Tag Archives: Cayman Islands

Cole Frieman & Mallon 2018 End of Year Update

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

****

December 15, 2017

Clients, Friends, Associates:

Holiday celebrations bring welcomed joy and excitement to the busiest time of year for most investment managers.  As we prepare for a new year, we also reflect on an eventful 2017 year that included the emergence of a new asset class, a steady upswing in the stock market, and proposed legislation to revise the United States tax code. Regardless of all of the changes to the investment management space, year-end administrative upkeep and 2018 planning are always particularly important, especially for General Counsels, Chief Compliance Officers (“CCO”), and key operations personnel. As we head into 2018, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.

This update includes the following:

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

****

Cryptocurrency Leadership:

This year digital assets and cryptocurrencies have emerged in force as a separate and distinct asset class. An increased interest in this asset class from fund managers, financial institutions and various government leaders and regulators throughout the world has led to an exponential growth of cryptocurrency investments, the CFTC’s approval of two exchanges to trade Bitcoin futures contracts has increased attention on the asset class.

For SEC registered investment advisers who are adding cryptocurrencies to their fund investment programs and for cryptocurrency focused fund managers who may be relying on SEC exemptions from registration, the need to understand the regulatory implication of certain practices is of utmost importance. Specifically, managers face uncertainty regarding the application of the qualified custodian requirement under Rule 206(4)-2 (“Custody Rule”) under the Investment Advisers Act of 1940, as amended (“Advisers Act”).  Under the Custody Rule, if a registered investment adviser has custody of “client funds or securities”, then it must maintain those client assets with a qualified custodian (generally a bank, broker-dealer, FCM or other financial institution), subject to certain exceptions. Currently we know of only one qualified custodian capable of holding certain cryptocurrencies or digital assets. Our firm participated in a meeting with the SEC in November about custody issues for cryptocurrency managers and continues to engage with the SEC on this issue as well as work with the SEC and other service providers in this space to help lead the way to comply with SEC rules and regulations.

****

Annual Compliance & Other Items:

Annual Privacy Policy Notice. On an annual basis, registered investment advisers (“RIAs”) are required to provide natural person clients with a copy of the firm’s privacy policy if (i) the RIA has disclosed nonpublic personal information other than in the connection with servicing consumer accounts or administering financial products; or (ii) the firm’s privacy policy has changed.

Annual Compliance Review. On an annual basis, the 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. For most managers, the Form ADV amendment would be due on March 31, 2018. This year, because March 31st is a Saturday and March 30th is a market holiday, annual amendments to the Form ADV shall be filed no later than the business day following the 90-day deadline (April 2, 2018). 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 includes the vehicle(s) managed by the adviser, and not the underlying investors. 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 with 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 investment advisers (“SEC RIAs”) 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.

SEC RIAs 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”).

Other State Registered IA. 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 is $10,000 for a CA RIA (i) deemed to have custody solely because it acts as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) that otherwise complies with the California custody rule described above (such advisers, the “GP RIAs”).

RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they 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 DBO 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 separately managed accounts (“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 who have at least $150 million in regulatory assets under management (“RAUM”) must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) 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 RAUM) 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 is publicly available on 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 18, 2017. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check or wire 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. 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 investor 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 who may be deemed a fiduciary under the Department of Labor’s (“DOL”) Fiduciary Rule (as further discussed below).

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 2017 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. Funds should monitor their compliance with U.S. Foreign Account Tax Compliance Act (“FATCA”) U.S. FATCA reports are due to the IRS on March 31, 2018 or September 30, 2018, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA requirements applicable to different jurisdictions, managers should review and confirm the specific U.S. FATCA reporting requirements that may apply. 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.

CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31, 2018. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the  Automatic Exchange of Information portal.  We recommend managers contact their tax advisors to stay on top of the U.S. FATCA and CRS 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 2017:

SEC Updates.

SEC Adopts Form ADV Amendments. On July 1, 2017, a technical amendment to Form ADV and ADV-W was implemented to reflect a new Wyoming Law that now requires investment advisers with $25 million to $100 million in RAUM and a principal place of business in Wyoming to register with the state as an investment adviser instead of the SEC.

On October 1, 2017, additional SEC amendments to Form ADV went into effect, which will apply to both RIAs and ERAs. Among other technical amendments, the new Form ADV requires investment advisers to provide detailed information with regard to their separately managed accounts SMAs, including aggregate level reporting of asset types across an adviser’s SMAs and reporting of custodian information under certain circumstances. Investment advisers that utilize borrowing or derivatives on behalf of SMAs will also need to report the RAUM attributable to various levels of gross notional exposure and corresponding borrowings and derivatives exposure. The SEC noted that advisers may not need to report this SMA information until its annual amendment. The SEC concurrently adopted an amendment to the books and records rule (Rule 204-2 under the Advisers Act), requiring RIAs to keep records of documentation necessary to demonstrate the performance or rate of return calculation distributed to any person as well as all written performance-related communications received or sent by the RIA. Advisers who have questions on any changes to the new Form ADV should contact their compliance groups.

SEC Action Against Outsourced CCO. On August 15, 2017, the SEC reached a settlement with an outsourced CCO and his consulting firm, which offered compliance consulting and outsourced CCO services to investment advisory firms. The outsourced CCO served as CCO for two registered investment advisers (collectively, “Registrants”). The SEC found the Registrants either filed their Form ADV annual amendments late or not at all, and the outsourced CCO relied on and did not confirm estimates provided by the Registrants’ CIO. It was established that the RAUM and number of advisory accounts reported on the Form ADV was greatly overstated. The SEC held that the outsourced CCO violated the Advisers Act by failing to amend the Form ADV annually and willfully submitting a false statement. The SEC suspended the outsourced CCO from association or affiliation with any investment advisers for one year and ordered him to pay a $30,000 civil penalty. Outsourced compliance persons solely relying on internal estimates of RAUM and number of advisory contracts, without further confirmation, should be aware of the risk of filing false reports and potential SEC enforcement actions.

CFTC and NFA Updates.

CFTC Amendments to Recordkeeping Requirements. On August 28, 2017, amendments to Regulation 1.31 allow the manner and form of recordkeeping to be technology-neutral (i.e. not requiring or endorsing any specific record retention system or technology, and not limiting retention to any format).

Digital Asset Updates.

CFTC Grants Permission for Bitcoin Futures Trading. On December 1, 2017, the CFTC issued a statement granting permission to the Chicago Mercantile Exchange Inc. (“CME”) and the Chicago Board Options Exchange Inc. (“CBOE”) to list Bitcoin futures contracts on the respective exchanges. Less than two weeks after the release of CFTC’s statement, Bitcoin futures contracts trading began on the CBOE futures exchange on December 10, 2017. Early reports suggest a strong interest in Bitcoin futures contracts set to expire in early 2018. CME is set to begin Bitcoin futures contracts trading next week.

CFTC Grants SEF and DCO Registration to LedgerX. The CFTC granted LedgerX registration status as both a swap execution facility (“SEF”) and a  derivative clearing organization. Now that the exchange is live, LedgerX is the first CFTC-approved exchange to facilitate and clear options on digital assets. Previously, the CFTC granted SEF registration to TeraExchange, which offers forwards and swaps on Bitcoin. LedgerX offers physically-settled and day-ahead swaps on Bitcoin to U.S.-based eligible contract participants and has a fully-collateralized clearing model where customers must post collateral to cover maximum potential losses prior to trading.

Other Updates.

DOL Implements Fiduciary Rule. On June 9, 2017, the DOL partially implemented its amended fiduciary rule (the “Fiduciary Rule”), which expands the definition of a “fiduciary” to apply to anyone that makes a “recommendation” as to the value, disposition or management of securities or other investment property for a fee or other compensation, to an employee benefit plan or a tax-favored retirement savings account such as an individual retirement account (“IRA”) (collectively “covered account”) will be deemed to be providing investment advice and, thus, a “fiduciary”, unless an exception applies. Fund managers with investments from covered accounts or that wish to accept contributions from covered accounts will need to consider whether their current business activities and communications with investors could constitute a recommendation, including a suggestion that such investors invest in the fund. The Fiduciary Rule provides an exception for activity that would otherwise violate prohibited transaction rules, which is applicable to investments made by plan investors who are represented by a qualified independent fiduciary acting on the investor’s behalf in an arms’ length transaction (typically for larger plans). The Fiduciary Rule also contemplates a Best Interest Contract (“BIC”) Exemption, which permits investment advisers to retail retirement investors to continue their current fee practices, including receiving variable compensation, without violating prohibited transactions rules, subject to certain safeguards. Managers with questions regarding the applicability of these exemptions should discuss with counsel.

Two New California Employment Laws Limit Inquiries into Certain Information During the Hiring Process. In October, California Governor Jerry Brown approved Assembly Bill No. 168 and Assembly Bill No. 1008, restricting certain information a California employer may inquire about and consider during its hiring process. Assembly Bill No. 168 restricts employers from requiring prospective employees to disclose salary history. An employer may not inquire or rely on such information when deciding whether to extend an offer to a job applicant or deciding an amount to offer to a job applicant. Assembly Bill No. 1008 restricts California employers with five or more employees from including, inquiring and considering information about an employee applicant’s criminal history until a conditional offer has been extended to a job applicant. Assembly Bill No. 1008 further provides certain requirements an employer must comply with after such information has been legally acquired and is taken into consideration when deciding whether to hire a job applicant, as well as certain procedures to comply with when deciding a job applicant is not suitable for the position. Both laws become effective January 1, 2018. With respect to California employees, you should review before year end, your job application, offer letter template, and compliance manual if they contain questions regarding salary or criminal history.

MSRB Establishes Continuing Education Requirements for Municipal Advisors. Beginning January 1, 2018, the Municipal Securities Rulemaking Board (“MSRB”) will implement amendments requiring municipal advisors to maintain a continuing education program in place for “covered persons”. The amendment will require an annual analysis to evaluate training needs, develop a written training plan, and implement training in response to the needs evaluated. The amendments promote compliance with the firms record-keeping policies regarding the continuing education program. Municipal advisors will have until December 31, 2018 to comply with the new requirements.

SIPC and FINRA Adopt Streamlined Reporting Process. As of September 1, 2017, investment advisory firms who are members of both the Securities Investor Protection Corporation (“SIPC”) and the Financial Industry Regulatory Authority (“FINRA”) now only need to file one annual report to both agencies through FINRA’s reporting portal. This will ease the reporting burden as well as cut down on compliance costs, for firms.

SEC Provides Guidance to Address MiFID II. On October 26, 2017, the SEC issued three no-action relief letters to provide guidance on the Markets in Financial Instruments Directive II (“MiFID II”). Effective January 3, 2018, MiFID II most notably introduces the requirement for UK broker-dealers to “unbundle” investment research from trading commissions, requiring distinct pricing for each of the services rendered. The first no-action letter provides that for the first 30 months from when MiFID II becomes effective, U.S. broker-dealers will not be considered an investment adviser upon accepting payments from an investment manager. The second no-action letter states that broker-dealers may continue to rely on the safe harbor under Section 28(e) of the Securities and Exchange Act of 1934, as amended, for payments made from client assets made alongside payments for execution to an executing broker-dealer. The final no-action letter addresses MiFID II’s various payment arrangements surrounding research activities and provides that an investment adviser may aggregate client orders, although research payments may differ for each client.

Tax Cuts and Jobs Act Impact on Hedge Funds. In late 2017, the House Ways and Means Committee and the Senate Finance Committee passed companion legislation in an attempt to reform the US tax system. One of the proposed revisions included in H.R. 1 or the Tax Cut and Jobs Act (“Tax Act”) is a reduction in the tax rate for a pass-through entity’s “capital percentage” business income. The applicable tax rate would be 25%, with the non-professional services entity’s “capital percentage” business income capped at 30%, and the remaining amount of income characterized as “labor”.

Offshore Updates.

Cayman and BVI Update Beneficial Ownership Regimes. Amendments to the Cayman Islands beneficial ownership laws went into effect on July 1, 2017, which require certain entities, including exempted funds, to take reasonable steps to identify their beneficial owners (generally persons holding more than 25% interests in such an entity). Of interest to fund managers, the following types of funds are exempted from the scope of these amendments: funds that are regulated by the Cayman Islands Monetary Authority, that employ a Cayman regulated administrator, or funds that are managed by an adviser regulated in an approved jurisdiction, such as a state or SEC RIA. The British Virgin Islands (the “BVI”) also implemented amendments to its beneficial ownership regime effective July 1, 2017, which requires registered agents of non-exempt BVI companies, such as unregulated private funds, to input beneficial ownership information into a platform called the BOSS (Beneficial Ownership Secure Search) System. The BOSS System is accessible only to select regulators and fulfills BVI commitments to the United Kingdom under the UK Exchange of Notes Agreement.

U.K. Transitions from U.K. FATCA to CRS. The U.K. transitioned from U.K. FATCA to CRS on July 1, 2017, and now joins more than 85 countries, including the Cayman Islands and the BVI, in the automatic exchange of information between participating countries. The full list of signatory countries is available here. Similar to U.S. FATCA, CRS sets forth a standard by which signatory countries can more easily and automatically exchange certain reportable tax information. We recommend that managers consult their tax advisors to determine whether they are subject to any CRS reporting requirements.

Cayman Islands Introduces New AML Regulations. New Cayman Islands AML regulations came into effect on October 2, 2017. The new regulations expand AML/CFT (anti-money laundering/ countering the financing of terrorism) obligations to unregulated investment entities and  additional  financial  vehicles,  which  are  seen  to  align  more  closely  with  the Financial Action Task Force (FATF) recommendations and global practice. In a shift to a risk- based approach to AML regulations, there will be two separate due diligence procedures depending on the risk assessment of investors. Certain investors that are deemed to be high-risk, such as politically exposed persons, will be required to go through a more extensive verification process, while low-risk investors will be able to submit to a simplified due diligence process. If you have any questions, we recommend that you reach out to your administrator or offshore counsel.

New PRIIPs Disclosure Requirements for EEA Retail Investors. Regulation (EU) No 1286/2014 (“Regulation”), effective January 1, 2018, requires manufacturers of Packaged Retail and Insurance-based Investment Products (“PRIIPs”) to make available Key Information Documents (“KIDs”) to “retail investors” (generally any investor that does not meet the “professional client” status) in member states of the European Union and the Economic European Area (collectively, “EEA”). If a PRIIP manufacturer, such as a fund manager, accepts additional investments or a new investment from an EEA retail investor on or after January 1, 2018, it must comply with the Regulation’s technical requirements pertaining to KIDs. “Retail investors” under the Regulation can include investors such as high net worth individuals, who are not traditionally considered retail investors. Fund managers should consider the applicability of the Regulation given the types of EEA investors they may be marketing to, and managers who wish to forego complying with the Regulation should not accept investments from EEA retail investors and implement additional procedures to ensure such investors are not marketed to or admitted in the fund.  Fund managers with questions regarding the Regulation should discuss with counsel.

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

Deadline – Filing

  • December 18, 2017 –  IARD Preliminary Renewal Statement payments due (submit early to ensure processing by deadline)
  • December 26, 2017 – Last day to submit form filings via IARD prior to year-end
  • December 31, 2017 – Review RAUM to determine 2018 Form PF filing requirement
  • January 15, 2018 – Quarterly Form PF due for large liquidity fund advisers (if applicable)
  • January 31, 2018 – “Annex IV” AIFMD filing
  • February 15, 2018–  Form 13F due
  • February 15, 2018 – Annual Schedule 13G updates due
  • February 15, 2018 – Annual Form 13H updates due
  • February 28, 2018 – Deadline for re-certification of CFTC exemptions
  • March 1, 2018 – Quarterly Form PF due for larger hedge fund advisers (if applicable)
  • April 2, 2018 – Annual ADV amendments due (for December 31st fiscal year end)
  • April 2, 2018 – Annual Financial Reports due for CA RIAs (if applicable)
  • April 18, 2018 – FBAR deadline for certain individuals with signature authority over, but no financial interest in, one or more foreign financial accounts
  • April 29, 2018 – 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

****

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

Offshore hedge funds – structure and considerations

Many people don’t understand what an offshore hedge fund is or the purpose of the offshore hedge fund.  An offshore hedge fund is simply a structure used by hedge fund managers as a way to attract offshore investors (non-U.S. citizens) or U.S. tax-exempt investors (explained later in this article).  The offshore hedge fund will generally be established in various jurisdictions through a variety of structures (that is, as a single entity structure, a side by side structure or a master-feeder structure).

I provided the information in the article below to inform you about the various jurisdictions in which offshore hedge funds will be established.  Please note that the driving considerations for establishing an offshore hedge fund will be tax efficiency (both the structure and jurisdiction should be discussed with your attorney), preference and perception of manager and prospective investors and the cost of establishing the fund in the various jurisdictions.  Your attorney should discuss these items with you when you consider in which jurisdiction to establish your hedge fund.

Offshore Hedge Fund Jurisdictions

The offshore hedge fund can be established in a variety of different jurisdictions and the driving force for the jurisdiction of choice will be tax considerations.  A vast majority of the hedge funds are established in low or zero tax jurisdictions.  This means that there is no corporate level tax for the offshore hedge fund – this does not, however, necessarily mean that there are no taxes for the investors in the fund.  Instead the investors in the fund will generally be taxed in their country of residence on the income from the fund.  Another consideration will be the regulatory laws in place in the jurisdiction.

The two most prevalent offshore jurisdictions are the Cayman Islands and the British Virgin Islands (BVI).  In both the Caymans and the BVI there are strong regulatory structures in place in order to assure investors that the managers of the offshore funds are legitimate.  Other offshore hedge fund jurisdictions include: Bahamas, Bermuda, Nevis, Guernsey, Jersey, Dubai, among many others.

Structure

There are three main offshore hedge fund structures: single, side by side and master-feeder.  The structure will be dictated in large part by the intent of the sponsor of the offshore fund.

Single fund structure – this is a structure which is geared primarily towards non-U.S. investors, and also potentially to U.S. based non-taxable investors (such as pensions and endowments).  The sponsor and management company can be either U.S. based or offshore based, but most offshore stand alone fund structures are managed by offshore individuals.

Side by Side structure – in this structure a U.S. based (typical) investment manager will run two completely separate funds in the exact same manner.  This means that the manager will form both a domestic and offshore hedge fund.  This structure is often good for certain strategies such as a fund of funds strategy.  It is not as good for other, trading intensive strategies simply because trade tickets are typically split between the domestic and offshore fund which creates administrative hassles.

Master-feeder structure – this is a very common structure which will have a domestic hedge fund “feeder,” an offshore hedge fund “feeder” and an offshore hedge fund “master.”   In many cases the master-feeder structure is the preferable structure from an ease of administration point of view.  However, please be aware that there are some accounting considerations which you should be aware of when establishing a master-feeder structure.  In many instances this structure can be used to minimize tax impact on the investment manager – our firm has substantial experience with this structure and would be happy to help you think through the issues involved.  Other law firms should also be able to help you use this structure to minimize tax impact to the manger.

Cayman Island hedge funds

Cayman is probably the most popular offshore jurisdiction and is viewed to be the pre-eminent offshore hedge fund jurisdiction.  The Cayman Islands regulatory body is named the Cayman Islands Monetary Authority or CIMA.  There are two types of offshore funds which can be structured in the Caymans:  a registered or non-registered fund.

Registration

A Cayman hedge fund is required to register with CIMA if:

  • The fund is open-ended and has more than 15 investors, OR
  • The fund has 15 or less investors and those investors do not have the right to appoint or remove a director.

A fund would not need to be registered with CIMA if neither of the above items were applicable.  Generally this will be the case for private equity funds and for offshore incubator hedge funds.

Requirements

If the Cayman offshore fund is registered with CIMA, it will need to comply with the following requirements:

  • payment of an up front and recurring annual fee of US$3048 to CIMA
  • at least 2 directors who must be individuals (the directors do not need to be resident in the Caymans)
  • an auditor who is situated in Cayman
  • a minimum initial investment of US$100,000 or higher

If the fund is not CIMA registered, the fund will only need to have 2 directors.

Other

It was recently released that Cayman Islands has over 10,000 offshore hedge funds registered with CIMA.

BVI hedge funds
[Information on the BVI will be coming soon!]

Tax Considerations
[Information on tax considerations will be coming soon!]

Offshore hedge fund director requirements

Two of the most popular offshore hedge fund jurisdictions are the Cayman Islands and the British Virgin Islands. In another post I will detail the requirements for registration or recognition with these jurisdictions, but for the purposes of this article it is enough to point out that both jurisdictions will generaly require each hedge fund entity (in the case of a master feeder structure there would normally be two offshore entities) to have two directors.

Cayman Islands Director Requirements

In the Cayman there are two types of funds – (i) Cayman Islands Monetary Authority (“CIMA”) registered funds and CIMA non-registered funds. CIMA registration is required if a hedge fund is open-ended (allows investors the option to redeem) and has 16 or more investors. CIMA registration is not required if a hedge fund is closed-edned (does not allow investor the option to redeem) or if a hedge fund has 15 or fewer investors who have the right to appoint or remove directors.

For CIMA registered funds, there must be at least 2 directors who must be individuals. For non-CIMA registered funds, there must be at least 1 director who must be an individual. The individual directors do need not to be a Cayman resident.

BVI “four eyes” policy

In the BVI most hedge funds are deemed to be mutual funds. Because they are mutual funds, they will need to be “recognized” as such with the BVI’s Financial Services Comission (“FSC”).

Pursuant to BVI laws and statutes all companies (including hedge funds) are only required to have 1 director. However the FSC has just recently instituted a new “four eyes” policy which effectively requires that all funds have two directors (the “four eyes” policy has been applied for some time in relation to BVI-incorporated investment managers; however, its application to BVI based funds is a new development). This policy is not codified and it seems to be enforced only on a case by case basis. We are recommending to our clients that they name 2 directors because the liklihood of the FSC requiring 2 directors prior to recognition is quite high.

In the BVI a hedge fund can name a company to be a director.

Offshore Nominee Directors

Not all hedge funds will not have two persons who wish to serve as directors of the fund. The reasons may vary from unwanted perceptions to unwanted responsibilities. For whatever reason in these instances the hedge fund will need to name another person (or a company, for the BVI) which will serve as a director for the fund.

In such cases an offshore hedge fund manager may want to think about using a “nominee” director. There are companies in both the BVI and the Cayman Islands which can provide nominee director services, usually on an annual basis, for a fee. While these fees will depend on a number of factors, including the percieved risk of the fund and the manager, you will probably be looking at anywhere from US $5,000-$10,000 per year.

When searching for a nominee director we recommend shopping around as there are going to be groups which naturally feel more and less comfortable with your program. Some nominees will require some sort of involvement in the high-level affairs of the fund. Some nominees will also ask to be at least be co-signatories on any bank accounts opened in the name of the fund. These precautions are understandable as the nominee services are typically provided by services companies (registered office, registered agent, etc) who could potentially lose their license if something happens with the fund.

Directors from non-US jurisdictions

Please note with all directors the issue of perception. There have been recent instances of large brokerage firms refusing to establish brokerage accounts for some hedge funds because the directors (or even a director) were from states known to support terrorism. It will be a good idea to think about selecting a director who is from country which supports or sponsors terrorism. I do not think that this is a wide-spread practice; however, if a brokerage firm does not allow for the account formation because a new director will need to be appointed, you are going to end up delaying your launch.

