Category Archives: Investment Advisor

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.

IA Annual Form ADV Update for 2017

Investment Adviser Registration Update Due March 31

Under SEC and state regulations, registered investment advisers and exempt reporting advisers (“ERAs”) must file an annual amendment to Form ADV within 90 days of the end of its fiscal year. For most firms this means that the annual updating amendment is due by March 31, 2017.

Process and Major ADV Update Items

The annual update can be completed through the IARD system either (i) internally by the firm’s CCO or (ii) externally by a firm’s compliance consultant or fund attorney. The process generally will entail a review of the current Form ADV, and Form ADV Part 2 if applicable, to make sure that all information is up to date and accurate. In general, once the review process has begun, the update can be completed in a few days depending on the complexity of firm’s operations and the capacity of the updater to make changes in the system. For many firms whose operations have not changed throughout the year, the update should be fairly straight forward – for private fund managers in this situation, the focus mostly will be on the Schedule D, Item 7.B.(1) items (Private Fund Reporting) which include updates to the following items for each fund:

  • Gross asset value of the private fund as of 12/31/16 (essentially RAUM of the fund, described below)
  • Total number of investors
  • % of the fund owned by the advisor and/or its related persons
  • % of the fund that is owned by fund of funds
  • % of the fund that is owned by non-US persons

Private Fund RAUM

The SEC has defined regulatory assets under management (“RAUM”) in Item 5b of the Form ADV instructions (see Form ADV and Filing Instructions for more information).  Generally, RAUM should include the securities portfolios for which a manager provides continuous and regular supervisory or management services as of the date of filing or update of the Form ADV. Unlike AUM, the RAUM calculation requires managers to report assets managed without the deduction of any outstanding indebtedness or other accrued but unpaid liabilities (including accrued fees or expenses) that remain in a client’s account. A fund manager’s RAUM may be higher than its normally reported AUM because it includes:

  • Cash and cash equivalents (i.e., bank deposits, certificates of deposit, bankers acceptances, and similar bank instruments)
  • Long and short positions (on a gross basis)
  • Leverage
  • Margin
  • Family or proprietary accounts
  • Accounts for which the manager receives no compensation for its services
  • Accounts of clients who are not United States persons

RAUM should be calculated based on the current market value of the assets as determined within 90 days prior to the date of filing the Form ADV.  For private funds, the SEC has stated that a manager may rely on the gross assets as reflected on the fund’s balance sheet, and the manager may assess the value of financial instruments under the applicable accounting standards, which is GAAP in this industry.  We urge managers to reach out to their accounting firm if they are unsure about the treatment of any financial instruments for purposes of the RAUM calculation.

Other Items

While it is important to make sure all parts of the Form ADV are accurate and complete, special attention should also be paid to the Part 2 brochures. Some firms also take this opportunity to review their compliance program but given this update requirement and the audit deadline for pooled investment vehicles, the annual compliance review will often be pushed back until later in the year.  While we are quickly coming up to March 31, there is still plenty of time to complete the update and private fund managers should reach out to us if they would like our assistance preparing the amendment for this year.

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Bart Mallon provides investment adviser registration and compliance services to investment advisers and private fund managers through Cole-Frieman & Mallon LLP.   Mr. Mallon can be reached directly at 415-868-5345.

New IA Rules in Washington State

Amendments to Investment Adviser Rules in Washington State

Washington State Department of Financial Institutions has amended the rules governing the registration and activities of investment advisers set forth in Chapter 460-24A WAC. Effective July 13, 2014, the amendments update various provisions, including examination and registration requirements, financial reporting requirements, custody, performance compensation arrangements, books and records requirements, and unethical business practices. There are new rules addressing compliance policies and procedures, proxy voting, and advisory contracts. In addition, there are new exemptions from registration for certain private fund and venture capital fund advisers. The amendments repeal WAC 460-24A-058, which defines when an application is considered filed; and make additional updates, clarifications, and changes to the rules.

