Articles Posted in Investment Advisers

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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.

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Written by Michael Wu

On July 28, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Part 2 of Form ADV, and related rules under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), to require registered investment advisers to provide clients with a “brochure” under Part 2A of Form ADV and a “brochure supplement” under Part 2B of Form ADV written in plain English.  The brochure contains information about the advisory firm and the brochure supplement contains information about the personnel who provide investment advice.

On December 28, 2010, the SEC extended the compliance dates for the brochure supplement.  Specifically, the new compliance dates are as follows:

  • New Investment Advisers: investment advisers filing their applications for registration between January 1, 2011 and April 30, 2011, have until May 1, 2011 to begin delivering brochure supplements to new and prospective clients and until July 1, 2011 to deliver brochure supplements to existing clients.  The compliance dates for investment advisers filing their applications for registration after April 30, 2011 remain unchanged.
  • Existing Investment Advisers: existing investment advisers with a fiscal year ending on December 31, 2010 through April 30, 2011, have until July 31, 2011 to begin delivering brochure supplements to new and prospective clients and until September 30, 2011 to deliver brochure supplements to existing clients.  The compliance dates for existing investment advisers with fiscal years ending after April 30, 2011 remain unchanged.

Please note that the SEC is not extending the compliance date for filing and delivery of the brochure required by Part 2A of Form ADV and the related rules under the Advisers Act.  The full text of the adopting rule is available here.

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Written by Michael Wu

The Alternative Investment Fund Managers Directive (the “Directive”) establishes a regulatory regime for all alternative fund managers, such as private equity and hedge fund managers, that are based in the European Union (the “EU”), manage funds based in the EU and market non-EU fund interests in the EU.  A general summary of the Directive is available here.

Although the majority of the Directive’s rules are likely to become effective by January 2013, some of the rules affecting non-EU funds and non-EU fund managers will be deferred until 2015 or later.  Thus, non-EU managers may still actively raise funds in the EU, but will have to comply with a number of additional regulatory requirements beginning in January 2013.

Beginning in January 2013, non-EU managers may actively fund raise in the EU provided that:

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

Beginning in early-2015, non-EU managers may be able to participate in the “passport” regime (i.e., they can fund raise in every EU country without obtaining separate regulatory authorization in each country) if the European Securities and Markets (“ESMA”) Authority decides to make the passport regime available to non-EU managers.  If the passport regime becomes available to non-EU managers, they would become authorized and regulated on the same basis as EU managers with respect to the passporting rights.  However, because the passport regime’s compliance obligations are onerous, non-EU managers may want to forgo the passporting rights and fund raise subject to country-by-country private placement regimes and the minimum directive requirements described above.

Beginning in mid-2018, non-EU managers may be required to operate under the passport regime in order to fund raise in the EU.  The Directive contains provisions that would ultimately terminate the national private placement regimes, leaving full authorization as the only option for non-EU firms that wish to fund raise in the EU.

ESMA and the European Commission have been tasked with issuing extensive implementing measures and guidance.  However, the details of these rules will not become clear for some time.

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Written by Michael Wu

On Friday, November 19, 2010, the Securities and Exchange Commission (the “SEC”) issued a Proposed Rule amending the Investment Advisers Act of 1940, as amended, and a Proposed Rule implementing provisions of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the “Dodd-Frank Act”). The purpose of the proposed rules is to strengthen the SEC’s oversight of investment advisers and fill key gaps in the regulatory landscape. The following is a summary of the key provisions of the proposed rules.

Increased Disclosure for Registered Advisers:  Under the proposed rules, advisers to private funds would have to provide the following information about the private funds they manage:

  • Basic organizational and operational information about the funds they manage, such as information about the amount of assets held by the fund, the types of investors in the fund, and the adviser’s services to the fund.
  • Identification of five categories of “gatekeepers” that perform critical roles for advisers and the private funds they manage (i.e., auditors, prime brokers, custodians, administrators and marketers).

In addition, the proposed rules would require registered advisers to provide more information about their advisory businesses, including information about:

  • The types of clients they advise, their employees, and their advisory activities.
  • Their business practices that may present significant conflicts of interest (such as the use of affiliated brokers, soft dollar arrangements and compensation for client referrals).

The proposed rules also would require advisers to provide additional information about their non-advisory activities and their financial industry affiliations.

Increased Disclosure for Exempted Advisers:  The proposed rules would require exempt reporting advisers (i.e., advisers that are exempt because they only advise venture capital funds or advise private funds with less than $150 million in assets under management (“AUM”)) to file, and periodically update, reports with the SEC, using the same registration form as registered advisers. Rather than completing all of items on the form, exempt reporting advisers would fill out a limited subset of items, including:

  • Basic identifying information for the adviser and the identity of its owners and affiliates.
  • Information about the private funds the adviser manages and about other business activities that the adviser and its affiliates are engaged in that present conflicts of interest that may suggest significant risk to clients.
  • The disciplinary history of the adviser and its employees that may reflect on their integrity.

As with registered advisers, exempt reporting advisers would file the reports on the SEC’s investment adviser electronic filing system (IARD), which means that such reports would be publicly available.

Pay-to-Play:  The proposed rules would amend the current investment adviser “pay-to-play” rule in response to changes made by the Dodd-Frank Act. The pay-to-play rule prohibits advisers from engaging in pay to play practices.  Under the proposed rules, an adviser could pay a registered municipal adviser, instead of a “regulated person,” to solicit government entities on its behalf if the municipal adviser is subject to a pay-to-play rule adopted by the MSRB that is at least as stringent as the investment adviser pay-to-play rule.

Dodd-Frank Act Exemptions:  Under the Dodd-Frank Act, the following advisers would not need to register with the SEC: (i) advisers solely to venture capital funds; (ii) advisers solely to private funds with less than $150 million in AUM in the U.S. or (iii) certain foreign advisers without a place of business in the U.S.  The proposed rules provide further guidance regarding these exemptions.

Definition of Venture Capital Fund:  Under the proposed rules, a venture capital fund is a private fund that:

  • Represents itself to investors as being a venture capital fund.
  • Only invests in equity securities of private operating companies to provide primarily operating or business expansion capital (not to buy out other investors), U.S. Treasury securities with a remaining maturity of 60 days or less, or cash.
  • Is not leveraged and its portfolio companies may not borrow in connection with the fund’s investment.
  • Offers to provide a significant degree of managerial assistance, or controls its portfolio companies.
  • Does not offer redemption rights to its investors.

Under a grandfathering provision, private funds that currently make venture capital investments and represent themselves as venture capital funds would generally be deemed to meet the proposed definition.

Definition of Private Fund Advisers with less than $150 million AUM in the U.S.:  Under the proposed rules, in order to rely on this exemption, a U.S. adviser would have to meet the conditions of the exemption with respect to all of its private fund AUM. A foreign adviser would have to meet the conditions of the exemption only with respect to its AUM in the U.S., but generally not with respect to its assets managed from abroad.

Definition of Foreign Private Advisers:  The proposed rules would define certain terms included in the statutory definition of “foreign private adviser” in order to clarify the application of the foreign private adviser exemption. The proposed rules incorporate definitions set forth in other SEC rules, all of which are likely to be familiar to foreign advisers active in the U.S. capital markets.

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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.

Scope: The Directive regulates AIFMs, rather than the Funds that they manage.  Specifically, the Directive regulates (a) EU AIFMs and (b) non-EU AIFMs that either (i) manage a Fund that is domiciled in the EU or (ii) market a Fund to investors in the EU.  A “small fund manager” that is regulated by its home EU Member State will be exempt from the majority of the Directive’s provisions if the AIFM manages less than €100 million in assets (or €500 million in assets, if its Funds do not use leverage and have at least a 5-year lock-up).

Marketing of Funds: The Directive defines “marketing” to mean “any direct or indirect offering or placement at the initiative of the AIFM or on behalf of the AIFM of units or shares in a [Fund] it manages to or with investors domiciled in the [EU].”  Under this definition, passive marketing (i.e., responding to inquiries from investors) would not be considered “marketing” under the Directive.  However, an AIFM’s use of a marketing or placement agent to conduct marketing activity in the EU would be considered “marketing” under the Directive.  The Directive implements a dual regime for marketing Funds in the EU.  An AIFM may market its Funds either (a) into an EU Member State if the EU Member State’s securities regulator expressly allows it, or (b) into all EU Member States under the EU “passport” regime.  However, the availability, applicable starting date and possible ending date will depend on whether the AIFM and/or the Fund is based in the EU or based outside of the EU.

Capital Requirements: If an AIFM only manages its own Funds, it must have initial capital of at least €300,000.  If an AIFM manages third party Funds, it must have initial capital of the higher of (a) ¼ of its annual expenditures and (b) €125,000.  In addition, if the Fund(s) managed by the AIFM have over €250 million in assets, the AIFM must have additional capital equal to 0.02% of the Fund(s) assets over €250 million.  However, in no event is the AIFM required to hold initial capital of more than €10 million.

Conduct of Business: The Directive will require AIFMs to meet certain conduct of business requirements, including the following:

  • No investor may obtain preferential treatment unless such treatment is disclosed in the Fund’s documentation.  Thus, side letter provisions would need to be disclosed to all investors in the Fund.
  • Conflicts of interest between the AIFM and the Fund or its investors must be disclosed and managed by the AIFM.
  • Risk management and portfolio management must be kept separate.
  • AIFMs must conduct stress tests and monitor the liquidity risk of open-ended Funds regularly.  The investment strategy, liquidity profile and redemption policy of each Fund managed by the AIFM must be consistent with each other.
  • In order to invest the Fund’s assets in any securitization positions, the originator of the securitization must retain at least a 5% net economic interest in the securitization.

Remuneration: AIFMs must have remuneration policies and practices that are consistent with and promote sound and effective risk management and do not encourage excessive risk taking.  For example, AIFMs may not guarantee multi-year bonuses, 50% of bonuses must be paid in the form of interests/shares of the Fund and 40-60% of bonuses must be deferred at least 3 to 5 years.  The remuneration policies and practices must apply to senior managers, but also to “control staff.”

Valuation: If an AIFM performs valuations internally, it must ensure that the valuation process is independent of the portfolio management and remuneration policies of the Fund and that measures are in place to identify and resolve conflicts of interest.  However, EU Member States have the authority to require an AIFM to subject its valuations to verification by external valuation agents or auditors.

Depositary: An AIFM must appoint a single depositary, such as an EU regulated bank or an EU securities firm, for each of its Funds.  If an AIFM manages a private equity fund, the depositary may be an “entity” that carries out depositary functions as part of its business activities.  For a non-EU Fund, generally, the depositary must be established in the jurisdiction where the non-EU Fund was formed or the jurisdiction of the AIFM’s principal place of business.

Delegation of AIFM Responsibilities: An AIFM must notify its regulator prior to delegating any of its responsibilities.  AIFMs may only delegate portfolio and/or risk management functions to regulated entities or with prior authorization from the AIFM’s regulator.  However, regardless of any delegation of functions, the AIFM will remain liable to the Fund and its investors as though no delegation was made.

Disclosure: Among other things an AIFM must satisfy the following disclosure requirements:

  • If the AIFM’s publicly available annual financial report does not satisfy the disclosure requirements of the Directive, each of its Funds must be audited annually.  The annually audited report must be made available to investors and the relevant regulatory agencies.  The report must provide details of remuneration.
  • An AIFM must provide its investors with information about the Fund, including its strategy (which may not work for “black box” hedge funds), what assets it may invest in, its valuation procedures, any descriptions of preferential treatment, the percentage of assets that are illiquid and subject to side pockets, changes in managing liquidity and its risk profile.  The AIFM must also regulatory disclose the amount of leverage the Fund employs.
  • An AIFM must report to its home EU Member State regulator(s) matters relating to the Fund, including those disclosed to its investors.  In addition, if the Fund uses leverage on a “substantial basis,” the AIFM must report the specifics regarding the Fund’s use of leverage.
  • If a Fund acquires 50% or more of the voting rights of a private company, the AIFM would have to provide information of its holding (a) to the company, (b) to all other shareholders of the company and (c) to its home EU Member State regulator.  The AIFM would need to disclose, among other things, the future development of the private company either in the company’s annual report or in the AIFM’s annual report.

Leverage: An AIFM must set and comply with reasonable leverage limits for each Fund that it manages.  EU Member States will have the authority to impose restrictions on the use of leverage.

The Directive will become effective in January 2011.  The EU Member States will then have two years to transpose the Directive into their respective national laws.  Over the next four years, the European Commission will pass further legislation to ensure consistent interpretation and effective implementation of the rules by the EU Member States.  The European Commission will also review the application and scope of the Directive four years after the Directive’s effective date, including its impact on private equity and venture capital funds.

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Written by Jay Gould

On November 16, 2010, the U.S. Securities and Exchange Commission (“SEC”) instituted public administrative and cease-and-desist proceedings against Thrasher Capital Management, LLC (“Thrasher”) and its Chief Executive Officer and Managing Member, James Perkins, pursuant to Sections 203(e), 203(f) and 203(k) of the U.S. Investment Advisers Act of 1940, as amended (the “Advisers Act”).  The proceedings were instituted because (i) Thrasher, a SEC-registered investment adviser, failed to make available to the SEC the books and records that Thrasher was required to make available under Section 204 of the Advisers Act and (ii) Thrasher’s Form ADV contained untrue statements of material facts regarding its client base and its ownership.  The SEC Order indicates that Thrasher did not respond to the SEC Examination Staff to contact them, which precipitated the SEC issuing a subpoena in order to compel cooperation.  The SEC also found material discrepancies in Thrasher’s Form ADV that could have been easily remedied with only a minimum of compliance oversight.  As a result of such conduct, the SEC found that Thrasher willfully violated Section 204(a) of the Advisers Act, which requires advisers that use the mails or interstate commerce to maintain and make available to the SEC certain books and records and Section 207 of the Advisers Act, which prohibits any “person” (defined to include advisers, such as Thrasher) to “make any untrue statement of a material fact in any registration application or report filed with the [SEC] under section 203 or 204, or willfully to omit to state in any such application or report any material fact which is required to be stated therein.”  Perkins was found to have willfully aided and abetted and to have caused Thrasher’s violations of Sections 204(a) and 207 of the Advisers Act.

In anticipation of the institution of the proceedings, Thrasher and Perkins submitted an Offer of Settlement (“Offer”), which the SEC accepted.  In connection with the Offer, the SEC ordered that (i) Thrasher and Perkins cease and desist from committing or causing any violations and any future violations of Sections 204(a) and 207 of the Advisers Act; (ii) Thrasher’s investment adviser registration be revoked; and (iii) Perkins be suspended from association with any investment adviser for nine months.  No monetary penalty was imposed on Perkins because he submitted a sworn Statement of Financial Condition along with other evidence and has asserted that he is unable to pay a civil penalty.

Investment advisers, whether registered with the SEC or a state, should view this particular enforcement action as an example of how not to interact with their primary regulator.  When the SEC or a state Securities Commission asks for information, advisers should respond promptly and professionally.  Additionally, with the new disclosure requirements that will be required in 2011 under the new “Brochure Rule,” advisers must be vigilant to maintain the accuracy of their disclosures in both their filings with regulators and their communications to clients.  The settlement of this enforcement action by Thrasher is now a material proceeding that must be disclosed to all current and potential clients.  Investment advisers should make every effort to avoid a similar fate and can do so with an effective compliance program that is appropriate to the business of each adviser.

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Written by Jay Gould

On March 10, 2010, the Securities and Exchange Commission (“SEC”) adopted amendments to Rule 201 and Rule 200(g) of Regulation SHO (“Rules”).  In order to give certain exchanges additional time to modify current procedures for conducting single-priced transactions for covered securities that have triggered Rule 201’s circuit breaker and to give industry participants additional time for programming and testing for compliance with the requirements of the Rules, the SEC has extended the compliance date for both Rules from November 10, 2010 to February 28, 2011.  A full text of the adopting rule is available here.

 

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As we have previously discussed here, the Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers overvalue illiquid assets so as to generate higher management fees. Most recently, on October 25, 2010, the SEC charged hedge fund manager Stephen M. Hicks and his investment advisory businesses with defrauding investors in funds managed by Southridge Capital Management LLC and Southridge Advisors LLC by overvaluing the largest position held by the funds.

According to the SEC’s complaint, the largest holding of the Southridge funds was an investment in Fonix Corporation, which was valued at $30 million. The Southridge funds had acquired Fonix securities in exchange for securities of two telecommunications companies owned by the Southridge funds – LecStar Telecom, Inc. and LecStar DataNet, Inc. (collectively, “LecStar”). Southridge and Hicks valued the Fonix securities at their cost of acquisition, which they determined to be equal to the appraised value of the LecStar securities at the time of the exchange. The SEC alleges that the defendants knew or should have known that this appraisal did not reflect the “real” acquisition cost of the Fonix securities because it was based on erroneous information indicating that LecStar was profitable and assumed that an earlier transaction in LecStar securities had been negotiated at arm’s length when in fact it was a transaction between affiliates.

