In a Nov. 25 article in Pensions & Investments, it was suggested the National Securities Markets Improvement Act of 1996 will not be the landmark legislation intended by its framers - at least with respect to the hedge fund industry.
The reporter, Vineeta Anand, focused on the NSMIA's apparent incompatibility with the current tax laws. Ms. Anand's thesis was that even though the act provides for sweeping reform, its practical consequences may either be nullified or certainly drastically reduced by existing tax rules. The Hennessee Group disagrees.
Although the Hennessee Group agrees there are conflicts that might slow the framers' intent, we entirely disagree the new legislation has lost its meaning. The NSMIA will not change the hedge fund community "overnight" as some had hoped, but it definitively sets the groundwork for major changes. Make no mistake; as with any landmark event there may be some short-term kinks, but in the end, and as applied to the hedge fund community and to the history of investments, the act will be judged as watershed legislation.
A new 3(c)(7), an amended 3(c)(I)
As a preliminary matter, even accepting the argument that the impact of the new 3(c)(7) funds will be nullified because of the tax issues, the provisions of the act are not entirely nor directly in conflict. The NSMIA not only created a new 3(c)(7), but also it amended 3(c)(I). Therefore, on its face, the act will have direct consequences on the hedge fund community that will not be nullified by tax code and regulations. One example is that it amends the "look-through test" contained in section 3(c)(I) so as to eliminate the second prong of that test (i.e., that not more than 10% of the investor's assets may be invested in section 3(c)(I) funds) and make the first prong of the test (i.e. the investor may not own 10% or more of the outstanding voting securities of the fund) applicable only to an investor that is a registered investment company. This has resounding implications, especially for endowments or pension plans, because they could now acquire more than 10% of the outstanding voting securities of a section 3(c)(I) fund without being subject to a "look-through."
Reducing tax rule impact
We agree with Ms. Anand that it is indisputable there are significant tax differences between the treatment of an "investment partnership" and a "publicly traded partnership." We do not agree with her application of the meaning of these terms.
Hedge funds now are taxed as a partnership, which in effect means they "pass through" all of their profits and losses directly to the partners. The partners then pay taxes only on their share of the fund's profits, at their tax rate. In a publicly traded partnership, taxes are paid at the partnership level and each partner also pays taxes at their rate, creating double taxation. First, when the corporation pays taxes on its income, and then when investors pay taxes on dividend income.
Because, under recently introduced Internal Revenue Service regulations, partnerships with more than 100 partners may be deemed PTPs, and because the very purpose of the NSMIA is to allow hedge funds to expand their investors beyond 99, Ms. Anand asserts the new 3(c)(7) or 3(c)(I) converts will be considered PTPs, subject to sharply higher taxes, with the result being "investors might not find it worthwhile throwing their money into funds that sent 40% of their profits to the U.S. Treasury."
Although Ms. Anand admits hedge funds with more than 100 investors still might be able to claim some exemptions "the exemptions are so narrow few hedge funds will be able to claim them." The Hennessee Group disagrees.
First, a hedge fund will not be treated as a publicly traded partnership if interests therein are not "readily tradable on a secondary market or the substantial equivalent thereof." Under the new PTP regulations, the fact a partnership has more than 100 partners does not prevent it from avoiding PTP status. Rather, under a "facts and circumstances" test in the regulations, a hedge fund should be able to avoid PTP status if transfers of interests are restricted (they typically are) and redemptions permitted infrequently (e.g. once or twice a year). In these situations, which apply to many hedge funds, interests in the hedge funds should not be considered "readily tradable."
Second, if a hedge fund has more frequent redemptions (e.g. monthly) and therefore may not clearly be exempt under the "facts and circumstances" test, it might be able to rely on the exemption from PTP status for non-registered partnerships having more than 90% of their gross income from "passive-type" income. Many hedge funds earn substantially all of their income from interest, dividends and capital gains from securities transactions and therefore should clearly qualify for this exemption. Ms. Anand incorrectly states that short selling does not result in "passive-type income." The gain comes within the definition of passive-type income.
It is true there is uncertainty as to whether income from certain types of transactions engaged in by the hedge funds (e.g. swaps) is passive-type income. However, the IRS has indicated it is working on regulations that presumably will expand the definition of passive-type income to include the type of financial instruments that were not being used in 1987 when the PTP rules were adopted.
Finally, existing partnerships that are expanded to take advantage of Section 3(c)(7) may well be grandfathered from application of the new PTP rules until Jan. 1, 2006.
Tax rules will give way
Even if the two laws are incompatible - and we are not convinced they are - historical precedent and American politics and jurisprudence indicate that when two laws are incompatible, Congress will prevail. There is evidence that actions to reconcile the tax rules with the NSMIA already are under way. As Ms. Anand observed, "sources outside the government expect the Treasury Department to eventually change the tax rule to stay in sync with the new securities law, but few expect changes soon." Ms. Anand also noted "hedge funds already are preparing to ask the IRS for permission to expand beyond the 100 investors and keep their tax status as private partnerships." We believe, that as with all major legislation, there will be numerous exemptions that may ultimately have the exceptions being the rule, and the rule the exception.
The Hennessee Group believes the laws will be resolved favorably to investors and hedge fund managers, but how quickly and to what extent is to be determined. Make no mistake, this law will have the power it claims. And its real truth is that by enabling new investors to enter the hedge fund arena and to lift the restrictions that now impale managers, competition and improved efficiency should result. Previously closed managers will be able to reopen. New managers will have greater access to capital. Investors will have greater manager selection. And the United States will join the rest of the investing world by introducing hedge investing as another options.
Greater accessibility, more choice and more competition - these are the results that ultimately will be the result of this law.
And, for these reasons, this law has landmark importance. The only real question then, is not its inevitability, but the duration before these effects are realized.
E. Lee Hennessee and Charles J. Gradante are directors of WPG-Hennessee Hedge Fund Advisory Group, New York.