The full text of the revised rules can be found here.  Some notable amendments:

Exemptions from Registration for 3(C)(7) Fund Advisers and Venture Capital Fund Advisers

The amendments created a new exemption from registration for investment advisers who provide advisory services solely to one or more qualifying private funds (as defined by the SEC Rule 203(m)-1, but excluding 3(c)(1) funds) or venture capital funds. In order to qualify for this exemption, investment advisers have to satisfy the following requirements: (i) an investment adviser and its affiliates are not subject to disqualification pursuant to WAC 460-44A-505(2)(d); and (ii) an investment adviser has to file with WA Securities Division same reports and amendments as an exempt reporting adviser is required to file with the SEC. The filings must be submitted electronically through IARD.

Compliance Policies and Procedures

The amendments codified the requirement that investment advisers registered or required to be registered in WA adopt and implement written compliance procedures designed to prevent violation of the securities laws.  Investment advisers must review the procedures at least annually, and designate an individual administering the adopted code of ethics.

Proxy Voting

The amendments make it unlawful for an investment adviser registered or required to be registered in WA to exercise voting authority with respect to client securities absent: (1) the implementation of written policies and procedures designed to ensure proxy voting will be in the best interests of clients and include how to address material conflicts that may arise between the investment adviser and the clients; (2) disclose to clients how they may obtain information on the investment adviser voted with respect to their securities; and (3) describe to clients the proxy voting policies and procedures, and provide a written copy upon request.

Financial Reporting Requirements

The amendments created the following financial reporting requirements for investment advisers:

(1) An investment adviser with custody of client accounts must submit an audited balance sheet within 120 days of the end of the adviser’s fiscal year. Each balance sheet must be prepared in conformity with generally accepted accounting principles, audited by an independent certified public accountant, and accompanied by an audit opinion of the accountant.
(2) An investment adviser with custody of client accounts that manages pooled investment vehicles must provide audited financial statements of each pooled investment vehicle of which the investment adviser is a general partner (or comparable position) within 120 days of the end of the pooled investment vehicle’s fiscal year.
(3) An investment adviser who does not have custody of client accounts must submit a yearly unaudited balance sheet within 120 days of the end of the adviser’s fiscal year.

New Custody Requirements for Investment Advisers that Manage a Pooled Investment Vehicle

The amendments created new safekeeping and reporting requirements for investment advisers that manage a pooled investment vehicle. Such advisers must: (a) enter into a written agreement with an independent party to review all fees, expenses, and capital withdrawals from the pooled accounts and approve all payments; or (b) provide audited financial statements of the pooled investment vehicle to all limited partners within 120 days of the end of the pooled investment vehicle’s fiscal year. Further, investment advisers that manage a pooled investment vehicle must deliver account statements at least quarterly to all limited partners in accordance with WAC 460-24A-105 and include the following information:

(1) The total amount of all additions to and withdrawals from the fund as a whole, as well as the opening and closing net asset value of the fund at the end of the quarter;
(2) listing of the fund’s long and short positions on the closing date of the statement; and
(3) The total amount of additions to and withdrawals from the fund by the investor, as well as the total value of the investor’s interest in the fund at the end of the quarter.

Conclusion

Washington state investment advisors should review their practice to determine if they must implement new procedures in order to comply with the amendments. For individuals who are considering becoming an investment adviser in Washington, it will be important to review the new examination and registration requirements.  If you have any questions or would like assistance, please contact us.

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Cole-Frieman & Mallon LLP 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.

SEC Compliance – Custody Issue

Annual Update Guidance on Custody Issue

It is that time of year that registered investment advisers are focusing on the ADV annual updating process.  Occasionally the SEC will provide guidance to managers on common questions applicable to the application or updating process.  Below is a note the SEC sent out to all registered investment advisers regarding the custody issue.  If you have questions on the application of the custody rules to your particular situation, you should discuss with your law firm or compliance consultant.

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To: SEC-Registered Investment Advisers,

This email is a reminder that all SEC-registered advisers that have custody of client assets should answer all questions in Item 9 of Part 1A of Form ADV. Each adviser’s answers will vary depending on facts and circumstances.

For example, advisers that have custody solely because they deduct fees from client accounts would respond “no” in Item 9.A. Additionally, these advisers would likely respond “no” in Items 9.B., and 9.D., and they likely would not need to provide information in Items 9.C. or 9.E. However, in Item 9.F., these advisers likely would need to indicate that there is at least one person acting as qualified custodian for their clients in connection with advisory services they provide to clients.

If you have questions, you may reply to this email.

U.S. Securities and Exchange Commission
Division of Investment Management
100 F Street, N.E.
Washington, DC 20549-8549
Phone | 202.551.6999

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Cole-Frieman & Mallon is a boutique law firm which provides regulatory compliance and consulting services to the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

Regulation S-ID Identity Theft Rules

Identity Theft Red Flag Rules Effective November 20, 2013

Pursuant to new SEC and CFTC rules, many registered managers, including private fund managers are now required to have identity theft programs in place.  Such managers will need to have robust policies in place in order to be compliant with the new rules.  Such policies will include: staff training for appearance of red flags, procedures for dealing with red flags, certification of procedures from administrators and/or custodians dealing with investor/customer accounts.

Below we have reprinted an article from the Compliance Focus blog maintained by Sansome Strategies LLC, a regulatory and compliance consulting company described in greater depth below.  The article reprinted below can be found here.

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Identity Theft Issues for Investment Advisers and Futures Participants
Jennifer Dickinson, Sansome Strategies

A little-known provision of the Dodd-Frank Act shifted responsibility over existing identity theft rules from the Federal Trade Commission to the Securities and Exchange Commission (“SEC”) and the Commodity Futures Trading Commission (“CFTC”). The rules became effective May 20, 2013 and certain entities regulated by the SEC and CFTC will need to comply by November 20, 2013.

Overview

SEC and CFTC registrants that are “financial institutions” or “creditors” and that offer or maintain “covered accounts” for their clients will need to comply with the identity theft rules:

  • Financial institution: a bank, credit union or other person who holds a transaction account belonging to a consumer (a transaction account is one that permits withdrawals, payment orders, transfers or similar means for making payments to third parties);
  • Creditor: any person that regularly extends, renews or continues credit to others.
  • Covered account: any account that a financial institution or creditor offers or maintains:
    1. Primarily for personal, family or household purposes that involves or is designed to permit multiple payments or transactions; and
    2. There is a reasonably foreseeable risk to customers or to the safety and soundness of the financial institution or creditor from identity theft, including financial, operational, compliance, reputation or litigation risks. Examples include: for the SEC, brokerage or mutual fund accounts that permit wire transfers or other payments to third parties; for the CFTC, margin accounts.

Who will be affected, and how?

On the SEC side, broker-dealers, investment companies and investment advisers are considered financial institutions. On the CFTC side, commodity pool operators and commodity trading advisers will be considered creditors if they:

  • Regularly extend, renew or continue credit or arrange for the extension, renewal or continuation of credit; or
  • Acting as an assignee of an original creditor, participate in the decision to extend, renew or continue credit.

Firms that meet these definitions are required to implement reasonable policies and procedures that:

  • Identify “red flags” to prevent identity theft in the covered accounts they manage, and document them in the compliance program. Red flags can exist in the types of accounts the firm manages, the manner in which accounts are opened or accessed, and the firm’s previous experiences (if any) with identity theft;
  • Provide for monitoring accounts on an ongoing basis to detect red flags;
  • Respond appropriately to red flags;
  • Is periodically updated to reflect any changes in risks; and
  • Describe the various appropriate responses to red flags.

Whether a firm will meet the definitions will depend significantly on its client base and account structures. Traditional RIAs and other firms that manage accounts for individuals or family offices should look closely at those accounts to determine the types of activities that will be processed in them. A firm that handles bills or other third-party payments on behalf of its clients will need to undertake the most review and implement the most rigorous compliance program contemplated by the rules.

At first blush, fund managers may assume that these rules will not apply to them; however, care should be taken to ensure that investors’ accounts are set up to receive and hold investment amounts, and the only transfers permitted will be for management fees, performance allocations to the manager/general partner as applicable, and withdrawals by (and most importantly, back to) the investor to minimize identity theft risks. Even so, additional procedures around investor intake and withdrawal may need to be implemented.

CPOs and CTAs may undertake a similar evaluation and should also look at their investment strategies to determine the extent to which they meet the creditor definition.

Finally, even if a firm is not registered with the SEC or CFTC, identity theft can be a significant reputational and litigation risk for if they handle third-party payments on behalf of clients or investors. Accordingly state registrants and exempt firms should consider implementation as a best practice.

Compliance Strategies

The rules identify five specific categories that every compliance program should address:

  • Alerts, notifications or other warnings received from consumer reporting agencies or other service providers;
  • Presentation of suspicious documents;
  • Presentation of suspicious personal information (e.g., an unexpected or unusual address change);
  • Unusual usage of a particular account; and
  • Notices from customers, victims of identity theft, law enforcement agencies or others regarding possible identity theft in an account.

Employees should be trained to identify the above and any other red flags that are specific to the firm’s business.

Appropriate responses to a red flag incident will vary significantly depending on the circumstances. The rules mention:

  • Monitoring an account for evidence of identity theft;
  • Contacting the customer;
  • Changing passwords, security codes or other devices that permit access to an account;
  • Reopening accounts with new numbers;
  • Refusing to open an account;
  • Closing an existing account;
  • Refraining from collection activities on an account;
  • Notifying law enforcement; and

Determining that a response is warranted in a particular instance.

Other, proactive safeguards can include standardizing the forms and processes used to effect transactions in client accounts, designating a person or team of people to handle those transactions under supervision (and training them to detect identity theft), preparing and reviewing a daily transaction blotter, requiring additional approvals and documentations for higher risk transactions and implementing PINs or security questions and client call-backs, to name a few.

To the extent that safeguards are client or investor-facing (such as call-backs, PINs or other identity verification tools), these should be standardized and clients/investors notified of the procedures so they know what to expect. Obtaining client’s acknowledgment of these processes via the investment advisory or subscription agreement is a good way to handle this clearly and consistently.

To ensure compliance by November 20, 2013, we encourage all firms to reach out to their compliance consultant or legal counsel as soon as possible. Rolling out the program early will afford plenty of time to refine it by the deadline.

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About Cole-Frieman & Mallon LLP

Cole-Frieman & Mallon LLP provides legal services to the investment management community.  Please reach out to us through our contact form or call Bart Mallon directly at 415-868-5345 if you have questions on implementation. 

About Sansome Strategies LLC

Sansome Strategies is a compliance consulting firm specializing in high-touch, outsourced compliance services for businesses in the investment management industry. Clients include investment advisers, futures managers, broker-dealers, hedge funds, and private equity firms. Sansome Strategies provides tailored compliance management solutions to the unique needs of each client and is focused on helping clients build and enhance their business by simplifying the compliance and regulatory process.  Sansome Strategies is wholly owned by Karl Cole-Frieman and Bart Mallon.  For more information, please contact Sansome Strategies here.

SEC Compliance Manual Violations Mean Enforcement Action for Investment Adviser

Manager Subject to Enforcement Action for Compliance Manual and Books and Records Violations

The SEC recently announced a settlement with a former federally registered Investment Adviser that will, among other things, bar the firm and its sole owner from the financial services industry for two years. Citing violations of the Investment Advisers Act, perhaps the SEC’s most impactful charge involved lack of compliance with Rule 206(4)-7, which requires a firm to adopt and implement written policies and procedures reasonably designed to prevent violations of the Advisers Act and its rules.

Background

The respondent, Barthelemy Group LLC (“the firm”) and its sole owner and adviser Evens Barthelemy, was a SEC registered adviser from 2009-2011. Mr. Barthelemy formed the firm in 2009 after having worked as a registered representative for two broker-dealers since 2000. In 2011, the firm withdrew its SEC registration after the SEC found that it did not meet the multi-state exemption nor did it have the required amount of assets under management ($25 million at the time). Since then, the firm has been registered in New York and New Jersey.

Summary of Violations

Compliance Failures

The SEC found that the firm did not institute written policies and procedures in accordance with Adviser Act Rule 206(4)-7. That rule requires advisers to adopt written policies and procedures that are designed to prevent violation (by the principal and all supervised persons) of the Act and SEC rules related to it. The settlement order noted that Mr. Barthelemy prepared the firm’s compliance manual in 2010 but that he had “largely adopted it verbatim from a 2009 version he obtained from his prior employment at a registered broker-dealer”. Given that the broker-dealer did not engage in the advisory business, the SEC found that the firm’s compliance manual violated Rule 206(4)-7, noting that the manual referred to the Securities Act of 1933 and the Securities Exchange Act of 1934 but made no reference to the Advisers Act. In the same vein, the manual referred to duties of suitability and fairness but never mentioned the fiduciary duty that advisers owe their clients. The firm’s manual also referenced commission-based compensation and broker-dealer filings, none of which are relevant to comply with Rule 206(4)-7. Finally, the SEC found that the firm did not undertake an annual review of the adequacy of the compliance manual.

Books and Records Failures

The firm was found to be non-compliant with Rule 204-2(a) which requires advisers to make and keep true, accurate and current certain books and records relating to the advisory business. Specifically, the SEC stated that the firm did not have copies of the written acknowledgements of the firm’s code of ethics. Additionally, in connect with Rule 204-3 which requires delivery of a firm’s Form ADV to clients or prospective clients, the firm did not have records of such delivery also required by Rule 204-2(a).

Overstating Assets Under Management on Form ADV

The SEC found that the firm was not eligible for SEC registration under both the multi-state exemption or by meeting the minimum threshold test ($25 million at the time). The now rescinded multi-state exemption permitted those advisers subject to regulation by thirty or more states, to register with the SEC. However, the SEC found that the firm was subject to at most three states’ regulatory regimes. In addition, the SEC found that the firm managed nowhere near the $26.5 million it claimed, but rather the total was around $2.6 million. This misrepresentation violated Section 207 of the Act, which makes it unlawful for any person to willfully make untrue statements of material fact in a registration statement. In addition, this conduct violated Section 203A of the Act, which prohibits SEC registration as an adviser unless the firm meets a relevant exemption.

Penalties

Given the adviser’s inability to pay, no civil penalty was asserted. However, the following penalties were instituted:

  • The firm must furnish a copy of the SEC order to each existing client;
  • The firm must post a copy of the order on its website for a period of two years;
  • Certify evidence in writing of the steps taken to comply with all violations of the Act and its rules;
  • Mr. Barthelemy is barred from employment in the financial services industry for a period of two years; and
  • Mr. Barthelemy is censured.

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Cole-Frieman & Mallon LLP provides legal services to the investment management industry. The firm provides regulatory and compliance support and other legal services to hedge fund managers. The firm can be reached here and Bart Mallon can be reached directly at 415-868-5345.

Investment Adviser and IA Representative Registration Renewal 2013

If your firm is registered as an investment adviser (IA) then you may have received notice from FINRA to renew your firm’s registration for 2013. If you have not received the notice or have not paid the renewal fees, the following provides an overview of the process.

Background

IA firms and IA representatives (RAs) should be aware that registrations expire annually on December 31. In order for an IA firm to maintain their active registrations and/or notice filing statuses and for RAs to maintain active registration statuses, the IA firms must pay applicable renewal fees annually. The IARD Renewal Program facilitates the annual renewal process. A Preliminary Renewal Statement which is made available on the IARD system, will include an amount that must be paid to FINRA by December 13, 2012. Remember to allow sufficient

time for payments made by check and sent through the postal service. Online payments made via E-Pay should be made by December 10, 2012 in order for the funds to be posted by December 13, 2012.

Submitting Payment

The preliminary renewal statement have been made available. IA firms can access this statement via IARD by following these steps:

1. Log onto IARD here.

2. Enter your firm’s ID and password.

3. Review and accept the terms and conditions.

4. Under the “Accounting” tab at the top of the page, select “Renewal Account.”

5. One the left column, select “Renewal Statement.”

The bottom of the page provides an itemized list of all applicable fees.

Payment by Check

If you choose to submit payment by check, print the statement and mail it, along with the check to the following address:

U.S. Mail:

FINRA

FINRA/CRD

P.O. Box 7777-9995

Philadelphia, PA 19175-0001

(Note: this P.O. Box address will not accept courier or overnight deliveries.)

Express Delivery:

FINRA/CRD

Attn: 9995

500 Ross Street 154-0455

Pittsburgh, PA 15262

(240) 386-4848

The check should be made payable to: FINRA. Be sure to write your CRD Number and the word “Renewal” on the face of the check. Be sure to also include the first page of the Renewal Statement.

Payment via CRD/IARD E-Pay

Payment can also be submitted online via CRD/IARD E-Pay. To do so, follow these instructions:

Go to the E-Pay website and:

1. Enter your login and password. If you have not yet created an account, do so by clicking “sign up.”

2. On the left column under “Payments,” click “Pay my accounts.”

3. Select the account and click “Continue.”

4. Enter the total Payment Amount and check “Renewal” under Account Type. Then enter the payment method and click “continue.”

5. Review the information and click “Make Payment.”

6. Log out and the money should post within about 2 days.

Automatic Daily Account-to-Renewal Account Transfer

If your firms has sufficient funds in the Daily Account to cover the total renewal amount, FINRA will automatically process the renewal payment by the payment deadline.

Other Payment Methods

Wire payments sent by 2 p.m. (ET), should post the next business day. Wire payments sent after 2 p.m., ET, may take up to 2 business days to post. Instructions for initiating a wire can be found here.

Confirming Payment

After payment is submitted, you will be able to retrieve your firm’s online Final Renewal Statement on IARD on or after January 2, 2013. These statements will reflect the final registration status of the IA firm and RAs. To do so, follow the instructions above to log onto IARD. Under the “Renewal Statement” link in the “Accounting” section, you can retrieve the Final Renewal Statement, which will state “Paid in Full” or “Amount Due.” If an amount is due, the balance must be paid by February 1, 2013.

It is important to make sure payment is made by the deadline, otherwise the registration may be terminated. The firm will then have to contact each regulator to request re-registration instructions.

More information about the Renewal Program can be found on the IARD website. FINRA has also posted a bulletin on the 2013 IARD Renewal Program, available here.

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Cole-Frieman & Mallon LLP provides legal services to hedge fund managers and investment advisers. Bart Mallon can be reached directly at 415-868-5345.

California Private Fund Adviser Exemption Approved

California Hedge Fund Managers Relieved of IA Registration Requirement

On August 27, 2012 (“Effective Date”), the California Office of Administrative Law approved the long awaited private fund adviser exemption (“Private Fund Exemption”). The immediately effective exemption is only available to advisers who provide advice solely to “qualifying private funds,” which include venture capital funds, Section 3(c)(1), and Section 3(c)(7) funds. The Private Fund Exemption is not available to advisers who also manage separate accounts.

Currently, a California based adviser who manages less than $100,000,000 must either register as an investment adviser with the California Department of Corporations (“Department”), or rely on an exemption from registration. Under the new Private Fund Exemption advisers can file as “exempt reporting advisers” (“ERAs”) and thereby avoid the burdensome registration process.

