Investment Fund Law Blog - Legal News Updates for Investment Fund Managers & Investors : Pillsbury Winthrop Shaw Pittman LLP

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. 

REGISTER NOW!

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:

• Eligibility for reliance on the “exempt reporting adviser” provisions and what that means in the registration process
• What the DOC and SEC expect to see in hedge fund manager and investment adviser compliance programs
• Examination and enforcement by the DOC and the SEC and coordination efforts between the two agencies
• Tax planning and compliance for fund managers at the state, local and federal levels
• New DOC and SEC rules in the concept or proposal stage aimed at investment advisers

Date & Time
4/25/2013

3:30 pm - 4:00 pm PT
Registration

4:00 pm - 4:30 pm PT
Keynote: Jan Lynn Owen

4:30 pm - 5:45 pm PT
Panel Discussion

5:45 pm - 7:30 pm PT
Reception

Location
Pillsbury’s San Francisco Office
Four Embarcadero Center
22nd Floor
San Francisco, CA 94111

Event Contact
Juliana Curmi 

Featured Speaker
Jan Lynn Owen, Commissioner, California Department of Corporations

Host and Moderator
Jay B. Gould, Partner, Pillsbury

Additional Speakers
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 and Michael Wu

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.

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

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:

CONTINUE READING...

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:

• Buying and selling Indian securities on Indian stock exchanges on behalf of U.S. investors;
• Managing public offerings for Indian issuers in which shares were sold to U.S. investors;
• Soliciting U.S. investors by email, phone calls, and in-person meetings between Indian issuers and U.S. investors;
• Engaging in commission sharing agreements with U.S. registered broker-dealers, in which the firms provided research to U.S. investors in exchange for commission income;
• Organizing and sponsoring conferences in the U.S. bringing together representatives of Indian issuers and U.S. investors; and
• Sending firm employees to the U.S. to meet with U.S. investors and attend corporate road shows.

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 and Peter Chess

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:

• the adviser only advises private funds that rely on either Section 3(c)(1) or Section 3(c)(5) of the Investment Company Act of 1940, as amended, (which the DOC defines as “Retail Buyer Funds”) the investors of which are all “accredited investors”;
• the adviser is not subject to any statutory disqualifications;
• the adviser files certain periodic reports and notices; and
• the adviser pays the annual registration fee of $125.  

Additionally, with respect to Retail Buyer Funds:

• the adviser may only charge performance fees to investors that meet the Advisers Act definition of a “qualified client”;
• the Retail Buyer Fund must be audited annually by a Public Company Accounting Oversight Board (“PCAOB”) registered accounting firm and deliver a copy of the audited financial statements to each beneficial owner; and
• the adviser must provide “material disclosures” to fund investors that adequately and accurately describe the investment program of the fund and the relationship of the adviser to the fund (e.g., the type of disclosures that competent counsel drafts on behalf of fund managers now).

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.”

Written by: Jay Gould and Peter Chess

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.

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:

• Revisiting the brand and value proposition on a regular basis to ensure it accurately and effectively reflects a “firm’s DNA.”
• Implementing a consistent process that provides for the regular refreshing of value-added content to communications vehicles.
• Creating content that provides true thought leadership, enhanced with proprietary surveys, and investment & industry commentary.
• Considering a broad range of distribution and engagement vehicles to build awareness of the firm, including: web and mobile devices, public relations, marketing communications, targeted advertising and investor communications.

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.

Written by:  Jay Gould and Peter Chess

In a July 10, 2012, no-action letter[1], 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:

• Interests in the pool are exempt from registration under the Securities Act of 1933, as amended (the “Securities Act”), and such interests are offered and sold without marketing to the public;
• The CPO reasonably believes, at the time of investment, that (i) each natural person participant is a “qualified eligible person” as that term is defined in Section 4.7(a)(2) of the Commodity Exchange Act; and (ii) each non-natural person participant is a “qualified eligible person” as that term is defined in Section 4.7 of the Commodity Exchange Act or an “accredited investor” as defined under the Securities Act; and
• In addition, no-action relief will be granted where each pool for which the CPO claims relief is a registered investment company under the Investment Company Act of 1940, as amended.

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:

• The CTA’s commodity interest trading advice is directed solely to, and for the sole use of, the pools that it operates; or
• The CTA’s commodity interest trading advice is directed solely to, and for the sole use of, pools operated by CPOs who claim relief from CPO registration under Rules 4.13(a)(1), (a)(2), (a)(3), (a)(4) or 4.5 of the Commodity Exchange Act, or under no-action relief provided by the no-action letter.

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.

[1]   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.

Written by:  Jay B. Gould, Michael Wu and Peter Chess

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.

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Written by: Jay B. Gould and Peter Chess

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[1] 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:

• Holds itself out as a dealer in swaps;
• Makes a market in swaps;
• Regularly enters into swaps with counterparties as an ordinary course of business for its own account; or
• Engages in activity causing itself to be commonly known in the trade as a dealer or market maker in swaps.

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:

• A person that maintains a “substantial position” in any of the major swap categories, excluding positions held for hedging or mitigating commercial risk and positions maintained by certain employee benefit plans for hedging or mitigating risks in the operation of the plan.
• A person whose outstanding swaps create “substantial counterparty exposure that could have serious adverse effects on the financial stability of the United States banking system or financial markets.”
• Any “financial entity” that is “highly leveraged relative to the amount of capital such entity holds and that is not subject to capital requirements established by an appropriate Federal banking agency” and that maintains a “substantial position” in any of the major swap categories.

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.”

The full text of the SEC press release and fact sheet is available here.  The full text of the CFTC release is available here.

[1]               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. 

Written by Jay Gould, Michael Wu and Peter Chess

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:     

• If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, which do not satisfy the trading limits of CFTC Rule 4.13(a)(3)[1] (“Trading Limits”) and each of which is operated by a registered CPO, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may only rely on Section 4.13(a)(3) if the Fund of Funds itself satisfies the Trading Limits.
• If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, each having a CPO who is either (a) exempt under CFTC Rule 4.13(a)(3) or (b) a registered CPO that complies with the Trading Limits, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may rely on Section 4.13(a)(3).
• If a fund (i) allocates a Fund of Fund’s assets to one or more underlying funds, each of which satisfies the Trading Limits, and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may multiply the percentage restriction applicable to each underlying fund by the percentage of the Fund of Fund’s allocation of assets to such underlying fund, to determine whether that fund may rely on Section 4.13(a)(3).
• If a fund (i) allocates the Fund of Fund’s assets to one or more underlying funds, and it has actual knowledge of the Trading Limits of the underlying funds (e.g., where the underlying funds or their CPOs are affiliated with a fund), and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may aggregate the commodity interest positions across the underlying funds to determine compliance with the Trading Limits and whether or not that fund may rely on CFTC Rule 4.13(a)(3). 
• If a fund (i) allocates no more than 50% of the Fund of Fund’s assets to underlying funds that trade commodity interests (regardless of the level of trading engaged by such underlying funds), and (ii) does not allocate the Fund of Fund’s assets directly to commodity interest trading, that fund may rely on CFTC Rule 4.13(a)(3).

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.

[1]   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.

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.

Written by Jay Gould and Peter Chess

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:

• the investment adviser to a private fund establishes the SPV to act as the private fund’s general partner or managing member;
• the SPV’s formation documents designate the investment adviser to manage the private fund’s assets;
• all of the investment advisory activities of the SPV are subject to the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”); and
• the registered adviser subjects the SPV, its employees and persons acting on its behalf to the registered adviser’s supervision and control and, therefore, the SPV, all of its employees and the persons acting on its behalf are “persons associated with” the registered adviser.

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:

• The filing adviser and each relying adviser advise only private funds and separate account clients that are qualified clients and are otherwise eligible to invest in the private funds advised by the filing adviser or a relying adviser and whose accounts pursue investment objectives and strategies that are substantially similar or otherwise related to those private funds. 
• Each relying adviser, its employees and the persons acting on its behalf are subject to the filing adviser’s supervision and control and, therefore, each relying adviser, its employees and the persons acting on its behalf are “persons associated with” the filing adviser. 
• The filing adviser has its principal office and place of business in the United States and, therefore, all of the substantive provisions of the Advisers Act and the rules thereunder apply to the filing adviser’s and each relying adviser’s dealings with each of its clients, regardless of whether any client or the filing adviser or relying adviser providing the advice is a United States person. 
• The advisory activities of each relying adviser are subject to the Advisers Act and the rules thereunder, and each relying adviser is subject to examination by the SEC.
• The filing adviser and each relying adviser operate under a single code of ethics and a single set of written policies and procedures, administered by a single chief compliance officer.
• The filing adviser discloses in its Form ADV (Miscellaneous Section of Schedule D) that it and its relying advisers are together filing a single Form ADV in reliance on the 2012 Letter and identifies each relying adviser by completing a separate Section 1.B., Schedule D, of Form ADV for each relying adviser and identifying it as such by including the notation “(relying adviser).”

