Today, Jay Gould was interviewed by Deirdre Bolton on Bloomberg TV’s “Money Moves” where Jay discussed lifting the ban on hedge fund advertising.
Today, Jay Gould was interviewed by Deirdre Bolton on Bloomberg TV’s “Money Moves” where Jay discussed lifting the ban on hedge fund advertising.
Written by: Jay Gould
On April 8, 2013, we reviewed a recent speech by David Blass, the Chief Counsel of the Division of Trading and Markets of the Securities and Exchange Commission (the “SEC”), in which Mr. Blass provided his views on whether certain investment fund managers might be operating in a way that would require registration as a broker dealer. For hedge fund managers, the problem typically arises in the context of paying internal sales people based on the amount of capital raised. As we noted, the widespread misreading or abuse of Rule 3a4-1, the issuer’s exemption safe harbor on which so many hedge fund managers rely, is now clearly on the SEC’s radar.
But there are other ways to become entangled in broker dealer registration requirements that many private equity funds (and some hedge funds) will also need to consider. The SEC staff is aware that advisers to some private funds, such as managers of private equity funds executing a leverage buyout strategy, may collect fees other than advisory fees, some of which look suspiciously like brokerage commissions. It is not uncommon for a fund manager to direct the payment of fees by a portfolio company of the fund to one of its affiliates in connection with the acquisition, disposition (including an initial public offering), or recapitalization of the portfolio company. These fees are often described as compensating the fund manager or its affiliated company, or personnel for “investment banking activity,” including negotiating transactions, identifying and soliciting purchasers or sellers of the securities of the company, or structuring transactions. These are typical investment banking activities for which registration as a broker dealer is required.
Perhaps through its presence exams, the SEC staff recognizes that the practice of charging these transaction fees is fairly common among certain private equity fund managers. Blass suggested that if the payment of these investment banking type fees were used to offset the management fee, then a valid argument could be made that no separate brokerage compensation was generated. However, the industry argument that the receipt of such fees by the general partner of the fund should be viewed as the same person as the fund, so there are no transactions for the account of others was not an argument that the SEC staff appeared ready to endorse. As long as the fee is paid to someone other than the fund for the types of activities described above, then the general partner or its affiliate would need to go through the analysis as to why broker dealer registration is not required. The private equity fund bar has also advanced the policy argument that requiring private equity fund managers to register as broker dealers serves no useful purpose. This policy argument that advocates the position that the SEC should exempt certain firms and not others for the same conduct, as attractive as it might be for managers of private equity funds, is a total non-starter from the regulator’s perspective. The SEC staff will remain fixated on the type of activity and the fees generated from that activity when attempting to determine whether registration is required.
Particularly among private equity fund managers, many of which have not had a history of being a regulated entity, this violation of the broker dealer registration requirement is not viewed as a serious matter because “everyone else is doing it.” But the SEC is putting private equity on notice that this is an area that the staff will focus on in examinations and will eventually bring enforcement action. In addition to being subject to sanctions by the SEC, another possible consequence of acting as an unregistered broker-dealer is the potential right to rescission by investors. A transaction that is intermediated by an inappropriately unregistered broker-dealer could potentially be rendered void. A purchaser of securities would typically seek to void a transaction if the price had moved against him, leaving the fund manager scrambling to make up the difference between the sales price and the value at rescission. Private equity fund managers and those hedge fund managers that conduct similar activities should give greater attention to this issue for which the SEC staff has provided fair warning.
Written by: Jay Gould
In a speech before the American Bar Association’s Trading and Markets Subcommittee on April 5, 2013, David Blass, the Chief Counsel of the Division of Markets and Trading, put hedge fund managers and private equity fund managers on notice that they may be engaged in unregistered (and therefore, unlawful) broker dealer activities as a result of the manner by which hedge fund managers compensate their personnel and, in the case of private equity fund managers, the receipt of investment banking fees with respect to their portfolio companies. The good news is that Mr. Blass indicated that the Staff of the Securities and Exchange Commission (the “SEC”) is willing to work with the industry to come up with an exemption from broker dealer registration for private fund managers that would allow some relief from the prohibitions against certain sales activities and compensation arrangements regarding the sales of private fund securities. This post will address only the sales compensation activities of hedge funds with an explanation of the private equity investment banking fee discussion to follow.
Mr. Blass indicated that he believed that private fund advisers may not be fully aware of all of the activities that could be viewed as soliciting securities transactions, or the implications of compensation methods that are transaction-based that would give rise to the requirement to register as a broker dealer.
Mr. Blass provided several examples that fund managers should consider to help determine whether a person is acting as a broker-dealer:
How does the adviser solicit and retain investors? Thought should be given regarding the duties and responsibilities of personnel performing such solicitation or marketing efforts. This is an important consideration because a dedicated sales force of internal employees working in a “marketing” department may strongly indicate that they are in the business of effecting transactions in the private fund, regardless of how the personnel are compensated.
Do employees who solicit investors have other responsibilities? The implication of this point is that if an employee’s primary responsibility is to solicit investors, the employee may be engaged in a broker dealer activity irrespective of whether other duties are also performed.
How are personnel who solicit investors for a private fund compensated? Do those individuals receive bonuses or other types of compensation that is linked to successful investments? A critical element to determining whether one is required to register as a broker-dealer is the existence of transaction-based compensation. This implies that bonuses tied to capital raising success would likely give rise to a requirement for such individuals to register as broker dealers.
Does the fund manager charge a transaction fee in connection with a securities transaction? In addition to considering compensation of employees, advisers also need to consider the fees they charge and in what way, if any, they are linked to a security transaction. This point is aimed more at the investment banking type fees that a private equity fund might generate, but it would also be relevant in the context of direct lending funds or other types of funds that generate income outside of the increase or decrease of securities’ prices.
Mr. Blass also addressed the use or misuse of Rule 3a4-1, the so-called “issuer exemption.” That exemption provides a nonexclusive safe harbor under which associated persons of certain issuers can participate in the sale of an issuer’s securities in certain limited circumstances without being considered a broker. Mr. Blass stated his mistaken belief that most private fund managers do not rely on Rule 3a4-1, which, in fact, they do. Blass suggests that private fund managers do not rely on this rule because in order to do so, a person must satisfy one of three conditions to be exempt from broker-dealer registration:
Mr. Blass rightly points out that it would be difficult for private fund advisers to fall within these conditions. That, however, has not stopped most private fund managers from relying on some interpretation of the “issuer’s exemption” no matter how attenuated the adherence to the conditions might be.
Although Mr. Blass indicated a willingness to work with the industry to fashion an exemption from broker dealer registration that is specifically tailored to private fund sales, he also reminded the audience that the SEC is quite willing to take enforcement action against private funds that employ unregistered brokers. Last month, the SEC settled charges in connection with alleged unregistered brokerage activities against Ranieri Partners, a former senior executive of Ranieri Partners, and an independent consultant hired by Ranieri Partners. The SEC’s order stated (whether or not supported by the facts) that Ranieri Partners paid transaction-based fees to the consultant, who was not registered as a broker, for the purpose of actively soliciting investors for private fund investments. This case demonstrates that there are serious consequences for acting as an unregistered broker, even where there are no allegations of fraud. The SEC believes that a fund manager’s willingness to ignore the rules or interpret the rules to accommodate their activities can be a strong indicator of other potential misconduct, especially where the unregistered broker-dealer comes into possession of funds and securities.
Private fund managers are encouraged to consider this statement and review their sales and compensation arrangements accordingly.
Pillsbury and the California Hedge Fund Association invite you to join us on Thursday, April 25, 2013 for an educational program featuring Ms. Jan Lynn Owen, the Commissioner of the California Department of Corporations (DOC) and Person to be Announced from the U.S. Securities and Exchange Commission.
The Commissioner and her staff will discuss the new investment adviser registration rules that were recently adopted by the DOC, including the “exempt reporting adviser” provisions, the interplay between the DOC rules and those of the post-Dodd-Frank rules of the Securities and Exchange Commission.
This program will provide startup hedge fund managers and new investment advisers with the information they need to navigate the registration process, regulatory requirements, and examination focus of the DOC and the SEC, including:
Date & Time
3:30 pm - 4:00 pm PT
4:00 pm - 4:30 pm PT
Keynote: Jan Lynn Owen
4:30 pm - 5:45 pm PT
5:45 pm - 7:30 pm PT
Pillsbury’s San Francisco Office
Four Embarcadero Center
San Francisco, CA 94111
Jan Lynn Owen, Commissioner, California Department of Corporations
Host and Moderator
Jay B. Gould, Partner, Pillsbury
Jerry Twomey, Deputy Commissioner, Division of Securities Regulation, California Department of Corporations
Doug Bramhall, Tax Managing Director, KPMG
Kristin A. Snyder, Associate Regional Director–Examinations, Securities and Exchange Commission, San Francisco Regional Office
Contributed by: The Family Office Association
The Family Office Association is pleased to contribute its latest Q&A “white paper” regarding family enterprise governance to the Investment Funds Law Blog. The Q&A has contributions from James Grubman, Ph.D. and Dennis Jaffe, Ph.D., two of the world’s leaders on the topic of family enterprise governance. Among other things, the Q&A discusses implementing mechanisms for inclusive decision-making, formulating a family governance plan, including non-blood line family members into the governance process and incorporating a family council. Read more from the Family Office Association Q&A white paper.
Written by: Jay Gould
Last month, the Securities and Exchange Commission (the “SEC”), published its examination priorities for 2013. As we suggested in our Blog posting at that time, the SEC is fixated on examining and bringing enforcement against its newest class of investment adviser – managers of private equity funds. Fast forward four weeks, and we should not be surprised to see that the SEC is doing what they said they would do. Today, the SEC charged two investment advisers at Oppenheimer & Co. with misleading investors about the valuation policies and performance of a private equity fund of funds they manage.
The SEC investigation alleged that Oppenheimer Asset Management and Oppenheimer Alternative Investment Management disseminated misleading quarterly reports and marketing materials, which stated that the Oppenheimer Global Resource Private Equity Fund I L.P.’s holdings of other private equity funds were valued “based on the underlying managers’ estimated values.” The SEC, however, claimed that the portfolio manager of the Oppenheimer fund actually valued the Oppenheimer fund’s largest investment at a significant markup to the underlying fund manager’s estimated value, a change that made the performance of the Oppenheimer fund appear significantly better as measured by its internal rate of return. As part of the Order entered by the SEC, and without admitting or denying the regulator’s allegations, Oppenheimer agreed to pay more than $2.8 million to settle the SEC’s charges and an additional $132,421 to the Massachusetts Attorney General’s office.
In its press release, the SEC reiterated its focus on the valuation process, the use of valuations to calculate fees and communicating such valuations to investors and to potential investors for purposes of raising capital. The SEC’s order also claimed that Oppenheimer Asset Management’s written policies and procedures were not reasonably designed to ensure that valuations provided to prospective and existing investors were presented in a manner consistent with written representations to investors and prospective investors. This claim gave rise to an alleged violation of Rule 206(4)-8 (among other rules and statutes) under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), the rule that the SEC passed after the Goldstein case permitted many funds to de-register as investment advisers from the SEC.
This case illustrates the new regulatory landscape for private equity fund managers. Many private equity fund managers have not dedicated the time and resources to bringing their organizations in line with the fiduciary driven rules under the Advisers Act. Many of these managers have not implemented the compliance policies and procedures required by the Advisers Act, nor have their Chief Compliance Officers been empowered to enforce such compliance policies and procedures when adopted. Much of this oversight goes to the fact that many private equity fund managers do not have a history of being a regulated entity nor have they actively sought out regulatory counsel in their typical business dealings. Private equity fund managers generally use outside counsel to advise them on their transactional or “deal” work and they often do not receive the advice that a regulated firm needs in order to meet its regulatory obligations. Oppenheimer serves notice that failing to meet these regulatory obligations can have dire consequences.
Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program ("NEP") observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers. The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule. The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors. We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds, fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for "privately offered securities" (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities. Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.
On February 21, 2013, the Staff of the Securities and Exchange Commission (the “Staff” and the “SEC,” respectively) published its 2013 priorities for the National Examination Program (“NEP”) in order to provide registrants with the opportunity to bring their organizations into compliance with the areas that are perceived by the Staff to have heightened risk. The NEP examines all regulated entities, such as investment advisers and investment companies, broker dealers, transfer agents and self-regulatory organizations, and exchanges. This article will focus only on the NEP priorities pertaining to the investment advisers and investment companies program (“IA-ICs”)
As a general matter, the Staff is concerned with fraud detection and prevention, corporate governance and enterprise risk management, conflicts of interest, and the use and implications of technology. The 2013 NEP priorities, viewed in tandem with the “Presence Exam” initiative that was announced by the SEC in October 2012, makes it abundantly clear that the Staff will focus on the approximately 2000 investment advisers that are newly registered as a result of the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd Frank”).
Written by: Louis A. Bevilacqua
On January 10, 2013 the Financial Industry Regulatory Authority (“FINRA”) issued a voluntary Interim Form for funding portals (the “Interim Form”). The Interim Form is designed for prospective crowdfunding portals under the Jumpstart our Business Startups Act (the “JOBS Act”), which was enacted on April 5, 2012. Title III of the JOBS Act, which relates to crowdfunding, requires the Securities and Exchange Commission (the “SEC”) and FINRA to promulgate rules before crowdfunding portals can commence operations. The Interim Form permits companies that intend to become funding portals under Title III of the JOBS Act to voluntarily submit to FINRA information regarding their business. FINRA expects that the information received will help it develop rules specific to crowdfunding portals.
As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware of.
See upcoming deadlines below and in red throughout this document.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary is not intended to be a comprehensive review of an Investment Adviser’s securities, tax, partnership, corporate or other annual requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
u List of annual compliance deadlines in chronological order:
State registered advisers pay IARD fee
November-December (of 2012)
Form 13F (for 12/31/12 quarter-end)
February 14, 2013
Form 13H annual filing
February 14, 2013
Schedule 13G annual amendment
February 14, 2013
Registered CTA Form PR (for December 31, 2012 year-end)
February 14, 2013
TIC Form SLT
Every 23rd calendar day of the month following the report as-of date
TIC Form SHCA
March 1, 2013
Affirm CPO exemption
March 1, 2013
Registered Large CPO Form CPO-PQR December 31 quarter-end report
March 1, 2013
Registered Small CPO Form CPO-PQR year-end report
March 31, 2013
Registered Mid-size CPO Form CPO-PQR year-end report
March 31, 2013
Registered CPOs filing Form PF in lieu of Form CPO-PQR December 31 quarter-end report
March 31, 2013
SEC registered advisers and ERAs pay IARD fee
Before submission of Form ADV annual amendment by March 31, 2013
Annual ADV update
March 31, 2013
Delivery of Brochure
April 30, 2013
Form PF Filers pay IARD fee
Before submission of Form PF
Form PF (for advisers required to file within 120 days after December 31, 2012 fiscal year-end)
April 30, 2013
FBAR Form TD F 90-22.1 (for persons meeting the filing threshold in 2012)
June 30, 2013
Form D annual amendment
One year anniversary from last amendment filing
San Francisco Corporate & Securities partner Jay Gould is quoted in Compliance Week on new investor accreditation practices associated with the JOBS Act.
JOBS Act Puts Spotlight on Investor Accreditation Practices
January 23, 2013
When the Jumpstart Our Business Startups Act, known as the JOBS Act, was enacted last year, a key piece was eliminating solicitation and advertising restrictions on hedge funds and private securities offerings.
Jay Gould, a partner with the law firm Pillsbury Winthrop Shaw Pittman, says the renewed focus on investor accreditation follows years of the private fund industry sliding into a mere cursory “check-the-box” approach. While 20-30 years ago, thorough pre-evaluation of clients or targeting only those with pre-existing relationships was the norm, more recent years have seen evaluation standards decline. “When hedge funds really proliferated in the last 15 years or so, a lot of that stuff just didn't get done any more,” he says.
Instead, funds began to rely primarily on the representations in subscription agreements. “You sent out a questionnaire, people answered the questions, and unless the guy was pushing a Safeway cart down skid row there was really no reason to think he or she was not an accredited person or a qualified client.”
The requirement of having a pre-existing substantial relationship with the investor similarly fell by the wayside or became loosely interpreted, all under the blinking eyes of regulators. Brazen fund managers even began to brag openly that “nobody checks this stuff any way” and “nobody really knows if anyone is accredited.”
A few years ago, such talk began to wake up regulators, who then began to once again pay more attention to procedures for verification, Gould says. By the time the JOBS Act was enacted last April it became clear that these laissez faire approaches were coming to an end.
At the time, Gould expected that the Commission would go back to some of these old standards of requiring a balance sheet or income statement, or some kind of independent verification. “But they really didn't do that in the rule,” he says. “They just said it is mushy, so if somebody has a job where it is obvious they make $200,000 a year then you can rely on that, or you can outsource it, or rely on third parties. You just have to come up with something that makes sense for you.”
This has led to considerable debate about whether a principle-based approach is preferable to having hard-and-fast rules. Some contend that issuers want clear-cut rules “so they know how to avoid them,” says Gould.
The NFA recently issued a notice entitled “Guidance on the Annual Affirmation Requirement for those Entities that are currently operating under an exemption or exclusion from CPO or CTA registration.” As of February 2012, each person claiming an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) is required to annually affirm the exemption or exclusion upon which it relies. The annual notice affirming the exemption or exclusion is due within 60 days of the calendar year end. The first notice is due for the calendar year ending December 31, 2012. The required affirmation must be filed electronically on the NFA’s Exemption System. A full version of the NFA notice along with FAQs regarding the annual affirmation requirement is available here.
Written by: Jay Gould
The Securities and Exchange Commission (the “SEC”) recently charged and entered into consent decrees with four India-based brokerage firms for providing brokerage services to U.S. investors without being registered as broker dealers under the U.S. securities laws. This otherwise mildly interesting enforcement action by the SEC should serve as a cautionary tale to hedge fund managers based outside the U.S. that seek to raise capital from U.S. investors, as well as U.S. fund managers that seek to sell their fund shares in foreign countries.
Many non-U.S.-based fund managers seek to raise money from U.S. investors due to the large amounts of available capital in this country and the relative willingness of U.S. investors to consider managers from foreign jurisdictions. However, visiting potential U.S. investors or sending fund marketing materials into the U.S. without complying with the U.S. broker dealer rules could result in a fate similar to that suffered by the four Indian brokerage firms that were sanctioned and fined by the SEC. In order to avoid an enforcement proceeding, non-U.S. fund managers should retain a properly registered U.S. brokerage firm to sell the fund’s securities, enter into a “chaperoning” arrangement with a U.S. broker or register a subsidiary as a broker-dealer in the U.S.
Whether prudent or not, most U.S.-based fund managers rely on Rule 3a4-1, the so-called “issuers exemption,” under the Securities Exchange Act of 1934 (the “1934 Act”) in order to avoid either registering the general partner or an affiliate of the fund as a broker, or retaining an unrelated broker to sell the fund’s interests. But when U.S. fund managers travel outside the U.S. to gauge interest or solicit potential investors, the U.S. rules are not applicable. Each country has its own regulatory scheme, and fund managers are well advised to understand what is permitted and prohibited in each country before visiting each country at the risk of being the subject of a new episode of “Locked Up Abroad.” Indeed, certain countries impose criminal sanctions for offering securities if the offeror is not properly authorized to do so.
The Investment Fund Law Blog boldly predicts that the SEC will one day soon re-visit the industry’s expansive interpretation of the “issuer’s exemption” and the result will not be pleasant for the private funds industry.
So what did these Indian brokerage firms do to incur the wrath of the SEC? The activities that these firms engaged in included:
Many of these activities no doubt sound hauntingly familiar to U.S.-based fund managers that travel abroad for the purpose of raising capital. All four firms were censured and ordered to pay a combined total of more than $1.8 million in disgorgements and prejudgment interest, but no civil penalties were imposed due to the firms’ cooperation with the SEC. The firms have all submitted settlement offers, without admitting or denying any wrongdoing.
The SEC’s press release on the matter can be found here.
Written by: Jay Gould
When can private fund managers start posting performance numbers on their websites and sponsoring the Super Bowl? Not yet, according to Senator Carl Levin (D-MI) in letters dated October 5,2012 and October 12, 2012, (the “Levin Letters”) rebuking the SEC for having missed the point of the legislation in the SEC rulemaking process. As you recall, on August 29, 2012, the SEC proposed rules pursuant to Section 201 of the Jumpstart our Business Startups Act (“JOBS Act”) that, if adopted in final form, would allow private issuers, including private funds, to generally solicit and advertise as long as the investors are all “accredited investors.”
Of most importance to hedge fund and private equity fund managers that have been anticipating a more relaxed and flexible approach of communicating with the public and soliciting new investors, the Levin Letters flatly accuse the SEC of failing to grasp the scope of the JOBS Act in applying it to private investment vehicles. According to Levin, the SEC should “distinguish between issuers that engage in operational businesses and those that are merely investment vehicles.” The October 12 letter further advises the SEC that “[c]ongress did not contemplate removing the general solicitation ban – without retaining any limitations on forms of solicitation – for private investment vehicles. Indeed, no argument was made during the debate of the bill that the objective was to ease the capital aggregation process for private investment vehicles. The words “hedge fund,” “private fund,” or “investment vehicle” were not used either during the committee or floor debate in the House of Representatives. Nor did the Senate engage in any debate relating to removing these advertising and marketing restrictions completely from private investment vehicles.”
According to the Levin staffer who is responsible for this area of the Senator’s legislative initiatives, we should no longer expect that the SEC will adopt the rules as proposed. The SEC must propose new rules that more accurately reflect the intent of Congress and not simply abdicate regulatory authority over the use of general advertising and solicitation by private funds, the Investment Fund Law Blog was told by Levin’s office.
This SEC mulligan may very well put back into play many of the criticisms of the JOBS Act that were expressed in the comment period after the JOBS Act was first signed into law. As you may recall, on May 21, 2012, the Investment Company Institute (the “ICI”) submitted a comment letter to the SEC regarding Section 201 of the JOBS Act in which the ICI encouraged the SEC to, among other things, adopt advertising rules for private funds that are at least as restrictive as those that apply to registered mutual funds, raise the income and net worth standards in the definition of “accredited investor,” and prohibit or limit performance advertising by hedge funds until the SEC has studied the implications of such advertising for 60 years. In a follow up letter to the SEC on August 17, 2012, the ICI, citing press reports and rumors, implored the SEC to not adopt “interim rules” pursuant to Section 201. Rather, the ICI suggested, full notice and comment should be employed in this rulemaking process so that the SEC might fully observe its fundamental mandate to protect investors. It should be noted that the SEC began accepting public comments on all aspects of the JOBS Act shortly after the legislation became law on April 5, 2012. The law itself requires the SEC to adopt rules pursuant to Section 201 within 90 days of the signing of the legislation, a time frame that, quite obviously, was not met.
The Levin Letters further admonished the SEC to establish “methods” for determining whether an investor meets the “accredited investor” standard. The rule proposal provided only that an issuer must take “reasonable steps” to determine accredited status, and provided significant flexibility for issuers to determine the appropriate level of due diligence in order to verify status. The Levin Letters requested that the SEC go back to the drafting table and come up with a new proposal that requires “common sense” documentation and/or verification practices and procedures. If, as Levin’s office suggests, the SEC does re-propose rules as a result of this criticism, it could result in issuers being required to follow definitive verification standards, such as obtaining an income statement, balance sheet, or bank or brokerage statements from investors.
It is possible that the last chapter of the JOBS Act rules regarding general solicitation may not yet be written. In the meantime, private fund managers should continue observing the current ban on general solicitation and advertising and put on hold those plans to post their performance returns on the back of Serena Williams’ tennis togs.
While you were touring the Champagne region or sipping umbrella drinks at the beach this summer, the California Department of Corporations (the “DOC”) was busy overhauling the rules applicable to investment advisers. On August 27, 2012, the DOC adopted final rules, available here, that provide for an exemption from registration for certain private fund managers pursuant to specific conditions. This exemption, along with the rules previously adopted by the Securities and Exchange Commission (the “SEC”), now permits certain investment advisers that provide advice only to private funds to operate without being fully registered with either the SEC or the State of California.
Unlike the SEC rules, this exemption does not prohibit a fund manager from registering with the DOC—it simply allows the fund manager to decide whether it would like to register or rely on the exemption. To rely upon this exemption, a California based adviser must complete and file the Form ADV (required under Rule 204-4 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”)) with the DOC that is required of an adviser that files for “exempt reporting adviser” status with the SEC. But why would any adviser that is eligible to take advantage of the exemption decide to register?
If a fund manager intends only to seek capital from “friends and family,” subjecting itself to the full registration requirements and the more complete compliance rules that are expected soon from the DOC could represent a significant expense to the manager. Or, if a manager is leaving another organization and must quickly get to market, the three to four month process associated with the DOC review of an investment adviser application may be viewed as too long to wait. But if a fund manager expects to target more institutional capital, or other investors that would have a reasonable expectation that the manager is subject to some regulatory oversight, the manager may very well decide that a California investment adviser registration is not so burdensome. After all, a manager that seeks to rely on the exemption must still file the Form ADV, prepare a private placement memorandum, and have the fund audited, among other requirements discussed below. The analysis that each fund manager must undertake in order to make this decision is multi-faceted and is ultimately one that is unique to each adviser and its own circumstance.
To briefly summarize the results of the DOC rulemaking, an investment adviser located in California may conduct its business without being a fully registered and regulated investment adviser under the DOC regulations so long as:
Additionally, with respect to Retail Buyer Funds:
When an adviser that is eligible for the California exemption reaches $100 million in assets, it would become an exempt reporting adviser with the SEC and would need to switch its status over to the SEC. And when it reaches $150 million it must become a fully registered investment adviser with the SEC; accordingly, investment advisers can operate without being fully registered with the SEC or the State of California so long as they have less than $150 million in assets and satisfy the conditions discussed above.
The California exemption contains a “grandfathering” provision for Retail Buyer Funds formed prior to the release of the exemption, as the additional requirements listed above are deemed satisfied if the Retail Buyer Fund: (i) distributes annual audited financial statements; (ii) pre-existing investors receive the “material disclosures” discussed above; (iii) from August 27, 2012 on, the Fund only sells interests to “accredited investors”; and (iv) the adviser receives performance-based compensation only from pre-existing investors or “qualified clients.”
Heath Abshure, President of the North American Securities Administrators Association (NASAA) and Arkansas State Securities Commissioner, sharply criticized the Securities and Exchange Commission’s (the SEC’s) new rulemaking that will lift restrictions on general solicitation and general advertising for hedge funds and other private investment vehicles in a press-teleconference on October 9, 2012. At the heart of the criticism is the contention that hedge funds and private equity funds could be among the amended rule’s biggest users and beneficiaries. “The SEC’s proposed rule would open the door for private equity and hedge funds, typically only offered to the most sophisticated investors, to advertise to the general public without putting in place basic disclosure requirements that would allow investors to make informed decisions about the products being offered. This is the wrong way to go,” remarked Heath Slavkin Corzo, senior legal and policy advisor of the AFL-CIO’s Office of Investment during the teleconference.
Under the Jumpstart Our Business Startups Act (the JOBS Act), as discussed here and here, the SEC was directed to amend Rule 506 of Regulation D under the Securities Act of 1933, as amended, to permit general solicitation and general advertising in unregistered offerings made under Rule 506, provided that all purchasers of the securities are accredited investors. In reaction to the SEC’s answer to the directives of the JOBS Act, Abshure called for the SEC to withdraw its proposal and draft a new rule that promotes capital formation without sacrificing investor protection.
“People don’t seem to think so, but this is a drastic change to the face of securities regulation,” Abshure said. “Rule 506 offerings already are the most frequent financial product at the heart of state enforcement investigations and actions. Lifting the advertising ban on these highly risky, illiquid offerings, without requiring appropriate safeguards, will create chaos in the market and expose investors to an even greater risk of fraud and abuse. Without adequate investor protections to safeguard the integrity of the private placement marketplace, investors should and will flee from the market, leaving small businesses without an important source of capital.”
“The Commission itself has acknowledged that lifting the ban on general solicitation in private offerings will increase the risk of fraud, potentially harming investors and issuers alike,” added Barbara Roper, Director of Investor Protection for the Consumer Federation of America and the chair of the Investor Issues task force of Americans for Financial Reform during the teleconference. “While the Commission is required by the JOBS Act to lift the solicitation ban, it also has an obligation to adopt rules that protect investors and promote market integrity and the authority to do so. A number of reasonable, concrete proposals have been suggested that, if adopted, would significantly improve safeguards for investors in private offerings. Its rule proposal completely ignores those suggestions. It cannot in good conscience continue to do so.”
The full press release about the teleconference is available here.
Effective December 3, 2012, hedge funds and other private funds that rely on Section 3(c)(1) of the Investment Company Act (“3(c)(1) Funds”) and which sell their interests through third party marketers, must ensure that their private placement memoranda (“PPM”) are filed with FINRA, the Financial Industry Regulatory Authority. The Securities and Exchange Commission recently approved new FINRA Rule 5123, Private Placements of Securities, which is part of an ongoing approach by FINRA to enhance oversight and investor protection in private placements. Under Rule 5123, each firm that sells a security in a private placement, subject to certain exemptions, must file a copy of the offering document with FINRA within 15 calendar days of the date of the first sale. If a firm sells a private placement without using any offering documents, then the firm must indicate that it did not use an offering document. The rule also requires firms to file any materially amended versions of the documents originally filed. Rule 5123 exempts some private placements sold solely to qualified purchasers, institutional purchasers and other sophisticated investors.
For hedge funds and other private funds that have hired a third party marketer, the fund manager must make sure that the agreement with the marketer, which is required to be a registered broker dealer, obligates the marketer to file the PPM with FINRA and amend the filing if the PPM is materially revised. The marketing agreement, or “placement agency agreement” as it is sometimes called, should indemnify the fund manager for the failure of the marketer to make these filings.
Rule 5123 will become effective December 3, 2012, and the full text of the FINRA regulatory notice regarding Rule 5123 is available here.
On August 30, 2012, Ildi Duckor and Michael Wu, members of Pillsbury’s Investment Funds and Investment Management practice, met with executives and staff of the California Department of Corporations at the Department’s invitation. The purpose of the meeting was to provide the Department’s investment adviser and broker dealer divisions (live in San Francisco and via teleconference in the Sacramento and Los Angeles offices) with a broad overview of the hedge fund industry. “We hope that a better understanding of the industry will help balance hedge fund managers’ business needs with the regulators’ need for investor and market protection, and will streamline both the adviser registration and the examination process” said Ildi Duckor. The Investment Funds and Investment Management team will continue to cooperate with the Department in an effort to provide industry insight with respect to future California regulation of hedge funds and their advisers.
This guest post from the Margolis Advisory Group, co-authored by River Communications, is reprinted with permission. The Executive Summary appears below and the full text is available here.
The JOBS Act is bringing change to the hedge fund industry, and, most likely, this change will accelerate the trend towards institutionalization. The lifting of the “advertising ban” opens the playbook, allowing hedge funds to engage in a wide range of strategic communications and marketing activities. For some, this will offer a new opportunity to compete for assets with traditional managers adept at managing their brands and marketplace perceptions. Others will resist, possibly to their detriment, as funds will no longer have the luxury of hiding “under the radar.”
Hedge funds who embrace the new, less restrictive environment will need to build mature, comprehensive strategic communications programs. The best practices include:
Hedge funds have thrived by embracing and even becoming catalysts for change. In this hyper-competitive industry, it is commonplace to expend disproportionate resources to capture even a minimal investment performance advantage. Because of this, it is surprising that there has not been more enthusiastic support in the trades for what is potentially the next major shift for the industry: the Jumpstart Our Business Startups Act or JOBS Act.
Passed with little fanfare, the JOBS Act lifts the ban on advertising for hedge funds (among other provisions) and has the potential to transform how managers market their firms, build their brands and communicate with their investors. Yet, much of the discussion in the trades and on the hedge fund industry speaking circuit has downplayed the potential impact of this provision as being only meaningful to the smaller funds. Large funds—as the typical explanation goes—believe they do not need to proactively market, as they commonly market off their mystique of exclusivity and will prefer to remain “under the radar” to protect their proprietary investment strategies. Furthermore, the larger funds are already staffed for one-on-one sales, and many in the hedge fund industry are under the false impression that sales are only based on individual contacts or “having the Rolodex.”
The fact is, change is coming to the hedge fund industry, and many managers will continue to adapt to the ongoing evolution as they always have. Most likely, this change will accelerate the trend towards resembling traditional managers—for hedge funds can now adopt advertising and marketing techniques, as well.
Consider the trends we have observed in the hedge fund and institutional asset management space, especially since the market declines of ’07-’08. New regulations have increased the demand for information on leverage and counterparty risk; the migration from single to multi-prime brokers has occurred, and institutional investors are demanding more transparency in investment operations, risk and administration. Perhaps, most significantly—the largest institutional investors have been allocating funds almost exclusively to the largest hedge funds.
According to “The Evolution of the Industry: 2012,” an annual KPMG/AIMA hedge fund survey, institutional investors now represent a clear majority of all assets under management by the global hedge fund industry, with 57 percent of the industry’s AUM residing in this category. And, the proportion of hedge fund industry assets originating from institutional investors has grown significantly since the financial crisis.
As a result, we are seeing a continuation of the institutionalization of hedge funds. The KPMG study confirmed this with survey data indicating that investors demand hedge funds look and act more like traditional institutional managers from an operational standpoint. In addition, 82 percent of respondents reported an increase in demand for transparency from investors, while 88 percent said investors are demanding greater due diligence.
Our own experience consulting with hedge funds and traditional managers has confirmed other indications of this trend, as well as with all investors—large and small—demanding greater operational efficiency; cost reduction; and models that enhance overall risk management, such as the move from single to multi-prime relationships; all delivered in an open and transparent way.
For hedge fund managers to attract large pools of money, they will increasingly need to be more institutional and transparent with all investors. This is a significant cultural shift for these firms. Not only do many hedge funds lack a strategic communications infrastructure, but the concept of such openness still runs contrary to the DNA of most firms.
The question then becomes: how should hedge funds that embrace a more open and inclusive communications strategy implement programs that will help them achieve this goal? The answer is they will need to develop an approach to communications that is similar to traditional institutional asset managers.
Written by: Jay Gould
On August 30, 2012, the Securities and Exchange Commission (the “SEC”) released the Dodd Frank Act’s mandated study (the “Study”) on the financial literacy of retail investors which concludes, as you might have predicted, that retail investors are essentially clueless about investing and financial matters generally. That slapping sound you heard was the high-fiving by stockbrokers everywhere across America. Among the selected findings were that retail investors lack “basic financial literacy” and that such investors have a weak grasp of elementary financial concepts and lack critical knowledge of ways to avoid investment fraud. It should come as no surprise that certain subgroups, such as women, African-Americans, Hispanics, the elderly, and the poorly educated have even less basic financial knowledge than the general population.
Without water boarding you with the details of this 182 page report, the SEC obtained the information necessary to reach these conclusions by conducting focus groups and quizzing investors through an online survey. These methods revealed that investors can’t identify basic financial products, can’t calculate fees, do not understand conflicts of interest, and, if that were not enough, can’t read an account statement. The Study concludes with a strategy and set of goals for increasing financial literacy among this retail class. The goals should be to improve investors’ understanding of risk, the fees and cost associated with investing, proactive steps for avoiding fraud and increasing general financial knowledge. These laudable goals are to be achieved, quite magically, by devising education programs that target specific groups that are deemed vulnerable, such as young investors, lump sum payout recipients, investment trustees, members of the military (if you ever want to know how much we value our military personnel, look into periodic payment plans), underserved populations, and older investors.
Certain members of the financial industry have agreed to work together on an “ask and check” campaign that would encourage individuals to check the background of investment professionals before using them, and to encourage investors to verify that a potential investment is legitimate before investing. Financial regulators have agreed that more information should be added to the investor protection section of the SEC’s website and that a general campaign should be embarked upon that will help individuals understand the fees and costs associated with financial products.
But why are the findings and conclusions of the Study important now? Well, a couple of reasons come to mind, one of an immediate concern, the other longer term in nature. First, you may have read that the SEC recently released for public comment the rules that will lift the ban on “general solicitation” for otherwise private offerings. These rules, if adopted in their proposed form, would permit private issuers, including private funds, to solicit investors generally through all forms of public media, including newspapers, the internet and mass mailings. Issuers will be required to take reasonable steps to determine that all investors meet sophistication and accreditation standards before accepting an investment, but make no mistake, these rules are the most significant changes to the securities offering process since the Securities Act of 1933 was signed into law. Many state securities regulators are predicting an avalanche of new frauds aimed squarely at those categories of vulnerable investors that the Study identified.
In a world where modern means of communication have forever blurred the lines between information that is privately distributed and that which is in the public domain, it makes little sense to cling to the old concepts of private offerings to investors with whom one has “pre-existing, substantial relationships,” and we have actively supported the lifting of the ban. However, with increased rights come increased responsibilities. It will be the responsibility of all of those in the private funds business to remain vigilant against potential frauds and scams, to adopt “best practices” on behalf of ourselves and our clients, and to work more closely with regulators in order to protect not just investors, but the viability of our industry itself. We hope that fund managers and those who serve them will take these obligations seriously with a longer term view.
As for the longer term, this November the U.S. will elect or re-elect a President. One of the most significant issues in this campaign will be around entitlement reform. That is, what to do about the long term health of Medicare, Medicaid and, for purposes of this discussion, Social Security. In his second term, Bush II attempted to privatize Social Security to some degree. This proposal generally envisioned allocating a third or a half of a retiree’s account into a “personal plan” over which the retiree would have investment discretion. Rather than a guaranteed payout from Social Security after choosing a retirement age, each retiree, most of which have the level of sophistication discussed in the Study, would be responsible for making his or her own investment decisions. It is fairly easy to figure out who might be in favor of putting millions of unsophisticated, financially illiterate people in charge of the assets that would otherwise be paid out by Social Security on a monthly basis. Whether and how the results of the Study are used in the debate on Social Security reform should be, at a minimum, very interesting to watch.
August 6, 2012
Hedge Fund Marketing Implications From New Survey
Findings On Investment Beliefs
by Bruce Frumerman, Frumerman & Nemeth Inc.
The recently published Pensions & Investments/Oxford University survey on long-term investment beliefs has implications for how hedge fund firms market their strategies and get buy-in from institutional investors.
Relevant findings for hedge fund firm owners
In offering conclusions from their survey results Gordon L. Clark, professor at Oxford University’s Centre for the Environment, who led the survey, offered the key observation that managers will increasingly be differentiated by “their strong belief systems and a rigorous investment process that matches those beliefs.” P&I reported that he went on to comment that “It’s terribly important for managers” to base investment decisions on a clear set of investment beliefs. “The whole logic of their business is premised on being able to articulate beliefs, testing beliefs and being able to revise beliefs in a very uncertain world.”
P&I also reported the comments of Rob Bauer, professor of finance and chair of the institutional investments division at Maastricht University, that more investment managers “now focus on the structure of their investment beliefs, how the beliefs translate into the design of the investment framework and how that framework is executed. The more sophisticated investment managers are really trying to have a coherent structure.”
What it means for hedge fund marketing
Marketing hedge funds has become more competitive.
Successful capital raising has always required having more than just performance that is within the ballpark of acceptance. Having institutional caliber operations and administration went from being a marketing differentiator to simply an expected cost of doing business. Along the way, from pre-crash to post-crash, the term transparency, and the call for it, changed in meaning. What began as calls for data — reveal the portfolio holdings and provide third-party reporting — morphed into a call for providing more explanation about the investment process and decision-making behind a firm’s strategy.
Institutional investors and their investment consultants have become more demanding for greater information detail about how hedge fund managers think and how they construct and manage their portfolios.
Is your firm communicating an institutional caliber explanation about its investment beliefs and the process behind its strategy? A few bullet points in a flip chart are not sufficient for accomplishing this. You cannot just claim you have a rigorous investment process and leave it at that. You have to prove it with a detailed explanation of this important subjective information that your hedge fund has to persuade people to understand and buy into: how it invests.
Reexamine your own communications. Are you truly differentiating your firm from the competition or are your marketing collateral, in-person presentations and responses to essay questions in RFPs and DDQs actually having you come across as a me-too copycat strategy-wise, offering no perceivable added value?
Have you given prospective investors easy access to a full, written explanation about your firm’s investment beliefs and investment process? Your hedge fund has a communications marketing risk management challenge. One of the important selling missions you have is to reduce the odds that a prospect will mess up retelling the subjective-based part of your firm’s story to others on the investment committee. Supplying them with the written long version story of investment beliefs and investment process will increase your control in how your prospect remembers and retells your story to other decision makers.
A flip chart pitchbook is not the right tool for this communications job. An additional marketing document that delivers this vital story in sentence and paragraph form about how your firm thinks is required. Such content is more suited to brochure format marketing collateral than to bullet point flip charts. If such a marketing tool is not already in your selling arsenal for making selecting your offering a more defensible decision in the minds of your prospects, creating this type of document should be at the top of your communications marketing To Do list.
The job of crafting the story of a hedge fund’s investment belief system and its investment process isn’t an assignment a portfolio manager can pass off to others to create with little or no participation from him. Too often, important parts of a hedge fund’s investment process story have never been fully communicated to people outside the firm. Also, many hedge fund firms find themselves unable to tell their investment beliefs and process story the same way twice. So, the portfolio manager’s participation with his communications marketing experts in locking down his firm’s storyline is vital.
Differentiate your hedge fund based on your investment beliefs and a demonstrable, rigorous investment process that matches those beliefs and you will improve your firm’s ability to out-market competitors and convert prospects to clients.
# # #
Bruce Frumerman is CEO of Frumerman & Nemeth Inc., a communications and sales marketing consultancy that helps financial services firms create brand identities for their organizations and develop and implement effective new marketing strategies and programs. His firm’s work has helped money management clients attract over $7 billion in new assets, yet Frumerman & Nemeth is not a Third Party Marketing firm. Bruce has over 30 years of experience in helping money managers to develop buyer-focused positioning strategies to differentiate them from their competitors; create more cogent and compelling sales presentations and marketing materials to better tell their story; and use media relations marketing and industry conference speaking opportunities to help establish a branded identity for their organization by generating third-party endorsement for the expertise of their people, the value of their services and the quality of their products. He has authored many articles on the topic of marketing money management services and is a frequent speaker on the subject at industry conferences. He can be reached at firstname.lastname@example.org, or by visiting www.frumerman.com.
© Frumerman & Nemeth Inc. 2012
In a July 10, 2012, no-action letter, available here, issued by a Division of the U.S. Commodity Futures Trading Commission (the “CFTC”) in response to requested relief from certain new CFTC registration obligations, the CFTC granted temporary relief to commodity pool operators (“CPOs”) and commodity trading advisors (“CTAs”). As previously discussed on this blog, earlier this year the CFTC rescinded an exemption under CFTC Rule 4.13(a)(4) used by many CPOs and CTAs. This rescission went into effect on April 24, 2012 and denied the use of the exemption under Rule 4.13(a)(4) to any CPOs and CTAs of new pools on or after that date, although CPOs and CTAs already availing themselves of the exemption were able to continue its use until the end of the year.
The no-action letter offers relief to CPOs and CTAs of new pools, recommending that the CFTC not take enforcement action against CPOs or CTAs for new pool launched after the issuance of the no-action letter for failure to register as such until December 31, 2012, as outlined below.
No-action relief will be granted for each pool for which the CPO submits a claim to take advantage of the no-action relief and remains in compliance with the following:
No-action relief will be granted when the CTA submits a claim to take advantage of the relief and remains in compliance with the following:
CPOs and CTAs should note that the no-action relief granted is not self-executing and must be affirmatively sought, and any relief sought and/or granted will expire at the end of the year and such CPOs and CTAs must remain in compliance with registration obligations going forward.
 The No-Action letter was issued by the Division of Swap Dealer and Intermediary Oversight of the U.S. Commodity Futures Trading Commission to the Managed Funds Association, the Investment Adviser Association, the Alternative Investment Management Association, Ltd., and the Investment Company Institute, collectively.
Written by: Jay B. Gould
The recently enacted JOBS Act requires the Securities and Exchange Commission (“SEC”) to promulgate rules that would effectively repeal the ban on general solicitation and general advertising under Rule 506 of Regulation D by private issuers, including private funds. Pursuant to the JOBS Act, the SEC has 90 days from the date of enactment (July 4, 2012) to adopt rules implementing this provision. In advance of publishing proposed rules, the SEC has started accepting comment letters on all aspects of the JOBS Act, including the repeal of the ban on general advertising.
Unsurprisingly, the Investment Company Institute (“ICI”), the lobby organization for mutual funds and other registered funds, has submitted a comment letter requesting that the SEC take a slow and deliberate approach to permitting private funds to generally advertise and solicit investors. How slow and deliberate? The ICI suggests that performance advertising by hedge funds should be prohibited altogether until the SEC has had the opportunity to study hedge fund advertising, “gain experience with private fund advertisements,” and craft a rule similar to Rule 482 to which mutual fund advertising is subject. The ICI tells us that Rule 482 is the culmination of 60 years of experience and that the SEC “should follow the same path here,” referring to advertising by hedge funds and other private funds. 60 years? Really?
The ICI has a long and storied history of blocking financial innovation and expansion of investment opportunities for the investing public. You may recall that the ICI sued the Office of the Comptroller of the Currency in an attempt to block banks from acting as investment advisers to mutual funds, a case that they ultimately lost at the Supreme Court. It is hardly surprising then that the mutual fund lobby would line up against competition by the private funds industry, even at a time when the registered funds and private funds businesses are converging at a rapid pace in terms of product offerings, investment strategies, and regulatory oversight and reporting. Last August the SEC issued a “concept release” that requested comment on whether registered funds should be able to use the same sorts of investment techniques and to the same extent as private funds, such as hedging, shorting, and use of leverage. Further action in this regard, coupled with the new reporting obligations of private funds as a result of Dodd Frank (e.g., Form PF) will serve to further blur the lines between registered and unregistered funds.
In addition to “urging” a ban on performance advertising and promoting the idea of other “content restrictions” by hedge funds and other private funds, the ICI suggests that private fund advertising should be subject to FINRA review to the same extent as mutual fund advertising, and that private fund advertising be clearly distinguished from mutual fund advertising. The ICI further suggests that the SEC should raise the net worth threshold for “accredited investors” in order to insure that private fund investors have the requisite sophistication to withstand the riskiness associated with private funds (See legalaffairs March–April 2004 issue). The ICI endorses a $600,000 annual income and $3 million net worth standard, a measure that would further reduce the potential private fund investor pool and drive more investors to the registered world.
More balanced voices have also started to comment on this issue, so it remains to be seen how much weight the SEC will ultimately attribute to the ICI comment letter. You may view all of the comment letters regarding the repeal of the ban on general solicitations here. And you are encouraged to submit your own.
 The Jumpstart Our Business Startups Act.
Note: Pillsbury and KPMG, along with the California Hedge Fund Association, will be sponsoring a “Managers Only” event on the JOBS Act and the new world of “general solicitation” for Funds on June 14.
The Jumpstart Our Business Startups Act (the “JOBS Act” or the “Act”), signed into law by President Obama on April 5, 2012, seeks to encourage economic growth through the easing of certain restrictions on capital formation and by improving access to capital. The JOBS Act contains a number of provisions that will directly impact private funds and their general partners, managers and sponsors. Below is a summary of the Act’s provisions that directly affect private funds, including ongoing requirements for funds that at this time do not appear to be affected by the Act.
The Form PF (PF is short for “private funds”) is a new Securities and Exchange Commission reporting form for investment advisers to private funds that have at least $150 million in private fund assets under management. Comprising 42 pages and divided into 4 sections with corresponding subsections, Form PF may appear daunting at first. The task of completing and filing the Form also entails categorizations, specific and nuanced reporting requirements and Form-specific calculations, not to mention the fact that improperly completed Forms may be delayed or even rejected. However, with the proper tools and plan of attack, an adviser will be able to fulfill its reporting requirements and improve its data platform for a host of other reporting and filing requirements. Form PF necessitates working with large amounts of data. So, early planning, coordination and organization are essential for success. In a guest article, Jay Gould, a Partner at Pillsbury Winthrop Shaw Pittman LLP and leader of Pillsbury’s Investment Funds & Investment Management practice team, and Kelli Brown, Director of Private Funds at Data Agent, LLC, describe ten steps that a hedge fund manager should take for successful Form PF completion and filing. The article can be accessed on the Hedge Fund Law Report’s website (www.hflawreport.com – subscription required).
Please contact Jay Gould if you have any further questions or seek further information about Form PF.
On April 18, 2012, the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”) voted to adopt rules defining “swap dealer,” “security-based swap dealer,” “major swap participant,” and “major security-based swap participant,” among other terms, as mandated by the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank Act”). The Dodd-Frank Act assigns to the SEC the regulatory authority for security-based swaps and assigns to the CFTC the regulatory authority for swaps.
Under the adopted rules, the definitions are as follows:
A swap dealer is defined as any person who:
The definition of security-based swap dealer tracks the definition of swap dealer, with “security-based swap” inserted where “swap” appears.
A major swap participant is a person that satisfies any one of the three parts of the definition:
The definition of major security-based swap participant tracks the definition of major swap participant with “security based-swap” inserted where “swap” appears.
The newly adopted rules contain further definitions for the terms “substantial position,” “hedging or mitigating commercial risk,” “substantial counterparty exposure,” “financial entity,” “highly leveraged,” and “eligible contract participant.” In addition, the adopting release provides interpretative guidance on the definitions of swap dealer and security-based swap dealer, and the CFTC provides further details on the exclusion for swaps in connection with originating a loan, the exclusion of certain hedging swaps and the exclusion of swaps between affiliates. Finally, the new rules call for a de minimis exemption from the definition of swap dealer and security-based swap dealer wherein a person who engages in a de minimis amount of swap or security-based swap dealing will be exempt from the respective definition.
The SEC and the CFTC adopted the new rules under joint rulemaking, and the SEC rules become effective 60 days after the date of publication in the Federal Register, although dealers and major participants will not have to register with the SEC until the dates that will be provided in the SEC’s final rules for the registration of dealers and major participants. The CFTC must adopt further rules defining the term “swap,” and swap dealers and major swap participants will need to register by the later of July 16, 2012, or 60 days after the publication of CFTC rules defining “swap.”
 Security-based swaps are broadly defined as swaps based on (i) a single security, (ii) a loan, (iii) a narrow-based group or index of securities, or (iv) events relating to a single issuer or issuers of securities in a narrow-based security index.
On April 5, 2012, the Jumpstart Our Business Startups Act (the “JOBS Act” or the “Act”) was signed into law, creating a new regulatory on-ramp for emerging growth companies going public. The JOBS Act also includes provisions that require the Securities and Exchange Commission (the “SEC”) to undertake various initiatives, including rulemaking and studies touching on capital formation, disclosure and registration requirements. Title II of the Act affects offerings by issuers pursuant to Regulation D under the Securities Act of 1933, as amended (the “Securities Act”), as well as resales under Rule 144A of the Securities Act. In particular, the Act directs the SEC to amend its rules to:
For Private Funds, Regulation D as we know it is still in effect for the next 90 days as the JOBS Act directs the SEC to make the relevant rule changes to Rule 506 and Rule 144A within 90 days, but it does not modify the current text of those rules. In addition, Funds should continue to follow applicable terms of SEC interpretative guidance. Senior members of the SEC staff participated in discussion of the JOBS Act yesterday that provided further guidance on this subject, and the SEC is still currently seeking public comments on SEC regulatory initiatives under the JOBS Act.
Pillsbury and KPMG, along with the California Hedge Fund Association, will be sponsoring a program on the JOBS Act and the new world of “general solicitation” for Funds in June.
By: Louis A. Bevilacqua, Joseph R. Tiano, Jr., David S. Baxter, Ali Panjwani and K. Brian Joe
On April 5, 2012, President Obama signed into law the Jumpstart Our Business Startups Act (JOBS Act), a bill with widespread bipartisan support and assembled from a combination of legislative initiatives introduced throughout 2011 targeting smaller companies and focusing on cheaper capital raising and job creation. We discuss the key provisions of the JOBS Act and their impact on these companies and securities offerings.
The Jumpstart Our Business Startups Act (JOBS Act) is a consolidation of several bills introduced throughout 20111 with the goal of making it easier for smaller companies to raise money and lessen their regulatory burden while doing so. The House of Representatives passed the JOBS Act on March 8 by a vote of 390-23, and the Senate passed the same bill, with one amendment, on March 22 by a vote of 73-26. The Senate amendment offered a more restrictive take on the House bill’s provisions dealing with the increasingly popular grass-roots financing method known as crowdfunding. On reconsideration of the bill with the Senate amendment, the JOBS Act passed the House by a vote of 380-41 on March 27, and President Obama signed it into law on April 5. The JOBS Act is one of the most comprehensive pieces of legislation in recent years to be specifically targeted at developing companies. This Alert summarizes the most important provisions of the JOBS Act and the implications of those provisions.
The Commodity Futures Trading Commission (the “CFTC”) recently amended its registration rules regarding Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”), which will require many general partners and managers of private investment funds that previously relied on an exemption from registration to now register with the CFTC. After a public comment period in which the industry overwhelmingly supported the continuation of these exemptions, the CFTC decided to rescind the CPO exemption under CFTC Rule 4.13(a)(4) and amend the CPO exemption under CFTC Rule 4.13(a)(3). Rule 4.13(a)(4) previously exempted private pools from registering as a CPO with the CFTC for funds offered only to institutional qualified eligible purchasers (“QEPs”) and natural persons who meet QEP requirements that hold more than a de minimis amount of commodity interests.
The CFTC's amendment did not change the application of CFTC Rule 4.13(a)(3) to a fund of a hedge fund (“Fund of Funds”). However, due to the repeal of these exemptions, many of the general partners or managers of a Fund of Funds’ underlying funds may be required to register as CPOs, thereby requiring registration of the Fund of Funds manager. The CFTC has provided guidance with respect to when a Fund of Funds manager may continue to rely upon an exemption from registration as a CPO. We have summarized these circumstances below:
The CFTC amended Section 4.13(a)(3) to address how to calculate the notional value of swaps and how to net swaps. In addition, the CFTC will now require a CPO relying on Section 4.13(a)(3) to submit an annual notice to the National Futures Association affirming its ability to continue relying on the exemption. If a CPO cannot affirm its ability to do so, the CPO will be required to withdraw the exemption and, if necessary, apply for registration as such.
For additional information on whether these rule amendments will require you to register as a CPO or CTA, or whether the CFTC guidance or another exemption might provide a further exemption from registration, please contact your Pillsbury Investment Funds Attorney.
 CFTC Rule 4.13(a)(3) requires that at all times either: (a) the aggregate initial margin and premiums required to establish commodity interest positions does not exceed five percent of the liquidation value of the Fund’s investment portfolio; or (b) the aggregate net notional value of the Fund’s commodity interest positions does not exceed one-hundred percent of the liquidation value of the Fund’s investment portfolio.
In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers. The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.
As the new year is upon us, there are some important annual compliance obligations Investment Advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) should be aware.
First, we wanted to address three situations where Investment Advisers may need to make changes with regard to their registration. These are:
(1) SEC-registered Investment Adviser switching to State registration. SEC-registered Investment Advisers are required to withdraw registration if they have less than $90 million in Assets under Management (“AUM”). Those Investment Advisers have a June 28, 2012 deadline for state approval. These advisers should submit a state Form ADV to the relevant state by March 20, 2012 to allow at least 90 days for state approval (California in particular).
(2) State-registered Investment Adviser switching to SEC registration. A state-registered Investment Adviser whose AUM as of December 31, 2011 was $110 million or more must register with the SEC by March 30, 2012. Going forward, state-registered Investment Advisers must apply for registration with the SEC within 90 days of becoming eligible for SEC registration and not relying on an exemption from registration. The threshold for registration with the SEC is $100 million or more in AUM, but you may stay registered with the state up to $110 million in AUM.
(3) Currently exempt Investment Adviser registering with the SEC. An Investment Adviser previously exempt from registration that is now registering with the SEC must do so by the March 30, 2012 deadline. The Form ADV should have been filed with the SEC by February 14, 2012.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary section begins with what we feel are “hot” areas of compliance for 2012, and then addresses continuing compliance and other regulatory issues. The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other year-end requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
Last week’s article on HFMWeek entitled “Disclosure Gets Closer” discussed registration requirements of investment advisers to hedge funds under the Dodd-Frank Act. The article, which was written by Will Wainewright, quoted Jay Gould, a partner and member of our Investment Fund and Investment Management team, who said “[T]he most difficult part of SEC registration – not an onerous process in itself – is implementing, testing, internally enforcing and updating the compliance procedures that the SEC will be checking on once you are registered.”
A full text of the article is available here.
1. What is the Form PF?
The Form PF (PF is short for “private funds”) is a new form that focuses mainly on private fund reporting with regard to information such as counterparty dealings, leverage, and investment exposure. A “private fund” under the Form PF refers to any issuer that would be an investment company under the Investment Company Act of 1940, as amended, if not for the exemptions provided by Sections 3(c)1 or 3(c)7 of that Act. Under some circumstances, non-“private funds” such as money market funds registered with the SEC may be required to report on the Form, in addition to “private funds.”
2. Do investment advisers need to file the Form PF?
Yes, in certain circumstances. Only investment advisers registered with the SEC that meet a $150 million threshold must report on the Form PF. The $150 million threshold refers to a specific and somewhat complicated calculation with regard to regulatory assets under management.
3. What are the categories of filers?
Advisers required to file the Form PF need to determine which category of filer corresponds to them. Large private fund advisers are categorized as either large hedge fund advisers, large liquidity fund advisers, or large private equity fund advisers. Large hedge fund advisers are those having at least $1.5 billion in regulatory assets under management attributable to hedge funds, subject to other conditions. Large liquidity fund advisers are those having at least $1 billion in regulatory assets under management attributable to “liquidity funds” and money market funds registered with the SEC, subject to other conditions. Large private equity fund advisers are those having at least $2 billion in regulatory assets under management attributable to private equity funds, subject to other conditions. All other filers are categorized as smaller private fund advisers.
4. What are the reporting deadlines?
Initial compliance under the Form PF will be in phases. The first required filers will be large private fund advisers with at least $5 billion attributable to hedge funds, to liquidity funds, or to private equity funds. These large hedge fund advisers will have 60 days, and large liquidity fund advisers will have 15 days, after the end of the first fiscal quarter ending on or after June 15, 2012, to file their first Form PF.
Other filers will have to make their first filing by the deadline following the end of the first fiscal quarter for each adviser, as applicable, on or after December 15, 2012. Under the initial compliance, many advisers will not need to file their first Form PF until 2013.
Going forward, the Form PF must be filed:
5. What constitutes the Form PF?
The Form PF, in its entirety, contains sixty pages, and is divided into four sections with corresponding subsections. Most advisers will not have to complete all four sections. The four sections feature reporting on, among other things: identifying information about the adviser; fund-by-fund reporting by all advisers about items such as fund identification, performance and valuation; fund-by-fund reporting by hedge fund advisers about items such as strategies, counterparties, and trading practices; aggregated private fund reporting for large hedge fund advisers; fund-by-fund reporting by large hedge fund advisers about items such as asset classes, portfolio liquidity, and risk metrics; fund-by-fund reporting for large liquidity fund advisers; and, fund-by-fund reporting for large private equity fund advisers.
6. What about the confidentiality of information reported?
Because of the nature of governmental sharing of the data provided on the Form PF, advisers should consider the options available to them with regard to preserving confidentiality. Consequently, advisers should consider changing their overall recordkeeping practices so that they routinely identify funds solely by numerical or alphabetical designations.
7. How is the Form PF filed?
The Form PF will be filed using the same IARD system on which advisers make the Form ADV filing.
Written by guest contributor, Bruce Frumerman, Frumerman & Nemeth Inc.
This article first appeared in FINAlternatives on January 30, 2012 and is re-printed with permission below.
It’s one thing when people who are not part of the hedge fund investor universe say hedge funds are money management firms that reveal too little about themselves. It’s another thing entirely when those folks investing in hedge funds are complaining about this.
In January SEI released part one of its results from its fifth annual survey of institutional hedge fund investors, conducted in collaboration with Greenwich Associates, The Shifting Hedge Fund Landscape. Three of the recommendations the report offers hedge fund firm owners give a glimpse into where surveyed investors are asking hedge funds to “provide more windows into investment processes and decision-making,” as SEI put it.
In re-proposed custody rules, the California Department of Corporations (“DOC”) has reflected the most important aspects of the comment letter that Pillsbury provided on July 27, 2011, such that all transactions and short positions need not be disclosed in the quarterly account statements. In general, the re-proposed custody rules define “custody,” and subject to certain limited exceptions, require that advisers with custody maintain the assets with a qualified custodian. The re-proposed custody rules also specify details with regard to audits and require compliance by advisers with specific safeguards.
The DOC also released proposed regulations that contain a successor to the private fund exemption, which are currently in the comment period. Under the DOC’s proposed private adviser exemption, advisers would be eligible provided they: (i) have not violated securities laws; (ii) file periodic reports with the DOC; (iii) pay the existing investment adviser registration and renewal fees; and (iv) comply with additional safeguards when advising 3(c)(1) funds. Additionally, under the proposed regulations, the exemption defines a private fund adviser as an investment adviser that provides advice only to qualifying private funds, which include 3(c)(1) and 3(c)(7) funds. A grandfathering provision for private advisers is also included.
The Massachusetts Securities Division released amendments similar to the DOC’s on January 18, 2012. These amendments contain regulations that relate to the private fund exemption and custody requirements, among others. The amendments, released after consideration of industry comments, make substantive changes to the definition of “institutional buyer,” re-propose a broadened private fund exemption that includes the introduction of a grandfathering provision, and propose requirements for advisers with discretion over, or custody of, client funds.
The purpose of the Massachusetts amendments is to coordinate with the new rule adopted by the Securities and Exchange Commission under the Dodd-Frank Act. Also included in the amendments is an exemption from state registration for advisers that provide advice solely to private funds that qualify as 3(c)(1) or 3(c)(7) funds.
