1. © Copyright, Briggs and Morgan, Professional Association, 2006-2007 HEDGE FUNDS CURRENT ISSUES 2007 NSCP National Membership Meeting October 17 th -19 th, 2007 Gerald T. Lins, General Counsel ING Investment Management Americas Christopher J. Mahon, Managing Director Deutsche Bank Securities, Inc. Frank A. Taylor, Practice Group Leader Briggs and Morgan, P.A.

2. Disclaimer This publication is circulated to bring useful and timely information to our clients and colleagues. The publication is for general information purposes only and is not legal advice. You should not rely on any information or views contained in the publication in evaluating any specific legal issues you may have. Please consult your Briggs and Morgan attorney for specific legal advice. Any U.S. Federal tax advice contained in this communication (whether distributed by mail, email or fax) is not intended or written to be used, and it cannot be used by any person for the purpose of avoiding U.S. Federal tax penalties or for the purpose of promoting, marketing or recommending any entity, investment plan or other transaction. (The foregoing legend has been affixed pursuant to U.S. Treasury Regulations governing tax practice.) ©Briggs and Morgan, P.A., 2007

3. Summary Introduction to Hedge Funds Maintaining Private Placement Exemption Conflicts of Interest Trading Practices Valuation – Recent Wall Street Journal article Proposed Registration ©Briggs and Morgan, P.A., 2007

4. What is a Hedge Fund? D.C. Circuit: “Entity that holds a pool of securities or other investments that does not register its offerings under the Securities Act, and is not registered under the Investment Company Act.” Alternative investment vehicle – Trades in stock, securities, other instruments – Free of regulatory constraints Originally, designed to reduce market risk through “hedging” – Hedge funds “market” inefficiencies No longer market neutral – Often employ “straddles” that bet whether trading ratio will contract or expand between two securities ©Briggs and Morgan, P.A., 2007

5. Hedge Fund v. Private Equity Fund Hedge Fund is NOT a private equity fund Liquidity – Hedge fund has more liquidity – Private equity investor is long term Hedge fund should have a perpetual life Hedge fund investor disposes of investment in a single transaction Hedge fund has a broader investment mandate Private equity funds often look to buy stakes in companies ©Briggs and Morgan, P.A., 2007

6. Hedge Fund v. Mutual Fund Hedge fund is not a mutual fund Both invest in marketable securities Both have liquidity Hedge fund tries to generate positive returns in all environments – Mutual fund return is compared to “benchmarks” Different in market risk, investors, fees, diversification, leverage and regulation ©Briggs and Morgan, P.A., 2007

7. Differences: Hedge Fund v. Mutual Fund Fees – Hedge fund manager charges fee as a fixed percentage of gain – Mutual fund cannot Mutual Funds are registered under ’33 Act – Hedge funds are not registered – Exempt from registration, § 4(2) of the Act Most hedge funds exempt from ’40 Act – § 3(c)(1), which excludes funds with 100 or less investors – § 3(c)(7), which excludes funds with “qualified purchasers” ©Briggs and Morgan, P.A., 2007

8. Advantages of not registering By not registering as investment company – Avoids leverage constraints on open ended fund – Avoids § 18(f) limits fund in issuing senior securities – Avoids §§ 12(a)(i) and (3) limitation on short selling and margin Portfolio manager did not register as an Advisor under the Advisors Act of 1940 – § 203(b)(3) exempts a manager with less than 15 clients Each hedge fund is a client – Carry can be charged under the Advisor’s Act for “qualified client[s]” ©Briggs and Morgan, P.A., 2007

9. SEC Release IA-2333 SEC endeavored to amend Rules to require “look through” hedge fund to count all the investors Required portfolio manager to register as an advisor under the Advisor’s Act June 23, 2006 D.C. Circuit reversed finding that the term “client” of a manager could not include an investor in hedge fund December 13, 2006: SEC proposed new anti-fraud rules that would prohibit making of false of misleading statements. Applies to all portfolio managers Effective on September 13, 2007: Rule 206(4)-8 ©Briggs and Morgan, P.A., 2007

10. Rule 206(4)-8 Applies to both registered and unregistered Investment Advisers Applies to pooled investment vehicles exempt from ’40 Act §§ 3(c)(1) or 3(c)(7) Does not matter whether malfeasance occurs when selling, offering or redeeming – Includes RFP process Rule prohibits advisers from – Making false or misleading statements to investors or prospective investors in hedge funds and other pooled investment vehicles – Otherwise defraud these investors “Rule clarifies that an adviser’s duty to refrain from fraudulent conduct under the federal securities laws extends to the relationship with the ultimate investors [in the fund]” – Commission may bring enforcement actions against investment advisors who defraud investors in those pooled investment vehicles Intent is to prohibit all fraud, without proving scienter No private right of action ©Briggs and Morgan, P.A., 2007

