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

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

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:

• the person limits the offering and selling of the issuer’s securities only to broker-dealers and other specified types of financial institutions;
• the person performs substantial duties for the issuer other than in connection with transactions in securities, was not a broker-dealer or an associated person of a broker-dealer within the preceding 12 months, and does not participate in selling an offering of securities for any issuer more than once every 12 months; or
• the person limits activities to delivering written communication by means that do not involve oral solicitation by the associated person of a potential purchaser.

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.

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 and Michael Wu

Last week the SEC issued a Risk Alert and an Investor Bulletin on the Custody Rule after its National Examination Program ("NEP") observed significant deficiencies in recent examinations involving custody and safety of client assets by registered investment advisers.  The stated purpose of the Risk Alert was to assist advisers with complying with the custody rule.  The Investor Bulletin was issued to explain the purpose and limitations of the custody rule to investors.  We encourage advisers and investors to review the Risk Alert and the Investor Bulletin, and remind advisers, particularly advisers to private equity funds,  fund of funds and funds that invest in illiquid assets that they may only self custody securities if they satisfy the requirements for "privately offered securities" (i.e., securities are (i) not acquired in any transaction involving a public offering, (ii) uncertificated, (iii) transferable only with the prior consent of the issuer and (iv) are held by a fund that is audited). Many advisers may not be in compliance with the custody rule because they self custody assets that do not satisfy the definition of privately offered securities.  Please feel free to contact us for more information on the Risk Alert, Investor Bulletin or the custody rule.

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.

CONTINUE READING...

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

Compliance Week
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.

Written by:  Jay Gould

The Securities and Exchange Commission (the “SEC”) recently charged and entered into consent decrees with four India-based brokerage firms for providing brokerage services to U.S. investors without being registered as broker dealers under the U.S. securities laws.  This otherwise mildly interesting enforcement action by the SEC should serve as a cautionary tale to hedge fund managers based outside the U.S. that seek to raise capital from U.S. investors, as well as U.S. fund managers that seek to sell their fund shares in foreign countries.

Many non-U.S.-based fund managers seek to raise money from U.S. investors due to the large amounts of available capital in this country and the relative willingness of U.S. investors to consider managers from foreign jurisdictions.  However, visiting potential U.S. investors or sending fund marketing materials into the U.S. without complying with the U.S. broker dealer rules could result in a fate similar to that suffered by the four Indian brokerage firms that were sanctioned and fined by the SEC. In order to avoid an enforcement proceeding, non-U.S. fund managers should retain a properly registered U.S. brokerage firm to sell the fund’s securities, enter into a “chaperoning” arrangement with a U.S. broker or register a subsidiary as a broker-dealer in the U.S.  

Whether prudent or not, most U.S.-based fund managers rely on Rule 3a4-1, the so-called “issuers exemption,” under the Securities Exchange Act of 1934 (the “1934 Act”) in order to avoid either registering the general partner or an affiliate of the fund as a broker, or retaining an unrelated broker to sell the fund’s interests.  But when U.S. fund managers travel outside the U.S. to gauge interest or solicit potential investors, the U.S. rules are not applicable.  Each country has its own regulatory scheme, and fund managers are well advised to understand what is permitted and prohibited in each country before visiting each country at the risk of being the subject of a new episode of “Locked Up Abroad.”  Indeed, certain countries impose criminal sanctions for offering securities if the offeror is not properly authorized to do so.

The Investment Fund Law Blog boldly predicts that the SEC will one day soon re-visit the industry’s expansive interpretation of the “issuer’s exemption” and the result will not be pleasant for the private funds industry.

So what did these Indian brokerage firms do to incur the wrath of the SEC?  The activities that these firms engaged in included:

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

Many of these activities no doubt sound hauntingly familiar to U.S.-based fund managers that travel abroad for the purpose of raising capital.  All four firms were censured and ordered to pay a combined total of more than $1.8 million in disgorgements and prejudgment interest, but no civil penalties were imposed due to the firms’ cooperation with the SEC.  The firms have all submitted settlement offers, without admitting or denying any wrongdoing.

The SEC’s press release on the matter can be found here. 

Written by:  Jay Gould and Peter Chess

While you were touring the Champagne region or sipping umbrella drinks at the beach this summer, the California Department of Corporations (the “DOC”) was busy overhauling the rules applicable to investment advisers.  On August 27, 2012, the DOC adopted final rules, available here, that provide for an exemption from registration for certain private fund managers pursuant to specific conditions.  This exemption, along with the rules previously adopted by the Securities and Exchange Commission (the “SEC”), now permits certain investment advisers that provide advice only to private funds to operate without being fully registered with either the SEC or the State of California. 

Unlike the SEC rules, this exemption does not prohibit a fund manager from registering with the DOC—it simply allows the fund manager to decide whether it would like to register or rely on the exemption.  To rely upon this exemption, a California based adviser must complete and file the Form ADV (required under Rule 204-4 of the Investment Advisers Act of 1940, as amended (the “Advisers Act”)) with the DOC that is required of an adviser that files for “exempt reporting adviser” status with the SEC.  But why would any adviser that is eligible to take advantage of the exemption decide to register? 

If a fund manager intends only to seek capital from “friends and family,” subjecting itself to the full registration requirements and the more complete compliance rules that are expected soon from the DOC could represent a significant expense to the manager.  Or, if a manager is leaving another organization and must quickly get to market, the three to four month process associated with the DOC review of an investment adviser application may be viewed as too long to wait.  But if a fund manager expects to target more institutional capital, or other investors that would have a reasonable expectation that the manager is subject to some regulatory oversight, the manager may very well decide that a California investment adviser registration is not so burdensome.  After all, a manager that seeks to rely on the exemption must still file the Form ADV, prepare a private placement memorandum, and have the fund audited, among other requirements discussed below.  The analysis that each fund manager must undertake in order to make this decision is multi-faceted and is ultimately one that is unique to each adviser and its own circumstance.

To briefly summarize the results of the DOC rulemaking, an investment adviser located in California may conduct its business without being a fully registered and regulated investment adviser under the DOC regulations so long as:

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

Additionally, with respect to Retail Buyer Funds:

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

When an adviser that is eligible for the California exemption reaches $100 million in assets, it would become an exempt reporting adviser with the SEC and would need to switch its status over to the SEC.  And when it reaches $150 million it must become a fully registered investment adviser with the SEC; accordingly, investment advisers can operate without being fully registered with the SEC or the State of California so long as they have less than $150 million in assets and satisfy the conditions discussed above.

The California exemption contains a “grandfathering” provision for Retail Buyer Funds formed prior to the release of the exemption, as the additional requirements listed above are deemed satisfied if the Retail Buyer Fund: (i) distributes annual audited financial statements; (ii) pre-existing investors receive the “material disclosures” discussed above; (iii) from August 27, 2012 on, the Fund only sells interests to “accredited investors”; and (iv) the adviser receives performance-based compensation only from pre-existing investors or “qualified clients.”

Written by: Jay Gould and Peter Chess

Effective December 3, 2012, hedge funds and other private funds that rely on Section 3(c)(1) of the Investment Company Act (“3(c)(1) Funds”) and which sell their interests through third party marketers, must ensure that their private placement memoranda (“PPM”) are filed with FINRA, the Financial Industry Regulatory Authority.  The Securities and Exchange Commission recently approved new FINRA Rule 5123, Private Placements of Securities, which is part of an ongoing approach by FINRA to enhance oversight and investor protection in private placements.  Under Rule 5123, each firm that sells a security in a private placement, subject to certain exemptions, must file a copy of the offering document with FINRA within 15 calendar days of the date of the first sale.  If a firm sells a private placement without using any offering documents, then the firm must indicate that it did not use an offering document.  The rule also requires firms to file any materially amended versions of the documents originally filed.  Rule 5123 exempts some private placements sold solely to qualified purchasers, institutional purchasers and other sophisticated investors.

For hedge funds and other  private funds that have hired a third party marketer, the fund manager must make sure that the agreement with the marketer, which is required to be a registered broker dealer, obligates the marketer to file the PPM with FINRA and amend the filing if the PPM is materially revised.  The marketing agreement, or “placement agency agreement” as it is sometimes called, should indemnify the fund manager for the failure of the marketer to make these filings.      

Rule 5123 will become effective December 3, 2012, and the full text of the FINRA regulatory notice regarding Rule 5123 is available here.

