Investment Management

Update

Fall 2008

In this issue:The Upcoming Federal Tax Policy Debate: Are You Prepared?.......................................... 1

Major Rogue Trader Cases and Their Compliance Program Implications ............................ 1

E*Trade CIP Settlement with the SEC—Lessons for Broker-Dealers and Mutual Funds ........... 2

Capital Markets Corner: Proposed Amendments to Rule 15a-6 ........................................ 4

Rewriting the Financial Services Laws .......................................................................... 5

Distributor FundsThe Draft Offshore Funds (Tax) Regulations .............................................. 6

The Treatment of Total Return SWAPS Under the Security Exchange Act of 1934 ................. 8

Tax Update .......................................................................................................... 11

Recent Guidance Creates Greater Flexibility for Investments by UCITS Funds ..................... 13

Industry Events ...................................................................................................... 19

The Upcoming Federal Tax Policy Debate: Are You Prepared? By Michael Evans & Patrick Heck

In 2009, the new Administration and

new Congress will face what many

have called “a perfect storm.” With the

2001 and 2003 tax cuts expiring, with

Congressional budget rules effectively

requiring additional tax revenues to

offset the cost of new initiatives, and

with growing concerns about the overall

health of the economy, about the shift

of jobs overseas, and about a host of

other issues with tax policy implications,

taxpayers are likely to see the most

significant tax policy debate in decades.

Major Rogue Trader Cases and Their Compliance Program Implications By Clifford J. Alexander

The events at Société Générale early this year highlight the need for firms to have strong

compliance and risk management programs for their proprietary trading activities. Proprietary

trading is potentially a source of significant profits for banks and securities firms. But the

potential risks can be enormous. There are many reasons why proprietary trading is a high-risk

area for firms: the financial rewards for success are great; it involves someone else’s money,

is highly leveraged and extremely complex; the risks may be difficult to identify, measure and

monitor; and accounting, legal, back office, compliance and risk management personnel

sometimes have difficulty keeping up with changes in instruments, strategies and markets.

Firms often seek to reduce and manage risk by restricting traders’ authorization to transactions that are

hedged, limiting the types of instruments and strategies they may utilize, controlling their borrowing, and

monitoring market exposure. However, even well-designed compliance programs and controls can be

evaded. This article describes some of the high-visibility events that resulted in large trading losses for

financial institutions. It identifies certain threads and red flags common to these cases. And it highlights a

number of compliance policies and controls that firms should consider.

Major Rogue Trader Cases In The Last 15 Years

Joseph Jett – Kidder Peabody & Co. (1994)

Jett was a 36-year-old government bond trader with Kidder. Coming off poor personal performance in

1991, Jett devised a trading strategy that involved exchanging U.S. Government “STRIPS” (Separate

Trading of Registered Interest and Principal of Securities) for whole bonds. Even though no actual sale

of securities had taken place, the system treated a reconstitution instruction as a sale of strips; and it

treated a strip instruction as a sale of a bond and purchase of its principal and interest components. In

fact, Jett’s trades were fictitious because the underlying reconstitution transactions entered by Jett were

rarely completed.continued on page 15

continued on page 17

Lawyers to the investment management industry

2 Investment Management Update

E*Trade CIP Settlement with the SEC Lessons for Broker-Dealers and Mutual Funds by Megan Munafo and András Teleki

These regulations include the CIP Rule, which

requires that broker-dealers, like banks and

mutual funds, establish, document and maintain

procedures for identifying customers and verifying

their identities. The required records under the CIP

Rule must include a description of the methods

and results of any measures undertaken to verify

the identity of the financial institution’s customers.

In connection with the settlement, E*Trade

agreed to, among other things, retain an

independent compliance consultant to (i) conduct

a comprehensive regulatory review of E*Trade’s

CIP; (ii) develop a written plan to achieve the

regulatory review objectives of its CIP procedures;

(iii) create written policies and procedures

designed to ensure that at all times E*Trade is in

full compliance with the CIP Rule; (iv) prepare a

final report to be submitted to the SEC regarding

this review; and (v) in one year, provide an

assessment of E*Trade’s remediation efforts. In

addition, E*Trade was ordered to pay a total civil

money penalty of $1,000,000.

What Went Wrong According to the SEC’s Order, from October

2003 until June 2005, E*Trade’s CIP procedures

stated that the firm would verify customer identities

through non-documentary means by primarily

comparing customer information with information

provided by a third-party vendor. E*Trade’s CIP

procedures also required the firm to keep records

that included a description of the identifying

information relied upon to verify the customer’s

identity. During this period, however, E*Trade

allegedly failed to follow this verification process

by failing to verify the identities of secondary

accountholders in newly opened joint accounts.

The SEC found that “E*Trade’s 20-month failure

to accurately document its CIP was systemic,

resulting from the lack of cohesive organizational

structure, the lack of adequate management

oversight, and miscommunications between

personnel in several E*Trade business groups.”

Prior to the effective date of the CIP Rule, E*Trade

expanded its contractual arrangement with its

third-party vendor to include vetting new customer

information for CIP purposes. Although E*Trade’s

CIP procedures provided that the names of new

customers were supposed to be “batched” at

the end of each day, the E*Trade system did not

include secondary accountholder information in

this process. By excluding this information from

the batching process, the SEC found that E*Trade

was not in compliance with its

own procedures.

During this 20-month period, the SEC found

that a series of incidents further exacerbated

the problem. In June and July 2004, the risk

operations group became aware that secondary

accountholder information was not being properly

vetted and reported the non-compliance to three

top compliance officers and other members

of E*Trade senior management. E*Trade,

however, allegedly failed to remedy the problem.

In November 2004, when E*Trade hired a

new risk operations manager to take over CIP

responsibilities, among other things, the manager

was not made aware of the ongoing failure to

revise its systems and vet secondary accountholder

information in joint accounts or to accurately

document the known CIP failures over the last risk

operations group became aware that secondary

accountholder information was not being properly

vetted and being properly vetted and reported the

The SEC recently settled with E*Trade Clearing LLC and E*Trade Securities (collectively,

“E*Trade”), each of which is a federally registered broker-dealer, for alleged failure to comply

with its customer identification program or CIP and alleged failure to remedy its non-compliance

even after the problem was identified internally. Section 17(a) of the Exchange Act of 1934, as

amended, and Rule 17a-8 there under, require a broker-dealer to comply with certain reporting,

recordkeeping and record retention requirements in the regulations implemented under the Bank

Secrecy Act.

Fall 2008 3

non-compliance to three top compliance

officers and other members of E*Trade senior

management. E*Trade, however, allegedly failed

to remedy the problem. In November 2004,

when E*Trade hired a new risk operations

manager to take over CIP responsibilities, among

other things, the manager was not made aware

of the ongoing failure to revise its systems and

vet secondary accountholder information in

joint accounts or to accurately document the

known CIP failures over the last six months.

After seven months of having assumed the role

as risk operations manager, in June 2005, the

manager discovered the CIP failure, identified

a total of 65,442 active joint accounts that

were opened after the CIP compliance date and

manually submitted the secondary accountholder

information for verification. According to E*Trade,

the verification process did not identify any joint

accounts that should not have been open had the

proper CIP procedures been followed.

Lessons from E*Trade’s Example

First and foremost, having a well-thought out and

well-documented customer identification program

is not enough. A financial institution must also

properly implement and execute the program.

This means that, to the extent the program

describes steps the financial institution will take

to verify a customer’s identity, those steps should

actually be taken for each customer and properly

documented. Furthermore, any exception to

the stated process or discrepancy in the results

should also be documented. It is also imperative

that a financial institution’s CIP reflect the firm’s

actual practices in this area. Undocumented

practices, including good practices, can raise

compliance problems where, as is often the case,

the undocumented practice is at odds with the

applicable procedure in the program.

The second lesson from the E*Trade settlement

is that once a problem is identified it must be

properly documented, addressed and rectified.

Action taken should include the adoption of

procedures to ensure that the problem (or similar

problems) does not reoccur in the future. It is also

good practice to employ back-testing to ensure

that the process failure does not mask other

problems. For example, if a financial institution’s

CIP is not properly applied in some cases, the

financial institution should go back and apply

the CIP to those customers to ensure that the firm

knows the identity of its customers in accordance

with applicable law. Finally, financial institutions

should have a process in place (e.g., a tickler

file or compliance report) for following up on

compliance problems so that known problems do

not remain unresolved for extended periods.

