I was at a presentation where one large allocator, Robert Schulman from Tremont, called Madoff “god.” Madoff’s investors were proud people and they bragged about “being with Bernie.”

Blaming other forfeits your power. Financial literacy is about managing risk, not being able to quote Suze Orman.

Tax-exempt organizations are well-advised to attribute significant focus and attention to the governance questions posed on Part VI of the Form 990, and to the underlying governance concepts raised by these questions.

On May 29, 2009, the Internal Revenue Service (IRS) posted a series of “FAQs” and other “Tips” associated with the completion of Part VI to the Form 990 (Governance, Management and Disclosure). Part VI is the section of the new, redesigned Form 990 that reflects the IRS’s major focus on the corporate governance of tax-exempt organizations. Thus, the new FAQs are likely to be welcome news to these organizations as they respond to the dramatic increase in governance-related questions in the new Form 990. The FAQs can be found here .

The FAQs contain 11 separate questions focused almost exclusively on Form 990, Part VI, Governance, Management and Disclosure. In the FAQs, the IRS makes it clear that many (if not all) of the policies and procedures about which it is asking in the Form 990 are not required under the law. Nonetheless, the IRS makes equally clear that, while none of the policies and procedures are required under the law, answering questions about whether the filing organization has adopted such policies and procedures on the Form 990 is required by law. While the IRS traditionally has not imposed penalties on failure to file substantially complete Form 990s in the past, it is an open question whether the IRS would pursue such path for an organization refusing to answer the governance questions on the current Form 990.

General Comments on Form 990 Part VI and the FAQs

Governance, in general, has become a pillar of the IRS enforcement and education programs for tax-exempt organizations. Given continued congressional scrutiny on whether tax exemption is a worthy federal subsidy for any type of tax-exempt organization, proper governance and accountability to the local community are key factors that may distinguish the tax-exempt sector from the taxable sector. From the IRS perspective, whether correct as a matter of law or not, the answers to the questions contained in Form 990, Part VI, are significant with respect to continued tax-exempt status for most tax-exempt organizations.

The FAQs may be loosely grouped into two main categories: FAQs relating to the existence of written policies on conflicts of interest, whistleblowers and document retention, and FAQs relating to whether information from organizations related to the filing organization is required to be included in the Form 990. Set forth below are discussions of the more important FAQs for filing organizations.

FAQs on Policies and Procedures

FAQ #10
Form 990, Part VI-B, asks whether the filing organization has adopted a written conflict of interest policy (Part VI-B, Question 12a), a written whistleblower policy (Part VI-B, Question 13), and a written document retention policy (Part VI-B, Question 14). FAQ #10 clarifies that, in responding to these questions, a filing organization may not rely on the fact that its parent organization may have adopted such policies even if the filing organization is acting pursuant to the parent organization’s policies. Instead, a filing organization may only indicate that it has such policies if it has expressly adopted such written policies itself. Presumably, expressly adopting the parent organization’s policies should be sufficient to allow the filing organization to check “yes” in response to the applicable questions. As in many other parts of the Form 990, the IRS notes that the filing organization has the ability to discuss any special circumstances on Schedule O.

FAQ #3
FAQ #3 clarifies that, for purposes of reporting whether the filing organization has adopted a particular written policy or procedure (e.g., conflict of interest policy), it may only answer “yes” (i.e., that it has adopted such policy) if it adopted such policy prior to the close of the reporting year. In other words, if the filing organization adopted a policy after the close of its reporting year but before it filed the Form 990 for such year, it must still answer that it does not have such policy. Again, Schedule O may be used to explain that the organization has adopted such policies after the close of the reporting year.

FAQ #8
In FAQ #8, the IRS notes that it will not provide sample policies for filing organizations (even though it did so with respect to the IRS Model Conflict of Interest Policy in the late 1990s).

FAQ #5
FAQ #5 notes that there is no legal requirement for a tax-exempt organization to show the Form 990 to its board but, nonetheless, notes that the filing organization must indicate whether it has done so in the Form 990.

FAQs on Activities of Related Organizations

FAQ #7
FAQ #7 attempts to clarify the level of effort needed by filing organizations to ascertain information regarding independent directors and family relationships among board members. However, the only guidance provided by the FAQ is that “reasonable efforts” must be made. The IRS notes that a simple questionnaire that includes the name, title of person responding, date and signature, and attaches the Form 990 Glossary definitions of “independent voting member of governing body,” “family relationship,” “business relationship” and “key employee” may be all that is needed.

Practice Note: While the IRS suggests the use of a very simplified questionnaire, it is possible that a limited questionnaire may not capture all the information required to complete Part IV, question 28, regarding business relationships among directors, officers, key employees and their family members. In addition, such a simplistic questionnaire may cause greater problems for the filing organization by requiring greater diligence in educating board members and officers as to what information is required to be provided and by placing a greater burden on the filing organization’s general counsel or compliance officer to make certain that questionnaires were completed accurately. In other words, in preparing responses to Form 990 Part VI, Questions 1 and 2, the organization should be careful in following the IRS guidance in these FAQs and should consider using a more detailed questionnaire that is designed to more fully collect the appropriate information for all parts of the Form 990. Organizations will have to balance the need for information against the administrative inconvenience.

FAQ # 6
FAQ #6 attempts to clarify the IRS’s three-part definition of “independent director” by indicating that the filing organization must use the three-part definition of “independent member” contained in the Form 990 instructions even if that definition is in conflict with state law definitions of independent members or in conflict with the filing organization’s definition of independent member in its conflict of interest policy.

Practice Note: Addressing issues of “independence” may trigger some controversy at the board level given the difference between the IRS definition of “independent” director and state law definitions of the same; potential confusion between application of the “independence” and “conflict concepts;” and potential confusion between “independence,” “conflicts” and “disinterested director” (for rebuttable presumption) concepts. In addition, application of the IRS definition of “independent” director could prompt a restructuring of the board in order to ensure independent control.

FAQ #4
FAQ #4 only applies to filing organizations that have members or that have local chapters, branches or affiliates. The purpose of this FAQ was not to provide additional instruction to filing organizations but, instead, merely to explain why the IRS included questions on members and local chapters, branches and affiliates in the first place.

FAQ #9
FAQ #9 discusses whether the filing organization must provide governance information regarding its related organizations. The IRS indicates that, as a general rule, the answer is no.

Practice Note: While it is not generally required, there are many situations where a filing organization should provide information about the governance of related organizations. For example, many health care organizations may not have “independent” boards (as defined in the Form 990) because they are controlled by a tax-exempt organization that has a community (i.e., independent) board. This structure has been expressly approved in IRS guidance regarding community-based boards and exemption. See, “Tax-Exempt Health Care Organizations Community Board And Conflicts Of Interest Policy,” 1997 Exempt Organizations Continuing Professional Education Text at 21, which may be found here. Unfortunately, Part VI of Form 990 fails to recognize that as a possible structure. For these filing organizations, Schedule O is the only place in Form 990 where they may describe the existence of the community (and independent) board at the parent level.

Further, many exempt organizations are exempt under the so-called integral part theory of exemption, which looks to the activities of related organizations to justify their own exemption. In isolation, these integral part organizations may appear less charitable than other exempt organizations since their exempt status is derived from another entity. Schedule O presents an opportunity for these organizations to explain the full array of charitable activities provided by the tax-exempt system. Similarly, Schedule O may be used to report community benefits provided by other tax-exempt entities within the filing organization’s tax-exempt system, to more accurately portray the true scope of activities being conducted by the filing organization’s family of tax-exempt organizations.

Discussion

Part VI to the Form 990 and the issuance of these FAQs underscore the importance that the IRS attributes to effective corporate governance by tax-exempt organizations. Over the last several years, IRS officials have repeatedly expressed their belief that the existence of an independent governing board, combined with well-designed governance and management policies and procedures, increases the likelihood that an organization will comply with the tax laws. To that end, the promotion of good governance, management and accountability has become a new “pillar” of the IRS’s compliance program for the tax-exempt sector. Furthermore, governance accountability is an important feature distinguishing the nonprofit model from the for-profit model for purposes of hospital tax exempt status.

There is no explicit statement of IRS jurisdiction over corporate governance of tax-exempt organizations in either the Internal Revenue Code or the associated Treasury Regulations. Rather, the IRS focus on governance is based upon what it refers to as “implicit jurisdiction,” i.e., the concept that the quality of governance affects all aspects of the IRS’s oversight over exempt organizations—furtherance of exempt purposes, private inurement, excess private benefit, reasonable compensation, informed and fair decision making regarding investments and fundraising practices, and self dealing. Furthermore, principles of good governance by nonprofit organizations are actively enforced by state charity officials, such as the attorney general, and actively monitored by donors’ rights organizations. Effective corporate governance is also favorably recognized in the credit rating analysis process.

While one can argue that the IRS is overreaching in prescribing specific governance procedures, tax-exempt organizations are well-advised to attribute significant focus and attention to the governance questions posed on Part VI of the Form 990, and to the underlying governance concepts raised by those questions. In that regard, these newly released FAQs offer helpful guidance.

Here is a link to the full article at McDermott Will & Emery.

