Richard A. Levan & Associates, PC - NSCP Currents March/April 1999

March/April 1999

Investment Advisers Doing Business Abroad:
Part One -- Offshore Funds
By Richard A. Levan

Introduction

As the tenor of investing becomes increasingly global, U.S. money managers are encountering unparalleled opportunities for the marketing of new products to new investors around the globe. Even small funds and advisers who traditionally catered to local clients now find themselves facing a jumble of jurisdictional issues involving tax and registration matters that seemed unimaginable a scant few years ago. With proper planning and foresight, U.S. firms can avail themselves of these new opportunities and expand their markets without running afoul of the maze of regulations that await them. This article examines some of the issues advisers are likely to encounter as they expand their horizons and position themselves to take advantage of the many opportunities in the international arena through the use of off-shore funds and offerings.

Background

Prior to 1998, foreign investment companies were limited in the activities they could perform in the U.S. without subjecting themselves to U.S. tax liability. Under the old law, a foreign fund was exempt from U.S.taxation if it could demonstrate that its "principal office" was located outside the U.S. Such a requirement drastically limited the contact that foreign funds could have with U.S. firms and individuals.

The test for determining a fund 's principal office under the old law -- commonly referred to as the "Ten Commandments" -- focused on the number of activities being performed by the fund or its sponsors in the U.S., and included the following activities:

Communicating with the company 's shareholders;

Communicating with the general public;

Soliciting sales of its own stock;

Accepting subscriptions of new shareholders;

Maintaining its principal corporate records and books of account;

Auditing its books of account;

Disbursing payments of dividends,legal fees,accounting fees,and officers' and directors' salaries;

Publishing or furnishing the offering and redemption price of the shares issued by it;

Conducting meetings of its shareholders and board of directors; and

Making redemptions of its own shares of stock.

As a result of the 1997 amendments to the U.S. tax code, the Ten Commandments test is no longer used to determine the taxable nature of a foreign investment company. Today, a fund organized in a?foreign jurisdiction may perform the majority of its administrative functions in the United States, as well as take corporate actions such as the holding of board meetings and communicating with shareholders without triggering U.S. income tax liability.

This change makes such funds extremely attractive to both foreign and U.S. investors, and creates significant marketing opportunities for the fund, its advisers and distributors. At the same time, however, such activities potentially subject these funds and their U.S. promoters and distributors to the purview of U.S. securities laws. Accordingly, great caution must be exercised by U.S. firms who participate in the activities of these funds.

Regulation S

Section 5 of the Securities Act of 1933 (the "1933 Act")requires that a registration statement be in effect prior to the offer or sale of securities.To avoid Section 5 's registration require ments, an issuer has several options. Section 4(2) and Regulation D of the 1933 Act provide exemptions from registration for certain private offerings. For foreign jurisdictional exemptions, however, an issuer must look to Regulation S.

The SEC adopted Regulation S in an attempt to clarify the extraterritorial application of the registration requirements of the 1933 Act. Regulation S contains a general statement that the registration requirements of the 1933 Act will not apply to offers and sales of securities that occur outside the United States. If an offering or sale does not fit within the general statement, an issuer must look to a "safe harbor".Regulation S provides two safe harbors that establish the guidelines under which a transaction may be considered to have occurred outside the U.S., and thus not be subject to 1933 Act registration requirements.

The first safe harbor is found in Rule 903 under the 1933 Act. This safe harbor was established for offers or sales of securities by an issuer, a distributor,1 any of their respective affiliates, or any person acting on behalf of the above, where the offer or sale is made in an offshore transaction, or where no "directed selling efforts" are made within the U.S.2 The second safe harbor,found in Ru le 904,is referred to as the "resale safe harbor." It applies to the resale of securities by an issuer, distributor or anyone acting on their behalf and exempts such resales from the 1933 Act registration requirements if they are made in an offshore transaction and no direct selling efforts are undertaken in the U.S.

If an issuer or distributor can apply one of these safe harbors to their securities transaction, then they can do so without registering the securities with the SEC, and thus are generally outside of the 1933 Act 's regulatory reach.

Suggestions to Avoid Violating Regulation S Safe Harbors

Money managers are encouraged to follow these suggestions to maintain their ability to use the Regulation S Safe Harbors:

Avoid specifically targeting U.S. citizens abroad. Marketing campaigns specifically targeting U.S. citizens abroad are not considered to be an offshore transaction under the rules. Thus, such offers would not qualify for safe harbor treatment under Rules 903 or 904 and would need to satisfy all registration requirements.

Make sure you and those acting on your behalf understand what constitutes a "directed selling effort.

"Directed selling efforts" are defined under the Securities Act as those activities designed, or expected to, condition the market with respect to any securities being offered. This definition encompasses obvious activities such as mailing marketing materials to U.S. investors; placing advertisements with selected media outlets; and conducting promotional meetings and seminars. It is important to understand, however, that this definition also includes almost any distribution of information, recommendations or opinions regarding specific securities and their issuers. Confusion on the part of individuals acting upon your behalf could lead to the inability to use a safe harbor.