Even if Southridge and Hicks had properly calculated the acquisition cost of the Fonix securities, they would not have been permitted to use this as the basis of a valuation. The offering materials for the Southridge funds indicated that such investments would be valued based on a valuation provided by a clearing broker or independent pricing service rather than acquisition cost.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

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The Securities and Exchange Commission’s Asset Management Unit has been investigating whether hedge fund managers have overvalued assets in “side pockets” and then charged investors higher fees based on those inflated values. A side pocket is a type of account that hedge funds use to separate certain illiquid investments from the rest of their portfolio. Investors are typically not permitted to redeem their interest in a fund with respect to assets allocated to a side pocket until such assets have been liquidated or reallocated to the general portfolio by the investment manager.

Recent charges brought by the SEC highlight the need for hedge fund managers to establish reasonable policies for the valuation of illiquid assets and carefully adhere to such policies when valuing assets allocated to a side pocket. On October 19, 2010, the SEC charged two hedge fund managers and their investment advisory businesses with defrauding investors by overvaluing illiquid fund assets they placed in a side pocket. According to the SEC complaint, Paul T. Mannion, Jr and Andrews S. Reckles, through their investment adviser entities PEF Advisors Ltd. and PEF Advisors LLC, caused certain investments made by Palisades Master Fund, L.P. to be overvalued by millions of dollars.

Beginning in August 2004, the fund, at the direction of Mannion and Reckles, invested millions of dollars in World Health Alternatives, Inc. By July 2005, World Health was the fund’s largest single position and constituted at least 20% of the fund’s assets. As World Health (now bankrupt) began to experience financial difficulties, Mannion and Reckles became concerned about the value of the fund’s World Health assets and the potential for any report of substantial losses in relation to such assets to cause investors to redeem their interests in the fund. Recognizing the risk of large scale redemptions, Mannion and Reckles decided to place the World Health assets in a side pocket.

Palisades had adopted specific policies on how it would value different categories of securities and communicated those policies to prospective investors in its offering memorandum and financial statements. Mannion and Reckles allegedly valued the World Health assets contrary to the disclosed valuation policies, which resulted in such assets being significantly overvalued. Mannion and Reckles then charged management fees that were improperly inflated by their overvaluation of fund assets.

Robert B. Kaplan, Co-Chief of the SEC’s Asset Management Unit, commented:

Side pockets are not supposed to be a dumping ground for hedge fund managers to conceal overvalued assets. Mannion and Reckles deceived investors about the fund’s performance and extracted excessive management fees based on the inflated asset values in a side pocket.

The SEC is seeking injunctive relief, disgorgement of profits, prejudgment interest, and financial penalties.

 

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Hedge fund and private equity fund managers that use registered broker-dealers to raise capital on behalf of their funds should be aware of a recent report from the North American Securities Administrators Association (“NASAA”). The 2010 Broker-Dealer Coordinated Examination Report identifies the most prevalent compliance deficiencies by broker-dealers and offers a series of recommended best practices for broker-dealers to consider in order to improve their compliance practices and procedures.

Fund managers should conduct initial and ongoing due diligence on all of their agents and service providers, and no less so with third party marketers, which must be registered as broker-dealers.  Agreements between fund managers and their third party marketers should include representations from the marketer that no information will be given to potential fund investors that is not approved by the fund manager.  The agreement should include an indemnification by the third party marketer to the fund manager in the event a fund investor relies on information produced by the marketer that is not accurate and complete in all material respects.

A fund manager that understands the nature of past violations by a broker dealer/third party marketer will be in a better position to protect the reputation of his/her firm.  When conducting due diligence of third party marketers, fund managers should view the FINRA “Broker Check” tool and information provided by the SEC, as well as request information regarding past engagements of the third party marketer.  Fund managers should inquire about pending or ongoing regulatory investigations, customer complaints, and whether the third party marketer has implemented NASAA’s “10 Best Practices” for broker-dealers.

The NASAA Report took into account a total of 290 examinations conducted between January 1, 2010 and June 30, 2010, which found 567 deficiencies in five compliance areas.  The greatest number of deficiencies (33 percent or 185 deficiencies) involved books and records, followed by sales practices (29 percent or 164 deficiencies), supervision (20 percent or 115 deficiencies), registration and licensing (10 percent or 56 deficiencies), and operations (8 percent or 47 deficiencies).

The three most commonly found problem areas involved failure to follow written supervisory policies and procedures, advertising and sales literature, and variable product suitability. Half of the examinations involved one-person branch offices, 19 percent were home offices, 18 percent were branch offices with two to five agents, 10 percent were branch offices with more than five agents and 3 percent were non-branch offices.