The Commodity Futures Trading Commission (CFTC) released a Final Rule on January 11, 2012, on the Registration of Swaps Dealers (SDs) and Major Swap Participants (MSPs). The Final Rule establishes the process for the registration of SDs and MSPs and now requires SDs and MSPs to become and remain members of a registered futures association. Included in the CFTC rulemaking is a definition of an “associated person” of an SD or MSP and an implementation of a prohibition on an SD or MSP permitting an associated person who is statutorily disqualified from registration from effecting or being involved in effecting swaps of behalf of the SD or MSP.
In a companion Notice and Order by the CFTC on the same day, the National Futures Association (NFA) was authorized to perform registration functions under the new rulemaking. Specifically, the NFA is authorized to perform the following registration functions:
The Final Rule and the Notice and Order released on January 11, 2012, are just a portion of a comprehensive new regulatory framework for swaps and security-based swaps under the Dodd-Frank Act. The goal of the legislation is to reduce risk, increase transparency, and promote market integrity within the financial system.
The Dodd-Frank Act further directs the CFTC, under Section 4s of the Commodity Exchange Act, to provide for the regulation of SDs and MSPs with respect to, among others, the following areas: capital and margin, reporting and recordkeeping, daily trading records, business conduct standards, documentation standards, duties, designation of chief compliance officer, and, with respect to uncleared swaps, segregation.
Pillsbury will continue to monitor the CFTC’s rulemaking and will provide further information as it becomes available.
Managed Funds Association (“MFA”) submitted a comment letter (the “Letter”) to the Securities and Exchange Commission (“SEC”) on January 6, 2012 with a rulemaking petition requesting the SEC to amend Rule 502(c) of Regulation D under the Securities Act of 1933. The Letter urges the SEC to exempt private funds from the ban on general solicitation and advertising under Regulation D.
Under the existing framework, hedge funds generally must avoid engaging in any “general solicitation” or “general advertising” in connection with offers and sales of their securities. MFA believes that changes in the securities markets and regulations have rendered the restrictions of Regulation D, enacted 30 years ago, unnecessary and increasingly unclear in practice. The Letter’s suggested changes would enhance the regulation of private fund offerings, promote investment, and enhance economic growth by:
If the MFA proposals were adopted, private funds would be able to engage in public communications and offering activity while remaining in compliance with Regulation D and the Investment Company Act of 1940. It would also allow a wider audience to learn about the hedge fund industry, and help combat inaccurate information and misperceptions of the industry. These misperceptions include the view of the industry as secretive, which creates an unwarranted negative inference by investors and regulators.
Written by Peter J. Chess
Many fund managers are required to submit reports every month and/or every five years to the Federal Reserve Bank of New York (“FRBNY”). The Department of the Treasury’s Treasury International Capital (“TIC”) data reporting system has two such upcoming reporting deadlines.
TIC Form SLT
The Aggregate Holdings of Long-Term Securities by U.S. and Foreign Residents (“TIC Form SLT”) is required to be submitted by entities with consolidated reportable holdings and issuances (positions) with a fair market value of at least $1 billion as of the last day of any month. These entities may include funds and their investment advisers, and U.S. companies. The purpose of the TIC Form SLT is to gather information from U.S. resident entities on foreign persons’ holdings of long-term U.S. securities and on U.S. persons’ holdings of long-term foreign securities.
If required to do so, fund managers and other entities must submit the report to the FRBNY by the 23rd day of each month with regard to the data of the previous month. The upcoming TIC Form SLT will contain consolidated data as of December 31, 2011 and must be submitted by January 23, 2012.
TIC Form SHC
The Report of U.S. Ownership of Foreign Securities, Including Selected Money Market Instruments (“TIC Form SHC”) is a mandatory survey of the ownership of foreign securities, including selected money market instruments, by U.S. residents as of December 31, 2011. The TIC Form SHC is a benchmark survey of all significant U.S. resident custodians and end-investors held every five years. Custodians are all organizations that hold securities in safekeeping for other organizations. End-investors are organizations that invest in foreign securities for their own portfolios or invest on behalf of others, such as investment managers/fund sponsors.
The TIC Form SHC is divided into three schedules: Schedule 1, Schedule 2, and Schedule 3. Schedule 1 must be filed by all entities that are notified by the FRBNY that they are required to file the TIC Form SHC, and by all U.S. resident custodians or end-investors that exceed the reporting thresholds of Schedules 2 and 3. Schedules 2 and 3 must be filed by entities that exceed the reporting threshold of $100 million for the respective specified safekeeping arrangements of foreign securities.
The data for the TIC Form SHC is as of December 31, 2011, and must be submitted by fund managers and other entities required to do so to the FRBNY no later than March 2, 2012.
Written by Jay Gould
On October 18, 2011, the SEC released a notice of FINRA’s filing of Proposed Rule 5123 (the “Proposed Rule”) which would require FINRA members and associated persons to: 1) provide to investors disclosure documents in connection with private placements prior to sale and 2) file with FINRA such disclosure documents within 15 days after the date of first sale and any subsequent amendments. These proposed changes would significantly affect fund managers who offer or sell their funds that are exempt from registration pursuant to Section 3(c)(1) of the Investment Company Act through third party marketers, nearly all of which are required to be registered as broker-dealers.
Pre-sale requirement to provide disclosure documents to investors
The Proposed Rule would require FINRA members and associated persons that offer or sell private placements or participate in the preparation of private placement memoranda (“PPM”), term sheets or other disclosure documents in connection with such private placements, to provide such disclosure documents to investors prior to sale. The disclosure documents must describe the anticipated use of offering proceeds, the amount and type of offering expenses, and the amount and type of offering compensation. Much of this information is currently captured in the Form D filing that most fund managers file with the SEC, but under the Proposed Rule, would go directly to investors in connection with the sale of fund interests.
As a practical matter, this likely means increased scrutiny of hedge fund and other private fund offerings by FINRA, as well as the likelihood that third party marketers that sell on behalf of hedge funds may request greater or more enhanced indemnification from fund managers in the placement agency agreement between the third party marketer and the fund manager. Accordingly, fund managers who use third party marketers to market their funds must keep their fund documents updated, taking into account all changes to fund strategies, material performance issues (to the extent applicable), regulatory changes and management personnel changes, to name a few.
Post-sale requirement to notice file with FINRA
The Proposed Rule would also require each FINRA member and associated person to notice file with FINRA by filing the PPM, term sheet or other disclosure documents no later than 15 days after the date of first sale. In addition, any amendments to such disclosure documents or disclosures required by the Proposed Rule would have to be filed no later than 15 days after such documents are provided to any investor or prospective investor. To the extent these documents are provided to investors, they would also be subject to the strict liability standard of Rule 206(4)-8 under the Investment Advisers Act to which all fund managers are already subject. Accordingly, fund managers must be careful to keep all of their documents current under the materiality standards of state and Federal securities laws.
Offerings Exempted from the Proposed Rule
The Proposed Rule would exempt several types of private placements including offerings sold only to any one or more of the following purchasers:
In addition, the Rule would exempt the following types of offerings:
Documents and information filed with FINRA pursuant to the Proposed Rule would be given confidential treatment. FINRA would use such documents and information solely for the purpose of determining compliance with FINRA rules or other applicable regulatory purposes. In addition, FINRA would afford confidential treatment to any comment or similar letters by FINRA and thus could not be discoverable by a litigant through a legal action.
A full text of the SEC Notice and Proposed Rule is available here.
Written by 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.
Two-stage phase-in compliance with Form PF filing requirements:
Form PF Filing Fees: $150 for initial, quarter or annual filing.
A full text of the SEC release is available here.
Written by Michael Ouimette
On October 11, 2011, the Federal Financial Regulators published for public comment a jointly proposed regulation implementing the so-called “Volcker Rule” requirements of the Dodd-Frank Wall Street Reform and Consumer Protection Act. The Volcker Rule generally contains two prohibitions, both of which are subject to certain exemptions. First, it generally prohibits insured depository institutions, bank holding companies, and their subsidiaries or affiliates (“Banking Entities”) from engaging in short-term proprietary trading of any security, derivative, and certain other financial instruments for their own accounts. Second, it generally prohibits Banking Entities from owning, sponsoring, or having certain relationships with, a hedge fund or private equity fund.
On October 9, 2011 Governor Brown signed into law Senate Bill 398 which is intended to clarify the current law regarding placement agents and lobbyist requirements.
In 2009, AB 1584 was enacted. AB 1584 imposed disclosure requirements for investment placement agents associated with public pension funds in California. It required public employee pension funds to adopt a disclosure policy requiring the disclosure of fees paid to investment placement agents and contributions and gifts made by placement agents to board and staff members.
In 2010, AB 1743 was passed. That bill subjected investment managers and placement agents to lobbyist registration. It also defined “placement agents” and revised the definition of “lobbyist” to include a placement agent. A placement agent includes employees of an external manager unless the employee spends more than 1/3 of his time managing assets for the external manager. AB 1743 also exempts from lobbyist registration requirements those advisers and broker-dealers who are registered with the SEC, obtained the business through competitive bidding process, and agreed to the California fiduciary standard imposed on public employee pension fund trustees.
The newly enacted and immediately effective SB 398 changes the current law to this extent:
1. It revises the definition of “external manager” to mean a person or an investment vehicle managing a portfolio of securities or other assets, or a person managing an investment fund offering an ownership interest in the investment fund to a board or an investment vehicle.
2. It revises the definition of “placement agent” to include an investment fund managed by an external manager offering investment management services of the external manager and an ownership interest in an investment fund managed by the external manager.
3. It defines “investment fund” and includes private equity fund, public equity fund, venture capital fund, hedge fund, fixed income fund, real estate fund, infrastructure fund, or similar pooled investment entity. It excludes an investment company that is registered with the SEC pursuant to the Investment Company Act of 1940 and that makes a public offering of its securities.
4. It defines “investment vehicle” to mean a “corporation, partnership, limited partnership, limited liability company, association, or other entity, either domestic or foreign, managed by an external manager in which a board is the majority investor and that is organized in order to invest with, or retain the investment management services of, other external managers.”
5. The exemptions from lobbyist registration for managers of local retirement system funds are extended to include the three exemptions similarly available to managers of state retirement system funds.
Written by Michael Wu
On September 29, 2011, the SEC’s examination staff issued a Risk Alert warning of significant concerns regarding trading through sub-accounts, and offered suggestions to help securities industry firms address these risks. In the alert, the staff identified certain risks associated with the master/sub-account trading model such as: i) money laundering, ii) insider trading, iii) market manipulation, iv) account intrusions, v) information security, vi) unregistered broker-dealer activity, and (vii) excessive leverage. The alert is the first in a continuing series of Risk Alerts that the staff expects to issue.
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 Michael Wu
Foreign Account Tax Compliance Act (FATCA), comprising of sections 1471 through 1474 of the Internal Revenue Code, was enacted in March 2010 as part of the Hiring Incentives to Restore Employment (HIRE) Act. FATCA imposes information reporting requirements on foreign financial institutions (FFIs) and withholding, documentation, and reporting requirements with respect to certain payments made to certain foreign entities. IRS Notice 2010-60 was released on August 29, 2010 to provide preliminary guidance regarding the implementation of FATCA. IRS Notice 2011-34 was released on April 8, 2011 which modified and supplemented Notice 2010-60. On July 14, 2011, the IRS released IRS Notice 2011-53 (the “Notice”). This Notice provides and describes the timeline for FFIs and U.S. withholding agents to implement the various FATCA requirements.
The IRS anticipates issuing proposed regulations incorporating guidance provided in all three notices by December 31, 2011 and final regulations along with final form of FFI Agreement and reporting forms in the summer of 2012.
In summary, the phased implementation of FATCA is as follows:
January 1, 2013: IRS will begin accepting FFI Applications no later than this date.
June 30, 2013: FFIs must register with the IRS and enter into FFI Agreement by this date to avoid the 30% withholding tax.
January 1, 2014: IRS begins 30% withholding tax on certain payments by non-participating FFIs and account holders who are unwilling to provide the required information.
January 1, 2015: Withholding on all withholdable payments will be fully phased in.
Due diligence procedures are required in order for FFIs to identify U.S. accounts. These procedures were prescribed in the prior IRS notices and will be finalized in forthcoming regulations. The Notice provides phased implementation of these due diligence procedures. A participating FFI with pre-existing private banking accounts with a balance or value equal to or greater than $500,000 on the FFI Agreement’s effective date has one year from its FFI Agreement’s effective date to complete its due diligence procedures. Those with pre-existing private banking accounts with a balance or value of less than $500,000 must have completed their due diligence procedures by December 31, 2014 or within one year following their FFI Agreements’ effective date. For all other pre-existing accounts, a participating FFI has two years from its FFI Agreement’s effective date to complete due diligence procedures.
