INSURANCE DEDICATED FUNDS: PRIVATE PLACEMENT INSURANCE MAKE AN UNEXPECTED COMEBACKBY STEVEN HUTTLER AND ALEX GELINAS

Edited by: Douglas R. Hirsch • dhirsch@sglawyers.com

WE PRACTICE LAW BUT WE LIVE BUSINESS

JANUARY 2015

Client Alert

On November 5, 2014, the U.S. Commodity Futures Trading Commission (“CFTC”) issued a no-action letter (“CFTC Letter 14-143”) regard-ing registration requirements for family offices. This letter was similar to CFTC Letter 12-37 which stated that family offices did not have to register as commodity pool operators (“CPOs”) if

they sent a notice to the CFTC identifying them-selves as family offices. CFTC Letter 14-143 extended this position to commodity trading advisors (“CTAs”). Thus, family offices that sat-isfy the U.S. Securities and Exchange Commis-sion’s definition of a “family office” must also

Family Offices Granted Relief From Registration As Commodity Trading AdvisorsBY DANIEL G. VIOLA

■ Inside this Issue 1 Insurance Dedicated Funds: Private

Placement Insurance Make an Unexpected Comeback

1 Family Offices Granted Relief From Registration As Commodity Trading Advisors

4 Insider Trading After the Newman Decision

7 The Latest On Virtual Currency

9 Private Equity Update: In Case You Missed It…

10 Sadis & Goldberg Wins 195% Above Merger Price for Cashed-Out Orchard Stockholders

10 Compliance Calendar For Investment Advisers – First Quarter 2015

11 SEC Adopts Recommendations for Changing Accredited Investor Definition

12 Upcoming Events

The alternative tax-motivated strategy of invest-ing in private investment funds through “insur-ance wrappers” has been around for close to two decades. During that period, such insurance products have waxed and waned in popularity with investors and the managers who create dedicated funds for use in such products. Recent federal and state tax increases, together with market develop-ments in the private investment world, have com-bined to strongly rekindle interest in this seem-ingly dated structure.

U.S. high net worth individuals and their advis-ers have long known that a great performing

investment, including various hedge fund strategies, can sometimes become mediocre once federal and state taxes are taken into account. Under the tax rules applicable to hedge fund partnerships, U.S. limited partners are subject to income tax on their allocable share of the part-nership’s net income for the year, regardless of whether any cash distributions are received from the partnership to even fund the payment of such tax liabilities. Further, many successful hedge funds pursue trading strategies that generate

Recent federal and state tax increases, together with market developments in the private investment world, have combined to strongly rekindle interest in this seemingly dated structure.

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substantial amounts of short-term capital gain and/or ordinary income, rather than only long-term capital gains or qualified dividends eligible for favorable tax rates. Two obvious examples: funds that trade a high volume of transactions (e.g., quantitative/black box strategies); and funds that are focused on fixed income, or fixed income like, portfolio holdings.

These tax inefficiency issues have been wors-ened by the 2013 federal tax law amendments which raised federal income tax rates on ordinary income, short-term capital gains and even long-term capital gains.

Investment industry participants have been responding to these developments through a renewed deployment of the insurance wrapper structures. For example, in 2013, Henry Paulson teamed up with insurer Philadelphia Financial Group to allow investors to put money into Paul-son’s merger-arbitrage strategy either through a life insurance policy that provides a tax-free death benefit to the beneficiaries or an annuity contract that provides tax deferral. Other insurance compa-nies that have issued products of this type include MassMutual, AIG, New York Life, Phoenix Co.’s AGL Life Assurance Company, Prudential, John Hancock

and Crown Global Insurance. The increase in these products is self-perpetuating: the more products there are available to those that invest through insurance wrappers, the more attractive they become, as investors legally may switch manag-ers within the wrapper, if the alternative funds are also established to accept such monies.

Sadis & Goldberg has seen a surge of interest in these products in the last twelve months. Our cli-ents and friends in the service provider community report similar experiences. Accordingly, we have decided to provide our readers with the following summary of some of the most important and basic information concerning these structures and their tax benefits:

Structure of Insurance Wrapper Transaction. In a typical “insurance wrapper” transaction, a U.S.

high net worth individual purchases a variable life insurance policy or annuity from an insurance company and the insurance company invests the proceeds in one or more hedge funds. The hedge fund investments are held by the insur-ance company in a segregated asset account (the “separate account”). The individual thus achieves effective exposure to the performance of the hedge fund investments, not directly, but as owner of the variable life insurance policy or annuity contract.

Summary of U.S. Tax Advantages. One of the primary U.S. income tax advantages of the struc-ture is deferral of income taxes for the investor in the policy. The insurance company is the legal and tax owner of the hedge fund investments held in its separate account, so it receives the partnership K-1 forms each year. The owner of the insurance contract has no income to report with respect to the realized or unrealized gains and other income generated by the underlying hedge funds (known as the “inside build-up” in the policy or annu-ity) unless the owner withdraws funds from the insurance or annuity contract. In the event of the death of the insured person under a policy which provides a death benefit, the designated ben-eficiary would receive such death benefit free of U.S. income taxes. Other income withdrawn from the policy is generally taxed as ordinary income tax rates. However, certain policies can be struc-tured to permit the owner to borrow funds from the insurance company and avoid current income taxation of such amounts.

Tax Law Diversification Requirements; For-mation of Insurance-Dedicated Funds. In order for the policyholder to qualify for the income tax advantages described above, the insurance company, on behalf of the policy owner, may only invest in private investment funds that (1) admit insurance companies (and their affiliates) as certain qualified investors; and (2) meet the investment diversification rules of section 817(h)

Insurance Dedicated Funds: Private Placement Insurance Make an Unexpected Comeback (continued from page 1)

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notify the CFTC to avoid CPO and CTA registra-tion. Specifically, the notice must:

■ State the name, main business address, and main business telephone number of the Family Office claiming the relief;

■ State the capacity (i.e., CTA) and, where applicable, the name of the pool(s), for which the claim is being filed;

■ Be electronically signed by the Family Office; and

■ Be filed with the Division using the email address dsionoaction@cftc.gov with the subject line “Family Office CTA Relief.”

