Articles Tagged with Private Funds

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The following are some of the important annual compliance obligations investment advisers either registered with the Securities and Exchange Commission (the “SEC”) or with a particular state (“Investment Adviser”) and commodity pool operators (“CPOs”) or commodity trading advisors (“CTAs”) registered with the Commodity Futures Trading Commission (the “CFTC”) should be aware of.

This summary consists of the following segments: (i) List of Annual Compliance Deadlines; (ii) 2017 Enforcement Priorities In The Alternative Space; (iii) New Developments; and (iv) Continuing Compliance Areas.

Table of Contents

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Table of Annual Compliance Deadlines……………………………………………………………. 3

2017 Enforcement Priorities In The Alternative Space………………………………………. 5

New Developments………………………………………………………………………………………. 7

 

CONTINUE READING…

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  • 3(c)(1) funds should update their offering documents to reflect $2.1 million net worth requirement.
  • Assets under management threshold remains unchanged at $1 million.
  • Only new client relationships entered and new investors admitted in private funds after August 15, 2016 are affected; new contributions by pre-August 15 investors are grandfathered.

The Securities and Exchange Commission (the “SEC”) issued an order on June 14, 2016 raising the net worth threshold for “qualified clients” in Rule 205-3 under the Investment Advisers Act of 1940, as amended (the “Advisers Act”).  Effective August 15, 2016, the dollar amount of the net worth test increased from $2 million to $2.1 million. The dollar threshold of the assets-under-management test has not changed and remains at $1 million.  Adjustments to the dollar thresholds for the assets-under-management and net worth tests under Rule 205-3 are made pursuant to section 418 of the Dodd-Frank Act and section 205(e) of the Advisers Act and are intended to reflect inflation.  The adjusted amounts would reflect inflation from 2011 until the end of 2015.

Under the Advisers Act, an investment adviser is generally prohibited from receiving performance fees or other performance-based compensation.  Section 205(e) of the Advisers Act provides for an exemption to this prohibition and Rule 205-3 under the Advisers Act permits an investment adviser to receive performance fees only from “qualified clients.”  The increased threshold affects private funds that rely on the exception to the definition of investment company provided in section 3(c)(1) of the Investment Company Act (“3(c)(1) Funds”) which, under the rule, are allowed to pay performance-based fees if their investors are qualified clients.  Accordingly, 3(c)(1) Funds must amend their offering documents to conform to the new qualified client net worth threshold.

Grandfathering:  Subject to the transition rules of Rule 205-3, the June 2016 SEC order generally does not apply retroactively to clients that entered into advisory contracts (including investors that invested in a private fund) prior to the August 15, 2016 effective date.

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President Obama signed into law the SBIC Advisers Relief Act (as part of the Fixing America’s Surface Transportation Act of 2015—the FAST Act) on December 4, 2015.  (See also our Annual Compliance Alert)  After the enactment of the Dodd-Frank Act, advisers to Small Business Investment Companies (SBICs) were limited in their choice to one of the available exemptions from registration under the Investment Advisers Act of 1940. The SBIC Advisers Relief Act provides certain additional relief for investment advisers that advise private funds and SBICs, and for those that advise venture funds and SBICs. The SEC’s Investment Management Guidance update  interprets the SBIC Advisers Relief Act and its implications.

What is an SBIC?

An SBIC is a privately owned and operated investment company making long term investments specifically in U.S. businesses and is licensed by the Small Business Administration (SBA). The primary reason firms choose to become licensed with the SBA is to secure SBA financing.

What is the SBIC Adviser Exemption?

As originally implemented by the Dodd-Frank Act, the SBIC adviser exemption provided relief from SEC registration to those advisers whose only clients consisted of one or more SBICs, irrespective of assets under management.  However, the SBIC adviser exemption did not allow advisers to combine multiple exemptions such as the private fund or venture capital fund adviser exemptions in order to avoid SEC registration.

For example, an Adviser to both a venture fund and an SBIC (that does not qualify as a venture fund) would not be able to rely on either the venture capital fund adviser exemption or the SBIC adviser exemption.  Instead, the adviser would have had to rely on the private fund adviser exemption which would only be available to it if it had less than $150 million in regulatory assets under management.

Impact of the SBIC Advisers Relief Act on the use of the Venture Capital Fund and Private Fund Adviser Exemptions

The SBIC Advisers Relief Act amends Investment Advisers Act by:

  • including in the definition of a venture capital fund SBIC funds (other than business development companies).
  • excluding from the private fund adviser exemption the $150 million asset limitation with respect to a private fund that is a SBIC fund (other than a business development company).

As a result, an adviser:

  • may rely on the venture capital fund adviser exemption and advise both SBICs and venture capital funds; or
  • may rely on the private fund adviser exemption and advise both SBICs and non-SBIC private funds as long as the non-SBIC private funds account for less than $150 million in assets under management.
  • that is registered and advises SBICs may be eligible to withdraw its registration and begin reporting to the SEC as an exempt reporting adviser under either the venture capital fund adviser exemption or the private fund adviser exemption.

In contrast to an adviser relying solely on the SBIC Adviser Exemption, the SEC staff believes that when an SBIC adviser choses to rely on the private fund or venture capital fund exemption, the adviser is required to submit reports to the SEC as an exempt reporting adviser.

Additionally, the SEC staff notes that (i) advisers currently relying on the private fund or venture capital adviser exemption may advise SBIC clients following the revised exemptions and (ii) certain registered advisers of SBICs may be eligible to withdraw their current registration and rely upon the private fund adviser or the venture capital fund exemption as exempt reporting advisers.

State Implications

It is important to note that the Investment Advisers Act, as amended by the SBIC Advisers Relief Act, now preempts states from requiring advisers that rely on the SBIC fund exemption to register, be licensed or qualify as an investment adviser in the state.  As a result of the federal preemption, advisers that manage only SBIC funds will be relieved from having to register (or may withdraw if registered) in states that have not adopted exemptions to investment adviser registration analogous to the Investment Advisers Act.

Please contact an Investment Funds and Investment Management group attorney for further detail and with your questions.

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On January 11, the Office of Compliance Inspections and Examinations (OCIE) of the SEC announced its 2016 Examination Priorities (“Priorities”). To promote compliance, prevent fraud and identify market risk, OCIE examines investment advisers, investment companies, broker-dealers, municipal advisors, transfer agents, clearing agencies, and other regulated entities. In 2016, OCIE will continue to rely on the SEC’s sophisticated data analytics tools to identify potential illegal activity.

This year, private fund advisers should pay attention to the following OCIE Priorities:

  • Side-by-side management of performance-based and asset-based fee accounts: controls and disclosure related to fees and expenses
  • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
  • High frequency trading: excessive or inappropriate trading
  • Liquidity controls: potentially illiquid fixed income securities – focus on controls over market risk management, valuation, liquidity management, trading activities
  • Marketing / Advertisements: new, complex, and high risk products, including potential breaches of fiduciary obligations
  • Compliance controls: focus on repeat offenders and those with disciplined employees

Highlights for other market participants:

  • Never-Before-Examined Investment Advisers and Investment Companies: focused, risk-based examinations will continue
  • Broker-Dealers:
    • Marketing / Advertisements: new, complex, and high risk products and related sales practices, including potential suitability issues
    • Fee selection / Reverse Churning: multiple fee arrangements – recommendations of account types, including suitability, fees charged, services provided, and disclosures
    • Market Manipulation: pump and dump; OTC quotes; excessive trading
    • Cybersecurity: testing and assessments of firms’ implementation of procedures and controls
    • Anti-Money Laundering: missed SARs filings; adequacy of independent testing; terrorist financing risks
    • Registered representatives in branch offices – focus on inappropriate trading
    • Retirement Accounts: suitability, conflicts of interest, supervision and compliance controls, and marketing and disclosure practices
  • Public Pension Advisers: pay to play, gifts and entertainment
  • Mutual Funds and ETFs: liquidity controls – potentially illiquid fixed income securities
  • Immigrant Investor Program: Regulation D and other private placement compliance

For additional details, visit the SEC’s Examination Priorities for 2016. Please call an Investment Funds and Investment Management Attorney to discuss your firm’s risk areas.

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The SEC, again, makes it clear:  all aspects of fee, expense and other arrangements must be disclosed accurately and in detail before commitments are accepted.

The SEC recently announced a settlement with three investment advisor affiliates of The Blackstone Group (the Advisors) that were accused of breaching their fiduciary duty to funds they manage or managed, failing to make necessary disclosure to the funds’ investors and failing to adopt and implement policies and procedures reasonably designed to prevent violations of the Investment Advisers Act of 1940 and its rules. The charges leveled against the Advisors centered on conflicts of interest involving monitoring fees and legal fee discounts. At the time the alleged violations occurred, each of the Advisors was an SEC-registered investment advisor. Although the Advisors neither admitted nor denied the SEC’s findings, they made several changes to existing business practices, agreed to pay the SEC a $10 million penalty and agreed to remit to their funds fees and interest approximating $29 million in response to allegations of violations of Section 206(2) and Section 206(4) of the Investment Advisers Act and Rules 206(4)-8 and 206(4)-7 thereunder.

