Today there are some regulatory challenges facing the industry that should be closely followed.

Carried Interest

If there are no changes to the rules governing carried interest income within the next year, managers of offshore funds could very well be facing heavy tax consequences for the 2017 tax year. In October 2008, President Bush signed the Emergency Economic Stabilization Act (EESA) which amended Section 457A of the Internal Revenue Code. The measure made during the financial crisis provides that any compensation deferred under a nonqualified deferred compensation plan or entity would be includable in taxable gross income as long as there was no substantial risk of forfeiture to receive the deferred compensation. This could mean that any offshore funds holding incentive based compensation in those vehicles would be required to repatriate their carried interest attributable to services performed after December 31, 2008. The taxable income would have to be recognized by 2017 and the deferred compensation would be treated as ordinary income and subject to estate taxes, if applicable. Managers of investment companies with offshore funds should consider tax planning now to mitigate the possible tax consequences.

Business Continuity

On June 28, the SEC proposed a new rule that would require registered investment advisors, including hedge fund managers, to develop formal plans and policies to minimize business disruptions such as a cyber-security threat, departure of key personnel, technology failure, natural disaster, or similar event. This proposed rule could also require investment advisors to thoroughly review third party service providers to ensure the business continuity of the third party as well. In addition, managers would need to create a transition plan in the event that the third party service provider could not perform their services. Comments can still be submitted on this proposed rule to the SEC through August.

 

Automated Trading

The CFTC is moving forward on some provisions of Regulation Automated Trading (Regulation AT) that would impose new risk and compliance controls on fund managers engaging in algorithmic trading. The proposed regulations was introduced in November 2015 after considering recent events, such as the May 2010 flash crash when a computer-driven trading error on a derivative exchange wreaked havoc on the stock market. It is likely that the CFTC will require fund managers to plan for potential market disruptions and submit annual compliance reports regarding their risk controls in the future. However, the more controversial rule that would require fund managers to share their computer codes with the CFTC does not look like it will be moving forward.

Form ADV

The SEC has been further discussing to expand the Form ADV to capture more information about investment advisors’ separately managed accounts. The rule proposed in May 2015 would require detailed information regarding types of assets held and the use of borrowing and derivatives, including specifying the percentage of regulatory assets under management among asset categories. Firms with more than $10 billion in separate accounts would also have to provide details about their derivative exposures. There is some controversy to the proposed regulation, managers are concerned with the SEC’s request because the ADV forms are public information. However, industry representatives are currently pushing to keep the additional information private.

Cayman Islands new LLC vehicle

The Cayman Islands has enacted the Limited Liability Companies Law, 2016, which will allow the formation of a LLC vehicle as of July 13, 2016. The LLC combines characteristics of the Cayman Islands exempted company and exempted limited partnership. Like an exempted company, the LLC is body corporate with a separate legal personality. However, the LLC is unique in that it does not have share capital. Like an exempted limited partnership, member liability is limited, capital accounts are permitted and members are free to determine how profits and losses are allocated. The vehicle also offers flexibility regarding the governance of the LLC; the vehicle can be either member managed or can allow the appointment of persons to manage the vehicle.