Tag Archives: Investment Advisor

SEC Supports Private Funds Transparency Act of 2009

Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools

The SEC released a testimony from Andrew J. Donohue before the U.S. Senate about the regulation of hedge funds and other private investment pools.  According to Mr. Donohue’s statement, securities laws have not kept pace with the growth market and thus the SEC has very little oversight authority over these advisors and private funds with regards to conducting compliance examinations, obtaining material information, etc primarily because these requirements only apply to those advisors  and entities registered with the SEC.  Because advisors to private funds have the option to ‘opt out’ of registration, they can easily bypass any monitoring and oversight. The Commission strongly supports the enforcement of the new Private Funds Transparency Act of 2009,* which attempts to close this regulatory gap by requiring advisors to private funds to register under the Advisers Act if they have at least $30 million of assets under management.  The Commission also notes that in order to be effective, the new regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

The various compliance requirements on advisors to private funds as set forth by this new legislation is outlined in the testimony, reprinted in full below.

*Note: this testimony was given the same day that the Treasury announced the Private Fund Investment Advisers Registration Act of 2009 which is very similar to the Private Funds Transparency Act of 2009.

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Testimony Concerning Regulating Hedge Funds and Other Private Investment Pools
by Andrew J. Donohue
Director, Division of Investment Management
U.S. Securities and Exchange Commission

Before the Subcommittee on Securities, Insurance, and Investment of the U.S. Senate Committee on Banking, Housing, and Urban Affairs
July 15, 2009

Chairman Reed, Ranking Member Bunning and Members of the Subcommittee:

I. Introduction

Thank you for the opportunity to testify before you today. My name is Andrew Donohue, and I am the Director of the Division of Investment Management at the Securities and Exchange Commission. I am pleased to testify on behalf of the Commission about regulating hedge funds and other private investment pools.1

Over the past two decades, private funds, including hedge, private equity and venture capital funds, have grown to play an increasingly significant role in our capital markets both as a source of capital and the investment vehicle of choice for many institutional investors. We estimate that advisers to hedge funds have almost $1.4 trillion under management. Since many hedge funds are very active and often leveraged traders, this amount understates their impact on our trading markets. Hedge funds reportedly account for 18-22 percent of all trading on the New York Stock Exchange. Venture capital funds manage about $257 billion of assets,2 and private equity funds raised about $256 billion last year.3

The securities laws have not kept pace with the growth and market significance of hedge funds and other private funds and, as a result, the Commission has very limited oversight authority over these vehicles. Sponsors of private funds—typically investment advisers—are able to organize their affairs in such a way as to avoid registration under the federal securities laws. The Commission only has authority to conduct compliance examinations of those funds and advisers that are registered under one of the statutes we administer. Consequently, advisers to private funds can “opt out” of Commission oversight.

Moreover, the Commission has incomplete information about the advisers and private funds that are participating in our markets. It is not uncommon that our first contact with a manager of a significant amount of assets is during an investigation by our Enforcement Division. The data that we are often requested to provide members of Congress (including the data we provide above) or other federal regulators are based on industry sources, which have proven over the years to be unreliable and inconsistent because neither the private funds nor their advisers are required to report even basic census-type information.

This presents a significant regulatory gap in need of closing. The Commission tried to close the gap in 2004—at least partially—by adopting a rule requiring all hedge fund advisers to register under the Investment Advisers Act of 1940 (“Advisers Act”).4 That rulemaking was overturned by an appellate court in the Goldstein decision in 2006.5 Since then, the Commission has continued to bring enforcement actions vigorously against private funds that violate the federal securities laws, and we have continued to conduct compliance examinations of the hedge fund advisers that remain registered under the Advisers Act. But we only see a slice of the private fund industry, and the Commission strongly believes that legislative action is needed at this time to enhance regulation in this area.

The Private Fund Transparency Act of 2009, which Chairman Reed recently introduced, would require advisers to private funds to register under the Advisers Act if they have at least $30 million of assets under management.6 This approach would provide the Commission with needed tools to provide oversight of this important industry in order to protect investors and the securities markets. Today, I wish to discuss how registration of advisers to private funds under the Advisers Act would greatly enhance the Commission’s ability to properly oversee the activities of private funds and their advisers. Although the Commission supports this approach, there are additional approaches available to that also would close the regulatory gap and provide the Commission with tools to better protect both investors and the health of our markets.

II. The Importance and Structure of Private Funds

Private funds are generally considered to be professionally managed pools of assets that are not subject to regulation under the Investment Company Act of 1940 (“Investment Company Act”). Private funds include, but are not limited to, hedge funds, private equity funds and venture capital funds.

Hedge funds pursue a wide variety of strategies that typically involve the active management of a liquid portfolio, and often utilize short selling and leverage.

Private equity funds generally invest in companies to which their advisers provide management or restructuring assistance and utilize strategies that include leveraged buyouts, mezzanine finance and distressed debt. Venture capital funds typically invest in earlier stage and start-up companies with the goal of either taking the company public or privately selling the company. Each type of private fund plays an important role in the capital markets. Hedge funds are thought to be active traders that contribute to market efficiency and enhance liquidity, while private equity and venture capital funds are seen as helping create new businesses, fostering innovation and assisting businesses in need of restructuring. Moreover, investing in these funds can serve to provide investors with portfolio diversification and returns that may be uncorrelated or less correlated to traditional securities indices.

Any regulatory reform should acknowledge the differences in the business models pursued by different types of private fund advisers and should address in a proportionate manner the risks to investors and the markets raised by each.

III. Current Regulatory Exemptions

Although hedge funds, private equity funds and venture capital funds reflect different approaches to investing, legally they are indistinguishable. They are all pools of investment capital organized to take advantage of various exemptions from registration. All but one of these exemptions were designed to achieve some purpose other than permitting private funds to avoid oversight.

A. Securities Act of 1933

Private funds typically avoid registration of their securities under the Securities Act of 1933 (Securities Act) by conducting private placements under section 4(2) and Regulation D.7 As a consequence, these funds are sold primarily to “accredited investors,” the investors typically receive a “private placement memorandum” rather than a statutory prospectus, and the funds do not file periodic reports with the Commission. In other words, they lack the same degree of transparency required of publicly offered issuers.

B. Investment Company Act of 1940

Private funds seek to qualify for one of two exceptions from regulation under the Investment Company Act of 1940 (Investment Company Act). They either limit themselves to 100 total investors (as provided in section 3(c)(1)) or permit only “qualified purchasers” to invest (as provided in section 3(c)(7)).8 As a result, the traditional safeguards designed to protect retail investors in the Investment Company Act are the subject of private contracts for investors in private funds. These safeguards include investor redemption rights, application of auditing standards, asset valuation, portfolio transparency and fund governance. They are typically included in private fund partnership documents, but are not required and vary significantly among funds.

C. Investment Advisers Act of 1940

The investment activities of a private fund are directed by its investment adviser, which is typically the fund’s general partner.9 Investment advisers to private funds often claim an exemption from registration under section 203(b)(3) of the Advisers Act, which is available to an adviser that has fewer than 15 clients and does not hold itself out generally to the public as an investment adviser.

Section 203(b)(3) of the Advisers Act contains a de minimis provision that we believe originally was designed to cover advisers that were too small to warrant federal attention. This exemption now covers advisers with billions of dollars under management because each adviser is permitted to count a single fund as a “client.” The Commission recognized the incongruity of the purpose of the exemption with the counting rule, and adopted a new rule in 2004 that required hedge fund advisers to “look through” the fund to count the number of investors in the fund as clients for purposes of determining whether the adviser met the de minimis exemption. This was the rule overturned by the appellate court in the Goldstein decision. As a consequence, approximately 800 hedge fund advisers that had registered with the Commission under its 2004 rule subsequently withdrew their registration.

All advisers to private funds are subject to the anti-fraud provisions of the Investment Advisers Act, including an anti-fraud rule the Commission adopted in response to the Goldstein decision that prohibits advisers from defrauding investors in pooled investment vehicles.10 Registered advisers, however, are also subject to periodic examination by Commission staff. They are required to submit (and keep current) registration statements providing the Commission with basic information, maintain business records for our examination, and comply with certain rules designed to prevent fraud or overreaching by advisers. For example, registered advisers are required to maintain compliance programs administered by a chief compliance officer.

IV. Options to Address the Private Funds Regulatory Gap11

As discussed below, though there are different regulatory approaches to private funds available to Congress, or a combination of approaches, no type of private fund should be excluded from any new oversight authority any particular type of private fund. The Commission’s 2004 rulemaking was limited to hedge fund advisers. However, since that time, the lines which may have once separated hedge funds from private equity and venture capital funds have blurred, and the distinctions are often unclear. The same adviser often manages funds pursuing different strategies and even individual private funds often defy precise categorization. Moreover, we are concerned that in order to escape Commission oversight, advisers may alter fund investment strategies or investment terms in ways that will create market inefficiencies.

A. Registration of Private Fund Investment Advisers

The Private Funds Transparency Act of 2009 would address the regulatory gap discussed above by eliminating Section 203(b)(3)’s de minimis exemption from the Advisers Act, resulting in investment advisers to private funds being required to register with the Commission. Investment adviser registration would be beneficial to investors and our markets in a several important ways.

1. Accurate, Reliable and Complete Information

Registration of private fund advisers would provide the Commission with the ability to collect data from advisers about their business operations and the private funds they manage. The Commission and Congress would thereby, for the first time have accurate, reliable and complete information about the sizable and important private fund industry which could be used to better protect investors and market integrity. Significantly, the information collected could include systemic risk data, which could then be shared with other regulators.12

2. Enforcement of Fiduciary Responsibilities

Advisers are fiduciaries to their clients. Advisers’ fiduciary duties are enforceable under the anti-fraud provisions of the Advisers Act. They require advisers to avoid conflicts of interest with their clients, or fully disclose the conflicts to their clients. Registration under the Advisers Act gives the Commission authority to conduct on-site compliance examinations of advisers designed, among other things, to identify conflicts of interest and determine whether the adviser has properly disclosed them. In the case of private funds, it gives us an opportunity to determine facts that most investors in private funds cannot discern for themselves. For example, investors often cannot determine whether fund assets are subject to appropriate safekeeping or whether the performance represented to them in an account statement is accurate. In this way, registration may also have a deterrent effect because it would increase an unscrupulous adviser’s risk of being discovered.

A grant of additional authority to obtain information from and perform on-site examinations of private fund advisers should be accompanied with additional resources so that the Commission can bring to bear the appropriate expertise and technological support to be effective.

3. Prevention of Market Abuses

Registration of private fund advisers under the Advisers Act would permit oversight of adviser trading activities to prevent market abuses such as insider trading and market manipulation, including improper short-selling.

4. Compliance Programs

Private fund advisers registered with the Commission are required to develop internal compliance programs administered by a chief compliance officer. Chief compliance officers help advisers manage conflicts of interest the adviser has with private funds. Our examination staff resources are limited, and we cannot be at the office of every adviser at all times. Compliance officers serve as the front-line watch for violations of securities laws, and provide protection against conflicts of interests.

5. Keeping Unfit Persons from Using Private Funds to Perpetrate Frauds

Registration with the Commission permits us to screen individuals associated with the adviser, and to deny registration if they have been convicted of a felony or engaged in securities fraud.

6. Scalable Regulation

In addition, many private fund advisers have small to medium size businesses, so it is important that any regulation take into account the resources available to those types of businesses. Fortunately, the Advisers Act has long been used to regulate both small and large businesses, so the existing rules and regulations already account for those considerations. In fact, roughly 69 percent of the investment advisers registered with the Commission have 10 or fewer employees.

7. Equal Treatment of Advisers Providing Same Services

Under the current law, an investment adviser with 15 or more individual clients and at least $30 million in assets under management must register with the Commission, while an adviser providing the same advisory services to the same individuals through a limited partnership could avoid registering with the Commission. Investment adviser registration in our view is appropriate for any investment adviser managing $30 million regardless of the form of its clients or the types of securities in which they invest.

B. Private Fund Registration

Another option to address the private fund regulatory gap might be to register the funds themselves under the Investment Company Act (in addition to registering their advisers under the Advisers Act). Alternatively, the Commission could be given stand-alone authority to impose requirements on unregistered funds. Through direct regulation of the funds, the Commission could impose, as appropriate, investment restrictions or diversification requirements designed to protect investors. The Commission could also regulate the structure of private funds to protect investors (such as requiring an independent board of directors) and could also regulate investment terms (such as protecting redemption rights).

C. Regulatory Flexibility through Rulemaking Authority

Finally, there is third option that in conjunction with advisers’ registration may be necessary to address the regulatory gap in this area. Because it is difficult, if not impossible, to predict today what rules will be required in the future to protect investors and obtain sufficient transparency, especially in an industry as dynamic and creative as private funds, an additional option might be to provide the Commission with the authority that allows for additional regulatory flexibility to act in this area. This could be done by providing rule-making authority to condition the use by a private fund of the exceptions provided by sections 3(c)(1) and 3(c)(7) of the Investment Company Act. These conditions could impose those requirements that the Commission believes are necessary or appropriate to protect investors and enhance transparency.13 In many situations, it may be appropriate for these requirements to vary depending upon the type of fund involved. This would enable the Commission to better discharge its responsibilities and adapt to future market conditions without necessarily subjecting private funds to Investment Company Act registration and regulation.

V. Conclusion

The registration and oversight of private fund advisers would provide transparency and enhance Commission oversight of the capital markets. It would give regulators and Congress, for the first time, reliable and complete data about the impact of private funds on our securities markets. It would give the Commission access to information about the operation of hedge funds and other private funds through their advisers. It would permit private funds—which play an important role in our capital markets—to retain the current flexibility in their investment strategies.

The Commission supports the registration of private fund advisers under the Advisers Act. The other legislative options I discussed above, namely registration of private funds under the Investment Company Act and/or providing the Commission with rulemaking authority in the Investment Company Act exemptions on which private funds rely, should also be weighed and considered as the Subcommittee considers approaches to filling the gaps in regulation of pooled investment vehicles.

I would be happy to answer any questions you may have.

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Endnotes:

1 Commissioner Paredes does not endorse this testimony.

2 The National Venture Capital Association (NVCA) estimates that 741 venture capital firms and 1,549 venture capital funds were in existence in 2007, with $257.1 billion in capital under management. NVCA, Yearbook 2008 at 9 (2008). In 2008, venture capital funds raised $28.2 billion down from $35.6 billion in 2007. Thomson Reuters & NVCA, News Release (Apr. 13 2009). In 2007, the average fund size was $166 million and the average firm size was $347 million. Id. at 9.

3 U.S. private equity funds raised $256.9 billion in 2008 (down from $325.2 billion in 2007). Private Equity Analyst, 2008 Review and 2009 Outlook at 9 (2009) (reporting Dow Jones LP Source data.

4 Investment Advisers Act Release No. 2333 (Dec. 2, 2004).

5 See Goldstein v. S.E.C., 451 F.3d 873 (D.C. Cir. 2006).

6 Section 203A(a)(1) of the Act prohibits a state-regulated adviser to register under the Act if it has less than $25 million of assets under management. The Commission has adopted a rule increasing the $25 million threshold to $30 million. See Rule 203A-1 under the Advisers Act. The threshold does not apply to foreign advisers. Section 3 of the Private Fund Transparency Act would establish a parallel registration threshold for foreign advisers, which would prevent numerous smaller foreign advisers that today rely on the de minimis exception, which the Act would repeal, from being required to register with the Commission.

7 Section 4(2) of the Securities Act of 1933 provides an exemption from registration for transactions by the issuer of a security not involving a public offering. Rule 506 of Regulation D provides a voluntary “safe harbor” for transactions that are considered to come within the general statutory language of section 4(2).

8 “Qualified purchasers” generally are individuals or family partnerships with at least $5 million in investable assets and companies with at least $25 million. The section 3(c)(7) exception was added in 1996 and specifically anticipated use by private funds.

9 Private funds often are organized as limited partnerships with the fund’s investment adviser serving as the fund’s general partner. The fund’s investors are limited partners of the fund.

10 See Rule 206(4)-8 under the Advisers Act.

11 Commissioner Casey does not endorse the approaches discussed in sections IV. B and C.

12 The Private Fund Transparency Act includes some important although technical amendments to the Advisers Act that are critical to the Commission’s ability to collect information from advisers about private funds, including amendments to Section 204 of the Act permitting the Commission to keep information collected confidential, and amendments to Section 210 preventing advisers from keeping the identity of private fund clients from our examiners.

13 For example, private funds might be required to provide information directly to the Commission. These conditions could be included in an amendment to the Investment Company Act or could be in a separate statute.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include:

Private Fund Investment Advisers Registration Act of 2009

Bart Mallon, Esq.
http://www.hedgefundlawblog.com

****UPDATE 10/27/2009****

The House Financial Services Committee voted on October 27, 2009 to pass the Private Fund Investment Advisers Registration Act of 2009 as H.R. 3818 (full text of bill as passed – please note that it is different from the earlier version of the bill reprinted below).  The bill as passed by the committee required private equity fund managers to register but specifically excludes managers of venture capital funds from the registration requirements.  The House Committee released a press release discussing the bipartisan vote.

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Text of Private Fund Investment Advisers Registration Act of 2009

Today the Obama Administration released its proposed legislation which would require hedge fund managers to register with the SEC (as well as private equity fund and venture capital fund managers). The full text of the Private Fund Investment Advisers Registration Act of 2009 has been copied below.

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TITLE IV—REGISTRATON OF ADVISERS TO PRIVATE FUNDS

SEC. 401. SHORT TITLE.

This Act may be cited as the “Private Fund Investment Advisers Registration Act of 2009”.

SEC. 402. DEFINITIONS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

“(29) The term ‘private fund’ means an investment fund that—

“(A) would be an investment company (as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3)), but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) or 80a-3(c)(7)); and

“(B) either—

“(i) is organized or otherwise created under the laws of the United States or of a State; or

“(ii) has 10 percent or more of its outstanding securities owned by U.S. persons.

“(30) The term ‘foreign private adviser’ means any investment adviser who—

“(A) has no place of business in the United States;

“(B) during the preceding 12 months has had—

“(i) fewer than 15 clients in the United States; and

“(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

“(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53), and has not withdrawn its election.”.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) is amended—

(a) in paragraph (1), by inserting “, except an investment adviser who acts as an investment adviser to any private fund,” after “investment adviser” the first time it appears;

(b) by amending paragraph (3) to read as follows:

“(3) any investment adviser that is a foreign private adviser;”; and

(c) in paragraph (6)—

(1) in subparagraph (A), by striking “or”;

(2) in subparagraph (B), by striking the period at the end and adding “; or”; and

(3) by adding at the end the following new subparagraph:

“(C) a private fund.”

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended—

(a) by redesignating subsections (b) and (c) as subsections (c) and (d); and

(b) by inserting after subsection (a) the following new subsection (b):

“(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

“(1) IN GENERAL.—The Commission is authorized to require any investment adviser registered under this Act to maintain such records of and submit to the Commission such reports regarding private funds advised by the investment adviser as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council, and to provide or make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council those reports or records or the information contained therein. The records and reports of any private fund would be an investment company, to which any such investment adviser provides investment advice, maintained or filed by an investment adviser registered under this Act shall be deemed to be the records and reports of the investment adviser.

“(2) REQUIRED INFORMATION.—The records and reports required to be filed with the Commission under this subsection shall include but shall not be limited to the following information for each private fund advised by the investment adviser:

“(A) amount of assets under management, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading and

investment positions, and trading practices; and

“(B) such other information as the Commission, in consultation with the Board of Governors of the Federal Reserve System, determines necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(3) MAINTENANCE OF RECORDS.—An investment adviser registered under this Act is required to maintain and keep such records of private funds advised by the investment adviser for such period or periods as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(4) EXAMINATION OF RECORDS.—

“(A) PERIODIC AND SPECIAL EXAMINATIONS.—All records of a private fund maintained by an investment adviser registered under this Act shall be subject at any time and from time to time to such periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe.

“(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this Act shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense or delay as the Commission or its representatives may reasonably request.

“(5) INFORMATION SHARING.— The Commission shall make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council copies of all reports, documents, records and information filed with or provided

to the Commission by an investment adviser under section 204(b) as the Board or the Council may consider necessary for the purpose of assessing the systemic risk of a private fund or assessing whether a private fund should be designated a Tier 1 financial holding company. All such reports, documents, records and information obtained by the Board or the Council from the Commission under this subsection shall be kept confidential.

“(6) DISCLOSURES BY PRIVATE FUND.—An investment adviser registered under this Act shall provide such reports, records and other documents to investors, prospective investors, counterparties, and creditors, of any private fund advised by the investment adviser as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(7) CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (b). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.”.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended—

(1) in subsection (a)—

(A) by striking the second sentence; and

(B) by striking the period at the end of the first sentence and inserting the following:

“, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may—

“(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

“(2) ascribe different meanings to terms (including the term ‘client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.”; and

(2) by adding at the end the following new subsection:

“(e) The Commission and the Commodity Futures Trading Commission shall, after consultation with the Board of Governors of the Federal Reserve System, within 6 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2009, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under the Investment Advisers Act of 1940 (15 U.S.C. 80b et seq.) and the Commodity Exchange Act (7 U.S.C. 1a et seq.).”.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions.  If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510.  Other related hedge fund law articles include:

Net Capital Requirement for State Registered Hedge Fund Managers

Overview of Net Capital Requirement and Bond Alternative

Hedge fund managers who need to register as investment advisors in their state of residence often have to deal with the net capital requirement issue.  Usually there will be two separate net capital requirements for the investment advisor (meaning the fund’s management company) depending on the nature of the advisor’s business:

Advisors with Discretionary Authority – $10,000
Advisors with Custody – $35,000

[Note: these requirements do not usually apply to forex hedge fund managers unless such managers are also registered as investment advisors.]

Generally all state-registered hedge fund managers will have discretionary authority of the hedge fund’s investments so most advisors will need to maintain the $10,000 requirement.  Also, most hedge fund managers will also be deemed to have “custody” of the fund assets because they will either have direct access to the hedge fund’s bank account or because they will directly deposit their management fees from the fund’s brokerage account.  Accordingly, most state-registered hedge fund managers will need to maintain the more burdensome $35,000 net capital requirement.  There is no requirement to combine the $10,000 with the $35,000 for managers with both discretionary authority and custody – in these situations the manager will only need to maintain the $35,000.

Investment Advisor Bond

As an alternative to maintaining a firm net capital according to the rules above, some states will allow hedge fund managers to post a bond in the required amount instead.  Not all states will allow a manager to post a bond instead, so you should be sure to talk with your hedge fund attorney or compliance professional before you begin the process of securing a bond.

Securing the Bond

There are a number of groups out there that can underwrite these sorts of bonds for the money managers.  The fees for such bonds will be anywhere from $250 to $1,000, depending on a number of factors including the credit history of the managing member of the fund management company.  It will generally take anywhere from a few days to a couple of weeks to secure the bond and from there, the manager will likely need to show proof to the state securities division that the bond has been secured in the appropriate amount.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs Hedge Fund Law Blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  Cole-Frieman & Mallon LLP will also help state based Investment Advisors to register with their state securities division.  If you are a hedge fund manager who is looking to start a hedge fund or an investment advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

California Investment Advisor FAQ

California Based Hedge Fund Managers Receive Answers to Common Questions

As I have discussed many times before, each state securities division has different rules and regulations.  In addition, each state has different interpretations of those rules and regulations. This makes it difficult for hedge fund managers to really know exactly what is required in each state unless they have representation from a specialized compliance group or hedge fund attorney.  Many securities regulators, also, do not completely understand their own rule and regulations and are not able to provide any sort of practicle advice to hedge fund managers regarding their obligations.  While not surprising, this lack of ability to provide general straight-forward answers to managers is what creates the need for specialized advice.  Some states however are recognizing that there are common questions which arise and that it makes sense to provide answers to those common questions and the FAQ below, provided by the California State Securities Regulation Division is a step in the right direction towards increasing the dialogue between regulators and market participants.

The following summary is also very helpful for manager because it discusses some of the nuances of California law as it relates to investment advisors who are also hedge fund managers.  Specifically the FAQ below deals with the issue of “custody,” the net worth requirements and the 120% net worth.  Also discussed is the “gatekeeper” issue (also known as the independant secondary signer service).

The entire text of the FAQ is reprinted below.  Please see below for additional hedge fund articles and please also see our guide to state hedge fund laws.

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1) What responsibilities do I have as an investment adviser?

As an investment adviser, you are a “fiduciary” to your advisory clients. This means that you have a fundamental obligation to act in the best interests of your clients and to provide investment advice in your clients’ best interests. You owe your clients a duty of undivided loyalty and utmost good faith. You should not engage in any activity in conflict with the interest of any client, and you should take steps reasonably necessary to fulfill your obligations. You must employ reasonable care to avoid misleading clients and you must provide full and fair disclosure of all material facts to your clients and prospective clients.

So, what is considered material? Generally, facts are “material” if a reasonable investor would consider them to be important. It is something a client would want to consider in determining whether to hire the adviser or follow the adviser’s recommendations. You must eliminate, or at least disclose, all conflicts of interest that might incline you to render advice that is not in the best interest of the client. If you do not avoid a conflict of interest that could impact the impartiality of your advice, you must make full and frank disclosure of the conflict. You cannot use your clients’ assets for your own benefit or the benefit of other clients. Departure from this fiduciary standard may constitute “fraud” upon your clients.

2) How are “assets under management” determined?

In determining the amount of your assets under management, include the securities portfolios for which you provide continuous and regular supervisory or management services as of the date of filing Form ADV. You provide continuous and regular supervisory or management services with respect to an account if:

(1)  You have discretionary authority over and provide ongoing supervisory or management services  with respect to the account; or

(2)  You do not have discretionary authority over the account, but you have an ongoing  responsibility to select or make recommendations, based upon the needs of the client, as to  specific securities or other investments the account may purchase or sell and, if such  recommendations are accepted by the client, you are responsible for arranging or effecting the  purchase or sale.

Other factors: You should also consider the following factors in evaluating whether you provide  continuous and regular supervisory or management services to an account:

(a)Terms of the advisory contract.
If you agree in an advisory contract to provide ongoing management services, this suggests that  you provide these services for the account. Other provisions in the contract, or your actual  management practices, however, may suggest otherwise.

(b)Form of compensation.
If you are compensated based on the average value of the client’s assets you manage over a  specified period of time, this suggests that you provide continuous and regular supervisory or  management services for the account.
If you receive compensation in a manner similar to either of the following, this suggests you do  not provide continuous and regular supervisory or management services for the account:

(a) You are compensated based upon the time spent with a client during a client visit; or
(b) You are paid a retainer based on a percentage of assets covered by a financial plan.

(3)Management practices.

The extent to which you actively manage assets or provide advice bears on whether the services  you provide are continuous and regular supervisory or management services. The fact that you  make infrequent trades (e.g., based on a “buy and hold” strategy) does not mean your services  are not “continuous and regular.”

3) Our firm is registered with the SEC or another state. Must we also register with the Department of Corporations?

SEC registered advisers with more than five clients who are residents of California must make a notice filing with the Department.

Other states registered investment advisers with a place of business in this state or more than five clients who are residents of California must also registered with the Department.

4) How does a firm convert from being a state-registered to an SEC-registered investment adviser or vice versa?

From State to SEC: To convert from being a state-registered adviser to being an SEC-registered adviser on the IARD system, mark the filing type “Apply for registration as an investment adviser with the SEC.” After the SEC approves your registration you should file a “Partial ADV-W” to withdraw your state registration(s). Do not file your Partial ADV-W until your application for SEC registration is approved or you will be unregistered and may be unable to conduct your business during this period of time.

From SEC to State: To convert from being a SEC-registered adviser to being a state-registered adviser, mark the filing type “Apply for registration as an investment adviser with one or more states.” After your state registration has been approved, then you should file a “Partial ADV-W” to withdraw your SEC registration. Do not file your Partial ADV-W until your state registration application(s) is approved by the Department or you will be unregistered and cannot conduct your business during this period of time.

5) What is an “investment adviser representative?”

An investment adviser representative (“IAR”), sometimes referred to as a registered adviser (“RA”), or associated person is defined in Code Section 25009.5(a) as any partner, officer, director of (or a person occupying a similar status or performing similar functions) or other individual, except clerical or ministerial personnel, who is employed by or associated with, or subject to the supervision and control of, an investment adviser that has obtained a certificate or that is required to obtain a certificate under this law, and who:

(1) Makes any recommendations or otherwise renders advice regarding securities,
(2) Manages accounts or portfolios of clients,
(3) Determines which recommendations or advice regarding securities should be given,
(4) Solicits, offers, or negotiates for the sale or sells investment advisory services, or
(5) Supervises employees who perform any of the foregoing.

Important: Each officer, director or partner exercising executive responsibility (or persons occupying a similar status or performing similar functions) or each person who owns 25% or more is presumed to be acting as an IAR or associated person.

6) I have an investment adviser representative who performs advisory services on behalf of my firm and is under my supervision. Does the investment adviser representative need to be registered with the Department?

Yes, investment adviser representatives must be registered with the Department if they have a place of business in California.

Important: This applies to both state (California and other states) and SEC registered investment advisers. Investment adviser representatives located in California or who have clients who are residents of California (whether they work for SEC, other states, or California’s registered investment adviser firms), must be registered with the Department.

7) How does my firm register individuals and what are the employment requirements?

Firms register individuals by completing Form U-4 through the electronic Central Registration Depository (“CRD”). Upon employment of an individual as an IAR, the investment adviser must obtain a properly executed Form U-4, evidence that the IAR meets the qualification requirements of CCR §260.236, and have the responsibility and duty to ascertain by reasonable investigation the good character, business reputation, qualifications, and experience of an individual upon employment or engagement as an IAR.

8) What are the qualification requirements for investment adviser representatives?

Each IAR, except those employed or engaged by an investment adviser solely to offer or negotiate for the sale of investment adviser services, must qualify by passing the examination(s) as specified in CCR §260.236(a). The examination requirements are the Uniform Investment Adviser Law Examination (“2000 Series 65”) passed on or after January 1, 2000; or the General Securities Representative Examination (“Series 7”) and Uniform Combined State Law Examination (“2000 Series 66”). Waivers and exemptions to the examination requirements may be found in subsection (b) and (c) of CCR §260.236, respectively. Individuals who hold in good standing an approved professional designation meet the exemption found in (c)(3) of CCR §260.236.

When a U-4 is filed to register someone as an IAR, the CRD will automatically open a Series 65 exam window if the individual is not shown as already having passed the exam, is not already licensed by another jurisdiction, or does not qualify for an automatic exam waiver.

9) What are the filing requirements for a firm who has an investment adviser representative?

(1) Employment –

Upon employment of an IAR, Form U-4, including any Disclosure Reporting  Page(s), should  be completed in accordance with the form instructions. The form is to be filed  with, and the  reporting fee paid to, CRD in accordance with its procedures. The filing of Form U- 4 with  CRD does not constitute an automatic approval of the filing by the Commissioner. The  investment adviser should not consider an IAR “registration” approved until approved by the  Commissioner and notification of the approval has been received through CRD.

(2) Changes – Within 30 days of any changes to Form U-4, an amendment to Form U-4 is to be  filed. The amendment is to be filed directly with CRD in accordance with its procedures.

(3)Termination – Within 30 days of termination of an IAR, Form U-5 is to be filed in accordance  with the form instructions. Form U-5 is to clearly state the reason(s) for termination. This form is  to be filed directly with CRD in accordance with its procedures.

10) What are the fees associated with registering an investment adviser representative?

The registration fee for each IAR is $25. This fee is paid to the Department through the IARD system. There is no annual renewal fee for an IAR.

There is also an annual filing fee of $30 for 2008 (subject to change for future years) that is paid to FINRA for the processing of forms for each IAR. FINRA charges this fee and the Department does not receive any portion of this.

11) Are owners and executive officers considered investment adviser representatives (IAR)? If so, how should I report owners and executive officers of my advisory firm to the Department?

All direct owners and executive officers should be reported on Schedule A of Form ADV and indirect owners should be reported on Schedule B of Form ADV.

Since officers, directors or partners who exercise executive responsibilities (or persons who occupy similar status or perform similar functions), or persons who own 25% or more are presumed to be IARs, a Form U-4 and a $25 reporting fee should be filed for each such individual through the Central Registration Depository (“CRD”).

A paper filing of Form U-4 should be filed directly with the Department for all other officers, directors or partners, or persons who own 10% or more who are not reported as IARs through the CRD.

12) I solicit clients for an investment adviser and receive referral fees for business I send to an investment adviser. Must I register?

Solicitors must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate.

13) I solely refer clients to registered investment advisers, what qualification requirements are there for solicitors?

Individuals who are reported as an IAR under an investment adviser solely to offer or negotiate for the sale of investment adviser services are exempted from the qualification requirements. However, solicitors seeking their independent registered investment advisory license must be qualified.

14) I’m a Certified Public Accountant (CPA) and refer my clients to third-party investment advisers for referral fees, what qualifications and requirements must I follow?

A special case arises when a CPA acts as referring agent. Like a solicitor, the CPA must be registered either as an investment adviser representative under a registered investment advisory firm or obtain their own independent registered investment adviser certificate. The difference is that the CPA must be qualified by passing the examinations, unless waived or exempted, even if the CPA is to be reported as an investment adviser representative under a registered investment advisory firm. This is because, according to the California Business and Profession Code and the Board of Accountancy, in order for a CPA to receive compensation from a referral, the CPA must provide a professional service related to the product or services that will be provided to the client by the third-party service provider. In addition, the CPA must maintain independence and provide full disclosure of its referral arrangement to the clients.

Please refer to California Business and Profession Code, Section 5061 and California Board of Accountancy, Article 9, Section 56 for more information.

15) Must I have a written contract with my clients? If yes, what information should my advisory contracts contain?

Yes. Advisers providing services pursuant to advisory contracts that are written are considered to promote fair, equitable, and ethical principles. Advisory contracts with clients must be in writing and, at a minimum, must disclose:

(1) The services to be provided;
(2) The term of the contract;
(3) The advisory fee or the formula for computing the fee amount or the manner of calculation  of the amount of the prepaid fee to be returned in the event of contract termination or  nonperformance;
(4) Whether the contract grants discretionary power to the adviser or its representatives; and
(5) That the contract will not be assigned without the consent of the client.

Please refer to CCC Section 25234 and CCR Section 260.238 for more information.

Important: The Form ADV may not specifically request certain information, however; it is the adviser’s fiduciary duty to disclose all material information in order not to mislead clients, so that the client can make informed decisions about entering into or continuing the advisory relationship.

During the Department examination, examiner will view perceived conflicts from the point of view of the customer: Was the disclosure or lack of disclosure a factor in the client’s decision to use an adviser’s services or ratify an adviser’s recommendations? Was the customer misled? Was the customer placed at a disadvantage or taken unfair advantage of as a result of the conflict and the adviser’s lack of disclosure? The burden of proof lies with the adviser.

16) I provide financial planning services to my clients. What disclosure information must I provide in my advisory contracts for my clients?

Financial planners should provide proper disclosures relating to any inherent conflict of interest that may result from any compensation arrangements connected with the financial planning services that are in addition to the financial planning fees and other financial industry activities or affiliations.

Advisers who provide financial planning services and receive compensation (e.g. commissions, fees) from the sale of securities, insurance, real estate or other product or services recommended in the financial plan, or otherwise has a conflict of interest, must deliver to the financial planning clients a notice in writing containing at least the information found below (in addition to the disclosure items in Question 15 at the time of entering into a contract for, or otherwise arranging for the provision of, the delivery of a financial plan:

(1) A conflict exists between the interests of the investment adviser or associated person and  the interests of the client, and
(2) The client is under no obligation to act on the investment adviser’s or associated person’s  recommendation. Moreover, if the client elects to act on any of the recommendations, the  client is under no obligation to effect the transaction through the investment adviser or the  associated person when such person is employed as an agent with a licensed broker-dealer or is  licensed as a broker-dealer or through any associate or affiliate of such person.

This statement may be included in the advisory contract or Schedule F of Form ADV, which for the latter, the client must acknowledge receipt of the disclosure.

Please refer to CCR Section 260.235.2 for more information.

17) When am I required to update my Form ADV?

Form ADV should always contain current and accurate information. Please note that Part 1A and Part 2 contain some similar questions and must be answered consistently. Therefore, both parts must be updated. In addition to your annual updating amendment, you must amend your Form ADV by filing additional amendments, referred to as “other-than-annual amendments,” during the year. If there are material changes to the Form ADV, an “other-than-annual amendment” should be filed within 30 days of the change.

Important: Advisers are recommended to utilize the tables found at the end of this packet to determine if a change to certain items in Form ADV requires prompt amendments. Because questions asked in Part 1 and 2 are similar, a table is also provided that references these questions. Advisers should make sure that the answers to cross-referenced items are answered the same.

Important: Any amendments to Parts 1 and 2 of Form ADV should be electronically filed through the IARD system.

REMEMBER: You must also amend your Form ADV each year by filing an “annual updating amendment” within 90 days after the end of your fiscal year. When you submit your annual updating amendment, you must update your responses to all items in Parts 1 and 2 of Form ADV.

18) Can Part 2 of Form ADV be filed electronically through the IARD system?

Yes, Form ADV Part 2 along with Schedule F must be filed through the IARD system. However, unlike Form ADV Part 1, Part 2 must be completed offline and uploaded to the IARD system. The form must be submitted in a text searchable pdf format in order to be accepted by the IARD system.

IARD system instructions for filing Part 2 of Form ADV can be found on the IARD web site at http://www.iard.com/part2instructions.asp .

An editable PDF version of Form ADV Part 2 with Schedule F can be obtained from the following website:

http://www.nasaa.org/Industry_Regulatory_Resources/Uniform_Forms.

19) Do I need to file an annual updating amendment for Part 2 of Form ADV when there are no changes with the information provided?

Yes, an annual updating amendment of Form ADV Parts 1 and 2 through the IARD system is required regardless of any changes in the business or with the information provided. When filing an annual updating amendment, the IARD system allows advisers to utilize the “Confirm” brochure option to confirm that brochures on file are still current, without having to upload a new version of the PDF file.

Specific instructions for filing Part 2 of Form ADV can be obtained from the IARD website at: http://www.iard.com/pdf/ADV_Part_II_Firm_User_90.pdf .

20) Should I file a new application with the Department if I change my sole proprietorship to a corporation?

No, if there is no practical change in control or management only an amendment to the application is necessary. Successors may file an amendment only if the succession results from a change: 1) in form of organization; 2) in legal status; or 3) in the composition of a partnership.

Change in Form of Organization:

This in an internal reorganization or restructuring. For example, a corporation has two affiliated entities, A and B. A is registered as an IA and provides advisory services. B does bookkeeping and does not perform advisory functions. Now, the corporation decides that B should now be performing advisory services and A should provide bookkeeping. In this situation, B may file an amendment of its predecessor’s application because there is no change in control, since the corporation hasn’t change and the beneficial owners remain the same.

Change in Legal Status:

This is a result of a change in the state of incorporation or a change in the form of the business. For example, a sole proprietorship converts it business to a corporation. This also does not involve a change of control.

Change in Composition of a Partnership:

This involves the death, withdrawal, or addition of a partner in the partnership and is not considered a change in control of the partnership.

To file the Amendment: Successors should check “Yes” to Part 1A, Item 4A; enter the date of succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. The successor will keep the same CRD number and the predecessor should NOT file Form ADV-W.

21) Should I file a new application if I am an unregistered person acquiring an existing registered investment adviser?

Yes, successors must file a new application for registration when the succession involves a change in control or management. The following types of successions require the filing of a new application:

Acquisitions:

Acquiring a preexisting investment adviser business by an unregistered person involving a change of control or management.

Consolidations:

When two or more registered investment advisers combine their businesses and decide to conduct their new business through a new unregistered entity.

Division of Dual Registrants:

An entity registered as both an IA and BD that decides to separate one of its functions to an unregistered entity.

These types of successions must be filed by a new application for registration. Setting up an IARD account is the first step in the registration process. Once an adviser establishes an IARD account, the adviser can access Form ADV on IARD and submit it electronically through IARD to the Department. On Form ADV, the successor should check “Yes” to Part 1A, Item 4A; enter the date of the succession in Part 1A, Item 4B; and complete Schedule D, Section 4 about the acquired firm information. A new CRD number will be issued upon approval. Once approved, the predecessor files Form ADV-W to withdraw its license from the Department.

22) What are my minimum financial requirements?

Investment advisers who:

(1) Have custody of client funds or securities must maintain at all times a minimum net worth of  $35,000.
(2) Have discretionary authority over client funds or securities but do not have custody of client  funds or securities must maintain at all times a minimum net worth of $10,000.
(3) Accept prepayment of fees more than $500 per month and six or more months in advance  must maintain at all times a positive net worth.

23) If I am an investment adviser and also a broker-dealer, do I need to meet the minimum net worth requirements for investment advisers?

No, the minimum financial requirements do not apply if the investment adviser is also licensed as a broker-dealer under Code Section 25210, or is registered with the SEC.

24) How is financial net worth determined?

“Net worth” should be calculated as the excess of assets over liabilities, as determined by generally accepted accounting principles. The following items should not be included in the calculation of assets: prepaid expenses (except as to items properly classified as current assets under generally accepted accounting principles), deferred charges, goodwill, franchise rights, organizational expenses, patents, copyrights, marketing rights, unamortized debt discount and expense, and all other assets of intangible nature; home, home furnishings, automobiles, and any other personal items not readily marketable in the case of an individual; advances or loans to stockholders and officers in the case of a corporation, and advances or loans to partners in the case of a partnership.

The Department has created a Minimum Financial Requirement Worksheet which advisers may utilize when computing their net worth, which can be obtained from the Department’s website at: http://www.corp.ca.gov/forms/pdf/2602372.pdf .

25) What happens if I do not meet the net worth requirement?

As a condition of the right to continue to transact business in this state, advisers must notify the Department of any net worth deficiency by the close of the next business day following the discovery that the net worth is less than the minimum required.
After transmitting such notice, advisers must file by the close of the next business day a report of financial condition, including the following:

(1)A trial balance of all ledger accounts;
(2) A statement of all client funds or securities which are not segregated;
(3) A computation of the aggregate amount of client ledger debit balance; and
(4) A statement as to the number of client accounts.

26) When computing my financial net worth on the Minimum Financial Requirement Worksheet provided by the Department, I notice that there is a “120% Test”. What is this 120% of minimum net worth requirement test?

An adviser who is subject to the minimum financial requirement must file interim financial reports with the Department within 15 days after its net worth is reduced to less than 120% of its net worth requirement. The first interim report shall be filed within 15 days after its net worth is reduced to less than 120% of its required minimum net worth, and should be as of a date within the 15-day period. Additional reports should be filed within 15 days after each subsequent monthly accounting period until three successive months’ reports have been filed that show a net worth of more than 120% of the firm’s required minimum net worth.

The submitted interim financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet);
(2) Minimum Financial Requirement Worksheet; and
(3) A verification form.

27) Do I need to file financial reports to the Department?

An adviser who is subject to the minimum financial requirements must file annual financial reports with the Department within 90 days after its fiscal year-end. The submitted annual financial reports should contain:

(1) A Statement of Financial Condition (Balance Sheet & Income Statement) that must be  prepared in accordance with generally accepted accounting principles;

(2) Supporting schedule containing the computations of the minimum financial requirement.  The Department has supplied a Minimum Financial Requirement Worksheet which advisers may  utilize, and which may be obtained from the Department’s website:
http://www.corp.ca.gov/forms/pdf/2602372.pdf ; and
(3) A verification form must accompany the financial statements. The verification form must: (a)  affirmatively state, to the best knowledge and belief of the person making the verification, that  the financial statements and supporting schedules are true and correct; and (b) be signed under  penalty of perjury. The verification form can be obtained from the Department’s website at:
http://www.corp.ca.gov/forms/pdf/2602412b.pdf

Important: Advisers who have custody of client funds or securities must file audited financial statements prepared by an independent certified public accountant along with the supporting schedule of the net worth computation and the verification form. Please refer to Question # 30 for other requirements pertaining to investment advisers with custody of client funds or securities.

28) I obtain the client’s permission before executing trades, but the brokerage firm will accept my instructions when trading on client accounts. Would I be considered to have discretionary authority?

An investment adviser will not be deemed to have discretionary authority over client accounts when it places trade orders with a broker-dealer pursuant to a third party trading agreement if all the following are met:

(1) The investment adviser has executed a separate investment adviser contract exclusively with  its client which acknowledges that the investment adviser must secure client permission prior to  effecting securities transactions for the client in the client’s brokerage account(s), and
(2) The investment adviser in fact does not exercise discretion with respect to the account,  maintains a log (date and time) or other documents each time client permission is obtained for  transaction, and
(3) A third party trading agreement is executed between the client and a broker-dealer which  specifically limits the investment adviser’s authority in the client’s broker-dealer account to the  placement of trade orders and deduction of investment adviser fees.

29) How is custody of client funds or securities determined?

A person will be deemed to have custody if said person directly or indirectly holds client funds or securities, has any authority to obtain possession of them, or has the ability to appropriate them. Also see Questions 30 through 33, below, for additional information on making custody determinations.

30) What are the requirements for advisers who have custody of client funds and/or securities?

Advisers deemed to have custody of client funds and securities are subject to the following custodial requirements:
(1) $35,000 minimum net worth requirement of CCR Rule 260.237.2,
(2) Surprise verification requirement of CCR Rule 260.237(e), and
(3) Audited financial statements requirement of CCR Rule 260.241.2.

31) I deduct advisory fees directly from the clients’ custodial accounts. Do I have custody of client funds and securities? If yes, are there any procedures I may follow to be exempted from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that any arrangement under which the adviser is authorized or permitted to withdraw client funds or securities maintained with a custodian upon the adviser’s instruction to the custodian is deemed to have custody of client funds and securities.

Safeguarding Procedures: The Department allows advisers who have this type of payment arrangement to be exempted from the requirements of: (1) $35,000 minimum net worth; (2) audited financial statements; and (3) surprise verification if all of the following procedures are administered:

(1) The client must provide written authorization permitting direct payment from an account  maintained by a custodian who is independent of the adviser;
(2) The adviser must send a statement to the client showing the amount of the fee, the value of  the client’s assets upon which the fee was based, and the specific manner in which the fee was  calculated;
(3) The Adviser must disclose to clients that it is the client’s responsibility to verify the accuracy  of the fee calculation, and that the custodian will not determine whether the fee is properly  calculated; and
(4) The custodian must agree to send the client a statement, at least quarterly, showing all  disbursements from the account, including advisory fees.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for direct fee deduction should respond accordingly on the following sections of their Form ADV:

  • Form ADV: Part 1A, Item 9 (A) – Yes
  • Part 1A, Item 9 (B) – Yes
  • Part 1B, Item 2 I (1) – Yes
  • Part 1B, Item 2 I (1) (a) – Yes
  • Part 1B, Item 2 I (1) (b) Yes
  • Part 1B, Item 2 I (1) (c) – Yes
  • Part 2, Item 14 – No

Important: This exemption does not relieve the advisers from the net worth requirements, which may be lowered to $10,000, or the filing of unaudited financial statements.

32) I manage a limited partnership (LP) and am the general partner of the LP. Am I considered to have custody? If yes, are there any procedures I may follow to receive an exemption from the financial requirements and surprise verification?

Yes and Yes. The Department takes the position that an adviser with any capacity (such as a general partner of a limited partnership, managing member of a limited liability company or a comparable position for another type of pooled investment vehicle) that gives the adviser legal ownership of or access to client funds or securities is deemed to have custody of client funds and securities.

Safeguarding Procedures: An investment adviser acting as a general partner of a limited partnership (or a comparable position for another type of pooled investment vehicle) may receive partnership funds or securities directly from the partnership’s account held by an independent custodian without complying with the surprise audit requirement of CCR Rule 260.237(e), audited financial statements requirement of CCR Rule 260.241.2, and higher net worth requirement of CCR Rule 260.237.2 if all the partnership assets are administered as follows:

(1) One or more independent banks or brokerage firms must hold the partnership’s funds and  securities in the name of the partnership.
(2) Funds received by the partnership for subscriptions must be deposited by the subscriber  directly with the custodian.
(3) The partnership must engage an independent party to approve all fees, expenses, and capital  withdrawals from the pooled accounts.
(4) Each time the general partner makes a payment or withdrawal request, it must  simultaneously send to the independent party and the custodian a statement showing: (a) the  amount of the payment or withdrawal; (b) the value of the partnership’s assets on which the fee  or withdrawal is based; (c) the manner in which the payment or withdrawal is calculated; and (d)  the amount in the general partner’s capital account before and after the withdrawal.
(5) The general partner must also give the independent party sufficient information to allow the  representative to determine that the payments comply with the partnership agreement. The  custodian may transfer funds from the partnership account to the general partner only with the  written authorization of the independent party, and only if the custodian receives a copy of the  written request from the general partner.
(6) The custodian must provide quarterly statements to the partnership and the independent  party.

Form ADV Disclosure: Advisers who follow the safeguarding procedures for pooled investment vehicles should respond accordingly on the following sections of their Form ADV:

Form ADV:

  • Part 1A, Item 9 (A)
  • Part 1A, Item 9 (B)
  • Part 1B, Item 2 I (2)
  • Part 1B, Item 2 I (2) (a)
  • Part 2, Item 14

Important: This exemption does not relieve advisers from the net worth requirement, which may be lowered to $10,000, or from the requirement to file unaudited financial statements.

33) I inadvertently received securities or checks from my advisory clients. Do I have custody?

Yes. To avoid having custody, you must return the securities to the sender promptly within two business days of receiving them. In the case of checks received inadvertently, the adviser must forward the checks to the third party within two business days of receipt.

Important: You are also required to keep accurate records of the securities and funds you received and returned. Such records should contain the description of the checks/securities, when and from whom they were received, where they were sent, and a record of how they were returned.

34) Who can be an independent party?

For purposes of the safeguarding procedures for pooled investment vehicles, an independent party must:

(1) Be a certified public accountant (CPA) or an attorney in good standing with the California  State Bar;
(2)Act as a gatekeeper for the payment of fees, expenses, and capital withdrawals from the  pooled investment;
(3) Not control, and is not controlled by or under common control with the adviser; and
(4) Not have, and have had within the past two years, a material business relationship with the  investment adviser.

35) An accounting firm acts as the independent CPA that audits annually my pooled investment vehicle. May the accounting firm also act as the independent representative for the investors in the pooled investment vehicle?

No, this accounting firm is not acceptable as an independent representative. The independent representative may not have, or have had within the past two years, a material business relationship with the adviser. Also, the purpose for this safeguard is for the independent representative to act as the agent for an advisory client and is thus obliged to act in the best interest of the advisory client, limited partner, member or other beneficial owner. When the CPA sent audited financial statements of the pooled investment vehicle, it would be, in essence, sending itself its own audit results. This is not in the best interest of the investors in the pooled investment vehicle and is not allowed.

Important: Alternatively, if the accounting firm audits the investment adviser’s financial statements or prepares tax filings for the pooled investment vehicle and its investors, the result would be the same. That is, the accounting firm would not satisfy the independence criteria since it has a material business relationship with the adviser

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Hedge Funds with $25MM of AUM to Register Under Commissioner Aguilar’s Plan

SEC Commissioner Aguilar Proposes Registration For Funds with as little as $25MM of AUM

Just today I had an opportunity to review the transcript of a speech by SEC Commissioner Aguilar in which he advocates that funds with as little as $25MM of AUM should register with the SEC.  Such a low threshold for registration is troubling in a number of ways.  Most importantly is the impact registration would have on the SEC immediately and in the future.  As we have seen most vividly over the past year, the SEC is overextended and underfunded.  The SEC’s ability to adequately deal with the 9,000 to 12,000 hedge funds which would come under its jurisdicition is suspect.  Registration aside, how will an agency which was not able to sniff out a Bernie Madoff be able to oversee such a large industry without making it cost prohibitive for funds to operate?  The money required to oversee these funds is likely to be substantial and will probably not be coming from Congress which means the cost of such a regulatory and oversight system will likely fall onto the managers themselves and then of course to the investors.

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

This is not to say I am not against reasonable, reasoned and fiscally responsible oversight and regulation.  I believe that systemic stability is critically important for the long term viability of the hedge fund industry as well as the capital markets.  In this vein, I think that Aguilar’s statement below represents the type of structures which would contribute to increased stability while minimizing regulation where it is not necessary.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

While I do not agree with many of the points regarding regulation the Commissioner discussed in the speech reprinted below, I do believe that the Commissioner does a good job at identifying issues which should be discussed publicly as regulators and industry participants move towards creating a reasonable regulatory regime.

Please feel free to include your comments below.

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Speech by SEC Commissioner:
Hedge Fund Regulation on the Horizon — Don’t Shoot the Messenger
by

Commissioner Luis A. Aguilar

U.S. Securities and Exchange Commission
Spring 2009 Hedgeworld Fund Services Conference
New York, New York

June 18, 2009

Thank you for that kind introduction. I am pleased to be here with you at the Spring 2009 Hedgeworld Fund Services Conference. This conference is timely given the current discussion regarding potential regulation of the hedge fund industry. Let me say at the outset, as is customary, my remarks today are my own and do not necessarily reflect the views of my fellow Commissioners or of the Commission staff.

My experience with the securities industry began in the late 1970’s. After three years with the SEC, I’ve spent the bulk of my 30 years as a lawyer focusing on the capital markets. Most of those years where in private practices in large law firms, although I spent most of the 90’s and the early part of this decade as General Counsel and Head of Compliance of a large global asset manager. While I’ve spent much of my professional career involved in capital formation though public and private offerings, a substantial portion has been spent working in the investment management industry, and I have worked with hedge funds.

As we all know, there has been much speculation about the impact of hedge fund activity on the broader capital markets. For example, there are questions about whether hedge funds may have contributed to the market turmoil and how hedge funds may have contributed to the demise of Bear Stearns, Lehman Brothers and others. Additionally, it is also not clear whether the lack of oversight of the industry resulted in large amounts of risk to the market through the use of short sales and derivatives, such as credit default swaps.

This year’s conference takes place at a key moment in the history of hedge funds. While hedge funds have remained largely unregulated, this seems to be coming to an end. All over the world, legislators, regulators, investor groups, industry representatives and others are loudly calling for the industry to be regulated.

In the United States, the calls for regulation are motivated by concerns that market integrity has been harmed and that systemic risk arose as a result of the exemptions and exclusions from the federal securities laws that permitted a private market to thrive in ways that may have harmed the public markets. In fact, the market turmoil clearly demonstrated that the private fund market does impact the broader capital markets. This does not mean that all fund activity must be equally regulated, but hedge funds, especially large ones, are thought to require greater regulatory oversight.

My goal with my remarks today is to:

  • First, lay out a current state of affairs regarding the hedge fund industry;
  • Second, describe the calls for regulation of the industry; and
  • Third, discuss key considerations that need to be assessed as hedge fund regulation moves forward.

Multiple Voices Calling For Regulation

The hedge fund industry looks very different today than from where it started. Since the first hedge fund was organized by Alfred Jones in 1949 with $100,000, the industry has exponentially grown both in number of funds and in number of assets under management. In recent years, this growth has been fueled in part by institutional investors, such as endowments, foundations, insurance companies, and pension plans. To give you an idea of the growth, it is believed that the industry managed around $38 billion in 1990, $625 billion in 2002, and reached $1.9 trillion at the end of 2007, although that the number decreased to $1.3 trillion at the end of 2008. It is still incredible growth from the $100,000 start.

The industry’s growth, and the concerns over the impact of hedge funds on the marketplace, has created a renewed call for regulation in the U.S. and abroad. For example, the European Commission recently proposed to regulate the managers of hedge funds and all private equity funds with 100 million euros in assets under management. The proposed regulations would require extensive disclosure of risk management procedures and other aspects of fund governance.

In the U. S., a few years ago the SEC unsuccessfully attempted to regulate hedge funds. More recently, in March of this year, Treasury Secretary Timothy Geithner testified about his plan to more tightly oversee hedge funds. In addition, there recently have been at least a half-dozen bills introduced in Congress requiring regulation of the hedge fund industry. Just this past Tuesday, Senator Jack Reed introduced a bill that would require that advisers to hedge funds, and to certain other investment pools, to register with the SEC. And yesterday, of course, the Obama Administration released a draft white paper that, among other things, proposes that advisers to large hedge funds register with the SEC, and that very large advisers be subject to additional federal supervision by the Federal Reserve Board.

What are the concerns underlying the call for government oversight? I will tell you what we are hearing. The concerns touch on the classic financial regulatory interests: such as market integrity concerns, systemic risk concerns, and investor protection concerns. This state of affairs is what you would expect when markets are inextricably integrated and the impact of hedge funds is significant, but their actions and their risks are opaque. Simply stated, regulators, legislators and the public have little credible information as to who is out there and what they are doing.

Market Integrity Concerns

Let’s start with the SEC’s responsibility to maintain fair and orderly markets. One of the concerns about hedge funds involves how hedge fund operations impact upon the fairness and the integrity of the broader market. The lack of transparency and oversight over hedge funds gives rise to a number of concerns — for example, market integrity concerns about the nature and extent of counterparty risk, concerns about whether hedge funds engage in insider trading, and questions about how hedge funds drive the demand for derivatives, such as CDSs, as well as how they impact the demand for securitized products.

As a predicate for discussion, let’s be clear about the significant market activity of hedge funds. For example, hedge funds reportedly account for more than 85% of the distressed debt market, and more than 80% of certain derivatives markets. Moreover, although hedge funds represent just 5% of all U.S. assets under management, they account for about 30% of all U.S. equity trading volume. In 2006, there were estimates that hedge funds were responsible for as much as half of the daily trading volume on the New York Stock Exchange.

Because hedge funds are not subject to leverage or diversification requirements, hedge fund managers can more easily take concentrated positions that can impact the market. For example, an entire fund or even multiple funds advised by the same hedge fund manager can be invested in a single position.

In addition, hedge funds are major players in the capital markets for reasons other than trading activity. As this audience knows well, hedge funds have significant business relationships with the largest regulated commercial and investment banks — and act as trading counterparties for a wide range of OTC derivatives and other financing transactions.

Counterparty Risk Concerns

Clearly, for all these reasons and others, hedge funds are significant players in the capital markets. As significant players, hedge funds are one source of counterparty risk, and this risk can be amplified by their leverage and opacity.

Today, commercial banks and prime brokers are called upon to bear and manage the credit and counterparty risks that hedge fund leverage creates. Up until now, it has been assumed that market discipline would effectively prevent hedge funds from detrimentally impacting the capital markets or from posing systemic risk. A January 2008 GAO Report, however, identified several concerns with that theory.[1] For example, the report noted that hedge funds use multiple prime brokers and questioned whether any single prime broker has a complete picture of a hedge fund client’s total leverage. Accordingly, the stress tests and other tools that a prime broker uses to monitor a given counterparty’s risk profile only incorporate the positions known to that particular prime broker. Thus, no single prime broker has the whole picture.

The GAO Report also stated that some counterparties may lack the capacity to assess risk exposures because of the complex financial instruments and secret investment strategies that some hedge funds use.

Unfortunately, the GAO Report also indicates that counterparties facing these structural limitations may have also actively relaxed credit standards in order to attract and retain hedge fund clients in response to fierce competition.

In each of these instances, the risks of hedge funds are being externalized to the regulated market — prime brokers, banks, and their shareholders each were asked to bear the costs of managing hedge fund risks. A concrete example you may remember was when two Bear Stearns-sponsored hedge funds collapsed in 2007. Merrill Lynch, one of the prime brokers, had to absorb an enormous loss because it could only sell the funds’ collateral for a fraction of its purported value.

It’s been obvious that the regulatory oversight of hedge funds has not matched their level of market activity. This difference has led to other concerns affecting market integrity.

Risks of Insider Trading Create Market Wide Concerns

For example, in addition to concerns about counterparty risk, there have also been concerns about hedge funds engaging in insider trading. Clearly, there has been an increase in the number of insider trading cases brought by the Commission that have involved hedge funds. Admittedly, it is incredibly difficult for the Commission to assess the frequency of insider trading because of the opacity of hedge funds and the investments they make, especially in OTC derivatives. Moreover, when you couple this with the fragmented nature of the securities markets and the broad potential for hedge funds to obtain inside information, it is a tough oversight situation indeed. Hedge funds who participate in private placements, talk with trading desks, and maintain connections with the street are, in many cases, in a position to obtain inside information and to use it in a way that traditional surveillance may not detect. This potential for insider trading has been well publicized and public investors are concerned about the possible effects on market fairness and integrity.

Hedge Funds And The Demand For CDS and Securitized Products

Additionally, hedge funds were significant players in the exponential growth in the now much maligned credit default swaps market. As the market to create CDSs grew, there were funds that bought these instruments for reasons that made sense. For example, in 2005 there were hedge funds who noticed that the U.S. housing market was weakening and they bought CDS instruments on the protection buyer side. A logical move.

On the other hand, it is well known that the credit risk reflected by CDSs is equal to multiples of the actual credit risk of the underlying bond market. How did that happen? Many CDSs were heralded as hedging tools — they were supposed to transfer risk to parties that could bear it from parties that could not. Now we see only too clearly that this was not the case. Instead, many CDSs actually created risk, rather than hedged risk. Hedge funds that sought to create profits from leveraged risk may have played a crucial role driving the growth in these products.

Systemic Risks

The concerns about hedge funds and market integrity often go hand in hand with concerns about systemic risk. In their current form, hedge funds pose a systemic risk threat to our financial system in several ways. First, hedge funds have such significant assets under management that some fear that the loss of one or more large firms could potentially reverberate throughout the capital markets. In addition, if a counterparty fails to effectively withstand a hedge fund loss, then the failure of the counterparty could itself threaten market stability.

There is also the issue that can occur when several hedge funds take the same position, whether through coordination or simply through similar trading strategies. These funds can have a large impact on the market when they adjust their positions en masse.

Thus, the concerns that the lack of oversight over the hedge fund industry may present to market integrity and to systemic risks seem to be well founded.

Investor Protection

In addition to concerns about market integrity, the SEC is also responsible for investor protection. Given the increase in complaints from hedge fund investors this has taken on a more immediate importance.

One of the underlying principles behind the idea that hedge funds could operate with little to no regulatory requirements was that interests in the funds were only sold in private offerings to wealthy investors. These investors were thought to be sufficiently “sophisticated” to protect their interests, and to be able to engage in effective arms-length negotiation in order to achieve fair and equitable terms.

I firmly believe that truly sophisticated investors in private deals should be held accountable to the terms that they knowingly negotiate — and if an investment were to go bad, they should bear the loss.

However, with the recent market turmoil and the ongoing economic upheaval that has caused trillions in wealth to vanish, millions of jobs to disappear and the liquidation of over 1,500 hedge funds, serious concerns have been raised about whether these wealthy and sophisticated investors are truly able to protect their interests. There seems to be evidence that these “sophisticated investors” may not have fully appreciated the risks they were taking. Perhaps it may make sense for the definitions of who qualifies as “sophisticated” under our rules to be reconsidered. For example, maybe the criteria for sophistication should focus on more relevant attributes — such as focusing on actual investment experience.

In any case, recent events have challenged the assumption that investors and market discipline can be relied upon to control the risks of hedge funds. And this is not surprising. First, these investors are typically passive and there is no legal obligation for hedge fund investors to monitor hedge fund activity. Second, even if investors wanted to actively monitor the investment, the nature of hedge fund activity and the information available may not currently support such a role.

Valuation and Performance

For example, it may be impossible for an investor to know the actual value of a hedge fund’s portfolio. Hedge funds are not subject to reporting requirements and because many instruments held by a hedge fund are illiquid or opaquely-priced OTC products, any information that is reported could be hard to evaluate.

Related to the concern of how a fund values its assets, is a hedge fund’s performance information — another hard to evaluate metric for investors. Without regulation, the only performance information that hedge funds provide is voluntary.

This quote by Harry Liem, a pension consultant, seems to sum it up when he said “It’s like someone walking into a casino and saying ‘I want everyone to come forward and tell me how much you have won or lost.’ Probably only the winners will come forward . . .”[2]

Not Being Able to Redeem

There is also the issue of investors not being able to redeem their investments from a fund. In recent times, due to the large amount of redemption requests and the current lack of an ability to raise cash, there are hedge fund managers who have put up gates and have restricted investors’ ability to redeem their monies. Although gates can benefit investors by giving the manager more time to sell off portfolio positions, for some investors it appeared to be a surprise.

On top of that, several hedge fund managers froze funds but continued to charge management fees on money that investors cannot access. Orin Kramer, a hedge fund manager, described the situation by stating: “It’s like telling someone at a hotel that they can’t check out and then charging them for the privilege of staying.”[3]

Let me be clear. I’m not saying that these situations are per se illegal. To the extent that sophisticated and qualified investors agreed to provisions providing for gates and the ongoing charge of management fees, one could say that investors walked into these agreements with open eyes.

However, because for the most part hedge funds are not registered with the SEC, we are not able to adequately oversee how they are operating. Moreover, this lack of transparency makes it difficult to assess whether the relationship between an investor and the hedge funds adviser, is functioning in the manner that underlie the presumptions that led to the exemptions.

Some recent reports do tend to show that investors are beginning to take their own initiatives, and give some indication that what investors may be willing to agree to in the future may be different. For example, a recent memo from CalPERS stated that it would no longer partner with managers whose fee structures result in a clear misalignment of interest between managers and investors. Moreover, more investors are now asking that hedge funds run assets in “managed accounts,” where their money is held separately and the holdings are transparent.

As you may expect based on concerns including ones I have mentioned, hedge fund investors have been calling the Commission in unprecedented numbers

Increased Cases Involving Hedge Funds

In fact, the Commission has more investigations involving hedge funds than ever before, and the number of cases actually brought also is increasing. In the first 4 months of 2009, the Commission filed 25 cases related to hedge funds. In contrast, we brought 19 cases in all of 2008, 24 in all of 2007, and 16 in 2006. Our cases cover the waterfront, charging everything from offering fraud and insider trading, to misrepresentations about performance and to misrepresentations about the actual due diligence undertaken. We are also seeing more cases involving conflicts of interest and outright theft of assets

Nature of Regulation

I have just laid out for you some of the concerns that are generally driving the calls for greater regulation and oversight of the hedge fund industry. Maybe even more important, it appears that some of the assumptions justifying the industry’s exclusion from regulation and oversight may be on faulty ground. As a result, it seems certain that regulation of the hedge fund industry is coming. But here is the harder question — what should it look like?

There are a number of questions as to exactly how, and to what extent, hedge funds may have contributed to the economic crisis and how they contributed to the overall systemic risk of the financial markets. To that end, I applaud Congress and President Obama for providing for an independent, bi-partisan Financial Crisis Inquiry Commission. By investigating and analyzing what happened, we can better assess whether the regulatory proposals should move forward.

Since coming to the Commission, I have been a vocal advocate for the Commission’s mission to protect investors, provide for fair and orderly markets, and promote capital formation. All aspects of this mission guide my thoughts as we consider the appropriate framework to regulate hedge funds.

Because of the size, complexity and market-wide impact of the hedge funds industry, potential regulation would need to be both comprehensive and flexible. Something not always easy to achieve.

I believe that the SEC must be an active participant in this process. Please remember that the SEC has been overseeing industry participants — such as, investment companies, investment advisers and broker-dealers — for over 69 years. The Commission staff has unsurpassed expertise in this area. Congress should take advantage of this expertise by providing the Commission with a broad mandate to oversee hedge funds. The Commission could then scale its regulation in a flexible manner to deal with the regulatory concerns of market integrity, investor protection, and, in coordination with other regulators, systemic risk.

Working with hedge fund advisers and with hedge fund investors, I am confident that we can find an appropriate balance.

As you know, there has been a general discussion over whether hedge fund advisers and/or hedge funds should register. In my mind, hedge funds advisers with over $25 million in assets should register with the Commission, but that may not be enough. Many hedge fund advisers are currently registered with the SEC but we still lack a complete picture of what is going on in the industry. Some have suggested that hedge funds should also register. Others have suggested that it may be appropriate to apply limited concepts from within the Investment Company Act of 1940 to hedge funds — what some have called a “40 Act-lite” regime.

Perhaps a tiered approach to registration, based on a fund’s potential to affect the market, would make sense. At the lowest tier would be small funds. These funds could be subject to a simple recordkeeping requirement as to positions and transactions, kept in a standardized format, to permit the SEC to efficiently oversee their activities. As funds grow in size, different standards may be appropriate.

For funds that could significantly affect the market, it may be appropriate to require more than recordkeeping. For example, it may be appropriate to think through whether some of the risk limitation concepts built into the Investment Company Act make sense to apply to these hedge funds — such as imposing limits on leverage.

Of course, these are only a few suggestions. Many others have been made — and others will follow — as the discussion turns from “whether to regulate” to “how to regulate.” The nature of the business of hedge funds is trading, and this necessarily requires interaction with the public marketplace — and the larger the investment fund, the greater the potential impact on the overall capital markets. When the hedge industry has the ability to significantly impact the market or other market participants, the public interest needs to be protected. A lesson of this economic crisis is that the U.S. regulatory interest in hedge funds arises because of the impact of the funds on the financial market, regardless of the sophistication of its investors or the number of investors.

When discussing “how to regulate,” it is clear to me that regulation is more than the bare requirements of registering and reporting — it should also include inspection authority. To have a chance to prevent problems before they occur, the SEC has to be able to inspect all hedge fund advisers, and the funds that they manage, and otherwise engage in oversight through surveillance systems. The public expects nothing less.

Greater Resources to SEC to Provide Effective Oversight

As we talk about regulation of the hedge fund industry, there is also the question of regulatory resources. Any future registration of hedge fund advisers and/or hedge funds will require that the SEC receive increased resources to provide effective oversight. We will need to hire staff and implementing new technology to effectively deal with a large and complex industry. To that end, I have previously called for Congress to pass legislation establishing the SEC as a self-funded agency, similar to the way other financial regulators are funded — such as the Federal Reserve Bank, the FDIC, OTS and OCC. This would help to solve the problem.

To the extent that funds are registering and reporting to the SEC, I encourage Congress to couple the authority increasing the SEC’s jurisdiction with the appropriate self-funding mechanism to allow us to provide effective oversight.

Conclusion

In conclusion, I am confident that regulation of the hedge fund industry can be done right — in a way that balances the needs of the industry with the needs of investors and the needs of the market. And if it is, it will be a good thing for all of us. The Congressional Oversight Panel’s Special Report on Regulatory Reform4 said it best with the following summary:

“By limiting the opportunities for deception and allowing for the necessary trust to develop between interconnected parties, regulation can enhance the vitality of the markets. Historically, new regulation has served that role.
For example, as the money manager Martin Whitman has observed, far from stifling the markets, the new regulations of the Investment Company Act enabled the targeted industry to flourish:

“’Without strict regulation, I doubt that our industry could have grown as it has grown, and also be as prosperous as it is for money managers. Because of the existence of strict regulation, the outside investor knows that money managers can be trusted. Without that trust, the industry likely would not have grown the way it had grown.’”[5]

The lack of transparency, potential imbalance of power between investors and managers, and impact on the entire capital market are driving the calls to regulate the hedge fund industry. The hedge fund industry has a lot to offer in determining how these calls are answered. Addressing these issues in an intelligent and rational manner is important, and ultimately will result in a stronger and more vibrant hedge fund industry. I welcome the ongoing discussion.

Thank you for inviting me here today.

Endnotes

[1] GAO Report: Regulators and Market Participants Are Taking Steps to Strengthen Market Discipline, but Continued Attention is Needed. January 2008. pg 27.

[2] Why people love to hate those risky hedge funds; An investment option that only the super rich can afford, by Naomi Rovnick. South China Morning Post Ltd. March 1, 2009.

[3] Hedge Funds, Unhinged by Louise Story. New York Times. January 18, 2009.

[4] Congressional Oversight Panel’s Special Report on Regulatory Reform: Modernizing the American Financial Regulatory System: Recommendations for Improving Oversight, Protecting Consumers, and Ensuring Stability. January 2009. pgs 18-19

[5] Letter from Third Avenue Funds Chairman of the Board Martin J. Whitman to Sharheolders, at 6 (Oct. 31, 2005) (online at www.thirdavenuefunds.com/ta/documents/sl/shareholderletters-05Q4.pdf).

http://www.sec.gov/news/speech/2009/spch061809laa.htm

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Please contact us if you have any questions or would like to  learn how to start a hedge fund.  Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website.  Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund.  If you are a hedge fund manager who is looking to start a hedge fund, please call Mr. Mallon directly at 415-296-8510.

Form U4 and Form U5 | Information About the Uniform Registration Forms for Broker-Dealers and Investment Advisors

Purpose of the Forms and Discussion of Recently Approved Changes & Requirements

The Financial Industry Regulatory Authority (FINRA), is the largest independent regulator for all securities firms doing business in the United States, and is the entity designated as the filing depository by the U.S. Securities and Exchange Commission for purposes of the Investment Advisers Act of 1940.  There are currently six different Uniform Registration Forms that are used to file information with FINRA. The Form U4 (Uniform Application for Broker-Dealer Registration) and the Form U5 (Uniform Termination Notice for Security Industry Registration) are used by broker-dealers to register, and terminate the registrations of, associated persons with self-regulatory organizations (SROs), and jurisdictions.

Representatives of broker-dealers and investment advisers use Form U4 to register with the states and with self-regulatory organizations (e.g., FINRA). Forms are filed electronically by their employing firms using the Central Registration Depository (Web CRD or IARD). Broker-dealer agents and investment adviser representatives have an obligation to update previously filed Forms U4 with any new information required to be disclosed. FINRA makes information filed on Form U4 publicly available through its BrokerCheck program.

Broker-dealers and investment advisers use Form U5 to terminate a representative’s registration in a particular jurisdiction or with a particular self-regulatory organization. Firms terminating the registration of an associated person must respond to a series of disclosure questions. Firms also have the obligation to update previously filed Forms U5 if they become aware of new disclosure information.

As discussed above, Form U4 and Form U5 filings (initial applications. termination notices, and amendments) will generally be made electronically through Web CRD or IARD. However, some individuals may need to file the form on paper, including: agents of issuers, certain persons filing with stock exchanges, and certain investment adviser representatives. In addition, NASD Rule 1013 requires the submission of certain paper Forms U4 along with an initial membership application.

The SEC recently approved amendments to Forms U4 and U5 that were proposed by FINRA that call for significant changes to disclosure questions on the Forms, including the addition of questions about certain regulatory actions. The new  amendments to the Forms include:

  • New regulatory action questions that will enable FINRA and other regulators to identify more readily persons subject to a particular category of “statutory disqualification” under the federal securities laws and the FINRA By-Laws. Among the items that would cause a person to become subject to a statutory disqualification are “willful” violations of the federal securities laws, the Commodity Exchange Act, or the rules of the Municipal Securities Rulemaking Board. Under the proposed rule changes, both Forms U4 and U5 would be amended to add questions requiring disclosure of findings of “willful” violations.
  • New questions that require firms to report allegations of sales practice violations made against a registered person in an arbitration or litigation in which the registered person is not a named party. Under the new amendment, reporting would be required if the registered person was either named in or could reasonably be identified from the body of the arbitration claim or civil litigation as a registered person who was involved in one or more of the alleged sales practice violations.
  • An increase in the monetary threshold for reporting settlements of customer complaints, arbitrations or litigation from $10,000 to $15,000.
  • The clarification that the date to be provided by a firm in the “date of termination” field is the “date the firm terminated the individual’s association with the firm in a capacity for which registration is required.” Under the new amendment, a firm would be permitted to change the date of and reason for termination, but would be required to state a reason for the change.

The revised Forms were implemented in Web CRD on May 18, 2009. The effective date for most of these changes  is May 18, 2009 (the “release date”). The effective date for the new regulatory action disclosure questions will be 180 days from the release date, or November 14, 2009.

Key Items Regarding the Forms Changes:

Invalidation of Pending Form Filings Upon Web CRD System Shutdown:

  • Implementation of the revised “form versions” will cause all pending (in-process) Form U4 and U5 filings that are not submitted to Web CRD prior to system shutdown on Friday, May 15, 2009, to become invalidated (i.e., converted to a read-only mode). Firm users that still need to submit the information on those invalidated filings will need to recreate the filings using the new forms.

Form U4 Amendments Required:

  • All registered persons are required to answer new regulatory action disclosure summary questions the next time they file a Form U4 amendment or no later than 180 days following the release date.

Copies of the revised Forms and instructions are available here.

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Please contact us if you have any questions or would like to start a hedge fund.  Other related hedge fund law articles include:

Hedge Fund Fraud Discussion

With all of the talk lately of new hedge fund regulations proposed by Obama and the likelihood of investment adviser registration for hedge fund managers, the focus has remained squarely on how to avoid hedge fund fraud situations and another Madoff.  The following post is from the blog by Rick Bookstaber who is a very well decorated author within the investment management industry.  Please feel free to leave your comments on this post below.

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The 7 Habits of Highly Suspicious Funds

Note: This post will appear in The Journal of Investment Management

You’ve heard this story before: A trader at a bank is knocking the cover off the ball. His success garners political power within the bank. He creates a fiefdom that insulates him from the rest of the firm; his trading group explodes in size. He lives a conspicuous, extravagant lifestyle. His ego alienates the management and intimidates the support staff. Then the trader hits a rough patch. He uses all the tricks in the book to keep his poor results under wraps while he tries to find a way to recoup. Everyone is gunning for him, so he has to get back into the black, and fast.

How does he try to do that? He ratchets up his risk. He knows he won’t be able to turn it around fast enough if he plays it prudently, whereas there is some chance to stay in the game if he bets it all on 00, or better yet, if he levers up as much as he can, borrows all the money he can get his hands on, and then bets all of that on 00. If he loses, well, he was going to be gone anyway, so he may as well try for the big time.

That is one of the reasons there are risk managers. Risk managers know to put extra focus on traders who are struggling and, for that matter, on traders who seem to have an eerily hot hand. Especially if those traders have the ability to lever and to obscure their risk through the use of sophisticated instruments.

This story is now primed to play out in the hedge fund space. How many hedge funds do you know that more or less fit this description: A hedge fund manager had a run of great returns. His fund has grown by leaps and bounds. He has doubled his staff year after year in anticipation of even greater things to come. He has enjoyed a Page Six lifestyle; he is the belle of the ball, his dance card always filled. But now his kingdom is under siege. Assets under management have dropped precipitously due to redemptions layered on top of poor trading results. The investors that remain are demanding reductions in management fees. Incentive fees are gone until he scales the wall to get back to high water mark. With the way his operation has ballooned, he realizes that if he doesn’t make serious returns over the next few years, he will be crushed under the costs and the dwindling asset base.

What does he do? If he follows the same course as the trader at the bank, he will try to find ways to take on more risk. Of course, any investment fund might face the same temptation, but hedge funds have more tools at their disposal to make good on the try. Hedge funds can lever, delve into wide-ranging and risky markets and readily employ the so-called innovative securities to increase risk in ways that are difficult to discern. And unlike the trader at the bank, the hedge fund can operate without anyone seeing what it is doing. No one is looking over its shoulder at the trading positions each night.

Is the risk management in place to deal with this scenario? Here are seven “habits” that an investor should look out for:

1. No independent risk reporting.

One lesson that has been driven home from Madoff is not to trust the numbers coming out of any fund. Or, at least, trust but verify. If things go wrong and that is what you relied on, you will look like a fool, or worse. The risk numbers must come from having a third party getting the fund’s positions and doing the analysis.

The risk reporting must go beyond the VaR numbers to include measures of leverage, concentration, degree of diversification and size in markets (to assess liquidity risk). Again, all independently provided.

The diversification and concentration are necessary because, as we now know all too well, the relationships between markets can change. These risk measures cannot be calculated simply by knowing how many markets the fund is trading. It is critical to know how linked the markets are; how concentrated positions are when aggregated across similar markets. With globalization, diversification opportunities aren’t what they used to be. And in any case, it isn’t much value to be active in twenty markets if two-thirds of the positions are in three or four markets that are closely related.

2. A change for the worse in the critical risk numbers.

When you get independent reporting, don’t stop with looking at these numbers as they stand today. Demand to know what they have been over the past years. Have the risk statistics changed for the worse? Have they been different than what was represented by the fund’s own, internally generated reports? For example, is the third-party view of leverage, liquidity or diversification as favorable as has been represented by the fund itself, both now and historically?

3. Increased use of derivatives.

In my recent Senate testimony, I said that derivatives are the weapon of choice for gaming the system. Among other things, derivatives can be used to hide increases in leverage. Their complexity and difficulty in marking means that they also can more easily hide losses. There should be extra concern if the fund has only recently decided to start using derivatives and swaps.

4. High level of secrecy.

Does the fund have a monolithic, scripted presence to outside investors? Does it obscure its approach with secret formulas and strategies? Does it invoke its need for secrecy to justify limiting access to essential risk information and to its production staff? If so, you might want to get ready for a Madoff moment.

5. Growth in headcount and lifestyle.

This is the firm’s equivalent of the trader’s lifestyle. The fund’s principles can stretch the envelope in terms of personal lifestyle, and, unlike their banker cousins, their firm is their own domain. They can get an “edifice complex”. If a firm has become bloated, if it has a growing cost base that forces it to be impatient, then it will be more desperate to swing for the fences.

6. Decline in assets under management.

This speaks to motive. The more assets have declined – or are projected to decline with expected redemptions – the greater the stress for the fund, and the more tempting to ratchet up the risk.

Related to this, is the fund far below high water mark? Hedge funds make money from fixed management fees based on assets under management and incentive fees based on the return they generate for their clients. Most hedge funds only start collecting the incentive fees after they get back to high water mark. If a hedge fund is thirty percent below high water market, it may need years of strong returns before any money starts ringing up in the incentive fee register.

7. Lackluster performance in recent years.

Most everyone was lackluster this past year. So you should look back at the recent performance before the 2008 debacle. A comparison of the performance over the past three to five years versus the performance in the more distant past can be an indicator of a failure of the fund’s inherent strategy. It could be that the space has become too crowded and competitive, that the fund has become too large to take advantage of inefficiencies, or that the inefficiencies the fund has focused on have closed down. This creates a pressure to reach. If things have been slowly petering out, if alpha has been diminishing, then more leverage and risk is needed to get back up to the target.

Or, in desperation, the fund might try something new. So a related phenomenon will be style drift or a move into new markets and strategies. Style drift can be an indication that the bread and butter strategy is not pulling its weight. Is there movement toward new markets, a.k.a. ‘new opportunities’. Is an equity fund hiring expertise to gear up in credit, is a macro fund starting to trade volatility?

Not everyone standing in the shadows is a mugger. And sometimes a cigar is just a cigar. Although “habits” like a lack of independent reporting are pretty obvious weaknesses, others, such as exploring new trading strategies, might be justifiable. But these are warning signs that justify deeper questioning and tighter oversight.

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Please contact us if you have any questions on the above article.  Other related hedge fund law blog articles include:

Private Fund Transparency Act of 2009 Text of Statute

Text of New Hedge Fund Registration Bill

Earlier we posted a press release about the Private Fund Transparency Act and that it would subject hedge fund managers to registration with the SEC.  Below is the actual text of the statute.

We will be bringing an in depth analysis of changes and consequences of this bill in the next couple of days.

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Private Fund Transparency Act of 2009 (Introduced in Senate)

S 1276 IS

111th CONGRESS

1st Session

S. 1276

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

IN THE SENATE OF THE UNITED STATES

June 16, 2009

Mr. REED introduced the following bill; which was read twice and referred to the Committee on Banking, Housing, and Urban Affairs

A BILL

To require investment advisers to private funds, including hedge funds, private equity funds, venture capital funds, and others to register with the Securities and Exchange Commission, and for other purposes.

Be it enacted by the Senate and House of Representatives of the United States of America in Congress assembled,

SECTION 1. SHORT TITLE.

This Act may be cited as the `Private Fund Transparency Act of 2009′.

SEC. 2. DEFINITION OF FOREIGN PRIVATE ADVISERS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

`(29) The term `foreign private adviser’ means any investment adviser who–

`(A) has no place of business in the United States;

`(B) during the preceding 12 months has had–

`(i) fewer than 15 clients in the United States; and

`(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

`(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’.

SEC. 3. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS.

Section 203(b)(3) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)(3)) is amended to read as follows:

`(3) any investment adviser that is a foreign private adviser;’.

SEC. 4. COLLECTION OF SYSTEMIC RISK DATA; ANNUAL AND OTHER REPORTS.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended–

(1) in subsection (a), by adding at the end the following: `The Commission is authorized to require any investment adviser registered under this title to maintain such records and submit such reports as are necessary or appropriate in the public interest for the supervision of systemic risk by any Federal department or agency, and to provide or make available to such department or agency those reports or records or the information contained therein. The records of any company that, but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940, would be an investment company, to which any such investment adviser provides investment advice, shall be deemed to be the records of the investment adviser if such company is sponsored by the investment adviser or any affiliated person of the investment adviser or the investment adviser or any affiliated person of the investment adviser acts as underwriter, distributor, placement agent, finder, or in a similar capacity for such company.’; and

(2) adding at the end the following:

`(d) Confidentiality of Reports- Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (a). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.’.

SEC. 5. ELIMINATION OF PROVISION.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 6. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended–

(1) by striking the second sentence; and

(2) by striking the period at the end of the first sentence and inserting the following: `, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may–

`(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

`(2) ascribe different meanings to terms (including the term `client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.’.

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Other related articles:

Form U4 and Form U5 Amendments

NASAA Requests Comments on Proposed Changes

Form U4 is the form used by Investment Advisory firms to register investment advisor representatives with their firm.  It is also used by broker-dealers to register reps with their firms.  Form U5 is used by both IA and BD firms to terminate a representative’s employment with such firm.  While I have not reviewed the changes to the forms in depth, the summary discussion (reprinted below) sounds reasonable.  We may be submitting comments on these proposals in the future as we discuss with other industry participant – please let us know if you have strong thoughts one way or another on the proposed changes.

The press release and discussion are both reprinted below.  For more information, please visit the NASAA site here.   Please also review our recommended articles at the very bottom of this page.

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Notice for Request for Comment on Amendments to Forms U4 and U5 and Proposed Guidance for Filings by Investment Adviser Representatives

The NASAA CRD/IARD Steering Committee and the CRD/IARD Forms and Process Committee have worked with FINRA, regulators, and representatives of the financial services industry in developing amendments to the Form U4 and Form U5.

The proposed changes have been published by both FINRA and the SEC for public comment.  On May 13, 2009, the SEC approved the proposed changes. NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this notice includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

The comment period begins June 9, 2009, and will remain open for 14 days. Accordingly, all comments should be submitted on or before June 23, 2009.