Written by Jay Gould and Peter Chess

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.

Written by Jay Gould, Ildiko Duckor and Peter Chess

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:

• Usage Guidelines.  Investment advisers may provide guidance in their policies on the appropriate and inappropriate use of social media;
• Monitoring.  Investment advisers may consider how to effectively monitor their social media sites or any use of third-party sites;
• Content Standards.  May include clear guidelines and the prohibition of specific content or other content restrictions; and
• Information Security.  Investment advisers may consider any information security risks posed by access to social media sites.  These could include dangers from hacking and other breaches of information security. 

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

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.

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. 

Information regarding the readoption of the  emergency proposal is posted on  the “What's New” section of the Department of Corporations’ home page  (available at www.corp.ca.gov).

Pillsbury will continue to monitor this development and post additional information as soon as it becomes available.

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 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: 

•  institutional accounts, as defined in NASD Rule 3110(c)(4);
• qualified purchasers, as defined in Section 2(a)(51)(A) of the Investment Company Act;  (Accordingly, 3(c)(7) funds would be exempt from the Proposed Rule.)
• qualified institutional buyers, as defined in Securities Act Rule 144A;
• investment companies, as defined in Section 3 of the Investment Company Act;
• an entity composed exclusively of qualified institutional buyers, as defined in Securities Act Rule 144A;
• banks, as defined in Section 3(a)(2) of the Securities Act; and
• employees and affiliates of the issuer.

In addition, the Rule would exempt the following types of offerings:

• offerings of exempted securities, as defined by Section 3(a)(12) of the Exchange Act;
• offerings made pursuant to Securities Act Rule 144A or SEC Regulation S;
• offerings of exempt securities with short term maturities under Section 3(a)(3) of the Securities Act;
• offerings of subordinated loans under Exchange Act Rule 15c3-1, Appendix D;
• offerings of “variable contracts” as defined in Rule 2320(b)(2);
• offerings of modified guaranteed annuity contracts and modified guaranteed life insurance policies, as referenced in Rule 5110(b)(8)(E);
• offerings of non-convertible debt or preferred securities by issuers that meet the eligibility criteria for incorporation by reference in Forms S-3 and F-3;
• offerings of securities issued in conversions, stock splits and restructuring transactions that are executed by an already existing investor without the need for additional consideration or investments on the part of the investor;
• offerings of securities of a commodity pool operated by a commodity pool operator as defined under Section 1a(11) of the Commodity Exchange Act; and
• offerings filed with FINRA under Rules 2310, 5110, 5121 and 5122.

Confidential treatment

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 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.

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.

• Large advisers to hedge funds must report on Form PF within 60 days of the end of each fiscal quarter, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover.  If a hedge fund has a net asset value of at least $500 million, the adviser must report information regarding the fund’s exposures, leverage, risk profile, and liquidity.
• Large advisers to liquidity funds must report on Form PF within 15 days of the end of each fiscal quarter, the types of assets in their liquidity funds, information relevant to the risks of the funds, and the extent to which the liquidity funds comply with Rule 2a-7 of the Investment Company Act of 1940, as amended.
• Large advisers to private equity funds must file Form PF annually within 120 days of the end of the fiscal year and respond to questions regarding the extent of leverage incurred by their funds’ portfolio companies, the use of bridge financing and their funds’ investments in financial institutions.

Two-stage phase-in compliance with Form PF filing requirements:

1. Advisers with at least $5 billion in hedge fund, liquidity fund, and private equity fund assets under management must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after June 15, 2012.
2. Other private fund advisers must begin filing Form PF following the end of their first fiscal year or fiscal quarter, as applicable, to end on or after December 15, 2012.

Form PF Filing Fees:  $150 for initial, quarter or annual filing.

A full text of the SEC release is available here. 

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 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.