If you would like to read CFTC Letter No. 14-143, click on the link below:http: //www.cftc.gov/ucm/groups/public/@lrlettergeneral/documents/letter/14-143.pdf

Daniel G. Viola is a Partner and Head of the Regulatory Compliance Group of Sadis & Goldberg. He structures and organizes broker-dealers and investment advisers and regularly counsels investment professionals in connection with regulatory matters. Dan can be reached at 212.573.8038, or dviola@sglawyers.com.

Client Alert: Family Offices Granted Relief From Registration As Commodity Trading Advisors (continued from page 1)

One of the primary U.S. income tax advantages of the structure is deferral of income taxes for the investor in the policy.

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shown an increased interest in embracing IDFs as an alternative, dramatically tax-efficient method of participating in hedge fund investments, to the extent that their investment horizon is long term. Of course, hedge fund managers that are inter-ested in attracting new investors would do well to offer products that appeal to these investors: in other words, establish “clone” funds that con-stitute IDFs. This is particularly true if the fund manager pursues one of the “tax inefficient” strategies mentioned above. Separately, family offices and HNW investors with long term invest-ment horizons should give serious consideration to establishing “proprietary” or “internal” IDFs, through which they can invest in multiple other funds and assets.

Steven Huttler is a Partner in Sadis & Goldberg’s Financial Services Group. He has extensive experience in corporate, investment and securities matters, including the representation of investment funds, U.S. and foreign issuers and underwriters in offering of debt and equity securities. Steven can be reached at 212.573.8424, or at shuttler@sglawyers.com.

Alex Gelinas is a Partner in the Tax Group of Sadis & Goldberg. Mr. Geli-nas focuses his practice on providing tax advice to investment managers of hedge funds, private equity funds and other investment funds on all aspects of their businesses, including management entity and fund formation, partnership taxation issues, compen-sation arrangements and ongoing investment activities and transactions. Mr. Gelinas also provides tax advice to U.S. pension funds, sovereign wealth funds and other U.S. and foreign institutional investors in connection with their investments in private equity funds, hedge funds and U.S. joint ventures. He also has extensive experience in providing tax planning advice to high-net-worth individuals and families. Alex can be reached at 212.573.8159, or agelinas@sglawyers.com.

of the Internal Revenue Code. With respect to the first requirement, a private hedge fund that only permits insurance companies to invest in the fund would qualify (hence the term “insurance-ded-icated fund” or “IDF”). The diversification rules generally require that the assets held in a seg-regated asset account of the insurance company must meet certain mathematical diversification tests. In order to satisfy such tests, it is necessary for a hedge fund held in the separate account to qualify for “look-through” treatment to its under-lying securities portfolio. The Code provides that such look through treatment will apply only if (1) insurance companies (or their affiliates) are the only entities holding interests in the hedge fund (other than the investment manager of the fund) and (2) public investment in the fund is available exclusively through the purchase of a variable insurance policy. Most insurance companies now comply with the diversification requirements by requiring hedge fund managers to establish sepa-rate clone funds open only to insurance companies as specified in applicable tax regulations.

Investor Control Issues. The Internal Revenue Service (“IRS”) will not respect the legal form of these variable insurance contracts, if the owner of the variable policy has “direct investment control and can exercise other incidents of own-ership” over the assets underlying its policy. If such rule is violated, the policy owner rather than the insurance company would be treated as the tax owner of the underlying hedge funds, and the tax deferral advantages discussed would disap-pear. The IRS has determined that it is permis-sible for an investor in the policy to choose from a menu of underlying funds or fund managers. The policy investor is not permitted to have input on specific investments made by the underlying IDF manager.

Special Tax Considerations for the Fund Manager. Under current IRS interpretations of the tax rules relating to these insurance prod-ucts, the fund manager’s equity interest in the IDF must be calculated in the same manner as the investment return provided on the equity interest in the IDF that is held by the insurance company separate account. This means that the manager’s incentive compensation must be structured as a performance fee (taxable as ordinary income) rather than a partnership carried interest allo-

Insurance Dedicated Funds: Private Placement Insurance Make an Unexpected Comeback (continued from page 2)

…the manager’s incentive compensation must be structured as a performance fee (taxable as ordinary income) rather than a partnership carried interest allocation.

cation. If the IDF’s trading strategy generates short-term capital gains and ordinary income, rather than long-term capital gains or qualified dividends, the use of such performance fee struc-ture instead of a carried interest allocation gener-ally would not result in a substantial increase in taxes for the manager.

Important “Takeaways” and Observations: the Business/Financial Opportunity. The IDF structure has several distinct and important impli-cations for the following different constituents of the world of alternative investments: high net worth individuals, family offices and investment managers. HNW investors and their advisers have

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The Government must prove both that the tipper received a valuable personal benefit in exchange for disclosing confidential information and that the tippee who traded know of that benefit.

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INSIDER TRADING AFTER THE NEWMAN DECISIONU.S. v. Newman, — F.3d —, 2014 WL 9611278 (2d Cir., Dec. 10, 2014)BY DOUGLAS R. HIRSCH, JENNIFER ROSSAN, AND SAMUEL J. LIEBERMAN

On December 10, 2014, the Second Circuit issued a decision reversing the insider trading convictions of Todd Newman and Anthony Chiasson and ordering the dismissal of their indictments with prejudice. The decision has been the talk of the legal com-munity and Wall Street, as it represents a rare loss for U.S. Attorney Preet Bharara in his signature insider trading crackdown—indeed it appears to represent just his second and third losses after the Rengan Rajaratnam trial. This decision is likely to give rise to a number of other reversals of convictions, thereby representing a serious set-back for the U.S. Attorney’s Office, and, by logical extension, the Securities and Exchange Commission (“SEC”).

