Source: https://www.hflawreport.com/articles/by/topic/428
Timestamp: 2018-07-19 08:05:59
Document Index: 785933479

Matched Legal Cases: ['art 2018', 'art 1', 'art 2', 'art 1', 'art 1', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2', 'art 2']

By Topic: Form ADV
From Vol. 11 No.23 (Jun. 7, 2018)
The SEC proposed – and recently withdrew – a rule that would have required registered investment advisers to adopt and implement detailed business continuity and transition plans. Despite the rule’s withdrawal, however, the SEC has signaled that it will continue to scrutinize the robustness of advisers’ plans. To the extent that advisers’ business continuity and transition plans cover the departure of key personnel, they generally do so only with respect to founders; yet, from a business and regulatory perspective, they should also cover others, including chief compliance officers (CCOs). The proposed rule would have also required advisers to evaluate third-party service providers’ business continuity and transition plans, including those of outsourced CCOs. This article, the first in a three-part series, discusses the SEC’s proposed rule on business continuity and transition plans; the impact, if any, of the rule’s withdrawal; the importance of CCO succession planning; and the risks of using an outsourced CCO. The second article will examine CCO hiring and onboarding; whether managers should separate their compliance departments from their legal departments; and the risks of high CCO turnover. The third article will evaluate the risks of poor succession planning and provide a roadmap for developing a robust succession plan. See “Pro-Business Environment of New Administration Continues to Have Challenges and Pitfalls for Private Funds” (Sep. 14, 2017).
When the SEC recently released proposed Form CRS, it explained that the new short-form disclosure document is intended to give retail investors simple, easy-to-understand information about the nature of their relationships with their investment professionals; prompt them to ask informed questions; and enable them to compare firms that offer the same or substantially similar services. Does Form CRS actually accomplish these goals, however? This two-part series analyzes the proposed Form CRS requirements, reviews various issues the form raises and provides insight from lawyers and compliance professionals on the proposal. This second article in the series discusses whether the form is likely to achieve the SEC’s stated goals and explores potential issues it raises for registered investment advisers. The first article provided an overview of proposed Form CRS and its key requirements. For additional proposals by the SEC that would further regulate fund managers, see “SEC Emphasizes Investment Adviser Fiduciary Duty and Proposes Enhanced Adviser Regulation” (May 10, 2018).
From Vol. 11 No.22 (May 31, 2018)
The SEC recently proposed new rules under the Investment Advisers Act of 1940 and the Securities Exchange Act of 1934 that would require registered investment advisers and registered broker-dealers to provide a brief customer- or client-relationship summary in a new short-form disclosure document: Form CRS. According to the SEC, Form CRS is intended to provide retail investors with simple, easy-to-understand information about the nature of their relationships with each investment professional and would supplement other, more detailed disclosures. Comments on the proposed new form must be submitted to the SEC over the next several months. This two-part series analyzes the proposed Form CRS requirements; discusses various issues the form raises; and provides insight from lawyers and compliance professionals on the proposal. This first article in the series provides an overview of the proposed Form CRS and its key requirements. The second article will discuss whether the form is likely to achieve the SEC’s stated goal and explore potential issues it raises for SEC-registered investment advisers. For more on the SEC’s focus on retail investors, see “Retail Investors Top List of OCIE 2018 Exam Priorities” (Mar. 8, 2018); and “Co-Director of SEC Enforcement Division Champions New Retail Strategy Task Force and Cyber Unit” (Nov. 16, 2017).
From Vol. 11 No.16 (Apr. 19, 2018)
Compliance Corner Q2-2018: Regulatory Filings and Other Considerations That Hedge Fund Managers Should Note in the Coming Quarter
The SEC continues to increase its touchpoints with registered investment advisers. In its most recently published Agency Financial Report, the Commission reported that it examined 15 percent of SEC-registered investment advisers during its 2017 fiscal year, up from 11 percent in 2016 and 8 percent five years ago. Given the SEC’s heightened examination coverage, private fund investment advisers should continue to ensure that they are making timely and accurate filings and meeting required compliance deadlines and obligations in order to reduce potential regulatory scrutiny from SEC staff during examinations. This fourth installment of The Hedge Fund Law Report’s quarterly compliance update, authored by Danielle Joseph and Anthony Frattone, director and consultant, respectively, at ACA Compliance Group, highlights regulatory filings and code of ethics reports that must be completed during the second quarter of 2018. In addition, this article discusses compliance deadlines relating to Rule 22e‑4 under the Investment Company Act of 1940 (the Liquidity Risk Management Program Rule) and the E.U. General Data Protection Regulation (GDPR). For more on GDPR, see “A Fund Manager’s Roadmap to Big Data: Privacy Concerns, Third Parties and Drones (Part Three of Three)” (Jan. 25, 2018).
From Vol. 11 No.4 (Jan. 25, 2018)
In light of SEC Chair Jay Clayton’s recent statement that the Commission will continue to focus on the compliance programs of private fund advisers, it is important for those advisers to start 2018 on the right note. See “Will Inadequate Policies and Procedures Be the Next Major Focus for SEC Enforcement Actions?” (Nov. 30, 2017). One effective measure that chief compliance officers can take at the start of this calendar year is to create or update a compliance calendar that tracks regulatory filing deadlines, code of ethics reporting requirements and other relevant compliance tasks and responsibilities. This third installment of The Hedge Fund Law Report’s quarterly compliance update, authored by Danielle Joseph and Manny Halberstam, director and senior compliance analyst, respectively, at ACA Compliance Group, aims to assist advisers with ensuring that their 2018 compliance calendars are current by highlighting regulatory filings and code of ethics reports that must be completed during the first quarter of 2018. In addition to addressing these first-quarter deadlines, this article discusses the treatment of virtual currency tokens held by employees for purposes of code of ethics reporting, along with the SEC’s growing use of data surveillance and analytics as part of its examination process. For additional guidance on the reporting obligations of advisers, see “Steps an Exempt Reporting Adviser Must Take to Transition to SEC Registered Investment Adviser Status: Regulatory Filings, Updates to Fund Documents and Preparation for SEC Examination (Part Three of Three)” (Oct. 19, 2017); and “Marketing and Reporting Considerations for Emerging Hedge Fund Managers” (Jun. 16, 2016).
From Vol. 11 No.2 (Jan. 11, 2018)
HFLR Program Parses OCIE’s Recent Advertising Risk Alert: Misleading Claims of GIPS Compliance, Past Specific Investment Recommendations and Results of SEC’s Touting Initiative (Part Two of Two)
SEC commentary provides valuable insight to compliance personnel on the hot-button issues being prioritized by the Commission, as well as the sort of conduct that does, and does not, lead to a referral to the SEC’s Division of Enforcement. By staying informed of the SEC’s approach to certain issues, advisers can learn from the mistakes of similarly situated advisers. A recent webinar presented by The Hedge Fund Law Report discussed six deficiencies identified in a National Exam Program Risk Alert that violate Rule 206(4)-1 of the Investment Advisers Act of 1940 – the so-called “Advertising Rule” – as well as other compliance issues that frequently arise with respect to an adviser’s advertising practices. Kara Bingham, Associate Editor of The Hedge Fund Law Report, moderated the discussion, which featured Todd Kaplan, founder and principal of Cloudbreak Compliance Group; Christine M. Lombardo, partner at Morgan Lewis; and Richard F. Kerr, partner at K&L Gates. This article, the second in a two-part series, explores the disclosures required when presenting gross performance in a one-on-one presentation to prospective investors, the circumstances under which claims of compliance with voluntary performance disclosure standards may be deemed misleading, ways to avoid deficiencies when discussing past specific recommendations in advertisements and the results of the touting initiative conducted by the SEC’s Office of Compliance Inspections and Examinations. The first article discussed the broad view that the SEC takes when deciding which communications fall within the definition of an advertisement, as well as four examples of deficiencies frequently found in performance advertising. See “Risk Alert Highlights Six Most Frequent Advertising Rule Compliance Issues” (Oct. 19, 2017).
From Vol. 10 No.45 (Nov. 16, 2017)
From Vol. 10 No.41 (Oct. 19, 2017)
Section 208(a) of the Investment Advisers Act of 1940, as well as prior statements made by the SEC, make it clear that an investment adviser is prohibited from using its registration status to suggest that the Commission has approved, recommended or sponsored the adviser. The fact remains, however, that being an SEC registered investment adviser (RIA) carries weight in the industry if for no other reason than registration with the Commission is a threshold issue for some investors. This final article in our three-part series outlining the steps that exempt reporting advisers (ERAs) must take to transition to RIA status reviews the key regulatory filings that RIAs must file examines amendments that ERAs may need to make to their fund documents in anticipation of their change in registration status and provides insight into what newly registered advisers should expect from the SEC examination process. The first article discussed the circumstances under which an ERA would be required to register as an RIA, along with considerations for ERAs augmenting their compliance programs. The second article outlined key policies and procedures that ERAs should consider when drafting their compliance manuals. For more on the examination of RIAs, see “OCIE 2017 Examination Priorities Illustrate Continued Focus on Conflicts of Interest; Branch Offices; Advisers Employing Bad Actors; Oversight of FINRA; Use of Data Analytics; and Cybersecurity” (Jan. 26, 2017).
Risk Alert Highlights Six Most Frequent Advertising Rule Compliance Issues
Rule 206(4)-1 under the Investment Advisers Act of 1940 prohibits investment advisers from including testimonials, certain past specific recommendations and misleading information in marketing materials. The SEC Office of Compliance Inspections and Examinations (OCIE) recently issued a Risk Alert that discusses the six most frequent advertising issues identified in deficiency letters from more than 1,000 adviser examinations, as well as the results of its 2016 “Touting Initiative,” which focused on nearly 70 advisers’ use of awards, rankings, professional designations and testimonials in their marketing materials. This article summarizes OCIE’s findings. See also our three-part advertising compliance series: “Ten Best Practices for a Fund Manager to Streamline Its Compliance Review” (Sep. 14, 2017); “Five High-Risk Areas to Focus on When Reviewing Marketing Materials” (Sep. 21, 2017); and “Six Methods to Test Advertising Review Procedures” (Sep. 28, 2017).
From Vol. 10 No.28 (Jul. 13, 2017)
Unexpected Traps for Filing Other-Than-Annual Amendments Using the Revised Form ADV and How to Avoid Them
New SEC rules to amend Part 1A of Form ADV will become effective on October 1, 2017. See “The ‘Why’ Behind the Recent Form ADV Amendments: What Information the SEC Will Require and How the Agency Intends to Use It” (May 4, 2017). Much has been written about how a fund manager should complete the amended Form ADV anew as part of its annual updating amendment, which most advisers will file in March 2018. See “A Roadmap of Potential Landmines for Fund Managers to Avoid When Completing the Revised Form ADV” (May 25, 2017). If an adviser is required to amend its Form ADV after October 1, 2017, but prior to its March 2018 annual update (Other-Than-Annual Amendment), however, it may have to disclose additional information, creating a new and larger project out of what otherwise might have been a simple change to its Form ADV. In a guest article, Steven M. Felsenthal, general counsel and chief compliance officer of Millburn Ridgefield Corporation, discusses two potential traps that may cause an adviser to file an Other-Than-Annual Amendment using the amended form, explores the ramifications of doing so and suggests an approach to avoid providing some of this information earlier than anticipated. This article incorporates insights gleaned from personal conversations the author had with industry participants on how to effectively navigate the nuances of the amended Form ADV for an Other-Than-Annual Amendment. For additional insight from Felsenthal, see “Further CFTC Harmonization of Rules for Hedge Funds: A Welcome and Continuing Trend” (Sep. 18, 2014); and “CFTC and SEC Propose Rules to Further Define the Term ‘Eligible Contract Participant’: Why Should Commodity Pool and Hedge Fund Managers Care?” (Jun. 23, 2011).
From Vol. 10 No.21 (May 25, 2017)
A Roadmap of Potential Landmines for Fund Managers to Avoid When Completing the Revised Form ADV
Effective October 1, 2017, advisers must contend with an updated Form ADV that makes a number of helpful technical changes and streamlines the process for filing umbrella registrations. Despite these beneficial changes, the amended Form ADV imposes significant new reporting duties for separately managed accounts and advisers operating multiple branches. A recent program presented by Proskauer Rose, Advise Technologies and The Hedge Fund Law Report offered a page-by-page guide to understanding the revised form. Moderated by Rorie A. Norton, Associate Editor of The Hedge Fund Law Report, the discussion featured Michael F. Mavrides, partner at Proskauer, and Jeanette Turner, chief regulatory attorney and a managing director at Advise Technologies. This article summarizes their insights. For more from Turner on Form ADV changes, see “The ‘Why’ Behind the Recent Form ADV Amendments: What Information the SEC Will Require and How the Agency Intends to Use It” (May 4, 2017). For additional commentary from Mavrides, see our two-part series on the latest revisions to Form ADV and the so-called “recordkeeping rule”: “Managed Account Disclosure, Umbrella Registration and Outsourced CCOs” (Nov. 10, 2016); and “Retaining Performance Records and Disclosing Social Media Use, Office Locations and Assets Under Management” (Nov. 17, 2016).
From Vol. 10 No.18 (May 4, 2017)
The “Why” Behind the Recent Form ADV Amendments: What Information the SEC Will Require and How the Agency Intends to Use It
On August 25, 2016, the SEC adopted amendments to Form ADV that will become effective October 1, 2017. The amendments are designed to improve the depth and quality of information collected, to facilitate risk-monitoring initiatives, to assist the SEC staff in its risk-based examination program and to provide additional disclosure to investors and the public. In a guest article, Jeanette Turner, chief regulatory attorney and a managing director at Advise Technologies, provides an introduction to these recent amendments to Form ADV to help firms determine how to alter their internal procedures and processes. For additional insight from Turner, see “MiFID II Expands MiFID I and Imposes Reporting Requirements on Asset Managers, Including Non-E.U. Asset Managers” (May 28, 2015). On Thursday, May 11, 2017, from 12:00 p.m. to 1:00 p.m. EDT, Turner will expand on the thoughts in this article – as well as other ramifications of the recent amendments to Form ADV – in a webinar entitled “2017 Form ADV Changes,” which will be moderated by Rorie A. Norton, an associate editor of The Hedge Fund Law Report. Turner will be joined by fellow panelist Michael F. Mavrides, a partner at Proskauer Rose. To register for the webinar, click here. For further commentary from Mavrides on what investment advisers need to know about these SEC revisions to Form ADV and the recordkeeping rule, see our two-part series: “Managed Account Disclosure, Umbrella Registration and Outsourced CCOs” (Nov. 3, 2016); and “Retaining Performance Records and Disclosing Social Media Use, Office Locations and Assets Under Management” (Nov. 17, 2016).
Advisers Investing Client Assets in Affiliated Funds Could Face SEC Scrutiny for Conflicts of Interest
Hedge fund managers and investment advisers periodically allocate client or fund assets to affiliated vehicles. The SEC remains highly attuned to the conflicts of interest inherent in those situations, including when an adviser improperly collects both a management fee from the client and an additional fee on the same client assets invested in the affiliated fund. That was precisely the case in the SEC’s recently settled enforcement proceeding against the principals of an investment adviser that used client funds to purchase shares in an affiliated mutual fund without providing adequate disclosure. See our three-part series on fee and expense allocations: “Practices Fund Managers Should Avoid” (Aug. 25, 2016); “Flawed Disclosures to Avoid” (Sep. 8, 2016); and “Preventing and Remedying Improper Allocations” (Sep. 15, 2016). This article summarizes the alleged improper conduct and the terms of the settlement. For coverage of a recent SEC enforcement action alleging similar issues, see “Undisclosed Increase in Investment Adviser’s Fees Could Result in Significant Penalties” (Jun. 23, 2016). Even an undisclosed “preference” for investing in proprietary funds can be problematic. See “Preference for Investing in Proprietary Hedge Funds Must Be Fully Disclosed by Investment Banks to Avoid Conflicts” (Jan. 7, 2016).
With the SEC continuing to focus on investment adviser compliance, a recent presentation hosted by compliance solutions provider MyComplianceOffice (MCO) and compliance consultant NorthPoint Compliance offered timely and practical guidance on preparing for SEC examinations, the examination process and examination trends. The program was moderated by Stephen Taylor, chief commercial officer at MCO, and featured Victoria Hogan, NorthPoint’s president, and Colleen Montemarano, a NorthPoint consultant, each of whom has more than six years’ experience as an SEC compliance examiner. This article highlights the key insights from the presentation. For another discussion of the exam process, see our two-part series: “What Hedge Fund Managers Need to Know About Getting Through an SEC Examination” (Jun. 16, 2016); and “Fees, Conflicts, Investment Allocations and Other Hot Topics” (Jun. 30, 2016).
From Vol. 9 No.25 (Jun. 23, 2016)
Undisclosed Increase in Investment Adviser’s Fees Could Result in Significant Penalties
Fee and expense practices of private fund advisers remain in the SEC’s crosshairs. See “SEC Division Heads Enumerate OCIE Priorities, Including Cybersecurity, Fees, Bad Actors and Never-Before Examined Hedge Fund Managers (Part One of Two)” (Apr. 28, 2016). The SEC recently brought suit in Connecticut against a registered investment adviser, alleging improper transfer of client assets into new mutual funds, thereby increasing client advisory fees without changing the clients’ investment strategy. The adviser failed to disclose the alleged conflict of interest to its clients. The SEC seeks an injunction, disgorgement and civil penalties. This article summarizes the facts giving rise to the action and the SEC’s civil complaint. For more on enforcement actions involving fee disclosures and practices, see “Blackstone Settles SEC Charges Over Undisclosed Fee Practices” (Oct. 22, 2015); and “SEC Enforcement Action Involving ‘Broken Deal’ Expenses Emphasizes the Importance of Proper Allocation and Disclosure” (Jul. 9, 2015).
Why All Investment Advisers – and Their Compliance Officers – Should Heed the SEC’s Risk Alert About Outsourced CCOs (Part One of Two)
As recent reports of the firing by JPMorgan Chase of the head of its government debt trading desk and another trader for compliance violations make clear, it is vital for hedge fund managers and other financial services firms to take compliance seriously. As part of its effort to ensure that regulated firms devote sufficient attention and resources to compliance, the SEC Office of Compliance Inspections and Examinations (OCIE) issued a Risk Alert in November describing its recent “Outsourced CCO Initiative.” In a two-part guest series, Andrew W. Reich, counsel at BakerHostetler, analyzes the Risk Alert and offers guidance on the issues addressed therein applicable to all investment advisers and investment companies as well as their CCOs (not just those employed at third parties), along with the application of those issues to their compliance programs. This first article explores the background that gave rise to the Risk Alert; allocation of resources to compliance; and CCO independence and empowerment. The second article will clarify written policies and procedures as well as outline steps to enhance firms’ culture of compliance. See “The Role of Outsourced Compliance Consultants in the Hedge Fund Compliance Ecosystem” (Jun. 27, 2014). For more on CCO responsibilities, see “SEC Chief of Staff Offers Nine Key Considerations for Investment Adviser and Broker-Dealer Compliance Officers” (Oct. 22, 2015); and “SEC Enforcement Action Shows Hedge Fund Managers May Be Liable for Failing to Adequately Support Their CCOs” (Jul. 23, 2015).
From Vol. 8 No.43 (Nov. 5, 2015)
The Risk and Examinations Office of the SEC Division of Investment Management recently released a compilation of Private Fund Statistics (Report) that provides data from filers of Form PF and Form ADV in 2013 and 2014. In a recent speech, SEC Chair Mary Jo White said of the Report, “The public availability of aggregated information should help to address persistent questions, and to some degree misconceptions, about the practices and size of the private fund industry.” Accordingly, the data in the Report helps identify trends within the hedge fund industry, allowing hedge fund advisers to benchmark themselves against their peers and competitors, as well as providing investors with information to refine their due diligence processes. This article examines the Report, focusing particularly on data relevant to hedge funds and hedge fund advisers, including leverage and liquidity practices. The SEC also issues an annual report on how it uses such data. See “Report Describes the SEC’s Use of Form PF for Hedge Fund Manager Examination Targeting and Risk Management,” The Hedge Fund Law Report, Vol. 7, No. 38 (Oct. 10, 2014); and “SEC’s First Report on Initial Form PF Filings Offers Insight into How the Agency Is Using the Collected Data for Examinations, Enforcement and Systemic Risk Monitoring,” The Hedge Fund Law Report, Vol. 6, No. 34 (Aug. 29, 2013).
As firms in the asset management industry structure merger and acquisition transactions – including joint ventures, acquisitions of minority interests and lift-outs of teams – they need to be aware of the potential issues that arise with such transactions. Integrating two businesses may result in tax consequences, regulatory issues or other compliance concerns. A panel of domain experts from K&L Gates recently discussed current trends in the asset management industry and a number of considerations in planning an acquisition or other deal with an asset manager, broker-dealer or adviser, including choice of partner, due diligence, structuring, taxation and various regulatory and compliance considerations. Moderated by Michael S. Caccese, a practice area leader, the program featured partners Kenneth G. Juster and Michael W. McGrath; and practice area leaders D. Mark McMillan and Robert P. Zinn. This article, the second in a two-part series, summarizes the key takeaways from that program with respect to taxation, regulatory and business integration concerns. The first article addressed asset management industry trends, choosing a partner, due diligence and structuring considerations. See also “PLI Panel Addresses Recent Developments with Respect to Prime Brokerage Arrangements, Alternative Registered Funds and Hedge Fund Manager Mergers and Acquisitions,” The Hedge Fund Law Report, Vol. 6, No. 41 (Oct. 25, 2013).
Swiss Hedge Fund Marketing Regulations, BEA Forms and Form ADV Updates: An Interview with Proskauer Partner Robert Leonard
The Hedge Fund Law Report recently interviewed Robert Leonard, a partner in Proskauer’s Hedge Funds Group, on implications of the recently effective Swiss Collective Investment Scheme for marketing hedge funds in Switzerland; two new forms required by the Bureau of Economic Analysis to be filed by certain hedge funds; and considerations arising out of Form ADV annual amendments. This interview was conducted in connection with the Hedge Funds Care 17th Annual NY Open Your Heart to the Children Benefit, to be held in New York City tonight, March 5, 2015. For more on Hedge Funds Care, click here; for registration information on tonight’s Open Your Heart to the Children Benefit, click here. See also “The Changing Face of Alternative Asset Management in Switzerland,” The Hedge Fund Law Report, Vol. 5, No. 5 (Feb. 2, 2012).
The task of serving as chief compliance officer (CCO) of a hedge fund manager is becoming progressively more challenging in light of ever-increasing regulatory obligations, heightened enforcement activity and resource constraints. CCOs can benefit from understanding the best practices being employed by their peers, and customizing relevant practices to their businesses. As Executive Director of Ernst & Young’s Asset Management Advisory Practice, Daniel New sees a cross-section of compliance practices at brand-name hedge fund managers. He sees what works from a compliance perspective, and what needs work. The Hedge Fund Law Report recently interviewed New on a range of issues regularly encountered by hedge fund manager CCOs. The interview spanned topics including consistency of fund marketing and disclosure documents; a CCO’s role in preparing and completing Form PF and other regulatory filings; structuring and memorializing annual compliance reviews; allocating expenses between a manager and its funds; insider trading and political intelligence controls; social media use by manager personnel; a CCO’s risk management responsibilities; outsourcing of CCO functions in light of resource constraints; and mitigating rogue trading risks. The breadth of topics covered reflects the expansiveness of a typical CCO’s portfolio. The idea behind this interview is to enable CCOs to allocate their scarcest resource – time – more effectively. This interview was conducted in connection with the Regulatory Compliance Association’s upcoming Compliance, Risk & Enforcement 2013 Symposium, to be held at the Pierre Hotel in New York City on October 31, 2013. For a fuller description of the Symposium, click here. To register for the Symposium, click here. Subscribers to The Hedge Fund Law Report are eligible for a registration discount.
Why and How Should Hedge Fund Managers Conduct Background Checks on Prospective Employees? (Part One of Three)
Hedge fund management is a human capital business, and employees are (or should be) the key asset of a manager. See “Key Legal Considerations in Connection with the Movement of Talent from Proprietary Trading Desks to Start-Up or Existing Hedge Fund Managers: The Hedge Fund Manager Perspective (Part Three of Three),” The Hedge Fund Law Report, Vol. 4, No. 4 (Feb. 3, 2011). However, employees can also be a manager’s most dangerous liability. One rogue employee can destroy or seriously damage even the best hedge fund franchise by, among other things, inviting a presumption that the employee is not rogue but representative of a culture of permissiveness. See “Rajaratnam Prosecutor and Dechert Partner Jonathan Streeter Discusses How the Government Builds and Prosecutes an Insider Trading Case against a Hedge Fund Manager,” The Hedge Fund Law Report, Vol. 5, No. 45 (Nov. 29, 2012). Recognizing the risks of picking bad apples, hedge fund managers are increasingly using employee background checks as a downside mitigation strategy. But the concept of a background check spans a wide range of activities – everything from a superficial online search to a deep, manual process. Whether to conduct a background check in the first instance, and what kind of background check to conduct, depends on dynamics specific to the industry, firm and prospective employee. To assist hedge fund managers in understanding the role of background checks in their hiring and “people” processes, The Hedge Fund Law Report is publishing a three-part series on the role of background checks in the hedge fund industry, with the three parts focusing on, respectively, three questions: Why, how and who. More specifically, this article – the first in the series – outlines the case for conducting background checks, cataloging the wide range of regulatory and other risks presented by employees (including discussions of insider trading, Rule 506(d), pay to play, track record portability, restrictive covenants and other topics). The second installment will describe the anatomy of an employee background check, highlighting mechanics, common mistakes and risks. And the third part will weigh the benefits and burdens of outsourcing background checks versus conducting them in-house.
ACA Compliance Report Facilitates Benchmarking of Private Fund Manager Compliance Practices (Part One of Two)
ACA Compliance Group (ACA) recently released the second part of its three-part report describing the results of its surveys of hedge fund and private equity fund manager compliance practices, focusing on the completion and preparation of regulatory filings, various insider trading issues and expense practices. ACA also presented a webcast explaining and expanding on the survey findings. The report and webcast provided important market color and guidance enabling hedge fund and private equity fund managers to benchmark their compliance practices against those of their peers. This article, the first of two installments covering the report and webcast, summarizes survey results relating to (1) the present status and focus areas of hedge fund and private equity fund manager presence examinations, and (2) fund managers’ preparation and completion of regulatory filings (e.g., Form ADV, Form PF and non-U.S. regulatory filings), including a discussion of how many managers are making various regulatory filings; what resources are being used to prepare such filings; how Form PF expenses are being allocated among a manager and its funds; and whether Form PF is being shared with fund investors. The second installment will address insider trading issues (including discussions of information barriers, online data rooms, non-disclosure agreements, restricted and watch lists, political intelligence, expert networks and public company contacts); and expense practices (including the use of expense caps and the allocation of expenses among a manager and its funds). For coverage of the first part of the ACA compliance report, conducted during the first quarter of this year, see “ACA Compliance Group Survey Provides Benchmarks for a Range of Hedge Fund Manager Compliance Functions, Including Dual-Hatting, Annual Compliance Reviews, Forensic Testing, Custody, Fees and Signature Authority,” The Hedge Fund Law Report, Vol. 6, No. 19 (May 9, 2013).
As filers continue to confront challenges in providing accurate and complete reporting on Form PF, the SEC has at various times during the past year provided answers to its Form PF Frequently Asked Questions (FAQs). The most recent of these updates were provided on March 8, 2013 and November 20, 2012, and addressed issues such as how to report various related persons; report certain disregarded investments; calculate derivatives position exposures and trading volumes; report private funds that are part of a master-feeder structure; and calculate the gross asset value and regulatory assets under management of a reporting fund. This article summarizes highlights from these most recent updates to the SEC’s Form PF FAQs. For coverage of previous updates to the FAQs, see “SEC Staff Publishes Answers to Frequently Asked Questions Concerning Form PF,” The Hedge Fund Law Report, Vol. 5, No. 26 (Jun. 28, 2012).
When and How Can Hedge Fund Managers Permissibly Disguise the Identities of Their Hedge Funds in Form ADV and Form PF?
Historically, hedge fund managers generally have not been required to disclose information about their funds to regulators or the public. Hedge funds were excluded from the definition of “investment company” in the Investment Company Act of 1940 and therefore did not have to file registration statements, as mutual funds do. Many hedge fund managers were not required to register as investment advisers and therefore did not have to file Form ADV, which contains fund information. And the U.S. had no analogue to the U.K. FSA’s periodic reports on systemic risk posed by hedge funds. Hedge funds are still excluded from the investment company definition, but many managers now must register and file Form ADV. See “How Can Hedge Fund Managers Rebut the Presumption of Materiality of Certain Disciplinary Events in Form ADV, Part 2?,” The Hedge Fund Law Report, Vol. 5, No. 1 (Jan. 5, 2012). And, as the industry well knows, the U.S. has implemented its own version of systemic risk reporting by private fund managers via Form PF. See “Assumptions to Consider in Completing Form PF Effectively: Experiences from First Filers,” The Hedge Fund Law Report, Vol. 5, No. 39 (Oct. 11, 2012). Form ADV requires hedge fund managers to disclose significant fund information to regulators and the public, and Form PF requires managers to disclose voluminous and detailed fund information to regulators. However, the instructions to both forms now allow a manager to preserve the anonymity of its private funds by using a code or designation to identify the funds referenced in those forms. Some well-known hedge fund managers reportedly have taken advantage of this new opportunity, and there is speculation that more managers will do so. Nonetheless, the relief provided in the instructions is conditioned on satisfaction of delineated obligations. This article provides an overview of key considerations for fund managers that wish to mask the identities of their private funds in Form PF and Form ADV filings. Specifically, this article outlines some of the reasons why hedge fund managers may wish to shield the identities of their private funds in Form ADV and Form PF; the circumstances under which hedge fund managers can mask the identity of their private funds; how fund managers can go about disguising the identities of their private funds; whether such masking will raise suspicion from regulators and investors; and best practices for managers that wish to implement a masking strategy.
Is the New Form ADV Investor Friendly?
When the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) repealed the “private adviser exemption” from registration contained in Section 203(b)(3) of the Investment Advisers Act (Advisers Act), many hedge fund managers who enjoyed the exemption found themselves facing the sure fate of having to register with the U.S. Securities and Exchange Commission as investment advisers. Many of these managers had to file their first Form ADV by March 30, 2012. March 30 was also the deadline for all previously registered investment advisers to file amendments to their current Form ADV. Over a month has passed since the March 30 deadline and it is clear, from the viewpoint of an investor, that the new Form ADV has proved to be a mixed bag of good and bad. In this guest op-ed, Siddhya Mukerjee and Michael Schmieder – both senior operational analysts at Aksia LLC, responsible for performing all aspects of hedge fund operational due diligence – analyze how new Form ADV has helped and hindered the operational and investment due diligence efforts of hedge fund investors.
From Vol. 5 No.18 (May 3, 2012)
An initial decision handed down by Chief Administrative Law Judge Brenda P. Murray (ALJ) on April 20, 2012 highlights the severe penalties that can be imposed on investment advisers and their principals for making materially false Form ADV filings. The enforcement action in question involved a registered investment adviser and its owner (respondents) that were charged with failing to disclose compensation received from a hedge fund manager that was recommended to the investment adviser’s clients. For a previous discussion of the initiation of this administrative proceeding, see “An Investment Adviser May Not Call Itself Independent If It Receives Fees from Underlying Managers,” The Hedge Fund Law Report, Vol. 4, No. 33 (Sep. 22, 2011). This article outlines: the factual background in this case; the holdings and legal analysis applied by the ALJ; the sanctions imposed on the respondents; and some lessons learned for investment advisers that file Forms ADV with the SEC.
ACA Webcasts Detail Exempt Reporting Adviser Qualifications and Compliance Obligations
While the Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act) repealed the exemption from registration found in Section 203(b)(3) of the Investment Advisers Act of 1940 (Advisers Act) historically relied upon by most hedge fund managers with fewer than 15 clients, it created several more narrowly tailored adviser registration exemptions, including separate exemptions for advisers solely to venture capital funds and advisers solely to private funds with aggregate regulatory assets under management (Regulatory AUM) of less than $150 million (private fund adviser exemption). See “Registration, Reporting, Disclosure and Operational Consequences for Hedge Fund Managers of the SEC’s New ‘Regulatory Assets Under Management’ Calculation,” The Hedge Fund Law Report, Vol. 5, No. 9 (Mar. 1, 2012). These advisers now fall into a newly created class of advisers called exempt reporting advisers. Although exempt reporting advisers are exempt from SEC registration, they are nonetheless required to fulfill certain regulatory obligations not applicable to unregistered advisers, including completing certain items in Part 1A of Form ADV, maintaining certain books and records and submitting to SEC examinations. Exempt reporting advisers are also subject to other compliance obligations imposed by the Advisers Act, including the pay-to-play restrictions contained in Rule 206(4)-5. See “Key Elements of a Pay-to-Play Compliance Program for Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 3, No. 37 (Sep. 24, 2010). With this in mind, the ACA Compliance Group (ACA) held two separate webcasts to highlight issues important to advisers that may qualify as exempt reporting advisers. This article summarizes some of the highlights from both webcasts with relevance to hedge fund managers.
The SEC’s newly-adopted assets under management (AUM) calculation, known as an investment adviser’s “regulatory assets under management” (Regulatory AUM), will have numerous important regulatory implications for hedge fund managers. Among other things, the calculation will govern whether the manager must or may register with the SEC as an investment adviser; whether the manager must file Form ADV; and which parts, if any, of Form PF the manager must complete and file. See “Former SEC Commissioner Paul Atkins Discusses the Big Issues Raised by Form PF: Law, Operations, Confidentiality, Risk Management, Disclosure, Enforcement and Policy,” The Hedge Fund Law Report, Vol. 5, No. 8 (Feb. 23, 2012). Unfortunately for many hedge fund managers, the calculation of a firm’s Regulatory AUM is quite different from the calculation of the firm’s traditional AUM. Also, in certain circumstances, large hedge fund managers may need to calculate their Regulatory AUM for each month. Therefore, hedge fund managers must understand their Regulatory AUM and arrange to have it calculated in a timely fashion to ensure that they will comply with applicable registration and reporting requirements. This article begins by defining Regulatory AUM and discussing how to calculate it. The article then discusses the applicability of a firm’s Regulatory AUM with respect to the hedge fund adviser registration regime; the various exemptions from adviser registration; and the various new reporting obligations imposed on hedge fund advisers, including those relating to Form PF. The article concludes with an analysis of some of the challenges associated with Regulatory AUM and specific guidance on navigating such challenges.
How Should Hedge Fund Managers Determine Which of Their Advisory Affiliates Should Register with the SEC?
On January 18, 2012, the SEC’s Division of Investment Management (Staff) issued a no-action letter in response to a request for guidance from the ABA Subcommittee on Hedge Funds seeking confirmation as to whether certain affiliates of an investment adviser must separately register with the SEC. This article discusses the Staff guidance in detail and outlines the implications of the guidance for hedge fund managers.
Recent SEC Enforcement Action Demonstrates the SEC’s Focus on the Accuracy and Consistency of Disclosures by Hedge Fund Managers in Form ADV
The SEC initiated a record number of enforcement actions in fiscal year 2011. Among other things, the SEC has focused more attention on ferreting out false and misleading statements made by investment advisers in communications with investors and regulators. As recently as November 2011, Robert Khuzami, Director of the SEC’s Division of Enforcement, explained that the SEC is specifically targeting investment advisers that it suspects may have filed Forms ADV containing false or misleading statements. This article describes a recent SEC action indicating that the agency will bring enforcement actions based on allegations of inaccuracies in Form ADV. This article also makes recommendations that hedge fund managers can implement to avoid Form ADV-related violations. For a discussion of another current SEC enforcement initiative, see “Hedge Fund Managers with Unexplained Aberrational Performance Are More Likely to Become Targets of SEC Enforcement Actions,” The Hedge Fund Law Report, Vol. 4, No. 44 (Dec. 8, 2011).
An Investment Adviser May Not Call Itself Independent If It Receives Fees from Underlying Managers
The SEC recently commenced administrative proceedings against an investment adviser that allegedly received undisclosed fees for channeling over $80 million into SJK Investment Management, LLC (SJK). As previously reported in The Hedge Fund Law Report, on January 6, 2011, the SEC filed an emergency civil injunctive action charging SJK and its principal, Stanley Kowalewski, with securities fraud, and obtained a temporary restraining order and asset freeze against SJK and Kowalewski. See “Thirteen Important Due Diligence Lessons for Hedge Fund Investors Arising Out of the SEC’s Recent Action against a Fund of Funds Manager Alleging Misuse of Fund Assets,” The Hedge Fund Law Report, Vol. 4, No. 3 (Jan. 21, 2011). The order in this administrative proceeding (Order) is interesting to hedge fund and hedge fund of funds managers primarily in helping clarify the circumstances in which managers may and may not claim to be “independent.” The facts alleged by the SEC are rather egregious, and thus the Order itself does not make noteworthy new law. However, the Order does raise close and interesting questions regarding the language of representations that hedge fund of fund managers and other investment advisers may make to investors with respect to independence; the channels through which such representations are made (including websites); how to approach disclosure with respect to conflicts and independence in Form ADV; and how to move client assets from one investment manager to another without breaching fiduciary duties or running afoul of the antifraud provisions of the federal securities laws.
Generally, two categories of hedge fund managers will be required to register with the SEC as investment advisers by March 30, 2012: (1) managers with assets under management (AUM) in the U.S. of at least $150 million that manage solely private funds; and (2) managers with AUM in the U.S. between $100 million and $150 million that manage at least one private fund and at least one other type of investment vehicle, such as a managed account. See “Will Hedge Fund Managers That Do Not Have To Register with the SEC until March 30, 2012 Nonetheless Have To Register in New York, Connecticut, California or Other States by July 21, 2011?,” The Hedge Fund Law Report, Vol. 4, No. 24 (Jul. 14, 2011). Registration will trigger a range of new obligations. For example, registered hedge fund managers that do not already have a chief compliance officer (CCO) will have to hire one. See “To Whom Should the Chief Compliance Officer of a Hedge Fund Manager Report?,” The Hedge Fund Law Report, Vol. 4, No. 22 (Jul. 1, 2011). Also, registered hedge fund managers will have to complete, file and deliver, as appropriate, Form ADV. See “Application of Brochure Delivery and Public Filing Requirements of New Form ADV to Offshore and Domestic Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 11 (Apr. 1, 2011). But perhaps the most onerous new obligation for newly registered hedge fund managers will be the duty to prepare for, manage and survive SEC examinations. Most hedge fund managers facing a registration requirement for the first time have hired high-caliber people and completed complex forms. Therefore, hiring a CCO and completing Form ADV will exercise existing skill sets. But few such managers have experienced anything like an SEC examination. On the contrary, many such managers have spent years behind a veil of permissible secrecy, disclosing little, rarely disseminating information beyond top employees and large investors and interacting with the government only indirectly. Examinations will change all that. The government will show up at your office, often with little or no notice; they will ask to review substantially everything; and a culture of transparency will have to replace a culture of secrecy, where the latter sorts of cultures still exist. (The SEC does not appreciate secrecy and has any number of ways of demonstrating its lack of appreciation.) Hedge fund managers facing the new examination reality will have to think about two sets of issues. The first set of issues relates to examination preparedness, and The Hedge Fund Law Report has written in depth on this topic. See, e.g., “Legal and Practical Considerations in Connection with Mock Examinations of Hedge Fund Managers,” The Hedge Fund Law Report, Vol. 4, No. 26 (Aug. 4, 2011). The second set of issues relates to examination management and survival, and that is the broad topic of this article. Specifically, this article addresses a question that hedge fund managers inevitably face in connection with examinations: What should we tell investors and when and how? To help hedge fund managers identify the relevant subquestions, think through the relevant issues and hopefully plan a disclosure strategy in advance of the commencement of an examination, this article discusses: the three types of SEC examinations and similar events that may trigger a disclosure examination; the five primary sources of a hedge fund manager’s potential disclosure obligation; whether and in what circumstances hedge fund managers must disclose the existence or outcome of the three types of SEC examinations; rules and expectations regarding responses to due diligence inquiries; selective and asymmetric disclosure issues; how hedge fund managers may reconcile the privileged information rights often granted to large investors in side letters with the fiduciary duty to make uniform disclosure to all investors; whether hedge fund managers must disclose deficiency letters in response to inquiries from current or potential investors, and whether such disclosure must be made even absent investor inquiries; whether managers that elect to disclose deficiency letters should disclose the letters themselves or only their contents; best practices with respect to the mechanics of disclosure (including how and when to use telephone and e-mail communications in this context); and whether deficiency letters may be obtained via a Freedom of Information Act request.
SEC Delays Registration Deadline for Hedge Fund Advisers, and Clarifies the Scope and Limits of Registration Exemptions for Private Fund Advisers, Foreign Private Advisers and Family Offices
At an open meeting held on June 22, 2011, the Securities and Exchange Commission adopted and amended rules that will directly affect the registration, reporting and disclosure obligations of U.S. and non-U.S. hedge fund managers. While the texts of most of those rules or rule amendments remain to be published as of this writing, comments by SEC commissioners at the open meeting outlined the general scope of the final rules and amendments. Of particular relevance to hedge fund managers, the SEC addressed the following topics at the open meeting: delay of registration and reporting deadlines; who may and must register with the SEC and the states based on assets under management; the private fund adviser exemption; the foreign private adviser exemption; continuing relevance of the Unibanco no-action letter for global hedge fund sub-­advisory relationships; filing, recordkeeping and examination obligations of exempt reporting advisers; and the exemption from registration for family offices. This article offers more detail on the SEC’s statements on each of the foregoing topics at the open meeting.
Impact of the Foreign Private Adviser Exemption and the Private Fund Adviser Exemption on the U.S. Activities of Non-U.S. Hedge Fund Managers
Passage of the Dodd-Frank Act and relevant SEC rulemaking has changed the regulatory landscape for non-U.S. hedge fund managers that have or plan to establish an advisory presence in the U.S. or that have or plan to target U.S. investors. Generally – and despite references to “international comity” in one of the relevant proposed rule releases – the Dodd-Frank Act has increased the regulatory burden on non-U.S. hedge fund managers wishing to access the U.S. market. Or, put another way, Dodd-Frank has narrowed considerably the range of conduct in which non-U.S. managers may engage without getting caught in the purview of U.S. investment adviser registration, or many of its substantive burdens. This article provides detailed synopses of the relevant provisions of the foreign private adviser exemption and the private fund adviser exemption, focusing in particular on: rules relating to counting clients and investors; measuring “regulatory assets under management”; definitions of “place of business,” “in the United States” and other relevant terms; and recordkeeping and reporting obligations and examination exposure of “exempt reporting advisers.” This article concludes by discussing how the exemptions may impact U.S. activities typically engaged in by non-U.S. hedge fund managers, such as marketing to U.S. tax-exempt entities and sourcing U.S. investment opportunities.
Many hedge fund managers that previously were not required to register with the SEC as investment advisers will be required to register by July 21, 2011 – that is, in just under four months – unless the SEC extends the registration deadline. Rule 203-1 under the Investment Advisers Act of 1940 (Advisers Act) currently provides that to apply for registration with the SEC as an investment adviser, a hedge fund manager must complete Form ADV, file Part 1A of Form ADV and file the brochure(s) required by Part 2A of Form ADV electronically with the Investment Adviser Registration Depository (IARD). Last July, the SEC finalized amendments to Part 2 of Form ADV and related rules under the Advisers Act. Those amendments were long in the making – a decade, by some counts – and they have changed Part 2 significantly. Most notably, Part 2 is now entirely narrative, publicly filed and deeper and broader in terms of the categories of required disclosure (including disciplinary history). So, hedge fund managers will have to register as investment advisers and registered investment advisers must file Form ADV, Part 2. Therefore, registered hedge fund managers will have to file Form ADV, Part 2. For managers, this has been an expensive syllogism. Many have hired compliance consultants with the goal of saying no more and no less than is required in their Part 2s. Recently, the staff of the SEC’s Division of Investment Management (Division) offered assistance in this collective benchmarking effort by publishing “Staff Responses to Questions About Part 2 of Form ADV” (Staff Responses). The Staff Responses include a series of commonly asked questions and answers to those questions. But the questions are broad and the answers are terse, in some cases, limited to a single, oracular word. While better than no statement from the Division, the Staff Responses raise as many questions as they answer. In particular, the Staff Responses say nothing about the background and context of the answers; provide no guidance on the interaction among and application of the answers; and fail to highlight the extent to which certain answers render others largely moot. This article seeks to fill in the blanks left by the Staff Responses. It does so by discussing: the legal and regulatory authority supporting some of the more relevant answers; where those answers fit into the more general patchwork of hedge fund regulation; the interaction among the answers; and the application of the answers to offshore advisers to offshore hedge funds. The article also offers guidance on implementing certain answers and highlights what certain of the answers do not cover.
On March 15, 2011, the SEC filed a complaint the U.S. District Court for the Southern District of New York against Juno Mother Earth Asset Management, LLC (Juno) and its principals, Arturo Rodriguez and Eugenio Verzili. The complaint alleges that Juno and its principals started selling interests in the Juno Mother Earth Resources Fund, Ltd. (Resources Fund) in late 2006, and by the middle of 2008, substantially all of the Resources Fund's investors had requested redemptions. The SEC alleges that during the short life of the Resources Fund, Rodriguez and Verzili engaged in a range of bad acts, including misappropriation of fund assets, inappropriate loans from the fund to the management company, misrepresentations of strategy and assets under management and disclosure violations. Assuming for purposes of analysis that the allegations in the complaint are true, the complaint illuminates a variety of pitfalls for institutional investors to avoid. This article describes the factual and legal allegations in the complaint, then details twelve important lessons to be derived from the complaint. Similar to other articles we have published extracting due diligence lessons from SEC complaints, the intent of this article is to serve as a tool for institutional investors or their agents that can be used directly in performing due diligence, or can be used to update a due diligence questionnaire. Our hope in publishing this article (and others of its type) is that at least one of the twelve lessons that we extract from the complaint enables an investor to identify a due diligence issue that it otherwise would have missed. We think that there is no better way to identify future hedge fund frauds than to understand the mechanics and lessons of past frauds.
Participants at Hedge Fund Compliance Summit Detail Best Practices with Respect to Insider Trading, SEC Examinations, Risk Mitigation, Marketing Materials, Valuation and Avoiding Investor Lawsuits: Part Two of Two
On November 15 and 16, 2010, Financial Research Associates, LLC and the Hedge Fund Business Operations Association presented a Hedge Fund Compliance Summit at the Princeton Club in New York City. In our issue of November 24, 2010, we detailed the key insights of Summit participants on topics including insider trading; the use by hedge fund managers of consultants and expert networks; sharing of information among personnel at different hedge fund managers; market rumors; insider trading considerations in connection with bank debt trading; and how to prepare for, handle and follow up on SEC examinations. See “Participants at Hedge Fund Compliance Summit Detail Best Practices with Respect to Insider Trading, SEC Examinations, Risk Mitigation, Marketing Materials, Valuation and Avoiding Investor Lawsuits: Part One of Two,” The Hedge Fund Law Report, Vol. 3, No. 46 (Nov. 24, 2010). As we observed in that article, the timing of the Summit was fortuitous because two weeks after it, The Wall Street Journal and other sources disclosed a wide-ranging, inter-agency insider trading investigation focusing on hedge fund managers, expert networks and other alternative research providers, investment banks and others. See “Lessons for Hedge Fund Managers and Expert Network Firms from the Government’s Criminal Complaint against Don Chu, Formerly of Primary Global Research LLC,” The Hedge Fund Law Report, Vol. 3, No. 47 (Dec. 3, 2010). This article finalizes our coverage of the Summit. Specifically, this article summarizes the most relevant points made by Summit participants with respect to: the revised “accredited investor” definition in Dodd-Frank; the consequences of violating Regulation D, and how to mitigate those consequences; how to negotiate the apparent conflict between the prohibition on general solicitation of Regulation D and the expanded disclosures required by revised Form ADV, Part 2; the importance of consistency between marketing materials and fund documents; recordkeeping with respect to hedge fund manager websites; the distinction between specific representations in and collective impressions created by marketing materials; rules with respect to presentation of performance information; four specific items that the SEC looks for in valuation policies and procedures of hedge fund managers; six specific red flags that the SEC looks for with respect to valuation in the course of inspections and examinations of hedge fund managers; big boy letters; what provisions in side letters may, in the view of the SEC, need to be disclosed to hedge fund investors; and why the fraud exclusion in D&O and E&O insurance policies may often be moot.
From Vol. 3 No.46 (Nov. 24, 2010)
SEC Sanctions Registered Investment Adviser Thrasher Capital Management and its CEO for Misleading Statements in Thrasher’s Form ADV
The Securities and Exchange Commission (SEC) has accepted an offer of settlement from James Perkins, the CEO and managing member of Thrasher Capital Management, LLC (Thrasher), an investment adviser registered with the SEC, for failing to make documents available to the SEC and for making false statements of material fact on Thrasher’s Form ADV. Pursuant to the settlement, on November 16, 2010, the SEC issued an Order setting forth civil penalties against Perkins and Thrasher, including a cease-and-desist order, suspending Perkins from association with any investment adviser for nine months and revoking Thrasher’s registration. Perkins escaped any monetary penalties because he submitted financial statements and other evidence of his inability to pay. Perkins and Thrasher did not admit or deny the SEC’s findings set forth in its Order, except for admission of the SEC’s jurisdiction and the subject matter of the Order. The matter helps define the appropriate scope of disclosure in a Form ADV. Such disclosure, in turn, is newly relevant to the hedge fund industry because the Dodd-Frank Act will require many hedge fund managers to file Form ADV, in many cases for the first time, by July 21, 2011.
How Does the Amended Custody Rule Change the Balance of Power Between Hedge Fund Managers and Accountants?
The bad news about the amended custody rule is the surprise examination requirement. The good news, at least for many hedge fund managers, is the annual audit exception. (That is, the amended custody rule contains an exception from the surprise examination requirement for advisers to pooled investment vehicles that are annually audited by a PCAOB-registered accountant and that distribute audited financial statements prepared in accordance with GAAP to fund investors within 120 days (180 days for funds of funds) of the fund’s fiscal year end.) See “SEC Adopts Investment Adviser Custody Rule Amendments,” The Hedge Fund Law Report, Vol. 3, No. 1 (Jan. 6, 2010). The qualified news is that while many hedge fund managers may avail themselves of the annual audit exception, an appreciable number may not. For example, managers whose funds are audited by non-PCAOB-registered accountants, or that do not (or cannot) distribute audited financial statements to fund investors within 120 days of the fund’s fiscal year end, would not be eligible for the annual audit exception. See “How Should Hedge Fund Managers Revise Their Compliance Policies and Procedures in Light of Amendments to the Custody Rule?,” The Hedge Fund Law Report, Vol. 3, No. 3 (Jan. 20, 2010). For such “ineligible” hedge fund managers, the surprise examination requirement may complicate operations for at least two reasons. First, it creates a de facto annual audit requirement. The substance of a surprise examination – explained in the SEC’s adopting release and a related interpretive release providing specific guidance for accountants – closely resembles the substance of an annual audit. (The substance of a surprise examination is discussed in more detail in this article.) Moreover, as the SEC pointed out in the adopting release accompanying the custody rule amendments, a hedge fund manager’s inability to predict which transactions an auditor will test in the course of an annual audit is analogous to the “surprise” element of the examination requirement. Second – and perhaps more controversially – the surprise examination requirement may complicate operations for hedge fund managers that are not eligible for the annual audit exception because of various SEC reporting requirements imposed on accountants that conduct surprise examinations. Those reporting requirements are described in more detail in this article, but in pertinent part would require an accountant to file with the SEC, within four business days of resignation, dismissal or other termination from an engagement to provide surprise examinations, Form ADV-E, along with an explanation of any problems that contributed to such resignation, dismissal or other termination. Importantly, Form ADV-E, along with the accompanying explanation, would be publicly available. According to the adopting release, the policy rationale for such public availability is to enable current and potential clients of an adviser to assess for themselves the importance of the explanation provided by the accountant for its resignation, dismissal or other termination. The concern haunting the subset of hedge fund managers that are (or are concerned about becoming) subject to the annual surprise examination requirement is that the Form ADV-E filing requirement may – in cases where reasonable minds can differ on close accounting and valuation calls – further enhance the leverage of accountants over managers. In other words, the concern is that revised Form ADV-E may increase the volume and specificity of an accountant’s “noisy withdrawal,” and in recognition of that, may increase risk aversion on the part of hedge fund managers in dealings with accountants. The rejoinder to this argument is that accountants already have considerable leverage over hedge fund managers, as evidenced most starkly by the consequences flowing from withholding of an unqualified audit opinion letter. See, e.g., “Former CFO of Highbridge/Zwirn Special Opportunity Fund Sues Ex-Partner Daniel B. Zwirn for Defamation and Breach of Contract,” The Hedge Fund Law Report, Vol. 2, No. 30 (Jul. 29, 2009). In an effort to assess the extent to which the custody rule amendments may alter the balance of power between accountants and hedge fund managers, this article examines: how custody is defined in the amended custody rules (because custody is a condition precedent for application of the surprise examination requirement); the substance of the surprise examination requirement; the three exceptions from the surprise examination requirement; relevant SEC reporting requirements (on Form ADV-E); expert insight on whether and how the SEC reporting requirements may increase the leverage of accountants vis-à-vis hedge fund managers; existing accountant leverage (including a discussion of audit representation letters); who bears the cost of a surprise examination; and PCAOB resource limits.
The SEC’s Proposed Custody Rule Changes: An Analysis of the Impact on Hedge Fund Managers
The SEC recently voted to propose changes to the Advisers Act custody rule. The SEC initiated this action with the intention of providing additional safeguards when an adviser has custody of client assets. The proposed changes follow a series of recent enforcement actions involving alleged misappropriation or other misuse of client assets. The proposed changes would primarily impose two new requirements on registered advisers with custody of client assets. First, those advisers would need to undergo an annual surprise examination by an independent public accountant to verify client assets. Second, those advisers who are qualified custodians and self custody client assets or use a related person who is a qualified custodian (rather than an “independent” qualified custodian) would need to obtain a written report from an independent public accountant. The report would include an opinion as to the qualified custodian’s controls regarding the custody of client assets. While the proposed changes would impact all registered advisers with custody of client assets, the changes would also have unique application to hedge fund managers. In a guest article, Terrance J. O’Malley and Jessica Forbes, both Partners at Fried, Frank, Harris, Shriver & Jacobson LLP, examine the proposed changes to the custody rule from the perspective of a hedge fund manager. Their article begins with a brief review of the rule’s history, then examines the current requirements under the rule and finally describes the proposed changes, including those most relevant to hedge fund managers.
Bill Requiring Hedge Fund Managers to Disclose “Material Conflicts of Interest” Passes Connecticut State Senate
On May 26, 2009, Connecticut’s Senate passed a bill that, if passed by the House and signed into law by the Governor, would require investment advisers to hedge funds and other private investment funds, whether or not registered with the Securities and Exchange Commission (SEC), to disclose “material conflicts of interest.” The heart of Connecticut Senate Bill No. 953, “An Act Concerning Hedge Funds,” is Subsection 1(b), which provides: “Any investment adviser to a private investment fund, regardless of whether such investment adviser is registered with the United States Securities and Exchange Commission, shall comply with the disclosure requirements of Rule 204-3 under the Investment Advisers Act of 1940 . . . provided nothing in this subsection shall require the disclosure of any information other than material conflicts of interest of the investment adviser.” We explore the bill’s legislative history, likelihood of passage, interaction with federal bills covering substantially similar substantive areas, the role of the Connecticut Banking Commissioner and the operation of Advisers Act Rule 204-3.
Vol. 11, No. 28 (Jul. 12, 2018)
Vol. 11, No. 27 (Jul. 5, 2018)
Vol. 11, No. 26 (Jun. 28, 2018)
Vol. 11, No. 25 (Jun. 21, 2018)
Vol. 11, No. 24 (Jun. 14, 2018)