This guest post from the Margolis Advisory Group, co-authored by River Communications, is reprinted with permission.  The Executive Summary appears below and the full text is available here. 

The JOBS Act is bringing change to the hedge fund industry, and, most likely, this change will accelerate the trend towards institutionalization. The lifting of the “advertising ban” opens the playbook, allowing hedge funds to engage in a wide range of strategic communications and marketing activities. For some, this will offer a new opportunity to compete for assets with traditional managers adept at managing their brands and marketplace perceptions. Others will resist, possibly to their detriment, as funds will no longer have the luxury of hiding “under the radar.” 

Hedge funds who embrace the new, less restrictive environment will need to build mature, comprehensive strategic communications programs. The best practices include:

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

Hedge funds have thrived by embracing and even becoming catalysts for change. In this hyper-competitive industry, it is commonplace to expend disproportionate resources to capture even a minimal investment performance advantage. Because of this, it is surprising that there has not been more enthusiastic support in the trades for what is potentially the next major shift for the industry: the Jumpstart Our Business Startups Act or JOBS Act.

Passed with little fanfare, the JOBS Act lifts the ban on advertising for hedge funds (among other provisions) and has the potential to transform how managers market their firms, build their brands and communicate with their investors. Yet, much of the discussion in the trades and on the hedge fund industry speaking circuit has downplayed the potential impact of this provision as being only meaningful to the smaller funds. Large funds—as the typical explanation goes—believe they do not need to proactively market, as they commonly market off their mystique of exclusivity and will prefer to remain “under the radar” to protect their proprietary investment strategies. Furthermore, the larger funds are already staffed for one-on-one sales, and many in the hedge fund industry are under the false impression that sales are only based on individual contacts or “having the Rolodex.” 

The fact is, change is coming to the hedge fund industry, and many managers will continue to adapt to the ongoing evolution as they always have. Most likely, this change will accelerate the trend towards resembling traditional managers—for hedge funds can now adopt advertising and marketing techniques, as well. 

Consider the trends we have observed in the hedge fund and institutional asset management space, especially since the market declines of ’07-’08. New regulations have increased the demand for information on leverage and counterparty risk; the migration from single to multi-prime brokers has occurred, and institutional investors are demanding more transparency in investment operations, risk and administration. Perhaps, most significantly—the largest institutional investors have been allocating funds almost exclusively to the largest hedge funds. 

According to “The Evolution of the Industry: 2012,” an annual KPMG/AIMA hedge fund survey, institutional investors now represent a clear majority of all assets under management by the global hedge fund industry, with 57 percent of the industry’s AUM residing in this category. And, the proportion of hedge fund industry assets originating from institutional investors has grown significantly since the financial crisis. 

As a result, we are seeing a continuation of the institutionalization of hedge funds. The KPMG study confirmed this with survey data indicating that investors demand hedge funds look and act more like traditional institutional managers from an operational standpoint. In addition, 82 percent of respondents reported an increase in demand for transparency from investors, while 88 percent said investors are demanding greater due diligence. 

Our own experience consulting with hedge funds and traditional managers has confirmed other indications of this trend, as well as with all investors—large and small—demanding greater operational efficiency; cost reduction; and models that enhance overall risk management, such as the move from single to multi-prime relationships; all delivered in an open and transparent way. 

For hedge fund managers to attract large pools of money, they will increasingly need to be more institutional and transparent with all investors. This is a significant cultural shift for these firms. Not only do many hedge funds lack a strategic communications infrastructure, but the concept of such openness still runs contrary to the DNA of most firms. 

The question then becomes: how should hedge funds that embrace a more open and inclusive communications strategy implement programs that will help them achieve this goal? The answer is they will need to develop an approach to communications that is similar to traditional institutional asset managers.

Written by:  Jay B. Gould 

The recently enacted JOBS Act[1] 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.

[1]   The Jumpstart Our Business Startups 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.

Written by: Jay B. Gould and Peter Chess

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:

• Repeal the ban on general solicitation and general advertising for offerings under Rule 506 of Regulation D when sales are only to accredited investors;
• Revise Rule 144A to provide that securities sold under Rule 144A may be offered to persons other than qualified institutional buyers (“QIBs”), including by use of general solicitation or general advertising, provided that securities are only sold to persons reasonably believed to be QIBs; and
• Amend Section 4 of the Securities Act such that offers and sales exempt under Rule 506 shall not be deemed public offerings under the federal securities laws as a result of general advertising or general solicitation.

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.

Written by Jay Gould, Michael Wu and Peter Chess

The Commodity Futures Trading Commission (the “CFTC”) recently amended its registration rules regarding Commodity Pool Operators (“CPOs”) and Commodity Trading Advisors (“CTAs”), which will require many general partners and managers of private investment funds that previously relied on an exemption from registration to now register with the CFTC.  After a public comment period in which the industry overwhelmingly supported the continuation of these exemptions, the CFTC decided to rescind the CPO exemption under CFTC Rule 4.13(a)(4) and amend the CPO exemption under CFTC Rule 4.13(a)(3).  Rule 4.13(a)(4) previously exempted private pools from registering as a CPO with the CFTC for funds offered only to institutional qualified eligible purchasers (“QEPs”) and natural persons who meet QEP requirements that hold more than a de minimis amount of commodity interests.

The CFTC's amendment did not change the application of CFTC Rule 4.13(a)(3) to a fund of a hedge fund (“Fund of Funds”).  However, due to the repeal of these exemptions, many of the general partners or managers of a Fund of Funds’ underlying funds may be required to register as CPOs, thereby requiring registration of the Fund of Funds manager.  The CFTC has provided guidance with respect to when a Fund of Funds manager may continue to rely upon an exemption from registration as a CPO.  We have summarized these circumstances below:     

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

The CFTC amended Section 4.13(a)(3) to address how to calculate the notional value of swaps and how to net swaps.  In addition, the CFTC will now require a CPO relying on Section 4.13(a)(3) to submit an annual notice to the National Futures Association affirming its ability to continue relying on the exemption.  If a CPO cannot affirm its ability to do so, the CPO will be required to withdraw the exemption and, if necessary, apply for registration as such.

For additional information on whether these rule amendments will require you to register as a CPO or CTA, or whether the CFTC guidance or another exemption might provide a further exemption from registration, please contact your Pillsbury Investment Funds Attorney.

[1]   CFTC Rule 4.13(a)(3) requires that at all times either: (a) the aggregate initial margin and premiums required to establish commodity interest positions does not exceed five percent of the liquidation value of the Fund’s investment portfolio; or (b) the aggregate net notional value of the Fund’s commodity interest positions does not exceed one-hundred percent of the liquidation value of the Fund’s investment portfolio.

Last week’s article on HFMWeek entitled “Disclosure Gets Closer” discussed registration requirements of investment advisers to hedge funds under the Dodd-Frank Act.  The article, which was written by Will Wainewright, quoted Jay Gould, a partner and member of our Investment Fund and Investment Management team, who said “[T]he most difficult part of SEC registration – not an onerous process in itself – is implementing, testing, internally enforcing and updating the compliance procedures that the SEC will be checking on once you are registered.” 

A full text of the article is available here.

Written by 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.

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Written by Jay Gould, Ildiko Duckor and Peter Chess

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: 

• To process and grant applications for registration and withdrawals from registration of SDs and MSPs, and to notify of provisional registration; 
• In connection with processing and granting applications for registration of SDs and MSPs, to confirm initial compliance with such other related CFTC regulations that may be adopted;  
• To conduct proceedings to deny, condition, suspend, restrict or revoke the registration of any SD or MSP or any applicant for registration in either category; and 
• To maintain records regarding SDs and MSPs, and to serve as the official custodian of those CFTC records.

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.

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

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 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.

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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

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. 

Phased Implementation

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.

• By entering into FFI Agreements by June 30, 2013, withholding agents are given sufficient time to refrain from withholding on those participating FFIs by January 1, 2014.
• The effective date of FFI Agreements entered into on or before June 30, 2013 will be July 1, 2013.
• The effective date of FFI Agreements entered into after June 30, 2013 will be the date the FFIs entered into such agreements.
• FFIs who enter into FFI Agreements after June 30, 2013 but before January 1, 2014 will be considered FFIs for 2014 but might not be identified as FFIs in time to prevent withholding beginning January 1, 2014.

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

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. 

Reporting

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. 

Withholding

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 Bruce Frumerman, guest contributor

Bruce Frumerman is the CEO of Frumerman & Nemeth Inc., a communications and sales marketing consultancy that assists financial services firms create brand identities for their organizations and develop and implement effective new marketing strategies and programs. 

In the article below, Mr. Frumerman offers effective marketing strategies for hedge fund managers to stay competitive and successful in the business.  This article first appeared in Reuters HedgeWorld on July 18 and is re-printed with permission below.

Rising competition among money managers is one of the key topics covered in Boston Consulting Group’s recently released ninth annual study of the worldwide asset management industry, Building on Success: Global Asset Management 2011...

A full text of the article is available here.

Written by Jay Gould and Michael Wu

On June 22, 2011, the Securities and Exchange Commission (SEC) adopted final rules that implement provisions of Title IV of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”) amending the Investment Advisers Act of 1940 (the “Advisers Act”).   The amendments include:

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

The SEC also adopted final rules that eliminated the private adviser exemption under the Advisers Act and created three new exemptions from SEC registration for:

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

Written by Michael Wu

The Securities and Exchange Commission (“SEC”) has adopted rules implementing the Dodd-Frank Wall Street Reform and Consumer Protection Act’s (“Dodd-Frank Act”) Whistleblower Program.  The Whistleblower Program requires the SEC to pay awards, under regulations prescribed by the SEC and subject to certain limitations, to eligible whistleblowers who voluntarily provide the SEC with original information about a violation of the federal securities laws, or a rule or regulation promulgated by the SEC, that leads to the successful enforcement of a covered judicial or administrative action, or a related action that results in monetary sanctions of more than $1,000,000.  Dodd-Frank Act also prohibits retaliation by employers against individuals who provide the SEC with information about possible securities violations.

To view a full text of the Final Rule, please click here.

Written by Michael Wu

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 Jay Gould, Ildi Duckor and Michael Wu

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. 

Written by Ildiko Duckor and Michael Wu

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.

Posted by Michael Wu and Judy Deng

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.

By: Michael Wu

As the new year is upon us, we wanted to take a moment to remind you of some of the annual compliance obligations that you may have as an investment adviser that is registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”).  In light of the current regulatory environment, now more than ever, it is critical for you to comply with all of the legal requirements and best practices applicable to Investment Advisers.  The beginning of the year is a good time to review, consider and, if applicable, satisfy these requirements and best practices.

The following is a summary of the primary annual or periodic compliance-related obligations that may apply to Investment Advisers.  The summary is not intended to be a comprehensive review of an Investment Adviser’s tax, partnership, corporate or other requirements, nor an exhaustive list of all of the obligations of an Investment Adviser under the Investment Advisers Act of 1940, as amended (the “Advisers Act”) or applicable state law.  Although many of the obligations set forth below apply only to SEC-registered Investment Advisers, state-registered Investment Advisers may be subject to similar and/or additional obligations depending on the state in which they are registered.  State-registered Investment Advisers should contact us for additional information regarding their specific obligations under state law. 

• Update Form ADV.  An Investment Adviser must file an annual amendment to Form ADV Part 1 and Form ADV Part 2 within 90 days of the end of its fiscal year.  Effective on January 1, 2011, Investment Advisers must file both Part 1 and Part 2A of the Form ADV with the SEC through the electronic IARD system.  Accordingly, if you are SEC-registered adviser whose fiscal year ends on or after December 31, 2010, you must file Part 1A and Part 2A as part of your annual updating amendment by March 31, 2011.  If you are a state-registered adviser whose fiscal year ends on or after December 31, 2010, you must also file Part 1A, Part 1B and Part 2A as part of your annual updating amendment by March 31, 2011.
• New FINRA Entitlement Program.  FINRA is implementing changes to its Entitlement Program, which provides access to an Investment Adviser’s IARD account.  Every adviser firm (new and existing) is now required to designate an individual as its Super Account Administrator (SAA).  The SAA must be an authorized employee or officer of the adviser firm. 
• Fund IARD Account.  An Investment Adviser must ensure that its IARD account is adequately funded to cover payment of all applicable registration renewal fees and notice filing fees.  Beginning November 15, 2010, Preliminary Renewal Statements (“PRS”), which list advisers’ renewal fees, are available for printing through the IARD system.  By December 10, 2010, an investment adviser should have submitted to FINRA through the IARD system, its preliminary renewal fee.  Any additional fees that were not included in the PRS will show in the Final Renewal Statements which are available for printing beginning January 3, 2011.  All final renewal fees should be submitted to FINRA through the IARD system by February 3, 2011.
• State Notice Filings/Investment Adviser Representatives.  An Investment Adviser should review its advisory activities in the various states in which it conducts business and confirm that all applicable notice filings are made on IARD.  In addition, an Investment Adviser should confirm whether any of its personnel need to be registered as “investment adviser representatives” in any state and, if so, register such persons or renew their registrations with the applicable states.
• Brochure Rule.  On an annual basis, an Investment Adviser must provide its private fund investors and separate account client(s) with a copy of its updated Form ADV Part 2A, or provide a summary of material changes and offer to provide an updated Form ADV Part 2A. The 2011 deadline for providing investors with Form ADV Part 2B depends on whether an Investment Adviser is a new or existing SEC-registered adviser and whether the Investment Adviser is providing it to prospective, new or existing investors.
• Annual Assessment.  At least annually, an Investment Adviser must review its compliance policies and procedures to assess their effectiveness.  The annual assessment process should be documented and such document(s) should be presented to the Investment Adviser’s chief executive officer or executive committee, as applicable, and maintained in the Investment Adviser’s files.  At a minimum, the annual assessment process should entail a detailed review of:

1)      the compliance issues and any violations of the policies and procedures that arose during the year, changes in the Investment Adviser’s business activities and the effect that changes in applicable law, if any, have had on the Investment Adviser’s policies and procedures;

2)      the Investment Adviser’s code of ethics, including an assessment of the effectiveness of its implementation and determination of whether they should be enhanced in light of the Investment Adviser’s current business practices; and

3)      the business continuity/disaster recovery plan, which should be “stress tested” and adjusted as necessary. 

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

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

Written by Michael Wu

On November 11, 2010, the European Parliament adopted the EU Directive on Alternative Investment Fund Managers (the “Directive”).  The Directive will affect a significant number of alternative investment fund managers (“AIFMs”) that manage and/or market alternative investment funds (“Funds”), including hedge funds, commodity funds, private equity funds and real estate funds, within the European Union (“EU”).  The text of the Directive is expected to be published in the Official Journal sometime in the first or second quarter of 2011.  The Directive will be effective 20 days after publication and the EU Member States will have two years from such date to implement the Directive.   

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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.

On September 22, 2010, the Managed Funds Association submitted initial comments to the Securities and Exchange Commission and the Commodity Futures Trading Commission on regulatory topics under the Dodd-Frank Wall Street Reform and Consumer Protection Act. The MFA’s comments reflected concerns that the broad wording of the Dodd-Frank Act would result in certain provisions being inappropriately applied to private investment funds. To address these concerns, the MFA proposed that:

• the SEC not create a self-regulatory organization to oversee investment advisers;
• the SEC and the CFTC adopt guidance clarifying the criteria relevant to determining whether an investment adviser or a CTA that is registered with one of the agencies can rely on the relevant exemption from registration with the other agency;
• strong confidentiality safeguards be put in place to protect proprietary information of private fund advisers provided to the SEC or CFTC;
• appropriate implementation periods be provided to allow market participants time to adjust to any change in the definitions of “accredited investor” or “qualified client;”
• the SEC define “accredited investor” to include “knowledgeable employees” of a private investment fund and amend Rule 3c-5 under the Investment Company Act of 1940 to expand the types of employees who can qualify as “knowledgeable employees” under that Rule;
• the SEC and CFTC define “Security-Based Swap Dealer” (“SSD”) to exclude those market participants who are not in the business of buying and selling securities as well as those who buy and sell for their own account;
• the SEC and CFTC exclude swap customers from SSD registration and regulation with respect to their cleared security-based swaps;
• in setting capital requirements for non-bank Major Security-Based Swap Participants (“MSSPs”), the SEC and CFTC count collateral posted by such non-bank MSSPs towards any capital requirements;
• position limits not be imposed on swaps;
• the SEC not apply rules prohibiting incentive-based compensation to advisers of private investment funds;
• the SEC retain the existing reporting periods under Section 13(d) and Section 16(a) of the Securities Exchange Act of 1934; and
• the SEC not impose a new standard of conduct for investment advisers with retail customers.

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.