Eliminate U.S. advertising. U.S. advertising of any type is risky under the Regulation S safe harbors. If marketing activities are found to condition the market, Regulation S safe harbors will not be available. To avoid this result, it is important to eliminate all advertising from U.S. media outlets. In addition, even the display of marketing materials in the U.S. offices of an investment adviser or distributor could be considered conditioning the market. To avoid any questions as to marketing practices, it is advisable to eliminate all U.S. advertising.

Watch who you invite to seminars. Promotional seminars should not be held in the United States, nor should invitations to such seminars be mailed to individuals in the United States. Even when seminars will be held outside of the U.S., invitations should not be mailed to individuals with U.S. mailing addresses. The reason again is that such activities are considered to condition the market and will violate Regulation S safe harbors.

Offshore fund sponsors need to adequately monitor the activities of distributors and others acting on their behalf. Offshore fund sponsors are encouraged to develop written procedures for distributors of their fund 's shares.Such procedures should be signed and agreed to by all distributors with whom the sponsor enters into dealer contracts. In addition, the sponsor should reserve the right to inspect the distributor 's books and records as well as off ice locations to ensure that the procedures adopted are being implemented and that the distributor and those acting on its behalf are in compliance.

Investment Company Act Issues

An offshore fund (i.e., a fund organized under the laws of a foreign jurisdiction), however, may still be subject to SEC regulation via the Investment Company Act of 1940 (the "'40 Act")unless it can satisfy one of two exceptions.Section 3(c)(1)of the '40 Act provides an exception to the definition of investment company, and thus to '40 Act regulation,for those funds that are beneficially owned by less than 100 persons and are not making and do not presently propose to make a public offering of its securities.Section 3(c)(7)of the '40 Act provides an exemption for a fund that is owned exclusively by qualified purchasers (where a qualified purchaser is a person or entity that meets?certain dollar thresholds for investment holdings) and also is not making nor presently proposes to make a public offering.

Even a U.S.-based adviser who advises an otherwise exempt offshore fund may find itself within the regulatory purview of the SEC. This situation recently arose during a routine SEC examination of a local adviser which provides investment advice to an offshore fund as well as to U.S. clients. The adviser was asked by the SEC staff to produce records relating to the offshore fund, including the names of investors in, and solicitors to, the fund. The staff justified its request under Section 204 of the Advisers Act, which provides the SEC with its inspection powers.

The adviser was surprised by the SEC 's position in light of the adviser 's reading of Section 204 and Rule 204-2 thereunder, which make no reference to the ability of the SEC to require U.S. advisers to maintain records relating to offshore funds, let alone to permit the SEC to inspect such records. The matter is complicated by the secrecy laws of the country where the fund in question is organized, which limit the ability of funds and their advisers to disclose the types of records the SEC is seeking. The issue of SEC access to such records is very much a live one, and it needs to be addressed squarely. In the meantime, U.S. advisers are encouraged to maintain the same books and records for offshore funds as they do for domestic ones, recognizing that such records may be requested by the SEC or a state securities regulator during the inspection process.

A recent federal case, United States v. Brown,3 amply demonstrates the jurisdictional problems created by offshore investment activity of U.S. citizens. In Brown, a U.S. court exercised its jurisdiction over a Utah resident who had participated in the fraudulent sale of securities to German investors. Although all of the selling activity occurred outside the U.S., the court ruled that the defendant was subject to prosecution under U.S. securities laws because the company which issued the fraudulent securities was incorporated in the U.S., the defendant mailed corporate documents from his office in Utah to colleagues stationed in Germany, and the offering proceeds were eventually wired from Germany to the U.S. The Brown case demonstrates that even limited involvement by U.S. citizens in offshore transactions may subject them to the requirements of U.S. law.

Suggestions to Avoid Violating Investment Company Act Exemptions

To maintain the use of exemptions under Section 3(c)(1)and 3(c)(7)of the '40 Act,the following practice tips are suggested:

Don 't use U.S.mails.Section 7(d)of the '40 Act prohibits an offshore fund from using the U.S. mails or any other means or instrumentality of interstate commerce in a public offering of its shares in the U.S. or to U.S. persons in foreign markets. As a result, to avoid potentially violating a safe harbor requirement, marketing efforts should be conducted from foreign offices.

Keep simultaneous public and private offerings within the respective exemptions. Section 7(d)of the '40 Act does not prohibit offshore funds from conducting an exempt public offering abroad while simultaneously conducting a private offering within the United States. A foreign fund may conduct a private offering satisfying one of the '40 Act exemptions (Section 3(c)(1)or Section 3(c)(7)) while publicly offering its securities abroad. So long as the fund avoids the use of the means?and instrumentalities of interstate commerce in marketing its public offering in the U.S. or to U.S. persons abroad, both offerings would avoid registration requirements.

Conclusion

As investment advisers continue to expand their practices globally, it is essential that they proceed cautiously, paying careful attention to U.S. securities laws and the jurisdictional reach of the SEC. Despite changes in the tax laws, geographic considerations remain paramount for determining whether the activities of issuers, distributors, and advisers will be subject to SEC regulation. Funds must be organized offshore, and must not offer shares within the U.S. unless relying upon an exemption from the definition of "investment company"or a safe harbor such as that provided by Regulation S. Advisers must be aware of the ramifications of dispensing advice through interstate commerce and transmitting foreign client information back to their offices in the U.S. In short, all those involved in the issuance, distribution and recommendation of securities must remember that the reach of the SEC is indeed a long one.