The Newman decision is surprising in that it reverses the convictions while making very little, if any, new law. In short, the decision simply re-examines the Supreme Court’s 1983 land-mark decision in SEC v. Dirks. Newman instructs that Dirks has been the law for over thirty years, and sets a high bar for prosecutors seeking to bring an insider trading case against a remote tippee: The Government must prove both that the tipper received a valuable personal benefit in exchange for disclosing confidential information and that the tippee who traded knew of that benefit. Until now, the Government had successfully argued in many cases that it only had to prove that the tipper received an abstract, intangible personal benefit and that the tippee only needed to know that infor-mation was disclosed in breach of a duty to keep it confidential.

The Decision

The Government’s case in Newman and Chiasson arose out of two tipping chains from insiders at Dell and NVIDIA. At the time of the alleged tips, Newman was a portfolio manager at Diamondback and Chiasson at Level Global.

Dell Tipping Chain

The evidence established that Rob Ray of Dell’s investor relations department tipped information regarding Dell’s consolidated earnings numbers to Sandy Goyal, an analyst at Neuberger Berman. Goyal then allegedly gave the information to Dia-mondback analyst Jesse Tortora. Tortora then

Newman and Chiasson four levels removed from the inside tippers.

The Second Circuit’s Explanation of Tipper-Tippee Liability

The Circuit noted that the original tippers—Ray and Choi—had not been charged administra-

tively, civilly or criminally for insider trad-ing or any other wrongdoing.

Yet the Government charged that Newman and Chiasson were liable criminally for insider trading because, as sophisti-cated traders, they must have known that information was disclosed by insiders in breach of a fiduciary duty, and not for any legitimate corporate purpose.

Although the Government conceded that tippee liability required proof of some type of personal benefit to the insider, it argued that it was not required to prove that Newman and Chiasson knew that the insiders at Dell and NVIDIA received a personal benefit in order to be found guilty of insider trading.

The Circuit emphatically rejected the Govern-ment’s position. It held that in order to sustain an insider trading conviction against a tippee, the Government must prove each of the following ele-ments beyond a reasonable doubt:

1. The corporate insider was entrusted with a fiduciary duty;

2. The corporate insider breached his fiduciary duty by (a) disclosing confidential informa-tion to a tippee (b) in exchange for a personal benefit;

3. The tippee knew of the tipper’s breach, that is, he knew the information was confidential and divulged for personal benefit; and

relayed the information to his boss, Newman, as well as to other analysts, including Level Global analyst Spyridon “Sam” Adondakis. Adonda-kis then passed along the Dell information to Chiasson.

So, Newman was three levels removed from the inside tipper and Chiasson was four levels removed from the inside tipper in the Dell chain.

NVIDIA Tipping Chain

The evidence in the NVIDIA tipping chain revealed that the tippee’s were even more remote then in the Dell chain. Chris Choi of NVIDIA’s finance unit tipped inside information to Hyung Lim, a former executive at technology companies Broadcom Corp. and Altera Corp., whom Choi knew from church. Lim passed the information to co-defendant Danny Kuo, an ana-lyst at Whittier Trust. Kuo circulated the infor-mation to a group of analyst friends, including Tortora and Adondakis, who in turn gave the information to Newman and Chiasson, making

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Insider Trading After the Newman Decision (continued from page 4)

4. The tippee still used that information to trade in a security or tip another individual for personal benefit.

The Court Rejects the Lower Court’s Jury Instruction as Fatally Flawed

In the case of Newman and Chiasson, the district court erroneously refused to instruct the jury that in order to be found guilty, Newman and Chias-son had to have known that the tippers received a personal benefit for their disclosure.

The Circuit noted that this mistake by the district court was critical. The Circuit explained that it is not enough if either defendant knew that an insider had divulged information that was required to be confidential—a breach of the duty of con-fidentiality is not fraudulent unless the tipper acts for personal benefit. The Circuit noted that “there is no breach unless the tipper ‘is in effect selling the information to its recipient for cash, reciprocal information, or other things of value for himself…’”1

The Circuit went on to analyze whether the evi-dence at trial satisfied all of the elements neces-sary to sustain the convictions. It concluded that there was insufficient evidence that the corporate insiders received any personal benefit in exchange for their tips.

As to the Dell tips, the evidence established only that Goyal and Ray had known each other for years and that Ray sought career advice from Goyal. As to NVIDIA, the evidence established that Lim and Choi were family friends who had met through church and occasionally socialized together. The Government argued that these facts established that the tippers derived some benefit from the tip.

The Circuit disagreed. Noting that while “per-sonal benefit” is broadly defined, the Government cannot prove the receipt of a personal benefit by the mere fact of friendship. Instead, the Govern-ment must provide “proof of a meaningfully close personal relationship that generates an exchange that is objective, consequential, and represents at least a potential gain of a pecuniary or simi-larly valuable nature.”2 This means proof of “a

Newman and Chiasson knew that they were trad-ing on information obtained from insiders or that those insiders received any benefit in exchange for the information or even that Newman and Chiasson consciously avoided learning those facts. But the Government was required to prove beyond a rea-sonable doubt that Newman and Chiasson knew that the insiders received a personal benefit in exchange for providing confidential information. It was undisputed that Chiasson and Newman, and even their analysts (who testified as cooperating witnesses for the Government), knew next to noth-ing about the insiders and nothing about what, if any, personal benefit had been provided to them. The Circuit rejected the Government’s argument that the jury could have found that Newman and Chiasson knew the insiders disclosed the infor-mation “for some personal reason rather than for no reason at all.” But the Circuit noted that the Supreme Court affirmatively rejected the premise that a tipper who discloses personal information necessarily does so to receive a personal benefit. Finally, the Court rejected the Government’s argu-ment that the specificity, timing, and frequency of the updates provided to Newman and Chias-son about Dell and NVIDIA were so “overwhelm-ingly suspicious” that they had to have known it was inside information. But the Court found that the evidence at trial undermined that inference because the financial information at issue was the kind that was regularly and accurately predicted by analyst modeling and the tippees are several levels removed from the source.