Having a well-thought out and well-documented customer identification program is not enough. A financial institution must also properly implement and execute the program.

4 Investment Management Update

In summary, the Proposed Amendments (i)

expand the categories of U.S investors that a

foreign broker-dealer (an “FBD”) may solicit, send

research to, and execute trades for, (ii) streamline

the conditions under which an FBD may engage

in these activities with certain U.S. investors,

and (iii) significantly reduce the role that the

U.S. broker-dealer (“U.S. BD”) must play

in intermediating transactions effected by an

FBD although a relationship with a U.S. BD

is still required.

The proposed revisions to the Rule would

exempt FBDs complying with the Rule from the

broker-dealer registration requirements of, and

all reporting and other requirements under, the

Exchange Act, except for those related to the

SEC’s disciplinary authority under Sections 15(b)

(4) and 15(b)(6). FBDs and their associated

persons, however, will continue to be subject to

Exchange Act provisions and rules unrelated to

the FBD’s status as a broker-dealer, such as the

general antifraud provisions of Section 10(b)

and Rule 10b-5.

Under the Proposed Amendments, certain U.S.

investors and FBDs, as well as U.S. BDs which

currently act as intermediaries for FBDs, would

be expected to benefit from cost efficiencies. Any

cost savings for broker-dealers, however, may

vary depending on whether the U.S. BD, which

often is an affiliate of an FBD, continues to play

a significant role in the overall client relationship

with U.S. investors.

The Proposed Amendments expand the types of

U.S. investors that an FBD may contact for the

purpose of soliciting securities transactions and

providing research reports. They would replace

the current categories of “major U.S. institutional

investor” (very generally one with $100 million

in assets or assets under management) and “U.S.

institutional investor” with the new category of

“qualified investor,” as defined in Section 3(a)

(54) of the Exchange Act. The qualified investor

definition includes most of the institutions that

are now covered by the Rule, such as banks,

insurance companies, and registered investment

companies. It also includes several new types of

investors, most significantly: private investment

funds relying on Section 3(c)(7) of the Investment

Company Act of 1940, as amended, regardless

of asset size or the registered status of their

investment advisers; and corporations, companies,

partnerships, and natural persons that own and

invest on a discretionary basis not less than $25

million in investments.

The Proposed Amendments also include additional

significant revisions to the requirements of

subsection (a)(3) of the Rule, which, if adopted,

would (i) allow all FBDs to solicit and trade with

qualified investors without any chaperoning by a

U.S. BD if the FBD meets certain conditions, (ii)

allow FBDs who conduct a “foreign business” (a

“Category 1” FBD) to execute, clear and settle

trades in foreign securities with, and custody

accounts for, qualified investors, and (iii) shift most

regulatory responsibilities from the U.S. BD to

the FBD. Most significantly, in the case of trades

solicited by a Category 1 FBD, the U.S. BD,

which does not otherwise participate in the trade,

has no responsibility for the transaction, including

no net capital, customer protection rule and anti-

money laundering responsibilities, or responsibility

to review trades for compliance with SEC or

In recognition of the increasing globalization of securities markets, the SEC has recently

proposed amendments (“Proposed Amendments”)2 to Rule 15a-6 (the “Rule”) under the

Securities Exchange Act of 1934, as amended (“Exchange Act”). If adopted, the Proposed

Amendments should give certain U.S. securities market participants improved and potentially

more cost-effective access to foreign securities markets and foreign securities experts.

1 This article is adapted from a July 10, 2008 Broker-Dealer Alert authored by Edward G. Eisert, Michael J. King and C. Dirk Peterson.

2 See Securities Exchange Act Release No. 58047 (June 27, 2008).

Proposed Amendments to Rule 15a-6 by Michael J. King1

Capital Markets Corner

Fall 2008 5

SRO requirements. Thus, under the Proposed

Amendments, the U.S. regulatory burdens on

both the Category 1 FBD and U.S. BD are

significantly reduced.

An FBD that does not meet the “foreign business”

requirement may trade directly with qualified

investors on less restrictive terms than currently

permitted, but on more limited terms than an FBD

who does meet the “foreign business” requirement.

Such “Category 2” FBDs may solicit and “effect”

trades directly with qualified investors and, thus,

presumably clear and settle such trades. They

may not, however, custody the qualified investor’s

account. There are also more burdens on the

U.S. BD intermediating on behalf of a Category

2 FBD. In the Category 2 FBD context, the SEC

views the U.S. BD as “carrying the account”

and being responsible for maintaining required

books and records and receiving, delivering

and safeguarding funds and securities on behalf

of qualified investors in compliance with the

3 Pursuant to the Proposed Amendments, an FBD conducts a “foreign business” if, generally, 85% of its securities business, on a rolling two-year basis, with qualified investors and U.S. fiduciaries effecting transactions for the account of “foreign resident clients,” is in transactions in “foreign securities.”

4 See, e.g., the September 8, 2008 comment letter from the Securities Industry and Financial Markets Association.

SEC’s customer protection rule. Nevertheless, the

burdens on the U.S. BD are still less onerous than

those currently imposed by the Rule.

The Proposed Amendments also include other

proposals to allow 1) the U.S. dissemination of

foreign quotes through third-party systems, and

2) Category 1 FBDs to solicit trades with U.S.

resident fiduciaries of accounts of a non-U.S.

resident client. As a separate regulatory initiative,

the SEC proposed a new exemption to allow a

Foreign Options Exchange (an “FOE”) and an

FBD that is a member of an FOE to engage in

certain activities to familiarize qualified investors

with the FOE and to allow such foreign exchanges

to make available to qualified investors the FOE’s

OTC options processing service.

The comment period on the Proposed

Amendments closed on September 8, 2008.

Industry reaction to the Proposed Amendments

was generally favorable, although certain aspects

of the Proposed Amendments, such as the “foreign

business requirement” for Category 1 FBD status,

were criticized. Nevertheless, Rule 15a-6 is over

19 years old and amendments are long overdue.

If the Rule is amended such that it incorporates

the most significant provisions of the Proposed

Amendments, the SEC will significantly reduce

the burdens on qualified U.S. investors seeking

cost-effective access to foreign securities markets

and experts.

Rewriting the Financial Services Laws By Daniel F. C. Crowley

The unprecedented events occurring in our capital markets will inevitably lead to the most significant

revisions to the legal and regulatory framework for financial services since the Great Depression.

The federal government’s short-term public policy responses are geared toward restoring liquidity

in the credit markets, enhancing transparency, and prohibiting certain previously accepted

practices. Many of these stop-gap measures are intended primarily to limit volatility and restore

orderly markets. Currently, the leadership of the White House, Treasury, Federal Reserve, SEC and

Congress are preparing emergency proposals to immediately achieve some of these objectives.

Beginning in January, 2009, the 111th Congress will consider comprehensive legislation to restructure financial services regulation. In addition to

the proposals outlined in the Treasury “Blueprint for a Modernized Financial Regulatory Structure” released in March 2008, and recently enacted

legislation relating to housing and the mortgage markets, current discussions include new capital reporting and other regulatory requirements for a

broad array of market participants and products including commodities, financial derivatives and hedge funds.

Two points bear mention as Congress begins to consider the public policy options: (1) the legislative outcome is uncertain and subject to input from

many different interest groups including investors, consumer advocates, labor unions, trade associations, think tanks and financial services providers,

and (2) market participants who are not adequately represented will likely have their new competitive environment determined largely by those who

are actively engaged in this process.

Mr. Crowley will expand on this topic at his lunchtime presentation at our annual Investment Management Training Seminar in Washington, D.C. on

November 5 and 6, 2008 and in New York on December 3, 2008. For additional information and to register for this seminar, please go to our website

at www.klgates.com and click on “Events.”

6 Investment Management Update

Following on from our article in the Summer 2008

K&L Gates Investment Management Update,

key points to note in the draft regulations include

the following:

Offshore funds wishing to attain distributor

status will no longer have to distribute

income to investors

Distributor funds will no longer be known as

“distributor” funds but as “reporting” funds.

Reporting funds will not have to distribute 85% of

their income to investors but will have the option

to either report, or report and distribute, 100% of

their income (with a 10% margin for error) to U.K.

investors. The amount reported or distributed will

be liable for income tax for individual investors,

and gains made by individual investors on the

disposal of their investment will be liable to capital

gains tax.

Offshore funds which are not reporting funds will

be known as “non-reporting funds,” and U.K.

individual investors in non-reporting funds will be

subject to income tax on any income received

from the fund and gains on disposal of their

investment in the fund. This mirrors the current rules

for investment in offshore funds that do not have

distributor fund status or that breach the 5% limit

on investments in other offshore funds (see below).

The disadvantage to distributor funds of having

to distribute income to their U.K. investors will be

removed, and reporting funds will be able to re-

invest their trading gains. U.K. individual investors

will derive the most benefit from capital gains tax

treatment on the disposal of their investment when

they invest in reporting funds, which focus more

on capital growth than short-term profits.

Income tax liability from interests in reporting

funds will crystallize for U.K. individuals prior

to any gain or income being received

The amount reported to U.K. individual investors

by reporting funds will be liable for income

Distributor Funds The Draft Offshore Funds (Tax) RegulationsBy Danny Asher Brower and Petre Norton

The U.K. Government has published draft regulations outlining the proposed changes to the

U.K. tax regime for offshore funds. These regulations have been open to consultation and are

likely to be significantly amended following input from the large number of interested parties

within the investment management industry. They are expected to be finalized by the end of

this year and to come into effect in the first half of 2009.

tax each financial year, but the U.K. individual

investor will not have received any physical

distribution (if reported but not distributed). The

U.K. individual must, therefore, find the money

from elsewhere to meet that income tax liability. In

comparison to investing in a non-reporting fund,

a U.K. individual investor will have his income

tax liability brought forward. This would be more

burdensome for an investor in a fund focusing on

short term trading gains than on capital growth.

Investment restrictions will be removed

The investment restrictions which currently prevent

distributor funds from investing more than 5% of

their assets in other offshore funds (other than

distributor funds) will be removed so that reporting

funds will be able to invest without limit in other

reporting funds and non-reporting funds. When

computing income, reporting funds will not have

to inquire as to the underlying investments in other

funds in which they invest and need only consider

their immediate, direct investments. Income from

reporting funds’ investments in other reporting

funds and non-reporting funds will be treated as

income of the reporting fund.

Fall 2008 7

Minor breaches of the regime

will not be unduly punished

Minor or inadvertent breaches of the regulations

by reporting funds will not prevent a reporting

fund from continuing to be a reporting fund unless

it is the fund’s third breach within the previous 10

years, in which case the reporting fund will be

treated as a non-reporting fund for the reporting

period in which the breach is discovered and for

all subsequent reporting periods.

Disclosure to H.M. Revenue & Customs

Reporting funds will be required to provide H.M.

Revenue & Customs with a computation of the

reported income for each U.K. investor together

with the name and address of that investor. This

onerous requirement was not proposed in earlier

consultation papers and is likely to be strongly

resisted by the industry.

Under the current law, U.K. individual taxpayers

pay income tax at 32.5% on the amount a

distributor fund (structured as a corporation)

distributes to them, whereas U.K. individual

taxpayers pay income tax at up to 40% on the gain

from the disposal of their interests in an offshore

fund which does not qualify for distributor status.

Gains made by individual investors on disposing

of their interests in a fund are treated as income

earned by the investors and not as distributions

received by them, hence the 40% rate (for a higher

rate taxpayer). Under the draft regulations, U.K.

individual higher-rate taxpayers will pay income

tax at 32.5% on the amount reported to them by

reporting funds, which need not be distributed,

and will therefore pay income tax at the lower rate

of 32.5% on income generated by offshore funds

which roll over their profits.

H.M. Revenue & Customs aims to encourage fund

managers who were previously reluctant to apply

for distributor status to apply for reporting status by

reducing the administrative burden and investment

restrictions. With each consultation, we can expect

the following draft regulations to reflect this aim.

8 Investment Management Update

The Treatment of Total Return SWAPS Under the Securities Exchange Act of 1934 CSX v. The Children’s Investment Fund Management (UK) LLP, et al. By Edward G. Eisert

This Article provides an overview of the CSX v. The Children’s Investment Fund Management

(UK) LLP, et al. litigation (“CSX Litigation”) and the alternate proposals before the Second Circuit

(on appeal of the decision of the Southern District of New York) as to whether and, if so, under

what circumstances, the long party to a Total Return SWAPS (“TRS”) has a reporting obligation

under Section 13(d) of the Securities Exchange Act of 1934 (“Exchange Act”).

The District Court Decision –

A Challenge to Market Expectations The June 11, 2008 decision of the Southern

District of New York in the action brought by

CSX Corporation (“CSX”) against The Children’s

Investment Fund Management (UK) LLP and its

affiliates (collectively, “TCI”) and 3G Fund L.P.

and its affiliates (collectively, “3G”) has called

into question a basic expectation of the equity

derivatives market: that the long party to a TRS

does not acquire beneficial ownership of the

referenced securities under the TRS for purposes

of Section 13(d) of the Exchange Act (“Section

13(d)”), absent a supplemental arrangement

outside of the TRS that provides a contractual

right to vote or dispose of such securities.

TCI and 3G have been engaged in a proxy fight

over the election of directors of CSX. CSX brought

claims against TCI and 3G in March 2008

alleging (1) that the defendants failed timely to

file a Schedule 13D under the Exchange Act after

forming a “group” (within the meaning of Section

13(d)) to act on these shares of CSX and (2) that

both the Schedule 13D and the proxy statement

they eventually filed were false and misleading.

CSX sought, among other things, an order

requiring corrective disclosure, voiding proxies

defendants obtained, and precluding defendants

from voting their CSX shares.

The District Court found that the defendants

had violated Section 13(d) and the rules

thereunder and enjoined further violations thereof,

dismissed all counterclaims, but found that it was

“foreclosed” under controlling Second Circuit

precedent from enjoining defendants from voting

the shares they had acquired from the date of the

violation to the trial date.

CSX appealed the decision of the District Court

and on June 20 the Second Circuit denied CSX’s

motion for an injunction “to hold in escrow,

pending the outcome of the appeal, approximately

6.4 percent of the outstanding shares in appellant

which the district court found to be the interest

that appellees acquired prior to fulfilling the

disclosure requirements set forth in Section 13(d)…”

The Second Circuit did grant CSX’s motion for

an expedited appeal and argument. The CSX

annual meeting was held on June 25, 2008,

as scheduled, but the outcome of the meeting

remained subject to the results of the appeal.

The Holding of the District Court – Beneficial

Ownership Found Under Rule 13d-3(b)

In rendering its opinion, the District Court found

that it was not necessary to reach the question

whether the defendants had acquired “beneficial

ownership” under Rule 13d-3(a) because of its

finding that the defendants had used the TRSs

with the “purpose and effect of preventing the

vesting of beneficial ownership of the referenced

shares…as part of a plan or scheme to evade the

reporting requirements of Section 13(d) [under

Rule 13d-3(b)].”

Implications for Equity Derivatives

Markets and Regulation

While the District Court’s decision regarding

beneficial ownership under Section 13(d) was

limited to the facts of the case, its holding that

defendants should be considered beneficial

owners of the referenced shares for their TRS

transactions has troubling implications for hedge

funds and other end-users of equity derivative

instruments. Not the least of these is that the novel

finding that the defendants were beneficial owners

under Rule 13d-3(b) raises the specter that any use

of TRSs by “activist investors” might be considered

an indicator of a “plan or scheme” to evade the

reporting requirements of Section 13(d) and must

be examined in each case.

Fall 2008 9

The Pending Second Circuit Appeal –

The Storm Gathers One aspect of the CSX appeal remains pending

before the Second Circuit: the decision of the

District Court not to enjoin the voting of the

shares of CSX acquired by the defendants. The

defendants’ pending appeal challenges the District

Court’s rulings in three respects: (i) that TCI should

be deemed to be a beneficial owner of the CSX

shares referenced by the TRSs to which it was a

party; (ii) that defendants formed a “group” under

Section 13(d); and (iii) that a permanent injunction

broadly prohibiting defendants from violating the

disclosure requirements of the Exchange Act with

respect to any future transactions should not be

entered. On September 15, the Second Circuit

issued a Summary Order deciding at that time

only to affirm the decision of the District Court

not to enjoin the voting of the CSX shares held

by the defendants. An opinion of the Second

Circuit will follow. Consequently, CSX announced

that its Board of Directors has invited the two

TCI nominees that had not already been seated

to join the Board immediately.

Understandably, the District Court’s novel

application of Rule 13d-3(b) in a manner that

has not previously been the subject of significant

guidance by the SEC or significant judicial

analysis has attracted a great deal of attention.

Amici curiae briefs have been filed by five

interested parties, including a joint brief of former

SEC Commissioners and officials and professors

(collectively, the “Former Commissioners”), a joint

brief of the International Swaps and Derivatives

Association, Inc. (“ISDA”) and the Securities

Industry and Financial Markets Association

(“SIFMA”), and a brief of the Managed Funds

Association (“MFA and, together with ISDA and

SIFMA, the “Associations”).

What Is and What Is Not at Stake

A TRS, standing alone, does not confer beneficial

ownership under Section 13(d). On this, CSX, the

defendants and amici would agree. All amici also

share a concern with the long-term implications

of the District Court’s decision, and there appears

to be a consensus that if there are circumstances

under which the position held by a long party

to a TRS must be disclosed under the Exchange

Act, that the factors to be considered should be

carefully and clearly articulated. However, the

Former Commissioners and the Associations have

starkly different views regarding the District

Court’s opinion and as to how these issues should

be addressed.

Alternate Approaches Proposed

The Former Commissioners

The Former Commissioners wholeheartedly

support the District Court’s opinion, which they

characterize as “thorough and well-reasoned,”

and urge the Second Circuit to affirm that portion

of the decision that held, under the “specific and

narrow facts and circumstances presented,” that

defendants engaged in a “scheme to evade

the reporting requirements of section 13(d)” in

violation of Rule 13d-3(b). While disavowing

any suggestion that they were proposing the

adoption of a formal legal test, the brief of the

Former Commissioners nonetheless lists six factors

present in the CSX case that they believe would

be sufficient to establish “evasive” conduct by any

person in violation of Rule 13d-3(b). It emphasizes

that each such factor should not be considered

a necessary element of such a violation and that

other circumstances might support a similar finding.

Specifically, in the judgment of the Former

Commissioners, a person should be deemed

a beneficial owner under Section 13(d) if that

person has:

1. Acquired a position in the derivative

markets that, if held in the form of the

registrant’s voting equity, would trigger

a disclosure requirement (emphasizing

that this factor constitutes a necessary but

insufficient condition for a violation of Rule

13d-3(b));

2. Engaged in significant efforts to influence

corporate management or corporate

control;

3. Engaged in efforts with the purpose or

effect of influencing the voting position

of counterparties who, by virtue of the

foreseeable equity hedges held as a result

of the equity swap positions at issue,

owned the registrant’s voting shares;

10 Investment Management Update

4. Caused a pre-positioning of the registrant’s

voting shares in a manner that materially

facilitates the rapid and low-cost acquisition

of a reportable position upon the

termination or other unwind of the

derivative transactions at issue;

5. Caused the derivative positions at issue

to be structured in a manner calculated

to prevent counterparties from becoming

subject to disclosure obligations under

the federal securities laws; and

6. Withheld from the market information

regarding the person’s activities (e.g.,

the person’s equity or derivative positions)

that is material.

It also is noteworthy how the Former

Commissioners addressed the argument of the

defendants (and the Associations) that the District

Court’s decision conflicts with the definition of

“security” in Section 3A of the Exchange Act,

which provides that the definition of “security”

under the Exchange Act “does not include any

security-based swap agreement.” Based upon this

wording, the defendants and a number of other

interested parties believe that TRSs cannot be

encompassed within the reporting requirements of

Section 13(d). The Former Commissioners respond

to this argument by noting that the District Court’s

decision was not predicated on holding that TRSs

were securities, only that the TRSs held by the

defendants gave rise to “beneficial” ownership of

CSX shares for purposes of Section 13(d).

ISDA and SIFMA

The Associations argue that the District Court

expanded the “scheme to evade” language

of Rule 13d-3(b) in a way that “the SEC never

applied (or intended) and no legal authority

has supported.” Moreover, they believe that the

decision has “created substantial uncertainties

for the equity derivatives and capital markets that

require correction on appeal, regardless of the

outcome of this particular case.” They conclude

that the decision of the District Court should

be reversed.

It is noteworthy that ISDA and SIFMA addressed

the fact, cited by the District Court, that the UK

requires the disclosure of economic stakes greater

than 1% in companies involved in takeovers and

is considering requiring disclosure at the 3% level

in other companies (the “UK Initiative”).

Amici’s primary concern is not with the

threshold disclosure levels per se, or even

with a potential reporting requirement.

Instead, amici are concerned about a

beneficial ownership test that is based on

the court’s uncertain standards that replaced

more objective—and well-settled—rules,

standards that result not merely in

reporting obligations, but potentially

significant short swing trading liabilities

under Section 16 [of the Exchange Act].

Expansion of the reporting requirements

through clear legislation and regulations,

as was the case in the United Kingdom,

does not raise the same concerns raised

by the court’s decision here.

MFA

MFA endorses the view of ISDA and SIFMA and

asserts that “[a]ll market participants…. need clear

rules relating to TRSs [although it] takes no position

concerning the findings [of the District Court] or

the proper outcome of this appeal…”

However, the MFA concluded that, regardless

of the result it reaches on the facts of this case:

this Court should adopt three clear rules:

(1) a TRS, standing alone, does not confer

beneficial ownership; (2) Rule 13d-3(b)

requires an agreement that conveys one

or more of the Rule 13d-3(a) indicia of

ownership and does not apply based

solely on a party’s motive; and (3) group

activity requires an agreement to act

together for the purpose of acquiring,

holding, voting or disposing of equity

securities, not merely information-sharing

or parallel investment activity based on

common interests.

Conclusions Pending the final outcome of the appeal, at a

minimum, the District Court’s decision cautions

against “activist investors” entering into TRSs under

circumstances from which a court could infer that

the avoidance of reporting beneficial ownership

is a primary objective.

The District Court decision, coupled with the U.K.

Initiative, has focused renewed, intense attention

on the treatment of TRSs under the Exchange

Act. The opinion of the Second Circuit will have

significant implications for all market participants.

Fall 2008 11

The Emergency Economic Stabilization Act of 2008 (“Act”), signed into law on October 3,

requires regulated investment companies (“RICs”) to report basis information to their shareholders

starting in 2012 and extends a number of tax provisions that are relevant to RICs, including the

ability to designate certain dividends so that they are not subject to U.S. withholding tax when

paid to non-U.S. shareholders. The Act also contains a provision that will effectively eliminate

the ability of hedge fund managers to defer fees from offshore funds starting in 2009.

RICs Must Report Basis to Shareholders

Starting in 2012

Under the Act, a “broker” that is required to

report to its customers on Form 1099-B the

gross proceeds realized from any sale effected

by the broker must also begin reporting basis

information. For this purpose, the term “broker”

includes “any corporation that regularly redeems

its own stock” and thus should cover most open-

end RICs with respect to their shareholders. The

basis reporting provisions in the Act grew out

of recommendations in the National Taxpayer

Advocate 2005 annual report and a June

2006 GAO report. Both reports concluded that

taxpayers were misstating (or over-stating) their

basis, and that basis reporting by brokers would

help to reduce the resulting “tax gap.”

For RIC shares, basis reporting is required for

shares acquired on or after January 1, 2012. For

shares of any other corporation, the applicable

date is January 1, 2011; for debt instruments,

commodities (including any contract or derivative

with respect to commodities), and any other

financial instrument designated by Treasury, the

applicable date is January 1, 2013 or such other

date determined by Treasury. RICs must generally

report using one of two “average basis” methods,

unless the shareholder selects another permissible

method (first-in-first-out or specific identification

of shares).

In determining the basis of any covered security,

a broker can generally ignore wash sales (which

require adjustments to stock basis) unless the wash

sale occurs in the same account with respect to

identical securities. The provision also requires

reporting of option transactions and reporting to

S corporations that sell shares.

If securities are transferred from an account at one

broker to a second broker, the first broker must

furnish a statement with basis information. The

second broker then must report basis information

on the transferred securities as if they had been

originally acquired in an account with such broker.

Finally, the Act extends the date for furnishing Form

1099-B from January 31 to February 15 of the

year following the year in which the transaction

occurs. This change applies to statements required

to be furnished after December 31, 2008.

Act Extends Withholding Exemption for

Interest-Related, Short-Term Capital Gain

Dividends Through 2009

The Act extended a provision that ensures that a

non-U.S. investor will generally be taxed in the

same manner whether they receive U.S.-source

interest income and short-term capital gains

directly or indirectly through a RIC distribution.

A non-U.S. investor is generally subject to U.S.

withholding tax (imposed at a rate of 30% or

possibly at a lower rate under a tax treaty) on the

receipt of passive income, such as dividends, from

U.S. sources. This withholding tax, however, does

not apply to most U.S.-source interest because of

an exemption for “portfolio interest,” and capital

gains (other than gains from U.S. real property

investments) because such gains are generally not

treated as U.S.-source. Before 2004, a non-U.S.

investor would generally obtain worse tax results

by earning this type of income indirectly through

a RIC rather than directly, because mutual fund

distributions (other than distributions designated as

long-term capital gains dividends) are generally

TaxUpdate

Emergency Economic Stabilization Act of 2008 Requires Basis Reporting Starting in 2012, Extends Expired Tax Provisions, Stops Deferrals of Fees from Offshore Hedge Funds By Roger S. Wise

12 Investment Management Update

treated as dividends, and are thus subject to

withholding tax, even if the underlying income

would not be subject to withholding.

To correct this disparity and encourage non-U.S.

investment in mutual funds, the American Jobs

Creation Act of 2004 added section 871(k) to

the Code, permitting a mutual fund to designate

“interest-related dividends” and “short-term

capital gains dividends” that are not subject

to withholding tax, to the extent of the fund’s

underlying interest income or short-term capital

gains, respectively. These provisions were initially

effective for dividends with respect to tax years

beginning on or before December 31, 2007, and

have now been extended by the Act to tax years

beginning on or before December 31, 2009.

Although these provisions apply retroactively, so

that a non-U.S. investor should not ultimately have

any substantive tax liability from receiving an

interest-related or short-term capital gain dividend

in 2008, it is possible that such an investor could

have been subject to withholding on any such

dividend received between January 1, 2008, and

the Act’s October 3, 2008 date of enactment.

(Note that the prior expiration date was based on

the RIC’s taxable year, so that a RIC with a June

30 taxable year, for example, could have paid

such a dividend in the first half of 2008 without

any withholding tax.) Although such a non-U.S.

investor should be entitled to a refund for any such

withheld tax, the investor would need to file a

2008 U.S. tax return to obtain the refund.

Fee Deferrals From Most Offshore Funds Will

No Longer Be Possible Starting in 2009 The Act includes a provision that effectively ends

the ability of investment managers to defer tax on

fees from most offshore funds starting in 2009,

although investment managers will generally

be able to continue deferring tax on previously

earned fees through the last taxable year ending

before 2018. Short-term deferrals of up to 12

months are permitted under the new law. In

addition, there may still be some ability to defer

fees through the use of fund entities established in

low-tax jurisdictions that have tax treaties with the

United States, although it is unclear whether these

jurisdictions will be as favorable for fund formation

as jurisdictions (like the Cayman Islands) with

which the United States has no tax treaties.

For a more detailed discussion of this provision,

please see our October 13 Alert, “Managers

Will No Longer Be Able to Defer Fees From

Most Offshore Funds Starting in 2009” at

www.klgates.com/newstand.

Fall 2008 13

The Committee of European Securities Regulators recently issued additional guidance on the types of

assets in which Undertakings for Collective Investment in Transferable Securities (“UCITS”) funds—

essentially, European mutual funds—may invest. The rules governing UCITS funds1 are intended

to establish harmonized rules in all countries of the European Union (“EU”), so that a UCITS fund

established in one EU country can be marketed to retail clients in other EU countries without any

additional authorizations.

Recent Guidance Creates Greater Flexibility for Investments by UCITS Funds

By Danny Asher Brower and Manjinder Cacacie

Various member states interpreted the rules of

UCITS III in differing ways and, consequently,

UCITS funds in some member states were allowed

to undertake transactions not permitted to UCITS

funds authorised in other member states. To

resolve this issue, the Eligible Assets Directive

(2007/16/EC) (“EAD”) came into force in

2007. Further guidance was required to make

the provisions of the EAD more comprehensive,

relevant and practical. The new guidance on the

EAD, which became effective on 23 July 2008

in all EU countries, provided detailed definitions

pertaining to the assets eligible for investment by

UCITS funds. The following is a brief summary of

the amended definitions:

Transferable securities

The EAD expands on the definition of transferable

securities in a way that permits UCITS funds to

invest in securities backed by, or linked to the

performance of, any other asset, provided that

the transferable security itself meets the following

criteria: (a) the potential loss exposure does not

exceed the amount paid for the security; (b) the

liquidity of the security does not compromise a

UCITS fund’s ability to comply with its redemption

obligations; (c) accurate, reliable and regular

prices are available; (d) regular, accurate and

comprehensive information is available to the

market; and (e) the security is negotiable. It is

generally presumed that the security is liquid. If a

UCITS fund knows, or ought reasonably to know,

that any particular security is not liquid, the UCITS

fund must assess the underlying security’s liquidity

risk. The EAD confirms that financial instruments

that meet the criteria set out above are permitted

investments for UCITS funds.

Money market instruments

UCITS III defines approved money market

instruments as instruments normally dealt in on the

money market, which are liquid and have a value

that can be accurately determined at any time

(for example, certificates of deposit, commercial

paper and banker’s acceptances, treasury and

local authority bills). The EAD expands on each of

these three criteria in detail.

Use of derivatives

The EAD elaborates on the term “liquid financial

assets” as it is used in UCITS III in relation to

financial derivatives. In particular, the new

guidance permits a UCITS fund to gain exposure

to hedge funds by investing in a derivative

instrument tied to a broadly diversified hedge fund

index (“HFI”), even though the UCITS fund may not

invest directly in a hedge fund. The EAD permits

UCITS funds to invest in derivative instruments

tied to assets in which UCITS funds are otherwise

permitted to invest, such as interest rates, foreign

exchange rates or currencies and financial

indices, but excluding non-financial indices

and commodities. Indices based on financial

derivatives on commodities or indices on property

may be eligible, provided they comply with the

criteria set out for financial indices in UCITS III.

The EAD clarifies the requirements of HFIs to be

classified as financial indices for the purposes of a

UCITS fund. HFIs must meet certain criteria: (i) the

composition is sufficiently diversified; (ii) the index

represents an adequate benchmark for the market

to which it refers; and (iii) the index is published

in an appropriate manner. These criteria also

apply to a UCITS fund replicating the composition

of stock or debt securities index. The EAD also

requires a UCITS fund to conduct appropriate

additional due diligence before deciding to

invest in HFIs, and maintain a record of such due

diligence. The effect of this clarification is that

although a UCITS fund may not invest directly in a

hedge fund, it can gain exposure to hedge funds

by investing in broadly diversified HFIs through

financial derivative instruments.

1 UCITS funds are governed by the UCITS Directive (85/116/EC) that came into force in 1985 and was amended by Directives 2001/107/EC and 2001/ 108/EC (“UCITS III”)

14 Investment Management Update

Efficient Portfolio Management (“EPM”)

A UCITS fund is permitted to employ EPM

techniques and instruments relating to transferable

securities and money market instruments such as

repurchase agreements, guarantees received

and securities lending and securities borrowing

to generate leverage through the re-investment

of collateral. However, their use is subject to

having an adequate risk management process

in place and they must be taken into account

when determining the global exposure of the

UCITS fund. The EPM techniques and instruments

must fulfill the criteria set out by the EAD: (a)

economically appropriate and (b) entered into

with one of these aims: (i) reduction of risk, (ii)

reduction of cost, (iii) generation of additional

capital or income of a UCITS fund with an

appropriate level of risk, or (iv) their risks are

adequately captured by the risk management

process for a UCITS fund.

