Monthly Archives: July 2016

Cole-Frieman & Mallon 2016 Second Quarter Update


July 22, 2016

Clients and Friends:

We hope that this message finds you well and that you are enjoying the first months of summer. As we move into the third quarter, we would like to provide you with a brief overview of some items that we hope will help you stay on top of the business and regulatory landscape in the coming months.


SEC Revises Qualified Client Threshold. The SEC recently published an order approving an adjustment to the definition of a “Qualified Client” under the Investment Advisers Act of 1940 (the “Advisers Act”). Specifically, the “net worth” threshold has been increased from $2,000,000 to $2,100,000 to account for inflation since the date the original definition was adopted. The Qualified Client threshold is critically important for investment advisers because in nearly all jurisdictions, including for SEC registered investment advisers, performance fees and incentive allocations can only be charged to investors who are Qualified Clients. The new definition becomes effective August 15, 2016 (the “Effective Date”), but will not be applied retroactively to contractual relationships existing as of such date. Additionally, investors who subscribed for interests in a private fund before the Effective Date may make additional subscriptions without needing to confirm the new net worth requirement.

All investment advisers should promptly update their subscription documents to ensure that new investors who agree to make investments on or after the Effective Date have provided accurate representations regarding their Qualified Client status.

Private Equity Fund Adviser Acting as an Unregistered Broker Settles SEC Charges. The SEC charged Blackstreet Capital, a private equity advisory firm, and its owner with performing in-house brokerage services without being properly registered as a broker-dealer. While the firm disclosed to investors that it would operate as a broker-dealer in exchange for a fee, it did not register as a broker-dealer with the SEC or any state securities commission. The SEC’s investigation also found that the firm engaged in several conflicted transactions and did not disclose certain fees and expenses to investors when such disclosure was warranted (such as using fund assets to make political and charitable contributions and pay for entertainment expenses). The firm and its owner have agreed to pay more than $3.1 million to the SEC in settlement of the charges. Broker-dealer activities are highly regulated, so we encourage all clients to not only confirm that any marketers they use are properly registered but also to ensure that their own marketing activities are in compliance with the applicable rules.

SEC to Require IAs to Adopt Business Continuity and Transition Plans. The SEC proposed a new rule on June 28, 2016, that would require SEC registered investment advisers to implement written business continuity and transition plans designed to mitigate the effects of significant internal or external disruptions in operations, such as natural disasters, cyber-attacks, technology failures, the departure of key personnel, and similar events. This is the SEC’s latest effort to encourage proper risk management in the asset management industry and minimize any potential client harm from material service disruptions. Under the proposed rule, the content of an SEC registered adviser’s business continuity and transition plan would be based upon risks associated with an IA’s operations and would include policies and procedures designed to address different elements of a firm’s business. Firms would be required to review the adequacy and effectiveness of their plans at least annually and to retain certain records.

No Expansion of SEC Examinations of Exempt Reporting Advisors. In our 2015 fourth quarter newsletter, we reported that the SEC intended to expand the scope of its on-going examination program to include Exempt Reporting Advisers (“ERAs”) who rely on the Private Fund Adviser Exemption or Venture Capital Fund Adviser Exemption to registration. The previous discussion was based on published reports interpreting comments made by Marc Wyatt, the Director of the SEC’s Office of Compliance Inspections and Examinations, at a conference in November 2015. Further investigation by our firm, however, has revealed that Mr. Wyatt’s comments were misreported and misinterpreted by the industry. We have received confirmation from the SEC that the agency does not intend to expand the scope of its on-going examination program to include ERAs. It should be noted, however, that the SEC does continue to conduct examinations of ERAs for cause and other misconduct.

Notwithstanding the SEC’s general stance on examinations of ERAs, the SEC has indicated that it is focusing some of its examination efforts on those who rely on the Venture Capital Fund Adviser Exemption. The SEC suspects that many ERAs who rely on this exemption are in fact not eligible to do so. With that in mind, we recommend all ERAs who rely on the Venture Capital Fund Adviser Exemption to confirm with counsel their eligibility to rely on this exemption.

SEC Signals a Focus on Cybersecurity.With a new hire to the agency’s cybersecurity division and cybersecurity charges being brought against an institutional wealth management firm, the SEC is signaling its focus on the issue to the investment management industry. In June, the SEC appointed Christopher R. Hetner, a career information security expert, to the role of Senior Advisor to the Chair for Cybersecurity Policy. Later in the month it was announced that Morgan Stanley had settled SEC charges brought against the firm for failure to protect digital customer information through failure to adopt the statutorily required written policies and procedures.  Failing to comply with cybersecurity laws didn’t just lead to a former Morgan Stanley employee accessing and transferring approximately 730,000 unique client accounts data to his personal server, which was ultimately hacked by third parties, but also led to Morgan Stanley having to pay a $1 million penalty to settle the SEC charges. Given the SEC’s recent emphasis on cybersecurity, firms should be moving forward with cybersecurity implementation and may want to discuss with counsel or other outside service providers.

Fund Administrator Settles with the SEC for Failure to Identify and Respond to Fraud by Two Investment Adviser Clients. A well-known fund administrator recently settled charges with the SEC due to its failure to identify and correct fraudulent faulty accounting perpetrated by two of its investment adviser clients. The SEC noted that fund administrators have a “gatekeeping responsibility” in relation to the investment funds which they administer and are primarily responsible for accurate reporting of fund assets to investors and other service providers. In this case, the administrator failed to uphold its gatekeeping responsibility by either missing or ignoring clear indications of fraudulent books which allowed the advisory firm’s scheme to persist until the SEC stepped in. Without admitting to the allegations, the firm agreed to pay a fine in its settlement. Managers might want to think about amending their administration agreements to include additional termination rights which could be exercised by the manager in the event their administrator suffers the same fate.

New Federal Law Expands Trade Secret Remedies. As the “secret sauce” for many investment managers may now take the form of a trade secret in an easily copied digital format, misappropriation of trade secrets by employees and other service providers has become an increasingly important area of concern for the investment management industry. President Obama recently signed into law the Defend Trade Secrets Act of 2016 (“DTSA”), which expands the options available to firms who suspect an employee misappropriated trade secrets. The DTSA permits a firm to sue for civil damages in federal court, considerably simplifying the litigation process. Further, the DTSA expands the scope of damages available for a successful claimant, including but not limited to royalties for the misuse of trade secrets as well as attorneys’ fees. In order for a firm to take advantage of the expanded options available under the DTSA, a firm must provide notice to its employees and other service providers of the confidentiality and whistleblower protections. Firms will likely need to amend their contracts with employees and service providers in order to provide such notice.

Cayman Islands Publishes LLC Law. On June 8, 2016, the Cayman Islands introduced the highly anticipated Cayman Islands Limited Liability Companies Law, developed in a joint effort by the Cayman Islands Government and the Cayman Islands Monetary Authority in response to requests from the investment funds industry. The law came into effect on July 8, 2016 and currently allows for the formation and operation of limited liability companies similar in structure and flexibility to that of a Delaware LLC. It is now possible to:

  • form and register a new Cayman Islands LLC;
  • migrate an entity organized in another jurisdiction (e.g., Delaware) into the Cayman Islands as an LLC;
  • convert an existing Cayman Islands exempted company into an LLC; and
  • merge an existing Cayman Islands exempted company into an LLC.

We have been in discussions with certain Cayman law firms about how managers might use such LLCs in their offshore structures in future. It seems like the best use will be for certain management company entities or as single-purpose investment vehicles under a larger fund structure. At this time we do not expect the LLC form to supercede the Ltd. form for actual fund entities in the Cayman Islands. If you are interested in how you might be able to utilize these vehicles in the futures, we recommend that you speak with your firm’s offshore counsel to discuss the entity’s advantage and disadvantages.

SEC Adopts Final Rules Implementing Business Conduct Standards for Security-Based Swap Dealers and Major Security-Based Swap Participants. On April 15, 2016, the SEC adopted new rules that would require security-based swap (“SBS”) entities to comply with a comprehensive set of business conduct standards and chief compliance officer (“CCO”) requirements. The SEC believes the new rules will enhance accountability and transparency in transactions with investors and special entities in the over-the-counter derivatives market, which, according to SEC Chair Mary Jo White, has lacked fundamental customer protections for years. Some of the provisions applicable to SBS dealers and major participants include:

  • disclosure to the counterparty of material information about the security-based swap, including material risks, characteristics, incentives, and conflicts of interest;
  • disclosure of information concerning the daily mark of the security-based swap and the ability of the counterparty to require clearing of the security-based swap;
  • communication with counterparties in a fair and balanced manner based on principles of fair dealing and good faith;
  • establishment of a supervisory and compliance infrastructure; and
  • designation of a CCO who must fulfill the described duties and prepare an annual compliance report.

Additional provisions and heightened protections apply in transactions with special entities, such as municipalities, pension plans, and endowments.

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

Other Items

  • Accounting Firm Charged for Deficient Surprise Exams. The SEC recently charged an accounting firm and one of its partners for failing to perform adequate surprise examinations of an SEC registered investment adviser which retained the firm for such purpose. The SEC noted that on two occasions the firm filed paperwork with the SEC containing false statements – first, that the manager had complied with certain procedures when in fact they had not, and second, that the manager’s client assets were held with a qualified custodian when in fact they were not. The accounting firm, without admitting or denying fault, agreed to pay disgorgement of fees and a penalty. The accounting firm and the partner in charge were also suspended from practicing before the SEC (including performing audits of public companies). In light of this action, investment managers would be well advised to ensure that the accountants they retain for surprise examinations dutifully comply with the applicable requirements.
  • SEC Charges Investment Adviser that Schemed to Acquire Larger Incentive Fees. On May 31, 2016, the SEC charged a Tennessee firm and its owner for orchestrating a fraudulent trading scheme designed to increase the incentive fees earned by the adviser. Specifically, the scheme caused large gains to be realized at the end of any given month and large losses to be realized at the beginning of the subsequent month, thereby artificially increasing the net gains subject to the incentive fee. The SEC’s investigation uncovered that the firm made millions of dollars in unearned incentive fees and that, without the fraudulent trading scheme, the firm would have earned almost no incentive fees since October 2014. The SEC is seeking disgorgement of fraudulently obtained gains, penalties, and permanent bans from the industry.
  • Cayman Islands FATCA Compliance Deadlines Further Extended. The Cayman Islands Department of International Tax Cooperation has recently extended both the notification and reporting deadlines for U.S. FATCA to August 10, 2016. This further extends the previously extended deadlines of June 10, 2016 and July 8, 2016 for notification and reporting of U.S. FATCA, respectively. We suggest speaking with your tax advisers to determine your notification and reporting obligations with respect to FATCA and confirm compliance with the new deadlines.
  • CFTC Issues a Compliance Advisory. The CFTC Division of Swap Dealer and Intermediary Oversight issued a Staff Advisory in early July, reminding Futures Commission Merchants (“FCMs”) and Introducing Brokers (“IBs”) to report suspicious activity and to comply with the economic sanctions programs administered by the Office of Foreign Affairs Control (“OFAC”). The suspicious activity reporting regulation requires every FCM and IB to report any possible violation of law or regulation no later than 30 calendar days after the date the suspicious activity is initially detected unless no suspect is identified. The economic sanctions regulations by OFAC generally prohibit U.S. persons from engaging in transactions with individuals or entities located in countries subject to sanction programs. Accordingly, FCMs and IBs should regularly review the economic sanctions programs each time they are updated and screen all new and current customers periodically.
  • Investment Advisers Modernization Act of 2016. The House of Financial Services Committee approved a bill directing the SEC to update portions of the Advisers Act by removing duplicative and burdensome regulations that impose an unnecessary burden on small business’ access to capital. Among the rules to be amended are Rule 206(4)-1 (Advertisements), Rule 206(4)-6 (Proxy Voting), and Rule 204(b)-1 (Form PF).
  • NFA Amends Compliance Rule 2-46. Effective September 30, 2016, each Form CPO-PQR or Form CTA-PR that is filed after the due date will be subject to a fee of $200 for each business day it is late. Generally, Form CTA-PR is due within 45 days and Form CPO-PQR is due within 60 days of the relevant calendar quarter end. Please examine the compliance calendar below for the relevant due dates.

MSRB to Launch Permanent Series 50 Exam in September. The Municipal Securities Rulemaking Board (“MSRB”) will make available the permanent Municipal Advisor Representative Qualification Examination (Series 50) beginning September 12, 2016. Any individual who engages in municipal advisory activities or supervises a municipal advisor representative is required to take the Series 50 to demonstrate the level of knowledge needed to perform municipal advisory activities. To facilitate the transition to the new exam requirement, the MSRB is providing a one-year grace period during which individuals will be able to take the municipal advisor representative exam while still engaging in municipal advisory activities.

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

Deadline             Description

Deadline Filing
June 1, 2016 Limited partnerships and limited liability companies formed in Delaware were required to pay the annual tax of $300.
June 30, 2016 Deadline for filing AIFMD annual report (AIFs with a financial year ending on December 31st).
June 30, 2016 Delivery of audited financial statements to investors (private fund managers to funds of funds, including SEC, State and CFTC registrants).
June 30, 2016 Deadline for Cayman Island registered funds with a fiscal year end of December 31 to file the Fund Annual Return and audited financial statements with Cayman Islands Monetary Authority.
June 30, 2016 Review transactions and assess whether Form 13H needs to be amended.
June 30, 2016 Annual Foreign Bank and Financial Accounts Report (FBAR).
July 30, 2016 Quarterly NAV Report (CPOs claiming the 4.7 exemption).
August 10, 2016 Deadline for Reporting Financial Institutions under U.S. FATCA to file both notification and reporting with the Cayman Islands Tax Authority.
August 14, 2016 CTA-PR filing with NFA.
August 15, 2016 Form 13F filing (advisers managing $100 million in 13F Securities).
August 29, 2016 CPO-PQR filing with NFA (large CPOs).
August 29, 2016 Form PF for quarterly filers.
September 28, 2016 CPO-PQR filing with NFA (mid-size and small CPOs).
Variable Distribute copies of Schedule K-1 to fund investors.
Periodic Filings Form D and Blue Sky filings should be current.

Please contact us with any questions or for assistance with any compliance, registration or planning issues on any of the above topics.


Karl Cole-Frieman, Bart Mallon & Lilly Palmer


Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers as well as multi-billion dollar firms. The firm provides a full suite of legal services to the investment management community, including: hedge fund, private equity fund, and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters.