NYSBL 96(1); 100; 234(1); 234-b
|To:||Deputy Superintendent Cofsky|
|From:||Assistant Counsel Sullivan|
November 10, 2008
|Subject:||[---] Bank – Proposed Hedge Fund|
[---] Bank ("Bank") is a New York-chartered savings bank. Under Section 234-b of the New York Banking Law (the "Banking Law"), the New York State Banking Board (the "Banking Board") on November 4, 2004 approved without limitation the application of Bank to exercise the powers specified in Sections 100, 100-a, 100-b and 100-c of the Banking Law - i.e. "fiduciary powers." Similarly, the Federal Deposit Insurance Corporation approved an application of Bank to exercise trust powers on October 7, 2004.
[---] Bank intends to establish a private money market hedge fund, NYPB&T Co-Investment Fund - MF1, LP (the "Fund"). The Fund will be formed as a Delaware limited partnership and will primarily invest in high quality municipal securities with low interest rate risk and high degree of short-term liquidity. Although the Fund will invest primarily in "bank-permissible securities," it will not be limited to such investments.
The Fund will be a master fund with two "Feeder Funds," each of which will be formed as a Delaware limited partnership or a limited liability company. The investors in the first Feeder Fund will be limited to no more than one hundred "accredited investors",1 as defined in Rule 501 of Regulation D2 under the Securities Act.3 The investors in the second Feeder Fund will be limited to "qualified purchasers",4 as defined in Section 2(a)(51) of the Investment Company Act5 (the Company Act.) This structure is designed to exempt the interests in each Feeder Fund from registration under the Securities Act and exclude each Feeder Fund from the definition of "investment company," and therefore, from regulation as such under the Company Act.6
[---] Alternative Investments LLC ("EAI") is currently a New York limited liability company and a wholly-owned operating subsidiary of Bank. In connection with establishing the Fund, EAI will form the "Manager" which will serve as the managing partner and investment manager of the Fund. The Manager will be a New York limited liability company and a wholly-owned operating subsidiary of EAI.
The Manager will make investments in the Fund which will not in the aggregate exceed the lesser of $100,000 or one percent of the equity capital of the Fund at the time the Manager makes such investments. The Manager will hold these investments in the Fund in the form of special general partnership interests ("Special Interests") in order that the Fund may facilitate favorable tax treatment for its investors. The Manager will not participate in all of the gains and losses of the Fund. Instead, the Manager will receive an allocation of the net gains of the Fund (the "Performance Allocation") in lieu of a fee for acting as investment manager. The Manager will also receive an allocation the net cumulative losses of the Fund up to the amount of the Manager's investment in the Fund.
The Performance Allocation will equal 15% of the excess of capital appreciation (net of all cumulative losses, fees and expenses, including the compensation paid to the Advisor) over a specified preferred rate (the Federal Funds Rate on an after-tax basis) (the "Specified Return"), to be earned by the other partners in the Fund ("Partners").7 The Performance Allocation will continue throughout the Fund's existence provided that: (i) the Partners first earn the Specified Return on their investments in the Fund and (ii) such Partners not be allocated cumulative net losses at the time the Manager is to receive the Performance Allocation.
Bank, itself, will form the "Advisor" as a New York limited liability company and a wholly-owned operating subsidiary. The Advisor will serve as the investment advisor to the Fund. The Advisor will not make an equity investment in the Fund. The Advisor will receive compensation equivalent to 0.15% per year of the total capital account balances 8 of the Partners, provided that: (i) the Partners first earn the Specified Return and (ii) the Partners are not allocated cumulative net losses at the time the Advisor is to receive its compensation.