Covered Bonds

Until now there has been no U.K. legislative

framework for the issue of covered bonds. New

rules permit a UCITS fund to invest up to 25% of

its assets in one or more covered bonds issued by

the same issuer, subject to an overall limit of 80%

to covered bonds as an asset class.

Guarantees and Indemnities

The EAD stipulates that indemnities will be

given between the parties to a UCITS fund,

that is, between the manager and trustee of a

unit trust, and between an Investment Company

with Variable Capital (“ICVC”), its directors and

its depositary, subject to the fund documents

permitting such payments from scheme property

and provided that depositaries are satisfied that

there are no undue risks to unitholders. Similarly,

where the ICVC or the depositary is delegating

a function within the limits permitted by UCITS III,

it is permissible in principle for them to give

a guarantee or indemnity on behalf of the

UCITS fund.

Further Developments

The Committee of European Securities Regulators

has introduced UCITS IV, with the following goals:

•Removeadministrativebarrierstothecross-

border distribution of UCITS funds;

•createaframeworkformergersbetween

UCITS funds;

•allowtheuseofmaster-feederstructures;

•replacethesimplifiedprospectusby

introducing a new concept of key investor

information; and

•improvecooperationmechanismsbetween

national supervisors.

If the proposal is adopted by the E.U. Council

of Ministers and the European Parliament in the

second quarter of 2009, its provisions will come

into force by mid-2011.

Fall 2008 15

Four Traders – National Australia Bank (2004)

In 2003, four traders on the NAB foreign

exchange option trading desk decided that the

U.S. dollar would rise after a September 2003

meeting of G-7 ministers. The traders took long

positions in the U.S. dollar utilizing options, spots

and forwards. Instead, the dollar fell, resulting in

losses of £360 million. The data posted at 8:00

a.m. was automatically included in NAB’s general

ledger and was the basis on which company

profits and traders’ bonuses were determined.

The traders would enter false transaction data

into the NAB system at about 8:00 a.m., and

just before 9:00 a.m., the system allowed them

to revise incorrect transaction prices and reverse

false trades without affecting profits resulting from

the earlier postings.

Brian Hunter – Amaranth Advisors (2006)

Hunter was hired to trade natural gas for a private

hedge fund managed by Amaranth. In 2005,

he made $1 billion for the fund (and $25 million

in bonuses for himself) by correctly betting that

Nick Leeson – Barings Bank (1995)

Leeson was the floor manager for Barings’

trading on the Singapore International Monetary

Exchange. He was also in charge of his office’s

settlement operations and records, which was

responsible for that office’s accounting system,

books and records. Leeson’s primary job involved

Barings’ arbitrage business; however, over

the years, he began to place big bets on the

Japanese yen utilizing futures contracts. Because

he was in charge of the office’s settlement

operations and records, he was able to alter his

branch’s records to hide over £800 million of

losses produced by his trades.

John Rusnak – Allfirst Bank (2002)

Rusnak was a foreign exchange trader authorized

to conduct an arbitrage operation at Allfirst Bank.

Sometime in 1997, he decided that the dollar

would fall against the yen and began to build

unhedged positions by purchasing yen for future

delivery. As the dollar instead rose during the

next few years, Rusnak tried to recoup losses

by increasing the value of his trades. In order

to cover up the losses, Rusnak created fictitious

options positions that gave the impression his real

positions were hedged. He was able to hide his

activities from the bank’s risk management system

because the group responsible for managing the

risk level of his trading positions relied on data in

spreadsheets that Rusnak prepared.

Continued from page 1

Major Rogue Trader Cases and Their Compliance Program Implications

Traders are gamblers by nature. While their activities are an important part of the business strategies of some firms, their “bets” also present potentially significant financial and regulatory risks.

natural gas prices would rise after Hurricane

Katrina hit the U.S. Gulf Coast. In the spring of

2006, Hunter’s group decided that natural gas

prices would fall at the same time fuel and heating

oil prices rose. At about this time, Amaranth lost

Hunter’s experienced supervisor, who left to start

his own fund. Although the traders’ bet paid off

for a number of months, in September, the markets

moved against their positions. During that one

month, the hedge fund lost $6 billion of its $9.6

billion in total net assets.

Jerome Kerviel – Société Générale (2008)

Kerviel worked on the European equity derivatives

desk of Société Générale --one of the world’s

leading equity derivatives trading firms. In the

summer of 2007, he reportedly began to acquire

large, unauthorized positions of futures contracts

on European stock indices. Initially, he bet the

market would fall and later that it would rise. Both

times, he was wrong. It has been reported that

at the time his positions were discovered, they

totaled €50 billion. Société Générale incurred €7

billion in losses as a result of the trades and from

unwinding Kerviel’s positions.

Kerviel had worked both in compliance and in

Société Générale’s middle office before becoming

a trader. His knowledge of systems allegedly

allowed him to input fictitious trades that offset

the real ones. It was reported that this went

undetected because the fictitious entries involved

certain types of options for which the systems

16 Investment Management Update

permitted the names of counterparties to be

omitted and which were not reviewed by Société

Générale’s back office until shortly before the

options expired.

Official Responses

A number of U.S. and European governmental

organizations responsible for financial institutions

promptly issued responses to the Société

Générale events.

The Financial Services Authority issued Market

Watch No. 25 in March 2008. The FSA

encouraged firms to contact the FSA if they had

suspicions of unauthorized trading. The FSA

discussed a number of possible systems and

controls that firms “should consider” that may be

effective for trading operations. The Financial

Industry Regulatory Authority issued Regulatory

Notice 08-18 in April 2008. FINRA stated that

the notice was intended “to highlight sound

practices for firms to consider” as they review their

internal controls and risk management systems for

trading activities.

The Committee of European Banking Supervisors

(“CEBS”) on July 18, 2008, issued a report titled

“Reactions to the Société Générale Loss Event:

Results of the Stock-Take.” CEBS conducted

a stock-take “on how [the Société Générale]

event affected other banks, their operational

risk practices, governance and internal control

environment.” Seventeen supervisory authorities

and nearly 100 banking groups participated.

Based on the survey, CEBS reached a number of

conclusions, including the following: the “main

drivers” for the Société Générale event were

- failure to adequately enforce segregation of

duties; lack of adequate IT controls; weakness in

management routines; inadequate monitoring and

reporting systems; and weak escalation policies.

Not surprisingly, the banks surveyed did not

believe it is likely they will have an event of the

same dimension. Rogue trading may occur more

often than is generally believed. Some banks

responded that they “have recently experienced

rogue trading events of lesser magnitude.” The

Société Générale problems have caused many

banks to review their own policies, procedures

and practices.

Common Threads

and Red Flags

A number of common facts are present in many

(although not all) of these cases: traders were

relatively young; traders became “superstars”

overnight; traders had a high degree of

autonomy; both the traders and their supervisors

resisted efforts to impose controls over the traders;

and traders were able to enter orders and data

with little or late independent review.

In many of these cases, there were numerous

events that might be considered red flags requiring

further attention from management, compliance

officers and risk management personnel. In some

cases, management may have ignored the red

flags - unusually large profits by a trader from a

supposedly conservative investment strategy; big

jump in a trader’s profits from one year to another;

questions raised by other employees; questions

from dealers who execute trades and exchanges

on which trades are executed; trader and/

or supervisor resists financial controls; frequent

overrides by PM’s of valuations from independent

sources of investment positions received from

independent sources; and high number of

unsettled, cancelled or amended trades.

Compliance and Controls

Traders are gamblers by nature. While their

activities are an important part of the business

strategies of some firms, their “bets” also present

potentially significant financial and regulatory

risks. The cases summarized above offer a number

of compliance and controls lessons that financial

institutions should consider:

•Firmsshouldfostera“cultureofcompliance.”

•Separationofdutiesshouldbestrictly

enforced.

•Exceptionstopoliciesshouldbeclearly

justified and rarely given.

•Performancerewardsshouldnotbea

one-way bet.

•Tradersshouldnotbepermittedtoutilize

products or strategies that they or their

supervisors do not understand.

•Firmsshouldinsistthatemployees

take vacations.

•Policiesandproceduresshouldrequire

that questions about trading activities be

escalated.

•IT-relatedcontrolsshouldbedesignedto

prevent traders from canceling, deleting

or overriding entries in systems.

•Tradersshouldnotbepermittedtooverride

valuations without formal, independent

approval.

•Complianceprogramsshouldrequire

automatic reporting and review of unusual

patterns of cancelled or amended trades,

overrides of valuations, trading limit

breaches, fails to deliver and delays in

confirmations and settlements of trades.

•Firmsshouldhaveapolicyandprocedures

designed to assure that new or complex

instruments or strategies cannot be utilized

without adequate knowledge, back office

systems, risk management measures and

compliance programs.

•Thereshouldbeclearandunambiguouslines

of reporting and accountability between a

parent company and its overseas units.

Fall 2008 17

It is clear that the next Administration and Congress will engage in the most significant tax debate in a generation. At stake will be important decisions regarding $4 trillion in tax law provisions, many of them set to expire in 2010.

Continued from page 1

The Upcoming Federal Tax Policy Debate: Are You Prepared?

This upcoming tax debate raises many questions

for individuals, businesses, and nonprofit

organizations such as:

•Willchangesinthetaxrulesforordinary

income, capital gains, and dividends

significantly alter the after-tax return

on investments?

•Whatwillhappentocorporatetaxrates?

•Willcertaintaxbenefitsbeonthechopping

block labeled by policy makers as

“loopholes?”

•Howwillchangesintheforeigntaxrules

affect international operations?

•Isthereachancethatnewtaxincentivescan

be enacted in these turbulent times?

The Political Setting Although it is impossible to predict the outcome

of the upcoming elections, there will be a

new Administration, and there is likely to be a

Democratic Congress with larger majorities in

both the House and Senate than exist today. New

presidents tend to push major tax bills quickly to

follow through on campaign promises and to take

advantage of the “honeymoon” period. If history

is any indication, there is a significant chance that

major tax legislation will be considered early in

2009, at a pace much faster than the usual pace

of tax legislation.

The Impending Expiration of the

2001 and 2003 Tax Cuts The new Administration and Congress will

immediately confront major tax policy issues.

The reasons are budgetary and structural. The

most recent Office of Management and Budget

projections show the projected 2009 federal

budget deficit to be $482 billion ($663 billion

if the deficit does not include the Social Security

surplus). Although this deficit is projected to turn

into a surplus by 2012, this projection assumes

the 2001 and 2003 tax cuts will be allowed

to expire as scheduled in 2010. The 2010

expiration date structurally embedded in the tax

code now serves as a trigger that will force the

new President and Congress to quickly choose

among competing priorities.

Thus far, the principal political debate, particularly

in the presidential campaign, has been whether

to extend some or all of the 2001 and 2003

tax cuts. According to the Joint Committee on

Taxation, permanently extending the 2001 and

2003 tax cuts would cost $3.3 trillion over ten

years. Regardless of who controls the White

House, there will be overwhelming bipartisan

support for extending portions of the 2001

and 2003 tax cuts that benefit middle- and

lower-income taxpayers. But extending even

some of these tax cuts will cost a small fortune.

For example, making the $1,000 child credit

permanent would cost $360 billion over the next

ten years. Extending relief from the marriage

penalty would cost $100 billion. On top of this,

18 Investment Management Update

Congress wants to limit the growing reach of the

Alternative Minimum Tax (AMT), which will cost

nearly $62 billion in 2008 alone to protect 25

million taxpayers from the AMT. The tax code

contains dozens of other temporary but worthy

policies, like the research and experimentation tax

credit and the deduction for college tuition, that

expire year-to-year and whose extensions will cost

at least another $25 billion annually.

The next Congress may not approve all of this

tax relief. But it will enact a substantial part. A

conservative estimate of the cost is at least $1

trillion (over ten years)—and it could be as much

as $2 trillion. On top of that, there are likely to be

new initiatives to address health care, education,

energy independence, and retirement security that

will necessarily involve changes to the tax code.

Thus, whatever the outcome of the presidential

election, there is likely to be an intense search

for politically palatable tax increases next year.

Even if the economy continues to sputter, the new

president could decide that economic stimulus

proposals should be considered first, and that

major tax increases are inconsistent with economic

stimulus; but that will only delay tax increases,

not prevent them. Before too long into 2009, the

Administration and Congress will have to confront

the impending expiration of the tax cuts, and will

require significant offsetting tax increases in an

effort to reduce the deficit.

Where will the New President and

Congress Look for Additional Revenue?

Next year there will be an intense search by

the new Administration and Congress for ways

to increase Federal tax receipts without broadly

raising tax rates. Consequently, politically

acceptable revenue options that can be

characterized as “loophole” closers or proposals

to reduce the tax gap will be high on the agenda.

Many of the likely revenue-raising proposals

can be identified today. The starting point is

proposals that have passed the House or Senate

but have not been enacted into law. One can

look to proposals made by major players such as

the chairmen of the tax committees, the Treasury

Department, and the Joint Committee on Taxation.

Some of the revenue-raising proposals that

are likely to receive serious consideration next

year include:

•changingtherulesforhedgefunds

and private equity funds, including

treating certain types of publicly traded

limited partnerships as corporations and

characterizing carried interest as ordinary

income rather than capital gain;

•repealingthesection199manufacturing

deduction;

•repealingorlimitingtaxprovisionsbenefiting

the oil and gas industries;

•repealinglowerofcostormarketand

last-in, first-out” (LIFO) methods of inventory

accounting;

•codifyingthe“economicsubstancedoctrine”

regarding tax shelters;

•limitingdeductibilityofexecutivepayand

curbing deferred compensation;

•changingtaxlawsaffectinginternational

activities, including deferral of income

earned abroad and eligibility for reduced

treaty withholding rates based on residency

of foreign parent;

•increasingreportingrequirements,including

basis reporting by securities brokers;

•changingthetaxtreatmentofvariousfinancial

products, like exchange-traded notes;

•clarifyingtheclassificationofemployeesas

independent contractors;

•increasingtheamortizationperiodfor

intangibles from 15 to 20 years; and

•increasingvariousexcisetaxes,suchas

on tobacco products, various aspects of

air and highway transportation, and tax-

exempt organizations.

It is likely that revenue-raising proposals

will be embedded in major tax initiatives

put forth by the new Administration and

approved by Congress under the fast-track

budget reconciliation process. These offsets

will be juxtaposed against popular tax relief

measures, making it politically difficult for

adversaries to oppose them.

Conclusion

It is clear that the next Administration and

Congress will engage in the most significant

tax debate in a generation, so it is critical

to prepare now. The tax debate has already

begun, and major decisions about the

country’s economic future will be made within

the next twelve months.

As this debate unfolds, undoubtedly there

will be winners and losers. Each taxpayer

will have different risks. Take the time to spot

issues that may affect your bottom line or

impact your organization, and understand

the details. There will be opportunities to seek

tax policies that will be beneficial to you,

so understanding what tax changes would

improve your competitiveness is crucial as well.

Those that are engaged in the process—

that is, educating policy makers today

about the benefits or consequences of

certain proposals—likely will have a more

successful outcome.

Fall 2008 19

Mark D. Perlow: Issues in the Derivatives Markets, Equity, Fixed Income and Derivatives Market Conference, Investment Company Institute, October 6, 2008, New York, NY

Mark D. Perlow: Trading and Soft Dollars and Business Continuity, Compliance Workshops, Investment Adviser Association, October 15 and 16, 2008, Los Angeles, CA and San Francisco, CA

Clifford J. Alexander, Michael S. Caccese, Mark P.

Goshko, Michael J. King and Ndenisarya Meekins: NSCP National Membership Meeting, October 20, 21, 22, 2008, Philadelphia, PA

Francine J. Rosenberger: Fall 2008 Compliance Workshop, Investment Adviser Association, November 5, 2008, Houston, TX

David Dickstein: Advisers Act: Sections 201-205, NRS Center for Compliance Professionals, November 11, 2008, New York, NY

Diane E. Ambler: Synthetic Annuities: Securities, Tax and Insurance Issues, 26th Annual Advanced ALI-ABA Conference on Life Insurance Company Products, November 13 and 14, 2008, Washington, D.C.

Thomas Hickey III: State Association of County Retirement Systems, November 13, 2008, Costa Mesa, CA

Mark D. Perlow: Recent Market Events, Ernst & Young Hedge Fund Symposium, November 13, 2008, San Francisco, CA

Robert J. Zutz: Board Meeting Simulation: From Fund Inception to Termination, Investment Company Directors Conference, Independent Directors Council, November 19–21, 2008, Chicago, IL

Josefina Fernandez McEvoy: Insolvency and the Increasing Role of Distressed Investment firms in the Pacific Rim; New Challenges and Opportunities in Asia, American Bankruptcy Institute Leadership Conference, December 5, 2008, Tucson, AZr

Industry Events

Please visit our website at www.klgates.com for more information on the following upcoming

investment management events in which K&L Gates attorneys will be participating:

Please join us for our 2008 Investment Management Training SeminarsAt these seminars, lawyers from our Investment Management practice will discuss a broad range of topics and practical issues. Each program will feature a “Hot Topics” panel discussing current issues confronting the investment management industry.

To register for this event, please go to www.klgates.com/events or for additional information e-mail invmgmt@klgates.com

Wednesday and Thursday, November 5 and 6Live at K&L Gates inWashington, DC and video conferenced to K&L Gates Dallas, K&L Gates Miami; K&L Gates Newark and K&L Gates Pittsburgh

Wednesday, November 12 Live at K&L Gates Boston

Tuesday, November 18 Live at the W Hotel San Francisco

Wednesday, November 19 Live at K&L Gates Los Angeles

Wednesday, December 3 Live at K&L Gates New York

Coming this Fall at our Boston, San Francisco, New York and Washington, D.C. offices and via Webinar:

How To Prepare For An Sec ExaminationThis program will provide practical suggestions for hedge fund managers to prepare for an SEC examination. The topic will be addressed from the standpoint of advisers managing hedge funds and/or separate accounts as well as an adviser with an affiliated broker/dealer. Topics to be discussed include pointers on preparing for and managing an SEC examination, SEC hot button topics, including valuation, short selling, insider trading, market manipulation, conflicts of interest and testing compliance procedures.

October 7, 2009 — BostonOctober 29, 2008 — San FranciscoNovember 12, 2008 — New York November 19, 2008 — Washington, D.C.

Live and via Webinar

To register for this event, please go to www.klgates.com/events

Special London Event

Please join our London office on Monday, January 26, 2009

for our fifth annual one-day workshop for SEC-registered Investment Advisers with offices or affiliates in the U.K., FSA-authorized Investment Managers and hedge fund/fund of fund managers on

Critical Regulatory Issues for International Fund Managers and Investment Advisers

Presented by Clifford J. Alexander, Danny Brower, Daniel F. C. Crowley, Edward G. Eisert, Robert V. Hadley, Cary J. Meer, Philip J. Morgan, Neil Robson and Francine J. Rosenberger

K&L Gates comprises approximately 1,700 lawyers in 28 offices located in North America, Europe and Asia, and represents capital markets participants, entrepreneurs, growth and middle market companies, leading FORTUNE 100 and FTSE 100 global corporations and public sector entities. For more information, visit www.klgates.com.

K&L Gates comprises multiple affiliated partnerships: a limited liability partnership with the full name K&L Gates LLP qualified in Delaware and maintaining offices throughout the U.S., in Berlin, in Beijing (K&L Gates LLP Beijing Representative Office), and in Shanghai (K&L Gates LLP Shanghai Representative Office); a limited liability partnership (also named K&L Gates LLP) incorporated in England and maintaining our London and Paris offices; a Taiwan general partnership (K&L Gates) which practices from our Taipei office; and a Hong Kong general partnership (K&L Gates, Solicitors) which practices from our Hong Kong office. K&L Gates maintains appropriate registrations in the jurisdictions in which its offices are located. A list of the partners in each entity is available for inspection at any K&L Gates office.

This publication is for informational purposes and does not contain or convey legal advice. The information herein should not be used or relied upon in regard to any particular facts or circumstances without first consulting a lawyer.

©2008 K&L Gates LLP. All Rights Reserved.

To learn more about our Investment Management practice, we invite you to contact one of the lawyers listed below, or visit www.klgates.com.

BostonJoel D. Almquist 617.261.3104 joel.almquist@klgates.com

Michael S. Caccese 617.261.3133 michael.caccese@klgates.com

Mark P. Goshko 617.261.3163 mark.goshko@klgates.com

Thomas A. Hickey III 617.261.3208 thomas.hickey@klgates.com

Nicholas S. Hodge 617.261.3210 nicholas.hodge@klgates.com

Clair E. Pagnano 617.261.3246 clair.pagnano@klgates.com

Rebecca O’Brien Radford 617.261.3244 rebecca.radford@klgates.com

George Zornada 617.261.3231 george.zornada@klgates.com

Hong Kong Navin K. Aggarwal +852.2230.3515 navin.aggarwal@klgates.com

London

Danny A. Brower +44.20.7360.8120 danny.brower@klgates.com

Philip J. Morgan +44.20.7360.8123 philip.morgan@klgates.com

Los Angeles William P. Wade 310.552.5071 william.wade@klgates.com

New York David Dickstein 212.536.3978 david.dickstein@klgates.com

Edward G. Eisert 212.536.3905 edward.eisert@klgates.com

Kay A. Gordon 212.536.4038 kay.gordon@klgates.com

Alan M. Hoffman 212.536.4841 alan.hoffman@klgates.com

Beth R. Kramer 212.536.4024 beth.kramer@klgates.com

San Francisco Elaine A. Lindenmayer 415.249.1042 elaine.lindenmayer@klgates.com

J. Matthew Mangan 415.249.1046 matt.mangan@klgates.com

David Mishel 415.249.1015 david.mishel@klgates.com

Mark D. Perlow 415.249.1070 mark.perlow@klgates.com

Richard M. Phillips 415.249.1010 richard.phillips@klgates.com

Seattle James A. Andrus 206.370.8329 james.andrus@klgates.com

Taipei Christina C. Y. Yang +886.2.2175.6797 christina.yang@klgates.com

Washington, D.C. Clifford J. Alexander 202.778.9068 clifford.alexander@klgates.com

Diane E. Ambler 202.778.9886 diane.ambler@klgates.com

Mark C. Amorosi 202.778.9351 mark.amorosi@klgates.com

Catherine S. Bardsley 202.778.9289 catherine.bardsley@klgates.com

Arthur C. Delibert 202.778.9042 arthur.delibert@klgates.com

Stacy L. Fuller 202.778.9475 stacy.fuller@klgates.com

Jennifer R. Gonzalez 202.778.9286 jennifer.gonzalez@klgates.com

Robert C. Hacker 202.778.9016 robert.hacker@klgates.com

Kathy Kresch Ingber 202.778.9015 kathy.ingber@klgates.com

Deborah A. Linn 202.778.9874 deborah.linn@klgates.com

Cary J. Meer 202.778.9107 cary.meer@klgates.com

Marc Mehrespand 202.778.9191 marc.mehrespand@klgates.com

R. Charles Miller 202.778.9372 chuck.miller@klgates.com

R. Darrell Mounts 202.778.9298 darrell.mounts@klgates.com

C. Dirk Peterson 202.778.9324 dirk.peterson@klgates.com

David Pickle 202.778.9887 david.pickle@klgates.com

Alan C. Porter 202.778.9186 alan.porter@klgates.com

Theodore L. Press 202.778.9025 ted.press@klgates.com

Francine J. Rosenberger 202.778.9187 francine.rosenberger@klgates.com

Robert H. Rosenblum 202.778.9464 robert.rosenblum@klgates.com

William A. Schmidt 202.778.9373 william.schmidt@klgates.com

Lori L. Schneider 202.778.9305 lori.schneider@klgates.com

Lynn A. Schweinfurth 202.778.9876 lynn.schweinfurth@klgates.com

Donald W. Smith 202.778.9079 donald.smith@klgates.com

Fatima S. Sulaiman 202.778.9223 fatima.sulaiman@klgates.com

Roger S. Wise 202.778.9023 roger.wise@klgates.com

Robert A. Wittie 202.778.9066 robert.wittie@klgates.com

Robert J. Zutz 202.778.9059 robert.zutz@klgates.com