11. Fund Structures Structures of Hedge Funds – Single Entity – Master-Feeder – Parallel – Multi-Manager Single Entity – Partnership or Limited Liability Company – Manager or GP receives a carried interest Fixed percentage of the net gains of the fund However, must be alert to effective carried interest – May have two entities that manage the fund Divide between the manager and the portfolio manager Reduces tax burden ©Briggs and Morgan, P.A., 2007

12. Master-Feeder Funds Taxable investors, tax-exempt investors and foreign investors Foreign feeder is a holding company – Tax-exempt and foreign investors make contribution here Organized in low-tax jurisdiction as a corporation for tax purposes Avoids Unrelated Business Taxable Income But, will be subject to federal tax if it engages in a United States trade or business – If it “trades” or “invests”, exempt Acts to increase after tax returns to feeder and its shareholders ©Briggs and Morgan, P.A., 2007

13. Parallel Funds Mirrors the Master-Feeder Two members of a hedge fund complex populated by same investors Parallel entity is created in a low-tax jurisdiction Invests in tandem with on-shore fund ©Briggs and Morgan, P.A., 2007

14. Fund of Funds Invests in different hedge funds Gives exposure to different market segments – Investor may not have time or qualifications to diversify ©Briggs and Morgan, P.A., 2007

15. Types of Funds Arbitrage Funds – Errors in market price – Often long and short positions in same stock Profit based upon whether profit exceeds loss Distressed Securities Funds – Invests in debt securities of bankrupt, insolvent or troubled company – Participates in restructuring – Takes over company by controlling debt Futures Funds – Futures market ©Briggs and Morgan, P.A., 2007

16. Types of Funds Event Funds – Anticipates certain corporate events, often spin-offs – Short one stock and purchased other – Sandell Asset Management Opportunistic Funds – Broad discretion to manager Macro Funds – Invests based upon macro events – Short or long asset classes Market Timing Funds ©Briggs and Morgan, P.A., 2007

17. Investors Individuals Public companies Tax-exempt investors; e.g., Pension Funds – Issue of fiduciary responsibility – UBTI issues Foreign Investors – Tax issues ©Briggs and Morgan, P.A., 2007

18. Private Placement § 4(2) of the Securities Act – Secrecy Reg. D – Accredited investors Sophisticated investors No general solicitations – Adverse tax issues: Market Rules (no violations) Secondary Market Rule (includes redemption) – See, Fortress Investment Group Holdings Registration Statement Limited transferability of interests State regulation ©Briggs and Morgan, P.A., 2007

19. Disclosure Private Placement Memorandum – Effort to achieve disclosure required by Registration Statement Although exempt from registration, still subject to anti-fraud provisions Disclosure may be governed by – Securities Act of 1933 – Securities Exchange Act of 1934 – Investment Company Act of 1940 – Investment Advisors Act of 1940 – State statutes ©Briggs and Morgan, P.A., 2007

20. Side Letters Different investors in same fund negotiate different deals – Creates difficulties in the event of litigation Expect increasing regulatory scrutiny Reduce risk – Alert potential investors to the different arrangements – Describe those arrangement in PPM or Form ADV, Part II – Make sure that side letters do not conflict with disclosure ©Briggs and Morgan, P.A., 2007

21. Side by Side Management Simultaneous service as advisor to hedge fund and mutual fund advisor – Performance based fee versus managed assets based fee account Trading Practices – Fairness Standard: trade allocation must be “fair and equitable over time.” – Policies and Procedures should try to achieve consistency over time ©Briggs and Morgan, P.A., 2007

22. Valuation Illiquid assets Much discretion to manager Conflicts of interest Domicile of ownership interest if investor is a pension plan Often the area of greatest concern ©Briggs and Morgan, P.A., 2007

23. Best Practices for Valuation Written policies and procedures Reliable and recognized pricing sources Settlement of disparate valuations Valuation Committees Independent third-party valuation testing ©Briggs and Morgan, P.A., 2007

24. Pension Funds Offshore money – How do you catch a thief living abroad? – Can you collect? Where is the money? – Do you have a remedy? – What law applies? Valuation – AICPA places the responsibility to determine “fair value” rests with plan’s named fiduciary – A plan auditor cannot give an unqualified opinion if the fiduciary cannot determine fair value – Hedge funds may suspend computation of NAV, causing off- cycle redemptions to be unfairly valued Assets should be custodied in U.S. – Certificates of ownership safe kept in the U.S. ©Briggs and Morgan, P.A., 2007