Author Archives: nedaj

Hedge Fund Bits and Pieces for April 7, 2017

Happy Masters Friday!

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End Game of Mini-Prime Consolidation? – earlier this week Cowen announced the acquisition of Convergex.  For Cowen, this is the second introducing prime (mini-prime) acquisition in the last two years, the earlier coming when they acquired Concept Capital in July of 2015.

There are a number of interesting things about this transaction – first, it appears that final consolidation of the introducing prime space has occurred (Cowen and BTIG).  Given the reluctance for any major prime to accept new introducing business, it seems unlikely we would see another group try to get into this space, at least in the current environment.  Second, Cowen has been very active and aggressive with its expansion activities and its efforts to rebrand.  Just last week Cowen announced it received a $100M investment from China Energy Company Limited along with a promise to provide up to $175M in debt financing (presumably this capital was for the purchase of Convergex).  Additionally, we have heard small rumors that Cowen is in the process of rebranding their Ramius division to more align with the Cowen name.

FINRA Blockchain Report Comments Posted – in January FINRA published a report entitled Distributed Ledger Technology: Implications of Blockchain for the Securities Industry.  The report provides an overview of blockchain technology and discusses, among other items, the regulatory considerations for groups who are implementing this technology in certain areas of the securities industry.  FINRA asked for comments on the report and that comment period ended last Friday.  There were a number of interesting comments from both regulatory groups as well as market participants.  In the coming weeks we are planning to provide more analysis on FINRA and other regulatory body efforts in this space.  An overview of the report and links to the comment letters can be found here.

Capital Acquisition Broker (CAB) rules effective April 14, 2017 – in our opinion, there have been a number of misguided attempts by FINRA to modernize and ease certain regulatory frameworks (see our earlier post on the proposal to scrap the Series 7 exam).  Late last year the SEC approved a new category of broker-dealer called a Capital Acquisition Broker which could engage in certain private placement, investment banking and capital raising activities and be subject to a separate set of broker-dealer rules and regulations.  In theory this might be a good thing, but there are a couple of issues with these new rules.  First, the subset of potential groups these rules apply to are very limited (only firms raising money from very large institutions and qualified purchasers can be CABs).  Second, the CAB rules really aren’t that different from the normal FINRA rules applicable to broker-dealers.  The real issue is that FINRA does not have staff who are appropriately trained to understand all the various business models that broker-dealers may have.  We do note that we (and many others) have brought these concerns to FINRA’s attention and we believe the new FINRA president is working to make this better.

In any event, the CAB rules will be effective next Friday and more information on CABs can be found here for those who are interested.  We have not heard of any groups decided to go the CAB route instead of the traditional broker-dealer route, and we will be interested to hear if this changes in the future.

SEC Increases Crowdfunding Limits – pursuant to the requirements under the Dodd-Frank Act that the SEC increase the limits proscribed in the crowdfunding regulations, the SEC increased certain limits under those regulations.  Among other increases, the maximum aggregate amount an issuer can sell in a 12-month period increases to $1,070,000 from $1,000,000 and the maximum amount that can be sold to an investor in a 12-month period increases to $107,000 from $100,000.  More information on the adjustments can be found in the SEC press release on this topic.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry.  He can be reached directly at 415-868-5345.

Hedge Fund Bits and Pieces for March 17, 2017

Happy Friday. This week’s updates below.

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Bitcoin ETF Rejected by SEC – an application to establish an ETF which would be based on a basket of Bitcoins was rejected by the SEC on March 10. The Winklevoss brothers, noted Bitcoin investorss, were the sponsors of the vehicle which was to be called the Winklevoss Bitcoin Trust. In rejecting the proposal, the SEC stated that the Bitcoin markets are unregulated and that the exchange the ETF would be traded on (Bats BZX Exchange) would not be able to enter into “surveillance-sharing” agreements that would be able combat fraudulent or manipulative acts and practices in the Bitcoin market. We expect that there will be future ETF proposals submitted to the SEC and that as the cryptocurrency industry (and specifically the exchanges hosting Bitcoin exchange) becomes more developed, a Bitcoin ETF will at some time be approved for trading. The SEC release can be found here.

Bitcoin Hedge Funds Article – we recently wrote about Bitcoin/ AltCurrency / Cryptocurrency hedge funds.  We believe that this is a burgeoning asset class and we will begin to see more private fund products launched in this space in the coming months.

FINRA Proposal to Scrap Series 7 – last week FINRA filed a proposed rule change with the SEC that would eliminate the Series 7 exam in favor of a more “streamlined” representative-level qualification exam that would include a general knowledge exam and specialized knowledge exam. We have strong thoughts about FINRA’s use of their time to create a new regulatory structure for exams when there has been no specific mandate for this update (no one is asking for this and we don’t know what problem this complete revamp is solving). We also (personally) believe that FINRA could better spend its time focused on matters that its member firms are asking to be addressed. While we are all for streamlining at Federal Agencies and self-regulatory organizations, we believe that streamlining should be reasonable and should serve a purpose – I am not sure if there was a purpose to this, but I also have not read through the entire 619 page FINRA submission to the SEC.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry. He can be reached directly at 415-868-5345.

Bitcoin Hedge Funds (Cryptocurrency / AltCurrency Funds)

Overview of Blockchain Based Digital Currency Investment Fund Structures

Bitcoin has recently been in the news again due to strong results over the last couple of months. Bitcoin and other digital currencies have been a bit of a fringe phenomenon in the investment management industry since inception. However, the power of the idea of distributed computing/ledgers has been evangelized in various parts of the tech industry and has attracted a significant amount of institutional investment into various digital currencies, and related infrastructure. It is not surprising then to see asset managers beginning to explore this space either through dedicated fund products, or through side pocket investments separate from more traditional products. This post discusses the various structural, regulatory, and operational issues that arise for managers who invest in these instruments.

Foundational Items – Definition

For purposes of this article, we make references to the term Bitcoin and digital currencies. These references will generally mean references to other blockchain-based currencies and/or digital tokens, which are sometimes referred to as cryptocurrencies or altcurrencies. There are various governmental agencies looking into how to define and regulate this space, and the CFTC has specifically defined the term “Bitcoin” in the following way:

Bitcoin is a “virtual currency,” defined here as a digital representation of value that functions as a medium of change, a unit of account, and/or a store of value, but does not have legal tender status in any jurisdiction. Bitcoin and other virtual currencies are distinct from “real” currencies, which are the coin and paper money of the United States or another country that are designated as legal tender, circulate, and are customarily used and accepted as a medium of exchange in the country of issuance. [See note 2 of the CFTC order discussed below.]

Another foundational item of this post is whether Bitcoin is a “security” under securities laws, or a currency under commodities laws, or both, or something else. We will discuss this issue in greater depth below under regulations, but for the general purposes of this article, we will take the position that Bitcoin is not a security regulated by the SEC nor state securities regulators. We will also take the position that Bitcoin is likely a currency that is subject (in some instances) to regulation by the CFTC.

Structural Considerations for Fund Formation

Although there are unique qualities of Bitcoin (it does not act like a security and it is debatable whether it acts like a commodity/currency), the big picture structural considerations for a fund manager in this space will not be significantly different than for a traditional hedge fund investing in securities and/or commodities.

Hedge Fund or Private Equity Strategy. For the Bitcoin funds we have worked with, the strategies tend to be more hedge fund styled than private equity styled. This generally makes sense given the relatively “liquid” nature of the instrument. If a fund invests directly into operating companies in the digital currency ecosystem, or if a fund sets up operations to mine for Bitcoin, there may be the need for side-pocket private equity style sleeves within a larger liquid framework.

Fund Terms. Normally we see standard hedge fund style terms; as well as expenses and fees that are generally similar to standard securities type fund programs (if anything, there may be greater management and performance fees because of the novel strategy / managers tend to have deep backgrounds in cryptography, mathematics and coding). Contribution provisions will also be standard. However, we tend to see greater attempts to limit withdrawals. Such measures could include longer withdrawal periods with longer notice provisions (60-90 days), and the use of investor level or fund level gates. Custody is a big issue, and valuation has the potential to be an issue as well. The use of leverage does not tend to be a major part of this investment strategy.

Onshore / Offshore Structures. As with other non-traditional hedge funds, the structure will be influenced by the taxation of the underlying investments and the nature of the investors. As of right now, we are not aware of any adverse tax consequences with respect to digital currencies for U.S. based investors; therefore, a standard domestic Delaware limited partnership structure should be sufficient. If the fund will have U.S. tax exempt investors, the domestic structure should be sufficient if the fund does not utilize leverage. To the extent the tax code changes in the future to tax digital currencies specifically, the structural considerations may change.

If the fund complex intends to have non-U.S. investors, the manager will choose between a mini-master structure or a master-feeder structure. Jurisdiction of any offshore structure will likely be the Cayman Islands or the British Virgin Islands. We have not seen and do not necessarily believe there would be a reason for a fund complex to introduce SPV structures to accommodate digital currency investment, but if that occurred, such structuring discussions would be based on normal factors like jurisdiction of the underlying asset, corporate necessity, etc.

Regulatory and Other Considerations for Bitcoin Investment Managers

There are a number of instrument-related issues which arise for fund managers who are investing in this space. Because of the relatively nascent stage of these instruments, managers and service providers are working out the below issues, and the way these issues are handled should become more standardized in the near future.

Federal & State Regulatory System.

SEC – Bitcoin and other digital currencies are most likely not securities; but, the SEC is currently examining how to deal with Bitcoin and other digital currencies. The biggest question is whether these instruments are securities or some other kind of asset subject to (or not subject to) regulation. If these digital currencies are securities, then the SEC will have jurisdiction to regulate the instruments, as well as the transfer of such instruments (including the regulation of any exchange facilitating such transfer). Because the SEC has not released any definitive guidance on the issue, Coinbase, a large Bitcoin wallet and exchange platform, has released the following discussion about how digital currencies fit into the SEC regulatory landscape (see Securities Law Framework for Bitcoin). Until we receive definitive guidance, or even informal guidance, from the SEC, the Coinbase framework discussion is probably the best reference material with respect to this particular issue.

CFTC – While it is clear that Bitcoin is fundamentally different from normal currencies traded on the Interbank or forex markets, what is less clear is whether and to what extent the CFTC has jurisdiction over the instrument and the exchanges on which they are traded on. Unfortunately, the answer is not exactly clear and the uncertainty, in part, comes from parts of the Dodd-Frank Act which provided the CFTC with new jurisdiction over parts of the currency trading systems in place in the United States. Because of certain the technical aspects of trading currencies both on the spot (interbank) and futures markets, and how those technical aspects inform the jurisdictional reach of the CFTC post Dodd-Frank, some part of this discussion is theoretical (what is delivery of a digital currency? what is custody of a digital currency and is this different from custody of a password?). While our law firm is currently in discussion with the CFTC as to whether a straight digital currency (as opposed to a digital currency forward or future) is a contract subject to CFTC jurisdiction, we currently believe that a private fund’s purchase of a Bitcoin or similar digital currency would not be subject to CFTC oversight (which would require the private fund manager to register as a CPO and CTA, or fit within exemptions). Notwithstanding the above, some types of instruments involving Bitcoin are commodities subject to CFTC oversight—please see Coinflip CFTC Order. In this order, there were a number of issues that led to the finding of regulatory oversight (products were deemed to be swaps; CFTC specifically mentioned OTC Bitcoin forward contracts as other contracts which may be subject to CFTC jurisdiction, see note 4).

CFTC and SEC? – In the future, it is likely that we will begin to see products linked to and based on Bitcoin, which have both the characteristics of a security and a futures product, thus subjecting such future instruments potentially to both CFTC and SEC jurisdiction. We would expect to see future legislation enacted both to define the nature of digital currencies, and any derivatives thereon, and also to define the scope of the CFTC and SEC’s jurisdiction over such products.

State – We have not heard of any state orders, actions or interpretations involving Bitcoin. We would expect the regulation of such assets to be driven by federal authorities, but we do not discount the fact that many state securities regulators (especially on the west coast) can take aggressive positions regarding new products.

Regulation of Management Company. Depending on where the manager fits within the regulatory spectrum discussed above, the manager may be subject to oversight and regulation. If the manager is deemed to be an investment adviser, or CTA and/or CPO, based on the above, the manager would be subject to the normal registration and compliance frameworks associated therewith. Managers who invest in other Bitcoin or cryptocurrency funds are definitely investing in securities (a private fund is a security), so a bitcoin fund of funds manager is deemed to be an investment adviser and would need to be registered (or fall within an exemption from registration) with the SEC or state securities commission. While we have seen some significant investment into the space, we acknowledge that the sector is still in its infancy and that we will probably begin to see more institutionalization among managers in this space.

Custody. Perhaps the biggest issue with respect to these instruments is how and where they are custodied, and also how and where the passwords, keys or other information related to the proof ownership are custodied. We believe that each manager needs to develop their own methods to deal with the custody issue, and that these methods will need to address the associated risks of ownership or the particular currency (as discussed in the Securities Law Framework for Bitcoin, each instrument has unique characteristics). In addition to the managers we have worked with, we have heard anecdotal stories about the many different ways managers store and protect the fund’s ownership and evidence of ownership of the digital currencies, including the use of thumb drives and bank safety deposit boxes.

Risks. A fund in this space will need to focus of the normal risks inherent for any private investment vehicle, but there are additional risks to consider related to the strategy, including: general risk of digital currencies, liquidity, ability to hedge, volatility, loss of private keys, technology and security issues, risk of exchanges (e.g. Mt. Gox), lack of FIDC or SIPC protection.

Service Providers. The typical service providers in this space (lawyers, administrators and auditors) have been working together to figure out how to deal with the novel and unique issues presented from these instruments.

Other Issues. There are a host of other issues which arise in this space that will continue to be flushed out over time. These include IT infrastructure for managers and general security over passwords. Valuation has the potential to be an issue depending on the exact nature of the digital currency, and whether the currency is fungible and traded on different exchanges that have different pricing. Valuation also may be an issue if it is determined that there is no public market or exchange for the instrument. Taxation of the gains on these instruments may also change in the future (right now, they presumably are taxed under IRC Section 988). Additionally, there may be capacity constraints as a large number of investors begin to pile into these investments, including when the derivatives markets take hold.

Conclusion

We have worked with a number of groups in this space over the past two years, and have seen an uptick in interest in managing a private fund to invest in Bitcoin and digital currencies. We believe the interest stems from the strong returns of Bitcoin, as well as the public’s growing acceptance of alternative currencies. We also think that a general increase in exposure of Bitcoin has contributed to an interest in being able to invest in digital currencies. As these investments become more standardized and regulated, we believe we will continue to see growth in this area.

Related articles:

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Hedge Fund / Investment Adviser Updates for March 10, 2017

Happy Friday.  Below are some recent updates that we thought were relevant and/or interesting.  Please contact us if you have any questions on the below.

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IA Annual Update – a reminder to investment advisers that the annual ADV update will be due in 3 weeks.  If you have not already begun the process, you should start working with your fund attorney or compliance consultant to finish the update which is due by March 31, 2017.  Please see our earlier post on the IA update process for more information.

Cybersecurity watch for fund managers – the SEC recently sent a note out to EDGAR users about a phishing email scam.  Emails were purportedly sent from the SEC about changes to the Form 10-K; the emails in fact were part a phishing scam.  A reminder for all to be vigilant with inbound emails.  For the release from the SEC, please click here.

DOL Fiduciary Rule – whether the Department of Labor’s new fiduciary rule will be enacted has been subject to constant speculation since the election of President Trump.  Speculation continues in the wake of the March 2nd notice by the DOL asking for comments on whether to delay application of the rule by 60 days (the rule is/was supposed to be applicable as of April 10, 2017).  Interestingly enough, the request for comments on whether to delay the application of the rule comes from pressure from the current administration; as specifically noted by the DOL in the Federal Register:

The President by Memorandum to the Secretary of Labor, dated February 3, 2017, directed the Department of Labor to examine whether the final fiduciary rule may adversely affect the ability of Americans to gain access to retirement information and financial advice, and to prepare an updated economic and legal analysis concerning the likely impact of the final rule as part of that examination.

Comments on the proposal to delay the rule are due to the DOL by March 17, 2017.   Expect to see a number of stories on this topic over the next couple of weeks.  For more information, see the notice in the Federal Register.

Marijuana / Cannabis Hedge Funds – we recently wrote a post about the legal and operational issues for hedge fund managers in the cannabis space.  We think there will be a lot of stories about this sector in the next few months as the Trump administration sorts out whether and how to enforce federal prohibitions against marijuana.

Other items of interest – we think there will continue to be interesting stories that affect the investment management industry, especially with respect to regulations and taxes (we’re hoping for more news on tax cuts, instead of news related to “closing the carried interest loophole”).  Always of interest are discussions related to the decrease of hedge fund management and performance fees – I’m sure we’ll see more stories and anecdotes likes these.

Have a great weekend!

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and focuses his legal practice on the investment management industry.  He can be reached directly at 415-868-5345.

Anecdotal Evidence of Strong Investor Appetite in 2017

Hedge funds to be attractive investments in new year?

By: Bart Mallon

Over the past couple of years hedge funds have seemingly taken a back seat to private equity, which has seen a significant amount of attention and inflows from institutional investors.  However, it is beginning to feel as though hedge funds are poised for a banner year – in the past two weeks we’ve received more investor due diligence inquires (confirmation of our law firm’s relationship with a manager) than we’ve had over the past six months.  Perhaps even more interesting is that investor demand is coming from all sources (fund of funds, institutional allocators, due diligence specialist firms and individual investors) and has been for potentially large subscription amounts.

Although our firm saw some managers receive major allocations from large pension funds and other investors in 2016, a high percentage of managers were seeing mild to poor interest in their products last year and it is no secret that fund launches were down significantly as well, continuing the trend of fewer fund launches over the last few years.  While to some extent investor appetite is driven by individual managers (right performance, right strategy, right time), it seems to us that we are seeing diligence inquiries that are not solely focused on the hot investment strategy du jour.  The inquiries also fall along various parts of the asset spectrum and can’t be solely classified as pertaining only to funds over say $250M AUM.

I did not expect this surge in inquiries, but I was not surprised it – in late November to early December (after the post-election market surge), we were hearing anecdotal evidence from some of our asset-raising friends that capital was ready to flow and that investors were inquiring about hedge fund products.  It seems the bullishness of late November and December has continued into this new year.  If this continues, we may see more launches in Q2 and Q3 of this year as portfolio managers decide to leave firms after bonus season, whether or not they have investors already lined up.  In any event, we hope we see both more launches in 2017 and more investment in those launches.

Here’s to the new year and my best wishes to all of you – managers, investors, allocators, compliance firms, service providers – for a fantastic 2017.

Bart Mallon
www.colefrieman.com/bart-mallon
415-868-5345

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP is a boutique hedge fund law firm and provides comprehensive formation and regulatory support for hedge fund managers.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Cole-Frieman & Mallon EOY Update

Below is our quarterly newsletter. If you would like to be added to our distribution list, please contact us

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January 4, 2016

Clients, Friends, Associates:While the holiday season is a cause for celebration and reflection, it is also the busiest time of the year for most investment managers.  Year-end administrative upkeep and 2017 planning are particularly important, especially for General Counsels, Chief Compliance Officers, and key operations personnel.  As we head into 2017, we have put together this checklist to help managers stay on top of the business and regulatory landscape for the coming year.

This overview includes the following:

  • Annual Compliance & Other Items
  • Annual Fund Matters
  • Annual Management Company Matters
  • Regulatory & Other Changes in 2016
  • Compliance Calendar

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Annual Compliance & Other Items:

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) must provide natural person clients with a copy of the firm’s privacy policy, even if there are no changes to the policy.

Annual Compliance Review. On an annual basis, the Chief Compliance Officer (“CCO”) of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Advisers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.

Form ADV Annual Amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority, must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule include the vehicle(s) managed by the adviser. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.

Switching to/from SEC Regulation.SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their fiscal year by filing Form ADV-W. Such managers should consult their state securities authorities to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment.Exempt Reporting Advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the SEC or the relevant state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.

Custody Rule Annual Audit.

SEC-Registered IA. SEC-registered advisers must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.

Advisers to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Statements must be sent to the fund or, in certain cases, investors in the fund, within 120 days after the fund’s fiscal year-end. Managers should review their custody procedures to ensure compliance with the rules.

California-Registered IA. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of assets. CA RIAs to pooled investment vehicles may avoid the independent party and surprise examinations requirements by having audited financial statements prepared by an independent public accountant registered with the PCAOB and distributing such audited financial statements to all limited partners (or members or other beneficial owners) of the pooled investment vehicle, and to the Commissioner of the California Department of Business Oversight (“DBO”).

Advisers registered in other states should consult with legal counsel about those states’ custody requirements.

California Minimum Net Worth Requirement and Financial Reports.

RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000. Notwithstanding the foregoing, the minimum net worth for a CA RIA (A) deemed to have custody solely because they act as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (B) that otherwise comply with the California custody rule described above (such advisers, the “GP RIAs”), is $10,000.

RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities but does not have custody, must maintain at all times a minimum net worth of $10,000.

Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the Department of Business Oversight within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and a verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody and is not a GP RIA.

Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the CFTC are required to re-certify their eligibility within 60 days of the calendar year-end. CPOs and CTAs currently relying on relevant exemptions will need to evaluate whether they remain eligible to rely on such exemptions.

CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the NFA, as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth quarter report on Form CTA-PR. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be corrected promptly, and the corrected version must be distributed promptly to pool participants.

Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year-end.

Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.

Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and SMAs) that are beneficial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to file the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after acquisition of more than 5% beneficial ownership of a registered voting equity security. For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter.

Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.

Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million filing threshold. The SEC lists the securities subject to 13F reporting on its website.

Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.

Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and have at least $150 million in regulatory AUM must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in regulatory AUM) must file Form PF annually within 120 days of their fiscal year-end. Larger private advisers (fund managers with $1.5 billion or more in regulatory AUM) must file Form PF within 60 days of the end of each fiscal quarter.

SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the most recently filed Form D. Copies of Form D can be obtained by potential investors via the SEC’s EDGAR website.

Blue Sky Filings. On an annual basis, a manager should review its blue sky filings for each state to make sure it has met any renewal requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filing deadlines for both new investors and renewals. We also recommend that managers review blue sky filing submission requirements. Many states now permit blue sky filings to be filed electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept filings through EFD.

IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 16, 2016. If you have not already done so, you should submit full payment now.

Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel and placement agents acting on their behalf, from seeking to be engaged by a governmental client if they have made political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition of “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Investment professionals (employees who spend at least one-third of their time managing the assets or securities of the manager) are statutorily excluded from California’s “placement agent” definition, and thus do not have to register as lobbyists. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties.

State laws on lobbyist registration differ widely, so we recommend reviewing your reporting requirements in the states in which you operate to make sure you are in compliance with the rules.

Annual Fund Matters:

New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues, pursuant to both FINRA Rules 5130 and 5131. Most managers reconfirm investors’ eligibility via negative consent (i.e. investors are informed of their status on file with the manager and are asked to inform the manager of any changes). A failure to respond by any investor operates as consent to the current status.

ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor.

Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in embarrassing book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.

Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.

NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).

Fund Expenses. Managers should wrap up all fund expenses for 2016 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion in the NAV for year-end performance.

Electronic Schedule K-1s. The IRS authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is effective and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.

“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe-harbor from SEC registration if the issuer or its “covered persons” are “bad actors”. Fund managers must determine whether they are subject to the bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements or undertakings in a questionnaire or certification. If an offering is continuous, delayed or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires and certifications, negative consent letters, periodic re-checking of public databases and other steps, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such an update at least annually.

U.S. FATCA and UK FATCA. Funds should monitor their compliance with U.S. FATCA and UK FATCA. U.S. FATCA reports are due on March 31, 2017 or September 30, 2017, depending on where the fund is domiciled. UK FATCA reports are due May 31, 2017. As a reminder for this year, we strongly encourage managers to file the required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late. We recommend managers contact their tax advisors to stay on top of these requirements and avoid potential penalties.

Annual Management Company Matters:

Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.

Employee Reviews. An effective annual review process is important to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place.

Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.

Insurance. If a manager carries D&O insurance or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as appropriate.

Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options.

Regulatory & Other Changes in 2016:

The Supreme Court Declines to Follow Newman in Ruling on Insider Trading Case. On December 6, 2016, The Supreme Court decided Salman v. United States, unanimously upholding the Ninth Circuit’s decision to affirm Bassam Salman’s conviction of insider trading, a decision we discussed previously. Salman was a closely-watched “tipper-tippee” liability case in which Mr. Salman traded on inside information he received from his future brother-in-law, who in turn received the information from his brother, a former investment banker at Citigroup. Historically, the Supreme Court has held that “tippers” are liable if they disclose material, nonpublic information in breach of a fiduciary duty and in order to receive a “personal benefit”; and tippees are liable for trading on the tip if they know the tipper’s disclosure was in breach of a duty and to receive a personal benefit. Salman sought to rely on the Second Circuit’s holding in Newman that a tipper must receive something of a “pecuniary or similarly valuable nature” in arguing that a gift of confidential information to a friend or family member was alone insufficient to establish the “personal benefit” required for tippee liability. The Supreme Court disagreed, holding that gifting inside information to “a relative or friend” constitutes a sufficient personal benefit to the tipper. Salman does not completely overturn Newman, and key questions remain unanswered (including how close the relationship must be between tipper and tippee) but it makes clear that gifting nonpublic confidential information to a friend or relative who trades on that information can trigger insider trading liability.

SEC Updates.

SEC Revised Qualified Client Threshold. Effective August 15, 2016, the SEC increased the “net worth” threshold in the definition of “Qualified Client” under the Investment Advisers Act of 1940, as amended (the “Advisers Act”), from $2,000,000 to $2,100,000 to account for inflation. The Qualified Client threshold is critically important for investment advisers because performance fees and incentive allocations can only be charged to investors who are Qualified Clients in nearly all jurisdictions. All investment advisers should examine their subscription documents to ensure that new investors have provided accurate representations regarding their Qualified Client status.

SEC Proposes Rule Requiring RIAs to Adopt Business Continuity and Transition Plans. The SEC’s proposed rule would require SEC RIAs to implement written business continuity and transition plans designed to mitigate the effects of significant internal or external disruptions in operations, such as natural disasters, cyber-attacks, technology failures, and departure of key personnel. The content of such plans would be based upon risks associated with a RIA’s operations and would include policies and procedures designed to address different elements of a firm’s business. Firms would also be required to review the adequacy and effectiveness of their plans at least annually and retain certain records.

SEC Emphasis on Cybersecurity. Throughout 2016, cybersecurity remained an enforcement priority for the SEC. In June, the SEC appointed Christopher R. Hetner, a career information security expert, to the role of Senior Advisor to the Chair for Cybersecurity Policy. Later that month, it was announced that Morgan Stanley had settled SEC charges brought against the firm for failure to protect digital customer information through failure to adopt the statutorily required written policies and procedures.  Given the SEC’s continued emphasis on cybersecurity, firms should be moving forward with cybersecurity implementation and may want to discuss with counsel or other outside service providers.

SEC Implemented Business Conduct Standards for SBS Dealers and Major SBS Participants. On April 15, 2016, the SEC adopted new rules that would require security-based swap (“SBS”) entities to comply with a comprehensive set of business conduct standards and CCO requirements. The new rules aim at enhancing accountability and transparency in transactions with investors and special entities in the over-the-counter derivatives market, which, according to SEC Chair Mary Jo White, has lacked fundamental customer protections for years. Additional provisions and heightened protections apply in transactions with special entities, such as municipalities, pension plans, and endowments.

SEC Amended Form ADV and Rule 204-2. On August 25, 2016, the SEC adopted rules to enhance the information reported by investment advisers on Form ADV with a goal of increasing transparency, efficiency and compliance. The rules increase reporting on Form ADV with respect to SMAs, formalize umbrella registration requirements for related investment advisers, and expand the books and records required to be kept related to performance. Advisers will need to begin complying with the amendments on October 1, 2017.

SEC Approved FINRA Pay-To-Play Rule. The SEC approved FINRA’s proposed Rule 2030 which applies to investment advisers who are also FINRA member firms (i.e. also broker-dealers).  Rule 2030 was modeled after Advisers Act Rule 206(4)-5 and addresses pay-to-play practices by investment advisers who are also broker-dealers. The elements and terms of FINRA’s rule are substantially similar to the SEC’s pay-to-play rule and prohibit covered members from engaging in distribution and solicitation activities for compensation with government entities on behalf of an investment adviser within two years after a contribution is made to an official of the government entity by the covered member. FINRA member firms that are not yet subject to the pay-to-play rule should familiarize themselves with its provisions.

Outgoing SEC Chair. SEC Chair Mary Jo White announced recently that she plans to step down from that role around when President Obama leaves office in January. During Ms. White’s tenure, the SEC focused on tightening rules implementing the Dodd–Frank Wall Street Reform and Consumer Protection Act and pursued record numbers of enforcement cases. President-elect Trump will appoint Ms. White’s successor, and it is not yet clear how the SEC’s focus and priorities may change under new leadership.

CFTC and NFA Updates.

NFA Proposed Amendments to Financial Reporting Rule and Amended Compliance Rule 2-46. The NFA proposed to revise forms PQR and PR to require CPOs and CTAs respectively to disclose two ratios related to their financial health that would measure the firm’s ability to pay its short-term obligations with current assets and the firm’s pricing strategy and operating efficiency. CPOs and CTAs would also be required to keep records demonstrating how the ratios were calculated. Additionally, effective September 30, 2016, each late Form CPO-PQR or CTA-PR will be subject to a $200 fee for each business day it is late. Generally, Form CTA-PR is due within 45 days and Form CPO-PQR within 60 days of the relevant calendar quarter end. Note, however, that payment and acceptance of the fees does not preclude the NFA from filing a disciplinary action for failure to comply with the deadlines imposed by NFA Compliance Rules.

CFTC Amended CPO Financial Report Requirements. On November 25, 2016, the CFTC published final rules amending certain CPO financial report requirements. Effective December 27, 2016, the amendments will permit the use of additional alternative generally accepted accounting principles, standards or practices; provide relief from the Annual Report audit requirement under certain circumstances; and clarify that an audited Annual Report must be distributed and submitted at least once during the life of a commodity pool. The amendments codify certain exemptions provided by the Commission over the years on a case-by-case basis through exemptive or no-action letters.  We recommend contacting counsel, or reviewing the Federal Register to determine eligibility for the amended regulations.

Prudential Regulators and CFTC Adopted Margin Rules for Uncleared Swaps. The prudential regulators – the Federal Deposit Insurance Corporation, the Department of the Treasury (the Office of the Comptroller of the Currency), the Board of Governors of the Federal Reserve System, the Farm Credit Administration and the Federal Housing Finance Agency – (“PRs”) adopted a joint final rule covering swap entities that are supervised by one of the PRs (such covered swap entities, “CSEs”). Shortly thereafter, the CFTC adopted its own final rule covering swap entities that are not supervised by one of the PRs, but that are registered with CFTC (“Non-Bank CSEs”). Both the PRs and the CFTC emphasized that the margin requirements are intended to reduce risk for individual CSEs and for the financial system as a whole. We recommend that you speak with your firm’s outside counsel to determine if either rule applies to you.

NFA Guidance Regarding Cybersecurity. Beginning March 1, 2016, each NFA member firm should have established a written information systems securities program (“ISSP”) discussing, among other items, the firm’s current cybersecurity risks and ongoing cybersecurity training, and creating an “incident response” plan to help manage, contain and mitigate identified security breaches. Each ISSP must be reviewed annually by an executive-level officer of the firm. NFA members should review their cybersecurity programs and promptly take appropriate steps to make sure they are in compliance with the new rule.

Municipal Advisor Rulemaking. On August 17, 2016, the Municipal Securities Rulemaking Board (“MSRB”) extended pay-to-play standards to municipal advisors. Amended Rule G-37 prohibits municipal advisors from engaging in municipal securities business for two years after making certain political contributions and from soliciting or coordinating contributions with certain municipal officials and political parties with which the municipal advisor is engaging, or seeking to engage, in business. The rule also requires quarterly disclosures of certain contributions to the MSRB. Municipal advisors should review their current policies and consider whether they adequately address the new pay-to-play rules.

Other Updates.

DOL Defined Fiduciary of an Employee Benefit Plan under ERISA. The United States Department of Labor (“DOL”) issued a new rule that will extend fiduciary status to all advisers offering investment advice to employee benefit plans, plan fiduciaries, and IRAs when the rule comes into effect early next year. Under the new rule, all investment advisers who provide such advice will be required to make recommendations that are in the “best interest” of their clients. Under certain exemptions, an investment adviser would be able to continue using methods of conflicted compensation as long as the adviser meets specific conditions that mitigate conflicts of interest and ensure that investment advice is in the best interest of their clients. The general fiduciary standard becomes effective on April 10, 2017. There is a fair amount of uncertainty regarding the new rule’s application to private fund advisers, but at this time we have no reason to believe it will apply to private funds that are not “plan assets” funds (i.e., funds that do not exceed the 25% ERISA threshold). Investment advisers are encouraged to review their client base and discuss with legal counsel to determine whether they are subject to this new regulation.

New Due Diligence Requirements for Covered Financial Institutions. The U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) issued new customer due diligence (“CDD”) requirements that covered financial institutions must comply with by May 11, 2018. Covered financial institutions (which include banks, broker-dealers in securities, mutual funds, futures commission merchants and introducing brokers in commodities) will be required to verify the identity of any natural person that is a beneficial owner of at least 25% of any legal entity applying to open a new account, develop a customer risk profile for each customer, and establish an account-monitoring system to report suspicious transactions. Certain types of customers are exempted from these requirements.

New Filing Deadline for Form 1099-MISC. The IRS now requires Form 1099-MISC to be filed on or before January 31, 2017, when reporting nonemployee compensation payments. Otherwise, Form 1099-MISC may be filed by February 28, 2017, if it is filed on paper, or by March 31, 2017, if it is filed electronically. Automatic 30-day extension is available by filing Form 8809 by January 31, 2017. No signature or explanation is required for the extension.

Offshore Updates.

Cayman Islands Publishes Limited Liability Company Law. The highly-anticipated Cayman Islands Limited Liability Companies Law came into effect on July 8, 2016, and allows for the formation and operation of a limited liability company similar in structure and flexibility to that of a Delaware limited liability company (“LLC”). We have been in discussions with certain Cayman law firms about how managers might use such LLCs in their offshore structures in future. It seems like the best use will be for certain management company entities or as single-purpose investment vehicles under a larger fund structure. At this time, we do not expect the LLC form to supersede the Ltd. form for actual fund entities in the Cayman Islands. If you are interested in how you might be able to utilize these vehicles in the future, we recommend that you speak with your firm’s offshore counsel to discuss the entity’s advantage and disadvantages.

ESMA Proposed Extension of Funds Passport to 12 Non-EU Countries. The European Securities and Markets Authority (“ESMA”) recommended this year that the Alternative Investment Fund Managers Directive (“AIFMD”) passport should apply to 12 non-EU countries: Australia, Bermuda, Canada, Cayman Islands, Guernsey, Hong Kong, Japan, Jersey, Isle of Man, Singapore, Switzerland, and the United States. The passport is currently available to EU entities, but according to ESMA, there are generally no significant obstacles impeding the application of AIFMD in these 12 countries. ESMA’s advice will be considered next by the European Commission, Parliament and Council. If the passport is extended, it will be easier for non-EU alternative investment fund managers and alternative investment funds to market and manage funds throughout the EU.

Compliance Calendar.  As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline – Filing

  • December 16, 2016 – IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
  • December 27, 2016 – Last day to submit form filings via IARD prior to year-end
  • December 31, 2016 – Review AUM to determine 2017 Form PF filing requirement
  • January 15, 2017 – Quarterly Form PF due for large liquidity fund advisers (if applicable)
  • January 31, 2017 – “Annex IV” AIFMD filing
  • February 14, 2017 – Form 13F due
  • February 14, 2017 – Annual Schedule 13G updates due
  • February 14, 2017 – Annual Form 13H updates due
  • March 1, 2017 – Deadline for re-certification of CFTC exemptions
  • March 1, 2017 – Quarterly Form PF due for larger hedge fund advisers (if applicable)
  • March 31, 2017 – Annual ADV amendments due
  • March 31, 2017 – Annual Financial Reports due for CA RIAs (if applicable)
  • February 14, 2017 – Annual Form 13H updates due
  • April 15, 2017 – Extended FBAR deadline for certain individuals with signature authority over, but no financial interest in, one or more foreign financial accounts
  • April 30, 2017 – Annual Form PF due for all other advisers (other than large liquidity fund advisers and large hedge fund advisers)
  • Periodic – Form D and blue sky filings should be current
  • Periodic – Fund managers should perform “Bad Actor” certifications annually.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP.  Mr. Mallon can be reached directly at 415-868-5345.

Cole-Frieman & Mallon 2016 Second Quarter Update

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 www.colefrieman.com

July 22, 2016

Clients and Friends:

We hope that this message finds you well and that you are enjoying the first months of summer. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.

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SEC Revises Qualified Client Threshold. The SEC recently published an order approving an adjustment to the definition of a “Qualified Client” under the Investment Advisers Act of 1940 (the “Advisers Act”). Specifically, the “net worth” threshold has been increased from $2,000,000 to $2,100,000 to account for inflation since the date the original definition was adopted. The Qualified Client threshold is critically important for investment advisers because in nearly all jurisdictions, including for SEC registered investment advisers, performance fees and incentive allocations can only be charged to investors who are Qualified Clients. The new definition becomes effective August 15, 2016 (the “Effective Date”), but will not be applied retroactively to contractual relationships existing as of such date. Additionally, investors who subscribed for interests in a private fund before the Effective Date may make additional subscriptions without needing to confirm the new net worth requirement.

All investment advisers should promptly update their subscription documents to ensure that new investors who agree to make investments on or after the Effective Date have provided accurate representations regarding their Qualified Client status.

Private Equity Fund Adviser Acting as an Unregistered Broker Settles SEC Charges. The SEC charged Blackstreet Capital, a private equity advisory firm, and its owner with performing in-house brokerage services without being properly registered as a broker-dealer. While the firm disclosed to investors that it would operate as a broker-dealer in exchange for a fee, it did not register as a broker-dealer with the SEC or any state securities commission. The SEC’s investigation also found that the firm engaged in several conflicted transactions and did not disclose certain fees and expenses to investors when such disclosure was warranted (such as using fund assets to make political and charitable contributions and pay for entertainment expenses). The firm and its owner have agreed to pay more than $3.1 million to the SEC in settlement of the charges. Broker-dealer activities are highly regulated, so we encourage all clients to not only confirm that any marketers they use are properly registered but also to ensure that their own marketing activities are in compliance with the applicable rules.

SEC to Require IAs to Adopt Business Continuity and Transition Plans. The SEC proposed a new rule on June 28, 2016, that would require SEC registered investment advisers to implement written business continuity and transition plans designed to mitigate the effects of significant internal or external disruptions in operations, such as natural disasters, cyber-attacks, technology failures, the departure of key personnel, and similar events. This is the SEC’s latest effort to encourage proper risk management in the asset management industry and minimize any potential client harm from material service disruptions. Under the proposed rule, the content of an SEC registered adviser’s business continuity and transition plan would be based upon risks associated with an IA’s operations and would include policies and procedures designed to address different elements of a firm’s business. Firms would be required to review the adequacy and effectiveness of their plans at least annually and to retain certain records.

No Expansion of SEC Examinations of Exempt Reporting Advisors. In our 2015 fourth quarter newsletter, we reported that the SEC intended to expand the scope of its on-going examination program to include Exempt Reporting Advisers (“ERAs”) who rely on the Private Fund Adviser Exemption or Venture Capital Fund Adviser Exemption to registration. The previous discussion was based on published reports interpreting comments made by Marc Wyatt, the Director of the SEC’s Office of Compliance Inspections and Examinations, at a conference in November 2015. Further investigation by our firm, however, has revealed that Mr. Wyatt’s comments were misreported and misinterpreted by the industry. We have received confirmation from the SEC that the agency does not intend to expand the scope of its on-going examination program to include ERAs. It should be noted, however, that the SEC does continue to conduct examinations of ERAs for cause and other misconduct.

Notwithstanding the SEC’s general stance on examinations of ERAs, the SEC has indicated that it is focusing some of its examination efforts on those who rely on the Venture Capital Fund Adviser Exemption. The SEC suspects that many ERAs who rely on this exemption are in fact not eligible to do so. With that in mind, we recommend all ERAs who rely on the Venture Capital Fund Adviser Exemption to confirm with counsel their eligibility to rely on this exemption.

SEC Signals a Focus on Cybersecurity.With a new hire to the agency’s cybersecurity division and cybersecurity charges being brought against an institutional wealth management firm, the SEC is signaling its focus on the issue to the investment management industry. In June, the SEC appointed Christopher R. Hetner, a career information security expert, to the role of Senior Advisor to the Chair for Cybersecurity Policy. Later in the month it was announced that Morgan Stanley had settled SEC charges brought against the firm for failure to protect digital customer information through failure to adopt the statutorily required written policies and procedures.  Failing to comply with cybersecurity laws didn’t just lead to a former Morgan Stanley employee accessing and transferring approximately 730,000 unique client accounts data to his personal server, which was ultimately hacked by third parties, but also led to Morgan Stanley having to pay a $1 million penalty to settle the SEC charges. Given the SEC’s recent emphasis on cybersecurity, firms should be moving forward with cybersecurity implementation and may want to discuss with counsel or other outside service providers.

Fund Administrator Settles with the SEC for Failure to Identify and Respond to Fraud by Two Investment Adviser Clients. A well-known fund administrator recently settled charges with the SEC due to its failure to identify and correct fraudulent faulty accounting perpetrated by two of its investment adviser clients. The SEC noted that fund administrators have a “gatekeeping responsibility” in relation to the investment funds which they administer and are primarily responsible for accurate reporting of fund assets to investors and other service providers. In this case, the administrator failed to uphold its gatekeeping responsibility by either missing or ignoring clear indications of fraudulent books which allowed the advisory firm’s scheme to persist until the SEC stepped in. Without admitting to the allegations, the firm agreed to pay a fine in its settlement. Managers might want to think about amending their administration agreements to include additional termination rights which could be exercised by the manager in the event their administrator suffers the same fate.

New Federal Law Expands Trade Secret Remedies. As the “secret sauce” for many investment managers may now take the form of a trade secret in an easily copied digital format, misappropriation of trade secrets by employees and other service providers has become an increasingly important area of concern for the investment management industry. President Obama recently signed into law the Defend Trade Secrets Act of 2016 (“DTSA”), which expands the options available to firms who suspect an employee misappropriated trade secrets. The DTSA permits a firm to sue for civil damages in federal court, considerably simplifying the litigation process. Further, the DTSA expands the scope of damages available for a successful claimant, including but not limited to royalties for the misuse of trade secrets as well as attorneys’ fees. In order for a firm to take advantage of the expanded options available under the DTSA, a firm must provide notice to its employees and other service providers of the confidentiality and whistleblower protections. Firms will likely need to amend their contracts with employees and service providers in order to provide such notice.

Cayman Islands Publishes LLC Law. On June 8, 2016, the Cayman Islands introduced the highly anticipated Cayman Islands Limited Liability Companies Law, developed in a joint effort by the Cayman Islands Government and the Cayman Islands Monetary Authority in response to requests from the investment funds industry. The law came into effect on July 8, 2016 and currently allows for the formation and operation of limited liability companies similar in structure and flexibility to that of a Delaware LLC. It is now possible to:

  • form and register a new Cayman Islands LLC;
  • migrate an entity organized in another jurisdiction (e.g., Delaware) into the Cayman Islands as an LLC;
  • convert an existing Cayman Islands exempted company into an LLC; and
  • merge an existing Cayman Islands exempted company into an LLC.

We have been in discussions with certain Cayman law firms about how managers might use such LLCs in their offshore structures in future. It seems like the best use will be for certain management company entities or as single-purpose investment vehicles under a larger fund structure. At this time we do not expect the LLC form to supercede the Ltd. form for actual fund entities in the Cayman Islands. If you are interested in how you might be able to utilize these vehicles in the futures, we recommend that you speak with your firm’s offshore counsel to discuss the entity’s advantage and disadvantages.

SEC Adopts Final Rules Implementing Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants. On April 15, 2016, the SEC adopted new rules that would require security-based swap (“SBS”) entities to comply with a comprehensive set of business conduct standards and chief compliance officer (“CCO”) requirements. The SEC believes the new rules will enhance accountability and transparency in transactions with investors and special entities in the over-the-counter derivatives market, which, according to SEC Chair Mary Jo White, has lacked fundamental customer protections for years. Some of the provisions applicable to SBS dealers and major participants include:

  • disclosure to the counterparty of material information about the security-based swap, including material risks, characteristics, incentives, and conflicts of interest;
  • disclosure of information concerning the daily mark of the security-based swap and the ability of the counterparty to require clearing of the security-based swap;
  • communication with counterparties in a fair and balanced manner based on principles of fair dealing and good faith;
  • establishment of a supervisory and compliance infrastructure; and
  • designation of a CCO who must fulfill the described duties and prepare an annual compliance report.

Additional provisions and heightened protections apply in transactions with special entities, such as municipalities, pension plans, and endowments.

New Due Diligence Requirements for Covered Financial Institutions. In an effort to promote enhanced transparency in financial transactions and help law  enforcement entities fight illegal money laundering,  the U.S. Treasury Department’s Financial Crimes Enforcement Network (“FinCEN”) has issued new customer due diligence (“CDD”) requirements that cover financial institutions, including, banks, broker-dealers, mutual funds, futures commission merchants and introducing brokers in commodities, must comply with by May 11, 2018. Covered financial institutions will now be required to verify the identity of any natural person that is a beneficial owner of at least 25% of any legal entity applying to open a new account, develop a customer risk profile for each customer, and establish an account monitoring system to report suspicious transactions. Certain types of customers are exempted from these requirements.

Other Items

  • Accounting Firm Charged for Deficient Surprise Exams. The SEC recently charged an accounting firm and one of its partners for failing to perform adequate surprise examinations of an SEC registered investment adviser which retained the firm for such purpose. The SEC noted that on two occasions the firm filed paperwork with the SEC containing false statements – first, that the manager had complied with certain procedures when in fact they had not, and second, that the manager’s client assets were held with a qualified custodian when in fact they were not. The accounting firm, without admitting or denying fault, agreed to pay disgorgement of fees and a penalty. The accounting firm and the partner in charge were also suspended from practicing before the SEC (including performing audits of public companies). In light of this action, investment managers would be well advised to ensure that the accountants they retain for surprise examinations dutifully comply with the applicable requirements.
  • SEC Charges Investment Adviser that Schemed to Acquire Larger Incentive Fees. On May 31, 2016, the SEC charged a Tennessee firm and its owner for orchestrating a fraudulent trading scheme designed to increase the incentive fees earned by the adviser. Specifically, the scheme caused large gains to be realized at the end of any given month and large losses to be realized at the beginning of the subsequent month, thereby artificially increasing the net gains subject to the incentive fee. The SEC’s investigation uncovered that the firm made millions of dollars in unearned incentive fees and that, without the fraudulent trading scheme, the firm would have earned almost no incentive fees since October 2014. The SEC is seeking disgorgement of fraudulently obtained gains, penalties, and permanent bans from the industry.
  • Cayman Islands FATCA Compliance Deadlines Further Extended. The Cayman Islands Department of International Tax Cooperation has recently extended both the notification and reporting deadlines for U.S. FATCA to August 10, 2016. This further extends the previously extended deadlines of June 10, 2016 and July 8, 2016 for notification and reporting of U.S. FATCA, respectively. We suggest speaking with your tax advisers to determine your notification and reporting obligations with respect to FATCA and confirm compliance with the new deadlines.
  • CFTC Issues a Compliance Advisory. The CFTC Division of Swap Dealer and Intermediary Oversight issued a Staff Advisory in early July, reminding Futures Commission Merchants (“FCMs”) and Introducing Brokers (“IBs”) to report suspicious activity and to comply with the economic sanctions programs administered by the Office of Foreign Affairs Control (“OFAC”). The suspicious activity reporting regulation requires every FCM and IB to report any possible violation of law or regulation no later than 30 calendar days after the date the suspicious activity is initially detected unless no suspect is identified. The economic sanctions regulations by OFAC generally prohibit U.S. persons from engaging in transactions with individuals or entities located in countries subject to sanction programs. Accordingly, FCMs and IBs should regularly review the economic sanctions programs each time they are updated and screen all new and current customers periodically.
  • Investment Advisers Modernization Act of 2016. The House of Financial Services Committee approved a bill directing the SEC to update portions of the Advisers Act by removing duplicative and burdensome regulations that impose an unnecessary burden on small business’ access to capital. Among the rules to be amended are Rule 206(4)-1 (Advertisements), Rule 206(4)-6 (Proxy Voting), and Rule 204(b)-1 (Form PF).
  • NFA Amends Compliance Rule 2-46. Effective September 30, 2016, each Form CPO-PQR or Form CTA-PR that is filed after the due date will be subject to a fee of $200 for each business day it is late. Generally, Form CTA-PR is due within 45 days and Form CPO-PQR is due within 60 days of the relevant calendar quarter end. Please examine the compliance calendar below for the relevant due dates.

MSRB to Launch Permanent Series 50 Exam in September. The Municipal Securities Rulemaking Board (“MSRB”) will make available the permanent Municipal Advisor Representative Qualification Examination (Series 50) beginning September 12, 2016. Any individual who engages in municipal advisory activities or supervises a municipal advisor representative is required to take the Series 50 to demonstrate the level of knowledge needed to perform municipal advisory activities. To facilitate the transition to the new exam requirement, the MSRB is providing a one-year grace period during which individuals will be able to take the municipal advisor representative exam while still engaging in municipal advisory activities.

Compliance Calendar.  As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:

Deadline             Description

Deadline Filing
June 1, 2016 Limited partnerships and limited liability companies formed in Delaware were required to pay the annual tax of $300.
June 30, 2016 Deadline for filing AIFMD annual report (AIFs with a financial year ending on December 31st).
June 30, 2016 Delivery of audited financial statements to investors (private fund managers to funds of funds, including SEC, State and CFTC registrants).
June 30, 2016 Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with Cayman Islands Monetary Authority.
June 30, 2016 Review transactions and assess whether Form 13H needs to be amended.
June 30, 2016 Annual Foreign Bank and Financial Accounts Report (FBAR).
July 30, 2016 Quarterly NAV Report (CPOs claiming the 4.7 exemption).
August 10, 2016 Deadline for Reporting Financial Institutions under U.S. FATCA to file both notification and reporting with the Cayman Islands Tax Authority.
August 14, 2016 CTA-PR filing with NFA.
August 15, 2016 Form 13F filing (advisers managing $100 million in 13F Securities).
August 29, 2016 CPO-PQR filing with NFA (large CPOs).
August 29, 2016 Form PF for quarterly filers.
September 28, 2016 CPO-PQR filing with NFA (mid-size and small CPOs).
Variable Distribute copies of Schedule K-1 to fund investors.
Periodic Filings Form D and Blue Sky filings should be current.

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.

Sincerely,

Karl Cole-Frieman, Bart Mallon & Lilly Palmer

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers as well as multi-billion dollar firms. The firm provides a full suite of legal services to the investment management community, including: hedge fund, private equity fund, and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters.

Hedge Fund Events December 2015

The following are various hedge fund events happening this month.  Please email us if you would like us to add your event to this list.

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Date: December 1-3, 2015

Date: December 2, 2015

Date: December 2, 2015

Date: December 2-4, 2015

Date: December 3, 2015

Date: December 3, 2015

Date: December 3, 2015

Date: December 3, 2015

Date: December 3, 2015

Date: December 6-8, 2015

Date: December 7, 2015

Date: December 7, 2015

Date: December 7-8, 2015

Date: December 7-8, 2015

  • Sponsor: IIR
  • Event: Yield Show
  • Location: New York, NY

Date: December 7-8, 2015

Date: December 7-8, 2015

Date: December 7-9, 2015

Date: December 7-10, 2015

Date: December 8, 2015

Date: December 8, 2015

Date: December 8, 2015

Date: December 8, 2015

Date: December 8, 2015

Date: December 9, 2015

Date: December 9, 2015

Date: December 9, 2015

Date: December 9-11, 2015

Date: December 10, 2015

Date: December 10, 2015

Date: December 10, 2015

Date: December 10-11, 2015

Date: December 11, 2015

Date: December 14, 2015

Date: December 14, 2015

Date: December 15, 2015

Date: December 15, 2015

Date: December 16, 2015

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Cole-Frieman & Mallon provides legal services for hedge fund managers and other groups within the investment management industry.  Bart Mallon can be reached directly at (415) 868-5345.

Hedge Fund Events November 2015

The following are various hedge fund events happening this month.  Please email us if you would like us to add your event to this list.

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Date: November 2-4, 2015

Date: November 2-6, 2015

  • Sponsor: Power Week
  • Event: Power Week
  • Location: Singapore

Date: November 3, 2015

Date: November 3, 2015

Date: November 3, 2015

Date: November 3, 2015

Date: November 3, 2015

Date: November 3-4, 2015

Date: November 4, 2015

Date: November 4-5, 2015

Date: November 4-5, 2015

Date: November 4-5, 2015

Date: November 4-6, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5, 2015

Date: November 5-6, 2015

Date: November 5-6, 2015

Date: November 9-10, 2015

Date: November 9-10, 2015

Date: November 9-10, 2015

Date: November 9-10, 2015

Date: November 9-11, 2015

Date: November 10, 2015

Date: November 10, 2015

Date: November 10-11, 2015

  • Sponsor: Worldwide Business Research
  • Event: FIMA
  • Location: London

Date: November 10-12, 2015

Date: November 11, 2015

Date: November 11, 2015

Date: November 11-12, 2015

Date: November 11-12, 2015

Date: November 11-13, 2015

Date: November 12, 2015

Date: November 12, 2015

Date: November 12, 2015

Date: November 12-13, 2015

Date: November 12-13, 2015

Date: November 12-13, 2015

Date: November 12-13, 2015

Date: November 15-16, 2015

Date: November 16-17, 2015

Date: November 16-17, 2015

Date: November 16-18, 2015

Date: November 16-19, 2015

Date: November 16-19, 2015

Date: November 17, 2015

Date: November 17, 2015

Date: November 17, 2015

Date: November 17, 2015

Date: November 17-18, 2015

Date: November 18, 2015

Date: November 18, 2015

Date: November 18, 2015

Date: November 18, 2015

Date: November 18, 2015

Date: November 18, 2015

Date: November 18-19, 2015

Date: November 18-19, 2015

Date: November 19, 2015

Date: November 19, 2015

Date: November 19, 2015

Date: November 19, 2015

Date: November 19-20, 2015

Date: November 23, 2015

Date: November 23-25, 2015

Date: November 23-25, 2015

Date: November 26-27, 2015

Date: November 30 – December 1, 2015

Date: November 30 – December 1, 2015

Date: November 30 – December 2, 2015

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Cole-Frieman & Mallon provides legal services for hedge fund managers and other groups within the investment management industry.  Bart Mallon can be reached directly at (415) 868-5345.

Hedge Fund Events August 2015

The following are various hedge fund events happening this month.  Please email us if you would like us to add your event to this list.

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Date: August 1, 2015

Date: August 5, 2015

Date: August 5, 2015

Date: August 10, 2015

Date: August 12, 2015

Date: August 18-20, 2015

Date: August 19, 2015

Date: August 20-21, 2015

Date: August 24-25, 2015

Date: August 24-27, 2015

Date: August 24-27, 2015

Date: August 25, 2015

Date: August 27, 2015

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Cole-Frieman & Mallon provides legal services for hedge fund managers and other groups within the investment management industry.  Bart Mallon can be reached directly at (415) 868-5345.