Accelerated Monitoring Fees

According to the SEC, the Advisors entered into monitoring agreements with each portfolio company owned by their funds and received, in addition to the annual management fees paid by their funds, monitoring fees from the portfolio companies. In accordance with the funds’ limited partnership agreements, fifty percent of the Advisors’ monitoring fees was used to offset the annual management fee otherwise payable by the funds. Under certain of the monitoring agreements, in the event of a private sale or initial public offering of a portfolio company, monitoring fees could be accelerated for the remaining years of the agreements’ terms (including extension periods), discounted to present value and paid in advance upon termination of the agreements. Notwithstanding that fifty percent of the accelerated monitoring fees inured to the benefit of the funds and their limited partners, the SEC found the arrangements problematic because the value of the funds’ assets was reduced by the net amount of the accelerated monitoring fee payments when the portfolio companies were sold or taken public, thereby reducing amounts available for distribution to the limited partners.

The SEC was particularly offended by the fact that, in certain instances, fees were accelerated beyond the period during which a fund owned the relevant portfolio company or beyond the period during which services were performed by the Advisors. In addition, the SEC alleged that, although the Advisors disclosed their ability to collect monitoring fees to the funds and the funds’ limited partners before capital was committed to the funds, the Advisors did not disclose the practice of accelerating monitoring fees prior to the time the Advisors received the accelerated fees. The SEC conceded, however, that monitoring fee acceleration was disclosed in distribution notices, quarterly management fee reports and, where there were public offerings of portfolio companies, in SEC filings on Form S-1. The SEC further acknowledged that the funds’ limited partner advisory committees could have objected to acceleration and arbitrated the matter, but never took such action. The problem, according to the SEC, is that, because of the conflict of interest, the Advisors could not effectively consent to the acceleration.

Disparate Discounts on Legal Fees

The Advisors also negotiated a single agreement with legal counsel pursuant to which legal counsel provided services to the funds and the Advisors.  According to the SEC, although the funds generated significantly more work than the Advisors, the Advisors received substantially greater discounts than the funds. In addition, the difference in the discounts was not disclosed to the funds, the funds’ advisory committees or limited partners. Again, because of the conflict, the Advisors could not consent effectively.

Takeaways

The findings made and penalties imposed by the SEC in the Blackstone matter highlight the SEC’s disdain of conflicts of interest between advisors and the private funds they manage. More importantly, the matter makes clear the SEC’s intention to go after even the most common business practices in private equity, if the SEC determines that aspects of those practices are not disclosed fully prior to the time capital commitments are accepted. Nothing is sacrosanct.

As was the case with Blackstone, a fund’s private placement memorandum typically discloses that the fund’s management entities and affiliates of those entities may receive fees to which the fund will not be entitled. It also customarily discloses actual and potential conflicts involving fund counsel. The SEC has made clear that those disclosures will not be sufficient if they do not describe all aspects of the relevant conflicts clearly, accurately and completely. Broad and generalized disclosures, even where sophisticated and experienced fund investors are able to discern the nature of the conflict, will not protect against violations of Sections 206(2) and 206(4) of the Investment Advisers Act and the rules promulgated under those sections of the Act. Further, disclosures made after investors’ capital commitments are accepted may not be sufficient.

This case also highlights the fact that the SEC will push back against attempts by an SEC-registered investment advisor to limit its fiduciary duty to the funds it advises. In addition, it appears that the SEC will apply Section 206(2) and Section 206(4) of the Investment Advisers Act broadly and with a big stick.

As is always the case, cooperation with the SEC in connection with an examination or investigation is critical. In addition, as is evidenced in the Blackstone matter, taking remedial action to eliminate or ameliorate conflicts can be very helpful to an advisor that is under SEC scrutiny and seeking to minimize exposure to punitive action.

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Brian Finch, a partner in Pillsbury’s Public Policy Practice, will be speaking on cybersecurity at a 100WHF event in San Francisco on October 13, 2015.  The event is titled Under Attack: Cyberdefense in the Network Age. Mr. Finch is recognized as a leading legal authority on matters related to cyber security.  He co-authored an article on Cybercrimes affecting hedge funds, posted in our blog.

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U.S. Investment advisers, other financial services providers, and pooled investment vehicles – private and public funds – involved in certain cross-border transactions must file.