Requirements Generally

To qualify for the Private Fund Exemption, the adviser must

  1. have not violated any securities laws;
  2. file and periodically update certain items on Part 1 of the Form ADV;
  3. pay California’s investment adviser registration and renewal fees; and
  4. fulfill any additional requirements when advising funds organized under Section 3(c)(1).

Additional Requirements for 3(c)(1) Fund Managers

The additional requirements for advisers advising 3(c)(1) funds include:

1. All investors in the fund must either (i) be accredited investors; (ii) be managers, directors, officers or employees of the adviser; or (ii) have received the fund interest via a transfer not involving a sale.

2. Advisers may only charge performance fees to qualified clients; and

3. Advisers shall provide each investor with annual audited financial statement of the fund within 120 days after the end of each fiscal year; provided, however, advisers who begin operations more than 180 days into a fiscal year may include the audit of the initial fiscal year in the fiscal year immediately succeeding the initial fiscal year.

Other Information

An adviser to 3(c)(1) funds that existed prior to Effective Date may take advantage of the Private Adviser Exemption if, as of the Effective Date, it complies with the requirements enumerated above. Any investors in funds existing prior to the Effective Date who do not meet the standards outlined in Item 1 above, will be allowed to remain in the funds provided that they do not make any additional capital contributions. Furthermore, as of the Effective Date, advisers must cease charging performance fees to any investors who do not meet the “qualified client” definition.

To take advantage of the Private Fund Exemption, an adviser must file a partial Form ADV with the Department via the IARD system no later than 60 days from the Effective Date. Advisers currently registered with the Department may choose to withdraw their registration and make a filing under the Private Fund Exemption.

For information on whether your firm may be able to claim an exemption from registration, please see the California Private Fund Adviser Exemption Chart.

If you would like help to utilize the California exemption, please contact us directly.

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart can be reached directly at 415-868-5345.

Recent Enforcement Actions Illustrate the Need for Good Recordkeeping

SEC v. Gold Standard Mining Corp.

SEC v. Orthofix International N.V.

In the Matter of Altamont Global Partners

Since the end of June, there have been three enforcement actions dealing with inadequate or improper accounting methods that did not follow generally accepted accounting practices (GAAP). Two enforcements were brought by the SEC and one by the NFA. Gold Standard Mining Corp. and Altamont Global Partners involve making false statements regarding the value of assets. Orthofix deals with the failure to adopt and follow appropriate internal procedures to ensure proper accounting. We are providing an overview of these actions and some of our thoughts below.

SEC v. Gold Standard Mining Corp.

  • Gold Mining Corp. made false and misleading statements in filings with the SEC regarding the acquisition, operations, and assets of a Russian subsidiary.
  • Gold Mining Corp. filed fraudulent financial statements from 2009-2011 that did not follow GAAP. Revenues were not reported accurately, and assets were grossly inflated. For example, one asset, a hotel, was valued as $3MM per room.
  • Gold Mining Corp. also failed to disclose a profit sharing agreement with the former owner of the Russian subsidiary.

The complaint can be found here.

SEC v. Orthofix International N.V.

  • Wholly owned Mexican subsidiary of Orthofix, Promeca, paid $317,000 in bribes to Mexican officials in order to obtain sales contracts from the Mexican government.
  • Promeca employees referred to the bribes as “chocolates” and fraudulently recorded the transactions as cash advances or promotional and training expenses.
  • Prior to the discovery of the bribery scheme, Orthofix did not have an effective Foreign Corrupt Practices Act compliance manual or training regime in place. The only anti-bribery materials given to Promeca were in English only.
  • Orthofix did not have an adequate internal auditing system in place and failed to conform with GAAP.

The complaint can be found here.

In the Matter of Altamont Global Partners

  • Funds managed by Altamont made loans to Altamont in violation of NFA Compliance Rule 2-45 which prohibits loans by commodity pools to its CPO/affiliated persons or entities.
  • Loan proceeds were used to pay operating expenses or paid directly to employees of Altamont.
  • Altamont falsified quarterly statements by hiding losses and inflating funds’ net asset value to make it appear as if trading had been successful.

The complaint can be found here.

Takeaways for Managers

Above all else, keep accurate and honest records. Managers should be sure to follow GAAP when creating financial records for their funds, and never falsify accounting documents. As Orthofix demonstrates, it is also crucially important that managers employ appropriate internal mechanisms to avoid fraudulent or harmful practices from developing. Rule 204-2 under the Advisers Act requires registered advisers to maintain true, complete, and current books and records relating to its investment advisory business. Generally, there are three categories of records to be maintained: (i) business records of the advisor, (ii) records of the adviser that relate to the adviser’s clients and the adviser’s advisory activities, and (iii) records relating to the adviser’s compliance program.

Conclusion

While Gold Mining Corp. and Orthofix involve the relationships between businesses and their subsidiaries, they offer good examples of the need to establish and maintain policies designed to prevent inaccurate recordkeeping. Altamont Global Partners represents a warning for fund managers to avoid falsifying their funds’ financial documents to hide losses or inflate net asset value.

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Cole-Frieman & Mallon LLP provides a full suite of legal and compliance services to investment managers. The firm can be reached through our contact page and Bart Mallon can be reached directly at 415-868-5345.

SEC Guidance on Registration of Investment Advisory Affiliates

The SEC’s Division of Investment Management issued a no-action letter on January 18, 2012 that provides guidance for registered investment advisers who have multiple entities in control relationships. The no-action letter affirms prior SEC guidance for investment advisers who have entities that serve as general partners and managing members to private funds and other similar special purpose vehicles (“SPVs”). Additionally, other investment advisers who “conduct a single advisory business” through multiple separate legal entities may use a single registration (i.e. register on a single Form ADV) under certain circumstances.

Affiliates Serving as Fund General Partners, Managing Members and Similar SPVs

Entities that function as fund general partners, fund managing members, and similar SPVs are not required to separately register as an investment adviser, as long as the following conditions are satisfied:

1. The investment adviser to a private fund establishes the SPV to act as the fund’s general partner or managing member;

2. The SPV’s formation documents designate the investment adviser to manage the private fund’s assets;

3. All of the investment advisory activities of the SPV are subject to the Investment Advisers Act of 1940 (the “Advisers Act”), Advisers Act rules, and SEC examination; and

4. All employees and persons acting on behalf of the registered investment adviser and/or an SPV are subject to supervision and control of the investment adviser.

For SPVs that have independent directors, the independent directors are excepted from the condition that they be under the registered investment adviser’s supervision and control, and thus are not “persons associated with” the registered investment adviser.

Other Investment Advisory Affiliates Under Common Control

Under the SEC’s guidance, a registered investment adviser (the “filing adviser”) can file a single Form ADV on behalf of itself and each entity that is controlled by or under common control with the filing adviser (each, a “relying adviser”) as long as those entities are conducting a single advisory business. Under the no action letter, using a single registration is appropriate under the following circumstances:

1. The filing adviser and each relying adviser advise only private funds and separate account clients that are “qualified clients” (as defined in Rule 205-3 promulgated under the Investment Advisers Act of 1940 (the “Advisers Act”));

2. Each relying adviser, its employees and the persons acting on its behalf are subject to the filing adviser’s supervision and control;

3. The filing adviser has its principal office and place of business in the United States;

4. The advisory activities of each relying adviser are subject to the Advisers Act and SEC examination;

5. The filing adviser and each relying adviser operate under a single code of ethics and single set of compliance policies and procedures; and

6. The filing adviser discloses in its Form ADV (Miscellaneous Section of Schedule D) that it and its relying advisers are together filing a single Form ADV and each relying adviser is identified by completing a separate Section 1.B, Schedule D, with the notation “relying adviser.”

For more information on whether the above guidance applies to your firm, please contact us directly.

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Cole-Frieman & Mallon LLP provides investment adviser registration and compliance services. Bart Mallon can be reached directly at bmallon@colefrieman.com and by phone at 415-868-5345.