Today, Jay Gould was interviewed by Deirdre Bolton on Bloomberg TV’s “Money Moves” where Jay discussed lifting the ban on hedge fund advertising.
Today, Jay Gould was interviewed by Deirdre Bolton on Bloomberg TV’s “Money Moves” where Jay discussed lifting the ban on hedge fund advertising.
Written by: Jay Gould
On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer. For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised. As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar.
But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider. The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions. It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company. These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions. These are typical investment banking activities for which registration as a broker dealer is required.
Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers. Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated. However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse. As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required. The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose. This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective. The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required.
Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.” But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action. In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors. A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void. A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission. Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning.
Written by: Jay Gould
In a speech before the American Bar Association’s Trading and Markets Subcommittee on April 5, 2013, David Blass, the Chief Counsel of the Division of Markets and Trading, put hedge fund managers and private equity fund managers on notice that they may be engaged in unregistered (and therefore, unlawful) broker dealer activities as a result of the manner by which hedge fund managers compensate their personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies. The good news is that Mr. Blass indicated that the Staff of the Securities and Exchange Commission (the “SEC”) is willing to work with the industry to come up with an exemption from broker dealer registration for private fund managers that would allow some relief from the prohibitions against certain sales activities and compensation arrangements regarding the sales of private fund securities. This post will address only the sales compensation activities of hedge funds with an explanation of the private equity investment banking fee discussion to follow.
Mr. Blass indicated that he believed that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based that would give rise to the requirement to register as a broker dealer.
Mr. Blass provided several examples that fund managers should consider to help determine whether a person is acting as a broker-dealer:
How does the adviser solicit and retain investors? Thought should be given regarding the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of internal employees working in a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.
Do employees who solicit investors have other responsibilities? The implication of this point is that if an employee’s primary responsibility is to solicit investors, the employee may be engaged in a broker dealer activity irrespective of whether other duties are also performed.
How are personnel who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that is linked to successful investments? A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation. This implies that bonuses tied to capital raising success would likely give rise to a requirement for such individuals to register as broker dealers.
Does the fund manager charge a transaction fee in connection with a securities transaction? In addition to considering compensation of employees, advisers also need to consider the fees they charge and in what way, if any, they are linked to a security transaction. This point is aimed more at the investment banking type fees that a private equity fund might generate, but it would also be relevant in the context of direct lending funds or other types of funds that generate income outside of the increase or decrease of securities’ prices.
Mr. Blass also addressed the use or misuse of Rule 3a4-1, the so-called “issuer exemption.” That exemption provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker. Mr. Blass stated his mistaken belief that most private fund managers do not rely on Rule 3a4-1, which, in fact, they do. Blass suggests that private fund managers do not rely on this rule because in order to do so, a person must satisfy one of three conditions to be exempt from broker-dealer registration:
Mr. Blass rightly points out that it would be difficult for private fund advisers to fall within these conditions. That, however, has not stopped most private fund managers from relying on some interpretation of the “issuer’s exemption” no matter how attenuated the adherence to the conditions might be.
Although Mr. Blass indicated a willingness to work with the industry to fashion an exemption from broker dealer registration that is specifically tailored to private fund sales, he also reminded the audience that the SEC is quite willing to take enforcement action against private funds that employ unregistered brokers. Last month, the SEC settled charges in connection with alleged unregistered brokerage activities against Ranieri Partners, a former senior executive of Ranieri Partners, and an independent consultant hired by Ranieri Partners. The SEC’s order stated (whether or not supported by the facts) that Ranieri Partners paid transaction-based fees to the consultant, who was not registered as a broker, for the purpose of actively soliciting investors for private fund investments. This case demonstrates that there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud. The SEC believes that a fund manager’s willingness to ignore the rules or interpret the rules to accommodate their activities can be a strong indicator of other potential misconduct, especially where the unregistered broker-dealer comes into possession of funds and securities.
Private fund managers are encouraged to consider this statement and review their sales and compensation arrangements accordingly.
Pillsbury and the California Hedge Fund Association invite you to join us on Thursday, April 25, 2013 for an educational program featuring Ms. Jan Lynn Owen, the Commissioner of the California Department of Corporations (DOC) and Person to be Announced from the U.S. Securities and Exchange Commission.
The Commissioner and her staff will discuss the new investment adviser registration rules that were recently adopted by the DOC, including the “exempt reporting adviser” provisions, the interplay between the DOC rules and those of the post-Dodd-Frank rules of the Securities and Exchange Commission.
This program will provide startup hedge fund managers and new investment advisers with the information they need to navigate the registration process, regulatory requirements, and examination focus of the DOC and the SEC, including:
Date & Time
3:30 pm - 4:00 pm PT
4:00 pm - 4:30 pm PT
Keynote: Jan Lynn Owen
4:30 pm - 5:45 pm PT
5:45 pm - 7:30 pm PT
Pillsbury’s San Francisco Office
Four Embarcadero Center
San Francisco, CA 94111
Jan Lynn Owen, Commissioner, California Department of Corporations
Host and Moderator
Jay B. Gould, Partner, Pillsbury
Jerry Twomey, Deputy Commissioner, Division of Securities Regulation, California Department of Corporations
Doug Bramhall, Tax Managing Director, KPMG
Kristin A. Snyder, Associate Regional Director–Examinations, Securities and Exchange Commission, San Francisco Regional Office
Written by: Jay Gould
Last month, the Securities and Exchange Commission (the “SEC”), published its examination priorities for 2013. As we suggested in our Blog posting at that time, the SEC is fixated on examining and bringing enforcement against its newest class of investment adviser – managers of private equity funds. Fast forward four weeks, and we should not be surprised to see that the SEC is doing what they said they would do. Today, the SEC charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund of funds they manage.
The SEC investigation alleged that Oppenheimer Asset Management and Oppenheimer Alternative Investment Management disseminated misleading quarterly reports and marketing materials, which stated that the Oppenheimer Global Resource Private Equity Fund I L.P.’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.” The SEC, however, claimed that the portfolio manager of the Oppenheimer fund actually valued the Oppenheimer fund’s largest investment at a significant markup to the underlying fund manager’s estimated value, a change that made the performance of the Oppenheimer fund appear significantly better as measured by its internal rate of return. As part of the Order entered by the SEC, and without admitting or denying the regulator’s allegations, Oppenheimer agreed to pay more than $2.8 million to settle the SEC’s charges and an additional $132,421 to the Massachusetts Attorney General’s office.
In its press release, the SEC reiterated its focus on the valuation process, the use of valuations to calculate fees and communicating such valuations to investors and to potential investors for purposes of raising capital. The SEC’s order also claimed that Oppenheimer Asset Management’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations to investors and prospective investors. This claim gave rise to an alleged violation of Rule 206(4)-8 (among other rules and statutes) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the rule that the SEC passed after the Goldstein case permitted many funds to de-register as investment advisers from the SEC.
This case illustrates the new regulatory landscape for private equity fund managers. Many private equity fund managers have not dedicated the time and resources to bringing their organizations in line with the fiduciary driven rules under the Advisers Act. Many of these managers have not implemented the compliance policies and procedures required by the Advisers Act, nor have their Chief Compliance Officers been empowered to enforce such compliance policies and procedures when adopted. Much of this oversight goes to the fact that many private equity fund managers do not have a history of being a regulated entity nor have they actively sought out regulatory counsel in their typical business dealings. Private equity fund managers generally use outside counsel to advise them on their transactional or “deal” work and they often do not receive the advice that a regulated firm needs in order to meet its regulatory obligations. Oppenheimer serves notice that failing to meet these regulatory obligations can have dire consequences.
Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program ("NEP") observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers. The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule. The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors. We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds, fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for "privately offered securities" (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities. Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.
On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk. The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges. This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)
As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology. The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).
Pillsbury partner Jay Gould talks about Challenges and Opportunities for Starting a Hedge Fund in 2013, a program co-sponsored by the law firm, and why he thinks 2013 will indeed be a good year for hedge fund managers. Learn more: http://www.pillsburylaw.com/investment-funds-and-investment-management
Written by: Louis A. Bevilacqua
On January 10, 2013 the Financial Industry Regulatory Authority (“FINRA”) issued a voluntary Interim Form for funding portals (the “Interim Form”). The Interim Form is designed for prospective crowdfunding portals under the Jumpstart our Business Startups Act (the “JOBS Act”), which was enacted on April 5, 2012. Title III of the JOBS Act, which relates to crowdfunding, requires the Securities and Exchange Commission (the “SEC”) and FINRA to promulgate rules before crowdfunding portals can commence operations. The Interim Form permits companies that intend to become funding portals under Title III of the JOBS Act to voluntarily submit to FINRA information regarding their business. FINRA expects that the information received will help it develop rules specific to crowdfunding portals.
As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware of.
See upcoming deadlines below and in red throughout this document.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary is not intended to be a comprehensive review of an Investment Adviser’s securities, tax, partnership, corporate or other annual requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
u List of annual compliance deadlines in chronological order:
State registered advisers pay IARD fee
November-December (of 2012)
Form 13F (for 12/31/12 quarter-end)
February 14, 2013
Form 13H annual filing
February 14, 2013
Schedule 13G annual amendment
February 14, 2013
Registered CTA Form PR (for December 31, 2012 year-end)
February 14, 2013
TIC Form SLT
Every 23rd calendar day of the month following the report as-of date
TIC Form SHCA
March 1, 2013
Affirm CPO exemption
March 1, 2013
Registered Large CPO Form CPO-PQR December 31 quarter-end report
March 1, 2013
Registered Small CPO Form CPO-PQR year-end report
March 31, 2013
Registered Mid-size CPO Form CPO-PQR year-end report
March 31, 2013
Registered CPOs filing Form PF in lieu of Form CPO-PQR December 31 quarter-end report
March 31, 2013
SEC registered advisers and ERAs pay IARD fee
Before submission of Form ADV annual amendment by March 31, 2013
Annual ADV update
March 31, 2013
Delivery of Brochure
April 30, 2013
Form PF Filers pay IARD fee
Before submission of Form PF
Form PF (for advisers required to file within 120 days after December 31, 2012 fiscal year-end)
April 30, 2013
FBAR Form TD F 90-22.1 (for persons meeting the filing threshold in 2012)
June 30, 2013
Form D annual amendment
One year anniversary from last amendment filing
The NFA recently issued a notice entitled “Guidance on the Annual Affirmation Requirement for those Entities that are currently operating under an exemption or exclusion from CPO or CTA registration.” As of February 2012, each person claiming an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) is required to annually affirm the exemption or exclusion upon which it relies. The annual notice affirming the exemption or exclusion is due within 60 days of the calendar year end. The first notice is due for the calendar year ending December 31, 2012. The required affirmation must be filed electronically on the NFA’s Exemption System. A full version of the NFA notice along with FAQs regarding the annual affirmation requirement is available here.
Written by: Jay Gould
The Securities and Exchange Commission (the “SEC”) recently charged and entered into consent decrees with four India-based brokerage firms for providing brokerage services to U.S. investors without being registered as broker dealers under the U.S. securities laws. This otherwise mildly interesting enforcement action by the SEC should serve as a cautionary tale to hedge fund managers based outside the U.S. that seek to raise capital from U.S. investors, as well as U.S. fund managers that seek to sell their fund shares in foreign countries.
Many non-U.S.-based fund managers seek to raise money from U.S. investors due to the large amounts of available capital in this country and the relative willingness of U.S. investors to consider managers from foreign jurisdictions. However, visiting potential U.S. investors or sending fund marketing materials into the U.S. without complying with the U.S. broker dealer rules could result in a fate similar to that suffered by the four Indian brokerage firms that were sanctioned and fined by the SEC. In order to avoid an enforcement proceeding, non-U.S. fund managers should retain a properly registered U.S. brokerage firm to sell the fund’s securities, enter into a “chaperoning” arrangement with a U.S. broker or register a subsidiary as a broker-dealer in the U.S.
Whether prudent or not, most U.S.-based fund managers rely on Rule 3a4-1, the so-called “issuers exemption,” under the Securities Exchange Act of 1934 (the “1934 Act”) in order to avoid either registering the general partner or an affiliate of the fund as a broker, or retaining an unrelated broker to sell the fund’s interests. But when U.S. fund managers travel outside the U.S. to gauge interest or solicit potential investors, the U.S. rules are not applicable. Each country has its own regulatory scheme, and fund managers are well advised to understand what is permitted and prohibited in each country before visiting each country at the risk of being the subject of a new episode of “Locked Up Abroad.” Indeed, certain countries impose criminal sanctions for offering securities if the offeror is not properly authorized to do so.
The Investment Fund Law Blog boldly predicts that the SEC will one day soon re-visit the industry’s expansive interpretation of the “issuer’s exemption” and the result will not be pleasant for the private funds industry.
So what did these Indian brokerage firms do to incur the wrath of the SEC? The activities that these firms engaged in included:
Many of these activities no doubt sound hauntingly familiar to U.S.-based fund managers that travel abroad for the purpose of raising capital. All four firms were censured and ordered to pay a combined total of more than $1.8 million in disgorgements and prejudgment interest, but no civil penalties were imposed due to the firms’ cooperation with the SEC. The firms have all submitted settlement offers, without admitting or denying any wrongdoing.
The SEC’s press release on the matter can be found here.
Written by: Jay Gould
When can private fund managers start posting performance numbers on their websites and sponsoring the Super Bowl? Not yet, according to Senator Carl Levin (D-MI) in letters dated October 5,2012 and October 12, 2012, (the “Levin Letters”) rebuking the SEC for having missed the point of the legislation in the SEC rulemaking process. As you recall, on August 29, 2012, the SEC proposed rules pursuant to Section 201 of the Jumpstart our Business Startups Act (“JOBS Act”) that, if adopted in final form, would allow private issuers, including private funds, to generally solicit and advertise as long as the investors are all “accredited investors.”
Of most importance to hedge fund and private equity fund managers that have been anticipating a more relaxed and flexible approach of communicating with the public and soliciting new investors, the Levin Letters flatly accuse the SEC of failing to grasp the scope of the JOBS Act in applying it to private investment vehicles. According to Levin, the SEC should “distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.” The October 12 letter further advises the SEC that “[c]ongress did not contemplate removing the general solicitation ban – without retaining any limitations on forms of solicitation – for private investment vehicles. Indeed, no argument was made during the debate of the bill that the objective was to ease the capital aggregation process for private investment vehicles. The words “hedge fund,” “private fund,” or “investment vehicle” were not used either during the committee or floor debate in the House of Representatives. Nor did the Senate engage in any debate relating to removing these advertising and marketing restrictions completely from private investment vehicles.”
According to the Levin staffer who is responsible for this area of the Senator’s legislative initiatives, we should no longer expect that the SEC will adopt the rules as proposed. The SEC must propose new rules that more accurately reflect the intent of Congress and not simply abdicate regulatory authority over the use of general advertising and solicitation by private funds, the Investment Fund Law Blog was told by Levin’s office.
This SEC mulligan may very well put back into play many of the criticisms of the JOBS Act that were expressed in the comment period after the JOBS Act was first signed into law. As you may recall, on May 21, 2012, the Investment Company Institute (the “ICI”) submitted a comment letter to the SEC regarding Section 201 of the JOBS Act in which the ICI encouraged the SEC to, among other things, adopt advertising rules for private funds that are at least as restrictive as those that apply to registered mutual funds, raise the income and net worth standards in the definition of “accredited investor,” and prohibit or limit performance advertising by hedge funds until the SEC has studied the implications of such advertising for 60 years. In a follow up letter to the SEC on August 17, 2012, the ICI, citing press reports and rumors, implored the SEC to not adopt “interim rules” pursuant to Section 201. Rather, the ICI suggested, full notice and comment should be employed in this rulemaking process so that the SEC might fully observe its fundamental mandate to protect investors. It should be noted that the SEC began accepting public comments on all aspects of the JOBS Act shortly after the legislation became law on April 5, 2012. The law itself requires the SEC to adopt rules pursuant to Section 201 within 90 days of the signing of the legislation, a time frame that, quite obviously, was not met.
The Levin Letters further admonished the SEC to establish “methods” for determining whether an investor meets the “accredited investor” standard. The rule proposal provided only that an issuer must take “reasonable steps” to determine accredited status, and provided significant flexibility for issuers to determine the appropriate level of due diligence in order to verify status. The Levin Letters requested that the SEC go back to the drafting table and come up with a new proposal that requires “common sense” documentation and/or verification practices and procedures. If, as Levin’s office suggests, the SEC does re-propose rules as a result of this criticism, it could result in issuers being required to follow definitive verification standards, such as obtaining an income statement, balance sheet, or bank or brokerage statements from investors.
It is possible that the last chapter of the JOBS Act rules regarding general solicitation may not yet be written. In the meantime, private fund managers should continue observing the current ban on general solicitation and advertising and put on hold those plans to post their performance returns on the back of Serena Williams’ tennis togs.
While you were touring the Champagne region or sipping umbrella drinks at the beach this summer, the California Department of Corporations (the “DOC”) was busy overhauling the rules applicable to investment advisers. On August 27, 2012, the DOC adopted final rules, available here, that provide for an exemption from registration for certain private fund managers pursuant to specific conditions. This exemption, along with the rules previously adopted by the Securities and Exchange Commission (the “SEC”), now permits certain investment advisers that provide advice only to private funds to operate without being fully registered with either the SEC or the State of California.
Unlike the SEC rules, this exemption does not prohibit a fund manager from registering with the DOC—it simply allows the fund manager to decide whether it would like to register or rely on the exemption. To rely upon this exemption, a California based adviser must complete and file the Form ADV (required under Rule 204-4 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”)) with the DOC that is required of an adviser that files for “exempt reporting adviser” status with the SEC. But why would any adviser that is eligible to take advantage of the exemption decide to register?
If a fund manager intends only to seek capital from “friends and family,” subjecting itself to the full registration requirements and the more complete compliance rules that are expected soon from the DOC could represent a significant expense to the manager. Or, if a manager is leaving another organization and must quickly get to market, the three to four month process associated with the DOC review of an investment adviser application may be viewed as too long to wait. But if a fund manager expects to target more institutional capital, or other investors that would have a reasonable expectation that the manager is subject to some regulatory oversight, the manager may very well decide that a California investment adviser registration is not so burdensome. After all, a manager that seeks to rely on the exemption must still file the Form ADV, prepare a private placement memorandum, and have the fund audited, among other requirements discussed below. The analysis that each fund manager must undertake in order to make this decision is multi-faceted and is ultimately one that is unique to each adviser and its own circumstance.
To briefly summarize the results of the DOC rulemaking, an investment adviser located in California may conduct its business without being a fully registered and regulated investment adviser under the DOC regulations so long as:
Additionally, with respect to Retail Buyer Funds:
When an adviser that is eligible for the California exemption reaches $100 million in assets, it would become an exempt reporting adviser with the SEC and would need to switch its status over to the SEC. And when it reaches $150 million it must become a fully registered investment adviser with the SEC; accordingly, investment advisers can operate without being fully registered with the SEC or the State of California so long as they have less than $150 million in assets and satisfy the conditions discussed above.
The California exemption contains a “grandfathering” provision for Retail Buyer Funds formed prior to the release of the exemption, as the additional requirements listed above are deemed satisfied if the Retail Buyer Fund: (i) distributes annual audited financial statements; (ii) pre-existing investors receive the “material disclosures” discussed above; (iii) from August 27, 2012 on, the Fund only sells interests to “accredited investors”; and (iv) the adviser receives performance-based compensation only from pre-existing investors or “qualified clients.”
On October 9, 2012, the Securities and Exchange Commission (SEC) announced the launch of an initiative to conduct focused, risk-based examinations of investment advisers to private funds that recently registered with the SEC. These “Presence Exams” are part of a two year initiative with three primary phases: engagement, examination and reporting. During the examination phase, staff from the National Exam Program (NEP) will review one or more of five areas identified by the SEC as “high-risk” areas for the business and operations of advisers:
Investment advisers should note that access to any advisory books and records will also need to be provided upon request during a Presence Exam. Prior to the examination phase, NEP staff will engage in a nationwide outreach to inform newly registered investment advisers about their obligations under the Advisers Act and related rules during the engagement phase. At the conclusion of the examination phase, the NEP will report its observations to the SEC and the public.
The NEP is administered by the Office of Compliance Inspections and Examinations within the SEC. The letter outlining the NEP’s initiative, available here, was distributed to certain executives and principals of newly registered investment advisers and posted on the SEC’s website. NEP staff will contact advisers separately if their firm is selected for an examination, and receipt of the letter announcing the launch of the initiative does not ensure that a Presence Exam will necessarily follow.
Effective December 3, 2012, hedge funds and other private funds that rely on Section 3(c)(1) of the Investment Company Act (“3(c)(1) Funds”) and which sell their interests through third party marketers, must ensure that their private placement memoranda (“PPM”) are filed with FINRA, the Financial Industry Regulatory Authority. The Securities and Exchange Commission recently approved new FINRA Rule 5123, Private Placements of Securities, which is part of an ongoing approach by FINRA to enhance oversight and investor protection in private placements. Under Rule 5123, each firm that sells a security in a private placement, subject to certain exemptions, must file a copy of the offering document with FINRA within 15 calendar days of the date of the first sale. If a firm sells a private placement without using any offering documents, then the firm must indicate that it did not use an offering document. The rule also requires firms to file any materially amended versions of the documents originally filed. Rule 5123 exempts some private placements sold solely to qualified purchasers, institutional purchasers and other sophisticated investors.
For hedge funds and other private funds that have hired a third party marketer, the fund manager must make sure that the agreement with the marketer, which is required to be a registered broker dealer, obligates the marketer to file the PPM with FINRA and amend the filing if the PPM is materially revised. The marketing agreement, or “placement agency agreement” as it is sometimes called, should indemnify the fund manager for the failure of the marketer to make these filings.
Rule 5123 will become effective December 3, 2012, and the full text of the FINRA regulatory notice regarding Rule 5123 is available here.
On August 30, 2012, Ildi Duckor and Michael Wu, members of Pillsbury’s Investment Funds and Investment Management practice, met with executives and staff of the California Department of Corporations at the Department’s invitation. The purpose of the meeting was to provide the Department’s investment adviser and broker dealer divisions (live in San Francisco and via teleconference in the Sacramento and Los Angeles offices) with a broad overview of the hedge fund industry. “We hope that a better understanding of the industry will help balance hedge fund managers’ business needs with the regulators’ need for investor and market protection, and will streamline both the adviser registration and the examination process” said Ildi Duckor. The Investment Funds and Investment Management team will continue to cooperate with the Department in an effort to provide industry insight with respect to future California regulation of hedge funds and their advisers.
This guest post from the Margolis Advisory Group, co-authored by River Communications, is reprinted with permission. The Executive Summary appears below and the full text is available here.
The JOBS Act is bringing change to the hedge fund industry, and, most likely, this change will accelerate the trend towards institutionalization. The lifting of the “advertising ban” opens the playbook, allowing hedge funds to engage in a wide range of strategic communications and marketing activities. For some, this will offer a new opportunity to compete for assets with traditional managers adept at managing their brands and marketplace perceptions. Others will resist, possibly to their detriment, as funds will no longer have the luxury of hiding “under the radar.”
Hedge funds who embrace the new, less restrictive environment will need to build mature, comprehensive strategic communications programs. The best practices include:
Hedge funds have thrived by embracing and even becoming catalysts for change. In this hyper-competitive industry, it is commonplace to expend disproportionate resources to capture even a minimal investment performance advantage. Because of this, it is surprising that there has not been more enthusiastic support in the trades for what is potentially the next major shift for the industry: the Jumpstart Our Business Startups Act or JOBS Act.
Passed with little fanfare, the JOBS Act lifts the ban on advertising for hedge funds (among other provisions) and has the potential to transform how managers market their firms, build their brands and communicate with their investors. Yet, much of the discussion in the trades and on the hedge fund industry speaking circuit has downplayed the potential impact of this provision as being only meaningful to the smaller funds. Large funds—as the typical explanation goes—believe they do not need to proactively market, as they commonly market off their mystique of exclusivity and will prefer to remain “under the radar” to protect their proprietary investment strategies. Furthermore, the larger funds are already staffed for one-on-one sales, and many in the hedge fund industry are under the false impression that sales are only based on individual contacts or “having the Rolodex.”
The fact is, change is coming to the hedge fund industry, and many managers will continue to adapt to the ongoing evolution as they always have. Most likely, this change will accelerate the trend towards resembling traditional managers—for hedge funds can now adopt advertising and marketing techniques, as well.
Consider the trends we have observed in the hedge fund and institutional asset management space, especially since the market declines of ’07-’08. New regulations have increased the demand for information on leverage and counterparty risk; the migration from single to multi-prime brokers has occurred, and institutional investors are demanding more transparency in investment operations, risk and administration. Perhaps, most significantly—the largest institutional investors have been allocating funds almost exclusively to the largest hedge funds.
According to “The Evolution of the Industry: 2012,” an annual KPMG/AIMA hedge fund survey, institutional investors now represent a clear majority of all assets under management by the global hedge fund industry, with 57 percent of the industry’s AUM residing in this category. And, the proportion of hedge fund industry assets originating from institutional investors has grown significantly since the financial crisis.
As a result, we are seeing a continuation of the institutionalization of hedge funds. The KPMG study confirmed this with survey data indicating that investors demand hedge funds look and act more like traditional institutional managers from an operational standpoint. In addition, 82 percent of respondents reported an increase in demand for transparency from investors, while 88 percent said investors are demanding greater due diligence.
Our own experience consulting with hedge funds and traditional managers has confirmed other indications of this trend, as well as with all investors—large and small—demanding greater operational efficiency; cost reduction; and models that enhance overall risk management, such as the move from single to multi-prime relationships; all delivered in an open and transparent way.
For hedge fund managers to attract large pools of money, they will increasingly need to be more institutional and transparent with all investors. This is a significant cultural shift for these firms. Not only do many hedge funds lack a strategic communications infrastructure, but the concept of such openness still runs contrary to the DNA of most firms.
The question then becomes: how should hedge funds that embrace a more open and inclusive communications strategy implement programs that will help them achieve this goal? The answer is they will need to develop an approach to communications that is similar to traditional institutional asset managers.
August 6, 2012
Hedge Fund Marketing Implications From New Survey
Findings On Investment Beliefs
by Bruce Frumerman, Frumerman & Nemeth Inc.
The recently published Pensions & Investments/Oxford University survey on long-term investment beliefs has implications for how hedge fund firms market their strategies and get buy-in from institutional investors.
Relevant findings for hedge fund firm owners
In offering conclusions from their survey results Gordon L. Clark, professor at Oxford University’s Centre for the Environment, who led the survey, offered the key observation that managers will increasingly be differentiated by “their strong belief systems and a rigorous investment process that matches those beliefs.” P&I reported that he went on to comment that “It’s terribly important for managers” to base investment decisions on a clear set of investment beliefs. “The whole logic of their business is premised on being able to articulate beliefs, testing beliefs and being able to revise beliefs in a very uncertain world.”
P&I also reported the comments of Rob Bauer, professor of finance and chair of the institutional investments division at Maastricht University, that more investment managers “now focus on the structure of their investment beliefs, how the beliefs translate into the design of the investment framework and how that framework is executed. The more sophisticated investment managers are really trying to have a coherent structure.”
