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 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.
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.
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: