NEW 2011 Edition of

Structuring Venture Capital,Private Equity, and

Entrepreneurial Transactionse are proud to enclose the 2011 edition of Structuring Venture Capital, PrivateEquity, and Entrepreneurial Transactions by Jack S. Levin, a senior partnerin the international law firm of Kirkland & Ellis LLP, in conjunction with specialeditors Donald E. Rocap and Russell S. Light of Kirkland & Ellis LLP and thelate Martin D. Ginsburg of Georgetown University Law Center.

Here is a summary, written by the authors, of major developments reflectedin the new edition.

l Tax rates.

n 2011–12 individual income tax rates. The top individual federal income tax rates

continue (through 2013) at 35% for OI, 15% for normal LTCG, and 15% for qualified

dividend income (i.e., the same as for LTCG). For Code §1202 LTCG (on ‘‘qualified

small business stock’’ held more than 5 years), the top federal income tax rate is 0%

if the stock was (or is) acquired between 9/28/10 and 12/31/11, 7% if the stock was

acquired between 2/18/09 and 9/27/10, or 14% if the stock was acquired before 2/18/09

(but after 8/93) or is acquired after 12/31/11.

The top individual federal income tax rate is scheduled to rise on 1/1/13 to 39.6%

for OI and dividend income and 20% for regular LTCG.

The Code §68 phase-out of a portion of a high-income individual’s itemized

deductions (equal to 3% of a joint return individual’s AGI in excess of approximately

$175,000 adjusted for post-2010 inflation) and the Code §151 phase-out of a high-

income individual’s personal exemptions (as a joint return individual’s AGI rises from

approximately $250,000 to $375,000 adjusted for post-2010 inflation), both of which

were repealed by Bush-era legislation, are scheduled to return for 2013 and thereafter.

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Highlights of the New Edition

Copyright © 2011 CCH Incorporated. All Rights Reserved.

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In addition to normal income tax as described above, an individual’s compensation

and self-employment income is subject to an uncapped Medicare tax (i.e., with no

ceiling on the amount subject to the tax) equal to 1.45% (non-deductible) on the

employee and 1.45% (deductible) on the employer (with the full 2.9% [one-half

deductible] imposed on an individual’s self-employment income). However, beginning

1/1/13 this uncapped Medicare tax on a high-income individual’s compensation and

self-employment income increases by 0.9% (from 2.9% to 3.8%) on the portion of the

individual’s compensation and self-employment income in excess of $250,000 (with no

inflation adjustment) on a joint return ($200,000 on an unmarried return), with the

entire 0.9% increase payable by the employee (or self-employed individual).

Also, beginning 1/1/13 a high-income individual’s passive income (such as CG,

dividends, and interest) not derived from his or her active conduct of a business—to

the extent such passive income constitutes taxable income for regular income tax

purposes—is subject to a 3.8% uncapped Medicare tax (i.e., with no ceiling on the

amount subject to the tax) but only if (and to the extent) the individual’s AGI

exceeds $250,000 (with no inflation adjustment) on a joint return ($200,000 on an

unmarried return).

n 2011–12 estate tax rates. The top individual federal estate tax rate for 2011–12 is

35% with a $5 million exemption, scheduled to rise to 55% with only a $1 million

exemption on 1/1/13.

n 2011–12 corporate income tax rates. The top corporate income tax rate (on both

OI and CG) for 2011–12 continues at 35%, with a slight reduction for U.S. domestic

production business net income (which slight rate reduction also applies to an

individual’s U.S. domestic production business net income). See discussion at ¶107and ¶201.1.1.

l Newco formation.

n Newco fundraising by selling unregistered stock under SEC Reg. D.

5 Accredited investor definition. Newco can sell unregistered stock (i.e.,

without 1933 Act registration) in a private placement under Reg. D. Where

Newco’s stock offering exceeds $1 million, Newco can sell to an unlimited

number of accredited investors (‘‘AIs’’) and up to 35 non-AIs. One category of

AI is an individual with a $1 million or greater net worth. The 7/10 Dodd-

Frank Act changed the calculation of such AI net worth to exclude the

individual’s primary residence FV (and indebtedness relating to the residence

up to the residence’s FV). See discussion at ¶207.3.2(1).

5 Integration. When Newco sells stock over an extended period of time, it is

often unclear whether various stock sales must be integrated (as if they were a

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single stock offering) or whether they can be treated as several separate stock

offerings for Reg. D purposes (e.g., in determining whether the relevant Reg. D

offering was more or less than $1 million, or in determining whether the relevant

offering was sold to more or less than 35 non-AIs, etc.). The authors have

expanded their explanation of SEC’s complex web of subjective and objective

integration rules used in making such determination. See discussion at ¶207.3.5.

5 Raising capital without 1933 Act or 1934 Act SEC registration. When

Newco raises capital—upon its initial formation and/or in subsequent financing

rounds—Newco often seeks to sell its securities to numerous buyers without

1933 Act or 1934 Act SEC registration, since either type of such registration

would be time consuming, expensive, and require public disclosure of Newco’s

game plan (including to its competitors).

Newco can avoid 1933 Act registration by qualifying its securities sales for

SEC Reg. D and/or SEC Rule 701 and can avoid 1934 Act registration by both

avoiding a 1933 Act public offering of its securities and also by ensuring that no

class of its equity securities (viewing different classes with substantially similar

character and substantially similar rights and privileges as one class) is held by

500 or more record holders, based on Newco’s records maintained in

accordance with accepted practice, but modified to the extent Newco knows or

has reason to know that a record holder (e.g., a custodian or entity) is being

used primarily to circumvent (i.e., reduce) the number of record holders.

However, one way in which Newco’s plan to avoid 1933 Act registration and

public disclosures may be thwarted is that Reg. D (Rules 505 and 506, as well

as Rule 504 with an exception) prohibits Newco from engaging in general

solicitation or advertising during a Reg. D offering (including general advertising

or solicitation solely to AIs in an offering open only to AIs).

And Newco’s plan to avoid 1934 Act registration and public disclosures may

be thwarted if Newco’s private-placement stock (even if issued by Newco to

far fewer than 500 record holders) ends up being held by 500 or more record

holders, e.g., through a cascading series of private-placement resales by the initial

purchasers and/or by Rule 144 public resales by the initial purchasers after the

required 6 month or 1 year holding period.

In addition, even where Newco’s stock is held by fewer than 500 record

holders, if Newco’s private placement stock was issued (a) to an entity (e.g., a

partnership or LLC) with a large number of owners, perhaps formed by (e.g.) a

broker-dealer or investment bank to purchase Newco’s private-placement

stock, or (b) to a broker-dealer or investment bank acting as nominee for a large

number of underlying purchasers, the scope of SEC’s subjective 1934 Act look-

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through rule (where Newco knows or has reason to know such record holder is

being used primarily to circumvent the 500-record-holder limitation) is unclear.

In early 2011 a large investment bank was in the process of forming an

entity (likely a limited partnership or LLC) and selling equity interests in the

entity to a large number of AIs in a Rule 506 private placement with the

entity’s proceeds to be used to buy (in a Rule 506 private placement) a very

substantial primary offering of stock in a rapidly expanding privately held social

network company. Because of uncertainty about both the 1933 Act Reg. D no-

general-solicitation-or-advertising rule and the 1934 Act 500-record-holders-look-

through rule, the offering was substantially restructured and potential U.S. buyers

excluded. In the aftermath of this controversial transaction, SEC has indicated

that it is re-examining both its 1933 Act Reg. D no-general-solicitation-or-

advertising rule and its 1934 Act 500-record-holders rule. See discussion at

¶207.3.9.

n Newco as partnership—GP liability for Newco’s unpaid liabilities. Where

Newco is organized as a partnership in one of the 39 states granting full shield

protection to a partnership formed in such state and electing to be a ‘‘limited

liability partnership’’ (an LLP), such LLP now qualifies for full shield protection in 47

states (all states except Pennsylvania, Louisiana, and California), after Utah’s recent

move to full shield status. See discussion at ¶302.1.2.

n Newco as partnership or LLC—fiduciary duties. In the case of a corporation,

principles of corporate governance (including fiduciary duties) are dictated largely by

state statute and case law and generally cannot be altered by contract (e.g., by the

corporation’s articles of incorporation). On the other hand, in the case of a partnership

or LLC, most state partnership and LLC laws are silent (and hence ambiguous) on

whether traditional principles of corporate governance also apply to a partnership or

LLC.

However, Delaware’s partnership and LLC law is more expansive (and more liberal)

on the topic of partnership/LLC governance (including fiduciary duties). Since most

states treat the law of a partnership/LLC’s organization state as determinative of the

entity’s internal governance issues, a partnership/LLC formed in Delaware can invoke

Delaware’s more expansive (and more liberal) governance provisions.

In general, Delaware’s partnership/LLC statutes allow ‘‘A [partnership/LLC]

agreement [to] provide for the limitation or elimination of any and all liabilities

for breach of contract and breach of duties (including fiduciary duties),’’ allowing a

Delaware partnership/LLC to reduce or even eliminate fiduciary duties, so long as the

governing document embodies a clear, express waiver of fiduciary duties, subject to

another statutory proviso that ‘‘a [partnership/LLC] agreement may not limit or

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eliminate liability for any act or omission that constitutes a bad faith violation of the

implied contractual covenant of good faith and fair dealing.’’

Although the Delaware courts have not yet provided a clear interpretation of the

non-waivable implied good faith and fair dealing covenant, the authors analyze a

number of Delaware-decided cases dealing with the implied covenant and suggest that it

is desirable for the partnership/LLC agreement to speak explicitly with respect to

concrete fiduciary duty issues: e.g., where the governing agreement contains a general

statement waiving the manager’s fiduciary duties and also authorizes the manager in his

or her discretion to operate the business, specifically including hiring, firing, and

establishing compensation for partnership/LLC employees and consultants, as well as

buying and selling partnership/LLC assets and establishing the purchase/sale price

therefor, it is desirable for the partnership/LLC agreement to specifically cover a

possible transaction between the manager and his or her relatives or affiliates, either by

(1) adding a clause expressly requiring any such transaction between the entity and the

manager’s relative or affiliate (broadly defined) to be at a reasonable arm’s length price

or (2) explicitly stating that such a related-party transaction need not be at an arm’s

length price. See discussion at ¶302.1.4 and ¶303.1.3.

n Accounting treatment for Newco’s preferred stock. Although preferred stock

is normally treated, for accounting purposes, as net worth, which is important in

calculating Newco’s compliance with loan agreement financial covenants

(e.g., maximum permitted debt/equity ratio), two rules alter this accounting

conclusion:

First, FASB 150 requires that mandatorily redeemable preferred stock be treated

for GAAP purposes as a liability, not as equity (and that yield thereon be treated as

interest expense). Preferred stock falls within this rule if mandatorily redeemable

on a fixed date(s) or upon the occurrence of an event certain to occur, but preferred

stock puttable at the holder’s option does not.

Second, if Newco is a 1934 Act registered company—generally a company with a

class of debt or equity listed on a national securities exchange, or with a class of stock

held by 500 or more holders, or with debt or stock issued pursuant to a 1933 Act

registration statement—SEC rules (applicable to 1934 Act registered companies) would

require Newco preferred stock not covered by FASB 150 (and hence not treated as a

liability for GAAP purposes) to be treated as temporary capital, and hence shown on its

balance sheet above net worth but below liabilities if such preferred stock is either

puttable, or held by persons who control Newco, or mandatorily redeemable under

specified circumstances not in Newco’s control. If this SEC rule applies to Newco’s

preferred stock (but FASB 150 does not apply), then for purposes of calculating

Newco’s covenant compliance, it is not clear (absent specific language in Newco’s loan

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agreement) whether such temporary capital would be treated as debt or as equity or as

neither. See discussion at ¶402.2 and ¶601.3.

n SBIC fund as investor in Newco. Where a VC fund investing in Newco is an SBIC,

the rules on the percentage of an SBIC’s assets which must be invested in ‘‘smaller

enterprises’’ (as opposed to ‘‘small businesses’’) have changed.

Also, the maximum percentage of an SBIC’s assets which can be invested in any single

portfolio company has also changed. See discussion at ¶209.1 (Smaller Enterprise

requirement and Other restrictions).

l Buyout transaction.

n HSR filing for Newco-Target acquisition. A Hart-Scott-Rodino filing with FTC/

DOJ is required if the size of Newco’s acquisition of Target (and, in certain cases, the

size of the parties to the transaction) exceeds specified tests.

5 Annual inflation adjustment. The authors have updated the entire HSR

discussion to reflect the 2/11 annual inflation adjustment of all the HSR tests,

thresholds, and filing fees.

5 Proposed increase in information required to be submitted. 8/10 proposed

HSR amendments, if adopted, would significantly increase the information

Newco and Target are required to provide to FTC/DOJ with an HSR filing. In

particular, the proposed amendments would require submission of synergy and/

or efficiency studies prepared in connection with the transaction and the

following categories of documents prepared up to two years before the HSR

filing referencing the assets or entities to be acquired: (i) offering memoranda (or

documents serving such function) and (ii) studies, surveys, analyses, and reports

prepared by investment bankers, consultants, or other third-party advisers for

any officer or director (or person exercising similar functions in an unin-

corporated entity) of Target or Newco (including any controlling parent or other

controlled entity) addressing market shares, competition, competitors, markets,

and potential for sales growth or expansion (either geographic or with new

products). See discussion at ¶501.3.3.

n Newco subsidiary’s upstream guarantee of Newco’s acquisition debt. Where a

subsidiary entity guarantees a parent entity’s debt (e.g., a Newco subsidiary guarantees

Newco’s financing for its Target acquisition) but the subsidiary doesn’t receive the

loan proceeds, there are substantial questions as to whether the subsidiary’s guarantee

of the parent’s debt constitutes a fraudulent conveyance. In the 2009 TOUSA case,

the bankruptcy court held that such a guarantee did constitute a fraudulent conveyance

and also held invalid a savings clause in the guarantee that purported to limit the

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subsidiary’s guarantee liability to the maximum amount that would not result in a

fraudulent conveyance.