FATCA requires a participating FFI to annually report to the IRS certain information regarding its U.S. accounts. An account for which a participating FFI has received a Form W-9 from the account holder (or if the account is held by a U.S. owned foreign entity, from the substantial owner of such entity) by June 30, 2014, must report the account to the IRS as a U.S. account by September 30, 2014. By this first reporting deadline, a participating FFI needs to report only: i) the name, address and TIN of the U.S. account holder, ii) the account balance as of December 31, 2013, or if the account was closed after the effective date of the FFI’s FFI Agreement, the account balance immediately before such account closure, and iii) the account number.
Additional information will be required in subsequent reporting years.
The Notice provides delayed implementation of the 30% withholding requirement. For withholdable payments made on or after January 1, 2014, withholding agents will be obligated to withhold the 30% tax only on U.S. source FDAP payments. (FDAP means fixed, determinable, annual or periodical income or payments and includes interest and dividends.) For payments made on or after January 1, 2015, withholding agents will be obligated to withhold the 30% tax on all withholdable payments, including gross proceeds.
The Notice also provides that a participating FFI is not obligated to withhold with respect to passthru payments made before January 1, 2015. (A passthru payment is a withholdable payment or other payment to the extent attributable to a withholdable payment.) FATCA requires a participating FFI to withhold the 30% tax on passthru payments made to a recalcitrant account holder or non-participating FFI.
Written by Jay Gould
Pillsbury’s Investment Funds & Investment Management team has submitted a comment letter to the California Department of Corporations (the “DOC”) on behalf of the California Hedge Fund Association in connection with the DOC’s recently proposed amendments to the California custody rule.
In its letter to the Commissioner, Pillsbury requested that the DOC amend the California custody rule in a manner that balances investor protection and the need for fund managers to maintain confidentiality of certain portfolio positions. Specifically, the letter requested that the quarterly reports California-registered advisers to private funds are required to send to their investors be required to disclose only those positions that comprise more than 5% of the fund’s assets, and that the names of short positions not be disclosed at all, but be provided as an aggregate number. “Implementing our suggestions would be consistent with the quarterly disclosure of schedule of investments based on the FASB’s U.S. financial reporting standards, and would also protect fund investors from short squeezes,” explained Jay Gould, head of the Pillsbury Investment Funds & Investment Management team.
The letter was provided in response to the DOC Commissioner’s invitation for comment on the proposed changes to the California custody rule that will apply to California-registered investment advisers, including those investment managers that are currently either registered with the Securities and Exchange Commission or are not registered at all. By February 15, 2012, investment advisers to private funds with less than $100 million under management will need to register with the DOC, if they have not already done so.
“The California Hedge Fund Association expects to provide comments to the DOC in connection with future rulemaking proposals and encourages California-based fund managers to become active in this process,” explains Chris Ainsworth, President of the Association.
A full text of the letter to the Commissioner is available here.
Written by Bruce Frumerman, guest contributor
Bruce Frumerman is the CEO of Frumerman & Nemeth Inc., a communications and sales marketing consultancy that assists financial services firms create brand identities for their organizations and develop and implement effective new marketing strategies and programs.
In the article below, Mr. Frumerman offers effective marketing strategies for hedge fund managers to stay competitive and successful in the business. This article first appeared in Reuters HedgeWorld on July 18 and is re-printed with permission below.
Rising competition among money managers is one of the key topics covered in Boston Consulting Group’s recently released ninth annual study of the worldwide asset management industry, Building on Success: Global Asset Management 2011...
A full text of the article is available here.
Effective on September 19, 2011, investors that pay performance fees to an adviser must either have at least $1 million managed by the adviser or a net worth of at least $2 million.
As mandated by the Dodd-Frank Act, the SEC today issued an order that raises two of the thresholds that determine whether an investment adviser can charge its clients performance fees. As discussed in the article we posted here on May 11, under the current Rule 205-3 of the Investment Advisers Act of 1940, an investment adviser may charge its investors a performance fee if (i) the investor has at least $750,000 under management with the investment adviser (“asset-under-management test”), or (ii) the investment adviser reasonably believes that the investor has a net worth of more than $1.5 million (“net worth test”). Today’s SEC order adjusted the amounts for the asset-under-management test to $1 million and the net worth test to $2 million. The SEC order is effective on September 19, 2011.
Accordingly, it is important for investment fund managers to amend their offering materials to comply with the new requirements of Rule 205-3 under the Advisers Act.
On June 22, 2011, the Securities and Exchange Commission (SEC) adopted final rules that implement provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amending the Investment Advisers Act of 1940 (the “Advisers Act”). The amendments include:
The SEC also adopted final rules that eliminated the private adviser exemption under the Advisers Act and created three new exemptions from SEC registration for:
On March 2, 2011, Pillsbury’s Investment Fund and Investment Management group (“Pillsbury IFIM Group”) submitted a comment letter to the North American Securities Administrator’s Association (the “NASAA”) on behalf of the California Hedge Fund Association and the Florida Alternative Investment Association. The letter to the NASAA was intended to provide comments regarding the proposed model custody rule of the NASAA that was released on February 17, 2011. A copy of the March 2, 2011 comment letter was posted here on March 8, 2011.
On May 23, 2011, Pillsbury IFIM Group submitted a second comment letter on behalf of the California and Florida fund groups to the NASAA commenting on the re-proposal of the model custody rule on April 18, 2011 (the “Re-Proposed Rule”). The Re-Proposed Rule reflected certain suggestions made in the first letter to the NASAA, but would require that all portfolio positions be provided to all fund investors at the end of each quarter. The letter requested that the NASAA limit quarter end disclosure to positions that comprise 5% or more of a fund’s portfolio and exclude all disclosure with respect to short positions. Pillsbury believes that it is critical for fund managers and hedge fund industry groups to comment on the NASAA rule proposals, as it is likely that many states will simply adopt the NASAA rules without providing a robust public comment process as a result of the many new registrants for which the states will be responsible when the investment adviser registration provisions of Dodd Frank Act are fully implemented.
A full text of the second letter can be found here.
Written by Michael Wu
The Securities and Exchange Commission (“SEC”) has adopted rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (“Dodd-Frank Act”) Whistleblower Program. The Whistleblower Program requires the SEC to pay awards, under regulations prescribed by the SEC and subject to certain limitations, to eligible whistleblowers who voluntarily provide the SEC with original information about a violation of the federal securities laws, or a rule or regulation promulgated by the SEC, that leads to the successful enforcement of a covered judicial or administrative action, or a related action that results in monetary sanctions of more than $1,000,000. Dodd-Frank Act also prohibits retaliation by employers against individuals who provide the SEC with information about possible securities violations.
To view a full text of the Final Rule, please click here.
Earlier this year, the People’s Bank of China (PBoC) issued its Administrative Measures over Pilot Projects on Settlement of Overseas Direct Investments in Renminbi (the “PBoC Measures”). The PBoC Measures permit the PBoC, under a pilot project, to loan renminbi to Chinese investors to fund outbound acquisitions. The PBoC Measures are expected to have a positive impact on leveraged buy-out (LBO) firms in China that acquire interests in non-Chinese companies. Effectively, the PBoC Measures extends the M&A loan capacity of Chinese banks from Chinese domestic M&A transactions to overseas, non-Chinese M&A transactions. For a more detailed discussion of the PBoC Measures, please click here.
Written by Michael Wu
California’s Department of Corporations (the “Department”) intends to issue emergency regulations to address the elimination of the “private adviser exemption” under Section 203(b)(3) of the Investment Advisers Act of 1940, as amended (the “Advisers Act”). Currently, an investment adviser in California may rely on the private adviser exemption by virtue of California Department of Corporations Rule 260.204.9, which specifically refers to the private adviser exemption under Section 203(b)(3) of the Advisers Act. The Dodd-Frank Wall Street Reform and Consumer Protection Act will eliminate the private adviser exemption under Section 203(b)(3) effective as of July 21, 2011, which in turn would affect a California investment adviser's ability to rely on Rule 260.204.9. The Department will issue emergency regulations amending Rule 260.204.9 to preserve the status quo. Therefore, California investment advisers that currently rely on the exemption from registration for private advisers will be able to continue to rely on that exemption until the Department adopts a final rule regarding private fund advisers. For more information about this new development please click here.
Written by Michael Wu
The Securities and Exchange Commission (the “SEC”) recently published a notice of its intent to raise the dollar thresholds that would need to be satisfied in order for an investment adviser to charge its investors a performance fee. Currently, under Rule 205-3 of the Investment Advisers Act of 1940, as amended, an investment adviser may charge its investors a performance fee if (i) the investor has at least $750,000 under management with the investment adviser, or (ii) the investment adviser reasonably believes that the investor has a net worth of more than $1.5 million. To comply with the Dodd-Frank Act, the SEC must adjust these dollar amounts for inflation by July 21, 2011 and every five years thereafter.
Thus, the SEC intends to issue an order that would revise the dollar amount tests to $1 million for assets under management and $2 million for net worth. The SEC is also proposing to amend Rule 205-3 to: (i) provide the method for calculating future inflation adjustments of the dollar amount tests, (ii) exclude the value of a person’s primary residence from the net worth test, and (iii) modify the transition provisions of the rule. The SEC is seeking public comment on the proposed rule.
On March 18, 2011, the Securities and Exchange Commission released new guidance regarding Form ADV. The SEC’s Q&As can be found here. The most significant development pertains to a registered adviser’s obligation to deliver Part 2. Specifically, Question III.2 reads as follows:
Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?
A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)
Although the SEC’s response focuses on “hedge funds,” because the term “client” is defined the same way for all “private funds,” we can reasonably conclude that advisers to private equity funds and other private funds can satisfy the delivery obligations by delivering the new Part 2 to the general partners of the private equity funds or private funds that they manage - as opposed to the investors in such funds. This is a significant change because previously most registered advisers provided Part 2 to all of the investors in the funds that they managed.
Please note that registered advisers are still required to file Part 2 of Form ADV with the SEC.
Pillsbury’s Investment Fund and Investment Management group recently submitted a comment letter to the North American Securities Administrator’s Association (the “NASAA”) on behalf of the private investment fund industry. Specifically, the letter to the NASAA was intended to provide comments regarding the proposed model custody rule of the NASAA that was released on February 17, 2011.
Pillsbury’s letter to the NASAA was written in response to the NASAA’s request for comment regarding its proposed revision to the model rules on NASAA Custody Requirements for Investment Advisers (the “Proposed Rule”). The letter requested that NASAA reconsider requiring state-registered investment advisers to hedge funds and other private investment funds to provide detailed quarterly statements of all fund trading activity to all investors in their funds. In Pillsbury’s view, this requirement falls seriously short of both protecting and advancing the interests of investors in such funds.
As written, the Proposed Rule would require state-registered investment advisers to unregistered pooled investment vehicles (i.e., private investment funds) to provide all fund investors with a list of all trading activity by the fund during the previous quarter. Pillsbury contended that disclosing such information amounts to a requirement that investment advisers disclose their trade secrets. A fund adviser’s trade secret is how it turns an easily described strategy into competitively differentiated results, and these trade secrets are expressed in the record of an adviser’s actual trade activity and positions over time. Pillsbury strongly urged the Director to consider revising the Proposed Rule so that it is analogous to the Securities and Exchange Act’s custody rule (i.e., Rule 206(4)-2 of the Advisers Act).
Pillsbury will continue to monitor this and other regulatory developments that affect investment advisers and their investment funds and stands ready to take appropriate action to ensure that the laws and regulations purporting to protect investors are not unduly burdensome for investment advisers and the investment fund industry.
To see a full text of the letter, please continue reading…
The Commodity Futures Trading Commission (the “CFTC”) recently issued a proposed rule regarding commodity pool operators (“CPOs”) that would rescind the exemptions from CPO registration under CFTC Rules 4.13(a)(3) and 4.13(a)(4). These exemptions are widely used by hedge fund and other private fund managers advising funds that trade futures and other listed commodity positions, such as commodity options or swaps. If adopted, managers, sponsors and operators of such funds would need to register as CPOs with the CFTC and become members of the National Futures Association (the “NFA”). The proposed rule does not have a transition period or any grandfathering provisions.
Full registration as a CPO is a time consuming process and typically takes six to eight weeks. Unlike hedge fund and other private fund managers currently taking advantage of the exemptions under CFTC Rules 4.13(a)(3) and 4.13(a)(4), registered CPOs are subject to full regulation by the CFTC and NFA. As a result, registered CPOs must comply with rules that require them to provide disclosure documents to investors (which are subject to review by the NFA) and fulfill recordkeeping and reporting requirements, including the delivery of audited annual financial statements. Although registered CPOs may continue to rely on CFTC Rule 4.7 for relief from certain disclosure, recordkeeping and reporting requirements, the proposed rule would require CPOs relying on CFTC Rule 4.7 to deliver audited annual financial statements to investors.
