CPDIs, the Notes were treated under the noncontingent cy which is a currency in which positions are also bond method whereby holders of the Notes (“the traded through regulated futures contracts, “Noteholders”) would accrue original issue discount (ii) which is traded in the interbank market, and at the Taxpayer’s “comparable yield,” the rate at which Taxpayer would otherwise borrow on a similar (iii) which is entered into at arm’s length at a price noncontingent debt instrument. Likewise, Taxpayer determined by reference to the price in the inter- was allowed to take deductions at the comparable bank market. yield. Additionally, a “projected payment schedule” is determined for the Notes that serves as a benchmark by The Commissioner took the position that Section which Noteholders recognize income on the Notes as 1256(g)(2) is a unified provision that provides that a contingencies resolve. If Noteholders receive an amount contract must mandate at maturity either a physical greater than the projected payment amount, this results delivery of a foreign currency or a cash settlement based in a “positive adjustment” that is generally treated as on the value of the currency; however, the Sixth Circuit additional interest. If Noteholders receive less than the disagreed with this interpretation of the statue. The projected amount, this results in a “negative adjustment” that can be used to offset prior interest inclusions, 2 134 T.C. 248 (2010). subject to limitation. 3 For a more detailed analysis of Summit v. Commissioner, please see our previous Tax Talk article at: http://media.mofo.com/files/Uploads/Images/100716TaxTalk.pdf.

3 Morrison & Foerster Tax Talk, January 2016 continued on page 4 Under the ruling, Taxpayer intended to achieve a yield on a hypothetical note that (1) is issued on the spinoff whereby assets would be contributed to a date of the modification, (2) has an issue price equal newly formed corporation (“SpinCo”) in exchange for to the adjusted issue price of the Notes, reduced by the SpinCo stock, followed by a distribution of SpinCo amount of the Consent Payment, and (3) a projected stock to Taxpayer’s shareholders in redemption of such payment schedule consisting of the remaining shareholders’ stock in Taxpayer. Taxpayer had recently projected payments on the Notes. If the “go-forward consummated a prior spinoff; however, a dispute arose yield” does not exceed the original yield by the greater as to whether the spinoff violated Taxpayer’s financial of (1) 25 basis points or (2) 5% of the original yield, the covenants under outstanding debt. Although Taxpayer modification is not significant. won the ensuing litigation, the process was costly and time-consuming. The PLR does not examine whether there is a significant modification of the Notes in question — the In order to ensure a smoother spinoff this time test outlined in the PLR would be run on the date of the around, Taxpayer sought to negotiate a payment Consent Payment. However, the PLR further finds that with Noteholders to make a one-time payment in if the modification is not “significant” under the Yield exchange for their consent to the spinoff (the “Consent Test, the Consent Payment would generally be treated Payment”). The Consent Payment would not otherwise as a “positive adjustment” under the CPDI rules and affect the terms of the Notes. At issue in the PLR is generally treated as additional interest to Noteholders. whether the Consent Payments result in a deemed exchange of the Notes under Section 1001, which EXTENSION OF DIVIDEND would cause Noteholders to realize any gain or loss in the Notes at the time the Consent Payment was made. EQUIVALENT RULES In September 2015, the IRS issued new final and The regulations under Section 1001 provide that temporary Treasury regulations under Internal gain or loss is recognized on an exchange of property Revenue Code Section 871(m) that cover dividend differing materially in kind or in extent. The regulations equivalent payments to nonresident aliens.4 Generally, also provide that alterations to the terms of a debt the rules treat “dividend equivalents” paid under instrument may result in a deemed exchange if (1) there certain notional principal contracts and equity-linked is a modification to the debt instrument and (2) such instruments as U.S. source dividends and therefore modification is significant. subject to U.S. withholding tax if paid to a non-U.S. First, the IRS found that the Consent Payment resulted person. The initial release of the rules had an effective in a modification of the debt instrument under the date that was graduated over 2015, 2016, and 2017. Section 1001 regulations because the Noteholders were Contracts entered into in 2015 were exempt from receiving a payment that they would not otherwise be the rules, contracts issued in 2016 were only subject entitled to. In other words, the Consent Payment altered to the rules if the contracts made payments in 2018 the legal rights of the Noteholders, which gives rise to a or onwards, and all contracts issued in 2017 were modification under the regulations. captured. The concern among issuers of financial contracts was that the two and a half months between Generally, whether the modification of a CPDI is September and January 1, 2016 was not enough time significant is based on the facts and circumstances. to put in place the infrastructure to comply with the In the case of debt instruments other than CPDIs, record-keeping, determination, and withholding the regulations provide a mechanical Yield Test that requirements under the regulations. On December examines the change in the yield on the debt instrument 7, 2015, the IRS issued an amendment to the new as a result of the modification. The PLR finds that, dividend equivalent regulations to change this effective under the facts of the PLR, it is appropriate to apply the date.5 Now, the dividend equivalent regulations only yield test to the Notes, despite the fact that the Notes apply to any payment made on or after January 1, are CPDIs. The PLR appears to be the first piece of IRS 2017, for any transaction issued on or after January 1, guidance that examines the application of the Section 2017. Thanks to the extension, issuers will have the full 1001 regulations to CPDIs. 2016 calendar year to develop the architecture to meet the requirements of the new regime. The Yield Test compares the original yield of the debt instruments (which, in this case, is the comparable yield, determined under §1.1275-4(b)(4) as of the 4 For a more detailed discussion of the new regulations, see our Client Alert, available at issue date of each note) with the “go-forward yield” http://www.mofo.com/~/media/Files/ClientAlert/2015/09/150921DividendEquivalent.pdf. of the debt instruments. The “go-forward yield” is the 5 The published amendment also makes some immaterial edits in other places in the rules.

4 Morrison & Foerster Tax Talk, January 2016 continued on page 5 (basically foreign pension funds) from FIRPTA’s RULING DESCRIBES HOW TO provisions and expand the FIRPTA exemption for ACCOUNT FOR NOTICE 2015- stock in publicly traded REITs. A summary of each new provision follows. 73 AND NOTICE 2015-74 Increase in Threshold of “Publicly Traded” Exception BASKET OPTION CONTRACTS to FIRPTA On October 21, 2015, the IRS issued Notice 2015-73 The Act makes two investor-friendly changes that and Notice 2015-74, which revoked Notice 2015-47 narrow FIRPTA’s reach. The first change increases the and Notice 2015-48, respectively, and replaced them ownership threshold for the “publicly traded” exception with new guidance.6 In addition to releasing the revised to FIRPTA. Previously, shares of a publicly traded class notices, in November, the IRS released CCA 201547004, of stock (including REIT stock) constituted a USRPI which elucidates the IRS’s view on how basket option only in the hands of a person who owned more than contracts that fit within the notices should be treated 5% of that class. As a result, when it came to publicly for federal income tax purposes. There, the taxpayer traded stock, only shareholders with a stake greater purchased two options on a basket of hedge fund than 5% could be subject to FIRPTA on dispositions of limited partnership interests from a bank, which the the stock itself. Similarly, shareholders owning 5% or taxpayer’s designee could and did change over the life of less of the publicly traded stock of a REIT were exempt the options. Consistent with the basket notices, the IRS from FIRPTA on capital gain distributions. The Act concluded that the contracts did not constitute options increases this threshold to 10% in both cases. This because they did not function or have the economic change applies only to REIT distributions made during characteristics of options. Since the contracts were not taxable years that end after the Act’s enactment. The options, the IRS explained two different treatments for Act also provides a number of technical changes to them. First, to the extent the bank held the referenced the attribution rules applicable to direct and indirect assets on the taxpayer’s behalf (including as a hedge for holders of REIT stock; these changes are effective the options), the option contracts transferred ownership immediately. of the referenced assets to the taxpayer for tax purposes. Exemption From FIRPTA for Qualified Pension Funds Second, if the taxpayer could not be considered the owner of the referenced assets for tax purposes (for The Act adds a FIRPTA exemption for “qualified example, if the bank did not hold the limited partnership pension funds” and their wholly owned subsidiaries. interests as a hedge) and the referenced asset was a Generally, qualified pension funds are non-U.S. passthrough entity, then the taxpayer would be subject to retirement or pension funds that do not have a the constructive ownership provisions of Code Sec. 1260 single participant or beneficiary with a right to 5% with respect to the referenced asset of the referenced or more of the fund’s assets or income, are subject asset under Code Sec. 1260. Additionally, the IRS stated to governmental regulation, and (in their country that where the taxpayer has discretion to change a basket of establishment or operation) receive preferential and exercises that discretion, changes in the reference tax treatment on either contributions to the fund or basket could constitute a fundamental change in the on investment income. This new exception covers option and result in a taxable deemed exchange for the both directly and indirectly held USRPIs, as well as taxpayer of the old options for new options. If taxpayers REIT distributions. It applies to dispositions and choose to file amended returns pursuant to the New distributions that occur after the Act’s enactment. Notices for basket option contracts they have already This is expected to significantly increase the amount entered into, CCA 201547004 provides a roadmap on of foreign capital invested in U.S. real estate by how to treat those transactions. removing the most significant barrier for non-U.S. pension plan investors. PATH ACT MAKES CHANGES Increased FIRPTA Withholding Rate TO FIRPTA The Act increases the amount of withholding tax on The PATH Act (the “Act”) makes changes to FIRPTA, dispositions of USRPIs by a foreign person from 10% which generally imposes a tax on a foreign person’s to 15%. If a property is acquired by the buyer to be gain or loss on the sale of a U.S. real property interest used as the buyer’s residence, and the price paid for (“USRPI”). These changes exempt some investors the property does not exceed $1,000,000, the 10% withholding rate under prior law would still apply. The new withholding rate is effective starting 60 days after 6 For a more detailed discussion of the Notice 2015-73 and Notice 2015-74, see our last issue, the enactment of the Act. available at http://www.mofo.com/~/media/Files/Newsletter/2015/11/151103TaxTalk.pdf.

5 Morrison & Foerster Tax Talk, January 2016 continued on page 6 Liquidating Distributions of REITs and RICs Taxable citizenship of a Maryland Title 8 Trust REIT must be Under FIRPTA determined by the citizenship of its shareholders for Prior to enactment of the Act, under Code section 897(c), the purposes of determining whether a federal court the definition of a USRPI excluded an interest in a has diversityofcitizenship jurisdiction rather than its jurisdiction of organization or its principal place of corporation if, as of the date of disposition of that interest, 8 the corporation did not hold any USRPIs, and all USRPIs business/headquarters, as with corporations. The held by the corporation at any time during the preceding petition to the Supreme Court (and a supporting brief five years were disposed of in transactions in which all by the National Association of Real Estate Investment gain was recognized. The Act adds another requirement: Trusts) argued that the citizenship of a Maryland Trust Neither the corporation nor its predecessor has been a REIT should be determined by the jurisdictions of REIT or a RIC during the preceding five years. its formation and headquarters like other Maryland corporations, since a Maryland Trust REIT has particular characteristics that make it materially TAX COURT DISALLOWS identical to a corporation. The characteristics include NETTING OF BLOCKS OF being an entity created by statute and not derived from common law, owning property in its own name, and STOCK IN REORGANIZATION suing and being sued in its own name rather than in In Michael Tseytin and Ella Tseytin v. Commissioner, T.C. the name of its trustees. If the Tenth Circuit’s view is Memo 2015-247, the Tax Court ruled in favor of the IRS followed, a widely held Maryland Trust REIT could regarding the calculation of gain on two blocks of stock potentially be a citizen of all 50 states for the purposes of the taxpayer held prior to a merger. The taxpayer owned testing federal court diversity of citizenship jurisdictional 75% of a corporation’s stock (“Block 1”) and an unrelated issues. The Supreme Court granted certiorari in the case, party owned the remaining 25% (“Block 2”). Before the and it was argued January 19, 2016. corporation merged into another corporation in a tax-free reorganization, the taxpayer purchased Block 2 from the TAX COURT RULES unrelated stockholder for $14 million. The taxpayer then exchanged Blocks 1 and 2 for $23 million cash, and stock “MONOGAMY PAYMENT” of the new corporation worth $31 million. IS INCOME The taxpayer calculated a short-term capital loss on Block In Blagaich v. Commissioner, the Tax Court held 2, which he used to partially offset a long-term capital that “monogamy payments” to a taxpayer constituted gain on Block 1. The IRS contended that the loss on Block income to the taxpayer, despite a state court ruling 2 should be disallowed pursuant to Section 356(c). The that the taxpayer was required to return the amounts. taxpayer argued (i) that it acted only as an agent regarding Block 2 and did not actually own that stock, and (ii) in the In 2010, taxpayer and “significant other” entered into alternative, that he should be able to net the two blocks of a “written agreement intended in part to confirm their stock. The Tax Court determined that the taxpayer was the commitment to each other and to provide financial owner of Block 2 because he was bound by the form of the accommodation for [taxpayer].” Under the agreement, transaction, which was a purchase of stock. Furthermore, significant other paid taxpayer $400,000. Not long after the Tax Court ruled that the taxpayer could not net the the agreement was executed, the relationship began two blocks of stock. The Tax Court favorably cited to Fifth to sour and significant other sent taxpayer a notice and Sixth Circuit cases that held that where separate terminating the agreement and the relationship. blocks of stock are sold together in the same transaction, After the breakup, significant other brought a suit in the IRS may disallow the netting of gains and losses. In state court in an attempt to recover the $400,000 as addition to the deficiency, the taxpayer was liable for an well as other property totaling $343,819 transferred accuracyrelated penalty under Section 6662(a). to taxpayer during the course of the relationship. Significant other also filed a Form 1099-MISC, SUPREME COURT GRANTS reporting the amounts transferred to taxpayer to the IRS. The IRS subsequently asserted a deficiency claim CERTIORARI IN REIT against taxpayer for failing to report the monogamy CITIZENSHIP CASE payment and other property as income in the year received. In Conagra Foods, Inc. v. Americold Logistics, LLC,7 the U.S. Tenth Circuit Court of Appeals held that the 8 Under the Federal Rules of Civil Procedure, a U.S. district court has the power to hear a civil case where the persons that are parties are “diverse” in citizenship, which generally means 7 776 F.3d 1175 (10th Cir.), as amended (Jan. 27, 2015), cert. granted, 136 S. Ct. 27, 192 L. Ed. 2d 997 (2015). that they are citizens of different states or non-U.S. citizens.

6 Morrison & Foerster Tax Talk, January 2016 continued on page 7 In the state court action, the court found that taxpayer and discussed expectations for 2016 during a had fraudulently induced significant other to enter teleconference entitled “Derivatives Regulation into the agreement and ordered taxpayer to return the Update: Latest Developments and What to Expect $400,000 to significant other. However, the court found in 2016.” Topics included: the final margin rules that other property transferred to taxpayer were “clearly for uncleared swaps of the CFTC and the prudential gifts” that did not have to be returned. regulators; the SEC’s proposed rules for investment companies’ use of derivatives; the ISDA 2015 In the Tax Court proceeding, taxpayer attempted to Universal Resolution Stay Protocol and related assert that the portion of the deficiency attributable to matters; the CFTC’s proposed rules for automated the $400,000 monogamy agreement payment should be trading on U.S. designated contract markets; disregarded by the IRS under the equitable rescission and the CFTC’s preliminary report relating to doctrine. The rescission doctrine allows taxpayers to potential changes in the current de minimis swap “undo” transactions as long as the transaction and dealing threshold for the swap dealer registration rescission occur in the same taxable year. The Tax Court requirement. ruled that taxpayer failed to rescind the monogamy agreement in the same year in which it was entered into, • On January 6, 2016, Partner James Tanenbaum and and therefore, the rescission doctrine was not applicable. Partner Anna Pinedo hosted a PLI webcast entitled “Financings in Close Proximity to Acquisitions.” The Additionally, taxpayer attempted to argue that the state presentation addressed: materiality of acquisitions; court proceeding collaterally estopped the IRS from assessing probability of an acquisition; when should asserting that the $343,819 in property were not gifts. an effective shelf registration become subject to Here, the Tax Court found that the IRS was not estopped black out; conducting a private offering and wall- from arguing that the $343,819 were gifts because the crossing investors; Nasdaq shareholder vote issues; IRS was not represented in the state court proceeding. effecting a 144A-qualifying offering to QIBs; and, confidentially marketed public offerings. PRESIDENTIAL CANDIDATES’ • On December 17, 2015, Partner Oliver Ireland and Partner Anna Pinedo hosted an IFLR webinar TAX POSITIONS entitled “TLAC, the Long-Term Debt Requirement, With the non-stop press coverage of the presidential and the Clean Holding Company Proposal.” Topics candidates, we figured a summary of the candidates’ included: the FSB’s final TLAC principles; the FRB’s tax positions would be helpful to our readers. Most of proposed requirements; the principal differences the Republican candidates would lower taxes across between the FSB’s and the FRB’s approach; the the board, while the Democratic candidates would all planning required of G-SIBs in order to prepare to raise taxes for at least some individuals. The following comply; potential effects for foreign banks subject to chart takes a look at the candidates’ proposed individual both regimes; and anticipated effect on how banks income, corporate, and capital gains tax positions. will fund going forward.

(See Chart on page 8) • On December 17, 2015, Partner Anna Pinedo spoke on the “Securities Act Exemptions/ Private Placements” panel on day one of the PLI MOFO IN THE NEWS; AWARDS “Understanding the Securities Laws Fall 2015” • Morrison & Foerster is one of five law firms seminar. Topics included: exempt securities versus shortlisted for Equity Derivatives Law Firm of exempt transactions; Regulation D and Regulation A the Year by EQDerivatives for their 2016 Global offerings and changes resulting from the JOBS Act; Derivatives Awards. In 2015, MoFo was named “crowd funding”; stock option grants and related Americas Firm of the Year at GlobalCapital’s issues; Rule 144A high yield and other offerings; and Americas Derivatives Awards. GlobalCapital also Regulation S offerings to “non-U.S. persons.” shortlisted us for Global Firm of the Year and • On December 16, 2015, Partner David Lynn and European Firm of the Year at the 2015 Global Partner Anna Pinedo led a PLI webcast entitled Derivatives Awards. myCorporateResource.com “FAST Act Securities Law Provisions.” The awarded MoFo with the 2015 Client Content Law presentation addressed the recently adopted FAST Firm of the Year Award in recognition of law firms Act, which amends certain provisions of the JOBS that produce worldbeating, client-facing content. Act, the Securities Act, and the Exchange Act. Topics • On January 14, 2016, Of Counsel Julian Hammar included: the changes to the JOBS Act, including the and Of Counsel James Schwartz reviewed the new 15day public filing requirement, the financial latest developments in derivatives regulation statement requirement, the EGC grace period, and

7 Morrison & Foerster Tax Talk, January 2016 continued on page 9 PRESIDENTIAL CANDIDATES’ TAX POSITIONS (CONTINUED) CANDIDATE INDIVIDUAL INCOME TAX CAPITAL GAINS TAX CORPORATE TAX Hillary Clinton (D)9 4% surcharge for income above For individuals in the top tax Not specified $5 million bracket, capital gains tax rate of 39.6% for investments held for less than two years, with rates gradually decreasing to 20% for investments held for more than six years Martin O’Malley (D)10 Top tax bracket of 45% for income Tax capital gains at ordinary Not specified above $1 million income rates

Bernie Sanders (D)11 Top bracket with a tax rate over 50% Tax capital gains at ordinary Not specified income rates Jeb Bush (R)12 Three brackets with tax rates of 10%, Capital gains tax rate of 20%; Top rate of 20% 25%, and 28% tax carried interest at ordinary income tax rates

Ben Carson (R)13 Flat tax of 14.9% Eliminate capital gains tax Flat tax of 14.9%

Chris Christie (R)14 Three brackets with bottom tax rate Not specified Top rate of 25% as a single digit and top tax rate of 28%

Ted Cruz (R)15 Flat tax rate of 10% Capital gains tax rate of 10% Flat tax rate of 16% on all capital income and labor payments

Carly Fiorina (R)16 Flat tax Not specified Flat tax

Jim Gilmore (R)17 Three brackets with tax rates of 10%, Eliminate capital gains tax Top rate of 15% 15%, and 25%

Mike Huckabee (R)18 Eliminate income tax and enact Eliminate capital gains tax and Eliminate corporate tax and national sales tax enact national sales tax enact national sales tax

John Kasich (R)19 Top rate of 28% Capital gains tax rate of 15% Top rate of 25%

Rand Paul (R)20 Flat tax rate of 14.5% Flat tax rate of 14.5% Flat tax rate of 14.5% on capital income and labor payments

Marco Rubio (R)21 Two brackets with rates of 15% and Eliminate capital gains tax 25%; owners of pass 35% through entities and sole proprietorships pay a maximum of 25%

Rick Santorum (R)22 Flat tax rate of 20% Flat tax rate of 20% Flat tax rate of 20%

