Hedge Fund Bits and Pieces for April 7, 2017

Happy Masters Friday!

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

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

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

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

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

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

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

Hedge Fund Bits and Pieces for March 31, 2017

Happy Friday and congrats to everyone on making it though the first quarter!  Our firm will be sending out a 2017 first quarter update sometime in the next couple of weeks – if you are not on the distribution list and would like to be, please contact us.  We will also post the update to this blog.

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Annual ADV Updatedue TODAY by 11pm ET (when IARD system shuts down).  The ADV annual updates are due today.  Most firms have submitted their updates by now but if you have not done so, please call your legal or compliance professional immediately.  Additionally, fund managers generally will have their audits completed by today and those should be sent to investors as per the firm’s compliance procedures.

Another Bitcoin Trust Rejected by SEC – on Tuesday the SEC rejected an application by NYSE Arca to list shares of SolidX Bitcoin Trust.  The trust was set to a publicly traded vehicle designed to track the price of bitcoins as measured by an index of unregulated bitcoin exchanges (Bitfinex, Bitstamp, GDAX, itBit, and OKCoin International).  In rejecting the application, the SEC stated that it believes that the bitcoin markets are unregulated.  This is the second rejected listing of a bitcoin product for retail investors (see earlier post discussing the rejection of the Winklevoss bitcoin ETF).

SEC Focus on FinTech – it is abundantly clear that technology is beginning to change the capital markets in profound ways.  As practitioners, we are working with our clients to figure out how new ways of investing fit within the current regulatory structures applicable to both products and managers.  As these changes take deeper root, there will be growing pains and the SEC realizes this – below are recent remarks made on Monday in Washington by acting SEC Chairman Michael Piwowar about the FinTech industry and how the SEC will be working in the space in the future.  The full speech, made at the beginning of the SEC’s 27th Annual International Institute for Securities Market Growth and Development, can be found here.

Financial technology (“FinTech”) is also revolutionizing our industry. FinTech can bring tremendous benefits – streamlined market operations and more affordable ways to raise capital and advise clients.  Fifty-nine percent of all adults in developing nations do not have a bank account – but this is changing fast. With cell phones now in the pockets of many individuals in even the poorest of nations, mobile technology has greatly cut down on barriers to accessing capital. In Kenya, for example, I saw firsthand the transformative power of FinTech. Sixty-eight percent of Kenyan adults use their mobile phones for monetary transactions. In 2013, over 25% of the Kenyan GNP was transferred via M-PESA, the leading mobile money transfer service in the country. Services like M-PESA are not only for the transfer of money, but also can be used to take out micro-loans that would have been previously unavailable to small businesses.  The question for us regulators is how can we encourage this innovation and all the potential benefits that it promises, while also managing the risks? At the SEC, we started a FinTech working group. Not surprisingly, FinTech firms report that their greatest struggle is navigating a complex regulatory environment. The SEC, and other securities regulators, should take the leading role in working with the FinTech community to adapt longstanding laws and regulations to newfangled technology. (footnotes omitted)

Other Items:

  • CFTC Announces Committee Meeting on Cybersecurity – the CFTC just announced that the Market Risk Advisory Committee (MRAC) will meet on April 25, 2017 to discuss a number of important issues related to the futures and commodities markets.  A central focus of this meeting will be focused on cybersecurity trends in the futures markets.  The discussion will also cover “how well the derivatives markets are currently functioning, including the impact and implications of the evolving structure of these markets on the movement of risk across market participants” – we anticipate that some part of the discussion will focus on certain new instruments like cryptocurrencies and the emerging derivate products linked to such instruments.  The MRAC’s meeting will be public and be held at the CFTC’s Washington, DC, headquarters.
  • Adidas Trademark Issue – while not directly related to the investment management industry, this blog post (produced by our Of Counsel trademark attorney Bill Samuels) highlights the technical nature of the enforcement of trademarks.  It also highlights the strength of a registered mark (the sale of only two hats, which contain a trademarked phrase, are enough to implicate interstate commerce and allow a trademarked phrase to be protected under the trademark laws).  It is important for managers with questions on their trademarks and other intellectual property to discuss these matters with counsel.