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NOTICE FOR REQUEST FOR COMMENT ON AMENDMENTS TO THE UNIFORM APPLICATION FOR SECURITIES INDUSTRY REGISTRATION OR TRANSFER (FORM U4), THE UNIFORM TERMINATION NOTICE FOR SECURITIES INDUSTRY REGISTRATION (FORM U5), AND PROPOSED GUIDANCE FOR FILINGS BY INVESTMENT ADVISER REPRESENTATIVES.

The NASAA CRD/IARD Steering Committee and the CRD/IARD Forms and Process Committee have worked with FINRA, regulators, and representatives of the financial services industry in developing amendments to the Form U4 and Form U5.  The proposed changes have been published by both FINRA and the SEC for public comment.  On May 13, 2009, the SEC approved the proposed changes.  NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this memo includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

Questions or comments regarding the revised forms should be directed to the following individuals:
Melanie Lubin
Office of the Attorney General
Division of Securities
200 Saint Paul Place
Baltimore, Maryland 21202-2020
(410) 576-6360
mlubin@oag.state.md.us

Pam Epting
Office of Financial Regulation
200 East Gaines Street
Tallahassee, Florida 32399-0372
(850) 410-9819
pam.epting@fldfs.com

Joseph Brady
NASAA
750 First Street, NE
Suite 1140
Washington, DC 20002
202-737-0900
jb@nasaa.org

The comment period begins June 9, 2009, and will remain open for fourteen (14) days.  Accordingly, all comments should be submitted to the individuals noted above on or before June 23, 2009.

Summary of Proposed Changes to Registration Forms

The SEC recently approved amendments for Forms U4 and U5 (“the Forms”).  These changes fall into the following categories.

  1. Willful Violations.  Additional questions have been added to Form U4 in order to enable regulators to identify more readily individuals and firms subject to a particular category of statutory disqualification pursuant to Section 15(b)(4)(D) of the Exchange Act.
  2. Revision to Arbitration and Civil Litigation Question.  Changes were made to the text of the question on the Form U4 regarding disclosure of arbitrations or civil litigation to elicit reporting of allegations of sales practice violations made against a registered person in arbitration or litigation in which that person was not named as a party to the arbitration or litigation.
  3. Revision to Monetary Threshold.  The monetary threshold for reporting settlements of customer complaints, arbitrations or civil litigation on the Forms has been raised from $10,000 to $15,000.
  4. Date and Reason for Termination.  The definition of “Date of Termination” in the Form U5 has been revised in order to enable firms to amend the “Date of Termination” and the “Reason for Termination” subject to certain conditions.
  5. Technical Amendments.  Certain technical and clarifying changes were made to the Forms.

The SEC approved these amendments effective May 18, 2009, except the new disclosure questions regarding willful violations, which become effective 180 days later on November 14, 2009.  Firms will be required to amend Form U4 to respond to the new disclosure questions the first time they file Form U4 amendments for registered persons after May 18, 2009, at which time they may provide provisional “no” answers.  However, firms must provide final answers to the questions no later than November 14, 2009.

Revisions Regarding Willful Violations.

The amendments modify the Forms to enable regulators to query the CRD system to identify persons who are subject to disqualification as a result of a finding of a willful violation.  Specifically, the amendments add additional questions to existing Questions 14C and 14E on Form U4.  Question 14C, which inquires about SEC and Commodity Futures Trading Commission (CFTC) regulatory actions, adds three new questions regarding willful violations.  Similarly, Question 14E, which concerns findings by a self-regulatory organization, adds three identical questions.  The Form U4 Regulatory Action Disclosure Reporting Page (DRP) will continue to elicit specific information regarding the status of the events reported in response to these questions.

Adding new disclosure questions to Form U4 requires firms to amend such forms for all their registered persons. To ensure that firms have appropriate time to populate the forms accurately, the SEC delayed the effective date for the new regulatory action disclosure questions for 180 days until November 14, 2009. This schedule will provide firms with up to 180 days from the release date to answer the regulatory action disclosure questions.  Additionally firms, at their discretion, can file provisional “no” answers to the six new regulatory action questions during the 180-day period between the release date and the effective date.  During this time, the regulatory action disclosure questions will appear in the CRD system in a manner designed to indicate that such questions are not effective until 180 days from the release date and that any answers provided in response to such questions are provisional until such time as those questions become effective.  Any “no” answers filed in response to the new regulatory action disclosure questions during such 180-day period that are not amended before November 14, 2009, will become final, and the firm and subject registered person will be deemed to have represented that the person has not been the subject of any finding addressed by the question(s).  If a firm determines that a registered person must answer “yes” to any part of Form U4 Questions 14C or 14E, the amendment filings must include completed DRP(s) covering the proceedings or action reported.

With respect to Form U5, the amendments did not alter Question 7D (Regulatory Action Disclosure), but added new Question 12C to the Form U5 Regulatory Action DRP. As of May 18, 2009, firms that answer “yes” to Question 7D on Form U5 will be required to provide more detailed information about the regulatory action in Question 12C of the DRP.  For regulatory actions in which the SEC, CFTC or an SRO is the regulator involved, Question 12C requires firms to answer questions eliciting whether the action involves a willful violation. These questions correspond to the questions added to the Form U4.  A firm will not be required to amend Form U5 to answer Question 12C on the DRP and/or add information to a Form U5 Regulatory Action DRP that was filed previously unless it is updating a regulatory action that it reported as pending on the current DRP.

Revisions to the Arbitration and Civil Litigation Disclosure Question.

The Forms have been revised to require the reporting of allegations of sales practices violations made against registered persons in a civil lawsuit or arbitration in which the registered person is not a named party.  Specifically, Question 14I on Form U4 and Question 7E on Form U5 were amended to require the reporting of alleged sales practice violations made by a customer against persons identified in the body of a civil litigation complaint or an arbitration claim, even when those persons are not named as parties. The new questions apply only to arbitration claims or civil litigation filed on or after May 18, 2009. A firm is required to report a “yes” answer only after it has made a good-faith determination after a reasonable investigation that the alleged sales practice violation(s) involved the registered person.

Revisions to the Monetary Threshold.

The current monetary threshold for settlements of customer complaints, arbitrations or litigation was set in 1998 and has not been adjusted since that time.  The changes to the Forms include raising the existing reporting threshold from $10,000 to $15,000 to reflect more accurately the business criteria (including the cost of litigation) firms consider when deciding to settle claims. This change is reflected in Question 14I on Form U4 and Question 7E on Form U5.

Revisions Regarding “Date of Termination” and “Reason for Termination.”

Revisions to Form U5 provide that the date to be provided by a firm in the “Date of Termination” field is the “date that the firm terminated the individual’s association with the firm in a capacity for which registration is required.”  The amendments further clarify that, in the case of full terminations, the “Date of Termination” provided by the firm will continue to be used by regulators to determine whether an individual is required to requalify by examination or obtain an appropriate waiver upon reassociating with a firm.  Revisions to Form U5 also clarify that the relevant SRO or jurisdiction determines the effective date of termination of registration. The rule change also permits a firm, as of May 18, 2009, to amend the “Date of Termination” and “Reason for Termination” fields in a Form U5 it previously submitted, but in such cases it requires the firm to provide a reason for each amendment. To monitor such amendments, including those reporting terminations for cause, FINRA will notify other regulators and the broker-dealer with which the registered person is currently associated (if the person is associated with another firm) when a date of termination or reason for termination has been amended. The original date of termination or reason for termination will remain in the CRD system in form filing history.

Technical Revisions.

The Forms were amended to make various clarifying, technical and conforming changes generally intended to clarify the information elicited by regulators and to facilitate reporting by firms and regulators. For example, the amendments eliminated as unnecessary certain cross-references in the Forms.  Additionally, certain “free text” fields were converted to discrete fields.  The amendments also add to Section 7 of Form U5 (Disclosure Questions) an optional “Disclosure Certification Checkbox” that will enable firms to affirmatively represent that all required disclosure for a terminated person has been reported and the record is current at the time of termination. Checking this box will allow the firm to bypass the process of re-reviewing a person’s entire disclosure history for purposes of filing Form U5 in situations in which disclosure is up to date at the time of the person’s termination.  The amendments make additional technical changes to the Forms. For example, they incorporate the definition of “found” from the Form U4 Instructions into the Form U5 instructions; provide more detailed instructions regarding the reporting of an internal review (conducted by the firm); and clarify how an individual may file comments to an Internal Review DRP.

Guidance Regarding U4 Filings for Investment Adviser Representatives.

As explained above, the questions added to items 14C and 14E have been approved by the SEC but the effectiveness of the questions has been delayed until November 14, 2009.  The questions currently appear on the form in a manner designed to indicate that they are not currently effective.  Further, the answers to the questions currently default to “no” and will continue to do so until they become effective later this year unless a filer manually selects a “yes” answer.  The delayed effective date coupled with the default “no” answer is a temporary accommodation in order to give filers an opportunity to determine the appropriate answers to the new questions.

The CRD/IARD Steering Committee has received inquiries regarding how investment adviser representatives should respond to these questions.  It is the Steering Committee’s recommendation that state and territorial securities regulators handle the filings for investment adviser representatives in the same manner as broker-dealer agents who file on or after May 18, 2009.  That is, investment adviser representatives should be allowed to file provisional responses to the questions contained in 14C and 14E on the Form U4 until such time as the questions become effective on November 14, 2009.

Forms.

Copies of the revisions as approved by the SEC are attached.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

NASAA Takes Sides on Proposed Hedge Fund Legislation

Endorses House Bill Over the Grassley-Levin Hedge Fund Bill

Last week the North American Securities Administrators Association (NASAA) announced its support of the Hedge Fund Adviser Registration Act of 2009, a house bill introduced earlier this year by Representatives Capuano and Castle.  The Hedge Fund Adviser Registration Act is one of two bills introduced in Congress which would effectively require many unregistered hedge fund managers to register with the SEC.  The other bill, the Hedge Fund Transparency Act, was introduced into the Senate by Senators Grassley and Levin.  While the Adviser Registration Act would close what some are calling a loophole in the Investment Advisers Act of 1940, the Transparency Act would create a whole new regime for regulating hedge fund entities (as opposed to the management company).  The Transparency Act also came under fire earlier this year for being poorly drafted.

The NASAA support was announced in the release we have reprinted below.  If you have any questions on this issue, please feel free to contact us.  Related hedge fund registration articles include:

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May 28, 2009

NASAA Supports the Hedge Fund Adviser Registration Act of 2009 (H.R. 711)

Legislation Would Require Hedge Fund Advisers to Register with SEC

WASHINGTON (May 28, 2009) – The North America Securities Administrators Association (NASAA) today endorsed proposed bipartisan legislation that would require hedge fund advisers to register with the Securities and Exchange Commission under the Investment Advisers Act of 1940.

The Hedge Fund Adviser Registration Act of 2009 (H.R. 711), sponsored by Reps. Michael E. Capuano (D-MA) and Michael Castle (R-DE), addresses one of NASAA’s Core Principles for Financial Services Regulatory Reform – closing regulatory gaps.

“NASAA appreciates the efforts of Rep. Capuano and Rep. Castle to promote the regulation of hedge fund advisers in a manner that will provide greater transparency to the marketplace while not overburdening the hedge fund industry,” said NASAA President and Colorado Securities Commissioner Fred Joseph. “Advisers to hedge funds should be subject to the same standards of examination as other investment advisers.”

Because they qualify for a number of exemptions to federal and state registration and disclosure laws, hedge funds remain largely unregulated today. The SEC has attempted to require hedge fund managers to register as investment advisers, but that effort was overturned by a U.S. Court of Appeals decision. “Given the need for greater oversight and transparency in many corners of the financial services industry in the wake of the market meltdown, Congress should give the SEC explicit statutory authority to regulate hedge fund advisers as investment advisers,” Joseph said.

Joseph noted that the Managed Funds Association, which represents the hedge fund industry, now supports the registration of investment managers – including hedge fund managers – with the SEC. “This is a step in the right direction,” Joseph said. “While hedge funds did not cause the current economic and financial crisis facing the United States, they, along with the rest of the shadow banking industry, played a role. This reason alone is enough to require greater regulation of all parties in question.”

Joseph said NASAA will continue to press Congress for additional reforms of the hedge fund industry, including granting the SEC authority to require hedge funds to disclose their portfolios, including positions, leverage amounts and identities of counterparties, to the appropriate regulators; and appropriating the necessary funds to ensure that the regulators are sufficiently equipped, in terms of personnel and technology, to provide meaningful analysis of this data and to exercise proper oversight over hedge funds.

NASAA is the oldest international organization devoted to investor protection. Its membership consists of the securities administrators in the 50 states, the District of Columbia, Puerto Rico, the U.S. Virgin Islands, Canada and Mexico.

For more information:
Bob Webster, Director of Communications
202-737-0900