Donald Trump (R)23 Four brackets with tax rates of 0%, Three brackets with tax rates of Flat tax rate of 15% 10%, 20%, and 25% 0%, 15%, and 20%

8 Morrison & Foerster Tax Talk, January 2016 the 12(g) threshold equalization for savings and • On December 2, 2015, Partner Anna Pinedo served loan holding companies; practical considerations as a panelist on the session “Social and CCOs: The for ongoing or planned EGC IPOs, the Regulation Latest in Tackling a Thorny Issue” at the Compliance S-K study, and the SEC’s ongoing disclosure review Reporter’s December Breakfast Briefing. The event initiative, forward incorporation in Form S-1 was centered on offering the latest practical advice registration statements, the new resale exemption for chief compliance officers at broker/dealers and under Section 4(a)(7) and its relationship to the investment managers on avoiding the pitfalls and “Section 4(a)(1-1/2) exemption;” application of the keeping a firm safe. new exemption for block trades, private secondary • On November 19, 2015, Senior Counselor Akihiro transactions for pre-IPO issuers; and other Wani, Of Counsel Julian Hammar, and Of Counsel legislative initiatives related to capital formation that James Schwartz hosted a teleconference titled are on the horizon. “Derivatives: Latest U.S. Regulatory Developments.” • On December 15, 2015, Partner James Tanenbaum The presentation provided an overview of the CFTC’s and Partner Anna Pinedo hosted a seminar in Tel crossborder and substituted compliance regime Aviv, Israel, entitled “Finding the Right Capital for derivatives, and addressed a number of recent Raising Tool.” The presentation addressed: early developments involving derivatives regulation in the stage private financings; venture and institutional United States. Further topics included: the margin financings; late stage or pre-IPO financings; and rules for uncleared swaps and their cross-border follow-on financings for already public companies, application; the ISDA Resolution Stay Protocol; and whether U.S. listed or TASE-listed. status of the SEC’s rules for security-based swaps. • On December 8, 2015, Partner James Tanenbaum • On November 18, 2015, Of Counsel Bradley Berman and Partner Anna Pinedo led a seminar entitled led a teleconference titled “Section 3(a)(2) Bank “Financing the Acquisition.” The presenters Note Programs.” The presentation addressed Section discussed various considerations for SEC reporting 3(a)(2) of the Securities Act, which provides an companies considering a capital raise to finance exemption from registration for securities issued a proposed acquisition, including the following: by banks. This program covered the requirements assessing probability and materiality of a proposed of the exemption, offering structures for non- acquisition; other disclosure considerations; pro U.S. banks, requirements for banks and branches forma financial statement requirements; financing regulated by the Office of the Comptroller of the pursuant to an effective shelf registration statement; Currency, offering documentation, and process tips using a PIPE transaction and Nasdaq concerns; and for launching a bank note program. Further topics effecting a 144A-qualifying offering to QIBs. included: What is a “Bank”?; non-U.S. Banks; the • On December 2, 2015, Partner Ze’-ev Eiger and Senior OCC Securities Offering Regulations; Rule 144A Of Counsel Jerry Marlatt hosted a teleconference Offering Alternative for non-U.S. banks; FINRA entitled “Commercial Paper Programs.” The matters; offering documentation; launching a bank presentation addressed the considerations relating note program; and liabilities. to the establishment and operation of commercial • On November 17, 2015, Partner James Tanenbaum paper programs as a financing tool. Topics included: and Partner Anna Pinedo led a seminar entitled the legal framework for commercial paper programs; “A Prerequisite: Pre-IPO Private Placements.” The market practice and documentation that is used; and presentation addressed pre-IPO private placements, practical advice for broker-dealers and personnel who including the structuring and other considerations handle issuances from these programs. for issuers contemplating such a financing. Topics • On December 2, 2015, Partner Jeremy Jennings- included: timing and process; diligence, projections Mares, Partner Peter Green, and Partner Vlad Maly and other information sharing; “cleaning up” introduced keynote speaker, Rick Grove (Rutter the cap table and providing liquidity to existing Associates) at a seminar titled “Avoidable Mistakes securityholders through a secondary component; in Derivatives Transactions.” Rick Grove presented terms of the security, such as liquidation preference; on lessons learned, including avoidable mistakes, IPO and acquisition protection; governance issues; from his many years of derivatives experience. valuation issues; the placement agent’s role; and Topics included: documentation problems and planning for the IPO in your negotiations. errors; issues arising from the early termination • On November 16, 2015, Partner David Lynn and of derivatives transactions; valuation issues in Partner Anna Pinedo hosted a teleconference titled derivatives disputes; and potential preventive “Too Many Exempt Offering Choices?” The session measures in trade execution and collateral practice. addressed the final Regulation Crowdfunding and