On appeal, the District Court in 2011 held that the guarantee was not a fraudulent

conveyance because the subsidiary received reasonably equivalent value in exchange

for its guarantee (even though the subsidiary did not receive any of the loan proceeds),

since the subsidiary’s guarantee prevented a possible large default on pre-existing

debt. Hence the District Court did not reach the validity of the savings clause. See

discussion at ¶501.4.3.9(1).

n Tax aspects of Newco’s acquisition of Target—use of consulting payments,non-compete payments, or sale of Target shareholders’ personal goodwill.

5 Consulting or non-compete payments. Where Newco’s acquisition of Target

is structured for asset COB (e.g., Newco purchase of Target C corporation’s

stock), it is generally tax efficient from Newco’s standpoint to pay as much of the

purchase price as possible directly to one or more Target shareholders as (1)

compensation for future executive or consulting services and/or (2) non-compete

payments. As long as reasonable in amount, such payments are:

(a) taxable to the recipients as OI,

(b) not taxable at the Target level, and

(c) deductible by Newco over (i) the life of the employment or consulting

arrangement (in the case of employment or consulting payments) or

(ii) 15 years under Code §197 (in the case of non-compete payments).

However, because Target’s individual shareholders are taxed at a substantially

higher top rate on OI (including a consulting or non-compete payment) than

on LTCG—a 35% top federal income tax rate for OI compared to a 15%

top federal income tax rate for LTCG—Target’s shareholders generally seek

to minimize allocation to consulting or non-compete payments and/or seek

a gross-up payment from Newco to compensate for the higher OI tax rate.

Where Target has multiple shareholders, some heavily involved in Target’s

business whose services or non-compete covenants are very valuable to Target

and some not, and Newco agrees to make payments to all of them pro rata in

accordance with their stock ownership, IRS can be expected to take the position

that the payments really constitute additional (disguised) consideration for the

Target stock (or assets) sold (rather than compensation for services or non-

competition). For Newco to justify treatment of such payments as deductible

service or non-compete payments, Newco must be able to justify the payment to

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each selling shareholder as reasonable in relation to the value of each such

shareholder’s services or non-compete covenant.

5 Personal goodwill payments. Where Newco’s acquisition of Target is

structured for asset COB, paying part of the purchase price to one or more

Target shareholders as consideration for goodwill personally owned by such

payee shareholder(s) may be more tax efficient for the recipients of such personal

goodwill payments than where they receive part of the purchase price as service or

non-competition payments. This is because in appropriate circumstances such

payments are:

(a) taxable to the recipient shareholder as CG (generally LTCG because

the goodwill being sold by the shareholder has a more than one year

holding period),

(b) not taxable at the Target level, and

(c) deductible by Newco over 15 years under Code §197 (as a non-compete

covenant would be).

Sale of a corporate shareholder’s personal goodwill to create shareholder-level

LTCG without corporate-level tax has been validated by only a few decided

cases and at best is available in only limited circumstances, likely only where

the payee-shareholder (1) has strong personal relationships with Target’s

customers and/or other key constituents and (2) has no pre-existing

non-compete covenant or employment contract with Target restraining

him or her from shifting his or her strong personal relationships from

Target to Newco or another third party. See discussion at ¶502.1.1.5 and

¶502.1.1.6.

n Structuring Newco’s acquisition of Target for asset SUB.Where Target is a C corp

(subject to the American double tax system) and Newco’s buyout of Target C corp is

structured to achieve tax SUB for Target’s asset—generally as Newco’s purchase of

Target’s assets or as Target’s forward cash merger into Newco or as Newco’s purchase

of Target’s stock with a Code §338(h)(10) election or as a Newco transitory subsidiary’s

reverse cash merger into Target with a Code §338(h)(10) election—there may be a threat

to Newco’s asset SUB where any one of the following six highly technical and fact-

specific ‘‘SUB threat’’ tax rules applies:

(1) D reorg risk

(2) Code §351 risk

(3) Constructive Code §351 risk

(4) Defective Code §338 election risk because of Code §351

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(5) Defective Code §338 election risk because of §338’s related party rule

(6) Defective Code §338 election risk because of Code §304

See discussion at ¶502.1.1.2.

n Code §1374 penalty tax where Target is SCo. Where Newco is buying Target and

Target is an SCo, Code §1374 has long imposed a corporate-level penalty tax on an SCo

selling assets within 10 years after (1) Target switched from C to S status or (2) Target

acquired COB assets from a C corp. In 2/09 Congress temporarily reduced the time

period from 10 years to 7 years for such gain recognized in 2009–10, and in 9/10

Congress further temporarily reduced the time period from 7 years to 5 years for such

gain recognized in 2011. See discussion at ¶301.2.2(8).

n Newco’s deal protective provisions in acquisition agreement with Target—hybrid no shop/go shop. Once Newco and Target reach a deal, Newco generally seeks

to include (in the Newco-Target acquisition agreement) deal protective provisions to

discourage competing bidders for Target and/or to compensate Newco should another

bidder for Target ultimately triumph, including a no-shop, and perhaps also a go-shop

clause, and also a breakup fee agreement covering Newco’s expenses plus a

compensatory element.

In addition to a no shop and a go shop, there is a hybrid approach—somewhere

between a pure no shop and a no shop with a go-shop period—which works as follows:

Target agrees (in the Newco-Target acquisition agreement) to a no shop (i.e., a

prohibition on Target soliciting third-party offers), but Target remains free to respond

to unsolicited third-party proposals, and if Target should accept a third-party proposal

received within a specified period after announcement of the Newco-Target transaction

(e.g., 30 days) which is superior to Newco’s proposal, Target owes Newco a reduced

breakup fee (often 1% to 2% of Newco’s acquisition price for Target rather than the full

3% to 4% breakup fee).

This hybrid approach (like a go shop) includes a reduced breakup fee for Target’s

termination of the Newco-Target acquisition on account of a superior unsolicited third-

party bid surfacing during the defined period, but eliminates Target’s often frenzied go-

shop search for third-party bids by assuming that the public announcement of the

Newco-Target transaction will be sufficient to attract third-party bids (if any would

have been forthcoming in response to Target’s active solicitation) even without Target’s

active solicitation. See discussion at ¶503.3.1.2 (Hybrid no shop/go shop).

n ERISA group liability where investor group acting in concert acquires Target.When Newco (or PE fund) acquires 80% or more of Target (calculated in a surprisingly

broad manner), Target becomes a member of Newco’s (or PE fund’s) ERISA

control group, so that all group members are jointly and severally liable for all group

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members’ ERISA obligations. A 7/10 court decision suggests that where Newco (or PE

fund) purchases less than 80% of Target while other persons acting in concert with

Newco (or PE fund) also purchase ownership interests in Target, with the persons so

acting in concert acquiring in the aggregate 80% or more of Target, a court might,

under circumstances not yet explicated, hold (in effect) that all of such persons are liable

for all group members’ ERISA group liabilities. The logic behind this surprising

conclusion is as follows:

5 The persons acting in concert in purchasing interests in Newco may constitute a

joint venture.

5 Under the Code, a joint venture constitutes a partnership.

5 Where the persons acting in concert (through such constructive partnership)

acquire 80% or more of Target in the aggregate, the constructive partnership is

viewed as acquiring 80% or more of Target, so that the constructive partnership

becomes a member of Target’s ERISA group.

5 Because the constructive partnership does not qualify as a limited partnership or

a limited liability partnership or an LLC, all of the constructive partnership’s

equity owners (including Newco and/or PE) are liable for the constructive

partnership’s unpaid debts, including Target’s ERISA liabilities (for which the

constructive partnership is liable as a member of Target’s ERISA group),

although the court did not explicitly discuss this latter point.

The actual facts of the 7/10 discussion involved a PE management company which

formed and acted as general partner of three private equity investing entities during

the same year (each of which had a different group of limited partners), referred

to informally by the PE management company as Fund II. Fund II co-invested in

each investment arranged by the PE management company (including the investment

in Target) pro rata in accordance with each entity’s available capital, with all

three investment entities purchasing their interests in Target pursuant to a single

securities purchase agreement.

The court denied the PE fund’s summary judgment motion on the ground that

whether there was a constructive partnership among the three investment entities and

the PE management company constitutes a question of fact requiring a trial. However,

because the parties thereafter settled the case, there will be no trial and no further

opinion.

The court’s constructive partnership conclusion seems at variance with a line of IRS

rulings dealing with Code §382 (which generally taints a corporation’s NOLs if

ownership of the corporation’s stock held by its 5% or greater shareholders changes by

more than 50% over a 36-month period). Where several persons each purchase less than

5% of an NOL corporation’s stock, but such persons, viewed in the aggregate, purchase

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5% or more of such NOL corporation’s stock, the question arises whether they should

each be viewed as a separate person (in which case none constitutes a 5% or greater

shareholder whose ownership change has §382 relevance) or whether they should be

viewed as having formed a constructive partnership which is treated as owning all the

stock purchased by all the members of the group (so that the constructive partnership

has purchased 5% or more of Target’s stock and is §382 relevant).

The IRS private letter rulings deal with a family of mutual funds with a common

investment adviser, with several private investment funds with a common adviser also

acting as the funds’ general partner, and with several pension funds for the employees of

a consolidated group of companies and conclude that each fund should be viewed

separately, even though in at least one of the letter rulings the group of funds regularly

invested in the same stocks in the same proportions. See discussion at ¶501.5.3.1.

l PE/VC fund formation.

n Investment Advisers Act—prohibition on carried interest for SEC-registeredinvestment adviser. A PE/VC fund’s GP management company constitutes an

‘‘investment adviser’’ (an ‘‘IA’’) under the Investment Advisers Act (the ‘‘IAA’’),

because the GP management company is a ‘‘person who, for compensation [here a

management fee and carried interest], engages in the business of advising others [here

PE/VC fund] . . . as to the advisability of investing in, purchasing, or selling securities

[i.e., the securities purchased by PE/VC fund].’’

An IA is required to register with SEC under the IAA unless an exemption is available.

Most PE/VC fund GPs have long utilized the IAA’s long-standing fewer-than-15-clients

exemption (with each fund advised by the IA generally counted as one client).

If an IA is SEC-registered, the GP management company is prohibited from receiving

carried interest unless an exemption is available. There are, however, exemptions which

allow a registered IA to receive carried interest:

(1) from a §3(c)(7) (all QP investors) fund, or

(2) from an LP in a §3(c)(1) (100 or fewer) fund who is a QP, or

(3) from an LP in a §3(c)(1) (100 or fewer) fund who (although not a QP) is a heavy

hitter/qualified client, i.e., who has at least $750,000 of assets under the GP’s

management (generally measured by the FV of such assets plus the amount of

uncalled commitments) or who has at least $1 million of net worth.

In determining whether an entity LP is a heavy hitter/qualified client for purposes

of exemption (3), SEC applies a look-through approach where both PE/VC fund

(the ‘‘lower-tier entity’’) and such entity LP (the ‘‘upper-tier entity’’) are ICA exempt

under ICA §3(c)(1) (100 or fewer), i.e., SEC focuses on the upper-tier entity’s equity

owners (or if an upper-tier entity has an equity owner which is also a §3(c)(1) [100 or

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fewer] fund, SEC focuses on the ultimate equity owners), so that each ultimate

equity owner must satisfy one of the above heavy hitter/qualified client tests.

In 5/11 SEC proposed several amendments to the $750,000 and $1.5 million

thresholds for determining heavy hitter/qualified client status, with the effective date to

be specified in SEC’s final rule. The SEC proposal would (1) increase the $750,000

assets under management threshold to $1 million and (2) increase the $1.5 million

net worth threshold to $2 million and (in the case of a human being) exclude the FV

of an individual’s primary residence and any debt secured thereby up to the residence’s FV.

The SEC proposal is not retroactive, so that (1) if the IA had entered into an

advisory contract with a client before the proposal’s ultimate effective date, the client’s

status as a heavy hitter/qualified client is determined based on the SEC rules in effect at the

time the advisory contract was entered into (including the $750,000 and $1.5 million

thresholds) and (2) if the IA had been exempt from IAA registration at the time it entered

into an advisory contract with the client (or with the fund in which the client is an LP),

the IAA’s carried interest prohibition does not apply to such IA-client relationship even

after the IA registers under the IAA.

However, if a person first became subject to a pre-existing advisory agreement

after adoption of the revised thresholds (as in (1) above) or after the IA ceased to be exempt

from the IAA (as in (2) above), such person’s heavy hitter/qualified client status vel non

would be determined when such person first became subject to the advisory agreement

(not at the earlier time when the IA entered into the advisory agreement). For example,

where IA is (and has long been) an adviser to (i.e., generally GP of) a private fund and a

person not previously an LP of such private fund acquires an LP interest in such

private fund, the new LP’s heavy hitter/qualified client status vel non is determined based

on the IAA rules in effect when the new LP acquires its interest in the fund. See discussion

at ¶1010.1 through ¶1010.5.

n Investment Adviser’s Act—7/10 Dodd-Frank Act Repeals Fewer-Than-15 IAAExemption and Enacts Several New Exemptions. Responding to the 2007-10

financial crisis, the 7/10 Dodd-Frank Act (1) repealed the IAA fewer-than-15-clients

exemption (exempting an IA with fewer than 15 clients from registering under the IAA)

and created instead a number of narrower IAA registration exemptions, with

substantial SEC power to elaborate on the requirements necessary to fit within the new

exemptions.