Written by Jay Gould and Michael Wu

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:

• Statutory Threshold for SEC Registration.   The Dodd-Frank Act increases the threshold for SEC registration by creating a new category of advisers called “mid-sized advisers.”  A mid-sized adviser has assets under management between $25 million and $100 million.  If the mid-sized adviser’s principal office and place of business is located in a state that requires it to register as an investment adviser, the adviser must register with the state.  A mid-sized adviser must register with the SEC if it is not required to register in the state where it maintains its principal office and place of business, or if registered with that state, the adviser would not be subject to examination by that state’s securities commissioner.
• Transition to State Registration, Registration Deadline.
   
  Existing SEC-registered adviser as of January 1, 2012 – must amend its Form ADV no later than March 30, 2012.
  
  Mid-sized adviser no longer eligible for SEC registration – must amend its Form ADV no later than March 30, 2012 to switch to state registration and withdraw its SEC registration by filing Form ADV-W no later than June 28, 2012.
  
  New Applicants.  Until July 21, 2011 (effective date of the final rules), advisers applying for registration that qualify as mid-sized advisers may register with either the SEC or the appropriate state securities authority.  Thereafter, mid-sized advisers must register with the appropriate state securities authority.
• Exempt Reporting Advisers.  These are advisers that rely on either the venture capital exemption or the private fund advisers exemption.  The final rules require these exempt reporting advisers to submit an annual report with the SEC by filing an abbreviated Form ADV Part 1 completing only Items 1 (Identifying Information), 2.B (SEC Reporting by Exempt Reporting Advisers), 3 (Form of Organization), 6 (Other Business Activities), 7 (Financial Industry Affiliations), 10 (Control Persons), 11 (Disclosure Information), and any corresponding section of Schedules A, B, C and D.  There will be fees associated with the filing which will be the same as those for registered advisers.
• Form ADV.  The SEC is amending Part 1 of Form ADV to require advisers to provide additional information: 1) about private funds they advise, 2) about their advisory business and business practices that may present conflicts of interest, and 3) about their non-advisory activities and financial industry affiliations.
• Family Office exemption.  By defining “family office,” the SEC is allowing family offices to continue to be exempt from regulation of the Advisers Act.  The final rules expanded the exemption by including additional categories of family members and key employees as family clients.
• Pay-to-Play Rule.  The final rules permit an adviser to pay a registered municipal advisor, or an SEC registered investment adviser or broker-dealer, to act as placement agent to solicit government entities on its behalf, so long as the municipal advisor is subject to the MSRB-adopted pay-to-play rule, or the SEC registered adviser or broker-dealer is subject to a FINRA-adopted pay-to-play rule, that is at least as stringent as the investment adviser pay-to-play rule.

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:

• Advisers solely to venture capital funds (venture capital fund exemption).  The final rules define “venture capital fund” as a private fund that: 1) holds no more than 20% of the fund’s capital commitments in non-qualifying investments (other than short-term holdings); 2) does not borrow or is not leveraged except for a limited short-term borrowing; 3) does not offer redemption or liquidity rights to its investors; 4) represents itself to investors as pursuing a venture capital strategy; and 5) is not registered under the Investment Company Act of 1940 and is not a business development company.
  
  The SEC also adopted the grandfathering provision for this exemption provided the following three requirements are met by the fund: (i) represented to investors that it pursues a venture capital strategy; (ii) has sold securities prior to December 31, 2010; and (iii) does not sell securities to, or accept any capital commitments from, any person after July 21, 2011.
• Advisers solely to private funds with less than $150 million in assets under management in the U.S. (private fund adviser exemption).  The instructions to Form ADV will be revised to provide a uniform method of calculating assets under management for regulatory purposes.
• Certain foreign advisers without a place of business in the U.S.  A non-U.S. adviser that has no place of business in the U.S. is not required to register with the SEC if it has fewer than total 15 U.S. clients and private fund investors, has less than $25 million in aggregate assets under management from U.S. clients and private fund investors, and does not hold itself out to the public as an investment adviser.

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

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

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.

Written by Jay Gould and Michael Wu

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…

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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.

• Large advisers to hedge funds would report, on an aggregated basis, information regarding exposures by asset class, geographical concentration and turnover.  If a hedge fund has a net asset value of at least $500 million, the adviser would report information regarding the fund’s investments, leverage, risk profile and liquidity.
• Large advisers to liquidity funds would report the types of assets in their liquidity funds, information relevant to the risks of the funds, and the extent to which the liquidity funds comply with Rule 2a-7 of the Investment Company Act of 1940, as amended.
• Large advisers to private equity funds would respond to questions regarding the extent of leverage incurred by their funds’ portfolio companies, the use of bridge financing and their funds’ investments in financial institutions.

The SEC’s public comment period on the proposed rule will last 60 days.   

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.

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. 

• Update Form ADV.  An Investment Adviser must file an annual amendment to Form ADV Part 1 and Form ADV Part 2 within 90 days of the end of its fiscal year.  Effective on January 1, 2011, Investment Advisers must file both Part 1 and Part 2A of the Form ADV with the SEC through the electronic IARD system.  Accordingly, if you are SEC-registered adviser whose fiscal year ends on or after December 31, 2010, you must file Part 1A and Part 2A as part of your annual updating amendment by March 31, 2011.  If you are a state-registered adviser whose fiscal year ends on or after December 31, 2010, you must also file Part 1A, Part 1B and Part 2A as part of your annual updating amendment by March 31, 2011.
• New FINRA Entitlement Program.  FINRA is implementing changes to its Entitlement Program, which provides access to an Investment Adviser’s IARD account.  Every adviser firm (new and existing) is now required to designate an individual as its Super Account Administrator (SAA).  The SAA must be an authorized employee or officer of the adviser firm. 
• Fund IARD Account.  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 15, 2010, Preliminary Renewal Statements (“PRS”), which list advisers’ renewal fees, are available for printing through the IARD system.  By December 10, 2010, 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, 2011.  All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2011.
• State Notice Filings/Investment Adviser Representatives.  An Investment Adviser should review its advisory activities in the various states in which it conducts business and confirm that all applicable notice filings are made on IARD.  In addition, an Investment Adviser should confirm whether any of its personnel need to be registered as “investment adviser representatives” in any state and, if so, register such persons or renew their registrations with the applicable states.
• Brochure Rule.  On an annual basis, an Investment Adviser must provide its private fund investors and separate account client(s) with a copy of its updated Form ADV Part 2A, or provide a summary of material changes and offer to provide an updated Form ADV Part 2A. The 2011 deadline for providing investors with Form ADV Part 2B depends on whether an Investment Adviser is a new or existing SEC-registered adviser and whether the Investment Adviser is providing it to prospective, new or existing investors.
• Annual Assessment.  At least annually, an Investment Adviser must review its compliance policies and procedures to assess their effectiveness.  The annual assessment process should be documented and such document(s) should be presented to the Investment Adviser’s chief executive officer or executive committee, as applicable, and maintained in the Investment Adviser’s files.  At a minimum, the annual assessment process should entail a detailed review of:

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. 