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

Hedge Fund Bits and Pieces for March 24, 2017

Happy Friday from rainy San Francisco. As a reminder, there is one week left for investment advisers to complete the annual ADV update.

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Notes on cryptocurrency and blockchain – earlier this week Coinbase added a new margin product for leveraged trading in certain leading cryptocurrencies including Bitcoin. We believe that a product like this would be subject to CFTC jurisdiction and certain registration (or exemption) requirements. As we’ve had more discussions with groups in this space over the last couple of weeks we are seeing both the difficulties of running a fund strategy in this space (hard to find banks willing to support crypto managers; lack of audit firms able to audit these strategies) and the possibilities of blockchain technology (potentially uses for compliance in the hedge fund space).  These discussions have come in the wake of significant client interest in this are and our article on bitcoin hedge funds.

Cannabis Investment Management Conference – continuing on our earlier discussion of the rise of investment opportunities in the cannabis space, MedMen and IMN are putting on The Institutional Capital & Cannabis Conference next week in San Jose. The conference will take place on March 28-29 and will include a number of funds and allocators in the cannabis space.

Regulations and Tax – not as much news this week on the regulatory front applicable to hedge funds – we expect to begin hearing more next week (after the Health Care Bill vote) when/if the discussion of tax reform begins. If Trump keeps his word to eliminate the “carried interest loophole”, we may see more discussion of the issue like we did back in 2011 and 2009.

Other Items:

  • SEC Compliance Seminars – the SEC announced compliance seminars in a number of cities. Please see the release here.
  • Connecticut Reminder to Exempt IAs – the Connecticut Department of Banking sent out a regulatory reminder about managers who utilize the Connecticut IA registration exemption (more information in our post about the Connecticut ERA filing) in the state. The release can be found here.
  • SEC Adopts T+2 – the settlement cycle for securities transactions gets shorter by one day on September 5, 2017. We expect to hear more from the brokerage firms about this change in the next couple of months as systems become integrated with the new requirements. The announcement can be found here.

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

Hedge Fund Bits and Pieces for March 17, 2017

Happy Friday. This week’s updates below.

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

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

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

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

Bitcoin Hedge Funds (Cryptocurrency / AltCurrency Funds)

Overview of Blockchain Based Digital Currency Investment Fund Structures

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

Foundational Items – Definition

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

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

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

Structural Considerations for Fund Formation

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

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

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

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

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

Regulatory and Other Considerations for Bitcoin Investment Managers

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

Federal & State Regulatory System.

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

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

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

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

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

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

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

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

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

Conclusion

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

Related articles:

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

Hedge Fund / Investment Adviser Updates for March 10, 2017

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

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

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

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

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

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

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

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

Have a great weekend!

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

Cannabis Hedge Funds

Overview of Private Fund Investment in the Marijuana Industry

After the elections of 2016, eight states and the District of Columbia have laws allowing for the recreational use of marijuana. Many other states have decriminalized the use of marijuana and most allow the use of medical marijuana. From the standpoint of the investment management industry, the expansion of the market for cannabis has created a new category of potential investments. Private investment funds that focus on this industry (so called marijuana or cannabis hedge funds) are still relatively rare but we anticipate that they are in the early stages of developing into a strong sector strategy moving forward. This post is designed to provide an overview of the structure and regulatory considerations for these vehicles.

Structural Considerations

In general, the structure of a cannabis hedge fund will be substantially the same as a standard hedge fund, with some minor items to keep in mind. Structurally, managers will focus on the type of strategy they will deploy, the investment terms for that strategy and whether to use offshore structures.

Hedge Funds or Private Equity Strategy. Each manager in the space will have their own idea of what would make an attractive investment in this space. If a manager is planning to make investments in companies that are publicly traded, then the fund structure will be the same as a traditional hedge fund (more liquidity, annual performance allocation). If a manager is interested in making investments directly into companies that are not publicly traded, then the fund structure will likely be private equity style (no liquidity, distributions only on disposition events). Many managers will find that their industry expertise will help them find attractive opportunities in both spaces and so these managers will most likely do some sort of combination structure—essentially a hedge fund with side pockets.

Fund Terms. Whichever structure is used, the terms are going to be substantially similar to other hedge funds and managers will need to determine what contribution schedule, redemption schedule, leverage amount, if any, and what other investment terms will work for their fund. Because of the industry focus, we’ve seen some groups form advisory boards. We’ve also seen groups who have decided to create SPV structures under the fund to facilitate direct investments, to navigate the regulatory landscape, or to create greater shields from liability.

Onshore / Offshore Structures. Whether to use an offshore structure will be determined mostly by the jurisdiction of investors in the fund. Like a normal private fund, if there are no offshore investors, then a standard domestic fund will usually be sufficient; if there will be offshore investors or if manager intends to use leverage and have IRA or 401k investors, an offshore structure will normally be utilized. If an offshore structure is used, the choice will generally be between the mini-master structure  and the master-feeder structure. In general, the manager will not want to create a standalone offshore structure if they are doing PE-style investments because of the likelihood that such investment would be deemed to be involved in a US trade or business, subject to additional tax planning. In addition to structure, managers will need to decide on offshore counsel and many managers will engage independent directors.  These items will be discussed with counsel during the formation process.

Regulatory and Other Considerations for Marijuana Fund Managers

While structuring of the fund and drafting of the fund documents will be fairly straightforward, there are some other operational issues for cannabis fund managers to keep in mind.

Regulation of Management Company. Like a normal hedge or PE fund manager, the management company to a cannabis fund would be deemed to be an investment adviser because the manager would receive compensation for providing advice regarding investment in securities. As any normal investment adviser, the manager would need to determine whether to register under the state or SEC regimes or whether the manager could utilize an exemption from registration.

Federal Legal Issues. There are two federal laws that impact investment managers in the cannabis industry:

Controlled Substances Act (CSA) – Notwithstanding minor federal action to the contrary (i.e. the “Cole Memos”), marijuana is still deemed to be a Schedule 1 controlled substance under federal law. While unlikely, it is possible that marijuana businesses abiding by state law could be subject to federal action with respect to the manufacturing and dispensing of the product. [Note: the above was accurate during the Obama administration; the Trump administration has indicated that federal action may occur.] Federal sanctions under the CSA are harsh and include jail time and fines.

Bank Secrecy Act (BSA) – Perhaps a bigger issue for the cannabis industry are the issues that arise under the BSA. The BSA provides a framework that banks must follow with respect to certain suspicious activity. Because marijuana is still classified as a Schedule 1 controlled substance, banks are technically required to report the activity of their clients in the cannabis industry to the U.S. Treasury. This sort of red tape, and the potential for liability to the bank for helping to facilitate this activity, makes banks less likely to deal with groups in this space. Although fund managers are a step removed from any growing or selling operations, we have generally found that managers will need to spend time finding a bank that is comfortable with the potential risks of holding the fund’s cash. Ultimately as the industry grows and federal law loosens (if they do), we believe the banking industry will come around. We have recently heard of groups who are trying to work on a bitcoin-type payment system for the cannabis industry.

State Laws. For states that now allow the recreational use of marijuana, there generally are a number of laws and regulations that both operating companies and fund managers must keep in mind. The laws and regulations will generally be implemented by a state regulatory body that will have the power to determine the manner in which leaf-based products (including seeds) are brought to market. Non-leaf based products (such as paraphernalia) generally will be subject to lesser or no scrutiny under state law.

Investment Size. Many private companies in the industry are new and subject to the same kinds of operational risks that apply to businesses in other industries. Additionally, these private companies are small and not yet able to deploy capital from large equity investments. In this way, fund projects tend to be on the smaller side because of capital constraints.

Service Providers. Some groups, especially audit firms, may be reticent to provide services to groups who focus on investments into this sector. As mentioned above, banking may be also be an issue for managers in this space. Some groups also may decide that there are specific issues they need to discuss with cannabis legal counsel.

Valuation. As with any private investment fund that deals with investments into non-publicly traded securities, a cannabis fund with investments in private companies may have to deal with valuation issues of the investments. To a certain degree, many issues can be side-stepped if the manager institutes side pockets, but this will be an area where the manager will want to discuss options with fund counsel as well as fund accountants and auditors.