The proposed rule would also require hedge fund and other private fund managers that are currently exempt from registration as commodity trading advisors (“CTAs”) because they only advise funds that are exempt under CFTC Rules 4.13(a)(3) and 4.13(a)(4), to register as CTAs with the CFTC and become members of the NFA. Once registered as a CTA, a hedge fund and other private fund manager would be subject to all of the CFTC and NFA’s requirements applicable to CTAs.
The CFTC has requested comments during the 60-day period beginning on Friday, February 11, 2011. If the proposed rule is adopted, the CFTC will issue a final rule that will specify when hedge fund and other private fund managers relying on CFTC Rules 4.13(a)(3) and 4.13(a)(4) will need to revise or cease their commodity interest trading or register as CPOs (and, if applicable, CTAs) and become members of the NFA.
The text of the proposed rule can be found here: http://www.cftc.gov/ucm/groups/public/@lrfederalregister/documents/file/2011-2437a.pdf
We will update you with more information as it becomes available.
Written by Michael Wu
On January 26, 2011, the SEC proposed a rule that would require SEC-registered advisers to hedge funds, private equity funds and other private funds to report information to the Financial Stability Oversight Council (“FSOC”) that would enable it to monitor risk to the U.S. financial system. The information would be reported to the FSOC on Form PF and the information reported on Form PF would be confidential.
The proposed rule would subject large advisers to hedge funds, “liquidity funds” (i.e., unregistered money market funds) and private equity funds to heightened reporting requirements. Under the proposed rule, a large adviser is an adviser with $1 billion or more in hedge fund, liquidity fund or private equity fund assets under management. All other advisers would be regarded as smaller advisers. The SEC anticipates that most advisers will be smaller advisers, but that the large advisers represent a significant portion of private fund assets.
Smaller advisers would be required to file Form PF once a year and would report only basic information about their hedge funds, private equity funds and/or other private funds, such as information regarding leverage, credit providers, investor concentration, fund performance, fund strategy, counterparty credit risk and the use of trading and clearing mechanisms.
Large advisers would be required to file Form PF quarterly and would provide more detailed information than smaller advisers. The information reported would depend on the type of private fund that the large adviser manages.
The SEC’s public comment period on the proposed rule will last 60 days.
On January 11, 2011, the Shanghai Municipal Government released its Implementation Measures on Trial Projects of Foreign-Invested Equity Investment Enterprises in Shanghai (the "Shanghai RMB Fund Regulation"), which will become effective on January 23, 2011. Prior to the release of this regulation, it was widely expected that the Shanghai Municipal Government would launch a Qualified Foreign Limited Partners ("QFLP") legal regime to help large international institutional investors invest in Shanghai-based private equity funds. Although the Shanghai RMB Fund Regulation was implemented in response to such expectations, we believe it is just the first of many regulations designed to confer national treatment to private equity funds formed by non-Chinese fund managers. For more information regarding the Shanghai RMB Fund Regulation, please see A Red Envelope From Shanghai? New RMB Fund Rules Create Opportunities for Non-Chinese Fund Managers.
Editorial Comment by Jay Gould
A recent action against a hedge fund manager by the Securities and Exchange Commission (the “SEC”) serves as interesting prologue to the state of enforcement against suspected securities frauds once the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) has been fully implemented. On January 7, 2011, the SEC charged SJK Investment Management LLC, a North Carolina-based hedge fund manager (“SJK”), and CEO Stanley Kowalewski, its owner, with defrauding its hedge fund investors by diverting millions of dollars to themselves through various self-dealing transactions.
Nothing in this case is particularly unique. Investment advisers who steal from their clients have proven to be a fairly routine occurrence and rarely attract mainstream press coverage unless the theft is on a significant scale. Briefly, the SEC alleged that Kowalewski diverted investor money from the SJK hedge funds to pay his personal expenses and placed $16.5 million of the hedge funds’ assets into an undisclosed, wholly-controlled, fund that he created, and then misused for, among other things, purchasing a vacation home valued at $3.9 million. The SEC stated that the agency became suspicious of Kowalewski as a result of an examination. The examination staff referred the matter over to the Enforcement Division of the Atlanta Regional Office which obtained an order to freeze the assets held by Kowalewski. Presumably, a receiver will be appointed by the court that will sift through the rubble and one day return whatever is left over to the investors. In the end, this is just another example of one of approximately 200 Ponzi/investment fraud cases that the SEC has uncovered since the Madoff embarrassment.
What is interesting about this case is that as of July 2011, the SEC will no longer examine the Stanley Kowalewskis of the world. In most cases, that job will be left to state securities commissions. As a result of the Dodd-Frank Act, private fund managers with less than $150 million under management and other investment advisers with less than $100 million under management will no longer register with or be routinely examined by the SEC. The SEC estimates that 4,100 investment advisers that are now registered with it will be forced to de-register and register with their respective state securities regulator. Although the SEC will retain anti-fraud jurisdiction over these state-registered advisers, the primary regulators will be the often ill-equipped, inexperienced and resource strapped state regulators. As a result of the budgetary concerns facing most states, it is unlikely that sufficient resources will be directed to enforcing investment frauds perpetrated by small, “under the radar” investment advisers.
And where do the majority of investment frauds occur? The most recent filing of Kowalewski’s Form ADV indicates that SJK had $71 million under management. This is not exactly an investment adviser that represents a systemic risk to the stability of the financial world, but this is the type of investment adviser that can cause great pain to every day investors seeking to diversify their assets or plan for their retirement. In fact, the vast majority of investment fraud schemes that the SEC has uncovered since Madoff have been perpetrated by investment advisers that will not be subject to SEC scrutiny under the new regulatory regime.
The Dodd-Frank Act addressed this concern in part by directing the SEC to conduct a number of studies regarding the regulation of investment advisers. One such study directs the SEC to make a recommendation as to whether investment advisers should be subject to a self-regulatory organization (“SRO”), much the same way broker-dealers are essentially required to become members of the Financial Industry Regulatory Authority (“FINRA”). In recent weeks, FINRA has shown great interest in taking on this responsibility, much to the dismay of most independent investment advisers. This SRO membership requirement would add another layer of expense to, and oversight of, investment advisers. And some might argue that FINRA, which opposes the idea of creating a uniform fiduciary standard for investment advisers and retail brokers, is exactly the wrong SRO to oversee advisers that have traditionally been subject to a much more rigorous code of conduct.
This shift in regulatory responsibility to the states does not necessarily bode well for small investment advisers and start-up hedge fund managers. Just as we have seen large investors gravitate toward established investment managers since 2008, the lack of effective regulatory oversight may portend an unwillingness for high net worth and smaller institutions to take a chance on a less well-established investment adviser or fund manager. Such investment advisers or fund managers can expect the lack of SEC oversight to be another hurdle in a very challenging capital raising environment.
But there are steps that state-registered and regulated advisers and fund managers can take to minimize this aspect of the Dodd-Frank Act. Taking seriously the responsibility for full and current disclosure in fund documents, providing transparency to investors and maintaining sufficient operating systems and infrastructure will help to address the concerns of circumspect investors. Also, providing clear and current disclosure in the new Form ADV Part 2 that explains the operations and investment approach and adhering to the traditional fiduciary standard that has applied to investment advisers for decades will provide greater comfort to investors. Finally, choosing the right partners and service providers that can provide the oversight, checks and balances and industry expertise will also be important to investors.
Small investment advisers and fund managers may initially welcome the idea of no longer being subject to direct SEC oversight, but if investment frauds continue at this end of the investment spectrum, that may prove to be a hollow victory.
By: Michael Wu
As the new year is upon us, we wanted to take a moment to remind you of some of the annual compliance obligations that you may have as an investment adviser that is registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”). In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers. The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.
The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers. The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law. Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered. State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law.
1) the compliance issues and any violations of the policies and procedures that arose during the year, changes in the Investment Adviser’s business activities and the effect that changes in applicable law, if any, have had on the Investment Adviser’s policies and procedures;
2) the Investment Adviser’s code of ethics, including an assessment of the effectiveness of its implementation and determination of whether they should be enhanced in light of the Investment Adviser’s current business practices; and
3) the business continuity/disaster recovery plan, which should be “stress tested” and adjusted as necessary.
If you have any questions regarding the summary above, please feel free to contact us.
Written by Michael Wu
The Alternative Investment Fund Managers Directive (the “Directive”) establishes a regulatory regime for all alternative fund managers, such as private equity and hedge fund managers, that are based in the European Union (the “EU”), manage funds based in the EU and market non-EU fund interests in the EU. A general summary of the Directive is available here.
Although the majority of the Directive’s rules are likely to become effective by January 2013, some of the rules affecting non-EU funds and non-EU fund managers will be deferred until 2015 or later. Thus, non-EU managers may still actively raise funds in the EU, but will have to comply with a number of additional regulatory requirements beginning in January 2013.
Beginning in January 2013, non-EU managers may actively fund raise in the EU provided that:
Beginning in early-2015, non-EU managers may be able to participate in the “passport” regime (i.e., they can fund raise in every EU country without obtaining separate regulatory authorization in each country) if the European Securities and Markets (“ESMA”) Authority decides to make the passport regime available to non-EU managers. If the passport regime becomes available to non-EU managers, they would become authorized and regulated on the same basis as EU managers with respect to the passporting rights. However, because the passport regime’s compliance obligations are onerous, non-EU managers may want to forgo the passporting rights and fund raise subject to country-by-country private placement regimes and the minimum directive requirements described above.
Beginning in mid-2018, non-EU managers may be required to operate under the passport regime in order to fund raise in the EU. The Directive contains provisions that would ultimately terminate the national private placement regimes, leaving full authorization as the only option for non-EU firms that wish to fund raise in the EU.
ESMA and the European Commission have been tasked with issuing extensive implementing measures and guidance. However, the details of these rules will not become clear for some time.
Written by Michael Wu
On November 11, 2010, the European Parliament adopted the EU Directive on Alternative Investment Fund Managers (the “Directive”). The Directive will affect a significant number of alternative investment fund managers (“AIFMs”) that manage and/or market alternative investment funds (“Funds”), including hedge funds, commodity funds, private equity funds and real estate funds, within the European Union (“EU”). The text of the Directive is expected to be published in the Official Journal sometime in the first or second quarter of 2011. The Directive will be effective 20 days after publication and the EU Member States will have two years from such date to implement the Directive.
Written by Jay Gould
On 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.
According to the Wall Street Journal, the Commodity Futures Trading Commission has sent subpoenas to hedge funds and other large natural gas traders seeking information regarding trading activity in natural gas derivatives. The subpoenas request information regarding trading activity in 2008 and 2009, a period during which natural gas prices fell by close to 80%. The full text of the article 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.
On September 22, 2010, the Managed Funds Association submitted initial comments to the Securities and Exchange Commission and the Commodity Futures Trading Commission on regulatory topics under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The MFA’s comments reflected concerns that the broad wording of the Dodd-Frank Act would result in certain provisions being inappropriately applied to private investment funds. To address these concerns, the MFA proposed that:
Bloomberg reports that the SEC is engaged in a probe of investment advisers who invest client assets in hedge funds, funds of funds, private equity, venture capital and other alternative investments. The SEC's Office of Compliance Inspections and Examinations has recently requested that advisers provide extensive information about their alternative investments, particularly in regards to the due diligence processes used when evaluating alternative investments. A copy of the letter sent by the OCIE to examined advisers and the accompanying information request list is available here.
Earlier this year the SEC staff commenced a review to evaluate the use of derivatives by mutual funds, exchange-traded funds and other investment companies, including, among other things, whether existing prospectus disclosures adequately address the particular risks created by derivatives. In a July 30, 2010 letter to the Investment Company Institute, the SEC staff indicated that the initial results of its review are not encouraging.
It found that funds are providing generic disclosure about derivatives that is not adequately tailored to the specific investment strategies of the fund and does not emphasize the specific types of derivatives used by the fund, the extent of their use and the purpose of using derivatives transactions. As a result, investors may not be receiving the disclosure they need in order to understand the risks associated with their investment in a fund. The staff urged all funds that use derivatives to assess the accuracy and completeness of their disclosure, tailor their disclosure to include a description of the fund's expected uses of derivatives and their relative importance and ensure that such disclosure is presented in an understandable manner using plain English.
Although the staff's letter only addresses the disclosure provided by registered investment companies, hedge funds and other private funds are subject to anti-fraud principles requiring them to disclose all material information to investors and, therefore, should also take into account this guidance when preparing derivatives-related disclosure.