SEC Registration of Fund Managers

The lack of specificity behind the “modest threshold” of assets under management that would trigger SEC registration leads the list of head-scratchers in the Obama plan. Obama has yet to suggest a particular number. Under current law, the SEC regulates managers with client assets over $25 million, while regulation of managers with client assets under $25 million is reserved for the states. Depending on the amount of the “modest threshold,” managers currently regulated by the SEC may instead become subject to state regulation. Considering recent SEC enforcement fumbles, Obama may have good reason to raise the $25 million threshold to avoid spreading the SEC too thin—a move that would appeal to state securities regulators. The “modest threshold” may take on greater relevance if the so-called “private client exemption” from registration under the Investment Advisers Act is eliminated as discussed below.

Another head-scratcher in the Obama plan is how he intends to rein in those managers who currently slip through the regulatory cracks (once beyond the grasp of state regulators) by the “private client exemption” from registration for advisers with 15 or fewer clients—where the term “clients” is defined in a way that allows each fund to be counted as a single client even where the underlying limited partners may number into the hundreds. Legislators in the current session of Congress have already proposed bills that would eliminate the private client exemption, including H.R. 711, “Hedge Fund Advisers Registration Act of 2009,” proposed by Representatives Michael Castle (R-DE) and Michael Capuano (D-MA), and S.1278, “Private Fund Transparency Act of 2009,” proposed by Senator Jack Reed (D-R.I.).

If the private client exemption is eliminated, all fund managers with client assets exceeding Obama’s “modest threshold” would be required to register with the SEC (absent the availability of another exemption). Fund managers with client assets under Obama’s “modest threshold” would likely fall under the supervisory authority of their home state, but not necessarily safe from registration—state legislatures, like Connecticut, are also considering closing the regulatory cracks for investment advisers and may follow suit. Ultimately, registration of fund managers with either the SEC or their home state securities regulator seems imminent.

As SEC-registered investment advisers, fund managers would be subject to the Investment Advisers Act of 1940 and its bevy of regulations, including significant recordkeeping requirements, compliance procedures, reporting requirements, advertising restrictions, and prohibitions on certain transactions. In addition, the Obama plan proposes to subject all funds advised by SEC-registered advisers to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; regulatory reporting requirements, and SEC examinations to monitor compliance with these requirements. The regulatory reporting requirements for such funds would require reporting on a confidential basis of the amount of assets under management, borrowings, off-balance sheet exposures, and other information necessary to assess whether the fund or fund family is so large, highly leveraged, or interconnected that requires greater regulation for financial stability purposes.

Possible Supervision and Regulation of Funds by Federal Reserve as a Tier 1 FHC

The Obama plan would authorize the SEC to share with the Federal Reserve the confidential reports of funds advised by SEC-registered investment advisers. The Federal Reserve would determine whether any of those funds or fund families requires greater regulation for financial stability purposes (the Obama plan refers to those funds as “Tier 1 Financial Holdings Companies” or “Tier 1 FHCs”). The Federal Reserve would also have authority to examine any of those funds if the Federal Reserve is unable to determine whether the fund’s financial activities pose a threat to financial stability based on regulatory reports, discussions with management, and publicly available information. Toward that end, the Obama administration will propose legislation setting forth criteria that the Federal Reserve should consider in identifying Tier 1 FHCs, which as presently envisioned would include the following factors:

* the impact the firm’s failure would have on the financial system and economy;
* the firm’s combination of size, leverage (including off-balance sheet exposures), and degree of reliance on short-term funding; and
* the firm’s criticality as a source of credit for households, businesses, and state and local governments and as a source of liquidity for the financial system.

In addition, the Federal Reserve would be allowed to consider other relevant factors and exercise discretion in applying the specified factors to individual financial firms.

Once identified as a Tier 1 FHC, a fund would be subject to heightened supervision and regulation by the Federal Reserve. At a minimum, Tier 1 FHCs would be required to meet the qualification requirements for “financial holding companies” set forth in the Bank Holding Company Act of 1956 and its regulations, including being well capitalized and well managed. However, the prudential standards for Tier 1 FHCs — including capital, liquidity and risk management standards — would be stricter and more conservative than those applicable to other financial firms to account for the greater risks that their potential failure would impose on the financial system. How much stricter and more conservative has yet to be revealed.

As if the obvious terminology weren’t a sufficient hint, funds identified as Tier 1 FHCs would be subject to regulation and supervision currently reserved for depository institutions and their holding companies. Obama’s message is clear: the presence of large, unregistered funds in the U.S. “shadow banking system” must come to a swift end.

