GAM, the global investment management firm with $38 billion in assets, could be in for a rocky ride and possible monetary damages if its new U.S.-based hedge fund restructuring initiative trips over hedge fund behemoth Man Investments' pending patent filed just weeks ago.
The patent request seeks to cover the specific hedge fund structure that Man believes it created last year with tax-exempt investors in mind. This precise hedge fund structure is what GAM plans to shortly mimic with at least one of its U.S.-based, SEC-registered hedge funds.
GAM, with offices in New York City and eight other worldwide locations, has been an indirect, wholly owned subsidiary of Swiss banking corporation UBS AG since 1999. GAM and Man Investments are head-to-head competitors in the alternative investment universe.
On March 31, GAM filed documents with the SEC disclosing that it intends to restructure its current GAM Avalon Lancelot registered hedge fund-of-funds under a master-feeder structure and rename the master fund GAM Avalon Multi-Strategy Investments. Through this restructuring the investment firm will be able to offer a new feeder fund to be named the GAM Avalon Multi-Strategy (TEI). (The TEI designation stands for tax-exempt investors). This new fund will allow tax-exempt as well as tax-deferred investors to invest in GAM's offering, but circumvent the dreaded "unrelated business taxable income" (UBTI) that hedge funds can often kick up.
UBTI is income that is often triggered by various leveraging techniques that hedge funds employ, such as the borrowing of money to invest in additional securities. But as explained in GAM's recently filed registration document, the Cayman Islands structure "enables tax-exempt investors to invest in the fund without receiving income in a form that would otherwise be taxable to such investors regardless of their tax-exempt status."
On a Pending Patent?
But this new initiative could spell trouble and monetary damages for GAM if Man successfully wins a patent for this type of hedge fund structure that it says it created last year. Moreover, it could mean trouble for others, including Deutsche Bank, which late last year launched its similar Topiary Fund for Benefit Plan Investors.
On May 1, 2004, Man Investments, the global hedge fund manager with its U.S. office hub in Chicago, debuted its new SEC-registered Man-Glenwood Lexington TEI fund-of-hedge funds, which was built as a feeder fund to the original Man-Glenwood Lexington hedge fund launched in January 2003.
The new fund spinoff was created to cater to endowments, foundations, employee benefit plans and other tax-exempt investments, including IRA and rollover plans. The structure Man devised created an offshore investment fund in the Cayman Islands through which investments would then be invested back into the master Man-Glenwood Lexington hedge fund portfolio.
In order to assure it wouldn't stumble into a regulatory quagmire, Man received a formal no-action letter from the Securities and Exchange Commission on April 30, 2004 regarding this structure. While a no-action letter is not an explicit blessing from regulators, it does offer a level of comfort by assuring that the SEC would not recommend enforcement action against Man for its registration of this hedge fund.
According to publicly filed fund documents, Man has successfully attracted $15 million to that feeder fund since inception. The greatest interest has been among wealthy individuals with IRA or rollover assets to invest, said a source familiar with the product.
That successful product creation, and recognition of the potential IRA rollover marketplace, apparently led Man Investments to apply for a patent on this particular hedge fund master-feeder structure sometime earlier this year, although the details of this patent are still a closely guarded secret.
Man officials could not be reached for comment by press time.
Patents for new inventions as well as specific business methods - under which Man's intended patent would likely fall - can take several years to come to fruition, explained Malvern ("Griff") Griffin, a partner with Sutherland Asbil & Brennan's Atlanta office and an expert on software and business method patents. "A business method patent is probably the most difficult patent to obtain," Griffin said.
Business method patents in particular can take more than three years to be approved, if they are approved by the United States Patent Office, he said. An examiner can take one to two years to make a preliminary assessment of what existed in the public domain at the time of the original application, with a second level examiner taking another year or even 18 months after that. And this lengthy process doesn't guarantee a patent will eventually be allowed, he noted.
During the review process, if a potential infringer comes along, the patent applicant could notify the alleged infringer in writing and put them on notice that a patent is pending. If the patent is eventually issued, then the patent holder can require the infringer to cease the activity, and claim a loss of monetary profits that would date back to the date of that letter. "But until the patent is issued, they have no enforcement rights," Griffin added.
The only exception would be if the patent applicant asks the U.S. Patent Office to keep the application confidential as a "non-published" application that cannot be viewed by others during the review process. This is sometimes done to safeguard business operating secrets, Griffin said. But in these cases, since the application information was not made public, enforcement would be more limited.
An infringer could also argue how its initiative is substantially different from the one covered under the patent, or that the issued patent should be invalidated, he added.
This would not be the first patent dispute within the investment industry. A very public dispute came to light in 1995 when State Street Bank challenged Signature Financial Group's 1993 patent for its "Data Processing System for Hub and Spoke Financial Services Configuration." The patent covered a structure and methodology for managing mutual funds. Although State Street had negotiated with Signature for a licensing agreement, the issue eventually went to court with State Street seeking to invalidate Signature's patent. After a District Court decision and an appeal, Signature prevailed.
Offshore Tax Benefits
With Domestic Appeal
"People are getting very creative in how they are structuring offerings," said one industry insider who spoke about new hedge fund structures on condition of anonymity. "This is one way to get around UBTI issues," he added.
Traditionally, hedge funds are taxed as partnerships and must pass through income to investors, who are then liable for taxes on that income, explained William S. Pilling, partner with the law firm of Stradley Ronon in Philadelphia. But if an offshore fund generates that income, such as an entity in the Cayman Islands or Bermuda, "UBTI doesn't flow through the corporation to the investors, so you've solved the problem," he said. This scenario created by Man and GAM "simply inserts an offshore entity between a tax-exempt investor and the security," he noted, and is common in the broader hedge fund industry.
The drawback is that it is more expensive to go offshore and is cheaper to create a hedge fund as a domestic limited liability company in the state of Delaware, Pilling said.
"The notion of tax planning around UBTI by using non-U.S. corporate entities is nothing new and has been standard tax planning for years," said Michael Tannenbaum, partner with the New York law firm of Tannenbaum Halpern Syracuse & Hirschtritt. That is why firms have traditionally offered one domestic hedge fund and one offshore fund, he added.
"Historically, UBTI has been a big problem" for tax-exempt investors, said Justin Dew, senior hedge fund specialist with Standard & Poor's in New York. "I am not surprised that funds-of-funds and major institutions have tried to get around this." With more and more institutions, including tax-exempt investors, allocating assets to alternative investments, "the effort to bring hedge funds to an ever broadening market is growing," he added.