Confidentiallity of Director information

In the BVI, the details of directors and shareholders of BVI funds is strictly confidential and not a matter of public record. Funds can if they wish elect to file a register or a document which details directors &/or shareholders but this is not common practice. Obviously the details of directors and shareholders may come into the public domian when they are distributed to third parties (e.g. administrators or auditors) but many times these third parties have previously agreed to keep also such information strictly confidential. Any information held by a fund’s registered agent, likewise, will be kept confidential unless required to be disclosed by order of the FSC (believing it to be in the best interests of the jurisdiction – this is not common and generally requires substantial proof of criminal activity), or a BVI Court.

Offshore Director due diligence requirements

Becoming a director of a company which acts as a hedge fund is not difficult but there are many due diligence requirements for all directors of these companies. While all jurisdictions will differ, the BVI and the Caymans will typically require the following documents from each director:

  • List of director details – name, address, etc
  • Copy of director utility bill – can include: gas, power, electric, water, television/cable, phone/internet; showing home address; notarized
  • Copy of director passport – showing a clear picture of the director, notarized
  • Director bank reference – should include length of relationship; may need to include average amount of assets
  • Director professional reference – should be from a lawyer or accountant who has had a previous professional relationship with the director
  • List of owners/shareholders of director (if an entity)
  • Copy of director formation documents (if an entity)
  • Other items as requested by the registered agent

Please contact us if you have any questions on any of the above or would like to inquire about a nominee director or establishing an offshore hedge fund.

Cayman notches 10,000th hedge fund

In a press release statement from Walkers, the Cayman law firm announces that the Cayman Islands have over 10,000 registered hedge funds as of the end of June 2008. Please see release below:

Cayman Islands Sets Milestone with 10,000 Registered Funds
28-Jul-2008

Recent second quarter figures from the Cayman Islands Monetary Authority (CIMA), have confirmed the achievement of a key milestone by the Cayman Islands financial services industry, with over 10,000 investment funds currently registered in the jurisdiction.

At the end of June 2008 there were 10,037 funds on CIMA’s register, compared with 9,681 at the end of the previous quarter and 8,972 at the mid point of 2007. The current annual growth rate of 12% in net new hedge funds, which takes cancellations into account, is particularly striking in the context of the deterioration in global markets following the sub-prime meltdown and associated credit crunch.

“This is yet another round of impressive statistics from CIMA,” said Mark Lewis, senior investment funds partner at Walkers. “The 10,000 barrier has been breached as hedge funds continue to be formed in the Cayman Islands, which remains the clear jurisdiction of choice for investment managers and their advisers around the world.

“Business remains active and the volatility which has impacted world markets as a result of the credit crisis, and the relatively weak valuations of many securities, has provided hedge fund managers with great opportunities to create alpha after a number of years of relatively flat returns”, Lewis added. “Hedge funds have also provided the market with much needed liquidity, which has been especially beneficial amid the current tight lending conditions.”

The continued growth in net hedge fund registrations is also partly explained by the absence of a significant spike in fund terminations. While there has certainly been a slight increase in terminations over the past 12 months, funds are not being closed at an unprecedented rate.

“There have been some forced closures, but in the cases where funds are struggling, the managers we work with are being pro-active by placing hard-to-value securities in side pockets, suspending redemptions and imposing gates. Such measures may enable a fund in distress to ride out the storm or to wind down its affairs in an orderly manner,” said Walkers investment funds partner Nick Rogers. “In the Cayman Islands the key drivers behind the actions being taken are the need to treat all investors equitably and to act in the best interests of the fund, and this provides a firm foundation for protecting market participants and preserving value.”

Among the new funds that have been established in the Cayman Islands, strategies such as distressed debt and special opportunities presented by the widespread markdown in asset prices have continued to feature strongly.

“There has also been significant ongoing activity in emerging markets and commodities,” Rogers added. “The convergence of these two hot asset classes has been particularly interesting.”

There are a number of factors behind the Cayman Islands’ attractiveness as a domicile for hedge funds, in particular the stable economic and political climate, the close relationship between the public and private sector and the presence of the world’s leading professional services firms. The regulatory regime in the Cayman Islands has been recognised internationally, notably by the International Monetary Fund (IMF) and the Caribbean Financial Action Task Force (CFATF) for its high standards. In the area of transparency and “know-your-client” regulations, these standards surpass many of the world’s top international financial centres.