The question lingering is how the framework established for banks and bank holding companies, including the prudential capital, liquidity and management standards, would be applied to private investment funds. Such concepts as maintaining risk-based capital and leverage ratios and restricting nonfinancial activities cannot be directly applied to a fund, at least not without further regulatory clarification. In fact, the concept of maintaining capital is in part contrary to the investment business of most funds. Unlike bank depositors, fund investors commit capital with the objective of capital appreciation, not preservation for liquidity. In addition, the legal form of most funds is a limited partnership, not a stock-based bank charter, rendering the current capital adequacy guidelines almost nonsensical in their application to funds. Although Gramm-Leach-Bliely permits financial holding companies to conduct all financial and many nonfinancial activities, the Glass-Steagall wall between the banking and commerce remains, at least in part.

The restrictions on nonfinancial activities (except insofar as found incidental or complementary to financial activities) would prohibit many controlling investments traditionally made by private equity and venture capital funds.

Greater SEC Regulation of All Investment Advisers

Even SEC-registered investment advisers who provide advice solely on a managed account basis face greater regulation. The Obama administration will propose legislation to empower the SEC to bolster protections for all clients of SEC-registered investment advisers by:

* Requiring simple and clear disclosure to investors regarding the scope of the terms of their relationships with investment advisers;
* Prohibiting certain conflicts of interest and sales practices that are contrary to the interests of investors — the SEC would be empowered to examine and ban forms of compensation that encourage investment advisers to put investors into products that are profitable to the adviser, but are not in the investors’ best interest; and
* Prohibiting mandatory arbitration clauses in investor contracts (after the SEC conducts a study on whether investors are harmed by being unable to obtain effective redress of legitimate grievances, as well as whether changes to arbitration are appropriate).

Although the Obama plan leaves many questions unanswered, greater regulation and supervision is imminent and fund managers should not assume the luxury of significantly delayed effective dates. However, fund managers should be cautioned not to run to register in advance without understanding its implications, or to adopt policies and procedures not specifically tailored to your business or risks. Instead, while Congress reviews the Obama plan, fund managers should review their business—identify conflicts of interest, business practices, arrangements, and other factors creating risk for the fund manager and its clients in relation to its operations. Then fund managers should review or develop, as the case may be, policies and procedures that specifically address those factors and the controls to be implemented to supervise and mitigate those areas of concern.

John Brunjes and Genna Garver are in the Private Investment Funds Group of Bracewell & Giuliani, LLP, representing hedge funds, private equity funds and venture capitalists in connection with fund formation and operations issues and illiquid investment transactions, with particular emphasis on advising private domestic and offshore capital pools and their stakeholders. John is head of the Fund Formation practice and a member of the Board of Directors of the Connecticut Hedge Fund Association.

Orange County Superior Court Judge Mary Fingal Schulte ruled Thursday that probate court was not the proper venue for Stacey Nicholas to seek to have her ex-husband removed as co-trustee of the family’s trust, which she estimated to be worth $600 million.

Attorneys for Henry Nicholas had contended that the action should have been filed in family court, where the couple’s divorce is being heard.

In November, Stacey Nicholas filed a petition in probate court accusing Henry Nicholas of squandering $60 million on misguided investments and personal indulgences, including $1 million she said he spent on private detectives who tailed her, once wearing gorilla masks to conceal their identities. She said his spending had left her so cash poor she couldn’t pay a tax bill.

She also accused Henry Nicholas of threatening to physically harm her, once whispering in her ear that he would have her “whacked.”

Nicholas, in turn, accused his ex-wife of filling her petition with “outrageous falsehoods” in an attempt to damage his reputation.

The couple’s wealth stems from the success of Broadcom, an Irvine-based manufacturer of computer chips used in such products as Apple’s iPhone.

An attorney for Henry Nicholas said Thursday that Judge Schulte’s decision was welcome news.

“It has always been our view that this petition was filed for improper purposes, as a publicity stunt to smear Dr. Nicholas with false accusations,” said attorney Richard Howell, a partner with the Costa Mesa office of Rutan & Tucker. “The court has rejected her petition across the board.”

Robert Sacks, an attorney for Stacey Nicholas, could not be reached.

Henry Nicholas is awaiting criminal prosecution under two federal indictments, one that alleges he provided illegal narcotics to friends and business associates and another that alleges he conspired to backdate stock options as secret rewards to employees without disclosing the arrangement to investors.

Nicholas contends he is innocent of any wrongdoing.

The outcome of this battle is likely to shape how much profit banks will make, who can get a mortgage, which federal regulators oversee different corners of the economy — and, ideally, whether the government is prepared for future financial threats.

With so much money and power on the line, interests inside the government and out are not waiting for the administration to reveal its plan, which sources say will be detailed next week. Lobbyists for financial firms and consumer activists, among others, have been meeting privately with the Treasury Department and the White House to press their views, according to people briefed on the discussions.