Special from Jay Gould and Scott Peterman, White & Case LLP

SAN FRANCISCO, CA (HEDGECO.NET) – On October 24, 2003, the U.S. Securities and Exchange Commission (the �SEC�) approved Rule 2790 (�Rule 2790� or, the �Rule�) of the U.S. National Association of Securities Dealers (the �NASD�) pursuant to which certain investors are restricted from participating in �new issues.� Compliance with the Rule became mandatory on March 23, 2004. Since that date, a number of hedge fund sponsors and broker dealers have raised questions with respect to the extra-territorial reach of the Rule 2790, and whether and to what extent the Rule applies to non-U.S. persons and to new issues outside the U.S. Accordingly, we will briefly review the requirements of Rule 2790, how some hedge fund sponsors are addressing the requirements of the Rule, and apprise you of the NASD�s view of its scope and breadth. To give you a hint, you are not going to like the way this story ends.

Under Rule 2790, all initial public offerings (�IPOs�) of equity securities are �new issues.� The Rule provides that an NASD member firm or a person associated with a member firm may not sell to or purchase a new issue in any account in which a �restricted person� has a beneficial interest. Restricted persons include, with some exceptions, NASD members firms, other broker-dealers and any officer, director, general partner, associated person or employee thereof; finders and fiduciaries of the managing underwriter of a new issue; portfolio managers who buy or sell securities for a bank, savings and loan institution, insurance company, investment company, investment advisor, or collective investment account, including an investment adviser to a hedge fund; owners and affiliates of most broker-dealers; and immediate family members of restricted persons.

The Rule prohibits brokers from selling IPO securities to a hedge fund, if the fund has investors who are restricted persons, unless the fund has a mechanism in place that excludes restricted persons from participating in the profits from new issues. Absent specific guidance from the NASD, hedge fund sponsors have created �carve-out� classes of shares for restricted persons and have allocated the new issues that they buy to the classes of shares that are sold to non-restricted persons. This approach permits hedge funds to continue to purchase IPO securities on behalf of their investors who are not restricted, but it does increase administrative and fund accounting costs to the fund.

Rule 2790 also contains a de minimis exemption to accommodate accounts with only a small percentage of restricted persons. The de minimis exemption permits a hedge fund to purchase new issues without creating separate classes of shares for restricted persons if, in the aggregate, restricted persons own less than 10% of the fund. To make this determination, most subscription agreements now require potential hedge fund investors to answer certain question to reveal an association with an NASD member firm or some other affiliation. Hedge funds that purchase new issues should by now have procedures in place both to identify investors who do not adequately identify themselves as non-restricted persons, so that such investors are either rejected or placed in a �restricted share� class, and to allow investors in a restricted class to convert to a non-restricted share class if the investor�s status changes. Hedge fund advisers must notify selling brokers if the fund is eligible to purchase new issues.

But to whom does this Rule from a U.S. self-regulatory agency apply and what IPOs are covered? It is the NASD�s position that the Rule applies to all persons associated with a U.S. broker dealer, whether or not the associated person is a U.S. citizen or resident. The NASD further takes the position that the Rule applies to all IPOs, whether or not the IPO is of a U.S. or non-U.S. issuer, and whether or not the IPO is sold within the U.S. Accordingly, if a hedge fund domiciled in the Cayman Islands and advised from Spain, intends to purchase IPOs in Brazil, but has investors in Japan who are associated with a U.S. broker, the fund would either need to establish a restricted share class, rely on the de minimis exemption, or reject the investors. Extra-territorial, indeed.