Articles Tagged with Investment Advisers Act Of 1940

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The Office of Compliance Inspections and Examinations (OCIE) of the SEC issued a Risk Alert yesterday providing a list of the most frequently identified compliance issues relating to the Advertising Rule (Rule 206(4)-1) under the Investment Advisers Act of 1940.  These compliance issues were identified as part of the OCIE examination of investment advisers:  misleading performance results, misleading one-on-one presentations, misleading claim of compliance with voluntary performance standards, “cherry-picked” profitable stock selections, misleading selection of recommendations and insufficient/inaccurate compliance policies and procedures.

Compliance with the Advertising Rule has long been, and remains, a favorite focus of the SEC.  In an age of fundraising challenges, investment advisers must balance the pressing need of appealing to prospective clients with adherence to precise regulatory standards.  Each marketing piece should go through rigorous internal review and sign-off procedures and, as necessary, outside counsel evaluation.  Investment advisers are urged to pay special attention to any form of performance or track record marketing.

Click here for the full Risk Alert. Contact your Pillsbury attorney for additional assistance.

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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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In line with the Securities and Exchange Commission’s (SEC) goal to enhance regulatory safeguards in the asset management industry, the SEC yesterday released a proposed new rule and rule amendments under the Investment Advisers Act of 1940. The proposed new rule 206(4)-4 would require SEC-registered investment advisers to adopt and implement written business continuity and transition plan (BCP) and review the plan’s adequacy and effectiveness at least annually.  The proposed amendment to rule 204-2 would require such advisers to keep copies of all BCPs that are in effect or were in effect during the last five years, and any records documenting the adviser’s annual review of its BCP.

The proposed rule is designed to address operational and other risks (internal or external) related to a significant disruption (temporary or permanent) in the investment adviser’s operations. Operational risks and disruptions generally include natural disasters or calamities, cyber-attacks, system failures, key personnel departure, business sale, merger, bankruptcy and similar events.

Under the proposed rule, an SEC-registered adviser should develop its BCP based upon risks associated with the adviser’s business operations and must include policies and procedures that minimize material service disruptions and address the following critical elements:

  • System maintenance and data protection
  • Pre-arranged alternate physical locations
  • Communication plans
  • Review of third-party service providers
  • Transition plan in the event of dissolution or inability to continue providing advisory services

The comment period will be 60 days after the proposed rule is published in the Federal Register.

A full copy of the proposed rule is available HERE.

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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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In commemorating the 75th anniversary of the Investment Company Act and Investment Advisers Act, David Grim discussed his views about the past, present and future of the investment management industry.  He selected four topics which in his opinion best illustrate the adaptability which the authors gave the 1940 laws governing the asset management industry.

Those topics are: (1) the role of exchange-traded funds (ETFs), (2) the role of private fund advisers, (3) the role of disclosure and reporting in our regulatory framework, and (4) the role of the board in fund oversight.

He called disclosure one of the critical pieces of the 40 Acts, and noted that the amount of information available to investors about funds and advisers through publicly available forms, prospectuses and offering documents has increased exponentially since 1940.  Specifically regarding private funds, he noted that the vast number of newly registered advisers after the passage of Dodd-Frank have resulted in a new era of transparency that has been beneficial to both investors and private fund advisers, in addition to the SEC.  The public availability of aggregated information has shed light on persistent questions and some misconceptions about the private fund industry. Investors have also benefitted by being able to make more informed choices when investing.

The full remarks are available here.

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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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On October 29, 2014, the Securities and Exchange Commission (“SEC”) announced an administrative enforcement action against an investment advisory firm and three top officials for violating rule 206(4)-2 under the Investment Advisers Act of 1940 (“Advisers Act”), the “custody rule,” that requires firms to follow certain procedures when they control or have (or are deemed to have) access to client money or securities.  This enforcement action follows closely on the heels of statements by SEC officials indicating that violations of the custody rule were a recurring theme during the “presence exams” of private equity fund advisers and other first time investment adviser registrants that have been conducted by the SEC staff over the last year and a half.