Background

The U.S. Department of Commerce’s Bureau of Economic Analysis (“BEA”) is conducting its next five-year “Benchmark Survey of U.S. Financial Services Providers and Foreign Persons” on Form BE-180. The survey is mandatory and collects data on cross-border trade and financial services transactions of U.S. financial services providers, including investment advisers and other asset managers, broker-dealers and banks. BE-180 covers cross-border purchase and sales transactions that occurred or were charged during the U.S. reporter’s 2014 fiscal year. BE-180 is one of a series of benchmark surveys[1] measuring international trade transactions and collecting data for use in various economic studies.

Who Is Required to Report

Each U.S. individual and entity that is a “financial services provider” and meets the reporting requirements must file form BE-180. Financial services providers include investment advisers and their pooled vehicles such as hedge funds, private equity funds, pension funds, mutual funds and real estate funds, and broker-dealers.[2]

Filing Thresholds

The reporting requirement applies to each U.S. individual or entity that is a financial services provider with (i) either[3] sales or purchases directly with non-U.S. individuals or entities in excess of $3 million or more on a consolidated basis during the 2014 fiscal year, or (ii) sales or purchases directly with non-U.S. individuals or entities of less than $3 million, that were notified by the BEA about the survey. Any U.S. individual or entity that is notified by the BEA about the survey but has no transactions of the types of services covered must complete pages 1-3 of the survey.

Reportable Transactions

Reportable financial transactions include investment management and advisory services, brokerage services, underwriting, custodial services, credit-related services, securities lending, and electronic funds transfer services – transactions involving cross-border payments, such as advisory or sub-advisory fees, brokerage commissions, custodial fees and securities lending fees.

Reportable data include the transactional counterparty’s location by country and the relationship between the U.S. reporter and its counterparty (i.e., foreign affiliates or unaffiliated foreign persons). You may have easy access to some of the required data (such as through your administrator or internal accounting systems). However, as with the other BE forms, obtaining some of the required information may involve additional legwork and cooperation with cross-border counterparties, which should be considered in meeting the deadlines.

Filing Deadline and Extensions

The BEA has granted automatic extensions to the original October 1 filing deadline, as follows:

File no later than November 1, 2015 if:

  • You were notified of the BE-180 survey by BEA and have a BE-180 identification number below 140012490.
  • You were NOT notified of the BE-180 survey by BEA and do NOT have a BE-180 identification number.

File no later than December 1, 2015 if:

  • You were notified of the BE-180 survey by BEA and have a BE-180 identification number above 140012490.

Additional extensions to each filing deadline will be granted by the BEA if a request is submitted by November 1, 2015 as instructed by the BEA.

Penalties

Failure to file a required report can lead to civil and criminal penalties.

Confidential Treatment

Like it is the case with the other BE forms, information reported on BE-180 is confidential and may be used for only analytical or statistical purposes.

Sources

Form BE-180 is available online here.

Instructions for new filers are available here.

Form instructions are available here.

FAQs regarding the BE-180 benchmark survey are available here.

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[1] See our alerts and articles on other BEA survey forms here.

[2] Additional entities included in the definition are commercial banking entities, bank holding companies, financial holding companies, savings institutions, check cashing and debit card issuing entities, underwriters, investment bankers, providers of securities custody services, insurance carriers, insurance agents, insurance brokers, and insurance services providers.

[3] The $3 million threshold applies to purchases and sales separately, and must be reported on separate schedules to the BE-180. Consequently, a U.S. reporter, for example, that only exceeds the threshold for sales but does not reach the threshold for purchases, is only required to complete the schedule relating to sales.

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The U.S. Treasury Department’s Financial Crimes Enforcement Network (FinCEN) issued a notice of proposed rulemaking on August 25, 2015 which, among other things, would add SEC-registered investment advisers to the “financial institutions” regulated under the Bank Secrecy Act (BSA). This represents another step by the U.S. government to expand the professions and industries deemed anti-money laundering (AML) gatekeepers. Covered investment advisers will face new AML program, reporting and record-keeping requirements, with implications for hedge, private equity and other funds; money managers; and public or private real estate funds.

FinCEN has long expressed an interest in regulating investment advisers, which it believes may be vulnerable to or may obscure money laundering and terrorist financing. Should the rule become final, SEC-registered investment advisers would be included in the regulatory definition of “financial institution” and, as a consequence, required to establish and implement appropriately comprehensive written AML programs and comply with a variety of reporting and recordkeeping requirements under the BSA. Investment advisers that already implemented AML programs would need to evaluate them to ensure they comply with BSA requirements.

Who are Covered “Investment Advisers”?

