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News August 16, 2004 Issue

Hedge Funds Shot Down on IPO Rule

If you think your hedge fund is safe to get IPOs because itís listed on a foreign exchange, think again.

On August 6, the NASD staff issued an interpretative memorandum stating that foreign investment companies limited to high-net worth investors are not eligible to receive IPOs in reliance on the foreign investment company exemption in new NASD Rule 2790(c)(6), even if they are listed on an exchange. Thatís a blow to offshore hedge funds listed on the Cayman Islands Stock Exchange or Irish Stock Exchange, which may have thought they were squarely within the foreign investment company exemption.

Some background: Rule 2790, which replaced the NASDís Free-Riding and Withholding Interpretation, prohibits NASD members and associated persons from selling IPOs to any account in which a "restricted person" has a beneficial interest. The rule contains several exemptions, including one for sales to and purchases by an investment company organized under the laws of a foreign jurisdiction. To qualify, the fund must be listed on a foreign exchange or authorized for sale to the public by a foreign regulatory authority, and no person owning more than five percent of the shares of the investment company may be a restricted person.

That language got some in the hedge fund industry hopeful that the phrase "for sale to the public" didnít modify the requirement "listed on a foreign exchange." If they were right, it would mean that an offshore listed hedge fund could receive IPOs. A November 2003 Sidley and Austin client memo said it would be "prudent" for offshore hedge funds to consider listing on the Cayman Island or Irish exchanges in order to qualify for the exemption.

At least three law firms asked the NASD to clarify the issue. Last week, the NASD staff rained on the parade, stating that the exemption applies to foreign investment companies that are "listed on a foreign exchange for sale to the public" or "authorized for sale to the public." Since U.S. registered investment companies are not limited to high net worth individuals, reasoned the staff, "it would be inconsistent to permit foreign investment companies to impose such requirements and still avail themselves of the [foreign investment company exemption]." The staff noted that foreign funds limited to select investors might still be eligible to purchase new issues in accordance with the ruleís de minimis exemption.