Conclusion

The marijuana/cannabis industry undoubtedly will become huge over time as more states allow recreational use of marijuana. Although currently still in its infancy, the cannabis industry is poised for significant growth and eventually capital will flow towards managers who focus on this space. While we would have predicted that there would be significantly more private funds focused on this area by now, we anticipate that this will be a strong and growing sector over the coming years as more states legalize the recreational use of the drug and the infrastructure around both companies and assets managers in this space becomes more institutionalized.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP and helped establish one of the first cannabis-focused hedge funds. For more information on this topic, please contact Mr. Mallon 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.

Anecdotal Evidence of Strong Investor Appetite in 2017

Hedge funds to be attractive investments in new year?

By: Bart Mallon

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

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

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

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

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

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Other related hedge fund law articles:

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

Cole-Frieman & Mallon EOY Update

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www.colefrieman.com
January 4, 2016

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

This overview includes the following:

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

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Annual Compliance & Other Items:Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) must provide natural person clients with a copy of the firm’s privacy policy, even if there are no changes to the policy.Annual Compliance Review. On an annual basis, the Chief Compliance Officer (“CCO”) of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management. We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Advisers should be careful that sensitive conversations regarding the annual review are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.Form ADV Annual Amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority, must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule include the vehicle(s) managed by the adviser. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.Switching to/from SEC Regulation.SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their fiscal year by filing Form ADV-W. Such managers should consult their state securities authorities to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment.Exempt Reporting Advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the SEC or the relevant state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.Custody Rule Annual Audit.

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

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

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

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

California Minimum Net Worth Requirement and Financial Reports.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Annual Fund Matters:

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

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

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

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

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

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

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

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

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

Annual Management Company Matters:

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

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

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

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

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

Regulatory & Other Changes in 2016:

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

SEC Updates.

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

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

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

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

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

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

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

CFTC and NFA Updates.

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

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

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

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

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

Other Updates.

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

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

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

Offshore Updates.

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

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

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

Deadline Filing
December 16, 2016 IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
December 27, 2016 Last day to submit form filings via IARD prior to year-end
December 31, 2016 Review AUM to determine 2017 Form PF filing requirement
January 15, 2017 Quarterly Form PF due for large liquidity fund advisers (if applicable)
January 31, 2017 “Annex IV” AIFMD filing
February 14, 2017 Form 13F due
February 14, 2017 Annual Schedule 13G updates due
February 14, 2017 Annual Form 13H updates due
March 1, 2017 Deadline for re-certification of CFTC exemptions
March 1, 2017 Quarterly Form PF due for larger hedge fund advisers (if applicable)
March 31, 2017 Annual ADV amendments due
March 31, 2017 Annual Financial Reports due for CA RIAs (if applicable)
April 15, 2017 Extended FBAR deadline for certain individuals with signature authority over, but no financial interest in, one or more foreign financial accounts
April 30, 2017 Annual Form PF due for all other advisers (other than large liquidity fund advisers and large hedge fund advisers)
Periodic Form D and blue sky filings should be current
Periodic Fund managers should perform “Bad Actor” certifications annually
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 & John Araneo
****Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, and with an office in New York City, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers, as well as multi-billion dollar firms. The firm provides a full suite of legal services to the investment management community, including: hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog which focuses on legal issues that impact the hedge fund community. For more information please visit us at: www.colefrieman.com.Cole-Frieman & Mallon LLPOne Sansome Street, Suite 1895San Francisco, CA  94104535 Fifth Avenue

New York, NY 10017

Karl Cole-Friemankarl@colefrieman.com415-762-2841 Bart Mallonbmallon@colefrieman.com415-868-5345
Lilly Palmerlpalmer@colefrieman.com415-762-2842 John Araneojaraneo@colefrieman.com646-535-0270

 

This newsletter is published as a source of information only for clients and friends of the firm and should not be construed as legal advice or opinion on any specific facts or circumstances. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Cole-Frieman & Mallon LLP is a California limited liability partnership and this publication may be considered attorney advertising in some jurisdictions.