And, even if the detail and nature of the informa-tion could support an inference that it was inside information, it could not permit an inference as to that source’s improper motive for disclosure—especially in this case, where evidence showed that corporate insiders at Dell and NVIDIA regu-larly worked with analysts and selectively leaked information to financial firms who might be in a position to buy the company’s stock.

The Circuit Orders the Lower Court to Dismiss the Indictments Altogether

In a striking move, the Circuit also took the extraordinary step of instructing the district court

In the case of Newman and Chiasson, the district court erroneously refused to instruct the jury that in order to be found guilty, Newman and Chiasson had to have known that the tippers received a personal benefit for their disclosure.

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For these reasons, the Circuit found that it was impossible for a jury to have found beyond a rea-sonable doubt that Ray received a personal ben-efit in exchange for the disclosure of confidential information.

In the NVIDIA chain, the evidence established only that Choi and Lim were casual acquaintances. There was no history of loans or personal favors between the two. Lim testified that he did not pro-vide anything of value to Choi in exchange for the information. Lim also testified that Choi did not know that Lim was trading NVIDIA stock (and for the relevant period Lim did not trade stock), which undermined any inference that Choi intended to make a “gift” of the profits earned on any transac-tion based on confidential information.

Even if the evidence was sufficient to support and inference of a personal benefit—which it was not—the Government presented no evidence that

relationship between the insider and the recipient that suggests a quid pro quo from the latter, or an intention to benefit the [latter].”3

The Circuit found that the Government did not establish personal benefit in the Dell chain because: i) the career advice Goyal gave Ray was nothing more than would be expected from a fellow alumnus or casual acquaintance; ii) Goyal testified that he would have given Ray the advice without receiving information because he routinely did so for colleagues; iii) Ray disavowed that any quid pro quo existed, and iv) Goyal had been giving Ray career advice for over a year before Ray began providing any insider information.

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Insider Trading After the Newman Decision (continued from page 5)

on remand to dismiss the Newman and Chiasson indictments altogether. No retrial, just a dis-missal of the entire case. The Circuit reasoned that dismissal was warranted both because (i) the Government’s evidence of any personal ben-efit received by the alleged insiders was insuf-ficient to establish the tipper liability on which defendants’ tippee liability was based, and (ii) the Government presented no evidence that Newman and Chiasson knew that they were trading on information obtained from insiders in violation of those insiders’ fiduciary duties, the indictments were dismissed with prejudice.

Key Takeaways

The decision flatly rejects the Government’s and the SEC’s view that all trading based upon con-fidential information is illegal. With this in mind, we believe that the following points represent the more important ramifications of this decision.

■ The Government Will Bring Fewer Remote Tippee Cases: The Circuit’s holding that the Government must prove a tippee knew an insider breached a fiduciary duty by disclos-ing information and received a “quid pro quo” personal benefit makes it very hard to prove a case where the ultimate tippee is several steps removed from the original tipper. It will be difficult to prove the ultimate tippee knew that the original tipper received a personal benefit from disclosing insider information. Where inside information passes through sev-eral people, the ultimate tippee may not know of any personal benefit. The “quid pro quo” benefit that Newman requires must be “objec-tive, consequential” and represent at least a potential financial or similarly valuable benefit. This means the government’s prior reliance on abstract, intangible “benefits” such as friend-ship, career advice, mentoring, or network-ing—which had previously been thought to be sufficient—will no longer be enough to prove insider trading.

■ There is Evidence the SEC is Already Start-ing to Re-Evaluate Their Cases: Just three business days after the Newman decision, the SEC announced that it was dismissing an

insider trading claim against a man the SEC alleged had traded on a tip that Bill Ackman would short Herbalife’s stock. SEC v. Peixoto, Ad. Pro. No. 3-16184 (filed Sept. 30, 2014). Although the SEC claimed the dismissal was due to the unavailability of witnesses, the suspicious timing—plus the fact that the SEC’s tipper personal benefit allegations were based on friendship—strongly suggests the dismissal was a response to the Newman decision.

■ Not Very Likely the Supreme Court Will Review This Case: It is unlikely that the Supreme Court will grant a petition for cer-tiorari to review the Newman decision, since it is rare for that court to grant such a peti-tion. The Newman decision merely applied principles from the Supreme Court’s prior decision in Dirks v. SEC, 463 U.S. 646 (1983), giving the Supreme Court very little reason to re-visit Dirks. Further, the Newman deci-sion did not explicitly identify a Circuit-Split with decisions by other Circuit Courts, which is the primary basis for obtaining Supreme Court review. So although Newman does create some tension with the insider trading rulings of other Circuit Courts, its refusal to acknowledge a clear Circuit-Split may end up insulating it from review by the Supreme Court in the short-term.

■ Will Congress Fill the Void? Unlikely. Con-gress has the power to address the obstacles to bringing remote-tippee cases or weak per-sonal benefit cases that Newman has created. But, at least at this point, there does not appear to be any groundswell for Congress to take action on this point. In fact, if Congress were to address this issue, it would require Congress to enact a comprehensive insider

trading statutory scheme which presently does not exist.

■ The SEC Will Bring More Insider Trading Cases in Administrative Proceedings: With Newman making it harder to prove insider trad-ing, expect the SEC to bring more insider trad-ing cases before its own administrative law judges. Prior to Newman, the SEC had already begun bringing more insider trading cases in administrative proceedings involving judges employed by the SEC and it will almost cer-tainly increase the pace as it gets more diffi-cult to prove insider trading before judges that are not on the S.E.C’s payroll.

1 2014 WL 9611278.2 Id.3 Id.

Douglas R. Hirsch is the Partner in charge of Sadis & Goldberg’s Litiga-tion Practice. Mr. Hirsch’s practice is focused on hedge fund and securities litigation and he regularly represents both investors and investment advi-sors in a wide range of investment related disputes, such as fraud, breach of fiduciary duty, derviative actions, class actions, and SEC enforcement actions. Mr. Hirsch’s 25 years of litigation experience has encompassed a broad range of trials, class action litigations, arbitrations and mediations. Doug can be reached at 212.573.6670, or at dhirsch@sglawyers.com.

Jennifer Rossan practices in the firm’s Litigation Group. Ms. Rossan has extensive trial experience and has obtained successful verdicts for her clients in a number of large federal court trials. Ms. Rossan focuses her practice on a wide range of financial services disputes including SEC and FINRA enforcement actions. She also litigates complex commercial matters and employment law matters, including claims of wrongful termination and harassment, and negotiates and reviews employ-ment contracts. Jennifer can be reached at 212.573.8783, or jrossan@sglawyers.com.

Samuel J. Lieberman is a Partner in the Litigation Group at Sadis & Goldberg LLP. He has extensive experience handling all stages of high-profile securities class actions, complex commercial litigation, and government investigations. Sam can be reached at 212.573.8164, or slieberman@sglawyers.com.

…expect the SEC to bring more insider trading cases before its own administrative laws judges.

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Currently, there is somewhat limited regulatory guidance on virtual currencies, including Bitcoin.

Anyone planning to enter the virtual currency market in any capacity (including as an investor and/or as an asset manager) should keep in mind the uncertainties of this new and rapidly-evolving industry.

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Understanding Virtual Currency (Including Bitcoin)

Over the last few years, the terms virtual currency and Bitcoin have received a lot of coverage, both in layman’s press as well as in the investment management and hedge fund industry news. To understand the impact of virtual currency on the investment management industry, a brief sum-mary is in order.

Virtual currency is a generic term for unregulated digital money that: (i) is issued and controlled by developers rather than a cen-tral bank of a public author-ity, (ii) may be accepted as a means of payment; and (iii) can be transferred, stored and/or traded electronically. Bitcoin is a type of virtual cur-rency that was created in 2009 by a person using the alias of Satoshi Nakamoto; the definitive identity of the creator of Bitcoin has not been revealed. Bitcoin is the most recognized type of virtual currency. Unlike currencies issued by various governments (also known as fiat currencies), Bitcoin networks are operated on a de-centralized basis. Interest-ingly, the Bitcoin “industry” is referred to in many sources as the Bitcoin “ecosystem.” The total supply of Bitcoins is finite and approaches 21 million. There are no physical Bitcoins. Bitcoins are stored in, and paid out of, an owner’s “digital wallet” electronically, using special “keys”. There are a number of ways in which Bitcoins can be acquired, including trading on “Bitcoin exchanges” that allow people to buy Bitcoins using differ-ent currencies, or creating Bitcoins by “mining”, which means using computers to solve complex mathematical equations in exchange for receiving Bitcoins. Bitcoin payments are made directly, on an anonymous basis, with lower (or zero) trans-actions fees compared to traditional online pay-ment mechanisms, and without a bank acting as the middleman. One criticism of Bitcoin is that,

because of its anonymity, Bitcoin may be an attractive mode of payment for criminal activities, such as money laundering and drug trafficking. In addition, Bitcoin is generally an extremely volatile currency. Finally, unlike bank accounts, Bitcoin wallets are not insured by the U.S. Federal Deposit Insurance Corporation.

Regulatory Landscape

Currently, there is somewhat limited regulatory guidance on virtual currencies, including Bitcoin. On January 30, 2014, the U.S. Department of the

currencies, including Bitcoin, would be taxed as property rather than currency, and that gains or losses from Bitcoin held as capital will be realized as capital gains or losses, while Bitcoin held as inventory will incur ordinary gains or losses.

In addition to the foregoing guidance from the FinCEN and the IRS, the recent bankruptcy of the Bitcoin exchange Mt. Gox (which resulted in the loss of approximately $500 million of investors’ money), coupled with the continued expansion and acceptance of the virtual currency market, has prompted other federal and state regulators to explore additional avenues for regulating virtual currencies. For example, the Commodity Futures Trading Commission (“CFTC”), during its technol-ogy advisory committee meeting on June 3, 2014, indicated that it may consider the issue of Bitcoin.

Also, on June 3, 2014, in In the Matter of Erik T. Voorhees (“Voorhees”), the Enforcement Division of the U.S. Securities and Exchange Commission (“SEC”) brought an action against Voorhees for actively soliciting investors to buy shares in two companies (which investors purchased using Bit-coin) without registering the offerings under U.S. federal securities laws. The SEC found such offer-ings to be in violation of Section 5(a) and Section 5(c) of the U.S. Securities Act of 1933, as amended (“Securities Act”). The SEC stated that, “despite these general solicitations, no registration state-ment was filed for the offerings, and no exemption from registration was applicable to these transac-tions.” Voorhees agreed to cease and desist from committing or causing any future violations of the registration provisions without admitting or deny-ing the SEC’s findings. Notably, in addition to the monetary sanctions, Voorhees agreed that he will not participate in any issuance of any security in an unregistered transaction in exchange for any virtual currency, including Bitcoin, for a period of five (5) years. Furthermore, the SEC concluded that the entry of the SEC’s order disqualifies Voorhees from relying on Rule 506(b) and Rule

THE LATEST ON VIRTUAL CURRENCYBY YELENA MALTSER

Treasury’s Financial Crimes Enforcement Network (“FinCEN”) issued the following guidance on vir-tual currency: (i) to the extent a user creates or “mines” a convertible virtual currency solely for a user’s own purposes, the user is not a money transmitter under the Bank Secrecy Act (“BSA”); and (ii) a company purchasing and selling con-vertible virtual currency as an investment exclu-sively for the company’s benefit is not a money transmitter under the BSA. On March 25, 2014, the U.S. Internal Revenue Service (“IRS”) stated that, for U.S. federal income tax purposes, all virtual

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be published in early 2015, and will go into effect shortly thereafter.