What it means for hedge fund marketing
Marketing hedge funds has become more competitive.
Successful capital raising has always required having more than just performance that is within the ballpark of acceptance. Having institutional caliber operations and administration went from being a marketing differentiator to simply an expected cost of doing business. Along the way, from pre-crash to post-crash, the term transparency, and the call for it, changed in meaning. What began as calls for data — reveal the portfolio holdings and provide third-party reporting — morphed into a call for providing more explanation about the investment process and decision-making behind a firm’s strategy.
Institutional investors and their investment consultants have become more demanding for greater information detail about how hedge fund managers think and how they construct and manage their portfolios.
Is your firm communicating an institutional caliber explanation about its investment beliefs and the process behind its strategy? A few bullet points in a flip chart are not sufficient for accomplishing this. You cannot just claim you have a rigorous investment process and leave it at that. You have to prove it with a detailed explanation of this important subjective information that your hedge fund has to persuade people to understand and buy into: how it invests.
Reexamine your own communications. Are you truly differentiating your firm from the competition or are your marketing collateral, in-person presentations and responses to essay questions in RFPs and DDQs actually having you come across as a me-too copycat strategy-wise, offering no perceivable added value?
Have you given prospective investors easy access to a full, written explanation about your firm’s investment beliefs and investment process? Your hedge fund has a communications marketing risk management challenge. One of the important selling missions you have is to reduce the odds that a prospect will mess up retelling the subjective-based part of your firm’s story to others on the investment committee. Supplying them with the written long version story of investment beliefs and investment process will increase your control in how your prospect remembers and retells your story to other decision makers.
A flip chart pitchbook is not the right tool for this communications job. An additional marketing document that delivers this vital story in sentence and paragraph form about how your firm thinks is required. Such content is more suited to brochure format marketing collateral than to bullet point flip charts. If such a marketing tool is not already in your selling arsenal for making selecting your offering a more defensible decision in the minds of your prospects, creating this type of document should be at the top of your communications marketing To Do list.
The job of crafting the story of a hedge fund’s investment belief system and its investment process isn’t an assignment a portfolio manager can pass off to others to create with little or no participation from him. Too often, important parts of a hedge fund’s investment process story have never been fully communicated to people outside the firm. Also, many hedge fund firms find themselves unable to tell their investment beliefs and process story the same way twice. So, the portfolio manager’s participation with his communications marketing experts in locking down his firm’s storyline is vital.
Differentiate your hedge fund based on your investment beliefs and a demonstrable, rigorous investment process that matches those beliefs and you will improve your firm’s ability to out-market competitors and convert prospects to clients.
# # #
Bruce Frumerman is CEO of Frumerman & Nemeth Inc., a communications and sales marketing consultancy that helps financial services firms create brand identities for their organizations and develop and implement effective new marketing strategies and programs. His firm’s work has helped money management clients attract over $7 billion in new assets, yet Frumerman & Nemeth is not a Third Party Marketing firm. Bruce has over 30 years of experience in helping money managers to develop buyer-focused positioning strategies to differentiate them from their competitors; create more cogent and compelling sales presentations and marketing materials to better tell their story; and use media relations marketing and industry conference speaking opportunities to help establish a branded identity for their organization by generating third-party endorsement for the expertise of their people, the value of their services and the quality of their products. He has authored many articles on the topic of marketing money management services and is a frequent speaker on the subject at industry conferences. He can be reached at firstname.lastname@example.org, or by visiting www.frumerman.com.
© Frumerman & Nemeth Inc. 2012
In a July 10, 2012, no-action letter, available here, issued by a Division of the U.S. Commodity Futures Trading Commission (the “CFTC”) in response to requested relief from certain new CFTC registration obligations, the CFTC granted temporary relief to commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). As previously discussed on this blog, earlier this year the CFTC rescinded an exemption under CFTC Rule 4.13(a)(4) used by many CPOs and CTAs. This rescission went into effect on April 24, 2012 and denied the use of the exemption under Rule 4.13(a)(4) to any CPOs and CTAs of new pools on or after that date, although CPOs and CTAs already availing themselves of the exemption were able to continue its use until the end of the year.
The no-action letter offers relief to CPOs and CTAs of new pools, recommending that the CFTC not take enforcement action against CPOs or CTAs for new pool launched after the issuance of the no-action letter for failure to register as such until December 31, 2012, as outlined below.
No-action relief will be granted for each pool for which the CPO submits a claim to take advantage of the no-action relief and remains in compliance with the following:
No-action relief will be granted when the CTA submits a claim to take advantage of the relief and remains in compliance with the following:
CPOs and CTAs should note that the no-action relief granted is not self-executing and must be affirmatively sought, and any relief sought and/or granted will expire at the end of the year and such CPOs and CTAs must remain in compliance with registration obligations going forward.
 The No-Action letter was issued by the Division of Swap Dealer and Intermediary Oversight of the U.S. Commodity Futures Trading Commission to the Managed Funds Association, the Investment Adviser Association, the Alternative Investment Management Association, Ltd., and the Investment Company Institute, collectively.
On July 1, 2010, the Securities and Exchange Commission (the “SEC”) adopted Rule 206(4)-5 under the Investment Advisers Act of 1940, as amended, which prohibited an investment adviser from providing advisory services for compensation to a government client for two years after the advisers or certain of its executives or employees make a contribution to certain elected officials or candidates. Rule 206(4)-5, also known as the Pay to Play Rule, also included a third-party solicitor ban that prohibited an adviser or its covered associates from providing or agreeing to provide, directly or indirectly, payment to any third-party for a solicitation of advisory business from any government entity on behalf of such adviser, unless such third-party was an SEC-registered investment adviser or a registered broker or dealer subject to pay to play restrictions.
As originally adopted, the third-party solicitor ban’s compliance date was September 13, 2011. However, not long after the Pay to Play Rule was adopted, Congress created a new category of SEC registrants called “municipal advisors” in the Dodd-Frank Wall Street Reform and Consumer Protection Act. Municipal advisors include persons that undertake a solicitation of a municipal entity. The SEC then amended the Pay to Play Rule on June 22, 2011 in order to add municipal advisors to the category of registered entities excepted from the third-party solicitor ban and extended the original compliance date of the third-party solicitor ban.
On June 8, 2012, the SEC released a final rule that extends (for a second time) the compliance date for the third-party solicitor ban. The SEC explained that it was necessary to ensure an orderly transition for advisers and third-party solicitors as well as to provide additional time for them to adjust compliance policies and procedures after the transition. The new compliance date for the third-party solicitor ban will now be nine months after the required registration date for municipal advisers with the SEC under the Securities Exchange Act of 1934, as amended. This compliance date has yet to be finalized as the SEC has not yet adopted the applicable rule.
Note: Pillsbury and KPMG, along with the California Hedge Fund Association, will be sponsoring a “Managers Only” event on the JOBS Act and the new world of “general solicitation” for Funds on June 14.
The Jumpstart Our Business Startups Act (the “JOBS Act” or the “Act”), signed into law by President Obama on April 5, 2012, seeks to encourage economic growth through the easing of certain restrictions on capital formation and by improving access to capital. The JOBS Act contains a number of provisions that will directly impact private funds and their general partners, managers and sponsors. Below is a summary of the Act’s provisions that directly affect private funds, including ongoing requirements for funds that at this time do not appear to be affected by the Act.
The Form PF (PF is short for “private funds”) is a new Securities and Exchange Commission reporting form for investment advisers to private funds that have at least $150 million in private fund assets under management. Comprising 42 pages and divided into 4 sections with corresponding subsections, Form PF may appear daunting at first. The task of completing and filing the Form also entails categorizations, specific and nuanced reporting requirements and Form-specific calculations, not to mention the fact that improperly completed Forms may be delayed or even rejected. However, with the proper tools and plan of attack, an adviser will be able to fulfill its reporting requirements and improve its data platform for a host of other reporting and filing requirements. Form PF necessitates working with large amounts of data. So, early planning, coordination and organization are essential for success. In a guest article, Jay Gould, a Partner at Pillsbury Winthrop Shaw Pittman LLP and leader of Pillsbury’s Investment Funds & Investment Management practice team, and Kelli Brown, Director of Private Funds at Data Agent, LLC, describe ten steps that a hedge fund manager should take for successful Form PF completion and filing. The article can be accessed on the Hedge Fund Law Report’s website (www.hflawreport.com – subscription required).
Please contact Jay Gould if you have any further questions or seek further information about Form PF.
On April 18, 2012, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) voted to adopt rules defining “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant,” among other terms, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The Dodd-Frank Act assigns to the SEC the regulatory authority for security-based swaps and assigns to the CFTC the regulatory authority for swaps.
Under the adopted rules, the definitions are as follows:
A swap dealer is defined as any person who:
The definition of security-based swap dealer tracks the definition of swap dealer, with “security-based swap” inserted where “swap” appears.
A major swap participant is a person that satisfies any one of the three parts of the definition:
The definition of major security-based swap participant tracks the definition of major swap participant with “security based-swap” inserted where “swap” appears.
The newly adopted rules contain further definitions for the terms “substantial position,” “hedging or mitigating commercial risk,” “substantial counterparty exposure,” “financial entity,” “highly leveraged,” and “eligible contract participant.” In addition, the adopting release provides interpretative guidance on the definitions of swap dealer and security-based swap dealer, and the CFTC provides further details on the exclusion for swaps in connection with originating a loan, the exclusion of certain hedging swaps and the exclusion of swaps between affiliates. Finally, the new rules call for a de minimis exemption from the definition of swap dealer and security-based swap dealer wherein a person who engages in a de minimis amount of swap or security-based swap dealing will be exempt from the respective definition.
The SEC and the CFTC adopted the new rules under joint rulemaking, and the SEC rules become effective 60 days after the date of publication in the Federal Register, although dealers and major participants will not have to register with the SEC until the dates that will be provided in the SEC’s final rules for the registration of dealers and major participants. The CFTC must adopt further rules defining the term “swap,” and swap dealers and major swap participants will need to register by the later of July 16, 2012, or 60 days after the publication of CFTC rules defining “swap.”
 Security-based swaps are broadly defined as swaps based on (i) a single security, (ii) a loan, (iii) a narrow-based group or index of securities, or (iv) events relating to a single issuer or issuers of securities in a narrow-based security index.
By: Louis A. Bevilacqua, Joseph R. Tiano, Jr., David S. Baxter, Ali Panjwani and K. Brian Joe
On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), a bill with widespread bipartisan support and assembled from a combination of legislative initiatives introduced throughout 2011 targeting smaller companies and focusing on cheaper capital raising and job creation. We discuss the key provisions of the JOBS Act and their impact on these companies and securities offerings.
The Jumpstart Our Business Startups Act (JOBS Act) is a consolidation of several bills introduced throughout 20111 with the goal of making it easier for smaller companies to raise money and lessen their regulatory burden while doing so. The House of Representatives passed the JOBS Act on March 8 by a vote of 390-23, and the Senate passed the same bill, with one amendment, on March 22 by a vote of 73-26. The Senate amendment offered a more restrictive take on the House bill’s provisions dealing with the increasingly popular grass-roots financing method known as crowdfunding. On reconsideration of the bill with the Senate amendment, the JOBS Act passed the House by a vote of 380-41 on March 27, and President Obama signed it into law on April 5. The JOBS Act is one of the most comprehensive pieces of legislation in recent years to be specifically targeted at developing companies. This Alert summarizes the most important provisions of the JOBS Act and the implications of those provisions.
The Commodity Futures Trading Commission (the “CFTC”) recently amended its registration rules regarding Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”), which will require many general partners and managers of private investment funds that previously relied on an exemption from registration to now register with the CFTC. After a public comment period in which the industry overwhelmingly supported the continuation of these exemptions, the CFTC decided to rescind the CPO exemption under CFTC Rule 4.13(a)(4) and amend the CPO exemption under CFTC Rule 4.13(a)(3). Rule 4.13(a)(4) previously exempted private pools from registering as a CPO with the CFTC for funds offered only to institutional qualified eligible purchasers (“QEPs”) and natural persons who meet QEP requirements that hold more than a de minimis amount of commodity interests.
The CFTC's amendment did not change the application of CFTC Rule 4.13(a)(3) to a fund of a hedge fund (“Fund of Funds”). However, due to the repeal of these exemptions, many of the general partners or managers of a Fund of Funds’ underlying funds may be required to register as CPOs, thereby requiring registration of the Fund of Funds manager. The CFTC has provided guidance with respect to when a Fund of Funds manager may continue to rely upon an exemption from registration as a CPO. We have summarized these circumstances below:
The CFTC amended Section 4.13(a)(3) to address how to calculate the notional value of swaps and how to net swaps. In addition, the CFTC will now require a CPO relying on Section 4.13(a)(3) to submit an annual notice to the National Futures Association affirming its ability to continue relying on the exemption. If a CPO cannot affirm its ability to do so, the CPO will be required to withdraw the exemption and, if necessary, apply for registration as such.
For additional information on whether these rule amendments will require you to register as a CPO or CTA, or whether the CFTC guidance or another exemption might provide a further exemption from registration, please contact your Pillsbury Investment Funds Attorney.
 CFTC Rule 4.13(a)(3) requires that at all times either: (a) the aggregate initial margin and premiums required to establish commodity interest positions does not exceed five percent of the liquidation value of the Fund’s investment portfolio; or (b) the aggregate net notional value of the Fund’s commodity interest positions does not exceed one-hundred percent of the liquidation value of the Fund’s investment portfolio.
In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers. The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.
As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware.
First, we wanted to address three situations where Investment Advisers may need to make changes with regard to their registration. These are:
(1) SEC-registered Investment Adviser switching to State registration. SEC-registered Investment Advisers are required to withdraw registration if they have less than $90 million in Assets under Management (“AUM”). Those Investment Advisers have a June 28, 2012 deadline for state approval. These advisers should submit a state Form ADV to the relevant state by March 20, 2012 to allow at least 90 days for state approval (California in particular).
(2) State-registered Investment Adviser switching to SEC registration. A state-registered Investment Adviser whose AUM as of December 31, 2011 was $110 million or more must register with the SEC by March 30, 2012. Going forward, state-registered Investment Advisers must apply for registration with the SEC within 90 days of becoming eligible for SEC registration and not relying on an exemption from registration. The threshold for registration with the SEC is $100 million or more in AUM, but you may stay registered with the state up to $110 million in AUM.
(3) Currently exempt Investment Adviser registering with the SEC. An Investment Adviser previously exempt from registration that is now registering with the SEC must do so by the March 30, 2012 deadline. The Form ADV should have been filed with the SEC by February 14, 2012.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary section begins with what we feel are “hot” areas of compliance for 2012, and then addresses continuing compliance and other regulatory issues. The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other year-end requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
Last week’s article on HFMWeek entitled “Disclosure Gets Closer” discussed registration requirements of investment advisers to hedge funds under the Dodd-Frank Act. The article, which was written by Will Wainewright, quoted Jay Gould, a partner and member of our Investment Fund and Investment Management team, who said “[T]he most difficult part of SEC registration – not an onerous process in itself – is implementing, testing, internally enforcing and updating the compliance procedures that the SEC will be checking on once you are registered.”
A full text of the article is available here.
1. What is the Form PF?
The Form PF (PF is short for “private funds”) is a new form that focuses mainly on private fund reporting with regard to information such as counterparty dealings, leverage, and investment exposure. A “private fund” under the Form PF refers to any issuer that would be an investment company under the Investment Company Act of 1940, as amended, if not for the exemptions provided by Sections 3(c)1 or 3(c)7 of that Act. Under some circumstances, non-“private funds” such as money market funds registered with the SEC may be required to report on the Form, in addition to “private funds.”
2. Do investment advisers need to file the Form PF?
Yes, in certain circumstances. Only investment advisers registered with the SEC that meet a $150 million threshold must report on the Form PF. The $150 million threshold refers to a specific and somewhat complicated calculation with regard to regulatory assets under management.
3. What are the categories of filers?
Advisers required to file the Form PF need to determine which category of filer corresponds to them. Large private fund advisers are categorized as either large hedge fund advisers, large liquidity fund advisers, or large private equity fund advisers. Large hedge fund advisers are those having at least $1.5 billion in regulatory assets under management attributable to hedge funds, subject to other conditions. Large liquidity fund advisers are those having at least $1 billion in regulatory assets under management attributable to “liquidity funds” and money market funds registered with the SEC, subject to other conditions. Large private equity fund advisers are those having at least $2 billion in regulatory assets under management attributable to private equity funds, subject to other conditions. All other filers are categorized as smaller private fund advisers.
4. What are the reporting deadlines?
Initial compliance under the Form PF will be in phases. The first required filers will be large private fund advisers with at least $5 billion attributable to hedge funds, to liquidity funds, or to private equity funds. These large hedge fund advisers will have 60 days, and large liquidity fund advisers will have 15 days, after the end of the first fiscal quarter ending on or after June 15, 2012, to file their first Form PF.
Other filers will have to make their first filing by the deadline following the end of the first fiscal quarter for each adviser, as applicable, on or after December 15, 2012. Under the initial compliance, many advisers will not need to file their first Form PF until 2013.
Going forward, the Form PF must be filed:
5. What constitutes the Form PF?
The Form PF, in its entirety, contains sixty pages, and is divided into four sections with corresponding subsections. Most advisers will not have to complete all four sections. The four sections feature reporting on, among other things: identifying information about the adviser; fund-by-fund reporting by all advisers about items such as fund identification, performance and valuation; fund-by-fund reporting by hedge fund advisers about items such as strategies, counterparties, and trading practices; aggregated private fund reporting for large hedge fund advisers; fund-by-fund reporting by large hedge fund advisers about items such as asset classes, portfolio liquidity, and risk metrics; fund-by-fund reporting for large liquidity fund advisers; and, fund-by-fund reporting for large private equity fund advisers.
6. What about the confidentiality of information reported?
Because of the nature of governmental sharing of the data provided on the Form PF, advisers should consider the options available to them with regard to preserving confidentiality. Consequently, advisers should consider changing their overall recordkeeping practices so that they routinely identify funds solely by numerical or alphabetical designations.
7. How is the Form PF filed?
The Form PF will be filed using the same IARD system on which advisers make the Form ADV filing.
On January 18, 2012, the Office of Investment Adviser Regulation, part of the Division of Investment Management, issued a no-action letter (the “2012 Letter”) in response to a request for guidance from the American Bar Association’s Subcommittee on Hedge Funds on issues regarding the registration of certain investment advisers that are related to investment advisers registered with the Securities and Exchange Commission (the “SEC”). The 2012 Letter both reaffirms previous positions of the SEC and provides additional guidance, as discussed below.
Special Purpose Vehicles (“SPVs”). In a December 8, 2005 letter, the SEC stated that it would not recommend enforcement action against a registered adviser and an SPV if the SPV did not separately register as an investment adviser, subject to conditions. The 2012 Letter reaffirms this position. The conditions in such a situation require that:
SPVs with Independent Directors. The 2012 Letter states that an SPV that relies on the above conditions may also have “independent directors” and therefore would not be required to meet the uniformity of personnel requirement.
Groups of Related Advisers. The 2012 Letter notes that for a variety of reasons, advisers to private funds may be part of a group of related advisers. In some situations these advisers, although organized as separate legal entities, conduct a single advisory business because they, among other things, are subject to a unified compliance program and use the same or similar names. The 2012 Letter states that a filing adviser and one or more relying advisers would be conducting a single advisory business and thus a single registration would be appropriate under the following circumstances:
Written by guest contributor, Bruce Frumerman, Frumerman & Nemeth Inc.
This article first appeared in FINAlternatives on January 30, 2012 and is re-printed with permission below.
It’s one thing when people who are not part of the hedge fund investor universe say hedge funds are money management firms that reveal too little about themselves. It’s another thing entirely when those folks investing in hedge funds are complaining about this.
In January SEI released part one of its results from its fifth annual survey of institutional hedge fund investors, conducted in collaboration with Greenwich Associates, The Shifting Hedge Fund Landscape. Three of the recommendations the report offers hedge fund firm owners give a glimpse into where surveyed investors are asking hedge funds to “provide more windows into investment processes and decision-making,” as SEI put it.
In re-proposed custody rules, the California Department of Corporations (“DOC”) has reflected the most important aspects of the comment letter that Pillsbury provided on July 27, 2011, such that all transactions and short positions need not be disclosed in the quarterly account statements. In general, the re-proposed custody rules define “custody,” and subject to certain limited exceptions, require that advisers with custody maintain the assets with a qualified custodian. The re-proposed custody rules also specify details with regard to audits and require compliance by advisers with specific safeguards.
The DOC also released proposed regulations that contain a successor to the private fund exemption, which are currently in the comment period. Under the DOC’s proposed private adviser exemption, advisers would be eligible provided they: (i) have not violated securities laws; (ii) file periodic reports with the DOC; (iii) pay the existing investment adviser registration and renewal fees; and (iv) comply with additional safeguards when advising 3(c)(1) funds. Additionally, under the proposed regulations, the exemption defines a private fund adviser as an investment adviser that provides advice only to qualifying private funds, which include 3(c)(1) and 3(c)(7) funds. A grandfathering provision for private advisers is also included.
The Massachusetts Securities Division released amendments similar to the DOC’s on January 18, 2012. These amendments contain regulations that relate to the private fund exemption and custody requirements, among others. The amendments, released after consideration of industry comments, make substantive changes to the definition of “institutional buyer,” re-propose a broadened private fund exemption that includes the introduction of a grandfathering provision, and propose requirements for advisers with discretion over, or custody of, client funds.
The purpose of the Massachusetts amendments is to coordinate with the new rule adopted by the Securities and Exchange Commission under the Dodd-Frank Act. Also included in the amendments is an exemption from state registration for advisers that provide advice solely to private funds that qualify as 3(c)(1) or 3(c)(7) funds.
The Commodity Futures Trading Commission (CFTC) released a Final Rule on January 11, 2012, on the Registration of Swaps Dealers (SDs) and Major Swap Participants (MSPs). The Final Rule establishes the process for the registration of SDs and MSPs and now requires SDs and MSPs to become and remain members of a registered futures association. Included in the CFTC rulemaking is a definition of an “associated person” of an SD or MSP and an implementation of a prohibition on an SD or MSP permitting an associated person who is statutorily disqualified from registration from effecting or being involved in effecting swaps of behalf of the SD or MSP.
In a companion Notice and Order by the CFTC on the same day, the National Futures Association (NFA) was authorized to perform registration functions under the new rulemaking. Specifically, the NFA is authorized to perform the following registration functions:
The Final Rule and the Notice and Order released on January 11, 2012, are just a portion of a comprehensive new regulatory framework for swaps and security-based swaps under the Dodd-Frank Act. The goal of the legislation is to reduce risk, increase transparency, and promote market integrity within the financial system.
The Dodd-Frank Act further directs the CFTC, under Section 4s of the Commodity Exchange Act, to provide for the regulation of SDs and MSPs with respect to, among others, the following areas: capital and margin, reporting and recordkeeping, daily trading records, business conduct standards, documentation standards, duties, designation of chief compliance officer, and, with respect to uncleared swaps, segregation.
Pillsbury will continue to monitor the CFTC’s rulemaking and will provide further information as it becomes available.
On January 4, 2012, the Securities and Exchange Commission (SEC) released a National Examination Risk Alert addressing investment adviser use of social media. Investment advisers should have policies regarding the use of social media, and the SEC outlined specific factors that need to be addressed by these policies. The SEC’s guidance could be particularly important given the “crowdfunding” legislation Congress is currently considering.
The January 4, 2012 National Examination Risk Alert (January Alert) states that investment advisers’ use of social media must comply with various provisions of the federal securities laws, including the antifraud provisions, the compliance provisions, and the recordkeeping provisions. The January Alert stresses that particular attention with regard to the use of social media must be paid to third party content (if permitted) and the recordkeeping responsibilities.
The January Alert provides staff observations of factors that an investment adviser may want to consider when evaluating a compliance policy for the use of social media. These include, but are not limited to:
Additionally, investment advisers that allow for third-party posting on their social media sites should consider having policies and procedures in place to address this. Reasonable safeguards should be in place to avoid any violation of the federal securities laws. Potential violations could result from the appearance of testimonials on a firm’s social media. For example, the SEC staff believes that the use of social plug-ins such as the “like” button could be considered a testimonial under the Investment Advisers Act of 1940.
Finally, the January Alert notes that investment advisers should consider reviewing their document retention policies so that the retaining of any required records generated by social media use complies with the federal securities laws. This review could include addressing factors such as: determining what types of social media use create a required record; maintaining applicable communications in electronic or paper format; creating training programs to educate advisory personnel about recordkeeping; and, using third parties in order to keep proper records.
The Financial Industry Regulatory Authority (FINRA) has echoed the January Alert in recent releases, such as Regulatory Notice 11-39 from August 2011. This Notice provided guidance on social media websites for broker-dealers, and addressed recordkeeping and third-party sites, among other topics. This Notice supplemented an earlier FINRA notice from January 2010 that provided guidance with regard to blogs and social networking websites.
The SEC has also recently increased its focus on internet-related enforcement actions. On January 4, 2012, the SEC charged an Illinois-based adviser with perpetrating a social media scam. The alleged scam involved offering fictitious securities that were promoted by using LinkedIn. This follows multiple enforcement actions from February 2011 for internet-related schemes, including boiler rooms and spam-email touted pump and dumps.
Crowdfunding is a method of capital formation where groups of people pool money, typically by use of very small individual contributions, in order to support the organizers that seek to accomplish a specific goal.
Congress has also been active in the realm of internet-related securities issues with its involvement in crowdfunding. The House of Representative passed the Entrepreneur Access to Capital Act (H.R. 2930) on November 3, 2011. H.R. 2930 provides for registration exemptions for certain crowdfunded securities if the aggregate amount raised through the issuance is $1 million or less each year and each individual who invests in the securities does not invest, in any year, more than the lesser of $10,000 or 10 percent of the investor’s annual income. Businesses could raise up to $2 million each year under the exemption if investors were provided with certain financial information.
The Senate currently is considering its own version of a crowdfunding bill, the Democratizing Access to Capital Act of 2011 (S. 1791). S. 1791 provides for registration exemptions for certain crowdfunded securities if the aggregate amount raised through the issuance is $1 million or less each year and each individual who invests in the security does not invest more than $1,000. The Senate Committee on Banking, Housing and Urban Affairs held hearings on December 1 and 14, 2011, regarding this legislation, but a vote on the bill has not yet occurred.
Reaction to the crowdfunding legislation has been mixed. Supporters, such as Tim Johnson, the Chairman of the Senate Committee on Banking, Housing and Urban Affairs, feel that the legislation will provide easier access to capital for smaller businesses and startups, which will grow business and create new jobs. Detractors, such as Professor John C. Coffee, Jr., in his testimony before the Committee, argue that S. 1791 could well be titled “The Boiler Room Legalization Act of 2011.”
The crowdfunding legislation and its developments promise to bring more scrutiny to the interplay of the federal securities laws and the internet. Investment advisers, and other financial firms, should examine and ensure related policies and procedures are up to par.
