Cole-Frieman & Mallon 2017 First Quarter Update

Below is our quarterly update which went out via email today to our firm’s clients and friends. ¬†Links coming soon.

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April 27, 2017

Clients, Friends, Associates:

We hope that you are enjoying an auspicious start to 2017. The first quarter of the year is typically one of the busiest for fund managers from a regulatory standpoint. As a variety of filing deadlines have passed and audit work is completed (or will be soon), we enter the second quarter with a number of important regulatory issues on the horizon, as well as many other topics worthy of discussion. Below, we have prepared a short overview of some of these items.

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Regulations and Proposed Regulations:

Trump Executive Order Could Reform Dodd-Frank. President Trump issued an executive order on February 3, 2017, setting out seven “Core Principles” which will serve as general guidelines for financial regulatory reform. The Core Principles include making regulation more efficient, effective and appropriately tailored, as well as rationalizing the Federal financial regulatory framework. The order appears implicitly targeted at reforming the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Dodd-Frank”) and decreasing many of the current financial regulations, but we note that any changes to the current regulatory landscape may not be as immediate as many initial reactions assumed. According to the order, the Treasury Secretary is to meet with the various agencies that oversee and implement Dodd-Frank (including the SEC), to discuss areas that may be amended. While a repeal of Dodd-Frank is unlikely, the coming months may bring a number of deregulatory changes. We will be following any resulting changes and will discuss significant impacts of such changes in future quarterly updates.

Department of Labor Delays Fiduciary Rule. On April 7, 2017, in response to a presidential memo from President Trump, the Department of Labor (“DOL”) issued a Final Rule delaying the applicability of the “Fiduciary Rule” until June 9, 2017, although full compliance with the Fiduciary Rule is still expected by January 1, 2018. We had previously discussed the Fiduciary Rule, which expanded the scope of who is considered a “fiduciary”, imposing fiduciary obligations on firms which were historically free from such obligations. While the DOL will use the delay to reexamine the Fiduciary Rule and consider modifications to it, if you have not already done so, we recommend that you review and speak with your counsel about whether you would be considered a fiduciary and what additional obligations and implementation processes will need to be incorporated into your business practices.

CFTC Regulation of Bitcoin and Virtual Currencies. There has been an increasing interest in investments in Bitcoin and other cryptocurrencies as the financial and technological landscape evolves, but determining the regulations applicable to such products is less clear. While the CFTC established that Bitcoin and other virtual currencies are “commodities” within the definition of the Commodity Exchange Act of 1936, as amended (“CEA”), under the CEA, only commodity interests (which include futures, options, derivatives and certain spot transactions) based on the commodity are within the scope of the CFTC’s jurisdiction. Recent enforcement actions brought by the CFTC have helped clarify whether a transaction is subject to CFTC regulation. In an Order issued against the Coinflip, Inc. platform (“Coinflip”), the CFTC imposed sanctions against Coinflip for operating a facility for trading Bitcoin derivatives without being registered as a futures exchange or swap execution facility. In a contrasting enforcement action brought against the Bitfinex platform (“Bitfinex”), which did not list or permit the trading of derivatives, the CFTC asserted its jurisdiction over Bitfinex on the basis that the platform dealt in “retail commodity transactions”— leveraged, margined or financed transactions involving a commodity that are offered to persons that are not “eligible contract participants” — without being registered as a futures commission merchant with the CFTC. Certain retail commodity transactions are exempt from CFTC jurisdiction if the seller “actually delivers” the commodity to the buyer within 28 days of the date the contract was entered into; the CFTC deemed that Bitfinex did not “actually deliver” the cryptocurrencies to buyers because among other reasons, Bitfinex held the private key controlling access to the wallet where the buyers’ cryptocurrencies were held.

Managers investing in Bitcoin or other virtual currencies should consider whether and to what extent the types of transactions may subject them to CFTC jurisdiction and potential registration as a CPO or CTA. In the current regulatory landscape, we believe managers who invest purely in virtual currencies and who do not employ virtual currency derivatives or leverage are outside the scope of the CFTC’s jurisdiction, and should not be required to register as a CPO or CTA. Although further regulation is expected, firms should speak with outside counsel to confirm their status in light of the current regulatory framework.

Other Regulation of Bitcoin and Virtual Currencies. While the CFTC has been the most active regulatory authority to address investments in cryptocurrencies, managers should be cognizant that states (including New York), the SEC, FINRA and FinCEN are also deliberating the question of appropriate regulatory oversight. We will continue to monitor regulatory developments and more information about certain regulatory aspects applicable to private funds can be found in our blog post on Bitcoin / Cryptocurrency Hedge Funds.

NFA Provides Guidance on Amended CPO Financial Report Requirements. In our previous 2016 End of Year Update we discussed the CFTC’s amendments providing relief from certain financial report requirements for commodity pool operators (“CPOs”), which became effective on December 27, 2016. The NFA released a Notice setting forth instructions regarding how CPOs can file the appropriate notices with the NFA to claim any of the relief provided for in the amendments. CPOs who are eligible for the amended regulations should contact counsel or compliance consultants, or review the Notice, to determine whether any further action may be warranted to claim the appropriate relief.

U.S. and Global Regulators Relax March 1st Deadline for Swap Variation Margin Compliance. The Federal Reserve and the International Organization of the Securities Commission have provided some flexibility for swap dealers facing a March 1, 2017, deadline to implement certain variation margin compliance requirements for uncleared swaps. The rules require swap dealers to collect and post variation margin with no credit threshold unless an exception applies. Further, covered counterparties would be required to enter into new or amended credit support documentation, limit the types of collateral that may be posted and prescribe minimum transfer amounts. Compliance with the requirements can be challenging for swap entities and their counterparties as they work to implement the necessary documentation and underlying operational processes. Except for transactions with financial end users that present “significant exposures,” the Federal Reserve’s guidance directs examiners of CFTC-registered swap dealers to focus on the dealer’s good faith efforts to comply as soon as possible but by no later than September 1, 2017.

BEA Makes Changes to Direct Investment Survey Reporting Requirements for Certain Private Funds. The Bureau of Economic Analysis’ (“BEA”) changes to its direct investment surveys went into effect on January 1, 2017. The reporting changes apply to investments by U.S. entities of a 10% or more voting interest in a private fund, and to investments by foreign entities of a 10% or more voting interest in a U.S. domiciled fund. Under these changes, any cross-border voting investments of 10% or more in, or by, private funds will be subject to BEA reporting only if such investments involve, directly or indirectly, a direct investment in an “operating company” that is not another private fund or a holding company. The changes will simplify reporting for private funds because certain direct investments in private funds will be re-characterized as portfolio investments depending on the nature of the private fund’s investments. Many hedge funds that were traditionally subject to BEA direct investment reporting because of cross-border voting interests will instead only be required to report on portfolio investments to the Treasury Department on Treasury International Capital (“TIC”) surveys. The BEA will notify any filers that may be potentially affected by these changes, but we recommend that advisers consult with counsel to determine what, if any, BEA and/or TIC reporting obligations they may have.

Treasury Department Proposes New Anti-Money Laundering Rules for Investment Advisers. The Treasury Department’s Financial Crimes Enforcement Network previously proposed extending the requirements of maintaining a formal anti-money-laundering (“AML”) program under the Bank Secrecy Act of 1970 to SEC-registered investment advisers (“RIAs”). The final rule is expected to be published soon, and would require SEC RIAs to establish a robust AML program with policies and procedures to identify questionable activity, periodic testing of the program and ongoing training of appropriate personnel.

Other Items:

California’s Public Investment Fund Disclosure Requirements Now Effective. In our third quarter update, we reported that California passed a bill requiring increased disclosure by private fund managers for funds with investments by California state and local public pension and retirement systems. The legislation went into effect on January 1, 2017. All public pension and retirement systems in California must require hedge funds, private equity funds, venture capital funds and any other alternative investment vehicles in which they invest to disclose certain information regarding the fund’s fees, expenses and performance. In addition to applying to new contracts entered into on or after January 1, 2017, and pre-existing contracts with new capital commitments made on or after January 1, 2017, the legislation requires that public pension and retirement systems make “reasonable” efforts to obtain the increased disclosure information for contracts entered into prior to January 1, 2017. Fund managers with California public plan investors should review the types of information that will need to be provided to such investors and prepare to provide the required information.

SEC No-Action Letter and Guidance Clarify Inadvertent Custody. On February 21, 2017, the SEC issued a no-action letter responding to a request for clarification from the Investment Advisers Association as to whether an investment adviser has custody of a client’s assets if the adviser acts pursuant to a standing letter of instruction or other similar arrangement established between the client and its custodian (“SLOA”), that grants the adviser limited authority to direct transfers of the client’s funds to one or more third parties. The SEC’s position is that an SLOA that authorizes the adviser to determine the amount and timing of payments, but not the payee’s identity, is sufficient authority to result in the adviser having custody of the assets. However, the SEC agreed that it would not recommend an enforcement action against an adviser that does not obtain a surprise examination, if the adviser acts pursuant to an SLOA under certain specific circumstances set forth in the SEC’s letter. The SEC also reaffirmed that advisers will not be deemed to have custody of client assets if the adviser is given limited authority to transfer client assets between the client’s accounts maintained at one or more custodians.

To further clarify its views on inadvertent custody, the SEC also issued a guidance update highlighting certain circumstances where an investment adviser may inadvertently have custody of client funds or securities. An adviser may have custody because of the wording or rights of custodial and advisory agreements, even if the adviser did not intend to have custody and was not aware it was granted the authority that resulted in its having custody. We urge advisers to separately managed accounts to review their client agreements and any SLOAs they have entered into to determine whether their specific arrangements may cause them to have custody, and to evaluate their policies and practices related to custody of client assets.

SEC Published Examination Priorities for 2017. The SEC announced its Examination Priorities for 2017, which focus on themes of examining matters of importance to retail investors, focusing on risks specific to elderly and retiring investors and assessing market-wide risks. Specifically, the SEC will focus on: (i) identifying initiatives designed to assess risk in the context of retail investors, including never-examined investment advisers and exchange-traded funds, and notably, robo-advisers and other automated, electronic investment advice platforms, including the investment advisers and broker-dealers that offer them; (ii) services provided to retirement accounts, such as variable insurance products and fixed-income cross-transactions, as well as investment advisers to pension plans and other large holders of U.S. investor retirement assets; and (iii) cybersecurity, and systems and technology procedures and controls.

FINRA Published Examination Priorities for 2017. Similar to the SEC, the Financial Industry Regulatory Authority, Inc. (“FINRA”) recently published its 2017 Regulatory and Examination Priorities Letter, outlining the organization’s enforcement priorities for the current year. FINRA’s specific focus areas for 2017 will include: (i) supervisory policies and compliance controls for high-risk and recidivist brokers; (ii) sales practices and product suitability for specific investors; (iii) firm liquidity management practices; and (iv) cybersecurity issues. We recommend that you speak with your firm’s outside counsel and service providers to learn more about these specific priorities and review your firm’s compliance with the applicable regulations.

Cayman Islands Extends CRS First Notification and Reporting Deadlines. The Cayman Islands Department for International Tax Cooperation (“DITC”) has issued an industry advisory stating that it is adopting a “soft opening” to the notification and return deadlines required for Financial Institutions’ (“FIs”) compliance with the Common Reporting Standard (“CRS”). All FIs in the Cayman Islands are required to register with the Cayman Islands Tax Information Authority (“TIA”) by April 30, 2017, and to submit returns to the TIA by May 31, 2017. With the DTIC’s adoption of a “soft opening,” FIs may submit CRS notifications on or before June 30, 2017, and file “accepted” CRS returns on or before July 31, 2017, without any compliance measures or penalties.

Ninth Circuit Rules Internal Reports Protected under Whistleblower Rules. On March 8, 2017, the Ninth Circuit followed a ruling by the Second Circuit in finding that an employee who makes a report internally, rather than to the SEC, is protected under Rule 21F-17 of the Securities Exchange Act of 1934, as amended (“Whistleblower Rule”) enacted under Dodd-Frank. In contrast, the Fifth Circuit previously ruled that the provisions of the Whistleblower Rule only apply when an employee makes disclosures directly to the SEC. The Ninth Circuit and Second Circuit rulings reflect a broad interpretation of the definition of a whistleblower, and signal a split among the circuit courts on who may be considered a whistleblower for purposes of protection under the Whistleblower Rule.

Regulatory Assets Under Management. We have observed that many managers have expressed confusion regarding the calculation of assets under management (“AUM”) for purposes of filing the Form ADV and determining when the manager may be subject to SEC registration. We thought it would be helpful to clarify that investment advisers must look to their “regulatory assets under management” (“RAUM”), a specific metric designed by the SEC, which is calculated differently from the more common and more traditionally understood calculation of AUM. In calculating RAUM, managers should include the value of all assets managed without deducting for any offsetting liabilities. Managers with questions about the calculation of specific assets or managers seeking further clarification of RAUM should speak with their firm’s outside counsel or compliance consultants.

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

Deadline – Filing

  • March 31, 2017 – Deadline to update and file Form ADV Parts 1, 2A & 2B
  • April 10, 2107 – Amendment to Form 13H due if necessary
  • April 15, 2107 – 1st Quarter 2017 Form PF filing for quarterly filers (Large Liquidity Fund Advisers)
  • April 28, 2107 – Collect quarterly reports from access persons for their personal securities transactions
  • April 28, 2107 – Distribute code of ethics and compliance manuals to employees. Require acknowledgement form to be executed in connection with such delivery
  • April 28, 2107 – Annual Privacy Notice sent to all clients or fund investors (for Advisers with Fiscal Year ending December 31)
  • April 28, 2107 – Distribute audited financial statements to investors (most private fund managers, including SEC, state and CFTC registrants)
  • April 28, 2107 – Distribute Form ADV Part 2 to clients
  • April 30, 2107 – Quarterly NAV Report (registered commodity pool operators claiming the 4.7 exemption)
  • May 1, 2107 – 2016 Annual Form PF due date for annual filers (Large Private Equity Fund Advisers and Smaller Private Fund Advisers)
  • May 15, 2017 – Quarterly Commodity Trading Advisor Form PR filing
  • May 15, 2017 – File Form 13F for first quarter 2017
  • May 31, 2017 – First deadline for Cayman Islands Financial Institutions to submit their CRS returns to the Cayman Islands Tax Authority
  • May 31, 2017 – Third reporting deadline (full reporting) for Cayman Islands Financial Institutions with reporting obligations under the Cayman FATCA regulatory framework to report their U.S. Reportable Accounts to the Cayman Islands Tax Authority
  • June 30, 2017 – Distribute audited financial statements to investors (private fund managers to funds of funds, including SEC, state and CFTC registrants)

Variable

  • Distribute copies of K-1 to fund investors
  • Ongoing All Limited Non-U.S. Financial Institutions and limited branches that seek to continue such status during the 2017 calendar year must edit and resubmit their registrations after December 31, 2015, on the FATCA registration website; SEC form D must be filed within 15 days of first sale of securities

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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