Private Equity Legal Briefs: Recent Legal Updates Spring 2004

Joseph W. Bartlett, Founder of VC

Partnership Entities, When to Put Them to Sleep

There is a very useful article in the January 2004 Journal of Taxation, entitled, "How Long Should Partnership Entities Be Kept Alive?" (100 J.Tax. 60, Jan. 2004). The issue is how long a general or limited partnership or LLC should be maintained as a legal entity, once the fund has sold its properties and made its "final" distributions. And, as is so often the case in the law, the answer is: "It depends." For example, it is conceivable that there could be a tax audit of the partnership or LLC at some future date, before the statute of limitations has been tolled, either directly through an audit of the entity's tax returns or indirectly through an audit of one or more of the members or partners, which could in turn lead to an entity level audit. The question then is whether, if the entity has been dissolved, there remains someone to act as the "tax matters partner." The editors cite an instance where it was impossible to figure out who the TMP was, leading to a situation where everybody who had any interest in the partnership had to be consulted and sign off on the final disposition of the audit. In the "on the other hand" category, the editors cite a decision of the California franchise tax board, which continues to assess franchise taxes against California limited partnerships even after the "final" federal and state tax returns have been filed, if the entity has not been dissolved under state law; the penalties in that case amounted to several thousands of dollars.

Some private equity funds, of course (indeed many) anticipate the organization of a liquidating trust to run off the last, and difficult-to-dispose of, positions in the fund. There is, however, the same question in that instance . i.e., the absence of a "tax matters partner" or anyone else able to settle in the case of a late arising audit.

Tax issues are not prominent in the private equity fund universe; but, Murphy's Law suggests that the general partner and the management company huddle up before making a final decision on whether file the appropriate paper work to dissolve the entity under state law.

Patriot Act

In our first "Tips to Fund Managers" we promised that my colleague at Fish & Richardson, Steve Block, would have a memorandum on the pending application of the USA Patriot Act. I apologize for the tardiness. That memorandum can be found in Section 10.1.10.a of the Encyclopedia of Private Equity. Steve's conclusion reads:


As of this date, neither of the proposed rules [applying the money laundering rules to funds and the GPs thereof] has been implemented by the Treasury. If the proposed rule governing unregistered investment companies becomes effective in its current form, then some investment funds will be required to adopt an anti-money laundering program. Further, if the proposed rule governing investment advisers becomes effective in its current form, then some private equity fund managers may be required to adopt an anti-money laundering program as well. It is also possible that these proposed rules may be revised, and the final versions that become effective may impact the rules' applicability to private equity funds and their managers. Accordingly, the conclusions in this memorandum are subject to change as rules are adopted, modified and clarified.

We are reaching out to all interested parties for updates; stay tuned.

Applications of NASD Rule 2210 to Sales Materials for Private Equity Fung Exempt from '40 Act Registration

A recent exchange of correspondence between Davis Polk (Ms. Yukako Kuwata) and the NASD has resulted in a letter from the NASD of the good news/potentially bad news variety. Ms. Kuwata is a member, as am I, of the Committee on Private Equity Funds based in New York. Her letter to the NASD dated December 1, 2003, was submitted on behalf of Credit Suisse First Boston and sought guidance on the application of NASD Rule 221, as interpreted by the NASD in a letter to the SIA, to sales materials for private equity funds which would prohibit the presentation by an NASD member of "related performance information," i.e., track record, in sales material by mutual funds, hedge funds and private equity funds. I quote in part from the NASD's December 30th response to Ms. Kuwata's letter:

"Nevertheless, the NASD staff recognizes the concerns that you have outlined in your letter. In particular, NASD staff recognizes that the presentation of related performance information with respect to an unregistered private fund (including an unregistered private hedge fund) that is excluded from the definition of "investment company" under Section 3(c)(7) of the 1940 Act does not present the same investor protection concerns as the presentation of related performance information with respect to the sale of mutual fund shares. Accordingly, as a general matter, the NASD staff would not object if a member includes related performance information in sales material for Section 3(c)(7) funds, provided that the member ensures that all recipients of such sales material are "qualified purchasers" under Section 2(a)(51) of the 1940 Act.

The NASD response refers to any earlier letter from the Securities Industry Association dated October 2, 2003. Thanks to Ms. Kuwata, the NASD reached the obvious conclusion, obvious at least to me, that Rule 2210 would pose all kinds of problems for buyout or venture funds raising money with the help of an NASD member as placement agent. The fact is, as the CSFB letter pointed out, investing in the illiquid security in private equity funds, with a 10 or 12 year lock up, is not a retail trade. The NASD's response is, accordingly, a recognition of the obvious. The problem is that NASD went only so far as to exempt private equity funds under 3(c)(7) of the `40 Act, with its significantly elevated standards for "qualified purchasers" the question of 3(c)(1) funds was left open. Obviously, Ms. Kuwata was going for what she could get. Whether there is a negative implication regarding 3(c)(1) funds . i.e., many if not most smaller venture funds (at least one "accredited" but not "qualified" investor) . is an open issue. My guess is that we will all let sleeping dogs lie for the time being. Many such funds use "finders," vs. NASD members, to raise capital, in which case the issue is moot. (For the latest on the unregistered "finder" issue, go to The Encyclopedia of Private Equity and Venture Capital, รตรต 4.3.2 and 4.3.2.a.)

A Mandatory 754 Election?

In the next edition it is likely we will have some commentary on proposed amendments to the Internal Revenue Code, see S.1637, Section 469(c) and 4 in H.R.2896, Section 3023(b), which would have the effect of amending the Code to cause a mandatory 754 election upon a transfer of an LP interest, at least in some instances. According to the fund that brought this issue to my attention, the mandatory 754 election will introduce heavy administrative burdens to venture capital and LBO funds. They will have to keep an additional set of tax books for every transfer that occurs. My correspondent adds it is already difficult enough to sell an interest in a private partnership; with this change the partnership manager may bar transfers or charge the seller or buyer a fee to offset the increased cost for having to keep a specific set of tax books for partnership interests. While investors in private partnerships rarely need to sell there are times that changed circumstances motivate a sale and the lack of a transfer option may reduce the amount of investment made, in the final analysis, in venture capital and LBO funds.[1]

Message Board Feedback to Influence Policy

With respect to the NASD and the Internal Revenue Code issues, it may be that one or more of you would like to take a position which I then could report either to the Committee on Private Investment Funds or to the Feds to attempt to shape a policy in way that is friendly to the private equity fund industry. If so, utilize our online forums and list post your ideas for feedback.

[1] You can find the bills online at Search for S.1637 and H.R.2896 and look at the reported (rather than introduced) versions. The following documents may also be helpful (these are explanations prepared by the Joint Committee of Taxation): http:/ and The Section numbers in the bills are as follows: Section 469(c) of S.1637 and Section 3023(b) of H.R.2896.