Other states and/or federal agencies may choose to follow suit and propose and ultimately adopt similar regulations.

Practical Implications for Investors and/or Managers Interested in Virtual Currency

Anyone planning to enter the virtual currency market in any capacity (including as an investor and/or as an asset manager) should keep in mind the uncertainties of this new and rapidly-evolving industry. Investors should make sure that the vehi-cle in which they are investing is in compliance with applicable laws, including securities laws. Conversely, hedge fund managers who wish to sponsor investment funds that will invest (directly or indirectly) in virtual currency need to under-stand the regulatory landscape to be in compli-ance with applicable laws. In addition, much like it is the case with other alternative asset classes, hedge fund managers should take special care to engage service providers (i.e., fund counsel, regulatory counsel, auditors, administrators and tax advisers) with specific expertise in the virtual currency marketplace.

It remains to be seen where the virtual currency market will end up over the long term. Currently, virtual currency is still far from being a universally adopted and accepted global currency. We will keep you informed of any new developments and clarifications regarding virtual currency (including Bitcoin) as they become available.

Yelena Maltser is Counsel in the Financial Services and Corporate groups at Sadis & Goldberg. Ms. Maltser practice focuses on the struc-turing, formation, capital raising and regulatory compliance of hedge funds and private equity funds. She coun-sels clients on structuring and forming U.S. and non-U.S. private investment funds, including the management entities for such funds. She regularly prepares offering and organizational documents, reviews marketing mate-rials and drafts various related agreements. Yelena can be reached at 212.573.8429 or ymaltser@sglawyers.com.

itself is a “security” within the meaning of U.S. federal securities laws. Accordingly, a collective investment scheme involving virtual currencies can be a “security;” however, the sale of virtual currencies does not fall under the definition of a “security” under the Securities Act. At present, it appears that the SEC does not have the authority to regulate virtual currency directly.

Virtual currency can be subject to state regulation. For example, on July 17, 2014, the New York State Department of Financial Services (“NYDFS”) pro-posed regulations requiring a license for certain businesses involved in virtual currencies (includ-ing Bitcoin). It is expected that the final rules will

506(c) of Regulation D under the Securities Act, as defined in the “bad actor” disqualification pro-visions of Rule 506. Ultimately, the SEC stated in Voorhees that “all issuers selling securities to the public must comply with the registration provi-sions of the securities laws, including issuers who seek to raise funds using Bitcoin,” and that the SEC “will continue to focus on enforcing [its] rules and regulations as they apply to digital curren-cies.” It is important to understand what the Voor-hees action accomplishes and how it is limited in scope. In Voorhees, the SEC focused on the rules governing unregistered offerings of securities but did not specifically address the fundamental issue of whether Bitcoin (or another virtual currency)

The Latest on Virtual Currency (continued from page 7)

JANUARY 2015

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On October 7, 2014, The Wall Street Journal reported that Blackstone Group LP will discontinue accelerating monitoring fees under the manage-ment services agreements that the world’s largest buyout firm enters into with its portfolio compa-nies. The U.S. Securities and Exchange Commis-sion (the “Commission” or the “SEC”) has been conducting examinations of private equity firms as a result of the enactment of the Dodd-Frank Wall Street Reform and Consumer Protection Act. Recently, the allocations and disclosures of vari-ous fees charged by private equity firms have been scrutinized and criticized by the Commission.

A “monitoring fee” or “advisory fee” is separate from a management fee charged to the limited partners. After a portfolio company is acquired by a private equity fund, the general-partner entity or the management company may enter into a management services agreement or a similarly-named agreement. Under a typical management services agreement, the portfolio company pays an on-going fee to the “manager” named in such agreement based on a percentage of the compa-ny’s EBITDA, which fee is subject to a floor (i.e., the portfolio company may be required to pay the minimum fee specified in the management ser-vices agreement even if it is losing money and/or having negative cash flows).

A management services agreement may provide for a “major transaction fee” or an “additional transaction fee” whereby the private equity firm would charge a fee on each major transaction con-

summated by the portfolio company, such as an add-on acquisition, a third-party debt financing, an affiliated debt financing, a new equity financing, an IPO, a sale of a division or a sale of the portfolio company. This fee is typically charged as a percentage (e.g., 1%) of the value of the major transaction.

The above two fees are in addition to a one-time “transaction,” “deal” or “success” fee whereby a private equity firm collects a fee from a newly-acquired portfolio company in connection with such acquisition. Such fee is typically 1% of the transaction value.

A typical management services agreement expires on the tenth anniversary, or upon an IPO or a sale of the company, if occurred sooner. A management services agreement may provide that all fees due but not yet earned under the agreement will be accelerated and must be paid at the time of early termination. The amount of such accelerated pay-ment can be staggering. In 2011, HCA Holdings paid its private equity firm owners approximately $181 million as a result of such acceleration. When going public in 2011 and 2012, Claire Stores and five other companies paid an aggregate of $126 million in fees accelerated under their manage-ment services agreements for cumulative 43 years of advisory services that Apollo Global Manage-ment, LLC would not provide.

The announcement by Blackstone will continue to be a discussion topic of private equity profession-als. It is not yet clear whether others would follow, although it is reported that TPG Capital, L.P. and Apollo will share the management services fees paid by their portfolio companies with the limited partners in their current or new funds. At least one regulator predicts that this would be the norm going forward. A senior SEC official who spoke at a private equity conference that the author attended on October 23, 2014 was quoted by Reuters as fol-lows: “Blackstone stopping monitoring fee accel-erations, they are a bellwether in the industry. The industry follows them.”

Jamie “Ji” Kim is Counsel in the Firm’s Corporate and Financial Ser-vices Groups. Mr. Kim focuses on mergers and acquisitions, private equity, venture capital, corporate finance and securities. Mr. Kim has advised clients in a variety of public and private M&A transactions, joint ventures, public equity offerings, pri-vate placement equity and debt transactions, spin-offs and recapitalizations in diverse industries. Ji can be reached at 212.573.8034 or jkim@sglawyers.com.

PRIVATE EQUITY UPDATE: IN CASE YOU MISSED IT…BY JI KIM

…the allocations and disclosures of various fees charged by private equity firms have been scrutinized and criticized by the Commission.

S&G INVESTMENT MANAGER ALERT

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DATE ACTIVITY

January 16 IARD Filing Fees. Ensure that the IARD account is properly funded to facilitate filing the annual adviser registration renewal Form ADV.

January 301 Access Person Annual Holdings Reports. Collect annual holdings reports from access persons for their personal securities holdings.

February 172 Schedule 13G. File any required Schedule 13G with the SEC and the issuer.

February 17 Form 13F. File any required Form 13F with the SEC.

February 17 Form 13H. Review transactions for annual amendment.

February 17 Form 5. File any required Forms 5 with the SEC, the issuer and the appropriate exchange.

March 2 NFA/CFTC - 2015 Annual Exemption Affirmation due no later than March 2, 2015.

March 313 Form ADV Part 1, Part 2. Amend Form ADV Part 1and Part 2, file the amended document with the SEC through the IARD system

March 31 Form PF. Review assets/holdings to determine filing requirements.

Anniversary Date of Filing Annual Form D. Amendment due on or before anniversary date of prior Form D filers.1 Although Rule 204A-1 does not specify the exact date when annual holdings reports must be submitted by access persons, January 30 seems to be an appropriate time to collect annual holdings reports. Fourth quarter brokerage statements, which generally should be deemed to satisfy this requirement (along with a separate report of any securities which do not appear on the brokerage statements), will be current as of 45 days prior to the date of submission, in accordance with the rule.2 When a Schedule 13G, Form F or Form 5 filing deadline falls on a weekend or federal legal holiday, a person may file a required report on the next business day. See Exchange Act Rule 0-3(a). 3 If the 90-day deadline for filing the annual Form ADV updating amendment falls on a weekend or a holiday, an adviser’s filing deadline is not extended by one business day. Rather, the adviser must file its amendment on the last business day preceding the 90-day deadline.

COMPLIANCE CALENDAR FOR INVESTMENT ADVISERSFirst Quarter 2015

Sadis & Goldberg announces a major litigation vic-tory in recovering 195% above the merger price for stockholders cashed-out in a going-private merger of Orchard Enterprises, Inc. (“Orchard”). As coun-sel for a merger arbitrage hedge fund and Co-Lead Counsel for the Class, Sadis & Goldberg obtained a $10.725 million settlement for all Orchard stock-holders as of the date of a merger with controlling stockholder, Dimensional Associates. This victory highlights the significant returns that hedge funds can obtain through engaging in shareholder activ-ism and appraisal rights litigation.

Douglas Hirsch, founding member of the firm and head of the Litigation Group, stated “The result obtained in this case is another example of our firm’s expertise in the area of corporate governance disputes and complex litigation. It also illustrates how our firm can help our invest-ment adviser clients generate alpha for their investors.”

The recovery from this litigation is exceptional in two ways: First, the 195% gross recovery above the merger price for cashed-out stockholders was greater than the fair value of Orchard stock as of merger. That is because Sadis & Goldberg was able to make a strong showing of rescissory damages, which are rarely recovered in merger liti-gation. Second, the settlement provided an even rarer second recovery of an additional 29% above the merger price for hedge funds that previously succeeded in an appraisal action.

Sadis & Goldberg achieved this victory by litigat-ing this action to the brink of trial. It won par-tial summary judgment that there was a mate-rial misrepresentation as a matter of law in the merger proxy statement and that the entire fair-ness standard applied. And with trial preparation under way, the Defendants agreed to the large settlement recovery. Sam Lieberman, a Sadis & Goldberg Litigation partner, argued all of the

SADIS & GOLDBERG WINS 195% ABOVE MERGER PRICE FOR CASHED-OUT ORCHARD STOCKHOLDERSBY DOUGLAS R. HIRSCH AND SAMUEL J. LIEBERMAN

motions in this action and the settlement fair-ness hearing.

Douglas R. Hirsch is the Partner in charge of Sadis & Goldberg’s Litiga-tion Practice. Mr. Hirsch’s practice is focused on hedge fund and securities litigation and he regularly represents both investors and investment advis-ers in a wide range of investment related disputes, such as fraud, breach of fiduciary duty, derviative actions, class actions, and SEC enforcement actions. Mr. Hirsch’s 25 years of litigation experience has encompassed a broad range of trials, class action litigations, arbitrations and mediations. Doug can be reached at 212.573.6670, or at dhirsch@sglawyers.com.

Samuel J. Lieberman is a Part-ner in the Litigation Group at Sadis & Goldberg LLP. He has extensive experience handling all stages of high-profile securities class actions, complex commercial litigation, and government investigations. Sam can be reached at 212.573.8164, or slieberman@sglawyers.com

JANUARY 2015

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Client Alert

SEC fully adopts its Investor Advisory Com-mittee’s recommendations to substantively overhaul the defining characteristics for an Accredited Investor.

The Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 mandates that the United States Securities and Exchange Commission (the “Commission”) review and update the definition of an “Accredited Investor”. On October 9, 2014, the Commission convened a meeting of its Inves-tor Advisory Committee (the “IAC”) to discuss the recommendations of the IAC’s subcommit-tees with regard to changing and updating the definition of an Accredited Investor. The Accred-ited Investor definition is significant because it serves as a central factor in determining who may participate in many private offerings under the Securities Act of 1933 (the “Securities Act”).