Advisory firms with custody of private fund assets can comply with the custody rule by distributing audited financial statements to fund investors within 120 days of the end of the fiscal year.  This provides investors with regular independent verification of their assets as a safeguard against misuse or theft.  The SEC’s Enforcement Division alleges that Sands Brothers Asset Management LLC has been repeatedly late in providing investors with audited financial statements of its private funds, and the firm’s co-founders along with its chief compliance officer and chief operating officer were responsible for the firm’s failures to comply with the custody rule.  As investment adviser registrants are painfully aware, chief compliance officers have personal liability for compliance failures under Advisers Act rule 206(4)-7.  This particular enforcement action was brought pursuant to section 203(f) of and rule 206(4)-2 under the Advisers Act.  It remains to be seen whether the SEC will bring a separate action against the Sands Brothers’ chief compliance officer under rule 206(4)-7.

Also nervously awaiting any further action by the SEC would be the accountants and lawyers that advised the Sands Brothers and their hedge funds with respect to the custody matter.  The accounting firm or firms that conducted the audit of the Sands Brothers hedge funds likely knew that the funds did not meet the requirements of the custody rule.  It is less certain whether the external lawyers knew or should have known about these violations.  However, if either the accountants or lawyers knew of these violations and advised that they were only technical in nature and immaterial or  unimportant, the SEC could take separate administrative action pursuant to SEC rule 102(e) to bar any such party from practicing before the SEC.  We previously wrote about the more aggressive posture that the SEC signaled with respect to service providers, specifically lawyers that assist or “aid and abet” violations of the securities laws.  The SEC has a fairly high standard to meet when bringing these types of cases, but that has not deterred the regulator from aggressively pursuing more accountants and lawyers in recent months.

According to the SEC’s order instituting the administrative proceeding, Sands Brothers was at least 40 days late in distributing audited financial statements to investors in 10 private funds for fiscal year 2010.  The next year, audited financial statements for those same funds were delivered anywhere from six months to eight months late.  The same materials for fiscal year 2012 were distributed to investors approximately three months late.  According to the SEC’s order, Sands Brothers and the two co-founders were previously sanctioned by the SEC in 2010 for custody rule violations.

If you have been late on the delivery of your audited financial statements and have not availed yourself of the “surprise audit” provision of the custody rule, or if you manage “side car” funds that have never been audited, you should immediately get in touch with your Pillsbury attorney contact.

 

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On September 22, 2014, the Securities and Exchange Commission (the “SEC”) charged private equity fund adviser, Lincolnshire Management, Inc. (“Lincolnshire”), with misallocating expenses shared between two portfolio companies. Lincolnshire integrated two portfolio companies that were each owned by a different Lincolnshire private equity fund. Lincolnshire owed a fiduciary duty to each fund and such fiduciary duty was breached when Lincolnshire would charge one portfolio company more than its fair share for expenses benefiting both portfolio companies.

Lincolnshire was aware of the complexity involved in sharing expenses and did have an expense allocation policy in place, though it was not in writing. The instances that resulted in a breach of Lincolnshire’s fiduciary duty were those in which the verbal expense allocation policy was not followed. The SEC also found, with respect to the integration of the portfolio companies, that Lincolnshire did not have sufficient written policies and procedures in place to prevent violations of the Investment Advisers Act of 1940 (“Adviser’s Act”). Lincolnshire agreed to a settlement with the SEC in excess of $2.3 million.

It is interesting to note that, while the SEC announced several months ago it had conducted presence exams and found many issues in private equity managers, Lincolnshire was not one of the companies subject to a presence exam. Private equity managers who have not had a presence exam should not assume they are unlikely to be examined outside of the presence exam protocol. This enforcement action reinforces the requirement that private equity fund advisers are required to have policies and procedures in place that are designed to prevent violations of the Adviser’s Act and other securities laws. More importantly, once in place, such policies and procedures must be monitored by the chief compliance officer and observed by all “covered persons.”