Investment advisers provide advisory services, such as portfolio management, financial planning, and pension consulting, to many different types of clients, including institutions, private funds and other pooled investment vehicles, pension plans, trusts, foundations and mutual funds. According to the proposed rule, an “investment adviser” would be defined as “[a]ny person who is registered or required to register with the SEC under section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(a)).”

The definition would cover all investment advisers, including subadvisers, subject to Federal regulation which, generally speaking, would include advisers that have $100 million or more in assets under management. This includes investment advisers engaging in activities with publicly or privately offered real estate funds. Small- and medium-sized investment advisers that are state-registered and other investment advisers that are exempt from SEC registration requirements would not be captured by the proposed rule. FinCEN indicated, however, that future rulemaking may include those types of advisers.

READ MORE…

Read this article and additional publications at pillsburylaw.com/publications-and-presentations.  You can also download a copy of the Client Alert.

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The expense provisions of many private fund governing documents are becoming longer and more detailed for good reason – increased Securities and Exchange Commission (SEC) scrutiny and prosecution relating to expense allocation and disclosure.

On April 29th, the SEC announced charges against Alpha Titans LLC, a hedge fund advisory firm, its principal, Timothy P. McCormack and its general counsel, Kelly D. Kaeser, for improper use of fund assets to pay expenses that were not previously disclosed to fund investors. According to the SEC, office rent, employee salaries and benefits and other expenses totaling more than $450,000 were paid by two affiliated private funds without adequate disclosure or authorization. The SEC further alleged that Alpha Titans, McCormack and Kaeser sent investors audited financials that did not disclose that approximately $3 million of expenses pertained to transactions involving affiliates of McCormack.

According to the SEC, the funds’ outside auditor, Simon Lesser, was aware of the manner in which expenses and assets were allocated, yet approved audit reports containing unqualified opinions that the financial statements were presented fairly. He was charged with engaging in improper professional conduct in connection with an audit of the funds’ financial statements. The advisory firm also was charged with custody rule violations relating to its distribution on non-GAAP-compliant financial statements.

All of the charges were settled without admission or denial of responsibility; however, not without significant cost. McCormack and Kaeser will be barred from the securities industry for one year and Kaeser will be unable to represent an SEC-regulated entity for one year. Lesser will be suspended from providing accounting services on behalf of an entity regulated by the SEC for at least three years. Substantial monetary penalties also were assessed and the advisory firm and its principal agreed to pay disgorgement and prejudgment interest.

The lesson for private funds, their advisers and outside auditors is simple. First, fund documents should clearly, accurately and thoroughly disclose the types and amounts of expenses to be charged to the fund or its investors. Second, fund managers must allocate expenses and use fund assets strictly in accordance with the relevant provisions in the fund documents. Finally, outside auditors must be diligent in reviewing expense allocations and the use of fund assets to determine compliance with fund documents.

There should be no doubt that the risk of non-compliance is real.

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On April 20, 2015, the Securities and Exchange Commission (“SEC”) issued an order against an investment advisory firm and its former chief compliance officer, for violating Sections 206(2) and 206(4) and rule 206(4)-7 of the Investment Advisers Act and rule 38a-1 of the Investment Company Act. The SEC charged BlackRock Advisors LLC with breaching its fiduciary duty by failing to disclose a conflict of interest involving the outside business activity of one of its top-performing portfolio managers, Daniel J. Rice III. BlackRock agreed to be censured and to settle the charges by paying a $12 million penalty and engaging an independent compliance consultant to conduct an internal review.

During his tenure as an energy sector portfolio manager at BlackRock, Rice founded an oil and gas exploration and production company, formed a joint venture with a public company held in his managed funds, and acquired a second public company also held in BlackRock portfolios. BlackRock learned of Rice’s outside business activity, but allowed him to continue his involvement. The SEC found that BlackRock failed to report the conflicts of interest to the board of directors of the affected registered funds or advisory clients and failed to monitor and reassess Rice’s outside business activity after discovering the conflicts of interest. The SEC also censured BlackRock for failing to maintain and implement internal policies regarding the outside activities of employees. While Blackrock’s policies required employees to report potential conflicts and to seek pre-approval before serving on a board of directors, the firm failed to outline how employees’ outside activities would be assessed for conflicts purposes or to identify the individuals responsible for assessing outside activities.

Additionally, the SEC found BlackRock’s former chief compliance officer personally liable for causing the failure by BlackRock funds to report material compliance matters—namely Rice’s violation of BlackRock’s private investment policy—to their board of directors. The ex-officer agreed to pay a $60,000 civil penalty to settle the charge.

If you have question concerning your firm’s internal policies on the outside business activities of employees, please reach out to your Pillsbury attorney contact.