The IAC recommended that the Commission evaluate whether the application of the current definition effectively identifies those financially sophisticated natural persons who do not need the protections under the Securities Act. Some of the factors suggested by the IAC include an individual’s occupation, educational background, professional accreditations or certifications and investment experience. The IAC also suggested that, to the extent the Commission may elect to continue using financial thresholds with regard

to the definition, it should consider limiting the percentage of such individual’s income or assets invested into any private offering, for a given period of time. The IAC also addressed the practical bur-dens currently being imposed on issuers with regard to verifying an Accredited Investor, by recommending to the Commission it consider developing an alter-nate verification regime that moves the obligations of investor qualification verification away from the issuers, to a well-qualified third party.

Finally, the IAC recommended that, in addition to any changes to the definition, the Commission should develop protections for those non-accred-ited individual investors (i.e., those who lack the financial sophistication of an Accredited Investor) and who participate in private offerings solely by relying on a purchaser representative. With regard to purchaser representatives, the IAC specifically recommended that purchaser representatives be prohibited from having any direct financial interest or stake in the investment being reviewed by the purchaser representative or receiving any direct or indirect compensation from the issuer.

The Commission approved the IAC recommenda-tions in full. The Commission has not provided a specific deadline or timeline for issuing a pro-posed rule and continues to accept comments from industry participants, advisers and other qualified parties.

SEC Adopts Recommendations For Changing Accredited Investor DefinitionBY RON S. GEFFNER AND JOHN T. ARANEO

Ron S. Geffner is a Partner and Head of the Financial Services Group of Sadis & Goldberg LLP. He regularly structures, organizes and counsels private investment vehicles, investment advisory organizations, broker-dealers, commodity pool opera-tors and other investment fiduciaries. Mr. Geffner also routinely counsels clients in connection with regula-tory investigations and actions. His broad background with federal and state securities laws and the rules, regulations and customary practices of the SEC, Financial Industry Regulatory Authority, Commodities Futures Trading Commission and various other regu-latory bodies enables him to provide strategic guid-ance to a diverse clientele. He provides legal services to hundreds of hedge funds, private equity funds and venture capital funds organized in the United States and offshore. Ron can be reached at 212.573.6660, or at rgeffner@sglawyers.com.

John T. Araneo practices in the firm’s Financial Services, Corporate and Litigation Groups. Mr. Araneo is an experienced business lawyer providing legal counsel on a wide range of legal issues relating to the formation, capitalization, operation and succes-sion of each business enterprise he represents. John has acted as the primary legal adviser to over 40 start-up new business launches and has worked on several significant corporate transactions and securi-ties offerings, as well as complex litigation, employ-ment and other legal matters. John can be reached at 212.573.8158 or jaraneo@sglawyers.com.

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Upcoming EventsTradeTech FXJanuary 26-27, 2015Trump International Beach Resort, Miami, FL

Daniel G. Viola, Partner and Head of the Regulatory Compliance Group, will be speaking at the upcoming TradeTech FX in Miami, Florida. Dan’s session is entitled “How can you manage conflicts in EMIR and Dodd Frank to ensure clients globally receive a uniform service?” at 11:40 am on January 26, 2015. For more information or to register for the conference, please go to: http://tradetechfxus.wbresearch.com/

Maples Investment Funds ForumFebruary 5-7, 2015Grand Cayman

Ron S. Geffner, Partner and Head of the Financial Services Group, will be speaking at the Maples Invest-ment Funds Forum which will be held from February 5th to February 7th in Grand Cayman. This is a “by invitation only” event. For more information, please go to: http://maplesforum.com.

Operations for Alternatives ConferenceFebruary 9-11, 2015PGA National Resort & Spa, Palm Beach Gardens, Florida

Yehuda Braunstein, Partner and member of the Financial Services Group, will be a speaker at the Opera-tions for Alternatives Conference at the PGA National Resort and Spa in Palm Beach Gardens, Florida. To register, please go to: www.ofa-america.com.

Malta Financial Services Authority/Directors Chambers ConferenceFebruary 16-17, 2015Hilton Hotel, St Julian’s, Malta

Steven Huttler, Partner and member of the Financial Services Group, with be a speaker at the Continu-ing Professional Development Course for Directors of Investment Companies and Investment Funds Conference on February 16 and 17, 2015 at the Hilton Hotel, St. Julian’s in Malta. Steven’s session is on February 16th at 2:30 pm and is entitled “Issues faced by Maltese structures in the US.” For more information or to register, please email go to registration@mfsa.com.mt.

The National Center for Employee Ownership SeminarMarch 19, 2015Duff & Phelps Securities, 52 East 52nd Street, New York City

Steven Etkind, Partner and Head of the Tax and Trust and Estates Groups, will be speaking at the National Center for Employee Ownership Seminar on March 19, 2015 in New York City. Steven will be speaking on “Shareholder Liquidity” at 1:30 pm. For more information or to register, please go to: http://www.nceo.org.

2015 Annual NCEO ConferenceApril 20-23, 2015Sheraton Denver DowntownDenver, CO

Steven Etkind, Partner and Head of Tax, Wealth and Estates Groups, will be speaking at the 2015 Employee Ownership Conference in Denver, Colorado. For more information or to register, please go tohttp://www.nceo.org/conference/

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U.S.Treasury Circular 230 Notice: Any U.S. federal tax advice included in this communication is not intended or written to be used, and cannot be used, for the purpose of avoiding U.S. federal tax penalties.

The information contained herein was prepared by Sadis & Goldberg LLP for general information purposes for clients and friends of Sadis & Goldberg LLP. Its content should not be construed as legal advice, and readers should not act upon the information in this newsletter without consulting counsel. This information is presented without any representation or warranty as to its accuracy, completeness or timeliness. Transmission or receipt of this information does not create an attorney-client relationship with Sadis & Goldberg LLP. Electronic mail or other communications with Sadis & Goldberg LLP cannot be guaranteed to be confidential and will not create an attorney-client relationship with Sadis & Goldberg LLP.

© 2015 Sadis & Goldberg LLP