Written by Peter J. Chess
Many fund managers are required to submit reports every month and/or every five years to the Federal Reserve Bank of New York (“FRBNY”). The Department of the Treasury’s Treasury International Capital (“TIC”) data reporting system has two such upcoming reporting deadlines.
TIC Form SLT
The Aggregate Holdings of Long-Term Securities by U.S. and Foreign Residents (“TIC Form SLT”) is required to be submitted by entities with consolidated reportable holdings and issuances (positions) with a fair market value of at least $1 billion as of the last day of any month. These entities may include funds and their investment advisers, and U.S. companies. The purpose of the TIC Form SLT is to gather information from U.S. resident entities on foreign persons’ holdings of long-term U.S. securities and on U.S. persons’ holdings of long-term foreign securities.
If required to do so, fund managers and other entities must submit the report to the FRBNY by the 23rd day of each month with regard to the data of the previous month. The upcoming TIC Form SLT will contain consolidated data as of December 31, 2011 and must be submitted by January 23, 2012.
TIC Form SHC
The Report of U.S. Ownership of Foreign Securities, Including Selected Money Market Instruments (“TIC Form SHC”) is a mandatory survey of the ownership of foreign securities, including selected money market instruments, by U.S. residents as of December 31, 2011. The TIC Form SHC is a benchmark survey of all significant U.S. resident custodians and end-investors held every five years. Custodians are all organizations that hold securities in safekeeping for other organizations. End-investors are organizations that invest in foreign securities for their own portfolios or invest on behalf of others, such as investment managers/fund sponsors.
The TIC Form SHC is divided into three schedules: Schedule 1, Schedule 2, and Schedule 3. Schedule 1 must be filed by all entities that are notified by the FRBNY that they are required to file the TIC Form SHC, and by all U.S. resident custodians or end-investors that exceed the reporting thresholds of Schedules 2 and 3. Schedules 2 and 3 must be filed by entities that exceed the reporting threshold of $100 million for the respective specified safekeeping arrangements of foreign securities.
The data for the TIC Form SHC is as of December 31, 2011, and must be submitted by fund managers and other entities required to do so to the FRBNY no later than March 2, 2012.
The California Commissioner of Corporations (Commissioner) has released a notice regarding readoption of the emergency regulation on private adviser exemption.
On January 5, 2012, the Commissioner will file with the Office of Administrative Law (OAL) the readoption of emergency regulations to extend the effectiveness of Rule 260.204.9 (10 C.C.R. §260.204.9) for a period of no longer than 90 days. The changes to the rule will extend the current exemption from registration for investment advisers who are deemed private advisers for an additional 90 days. The anticipated operative date of the emergency regulation is January 18, 2012.
Pillsbury will continue to monitor this development and post additional information as soon as it becomes available.
Written by Ildiko Duckor
An entity that meets the definition of a “Large Trader” after October 3, 2011 must file its initial Form 13H with the SEC by December 1, 2011 to be assigned a large trader identification number (LTID). The filing is done electronically through the SEC’s EDGAR system. The LTID must be disclosed to registered broker-dealers effecting transactions on behalf of the Large Trader.
If you as a general partner or investment adviser (including any entities or individuals over which you have control, e.g., the right to vote or direct the vote of 25% or more of a class of voting securities of an entity) have investment discretion over aggregate transactions in exchange-listed securities that equal or exceed the Identifying Activity Level of: (i) 2 million shares or $20 million during any calendar day or (ii) 20 million shares or $200 million during any calendar month, you may qualify as a Large Trader and may have to file a Form 13H.
When calculating the “Identifying Activity Level:” (i) aggregate all transactions during the specified period (one day and/or one month) (ii) for all “NMS securities” (national market securities, generally (exchange-listed securities including equities and purchases and sales (but not exercises) of options) and (iii) exclude the specified transactions that are exempt from consideration (as listed in the below-linked documents).
Form 13H filing is required to be filed annually with the SEC within 45 days after the end of a Large Trader’s full calendar year.
A full text of the SEC Final Rule and Form 13H is available here.
Please contact the IFIM team for assistance.
Written by Jay Gould
On November 28, 2011, the SEC charged OMNI Investment Advisors, Inc. of Utah, Feltl & Company Inc. of Minneapolis and Asset Advisors LLC of Troy, Michigan for failing to adopt and implement compliance procedures designed to prevent securities law violations.
The three enforcement actions discussed below should send a clear signal to investment advisers that are already registered and have implemented written compliance policies and procedures, as well as those advisers that will need to register by February 15, 2012, that the SEC is serious about adviser compliance and is willing to make examples of those advisers that do not fully implement a tailored compliance program.
All three investment advisers, including OMNI’s owner and chief compliance officer Gary R. Beynon, were found to be in violation of the “Compliance Rule” under Rule 206(4)-7 of the Investment Advisers Act and were separately ordered to pay penalty fees and institute a series of corrective measures to settle the SEC charges.
OMNI and Beynon failed to adopt and implement written compliance policies and procedures, failed to establish, maintain and enforce a written code of ethics and failed to maintain and preserve certain books and records. Under the settlement, Beynon agreed to pay a $50,000 penalty. He also agreed to be permanently barred from acting within the securities industry in any compliance or supervisory capacity and from associating with any investment company. In addition, as part of the settlement, OMNI agreed to provide a copy of the proceeding to all of its former clients between September 2008 and August 2011.
Feltl & Company failed to adopt and implement written compliance policies and procedures for its growing advisory business. It further neglected to adopt a code of ethics and collect the required securities disclosure reports from its staff. Under the settlement, Feltl & Company agreed to pay a penalty of $50,000 and return more than $142,000 to certain advisory clients. In addition, the firm will hire an independent consultant to review its compliance operations annually for two years, provide a copy of the SEC’s order to past, present and future clients, and prominently post a summary of the order on its website.
Asset Advisors failed to adopt and implement a compliance program. Asset Advisors adopted policies and procedures after SEC examiners brought it to the firm’s attention, but never fully implemented them. Similarly, Asset Advisors only adopted a code of ethics at the behest of the SEC exam staff and then failed to adequately abide by the code. Under the settlement, Asset Advisors agreed to pay a $20,000 penalty, cease operations, de-register with the Commission, and with clients’ consent, move advisory accounts to a new firm with an established compliance program.
A full text of the SEC release and orders is available here.
Written by Jay Gould
On Wednesday, November 16, 2011, the SEC charged Morgan Stanley Investment Management (“MSIM”) with violating securities laws in a fee arrangement that costs a fund and its investors approximately $1.8 million in sub-adviser fees.
MSIM is the primary adviser to The Malaysia Fund (the “Fund”), a closed-end investment company that invests in equity securities of Malaysian companies. AMMB Consultant Sendirian Berhad (“AMMB”) was an SEC registered adviser located in Malaysia. AMMB is a wholly owned subsidiary of AM Bank Group, one of the largest banking groups in Malaysia. Pursuant to a Research and Advisory Agreement entered into by the Fund with AMMB and MSIM in 1987, AMMB undertook to provide advice, research and assistance to MSIM for the benefit of the Fund. Every year AMMB submitted a report to MSIM which MSIM provided to the Fund’s board of directors in its evaluation for the renewal of the advisory and sub-advisory agreements. The board evaluated and approved AMMB’s sub-adviser agreement based on representations from MSIM that AMMB was providing advisory services to the Fund. AMMB did not actually provide those advisory services. MSIM also prepared and filed the Fund’s annual and semi-annual reports to investors that inaccurately represented AMMB’s services.
The SEC found that “MSIM failed its duty to provide the fund’s board members with the information they needed to fulfill their significant responsibility of reviewing and approving the sub-adviser’s contract.” In addition, MSIM did not adopt and implement policies and procedures governing the advisory contract renewal process and its oversight of AMMB.
According to the SEC’s order, MSIM willfully violated Section 15(c) and 34(b) of the Investment Company Act and Section 206(2) and (4) of the Investment Advisers Act of 1940, and Rule 206(4)-7 thereunder.
The SEC ordered MSIM to pay the Fund $1.845 million as reimbursement of the advisory fees the Fund paid to AMMB from 1987 to 2008. MSIM was also ordered to pay $1.5 million penalty fee. MSIM agreed to pay over $3.3 million to settle the SEC’s charges.
A full text of the SEC release and order are available here.
Written by Jay Gould
On October 18, 2011, the SEC released a notice of FINRA’s filing of Proposed Rule 5123 (the “Proposed Rule”) which would require FINRA members and associated persons to: 1) provide to investors disclosure documents in connection with private placements prior to sale and 2) file with FINRA such disclosure documents within 15 days after the date of first sale and any subsequent amendments. These proposed changes would significantly affect fund managers who offer or sell their funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act through third party marketers, nearly all of which are required to be registered as broker-dealers.
Pre-sale requirement to provide disclosure documents to investors
The Proposed Rule would require FINRA members and associated persons that offer or sell private placements or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, to provide such disclosure documents to investors prior to sale. The disclosure documents must describe the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of offering compensation. Much of this information is currently captured in the Form D filing that most fund managers file with the SEC, but under the Proposed Rule, would go directly to investors in connection with the sale of fund interests.
As a practical matter, this likely means increased scrutiny of hedge fund and other private fund offerings by FINRA, as well as the likelihood that third party marketers that sell on behalf of hedge funds may request greater or more enhanced indemnification from fund managers in the placement agency agreement between the third party marketer and the fund manager. Accordingly, fund managers who use third party marketers to market their funds must keep their fund documents updated, taking into account all changes to fund strategies, material performance issues (to the extent applicable), regulatory changes and management personnel changes, to name a few.
Post-sale requirement to notice file with FINRA
The Proposed Rule would also require each FINRA member and associated person to notice file with FINRA by filing the PPM, term sheet or other disclosure documents no later than 15 days after the date of first sale. In addition, any amendments to such disclosure documents or disclosures required by the Proposed Rule would have to be filed no later than 15 days after such documents are provided to any investor or prospective investor. To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act to which all fund managers are already subject. Accordingly, fund managers must be careful to keep all of their documents current under the materiality standards of state and Federal securities laws.
Offerings Exempted from the Proposed Rule
The Proposed Rule would exempt several types of private placements including offerings sold only to any one or more of the following purchasers:
In addition, the Rule would exempt the following types of offerings:
Documents and information filed with FINRA pursuant to the Proposed Rule would be given confidential treatment. FINRA would use such documents and information solely for the purpose of determining compliance with FINRA rules or other applicable regulatory purposes. In addition, FINRA would afford confidential treatment to any comment or similar letters by FINRA and thus could not be discoverable by a litigant through a legal action.
A full text of the SEC Notice and Proposed Rule is available here.
Written by Michael Wu
By order released by the SEC on November 10, 2011, Western Pacific Capital Management LLC, a San Diego-based investment adviser, and its President, Kevin James O’Rourke, were charged with fraud for failing to disclose a conflict of interest to clients and materially misrepresenting the liquidity of The Lighthouse Fund LP, a hedge fund they formed and managed.
Western Capital and O’Rourke urged clients to invest in a security without disclosing that Western Pacific would receive a 10 percent commission. They also failed to register as a broker, failed to provide required written disclosures to clients, improperly redeemed one hedge fund investor’s interest ahead of another’s, and made material misstatements and omissions to clients regarding the fund’s liquidity. As a result of these conducts, the SEC alleged that Western Capital and O’Rourke willfully violated Section 17(a) of the Securities Act of 1933, Sections 10(b) and 15(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, and Sections 206(1), 206(2), 206(3), and 206(4) of the Investment Advisers Act of 1940 and Rule 206(4)-8 thereunder.
A full text of the SEC release and order are available here.
Written by Jay Gould
The Pillsbury Investment Funds Team has over the past month reviewed several new Due Diligence Questionnaire (“DDQ”) forms on behalf of fund manager clients from institutional investors and family offices that contain a new inquiry that is potentially problematic for certain fund managers. Generally, this new inquiry requests information regarding any dispute over fees that the manager has had over a specific time period with certain service providers for the fund and the general partner of the fund. In its typical form, the question asks:
During the past three years, have you [the fund manager] or a controlled affiliate, had any amounts in dispute with or refused payment to any third party marketer or sales agent, any public relations firm or individual conducting a similar function, or any law firm or legal representative?
The DDQ goes on to request additional information about each disputed payment and requests permission from the fund manager for the potential investor to contact the service provider named with respect to the disputed fees. The Pillsbury Investment Funds Team found this question interesting and potentially troublesome and contacted one of the institutional investors with respect to this inquiry. We were informed that this particular investor was concerned that fund managers that do not honor their obligations to service providers are often the same ones that take a broad view regarding the services can be “soft dollared,” manager expenses that are chargeable to the fund, and creative calculations of management and performance fees. We were informed that these particular service providers to fund managers are often not in a position to pursue fees in dispute due to the potential public relations disaster such an action would cause to the allegedly aggrieved party. Or put another way, if a third party marketer brought an action against a fund manager for fees due on assets raised on behalf of a fund, what fund manager would ever retain that marketer again? Institutional investors are also concerned about the continuity of service providers and any pattern related to why high or constant service provider turnover. It is worth noting that auditors are not generally included in this type of question because changing auditors and the reason for it is covered in a separate inquiry. It is our understanding that this addition to the DDQ is gaining popularity among institutional investors and family offices and that follow up on the information provided in response to the inquiry is being conducted.
This development raises several potential issues for fund managers that are asked to respond to this inquiry. First, all responses to DDQs and other “marketing” materials are subject to the fiduciary standard set forth in Investment Advisers Act Rule 206(4)-8 which was adopted in 2007 in response to the Goldstein decision. Rule 206(4)-8 applies to every investment adviser, whether or not registered, and imposes a strict liability fiduciary standard on information that is provided to investors and potential investors. Accordingly, to the extent a fund manager refuses to answer the DDQ or does not answer the question fully and truthfully, such manager faces a potential violation of Section 206 of the Investment Advisers Act, which is a very serious offense. Additionally, to the extent a potential investor seeks to obtain information regarding legal fees in dispute, fund managers should be aware that they are being asked to waive the attorney client privilege with respect to this aspect of the relationship with their attorneys. Fund managers should seek to condition disclosure of this information on confidentiality, however, it is likely that such information could still be obtained from the investor by way of a subpoena from the Securities and Exchange Commission, a state regulator, or even a third party litigant.