9 Morrison & Foerster Tax Talk, January 2016 continued on page 10 all of the new offering formats contemplated by the alternative investments: what to expect from the JOBS Act that will be available to issuers, in addition SEC; and Cross-border derivatives issues, the ISDA to traditional private placements. Topics included: stay protocol margin, and related matters. an overview of Regulation Crowdfunding; choosing • On November 5, 2015, Partner Lloyd Harmetz between Regulation A, crowdfunding, and a Rule moderated the opening panel entitled “Disclosures, 506(c) offering; tier 2 of Regulation A compared to pricing, new products and emerging issues” and an IPO; life after the offering and ongoing reporting; a panel titled “Navigating the currents: How good-old 4(a)(2) and Rule 506(b); and offerings in product manufacturers are addressing today’s close proximity to one another. challenges” at the Structured Products Washington • On November 11, 2015, Partner Peter Green, 2015 Conference. Partner Oliver Ireland made a Partner Jeremy Jennings-Mares, and Senior Of presentation on “Bank regulatory issues affecting Counsel Jerry Marlatt led a teleconference entitled structured notes issuers.” Partner Remmelt “Treatment of Securitizations under LCR/NSFR.” Reigersman moderated a panel titled “Tax The presentation addressed Liquidity Coverage developments in the structured products market.” Ratio (“LCR”), which requires banks to hold Partner Anna Pinedo and Of Counsel Julian sufficient high-quality liquid assets to survive a Hammar co-led a panel titled “Derivatives and 30-day stress period, and the Net Stable Funding structured products.” Of Counsel Bradley Berman Ratio (“NSFR”), which provides a framework for a co-led a panel titled “Suitability, KYD and other longer-term liquidity model. This seminar focused, compliance issues and preparing for a FINRA or in particular, on how this new liquidity framework is OCIE exam compliance basics.” likely to impact structured finance and securitization • On November 4, 2015, Partner Brian Bates transactions globally. delivered the conference chair’s opening remarks • On November 10, 2015, Partner Anna Pinedo and and spoke on a panel entitled “What Drives the Of Counsel Bradley Berman led a two hour in-depth Decision to Issue through the Private Placement session entitled “Choosing among Capital-Raising market?” at the “Private Placements Global Forum and Funding Alternatives.” The presentation – Europe 2015.” Topics included: accessing the focused on the securities law, banking law, and other global private placement market for European regulatory considerations that may affect an issuer’s companies; outlining the reasons for issuance; choice as among reliance on MJDS regime and SEC which companies are private placements for; and registration; registered offerings and exempt offering what alternatives are considered alongside a private alternatives, such as the Section 4(a)(2) exemption, placement. Regulation D, Rule 144A, and Section 3(a)(2) (for • On November 2, 2015, Partner Oliver Ireland led banks); continuous issuance programs, such as bank a teleconference entitled “Total LossAbsorbing note, medium-term note, and commercial paper Capacity.” The presentation addressed the programs; and bank products, such as certificates of important issues in regards to the Financial deposit, market-linked CDs, and Yankee CDs. The Stability Board’s final total loss-absorbing capacity, program also included a discussion of the liquidity or TLAC, requirement for banks that are G-SIFIs. coverage ratio, leverage ratio, and TLAC in the Topics included: the FSB’s TLAC requirement; context of funding choices. the Federal Reserve Board’s proposed TLAC • On November 6, 2015, Partner Oliver Ireland, requirement; potential differences between the FSB Partner Jay Baris, Partner Anna Pinedo, Partner and the Fed standard; and the anticipated effect on Obrea Poindexter, Partner Remmelt Reigersman, various financial products. Of Counsel Sean Ruff, Of Counsel James Schwartz, • On November 2, 2015, Partner Anna Pinedo spoke and Of Counsel Julian Hammar hosted a seminar on a panel entitled “Oversight of Technology entitled “Financial Services Regulatory and and Social Media in Your Firm” at the “2015 Enforcement Current Issues.” Sessions included: NSCP National Conference.” Topics of the panel Living with the Volcker Rule; Money market fund included: overview of applicable regulations; regulation: Will a third shoe drop, and when; practical guidance regarding policy design and Liquidity and capital developments: the LCR, NSFR, implementation; integration with other systems and TLAC; Alternative (or “virtual”) currencies: and due diligence; compliance oversight of developing trends; Regulatory developments thirdparty vendors; and hands-on case studies affecting nonbanks, including nonbank servicers covering reallife scenarios. and nonbank lenders; The ABCs of BDCs; Liquid

10 Morrison & Foerster Tax Talk, January 2016 continued on page 11 • On October 26, 2015, Partner Anna Pinedo spoke 20 See https://www.randpaul.com/issue/taxes. on the “Welcome and Introduction to Private 21 See https://marcorubio.com/issues-2/rubio-tax-plan/. Placements and Hybrid Financings” panel on day 22 See http://taxfoundation.org/article/details-and-analysis-senator-rick-santorum-s-tax-plan. one of the PLI “Private Placements and Hybrid 23 See https://www.donaldjtrump.com/positions/tax-reform. Securities Offerings 2015” seminar. Ms. Pinedo served as chair for this conference and also spoke on the “Welcome and Introduction to Conducting Hybrid Offerings” panel on October 27, 2015. Partner James Tanenbaum spoke on panels titled ANNOUNCING OUR “Regulation A+” and “PIPE Transactions, Change of STRUCTURED THOUGHTS Control Transactions” on October 27, 2015. LINKEDIN GROUP 9 See http://www.wsj.com/articles/hillary-clinton-proposes-4-income-tax-surcharge-for-wealthy- americans-1452552083?cb=logged0.5793573611746292; http://www.wsj.com/articles/clinton- to-propose-rise-in-capital-gains-taxes-on-short-term-investments-1437747732. Morrison & Foerster has created a LinkedIn 10 See http://taxfoundation.org/blog/modeling-martin-o-malley-s-idea-tax-increases. group, StructuredThoughts. The group will 11 See http://www.bloomberg.com/politics/articles/2015-06-11/bernie-sanders-eyes-top-tax-rate- of-more-than-50-percent; http://www.nytimes.com/2016/01/22/upshot/sanders-makes-a-rare- serve as a central resource for all things pitch-more-taxes-for-more-government.html. Structured Thoughts. We have posted back 12 See https://jeb2016.com/backgrounder-jeb-bushs-tax-reform-plan/?lang=en; http://www.npr. org/sections/itsallpolitics/2015/09/09/438873030/everything-you-wanted-to-know-about-jeb- issues of the newsletter and, from time to bushs-tax-plan. time, will be disseminating news updates 13 See https://www.bencarson.com/issues/tax-reform.

14 See http://www.wsj.com/articles/my-plan-to-raise-growth-and-incomes-1431387102. through the group.

15 See http://www.wsj.com/articles/a-simple-flat-tax-for-economic-growth-1446076134. 16 See http://money.cnn.com/2015/11/11/pf/taxes/carly-fiorina-tax-code-three-page/. To join our LinkedIn group, please click 17 See http://www.gilmoreforamerica.com/tax-reform/. here and request to join or simply e-mail 18 See http://www.mikehuckabee.com/_cache/files/11ce70c7-bee1-4fc0-b428-65ccdad4e7d1/ B3BBF8906D52C920712799CAB662DB1F.fairtax-faq.pdf. Carlos Juarez at [email protected]. 19 See http://www.wsj.com/articles/kasich-tax-plan-aims-to-balance-u-s-budget-in-8- years-1444937757.

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Thomas A. Humphreys Remmelt A. Reigersman Nicole M. Humphrey Anna T. Pinedo (212) 468-8006 (212) 336-4259 (212) 336-4234 (212) 468-8179 [email protected] [email protected] [email protected] [email protected]

Stephen L. Feldman Shiukay Hung Brennan W. Young Lloyd S. Harmetz (212) 336-8470 (212) 336-4331 (212) 336-4233 (212) 468-8061 [email protected] [email protected] [email protected] [email protected]

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