Although originally scheduled to become effective in 7/11, SEC staff has announced

that the Act will (because substantial implementing regulations are not yet completed)

become effective sometime in the first quarter of 2012.

The first of the Dodd-Frank Act’s new IAA exemptions is for an IA with less than

$100 million assets under management (‘‘AUM’’), generally measured by the FV of

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investment assets plus the amount of uncalled commitments. This $100 million

threshold replaces the prior $30 million AUM threshold for mandatory IAA

registration, as well as the old $25 million AUM threshold for voluntary IAA

registration.

For purposes of measuring the IA’s AUM, as well as for measuring the number

and/or nature of the IA’s clients for purposes of the new exemptions discussed below,

the IA is likely viewed in conjunction with its related ‘‘alter ego’’ investment advisory

entities, although SEC’s proposed regulations are silent on the topic.

The second of the Dodd-Frank Act’s new exemptions (called the mid-sized private

fund adviser exemption) covers a U.S.-based IA which advises solely mid-sized ‘‘private

funds’’ (i.e., funds which are exempt from ICA registration under either ICA §3(c)(1)[100 or fewer investors] or ICA §3(c)(7) [all QP investors]) where the IA has less than

$150 million aggregate AUM from such funds.

Such an IA can voluntarily register under the IAA if it has $100 million AUM but

(because of this second exemption) is not required to register under the IAA until it has

$150 million AUM.

Because of the word ‘‘solely’’ in the exemption, an IA otherwise qualifying for this

exemption would cease to qualify if it managed other types of funds or accounts, e.g., if

it was also an IA to one or more managed separate accounts or employee securities

companies.

It appears likely that an IA otherwise qualifying for this exemption would not qualify

if a related investment adviser entity treated as an ‘‘alter ego’’ of the IA seeking to

qualify for the exemption is an adviser to other types of funds or accounts. Similarly, it

appears that in determining whether an IA has less than $150 million AUM, such IA

must be viewed in conjunction with all other related ‘‘alter ego’’ investment adviser

entities. However, it appears that if a related investment adviser entity is not an ‘‘alter

ego’’ to the IA seeking to utilize this exemption (because, e.g., the two IAs, although

commonly controlled, use different personnel and there is no information sharing

between the two IAs), the related investment adviser entity’s AUM and the nature of its

advisees would not taint the IA seeking to use this exemption.

The third of the Dodd-Frank Act’s new IAA exemptions is for an IA (likely viewed in

conjunction with its related alter ego investment adviser entities) solely to ‘‘venture

capital funds.’’ This exemption grants wide latitude to SEC to define venture capital

fund. SEC’s draft regulations defining a venture capital fund are very narrow, very

lengthy, and excessively detailed, requiring, in general, that all the following

requirements be met:

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l The fund must be a private fund (i.e., a fund qualifying for the ICA §3(c)(1) or§3(c)(7) exemption from ICA registration), not ICA registered and not a BDC.

l The fund must hold only qualifying portfolio company equity securities and cashequivalents, with equity securities likely meaning stock and securities (includingconvertible debentures and warrants) convertible or exercisable (with or withoutconsideration) into portfolio company stock.

l A qualifying portfolio company means an operating company (not, e.g., a fund) whichis neither publicly traded at the time of the fund’s investment, nor controlled by,controlling, or under common control with a publicly traded company.

l At least 80% of the portfolio company’s equity securities acquired by the fund must beacquired directly from the portfolio company, although up to 20% can be acquiredfrom the portfolio company’s old shareholders, and at least 80% of the capitalsupplied by the fund must be for the portfolio company’s operating or businessexpansion (rather than to buy out old shareholders).

l The fund must offer significant management assistance (i.e., active managementassistance or board representation) to, or exercise controlling influence over, theportfolio company. And if a group of venture capital funds are investing in theportfolio company, only those offering significant management assistance qualify.

l The portfolio company must not incur debt in connection with the fund’s investment,although the portfolio company can borrow in the ordinary course of business,e.g., to finance inventory and equipment, manage cash flows, and meet payroll.

l The fund must not offer redemption or similar rights to its limited partners, except inextraordinary circumstances.

l The fund must represent itself to its limited partners as a venture capital fund, not as ahedge or multi-strategy fund.

l The fund must not borrow or incur guarantees exceeding 15% of the fund’s capitalplus uncalled commitments, the term of any such debt cannot exceed 120 days,and such debt must be non-renewable.

l There is grandfathering for a fund formed before 12/31/10, which sells no securitiesand accepts no capital commitment after 7/21/11, and which represented itself toits limited partners as a venture capital fund when offering its securities.

The fourth of the Dodd-Frank Act’s new exemptions is for an IA (likely viewed in

conjunction with its related ‘‘alter ego’’ investment advisory entities) solely to SBICs.

14

The fifth of the Dodd-Frank Act’s new exemptions is for an IA (likely viewed in

conjunction with its related ‘‘alter ego’’ investment advisory entities) to one family

office.

The sixth of the Dodd-Frank Act’s new exemptions is for a foreign (non-U.S.)

private adviser (likely viewed in conjunction with its related ‘‘alter ego’’ investment

advisory entities) which meets all of the following tests:

l No U.S. place of business.

l Less than 15 clients and investors domiciled or resident in the U.S., with a look-through rule for private funds.

l Less than $25 million AUM attributable to U.S. clients and investors.

l Does not hold itself out as an investment adviser in the U.S.

l Does not advise any ICA registered investment company or BDC.

The seventh new exemption—contained in SEC proposed regulations and designed

for a non-U.S. based IA—is a particularized application of the second exception

discussed above (for an IA solely to mid-sized private funds where the IA has less

than $150 million aggregate AUM from such private funds). SEC’s proposed regulation

exempts a non-U.S. based IA which either has no U.S. office or has a U.S. office

or offices with responsibility for less than $150 million AUM, all of which comes

from private funds.

In summary, once the Dodd-Frank Act is effective:

l A U.S. fund manager with one or more advisees other than private funds (e.g., whichadvises one or more managed separate accounts or employee securities companies)and has at least $100 million AUM must register under IAA.

l A U.S. fund manager with only private fund advisees with at least $150 million AUMmust register under IAA.

l The test for voluntary IAA registration increases from $25 million to $100 millionAUM, so that a U.S. IA with less than $100 million AUM is regulated by thestates, not by SEC, as is a fund manager solely to private funds with $100 millionor more AUM but less than $150 million AUM who chooses not to voluntarily registerwith SEC.

Finally, some of the new exceptions are more liberal in at least one respect than

the old fewer-than-15-clients exception. An IA qualifying, for example, for the

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mid-sized private funds exemption, or the venture capital funds exemption, or the

SBIC exemption is exempt from IAA registration even if such IA has 15 or

more advisees. See discussion at ¶1010.8.

n Proposed carried interest tax legislation. Typically the GP entity for a PE/VC fund

(or certain other investment funds) has an approximately 20% carried interest in the

fund’s profits. Beginning in 2007, there have been legislative proposals, aimed solely at a

partnership or LLC engaged in investment or real estate activities, to change the Code’s

long-standing character flow-through regime for partnership/LLC income (including

LTCG) allocable to a service partner with a carried interest.

The 2010 version of this legislation (which passed the House of Representatives but

not the Senate) would have enacted new Code §710, treating a specified portion (50% to

75%) of Code §710-tainted income (including LTCG) as compensation OI. The bill was

primarily focused on a service provider’s carried interest, i.e., a profit allocation to a

service partner (that is, a partner who advises on purchasing, selling, managing, or

financing [i.e., renders ‘‘investment management services’’] with respect to stock,

partnership/LLC interests, or real estate held for rental or investment, and certain other

assets [‘‘specified assets’’]), to the extent the allocation is disproportionately greater than

the service partner’s capital contribution. However, because of extremely opaque

language in some portions of the bill and extremely sweeping language in other

portions, the bill potentially covered far more than merely traditional carried interest

allocations.

This carried interest legislation was not enacted in 2010 but, although not likely to be

enacted in 2011 or 2012 because of the 11/10 Congressional election results, may well

reappear at some time in the future. See discussion at ¶1006.4.

l Troubled company debt restructuring.

n Debt restructuring under state law. Many states have laws which would permit

Badco to effect a restructuring without resorting to a longer and more expensive federal

bankruptcy filing. The popularity of such non-bankruptcy procedures has increased as

state laws have become increasingly more sophisticated and troubled companies have

sought efficient methods for restructuring, while avoiding the time and expense of a

federal bankruptcy.

Delaware law, for example, permits a Delaware court to approve and make binding a

compromise or arrangement accepted by ‘‘a majority in number representing three

fourths in value of the creditors or class of creditors, and/or the shareholders or class of

shareholders’’ being impaired by the compromise or arrangement if the debtor’s

certificate of incorporation so permits. If all of Badco’s creditors and shareholders who

16

will be bound by the compromise consent to it, the procedure is straightforward and can

be completed at a relatively low cost within a week after filing in Delaware court.

If not all Badco creditors and shareholders consent, application of such a state

restructuring statute is limited by constitutional considerations including, in particular,

the supremacy of the federal Bankruptcy Code with respect to how a non-consenting

creditor may be bound to a discharge, adjustment, or restructuring of its claim. Such

constitutional considerations should not, however, apply to the portion of a state statute

which permits the alteration of shareholder rights, as those rights are themselves created

by the state statute. Thus, while only consenting creditors—and not non-consenting

creditors—may be bound by such a state law procedure, it is very likely that both

consenting and non-consenting equity holders are bound, if the compromise or

arrangement is accepted by the requisite majorities.

If a state court proceeding (rather than federal bankruptcy) is used to extinguish

creditor claims against Badco, Badco recognizes taxable CODI (because the Code

§108 bankruptcy exception to CODI recognition does not apply to a state court

proceeding)—except to the extent Badco can demonstrate it was insolvent at the time of

the debt cancellation (so that the Code §108 insolvency exception applies).

Such a state court proceeding would, however, qualify for two other tax advantages,

(1) the Code §382 opt out where at least 50% of Badco’s post-restructuring stock is held

by pre-restructuring shareholders and ‘‘good’’ creditors and (2) the §382 automatic

increase in stock FV for debt cancelled in the restructuring, both applicable to federal

bankruptcies as well as similar state court proceedings. See discussion at ¶808.5.

n Avoiding Code §382 limitations on post-restructuring NOL utilization. Code §382imposes an annual limitation on the use of Badco corp’s NOL carryforwards after a

more-than-50% change in Badco’s ownership within a 36-month period. The annual

limit is equal to the long-term tax-exempt bond rate times the FV of Badco’s stock

immediately before the ownership change. Moreover, if Badco’s business enterprise is

not continued for two years after the more-than-50% ownership change, Badco’s NOLs

are disallowed altogether.

Such a Code §382 NOL limitation is imposed (i.e., Badco’s NOLs become §382‘‘tainted’’) if the percentage of Badco’s stock owned by any one or more ‘‘5%

shareholders’’ is more than 50 percentage points higher than the lowest percentage of

Badco’s stock that such shareholder(s) owned at any time during the prior three years.

In general, a 5% shareholder is any individual or entity that directly or indirectly owns

5% or more of Badco’s ‘‘stock,’’ and all Badco stock owned by persons who are not 5%

shareholders of Badco is generally treated as stock owned by one 5% Badco shareholder.

If NOLs constitute a significant portion of Badco’s value, Badco and/or its

shareholders might adopt one or more of three devices in an effort to avoid the adverse

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effects of a Code §382 ownership change (and in some circumstances a Code §269ownership change) would have on Badco’s NOLs. The first device is for Badco’s

shareholders and/or creditors to enter into a consensual stand-still agreement

prohibiting (or restricting) stock transfers prior to or following a restructuring

transaction, and under some circumstances a bankruptcy court may be willing to impose

a standstill order on non-consenting shareholders and/or creditors.

A second device is for Badco’s board of directors to adopt a poison pill plan (more

commonly used as a takeover defense) granting Badco shareholders (other than the

shareholder triggering the poison pill) the right to purchase newly issued Badco stock at

a substantial discount from FV if, for example, a shareholder acquires 5% or more of

Badco’s stock.

A third device is for Badco’s board and shareholders to adopt a charter amendment

under which any transfer of Badco’s stock to a shareholder who owned, or who would

own as a result of the transfer, 5% or more of Badco’s stock would be null and void ab

initio.

A 2006 IRS letter ruling discusses the tax ramifications of this third device. Badco

adopted a charter amendment under which any sale or other transfer of Badco’s stock to

a shareholder who owned, or who would own as a result of the transfer, 5% or more of

Badco’s stock would be null and void ab initio unless certain requirements were satisfied.

If the purchasing shareholder obtained a waiver from Badco’s board and provided

Badco with an opinion that the Badco stock transfer would not result in a limitation on

Badco’s use of its NOLs or other tax attributes, then the Badco stock transfer would not

be precluded. If a shareholder acquired stock in violation of the charter amendment,

Badco was authorized to institute legal proceedings to set aside the transfer and enforce

the charter amendment.

Based on Badco’s representations to IRS that (1) the transfer limitations under the

charter amendment were legal, valid, binding, and enforceable against present and future

shareholders under applicable state law except to the extent enforceability could be

limited by bankruptcy, equitable principles, or exceptions under state law and (2) Badco

intended to ‘‘vigorously challenge and pursue by all available means any attempts to

violate’’ the charter amendment, IRS concluded that a purported transferee of Badco’s

stock in contravention of the charter amendment would not be considered as acquiring

ownership of the Badco stock for Code §382 purposes. See discussion at ¶809.9.

n Possible recharacterization of new debt (issued in debt restructuring) as equity.When Badco engages in a debt restructuring—exchanging Badco new debt for Badco

old debt (or merely significantly modifying Badco old debt which is then treated for

tax purposes as new debt)—the new debt may, under general tax principles, be

recharacterized as an equity instrument. Such recharacterization of the new instrument

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as equity can have many tax ramification, e.g., Badco’s recognition of debt cancellation

(‘‘DC’’), thus producing cancellation of debt income (‘‘CODI’’), disallowance of a

deduction for the yield on the new instrument, etc.

The tax recharacterization analysis takes into account many factors, some relating to

the terms of the instrument (e.g., the maturity of the instrument and subordination to

holders of other instruments) and others relating to Badco’s financial condition (e.g.,

Badco’s debt-equity ratio and projected ability to service the debt).

Because Badco may remain in precarious financial condition even after its

restructuring, application of these general income tax principles could create a

substantial risk of equity recharacterization for a new (or modified) Badco ostensibly-

debt instrument issued (or deemed issued) in the restructuring, resulting in (1) the

exchange (or deemed exchange) of the old debt instrument for the new (or modified)

instrument (which is treated for tax purposes as equity) being automatically treated as a

‘‘significant modification’’ and (2) Badco’s DC on such exchange (or deemed exchange)

being measured by the recharacterized (equity) instrument’s FV rather than its face

amount, even though neither the old nor the new instrument is publicly traded.

The regulations (as amended in 1/11) protect against such recharacterization and

state that, in determining whether such a new (or modified) ostensibly-debt instrument

(issued in exchange or deemed exchange for an old debt instrument) is treated for tax

purposes as debt or as equity, ‘‘any deterioration in [Badco’s] financial condition . . .

between the issue date of the [old] debt instrument and the date of the [exchange or

deemed exchange] (as it relates to [Badco’s] ability to repay the debt instrument) is not

taken into account.’’ Thus, where Badco’s financial deterioration is the reason the new

instrument might be recharacterized as equity, Badco’s new instrument would not be

recharacterized as equity.

If there is a ‘‘significant modification’’ of debt terms (e.g., a change in interest

rate greater than the de minimis exception or an extension of maturity greater than the

safe-harbor deferral period) resulting in a deemed debt-for-debt exchange under the

§1001 regulations without regard to Badco’s financial deterioration, the financial-

deterioration-ignored rule (as amended 1/11) still applies for purposes of determining

whether Badco’s new debt is respected as debt for tax purposes generally, so that the

new (or modified) instrument also constitutes debt for other federal income tax

purposes, including for example:

n measuring the amount of DC under Code §108, which is measured by the new

instrument’s face if the new instrument is treated as debt for §108 purposes

(assuming neither the old nor the new instrument is publicly traded and the new

instrument bears adequate stated interest) but by the new instrument’s FV if the

new instrument is treated as equity for §108 purposes,

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n determining whether yield on the new note is deductible as interest under Code

§163,

n determining how the holder is taxed on the new note’s yield (i.e., as interest or

dividend income),

n determining whether a Code §382 ownership change has occurred, and

n determining Code §368 reorganization qualification.

See discussion at ¶803.4(4).

n 7/10-enacted Volcker Rule’s restrictions on BHC-related entity investing inpublic securities, sponsoring/investing in most private funds, and lending toportfolio company related to BHC group. Responding to the 2007–10 financial

crisis, the 7/10 Dodd-Frank Act’s so-called Volcker Rule (when effective, likely 7/21/12)

narrows the ability of a BHC, its subsidiaries, and its affiliates, including (unless

otherwise stated) banks and their subsidiaries (a ‘‘BHC group’’), to (1) engage in

proprietary trading or (2) invest in or sponsor a private fund or (3) lend to a portfolio

company of a private fund which has a relationship to the BHC group. The exact scope

of such prohibitions are difficult to predict because of the Act’s vague wording and the

broad powers the Act grants to regulators to ‘‘adopt rules to carry out’’ the statute.

(1) Proprietary trading. The Volcker Rule prohibits a BHC group from engaging in

‘‘proprietary trading,’’ defined broadly by the Act as ‘‘engaging as a principal for

the trading account of the banking entity [meaning the BHC group] . . . in any

transaction to purchase or sell, or otherwise acquire or dispose of, any security, any

derivative . . . or any other security or financial instrument that the appropriate

[regulatory agencies] may, by rule . . . determine.’’ The reference to ‘‘trading

account’’ apparently limits the prohibition to publicly traded instruments (e.g.,

public stocks) which the BHC group is trading for short-term profit, since the Act

defines a ‘‘trading account’’ to mean ‘‘any account used for acquiring or taking

positions in the securities and instruments . . . principally for the purpose of selling

in the near term (or otherwise with the intent to resell in order to profit from short-

term price movements), and any such other accounts as the appropriate [regulatory

agencies] may, by rule . . . determine.’’

Regulations are likely to prohibit such proprietary trading indirectly as well as

directly, including through entities. However, the Act contains an explicit exception

for trading on behalf of customers or as part of market-making activities.

Nothing in the Act appears expressly to prohibit a BHC group from investing in

an operating company (which is not a private fund as discussed in (2) below),

whether the operating company is formed as a corporation or a partnership/LLC, so

20

long as the investment in the operating company is held as a long-term investment

and hence not in a ‘‘trading account.’’ Thus, most BHC group investments in an

operating company pursuant to Reg. Y, to Reg. K, as a part of merchant banking

activities, or as financial-in-nature (as discussed in ¶209.2.1.1 through ¶209.2.1.5) donot appear to be expressly prohibited by the bill.

(2) Restrictions on investing in or sponsoring a private fund, with exceptions.The Volcker Rule prohibits a BHC group from (1) ‘‘acquir[ing] or retain[ing] any

equity, partnership, or other ownership interest in’’ a private fund (i.e., a fund

exempt from SEC registration by ICA §3(c)(1) ([100 or fewer] or §3(c)(7) [all QP

investors] or ‘‘a similar fund’’) or (2) ‘‘sponsor[ing]’’ a private fund by serving as

‘‘general partner, managing member, or trustee, . . . select[ing] or . . . control[ling]

(or . . . hav[ing] employees . . . or agents who constitute) a majority [of a private

fund’s] directors, trustees, or management’’ or (3) shar[ing] . . . the same name or a

variation,’’ with rules (1) and (2) (but not rule (3)) subject to the following four

exceptions:

(a) The Volcker Rule does not prohibit a BHC group from (i) ‘‘organizing

and offering a [private fund] . . . , including serving as a general partner,

managing member, or trustee of the fund and in any manner selecting or

controlling (or having employees . . . or agents who constitute) a majority

of the directors, trustees, or management of the fund’’ and (ii) investing

in all such private funds in the aggregate up to 3% of the BHC’s tier 1

capital as start-up capital for funds being marketed to third parties, (iii)

‘‘but only if . . . the fund [or a feeder fund investing in the fund] is

organized and offered only in connection with the provision of bona fide

trust, fiduciary, or investment advisory services’’ offered by the BHC

group ‘‘and [offered] only to . . . customers of such services of the’’ BHC

group, (iv) but after the first anniversary of such a fund’s ‘‘establish-

ment,’’ the BHC group could own no more than 3% of ‘‘the total

ownership interests of the fund’’ (other than a fund covered by (b) or (c)

below, in which a BHC group’s investment or sponsorship is not limited

by the Volcker Rule).

(b) The Volcker Rule does not prohibit a BHC group from investing in or

sponsoring a fund qualified as an SBIC.

(c) The regulators are considering adding an exemption from the Volcker

Rule for a BHC group sponsoring and/or investing in a venture capital

fund, likely defined in the same manner as SEC is in process of defining

venture capital fund for purposes of the Dodd-Frank Act’s exemption

from IAA registration for an adviser to venture capital funds, which, as

described in ¶1010.8 (third exception) is currently in proposed form.

21

(d) The Volcker Rule does not prohibit a BHC group from lending to a

private fund, except where the loan is prohibited under the Volcker

Rule’s expansion of Federal Reserve Act §23A and §23B (discussed

below).

Nor does the Volcker Rule prohibit a BHC group from serving as investment

adviser to a private fund, so long as the BHC group does not (i) invest in the

equity of such private fund (except to the extent permitted by the organize-and-

offer rule or the SBIC rule described in (a) and (b) immediately above), (ii)

sponsor such a private fund (by serving as the fund’s management or selecting

those who do so), or (iii) share a name with such private fund.

(3) Federal Reserve Act §23A and §23B. Where a BHC group seeks to be both (a)

a substantial equity investor in a portfolio company (through one of the BHC

group’s PE/VC subsidiaries or a PE/VC fund controlled by the BHC group) and

(b) also a lender to such portfolio company (through the BHC group’s bank

subsidiary), Federal Reserve Act §23A may prohibit the BHC group from holding

both such debt and equity positions (unless the loan meets certain harsh collateral

tests).

In addition, Federal Reserve Act §23B requires that transactions between the

BHC group’s bank subsidiary (and also the bank’s subsidiaries) and the portfolio

company in which the BHC itself or its non-bank subsidiary holds an interest be

conducted (a) on terms no less favorable to the bank and its subsidiaries than

would be available from an unrelated third party and (b) consistent with safe and

sound banking practices.

In brief, the §23A prohibition and the §23B requirements (described above) are

most likely to apply (and hence to prohibit the BHC group’s bank subsidiary from

lending to the portfolio company) where (a) the BHC group (other than a bank

subsidiary or its subsidiary) acquires 25% or more of a class of portfolio company

voting stock or total equity (or possibly 15% of a class of voting stock) and (b) the

BHC group’s bank subsidiary (or its subsidiary) makes a loan to the portfolio

company.

Some BHC groups offer one-stop shopping, supplying a portfolio company

with both equity and debt capital. Where a BHC group offers one-stop shopping

and its bank subsidiary supplies debt capital to a portfolio company while its

PE/VC subsidiary acquires 25% or more of a class of the portfolio company’s

voting stock or total equity (or otherwise controls the portfolio company, with

control for §23A purposes presumed at 15% ownership of a class of the portfolio

company’s voting stock), the BHC group must generally acquire the portfolio

company stock through an SBIC subsidiary of its bank subsidiary. This is because

22

none of the other types of entities through which the BHC group could acquire the

portfolio company stock (i.e., a merchant banking entity, a Reg. Y entity, or generally

a Reg. K entity) are permitted to be direct or indirect subsidiaries of a bank.

Alternatively, the §23A issue can be solved by shifting the loan from the BHC

group’s bank subsidiary to the BHC itself or a BHC group non-bank subsidiary,

i.e., by having the BHC itself or a non-bank subsidiary (rather than the BHC’s bank

subsidiary) supply the debt capital to the portfolio company, unless the loan is

subject to the Volcker Rule prohibition discussed in (4) below.

Where the BHC group’s equity investment in a portfolio company is made

through a Reg. Y subsidiary which is not an SBIC, the BHCA generally prohibits

the BHC group from owning more than 5% of any class of the portfolio company’s

voting stock, as described in ¶209.2.1.1. Hence in this circumstance §23A would

seldom apply, because the BHC group and its Reg. Y subsidiary would not be

viewed as controlling the portfolio company as defined by §23A. However, §23A can

apply where the BHC group’s equity investment in the portfolio company is made

through an SBIC which is not a subsidiary of the lending bank (or of a sister bank to

the lending bank) or is made through an FHC engaged in merchant banking, since

neither an SBIC’s nor an FHC’s ownership of portfolio company voting stock is

limited by the BHCA 5% rule.

(4) Volcker Rule expansion of §23A and §23B. The 7/10 Dodd-Frank Act’s Volcker

Rule expands the restrictions otherwise contained in §23A and §23B (as discussed

in (3) above) to any private fund (i.e., a fund exempt from ICA registration by ICA

§3(c)(1) [100 or fewer] or §3(c)(7) [all QP investors] or ‘‘a similar fund’’) and its

affiliates (including a portfolio company in which the private fund has invested)

where (a) a member of the BHC group serves as an investment adviser, investment

manager, or sponsor to such private fund (including to an SBIC, although the

Volcker Rule permits a BHC to invest in an SBIC) or (b) a member of the BHC

group organizes and offers such private fund as a permitted activity under the

Volcker Rule (as described in (2)(a) above).

Although §23A applies only to a loan from a BHC group’s bank subsidiary

(or such bank’s subsidiary) to a portfolio company controlled (generally by

ownership of 25% or more of a class of voting stock or total equity or in some

cases 15% or more of a class of voting stock) by the BHC or its non-bank

subsidiary, the Volcker Rule applies more broadly to all loans from any BHC

group member to a private fund described above and its affiliates, including its

controlled portfolio companies. Thus, the Volcker Rule prohibits all such loans,

without regard to the collateral or the amount of the VC-related bank’s capital

stock and surplus.

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Consequently, under the Volcker Rule, a BHC group with no direct or indirect

equity interest in a private fund or its portfolio companies is nonetheless prohibited

from lending to that private fund and its controlled portfolio companies if the

BHC group provides investment management or advisory services to or sponsors

such private fund.

(5) Volcker Rule effective date. The Act grants regulators broad power to

‘‘adopt rules to carry out’’ the Act, makes the Act effective on the earlier of 7/21/12

or one year after promulgation of final regulations, and gives a BHC group two

years after the Act’s effective date to comply with the Act, with up to three one

year extensions in the regulator’s discretion and an additional extension of up to

five years for ‘‘illiquid funds’’ with respect to which the BHC group had a

contractual obligation as of 5/1/10. See discussion at ¶209.2.1.6 and ¶209.2.2.

l and much, much more . . .

This publication is designed to provide accurate and authoritative information in regard to the subjectmatter covered. It is sold with the understanding that the publisher is not engaged in rendering legal,accounting or other professional services [and that the authors are not offering such advice in this publication].If legal advice or other professional assistance is required, the services of a competent professional personshould be sought.

—From a Declaration of Principles jointly adopted by a Committee of the American Bar Association

and a Committee of Publishers and Associations

24