An investment adviser must ensure that its IARD account is adequately funded to cover payment of all applicable registration renewal fees and notice filing fees. Beginning November 14, 2011, Preliminary Renewal Statements (“PRS”), which list an adviser’s renewal fee amount, are available for printing through the IARD system. By December 9, 2011 (Friday), an investment adviser should have submitted to FINRA through the IARD system, its preliminary renewal fee. Any additional fees that were not included in the PRS will show in the Final Renewal Statements which are available for printing beginning January 3, 2012. All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2012. Please note that all renewal fees must be submitted for deposit to an adviser’s IARD “Renewal” Account.
For more information about the 2012 IARD Account Renewal Program including information on IARD’s Renewal Payment Options and Addresses, please follow this link: http://www.iard.com/renewals.asp
Please contact us if you have questions.
Written by Jay Gould
On October 26, 2011, the SEC adopted a new rule requiring SEC-registered advisers to hedge funds and other private funds with at least $150 million in private fund assets under management to report information to the Financial Stability Oversight Council (“FSOC”) to enable it to monitor risk to the U.S. financial system. The information which must be reported to the FSOC on Form PF will remain confidential, and not accessible to the general public.
These private fund advisers are divided into (1) large private fund advisers and (2) smaller private fund advisers. Large private fund advisers are advisers with at least $1.5 billion in hedge fund, $1 billion in liquidity fund, and $2 billion in private equity fund assets under management. All other advisers are regarded as smaller private fund advisers. The SEC anticipates that most advisers will be smaller private fund advisers, but that the large private fund advisers represent a significant portion of private fund assets.
Smaller private fund advisers must file Form PF once a year within 120 days of the end of the fiscal year, and report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding size, leverage, investor types and concentration, liquidity, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.
Large private fund advisers must provide more detailed information than smaller advisers. The focus and frequency of the reporting depends on the type of private fund the adviser manages.
Two-stage phase-in compliance with Form PF filing requirements:
Form PF Filing Fees: $150 for initial, quarter or annual filing.
A full text of the SEC release is available here.
On October 9, 2011 Governor Brown signed into law Senate Bill 398 which is intended to clarify the current law regarding placement agents and lobbyist requirements.
In 2009, AB 1584 was enacted. AB 1584 imposed disclosure requirements for investment placement agents associated with public pension funds in California. It required public employee pension funds to adopt a disclosure policy requiring the disclosure of fees paid to investment placement agents and contributions and gifts made by placement agents to board and staff members.
In 2010, AB 1743 was passed. That bill subjected investment managers and placement agents to lobbyist registration. It also defined “placement agents” and revised the definition of “lobbyist” to include a placement agent. A placement agent includes employees of an external manager unless the employee spends more than 1/3 of his time managing assets for the external manager. AB 1743 also exempts from lobbyist registration requirements those advisers and broker-dealers who are registered with the SEC, obtained the business through competitive bidding process, and agreed to the California fiduciary standard imposed on public employee pension fund trustees.
The newly enacted and immediately effective SB 398 changes the current law to this extent:
1. It revises the definition of “external manager” to mean a person or an investment vehicle managing a portfolio of securities or other assets, or a person managing an investment fund offering an ownership interest in the investment fund to a board or an investment vehicle.
2. It revises the definition of “placement agent” to include an investment fund managed by an external manager offering investment management services of the external manager and an ownership interest in an investment fund managed by the external manager.
3. It defines “investment fund” and includes private equity fund, public equity fund, venture capital fund, hedge fund, fixed income fund, real estate fund, infrastructure fund, or similar pooled investment entity. It excludes an investment company that is registered with the SEC pursuant to the Investment Company Act of 1940 and that makes a public offering of its securities.
4. It defines “investment vehicle” to mean a “corporation, partnership, limited partnership, limited liability company, association, or other entity, either domestic or foreign, managed by an external manager in which a board is the majority investor and that is organized in order to invest with, or retain the investment management services of, other external managers.”
5. The exemptions from lobbyist registration for managers of local retirement system funds are extended to include the three exemptions similarly available to managers of state retirement system funds.
Written by Michael Wu
The SEC is recommending filing fees related to the new report filing on Form ADV for exempt reporting advisers and Form PF filing for private fund advisers. The filing fee for exempt reporting advisers is expected to be $150 for each initial and annual report on Form ADV. The filing fee for private fund advisers’ Form PF filing is expected to be $150 for each quarterly and annual filing. Both Form ADV report and Form PF filings will be submitted through FINRA’s Investment Adviser Registration Depository system (IARD).
A full text of the SEC notice is available here.
Written by Jay Gould
Pillsbury’s Investment Funds & Investment Management team has submitted a comment letter to the California Department of Corporations (the “DOC”) on behalf of the California Hedge Fund Association in connection with the DOC’s recently proposed amendments to the California custody rule.
In its letter to the Commissioner, Pillsbury requested that the DOC amend the California custody rule in a manner that balances investor protection and the need for fund managers to maintain confidentiality of certain portfolio positions. Specifically, the letter requested that the quarterly reports California-registered advisers to private funds are required to send to their investors be required to disclose only those positions that comprise more than 5% of the fund’s assets, and that the names of short positions not be disclosed at all, but be provided as an aggregate number. “Implementing our suggestions would be consistent with the quarterly disclosure of schedule of investments based on the FASB’s U.S. financial reporting standards, and would also protect fund investors from short squeezes,” explained Jay Gould, head of the Pillsbury Investment Funds & Investment Management team.
The letter was provided in response to the DOC Commissioner’s invitation for comment on the proposed changes to the California custody rule that will apply to California-registered investment advisers, including those investment managers that are currently either registered with the Securities and Exchange Commission or are not registered at all. By February 15, 2012, investment advisers to private funds with less than $100 million under management will need to register with the DOC, if they have not already done so.
“The California Hedge Fund Association expects to provide comments to the DOC in connection with future rulemaking proposals and encourages California-based fund managers to become active in this process,” explains Chris Ainsworth, President of the Association.
A full text of the letter to the Commissioner is available here.
Written by Bruce Frumerman, guest contributor
Bruce Frumerman is the CEO of Frumerman & Nemeth Inc., a communications and sales marketing consultancy that assists financial services firms create brand identities for their organizations and develop and implement effective new marketing strategies and programs.
In the article below, Mr. Frumerman offers effective marketing strategies for hedge fund managers to stay competitive and successful in the business. This article first appeared in Reuters HedgeWorld on July 18 and is re-printed with permission below.
Rising competition among money managers is one of the key topics covered in Boston Consulting Group’s recently released ninth annual study of the worldwide asset management industry, Building on Success: Global Asset Management 2011...
A full text of the article is available here.
Effective on September 19, 2011, investors that pay performance fees to an adviser must either have at least $1 million managed by the adviser or a net worth of at least $2 million.
As mandated by the Dodd-Frank Act, the SEC today issued an order that raises two of the thresholds that determine whether an investment adviser can charge its clients performance fees. As discussed in the article we posted here on May 11, under the current Rule 205-3 of the Investment Advisers Act of 1940, an investment adviser may charge its investors a performance fee if (i) the investor has at least $750,000 under management with the investment adviser (“asset-under-management test”), or (ii) the investment adviser reasonably believes that the investor has a net worth of more than $1.5 million (“net worth test”). Today’s SEC order adjusted the amounts for the asset-under-management test to $1 million and the net worth test to $2 million. The SEC order is effective on September 19, 2011.
Accordingly, it is important for investment fund managers to amend their offering materials to comply with the new requirements of Rule 205-3 under the Advisers Act.
On June 22, 2011, the Securities and Exchange Commission (SEC) adopted final rules that implement provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amending the Investment Advisers Act of 1940 (the “Advisers Act”). The amendments include:
The SEC also adopted final rules that eliminated the private adviser exemption under the Advisers Act and created three new exemptions from SEC registration for:
On March 2, 2011, Pillsbury’s Investment Fund and Investment Management group (“Pillsbury IFIM Group”) submitted a comment letter to the North American Securities Administrator’s Association (the “NASAA”) on behalf of the California Hedge Fund Association and the Florida Alternative Investment Association. The letter to the NASAA was intended to provide comments regarding the proposed model custody rule of the NASAA that was released on February 17, 2011. A copy of the March 2, 2011 comment letter was posted here on March 8, 2011.
On May 23, 2011, Pillsbury IFIM Group submitted a second comment letter on behalf of the California and Florida fund groups to the NASAA commenting on the re-proposal of the model custody rule on April 18, 2011 (the “Re-Proposed Rule”). The Re-Proposed Rule reflected certain suggestions made in the first letter to the NASAA, but would require that all portfolio positions be provided to all fund investors at the end of each quarter. The letter requested that the NASAA limit quarter end disclosure to positions that comprise 5% or more of a fund’s portfolio and exclude all disclosure with respect to short positions. Pillsbury believes that it is critical for fund managers and hedge fund industry groups to comment on the NASAA rule proposals, as it is likely that many states will simply adopt the NASAA rules without providing a robust public comment process as a result of the many new registrants for which the states will be responsible when the investment adviser registration provisions of Dodd Frank Act are fully implemented.
A full text of the second letter can be found here.
Written by Michael Wu
The Securities and Exchange Commission (“SEC”) has adopted rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (“Dodd-Frank Act”) Whistleblower Program. The Whistleblower Program requires the SEC to pay awards, under regulations prescribed by the SEC and subject to certain limitations, to eligible whistleblowers who voluntarily provide the SEC with original information about a violation of the federal securities laws, or a rule or regulation promulgated by the SEC, that leads to the successful enforcement of a covered judicial or administrative action, or a related action that results in monetary sanctions of more than $1,000,000. Dodd-Frank Act also prohibits retaliation by employers against individuals who provide the SEC with information about possible securities violations.
To view a full text of the Final Rule, please click here.
Written by Michael Wu
California’s Department of Corporations (the “Department”) intends to issue emergency regulations to address the elimination of the “private adviser exemption” under Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Currently, an investment adviser in California may rely on the private adviser exemption by virtue of California Department of Corporations Rule 260.204.9, which specifically refers to the private adviser exemption under Section 203(b)(3) of the Advisers Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act will eliminate the private adviser exemption under Section 203(b)(3) effective as of July 21, 2011, which in turn would affect a California investment adviser's ability to rely on Rule 260.204.9. The Department will issue emergency regulations amending Rule 260.204.9 to preserve the status quo. Therefore, California investment advisers that currently rely on the exemption from registration for private advisers will be able to continue to rely on that exemption until the Department adopts a final rule regarding private fund advisers. For more information about this new development please click here.
Written by Michael Wu
The Securities and Exchange Commission (the “SEC”) recently published a notice of its intent to raise the dollar thresholds that would need to be satisfied in order for an investment adviser to charge its investors a performance fee. Currently, under Rule 205-3 of the Investment Advisers Act of 1940, as amended, an investment adviser may charge its investors a performance fee if (i) the investor has at least $750,000 under management with the investment adviser, or (ii) the investment adviser reasonably believes that the investor has a net worth of more than $1.5 million. To comply with the Dodd-Frank Act, the SEC must adjust these dollar amounts for inflation by July 21, 2011 and every five years thereafter.
Thus, the SEC intends to issue an order that would revise the dollar amount tests to $1 million for assets under management and $2 million for net worth. The SEC is also proposing to amend Rule 205-3 to: (i) provide the method for calculating future inflation adjustments of the dollar amount tests, (ii) exclude the value of a person’s primary residence from the net worth test, and (iii) modify the transition provisions of the rule. The SEC is seeking public comment on the proposed rule.
Written by Michael Wu
In early March, Pillsbury submitted a comment letter to the North American Securities Administrators Association (NASAA) on behalf of the private fund industry regarding NASAA’s proposed model custody rule. Please see here for more information. NASAA has recently confirmed that it has changed a key component of the proposed model custody rule, which required quarterly disclosure of transaction-level data, and will re-open the proposal for a second round of comments. NASAA’s original proposal would have required a private fund adviser to provide detailed quarterly statements of fund trading activity to each investor in its fund(s). Jay Gould, a partner with Pillsbury Winthrop Shaw Pittman LLP and the author of a comment letter to NASAA on behalf of the California Hedge Fund Association and the Florida Alternative Investment Association, stated that “the level of detail [required by the proposal] in many cases would be so overwhelming that it would be useless for any investors but detrimental to the managers executing their strategy.” In response to this comment letter and other comment letters, NASAA’s board of directors instructed its investment adviser section group to re-examine the provision. NASAA has indicated that the new proposal will likely require only aggregate fund data, rather than transaction-level data, to be disclosed quarterly to investors. We will continue to monitor NASAA’s proposed rule and post any new developments.
Written by Michael Wu
On April 8, 2011, the Associate Director of the SEC stated in a letter to the President of the North American Securities Administrators Association (NASAA) that the SEC may extend certain deadlines imposed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). Specifically, because the SEC has yet to complete its implementing rulemaking in accordance with the Dodd-Frank Act, the SEC would “consider” extending, to the first quarter of 2012, the date by which (i) advisers must register with the SEC and comply with the rules applicable to SEC-registered advisers and (ii) midsize advisers (i.e., advisers with over $25 million, but under $100 million, assets under management) must transition to state registration. Please click here to view the letter from the SEC regarding this issue.
On March 18, 2011, the Securities and Exchange Commission released new guidance regarding Form ADV. The SEC’s Q&As can be found here. The most significant development pertains to a registered adviser’s obligation to deliver Part 2. Specifically, Question III.2 reads as follows:
Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?
A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)
Although the SEC’s response focuses on “hedge funds,” because the term “client” is defined the same way for all “private funds,” we can reasonably conclude that advisers to private equity funds and other private funds can satisfy the delivery obligations by delivering the new Part 2 to the general partners of the private equity funds or private funds that they manage - as opposed to the investors in such funds. This is a significant change because previously most registered advisers provided Part 2 to all of the investors in the funds that they managed.
Please note that registered advisers are still required to file Part 2 of Form ADV with the SEC.
Pillsbury’s Investment Fund and Investment Management group recently submitted a comment letter to the North American Securities Administrator’s Association (the “NASAA”) on behalf of the private investment fund industry. Specifically, the letter to the NASAA was intended to provide comments regarding the proposed model custody rule of the NASAA that was released on February 17, 2011.
Pillsbury’s letter to the NASAA was written in response to the NASAA’s request for comment regarding its proposed revision to the model rules on NASAA Custody Requirements for Investment Advisers (the “Proposed Rule”). The letter requested that NASAA reconsider requiring state-registered investment advisers to hedge funds and other private investment funds to provide detailed quarterly statements of all fund trading activity to all investors in their funds. In Pillsbury’s view, this requirement falls seriously short of both protecting and advancing the interests of investors in such funds.
As written, the Proposed Rule would require state-registered investment advisers to unregistered pooled investment vehicles (i.e., private investment funds) to provide all fund investors with a list of all trading activity by the fund during the previous quarter. Pillsbury contended that disclosing such information amounts to a requirement that investment advisers disclose their trade secrets. A fund adviser’s trade secret is how it turns an easily described strategy into competitively differentiated results, and these trade secrets are expressed in the record of an adviser’s actual trade activity and positions over time. Pillsbury strongly urged the Director to consider revising the Proposed Rule so that it is analogous to the Securities and Exchange Act’s custody rule (i.e., Rule 206(4)-2 of the Advisers Act).
Pillsbury will continue to monitor this and other regulatory developments that affect investment advisers and their investment funds and stands ready to take appropriate action to ensure that the laws and regulations purporting to protect investors are not unduly burdensome for investment advisers and the investment fund industry.
To see a full text of the letter, please continue reading…
The Commodity Futures Trading Commission (the “CFTC”) recently issued a proposed rule regarding commodity pool operators (“CPOs”) that would rescind the exemptions from CPO registration under CFTC Rules 4.13(a)(3) and 4.13(a)(4). These exemptions are widely used by hedge fund and other private fund managers advising funds that trade futures and other listed commodity positions, such as commodity options or swaps. If adopted, managers, sponsors and operators of such funds would need to register as CPOs with the CFTC and become members of the National Futures Association (the “NFA”). The proposed rule does not have a transition period or any grandfathering provisions.
Full registration as a CPO is a time consuming process and typically takes six to eight weeks. Unlike hedge fund and other private fund managers currently taking advantage of the exemptions under CFTC Rules 4.13(a)(3) and 4.13(a)(4), registered CPOs are subject to full regulation by the CFTC and NFA. As a result, registered CPOs must comply with rules that require them to provide disclosure documents to investors (which are subject to review by the NFA) and fulfill recordkeeping and reporting requirements, including the delivery of audited annual financial statements. Although registered CPOs may continue to rely on CFTC Rule 4.7 for relief from certain disclosure, recordkeeping and reporting requirements, the proposed rule would require CPOs relying on CFTC Rule 4.7 to deliver audited annual financial statements to investors.
The proposed rule would also require hedge fund and other private fund managers that are currently exempt from registration as commodity trading advisors (“CTAs”) because they only advise funds that are exempt under CFTC Rules 4.13(a)(3) and 4.13(a)(4), to register as CTAs with the CFTC and become members of the NFA. Once registered as a CTA, a hedge fund and other private fund manager would be subject to all of the CFTC and NFA’s requirements applicable to CTAs.
The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011. If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.
The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf
We will update you with more information as it becomes available.
Written by Michael Wu
On January 26, 2011, the SEC proposed a rule that would require SEC-registered advisers to hedge funds, private equity funds and other private funds to report information to the Financial Stability Oversight Council (“FSOC”) that would enable it to monitor risk to the U.S. financial system. The information would be reported to the FSOC on Form PF and the information reported on Form PF would be confidential.
The proposed rule would subject large advisers to hedge funds, “liquidity funds” (i.e., unregistered money market funds) and private equity funds to heightened reporting requirements. Under the proposed rule, a large adviser is an adviser with $1 billion or more in hedge fund, liquidity fund or private equity fund assets under management. All other advisers would be regarded as smaller advisers. The SEC anticipates that most advisers will be smaller advisers, but that the large advisers represent a significant portion of private fund assets.
Smaller advisers would be required to file Form PF once a year and would report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding leverage, credit providers, investor concentration, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.
Large advisers would be required to file Form PF quarterly and would provide more detailed information than smaller advisers. The information reported would depend on the type of private fund that the large adviser manages.
The SEC’s public comment period on the proposed rule will last 60 days.
Written by Michael Wu
On January 21, 2011, the SEC released its study on the effectiveness of the standard of care required of broker-dealers and investment advisers that provide personalized investment advice regarding securities to retail customers (“Covered Broker-Dealers and Investment Advisers”). The study also considered the existence of regulatory gaps, shortcomings or overlaps that should be addressed by rulemaking. The study was prepared pursuant to Section 913 of the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010.
The study recommends that the SEC establish a uniform fiduciary standard for Covered Broker-Dealers and Investment Advisers that is at least as stringent as the fiduciary standard under Sections 206(1) and (2) of the Investment Advisers Act of 1940, as amended. The SEC staff stated that under this standard, Covered Broker-Dealers and Investment Advisers must “act in the best interest of the customer without regard to the financial or other interest of the broker, dealer, or investment adviser providing the advice.”
To implement the uniform fiduciary standard, the study recommends that the SEC adopt rules to address the following:
The study further recommends that the SEC harmonize other areas of broker-dealer and investment adviser regulation, such as regulations pertaining to advertising and communication, the use of finders and solicitors, supervision and regulatory reviews, licensing and registration of firms, licensing and registration of associated persons, and maintenance of books and records.
Based on the study, it appears likely that the SEC will adopt a uniform fiduciary standard in the near future. However, at this time, it is not clear how the standard would affect the manner in which Covered Broker-Dealers and Investment Advisers conduct their businesses.
Written by Michael Wu
On January 19, 2011, the Securities and Exchange Commission (“SEC”) released its study regarding the need for enhanced examination and enforcement resources for investment advisers. Specifically, the SEC examined the following areas: (i) the number and frequency of examinations of investment advisers by the SEC during the past 5 years, (ii) whether the SEC’s designation of one or more self-regulatory organizations (“SROs”) to augment the SEC’s oversight of investment advisers would improve the frequency of examinations of investment advisers, and (iii) the current and potential approaches to examining the investment advisory activities of dually registered broker-dealers and investment advisers and investment advisers that are affiliated with broker-dealers.
According to the study, the number of registered investment advisers, including hedge fund and private equity fund managers, and the overall assets managed by such advisers has increased over the past 6 years, while the SEC staff dedicated to examining investment advisers has declined. The study noted that the number of SEC examinations decreased since 2004 by nearly 30% and the frequency of such exams by 50% - this was before the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) created additional responsibilities for the SEC. Under the Dodd-Frank Act, the SEC will be required to (i) examine larger, more complex entities, which take more resources to examine; (ii) examine municipal advisers, security-based swap dealers, major security-based swap participants and security-based swap data repositories, which are now required to register with the SEC; and (iii) conduct annual examinations of credit rating agencies and clearing agencies designated as systemically important. In Commissioner Elisse B. Walter’s speech regarding the study, she stated that “the Commission is not, and, unless significant changes are made, cannot fulfill its examination mandate with respect to investment advisers.”
The SEC has recommended that Congress consider the following three approaches to strengthen the SEC’s investment adviser examination program: (i) authorize the SEC to charge SEC-registered investment advisers “user fees,” which would be used to fund the investment adviser examination program; (ii) authorize one or more SROs to examine, subject to SEC supervision, all SEC-registered investment advisers; or (iii) authorize the Financial Industry Regulatory Authority (FINRA) to examine dual registrants for compliance with the Investment Advisers Act of 1940, as amended.
Editorial Comment by Jay Gould
A recent action against a hedge fund manager by the Securities and Exchange Commission (the “SEC”) serves as interesting prologue to the state of enforcement against suspected securities frauds once the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) has been fully implemented. On January 7, 2011, the SEC charged SJK Investment Management LLC, a North Carolina-based hedge fund manager (“SJK”), and CEO Stanley Kowalewski, its owner, with defrauding its hedge fund investors by diverting millions of dollars to themselves through various self-dealing transactions.
Nothing in this case is particularly unique. Investment advisers who steal from their clients have proven to be a fairly routine occurrence and rarely attract mainstream press coverage unless the theft is on a significant scale. Briefly, the SEC alleged that Kowalewski diverted investor money from the SJK hedge funds to pay his personal expenses and placed $16.5 million of the hedge funds’ assets into an undisclosed, wholly-controlled, fund that he created, and then misused for, among other things, purchasing a vacation home valued at $3.9 million. The SEC stated that the agency became suspicious of Kowalewski as a result of an examination. The examination staff referred the matter over to the Enforcement Division of the Atlanta Regional Office which obtained an order to freeze the assets held by Kowalewski. Presumably, a receiver will be appointed by the court that will sift through the rubble and one day return whatever is left over to the investors. In the end, this is just another example of one of approximately 200 Ponzi/investment fraud cases that the SEC has uncovered since the Madoff embarrassment.
What is interesting about this case is that as of July 2011, the SEC will no longer examine the Stanley Kowalewskis of the world. In most cases, that job will be left to state securities commissions. As a result of the Dodd-Frank Act, private fund managers with less than $150 million under management and other investment advisers with less than $100 million under management will no longer register with or be routinely examined by the SEC. The SEC estimates that 4,100 investment advisers that are now registered with it will be forced to de-register and register with their respective state securities regulator. Although the SEC will retain anti-fraud jurisdiction over these state-registered advisers, the primary regulators will be the often ill-equipped, inexperienced and resource strapped state regulators. As a result of the budgetary concerns facing most states, it is unlikely that sufficient resources will be directed to enforcing investment frauds perpetrated by small, “under the radar” investment advisers.
And where do the majority of investment frauds occur? The most recent filing of Kowalewski’s Form ADV indicates that SJK had $71 million under management. This is not exactly an investment adviser that represents a systemic risk to the stability of the financial world, but this is the type of investment adviser that can cause great pain to every day investors seeking to diversify their assets or plan for their retirement. In fact, the vast majority of investment fraud schemes that the SEC has uncovered since Madoff have been perpetrated by investment advisers that will not be subject to SEC scrutiny under the new regulatory regime.
The Dodd-Frank Act addressed this concern in part by directing the SEC to conduct a number of studies regarding the regulation of investment advisers. One such study directs the SEC to make a recommendation as to whether investment advisers should be subject to a self-regulatory organization (“SRO”), much the same way broker-dealers are essentially required to become members of the Financial Industry Regulatory Authority (“FINRA”). In recent weeks, FINRA has shown great interest in taking on this responsibility, much to the dismay of most independent investment advisers. This SRO membership requirement would add another layer of expense to, and oversight of, investment advisers. And some might argue that FINRA, which opposes the idea of creating a uniform fiduciary standard for investment advisers and retail brokers, is exactly the wrong SRO to oversee advisers that have traditionally been subject to a much more rigorous code of conduct.
This shift in regulatory responsibility to the states does not necessarily bode well for small investment advisers and start-up hedge fund managers. Just as we have seen large investors gravitate toward established investment managers since 2008, the lack of effective regulatory oversight may portend an unwillingness for high net worth and smaller institutions to take a chance on a less well-established investment adviser or fund manager. Such investment advisers or fund managers can expect the lack of SEC oversight to be another hurdle in a very challenging capital raising environment.
But there are steps that state-registered and regulated advisers and fund managers can take to minimize this aspect of the Dodd-Frank Act. Taking seriously the responsibility for full and current disclosure in fund documents, providing transparency to investors and maintaining sufficient operating systems and infrastructure will help to address the concerns of circumspect investors. Also, providing clear and current disclosure in the new Form ADV Part 2 that explains the operations and investment approach and adhering to the traditional fiduciary standard that has applied to investment advisers for decades will provide greater comfort to investors. Finally, choosing the right partners and service providers that can provide the oversight, checks and balances and industry expertise will also be important to investors.
Small investment advisers and fund managers may initially welcome the idea of no longer being subject to direct SEC oversight, but if investment frauds continue at this end of the investment spectrum, that may prove to be a hollow victory.
By: Michael Wu
As the new year is upon us, we wanted to take a moment to remind you of some of the annual compliance obligations that you may have as an investment adviser that is registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”). In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers. The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
1) the compliance issues and any violations of the policies and procedures that arose during the year, changes in the Investment Adviser’s business activities and the effect that changes in applicable law, if any, have had on the Investment Adviser’s policies and procedures;
2) the Investment Adviser’s code of ethics, including an assessment of the effectiveness of its implementation and determination of whether they should be enhanced in light of the Investment Adviser’s current business practices; and
3) the business continuity/disaster recovery plan, which should be “stress tested” and adjusted as necessary.
If you have any questions regarding the summary above, please feel free to contact us.
Written by Michael Wu
On July 28, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Part 2 of Form ADV, and related rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), to require registered investment advisers to provide clients with a “brochure” under Part 2A of Form ADV and a “brochure supplement” under Part 2B of Form ADV written in plain English. The brochure contains information about the advisory firm and the brochure supplement contains information about the personnel who provide investment advice.
On December 28, 2010, the SEC extended the compliance dates for the brochure supplement. Specifically, the new compliance dates are as follows:
Please note that the SEC is not extending the compliance date for filing and delivery of the brochure required by Part 2A of Form ADV and the related rules under the Advisers Act. The full text of the adopting rule is available here.
Written by Michael Wu
The Alternative Investment Fund Managers Directive (the “Directive”) establishes a regulatory regime for all alternative fund managers, such as private equity and hedge fund managers, that are based in the European Union (the “EU”), manage funds based in the EU and market non-EU fund interests in the EU. A general summary of the Directive is available here.
Although the majority of the Directive’s rules are likely to become effective by January 2013, some of the rules affecting non-EU funds and non-EU fund managers will be deferred until 2015 or later. Thus, non-EU managers may still actively raise funds in the EU, but will have to comply with a number of additional regulatory requirements beginning in January 2013.
Beginning in January 2013, non-EU managers may actively fund raise in the EU provided that:
Beginning in early-2015, non-EU managers may be able to participate in the “passport” regime (i.e., they can fund raise in every EU country without obtaining separate regulatory authorization in each country) if the European Securities and Markets (“ESMA”) Authority decides to make the passport regime available to non-EU managers. If the passport regime becomes available to non-EU managers, they would become authorized and regulated on the same basis as EU managers with respect to the passporting rights. However, because the passport regime’s compliance obligations are onerous, non-EU managers may want to forgo the passporting rights and fund raise subject to country-by-country private placement regimes and the minimum directive requirements described above.
Beginning in mid-2018, non-EU managers may be required to operate under the passport regime in order to fund raise in the EU. The Directive contains provisions that would ultimately terminate the national private placement regimes, leaving full authorization as the only option for non-EU firms that wish to fund raise in the EU.
ESMA and the European Commission have been tasked with issuing extensive implementing measures and guidance. However, the details of these rules will not become clear for some time.
Written by Michael Wu
On Friday, November 19, 2010, the Securities and Exchange Commission (the “SEC”) issued a Proposed Rule amending the Investment Advisers Act of 1940, as amended, and a Proposed Rule implementing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The purpose of the proposed rules is to strengthen the SEC’s oversight of investment advisers and fill key gaps in the regulatory landscape. The following is a summary of the key provisions of the proposed rules.
Written by Michael Wu
On November 11, 2010, the European Parliament adopted the EU Directive on Alternative Investment Fund Managers (the “Directive”). The Directive will affect a significant number of alternative investment fund managers (“AIFMs”) that manage and/or market alternative investment funds (“Funds”), including hedge funds, commodity funds, private equity funds and real estate funds, within the European Union (“EU”). The text of the Directive is expected to be published in the Official Journal sometime in the first or second quarter of 2011. The Directive will be effective 20 days after publication and the EU Member States will have two years from such date to implement the Directive.
Written by Jay Gould
On November 16, 2010, the U.S. Securities and Exchange Commission ("SEC") instituted public administrative and cease-and-desist proceedings against Thrasher Capital Management, LLC ("Thrasher") and its Chief Executive Officer and Managing Member, James Perkins, pursuant to Sections 203(e), 203(f) and 203(k) of the U.S. Investment Advisers Act of 1940, as amended (the "Advisers Act"). The proceedings were instituted because (i) Thrasher, a SEC-registered investment adviser, failed to make available to the SEC the books and records that Thrasher was required to make available under Section 204 of the Advisers Act and (ii) Thrasher's Form ADV contained untrue statements of material facts regarding its client base and its ownership. The SEC Order indicates that Thrasher did not respond to the SEC Examination Staff to contact them, which precipitated the SEC issuing a subpoena in order to compel cooperation. The SEC also found material discrepancies in Thrasher's Form ADV that could have been easily remedied with only a minimum of compliance oversight. As a result of such conduct, the SEC found that Thrasher willfully violated Section 204(a) of the Advisers Act, which requires advisers that use the mails or interstate commerce to maintain and make available to the SEC certain books and records and Section 207 of the Advisers Act, which prohibits any "person" (defined to include advisers, such as Thrasher) to "make any untrue statement of a material fact in any registration application or report filed with the [SEC] under section 203 or 204, or willfully to omit to state in any such application or report any material fact which is required to be stated therein." Perkins was found to have willfully aided and abetted and to have caused Thrasher's violations of Sections 204(a) and 207 of the Advisers Act.
In anticipation of the institution of the proceedings, Thrasher and Perkins submitted an Offer of Settlement ("Offer"), which the SEC accepted. In connection with the Offer, the SEC ordered that (i) Thrasher and Perkins cease and desist from committing or causing any violations and any future violations of Sections 204(a) and 207 of the Advisers Act; (ii) Thrasher's investment adviser registration be revoked; and (iii) Perkins be suspended from association with any investment adviser for nine months. No monetary penalty was imposed on Perkins because he submitted a sworn Statement of Financial Condition along with other evidence and has asserted that he is unable to pay a civil penalty.
Investment advisers, whether registered with the SEC or a state, should view this particular enforcement action as an example of how not to interact with their primary regulator. When the SEC or a state Securities Commission asks for information, advisers should respond promptly and professionally. Additionally, with the new disclosure requirements that will be required in 2011 under the new "Brochure Rule," advisers must be vigilant to maintain the accuracy of their disclosures in both their filings with regulators and their communications to clients. The settlement of this enforcement action by Thrasher is now a material proceeding that must be disclosed to all current and potential clients. Investment advisers should make every effort to avoid a similar fate and can do so with an effective compliance program that is appropriate to the business of each adviser.
Written by Jay Gould
On March 10, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 201 and Rule 200(g) of Regulation SHO (“Rules”). In order to give certain exchanges additional time to modify current procedures for conducting single-priced transactions for covered securities that have triggered Rule 201’s circuit breaker and to give industry participants additional time for programming and testing for compliance with the requirements of the Rules, the SEC has extended the compliance date for both Rules from November 10, 2010 to February 28, 2011. A full text of the adopting rule is available here.
As we have previously discussed here, the Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers overvalue illiquid assets so as to generate higher management fees. Most recently, on October 25, 2010, the SEC charged hedge fund manager Stephen M. Hicks and his investment advisory businesses with defrauding investors in funds managed by Southridge Capital Management LLC and Southridge Advisors LLC by overvaluing the largest position held by the funds.
According to the SEC’s complaint, the largest holding of the Southridge funds was an investment in Fonix Corporation, which was valued at $30 million. The Southridge funds had acquired Fonix securities in exchange for securities of two telecommunications companies owned by the Southridge funds - LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively, “LecStar”). Southridge and Hicks valued the Fonix securities at their cost of acquisition, which they determined to be equal to the appraised value of the LecStar securities at the time of the exchange. The SEC alleges that the defendants knew or should have known that this appraisal did not reflect the “real” acquisition cost of the Fonix securities because it was based on erroneous information indicating that LecStar was profitable and assumed that an earlier transaction in LecStar securities had been negotiated at arm’s length when in fact it was a transaction between affiliates.
Even if Southridge and Hicks had properly calculated the acquisition cost of the Fonix securities, they would not have been permitted to use this as the basis of a valuation. The offering materials for the Southridge funds indicated that such investments would be valued based on a valuation provided by a clearing broker or independent pricing service rather than acquisition cost.
The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.
The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.
Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.
Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.
Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.
Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:
Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.
The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.
Hedge fund and private equity fund managers that use registered broker-dealers to raise capital on behalf of their funds should be aware of a recent report from the North American Securities Administrators Association ("NASAA"). The 2010 Broker-Dealer Coordinated Examination Report identifies the most prevalent compliance deficiencies by broker-dealers and offers a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures.
Fund managers should conduct initial and ongoing due diligence on all of their agents and service providers, and no less so with third party marketers, which must be registered as broker-dealers. Agreements between fund managers and their third party marketers should include representations from the marketer that no information will be given to potential fund investors that is not approved by the fund manager. The agreement should include an indemnification by the third party marketer to the fund manager in the event a fund investor relies on information produced by the marketer that is not accurate and complete in all material respects.
A fund manager that understands the nature of past violations by a broker dealer/third party marketer will be in a better position to protect the reputation of his/her firm. When conducting due diligence of third party marketers, fund managers should view the FINRA "Broker Check" tool and information provided by the SEC, as well as request information regarding past engagements of the third party marketer. Fund managers should inquire about pending or ongoing regulatory investigations, customer complaints, and whether the third party marketer has implemented NASAA's "10 Best Practices" for broker-dealers.
The NASAA Report took into account a total of 290 examinations conducted between January 1, 2010 and June 30, 2010, which found 567 deficiencies in five compliance areas. The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies).
The three most commonly found problem areas involved failure to follow written supervisory policies and procedures, advertising and sales literature, and variable product suitability. Half of the examinations involved one-person branch offices, 19 percent were home offices, 18 percent were branch offices with two to five agents, 10 percent were branch offices with more than five agents and 3 percent were non-branch offices.
The Securities and Exchange Commission has proposed a new rule under the Dodd-Frank Wall Street Reform and Consumer Protection Act to define the term "family offices." Advisers falling within this definition will be excluded from the definition of "investment adviser" under the Investment Advisers Act of 1940 and will therefore not be required to register with the SEC. Many family offices had previously relied on the "private adviser exemption" from registration, which exempted advisers with fewer than 15 clients from the registration requirement of the Advisers Act. As we have previously discussed, the Dodd-Frank Act removed the private adviser exemption from the Advisers Act.
Proposed Rule 202(a)(11)(G)-1 defines a family office as any firm satisfying the following three conditions:
The SEC noted that a family office that fails to meet the requirements of the new rule would still be able to seek an exemptive order from the SEC.
Comments on the proposed rule must be received by the SEC by Nov. 18, 2010.
On September 22, 2010, the Managed Funds Association submitted initial comments to the Securities and Exchange Commission and the Commodity Futures Trading Commission on regulatory topics under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The MFA’s comments reflected concerns that the broad wording of the Dodd-Frank Act would result in certain provisions being inappropriately applied to private investment funds. To address these concerns, the MFA proposed that:
The Securities and Exchange Commission has published its schedule for adopting rules to implement the Dodd-Frank Act. The proposed timetable for adopting rules related to the oversight of investment advisers and exempt offerings is as follows:
October - December 2010
January - March 2011
April - July 2011
Bloomberg reports that the SEC is engaged in a probe of investment advisers who invest client assets in hedge funds, funds of funds, private equity, venture capital and other alternative investments. The SEC's Office of Compliance Inspections and Examinations has recently requested that advisers provide extensive information about their alternative investments, particularly in regards to the due diligence processes used when evaluating alternative investments. A copy of the letter sent by the OCIE to examined advisers and the accompanying information request list is available here.
As we have previously discussed here, the Securities and Exchange Commission adopted significant changes to Part 2 of Form ADV. Among other things, the new Part 2 requires greatly expanded disclosure presented in a narrative, plain English format. The California Department of Corporations has now also adopted the new Part 2, effective October 12, 2010, thereby subjecting California-registered investment advisers to these same disclosure requirements. Compliance dates for California investment advisers are as follows:
In its first regulation implementing the requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Securities and Exchange Commission announced today its adoption of a temporary rule requiring municipal advisors to register with the SEC by October 1, 2010.
"Municipal advisors" are persons who provide advice to a state or local government regarding municipal derivatives, guaranteed investment contracts, investment strategies or the issuance of municipal securities. The term is also defined to include persons who solicit business for these advisory services from a state or local government on behalf of a third party broker, dealer, municipal securities dealer, municipal advisor or investment adviser.
Municipal advisors must register with the SEC by completing and submitting new Form MA-T, which requires a municipal advisor to disclose certain basic identifying and contact information concerning its business, indicate the nature of its municipal advisory activities, and supply information about its disciplinary history and the disciplinary history of its associated municipal advisor professionals. Municipal advisors must amend the form whenever any identifying or contact information or disciplinary information has become inaccurate in any way.
Form MA-T and the Municipal Advisor Temporary Registration website can be accessed through the SEC's website. Given the need to obtain an ID and password prior to submitting Form MA-T, it is recommended that municipal advisors begin the registration process immediately.
On July 21, 2010, the Securities and Exchange Commission voted to adopt changes to Part 2 of Form ADV (commonly referred to as the “brochure”), which is the principal disclosure document provided by SEC-registered investment advisers to their clients. SEC Chairman Mary Shapiro described the changes as being necessary to ensure that the information most relevant to clients is included in the brochure and that such information is presented in a way that is accessible to investors.
The amendments drastically alter both the form and content of Part 2. The principal changes are to require:
Advisers with a fiscal year end of December 31, 2010 must file an annual updating amendment with the new brochures no later than March 31, 2011. Given the need to provide greatly expanded and more individually tailored disclosure, investment advisers should anticipate that their next annual update will be a much more time and resource intensive exercise and involve the creation of a new, comprehensive disclosure document. Accordingly, they should begin their preparations, including discussions with outside counsel, well in advance of their filing deadline.
The Dodd-Frank Wall Street Reform and Consumer Protection Act will significantly change the regulatory regime governing investment advisers, particularly investment advisers to private funds, such as hedge funds and private equity funds. The primary purpose of the new rules and requirements is to “fill the regulatory gap,” by requiring advisers to private funds to register as investment advisers with the Securities and Exchange Commission or state securities regulators, unless an exemption applies, and provide information about their activities to the SEC. For a detailed discussion of the provisions of the Dodd-Frank Act applicable to advisers to private funds, please see our related Client Alert.