The structure under which the Manager will receive the Performance Allocation and the Advisor an advisory fee is designed to provide favorable tax consequences for the individual investors who will be direct investors in the Feeder Funds and indirect investors in the Fund. It is anticipated that both the Feeder Funds and the Fund will be taxed as partnerships. Consistent with this tax treatment, all the losses, gains, fees, and expenses will be passed through to the Fund's indirect investors. Under Federal income tax law, individual investors would have to include in income their allocable share of an investment fund's income and gains before deducting investment-related fees and expenses paid by the investment fund. The limitation on the deductibility of itemized deductions in Section 67 of the Internal Revenue Code9 may preclude high-income individuals from deducting their full proportionate share of the fees and expenses of the investment funds. On the other hand, Bank believes that if the Manager receives a profit allocation, rather a performance fee, the amount so allocated will not be included in the income of the investors who are not recipients of the allocation.
Bank indicates that it is an industry practice for investment managers of certain types of investment funds to receive performance-related compensation as a profit allocation. Similar funds are structured to provide allocations rather than fees to maximize tax efficiency for investors. Bank notes the Office of the Comptroller of the Currency (the "OCC") has permitted national banks to establish investment funds so structured and has also pointed out the Banking Department approved similar structure established by Bank last year.
- Whether Bank may establish the Fund, the Feeder Funds, the Manager and the Advisor.
- Whether the Manager may acquire the Special Interests in the Fund in the manner described above.
Bank may establish the Fund, the Feeder Funds, the Manager and the Advisor. The Manager may acquire the Special Interests in the Fund under the authority of Bank to provide investment management services, but only:
- To the extent necessary enable the Manager to receive its performance-based compensation in the form of a profit allocation;
- If the Manager withdraws such profit allocations immediately after they are made;
- If the Manager's total loss exposure is limited to the amount of its investments in the Fund;
- If the Manager disposes of the Special Interests if it no longer is providing investment management services to the Fund.
The authority of Bank and its operating subsidiaries to provide investment management services is essentially the same as that of a New York State-chartered bank with trust powers and the operating subsidiaries of such a bank. The fiduciary powers approved for Bank under Section 234-b of the Banking Law are identical to those of a trust company or of a bank with trust powers chartered under Article III of the Banking Law.
Under Section 97(4-a) of the Banking Law and Part 14 of the General Regulations of the Banking Board, New York State-chartered banks and trust companies may invest in the stock and other equity of "operating subsidiaries" - i.e., subsidiaries engaged in the transaction of any business in which the bank or trust company could engage directly. Similarly, as a New York State-chartered savings bank, Bank may establish "operating subsidiaries" pursuant to Sections 234(1) and 234(23) of the Banking Law, provided that such operating subsidiaries only engage in those activities in which Bank could engage directly.10
A trust company or a bank with trust powers may provide discretionary investment management services.11 The Banking Department has permitted such a trust company through a subsidiary to sponsor, organize and advise open-end mutual funds12 registered under the Company Act. In connection therewith, the subsidiary was allowed to acquire an equity interest of $100,000 in each fund for the purpose of providing initial capital as required by Section 14(a) of the Company Act. 13
For two reasons, it is also important to consider the investment management activities that have been found permissible for national banks and their operating subsidiaries. First, the fiduciary powers of New York banks and savings banks are analogous to those of national banks as are the "incidental powers" of each such entity.14 Second, under Section 24 of the Federal Deposit Insurance Act ("FDI Act"),15 subject to limited exceptions, a subsidiary of an insured state bank may not engage as principal in an activity that is not permissible for a subsidiary of a national bank.
A national bank may provide investment management services as part of the business of banking authorized under 12 U.S.C. § 24 (Seventh) and pursuant to its fiduciary powers under 12 U.S.C. §92a. Moreover, an operating subsidiary of a national bank may engage in those "activities that are permissible for a national bank to engage in directly either as part of, or incidental to, the business of banking, as determined by the OCC, or otherwise under other statutory authority.16
On a number of occasions, the OCC has permitted an operating subsidiary of a national bank to own limited interests in investment funds that the operating subsidiary managed, reasoning that such ownership is directly related to, and an integral part of, the subsidiary's activity of providing investment management and administrative services.17The operating subsidiary held such limited interests in order to structure its compensation like that of its competitors in the investment management industry. Such interests in the investment funds were not made for investment purposes but rather to enable the operating subsidiary to provide investment management services as conducted by its competitors. In the Blackrock Approval18 for example, ownership of the limited interests in investment funds would:
- "be restricted to a context where the holding is integral to facilitating a recognized bank-permissible activity and therefore such holdings are permissible as an incident to the bank-permissible investment management activities."
In September, 2007, the Banking Department approved a similar structure under which operating subsidiaries of Bank acted respectively as investment manager and investment advisor to a fund of hedge funds (the "2007 Fund".) In order to receive performance compensation in the form of a profit allocation, the investment manager acquired a limited interest in the 2007 Fund. That limited interest was analogous to the Special Interests that the Manager is to acquire in the Fund. The Banking Department determined that activities of the operating subsidiaries as investment manager and investment advisor were within the fiduciary powers approved for Bank by the Banking Board and the incidental powers of Bank under Section 234(23).
In approving the investment manager's acquisition of the limited interest in the 2007 Fund, the Banking Department relied on Section 235(31) of the Banking Law which section permits a savings bank to Invest in a limited amount of equity securities not otherwise permitted under the Banking Law. If, however, the Special Interests in the Fund are restricted to that which is necessary to enable the Manager to receive compensation in the form of a profit allocation and if the loss exposure of the Manager is limited to the amount of its investments in the Fund, then the Manager (and Bank indirectly) may acquire the Special Interests in the Fund under the authority to conduct investment management and advisory activities. The Banking Department is adopting a rationale analogous to that of the OCC - i.e., that the holding of the Special Interests is not viewed as an exercise of investment authority but rather as an activity incidental to providing investment management and advisory services.
As noted above, Section 235(31) of the Banking Law ("Banking Law") provides limited authority for a New York savings bank to make equity investments that are not otherwise authorized in the Banking Law. Theoretically, Bank could use this authority to make an investment in the Fund beyond the limitations applicable to the Special Interests. In such case, however, Bank would be relying on its authority to make investments rather than its authority to provide investment management services. Accordingly, Bank would have to evaluate the investment in light of its policies and procedures for investments. Moreover, if Bank's investment were beyond the authority of a national bank, the investment would be precluded by Section 24 of the FDI Act unless Bank obtained the FDIC's consent to the investment under Section 362.4(b) (1) of the FDIC's Regulations.19
The authority of Bank and its operating subsidiaries to provide investment management services together with its ability to establish "operating subsidiaries" pursuant to Sections 234(1) and 234(23) of the Banking Law is sufficient to allow it to establish the Manager and Advisor and for those entities to provide the investment management and advisory services described above. The Manager's acquisition of the Special Interests in the Fund would be included within such authority if such Special Interests were limited as described above.
Because of the 2007 Fund, Bank's establishing the Fund, the Feeder Funds, the Manager and the Advisor, and the Manager's acquisition of the Special Interests in the Fund would technically not be a "new product" within the meaning of the Banking Department's Industry Letter dated January 10, 2007. Still, in connection with similar structures, the OCC has required that the relevant national bank adopt a comprehensive risk management process acceptable to the relevant Examlner-in-Charqe.20 Among other things, such a process had to include the adoption and implementation risk management policies and procedures for monitoring the holding of interests in funds like the Special Interests as well as for addressing the inherent conflicts associated with holding such interests. Accordingly, the Capital Markets Unit of the Banking Department should conduct a risk management analysis of Bank's proposal prior to Bank's proceeding.
The above discussion has not considered the obligations of Bank and of the Fund, the Feeder Funds, the Manager and the Advisor under any laws other than the Banking Law including without limitation the securities laws.
Attached is draft letter responding to Bank's proposal. The letter has been prepared for your signature.
- The term "accredited investors" includes:
- Individuals who have a net worth, or joint worth with their spouse, above $1,000,000, or have income above $200,000 in the last two years (or joint income with their spouse above $300,000) and a reasonable expectation of reaching the same income level in the year of investment; or are directors, officers or general partners of the hedge fund or its general partner: and
Certain institutional investors, including: banks; savings and loan associations; registered brokers, dealers and investment companies; licensed small business investment companies; corporations, partnerships, limited liability companies and business trusts with more than $5,000,000 in assets; and many, if not most, employee benefit plans and trusts with more than $5,000,000 in assets.
- 17C.F.R. §230.501.
- 15 U.S.C. §§77a to 77aa.
- Section 2(a)(51) generally defines "qualified purchaser" to be: (1) any natural person who owns not less than $5 million in investments; (2) any family-owned company (as described in that section) that owns not less than $5 million in investments; (3) any other trust the trustee and settlor(s) of which are qualified purchasers that was not formed for the specific purpose of acquiring the securities of a fund exempt under Section 3(c)(7) of the Company Act; and (4) any person acting for its own account or the accounts of other qualified purchasers, that owns and invests on a discretionary basis not less than $25 million in investments.
- 15 U.S.C. §80a-2(a)(51).
- Assuming that neither Feeder Fund is making a "public offering," the first Feeder Fund would apparently fit within Section 3(c)(1) of the Company Act which excludes from the definition of investment company certain issuers whose outstanding securities (other than short-term paper) are beneficially owned by not more than 100 investors. The second Feeder Fund would apparently fit within Section 3(c)(7) of the Company Act which excludes from the definition of investment company certain issuers whose outstanding securities are owned exclusively by persons who, at the time of acquisition of such securities, are "qualified purchasers."
- The Partners will be the Feeder Funds.
- It is not clear whether the Manager's capital account balance will be included in this computation.
- 12 U.S.C. §67. Under Section 67, the "miscellaneous itemized deductions" of an individual are allowable only to the extent that the aggregate of such deductions exceeds two percent of the individual's "adjusted gross income."
- Letter dated May 30, 1985 from Michael Schussler of the Banking Department to Stephen B. Wilson of Thacher, Proffitt & Wood; letter dated March 9, 1998 from Barbara Kent of the Banking Department to Derrick D. Cephas of Cadwalader, Wickersham & Taft.
- A bank lacking such powers may provide investment advice only on a nondiscretionary basis i.e., where all investment decisions are made by the clients to whom the bank provides advice. Letter dated January 11, 1993 from Raymond L. Bruce of the Banking Department to Benjamin Raphan of Tenzer, Greenblatt, Fallon & Kaplan.
- Letter dated September 24, 1981 from Paul L. Lee of the Banking Department.
- Letter dated February 24, 1983 from Kevin F. Barnard of the Banking Department to Robert C. Pozen of Caplin & Drysdale.
- Section 96.1 of the Banking Law empowers a New York bank to "exercise all such incidental powers as shall be necessary to carryon the business of banking"; Section 234(1) authorizes a New York savings bank to "exercise all such incidental powers as shall be necessary to conduct the business of a savings bank," and the National Bank Act grants national banks the power to exercise "all such incidental powers as shall be necessary to carryon the business of banking." 12 U.S.C. § 24 (Seventh).
- 12 U.S.C. § 1831a(d)(1).
- 12 C.F.R. § 5.34(e)(1).
- OCC Conditional Approval No. 755 (August 26, 2006) (the "HSBC Approval"); OCC Conditional Approval No. 643 (June 16, 2004) (the "Blackrock Approval"); OCC Conditional Approval No. 578 (February 27, 2003) (the "B of A Approval"); OCC Interpretive Letter No. 940 (May 24, 2002 ("Interpretive Letter No. 940"); OCC Interpretive Letter No. 897 (October 23, 2000) ("Interpretive Letter No. 897").
- Note 17, supra.
- 12 C.F.R. §362.4(b).
- E.g., the HSBC Approval; the Blackrock Approval, and the B of A Approval, note17, supra.