• Annual/Surprise Audit.  Because Investment Advisers are generally deemed to have custody of client assets, they must provide audited financial statements of their fund(s), prepared in accordance with U.S. generally accepted accounting principles, to the fund(s)’ investors within 120 days of the end of the fund(s)’ fiscal year.  Investment Advisers that do not provide audited financial statements to fund investors should remind their auditors that an annual surprise audit is necessary. 
• Annual Privacy Notice.  Under SEC Regulation S-P, an Investment Adviser must provide its fund investors or client(s) who are natural persons with a copy of the Investment Adviser’s privacy policy on an annual basis, even if there are no changes to the privacy policy. 
• New Issues.  An Investment Adviser that acquires “new issue” IPOs for a fund or separately managed client account must obtain written representations every 12 months from the fund or account’s beneficial owners confirming their continued eligibility to participate in new issues.  This annual representation may be obtained through “negative consent” letters.
• ERISA.  An Investment Adviser may wish to reconfirm whether its fund(s)’ investors are “benefit plan investors” for purposes of reconfirming its fund(s)’ compliance with the 25% “significant participation” exemption under ERISA.  This is particularly important if a significant amount of a fund’s assets have been withdrawn or redeemed.  The reconfirmation may be obtained through “negative consent” letters.
• Anti-money Laundering.  Although FinCEN withdrew its proposed anti-money laundering regulations for unregistered investment companies, certain investment advisers and commodity trading advisors, an Investment Adviser is still subject to the economic sanctions programs administered by OFAC and should have an anti-money laundering program in place.  An Investment Adviser should review its anti-money laundering program on an annual basis to determine whether the program is reasonably designed to ensure compliance with applicable law given the business, customer base and geographic footprint of the Investment Adviser.
• Amend Schedule 13G or 13D.  An Investment Adviser whose client or proprietary accounts, separately or in the aggregate are beneficial owners of 5% or more of a registered voting equity security, and who have reported these positions on Schedule 13G, must update these filings annually within 45 days of the end of the calendar year, unless there is no change to any of the information reported in the previous filing (other than the holder’s percentage ownership due solely to a change in the number of outstanding shares).  An Investment Adviser reporting on Schedule 13D is required to amend its filings “promptly” upon the occurrence of any “material changes.”  In addition, an Investment Adviser whose client or proprietary accounts are beneficial owners of 10% or more of a registered voting equity security must determine whether it is subject to any reporting obligations, or potential “short-swing” profit liability or other restrictions, under Section 16 of the Securities Exchange Act of 1934, as amended (the “Exchange Act”).
• Form 13F.  An “institutional investment manager,” whether or not an Investment Adviser, must file a Form 13F with the SEC if it exercises investment discretion with respect to $100 million or more in securities subject to Section 13(f) of the Exchange Act (e.g., exchange-traded securities, shares of closed-end investment companies and certain convertible debt securities), which discloses certain information about such its holdings.  The first filing must occur within 45 days after the end of the calendar year in which the Investment Adviser reaches the $100 million filing threshold and within 45 days of the end of each calendar quarter thereafter, as long as the Investment Adviser meets the $100 million filing threshold.
• Offering Materials.  As a general securities law disclosure matter, and for purposes of U.S. federal and state anti-fraud laws, including Rule 206(4)-8 of the Advisers Act, an Investment Adviser must continually ensure that each of its fund offering documents is kept up to date, consistent with its other fund offering documents and contains all material disclosures that may be required in order for the fund investor to be able to make an informed investment decision. 
  • Full and accurate disclosure is particularly important in light of Sergeants Benevolent Assn. Annuity Fund v. Renck, 2005 NY Slip op. 04460, a recent New York Appellate Court decision, where the court held that officers of an investment adviser could be personally liable for the losses suffered by a fund that they advised if they breached their implied fiduciary duties to the fund.  The fiduciary nature of an investment advisory relationship and the standard for fiduciaries under the Advisers Act includes an affirmative duty of utmost good faith, and full and fair disclosure of all material facts, and an affirmative obligation to use reasonable care to avoid misleading clients.
  • Accordingly, it may be an appropriate time for an Investment Adviser to review its offering materials and confirm whether or not any updates or amendments are necessary.  In particular, an Investment Adviser should take into account the impact of the recent turbulent market conditions on its fund(s) and review its fund(s)’ current investment objectives and strategies, valuation practices, performance statistics, redemption or withdrawal policies and risk factors (including disclosures regarding market volatility and counterparty risk), its current personnel, service providers and any relevant legal or regulatory developments.
• Blue Sky Filings/Form D.  Many state securities “blue sky” filings expire on a periodic basis and must be renewed.  Accordingly, now may be a good time for an Investment Adviser to review the blue-sky filings for its fund(s) to determine whether any updated filings or additional filings are necessary.  We note that as of 2009, all Form D filings for continuous offerings will need to be amended on an annual basis.
• Liability Insurance.  Due to an environment of increasing investor lawsuits and regulatory scrutiny of fund managers, an Investment Adviser may want to consider obtaining management liability insurance or review the adequacy of any existing coverage, as applicable.

If you have any questions regarding the summary above, please feel free to contact us. 

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:

• A regulatory cooperation agreement is in place between all of the relevant regulators (i.e., the regulator in the non-EU manager’s home jurisdiction and the EU country where the fund raising occurs) under which the regulators agree to cooperate on monitoring and managing systemic risk.  In addition, the home jurisdiction must not be designated by the Financial Action Task Force as a non-cooperative country or territory.
• Non-EU managers comply with the following provisions of the Directive:
  • Transparency and Disclosure: the non-EU manager must prepare an annual fund report for investors in a prescribed format and disclose certain other prescribed information to investors and will be subject to regulatory reporting requirements aimed at monitoring systemic risk.  The European Commission will publish measures specifying the format and content of the reports.
  • Portfolio Company Disclosures: if a private equity fund acquires or disposes of a substantial stake in an EU company, the manager must formally notify the target company, the shareholders and the regulators.  Additional disclosures are required if a controlling stake is acquired.
  • “Asset-Stripping” Restrictions: the Directive restricts certain shareholder distributions for a period of 24 months after acquisition of an EU company (to prevent dividend recapitalizations during the period).
• Non-EU manager is aware of the securities laws of each EU country in which it intends to raise funds, which may impose more onerous rules.

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 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.   

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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.

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.

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:

• Family Clients. Family offices may only provide investment advice to "family clients." Family clients include family members, certain employees of the family office, charities established and funded exclusively by family members, trusts or estates existing for the sole benefit of family clients and entities wholly owned and controlled by family clients. Former family members may retain investments held through a family office but may not make new investments.
• Ownership and Control. The family office must be wholly owned and controlled by family members.
• Holding Out. The family office may not hold itself out to the public as an investment adviser. 

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.

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

• §§404 and 406: Propose (jointly with the CFTC for dual-registered investment advisers) rules to implement reporting obligations on investment advisers related to the assessment of systemic risk
• §§407 and 408: Propose rules implementing the exemptions from registration for advisers to venture capital firms and for certain advisers to private funds
• §409: Propose rules defining “family office”
• §410: Propose rules and changes to forms to implement the transition of mid-sized investment advisers (between $25 and $100 million in assets under management) from SEC to State regulation, as provided in the Act
• §418: Propose rules to adjust the threshold for “qualified client”
• §413: Propose rules to revise the “accredited investor” standard
• §926: Propose rules disqualifying the offer or sale of securities in certain exempt offerings by certain felons and others similarly situated

January - March 2011

• §913: Report to Congress regarding the study of the obligations of brokers, dealers and investment advisers
• §914: Report to Congress regarding the need for enhanced resources for investment adviser examinations and enforcement
• §919B: Complete study of ways to improve investor access to information about investment advisers and broker-dealers

April - July 2011

• §§404 and 406: Adopt rules (jointly with the CFTC for dual-registered investment advisers) to implement reporting obligations on investment advisers related to the assessment of systemic risk
• §§407 and 408: Adopt rules implementing the exemption from registration for advisers to venture capital firms and to certain advisers to private funds
• §409: Adopt rules defining “family office”
• §410: Adopt rules and form changes to implement the transition of mid-sized investment advisers (between $25 and $100 million in assets under management) from SEC to State regulation, as provided in the Act
• §418: Adopt rules to adjust the threshold for “qualified client”
• §413: Adopt rules to revise the “accredited investor” standard
• §926: Adopt rules disqualifying the offer or sale of securities in certain exempt offerings by certain felons and others similarly situated

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:

• As of January 1, 2011 all new investment adviser applicants will have to file the new Part 2 of Form ADV as part of their application.
• As of January 1, 2011 all licensed investment advisers will need to incorporate the new Part 2 of Form ADV with their next filing of an amendment to Form ADV, or their annual updating amendment to Form ADV.
• Between October 12, 2010 and January 1, 2011 applicants and currently licensed investment advisers filing amendments to their Part II of Form ADV may use either the current Part II or the new Part 2.

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:

• Narrative, plain English disclosure. Part 2 previously required advisers to respond to a series of multiple-choice and fill-in-the-blank questions organized in a “check-the-box” format.  The revised Part 2 directs advisers to provide a narrative brochure written in plain English. Advisers are to tailor the presentation of their disclosure to their clients’ level of financial sophistication, employ clear, concise language, use examples and otherwise seek to ensure that material information is effectively communicated to clients.
• Expanded disclosure. The amended Part 2 requires advisers to discuss more topics and provide more detailed disclosure regarding their business and employees, particularly in regards to any arrangements that may give rise to conflicts of interest. In addition to the information explicitly required to be disclosed in Part 2, advisers have a fiduciary duty to provide clients with all material information regarding the advisory relationship. Such disclosure may be included in Part 2 or disclosed to clients by some other means.
• Public accessibility. Part 2A of Form ADV must be filed electronically and will be publicly available on the SEC’s website.

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.

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