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Clients, Friends, Associates:
As we prepare for a new year, we also reflect on an eventful 2018 that included developments impacting both traditional hedge fund managers as well as those in the digital asset space. Regardless of these developments, year-end administrative upkeep and 2019 planning are always particularly important, especially for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2019, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.
This update includes the following:
We are also delighted to announce that effective December 22, 2018 our growing San Francisco team will complete their move to expanded premises at 255 California Street, San Francisco, CA 94111.
Annual Compliance & Other Items
Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This review should be in writing and presented to senior management. We recommend that ﬁrms discuss the annual review with their outside counsel or compliance ﬁrm, who can provide guidance about the review process as well as a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a compliance program as a best practice.
Form ADV Annual Amendment. RIAs or managers ﬁling as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must ﬁle an annual amendment to Form ADV within 90 days of the end of their ﬁscal year. For most managers, the Form ADV amendment will be due on March 31, 2019. This year, because March 31st falls on a Sunday, we recommend filing annual amendments to the Form ADV on Friday, March 29, 2019, and no later than the first business day following the 90-day deadline (Monday, April 1, 2019). RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (or a summary of changes with an oﬀer to provide the complete brochure) to each “client”. For SEC RIAs to private investment vehicles, a “client” for these purposes means the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.
Switching to/from SEC Regulation.
SEC RIAs. Managers who no longer qualify for SEC registration as of the time of ﬁling the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of their ﬁscal year (June 29, 2019 for most managers) by ﬁling a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register or file an exemption from registration in the states in which they conduct business.
ERAs. Managers who no longer meet the deﬁnition of an ERA will need to apply for registration with the SEC or the relevant state securities authority, if necessary. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of ﬁling the annual amendment (June 29, 2019 for most managers, assuming the annual amendment is filed on March 31, 2019).
Custody Rule and Annual Audits.
SEC RIAs. SEC RIAs must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualiﬁed custodian; (ii) having a reasonable basis to believe that the qualiﬁed custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant. SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited ﬁnancial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“Auditor”). Statements must be sent to investors in the fund within 120 days after the fund’s ﬁscal year end. Managers should review their custody procedures to ensure compliance with these rules.
California RIAs. California RIAs (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, similarly to SEC RIAs, CA RIAs can avoid these additional requirements by engaging an Auditor to prepare and distribute audited ﬁnancial statements to all investors of the fund, and to the Commissioner of the California Department of Business Oversight (“DBO”). Those CA RIAs that do not engage an auditor must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualiﬁed custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certiﬁed public accountant to conduct surprise examinations of client assets.
Other State RIAs. Advisers registered in other states should consult with legal counsel about those states’ custody requirements.
ERAs. Each state has its own requirements for ERAs. CA ERAs must undergo an annual audit and provide the audit to their investors within 120 days after the end of their fiscal year (April 30, 2019 for most managers).
California Minimum Net Worth Requirement and Financial Reports.
RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000, however, the minimum net worth is $10,000 for a CA RIA (i) deemed to have custody solely because it acts as general partner of a limited partnership, or a comparable position for another type of pooled investment vehicle; and (ii) that otherwise complies with the California custody rule described above (such advisers, “GP RIAs”).
RIAs with Discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000, and preferably $12,000 to avoid certain reporting requirements.
Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must ﬁle an annual ﬁnancial report with the DBO within 90 days after the adviser’s ﬁscal year end. The annual ﬁnancial report must contain a balance sheet, income statement, supporting schedule, and verification form. These ﬁnancial statements must be audited by an independent certiﬁed public accountant or independent public accountant if the adviser has custody of client assets.
Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs”) currently relying on certain exemptions from registration with the U.S. Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year end. Such CPOs and CTAs will need to evaluate whether they remain eligible to rely on such exemptions.
CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and ﬁle Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and ﬁle their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must ﬁle their fourth quarter report on Form CTA-PR. For more information on Form CPO-PQR, please see our earlier post. Unless eligible to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any document dated more than 12 months prior to the date of its intended use. Disclosure documents that are materially inaccurate or incomplete must be corrected promptly, and the corrected version must be distributed promptly to pool participants. Any amended disclosure documents must also be approved by the NFA.
Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be ﬁnalized, and if the manager is required to reimburse any of its funds or other clients, it should do so by year end.
Soft Dollars. Managers that participate in soft dollar programs should address any commission balances from the previous year.
Schedule 13G/D and Section 16 Filings. Managers who exercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”)) that are beneﬁcial owners of 5% or more of a registered voting equity security must report these positions on Schedule 13D or 13G. Passive investors are generally eligible to ﬁle the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to ﬁle Schedule 13G and is due 10 days after acquisition of more than 5% beneﬁcial ownership of a registered voting equity security.
For managers who are also making Section 16 ﬁlings, this is an opportune time to review your ﬁlings to conﬁrm compliance and anticipate needs for the ﬁrst quarter. Section 16 ﬁlings are required for “corporate insiders” (including beneﬁcial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.
Form 13F. A manager must ﬁle a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of the year in which the manager reaches the $100 million ﬁling threshold. The SEC lists the securities subject to 13F reporting on its website.
Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to ﬁle an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on Form 13H will require interim amendments following the calendar quarter in which the change occurred.
Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must ﬁle Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM) must ﬁle Form PF annually within 120 days of their ﬁscal year-end. Larger private advisers (fund managers with $1.5 billion or more in RAUM) must ﬁle Form PF within 60 days of the end of each fiscal quarter.
Form MA. Investment advisers that provide advice on municipal financial products are considered “municipal advisers” by the SEC, and must file a Form MA annually, within 90 days of their fiscal year end.
SEC Form D. Form D ﬁlings for most funds need to be amended on at least an annual basis, on or before the anniversary of the most recently ﬁled Form D. Copies of Form D are publicly available on the SEC’s EDGAR website.
Blue Sky Filings. On an annual basis, fund managers should review their blue sky ﬁlings for each state to make sure it has met any initial and renewal filing requirements. Several states impose late fees or reject late ﬁlings altogether. Accordingly, it is critical to stay on top of ﬁling deadlines for both new investors and renewals. We also recommend that managers review blue sky ﬁling submission requirements. Many states now permit blue sky ﬁlings to be ﬁled electronically through the Electronic Filing Depository (“EFD”) system, and certain states will now only accept ﬁlings through EFD.
IARD Annual Fees. Preliminary annual renewal fees for state-registered advisers, SEC RIAs, and ERAs (that are required to file a Form ADV) are due on December 17, 2018. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check, or wire as soon as possible.
Pay-to-Play and Lobbyist Rules. SEC rules disqualify investment advisers, their key personnel, and placement agents acting on their behalf, from seeking to be engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the deﬁnition of “placement agents” (people who act for compensation as ﬁnders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with oﬀering or selling investment advisory services to a state public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers oﬀering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on lobbyist registration diﬀer widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they are in compliance with the relevant rules.
Annual Fund Matters
New Issue Status. On an annual basis, managers need to conﬁrm or reconﬁrm the eligibility of investors that participate in initial public oﬀerings or new issues, pursuant to Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconﬁrm investor eligibility via negative confirmation (i.e. investors are informed of their status on ﬁle with the manager and are asked to inform the manager of any changes), whereby an investor’s failure to respond operates as consent affirmation of the current status.
ERISA Status. Given the signiﬁcant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers conﬁrm or reconﬁrm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.
Wash Sales. Managers should carefully manage wash sales for year end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including basket total return swaps and split strike forward conversions. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.
Redemption Management. Managers with signiﬁcant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.
NAV Triggers and Waivers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year (NAV declines are common counterparty agreement termination events).
Fund Expenses. Managers should wrap up all fund expenses for 2018 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up-to-date information about legal expenses for inclusion in the NAV for year-end performance.
Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies taxed as partnerships to issue Schedule K-1s to investors solely by electronic means, provided the partnership or company has received the investor’s aﬃrmative consent. States may have diﬀerent rules regarding electronic K-1s and partnerships and companies should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships and companies must also provide each investor with speciﬁc disclosures that include a description of the hardware and software necessary to access the electronic K-1s, the length of time that the consent is eﬀective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.
“Bad Actor” Recertiﬁcation Requirement. A security oﬀering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors”. Fund managers, and their applicable officers and directors, must determine whether they are subject to the bad actor disqualiﬁcation any time they are oﬀering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certiﬁcation. If an oﬀering is continuous, delayed, or long-lived, however, issuers must update their factual inquiry periodically through bring-down of representations, questionnaires, and certiﬁcations, negative consent letters, periodic re-checking of public databases, and other steps, depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such update at least annually.
U.S. FATCA. Funds should monitor their compliance with the U.S. Foreign Account Tax Compliance Act (“FATCA”). FATCA reports are due to the IRS on March 31, 2019 or September 30, 2019, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S. may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying FATCA requirements applicable to diﬀerent jurisdictions, managers should review and conﬁrm the speciﬁc reporting requirements that may apply. As a reminder, we strongly encourage managers to ﬁle the required reports and notiﬁcations, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.
CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31, 2019. Managers to funds domiciled in other jurisdictions should also conﬁrm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the Automatic Exchange of Information portal. We recommend managers contact their tax advisors to stay informed of FATCA and CRS requirements and avoid potential penalties.
Annual Management Company Matters
Management Company Expenses. Managers who distribute proﬁts on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or proﬁt percentages are adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.
Employee Reviews. An eﬀective annual review process is important to reduce the risk of employment-related litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals, and other employee-related matters at the ﬁrm. It is not too late to put an annual review process in place.
Compensation Planning. In the fund industry, and the ﬁnancial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management company structure, affiliated partnerships, or any shadow equity programs should be eﬀective on the ﬁrst of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.
Insurance. If a manager carries Directors & Officers or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all actual and potential claims. Newly launched funds should also be added to the policy as appropriate.
Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability, including: (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate, terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contributions. Managers should consult legal and tax professionals to evaluate these options.
Regulatory & Other Items from 2018
SEC Annual Enforcement Report. On November 2, 2018, the SEC Division of Enforcement published its Annual Report, which highlighted enforcement efforts protecting “main street investors” through initiatives such as the newly-created SEC Retail Strategy Task Force, disclosures of 12b-1 marketing and distribution fees by mutual funds, required cybersecurity disclosures by public companies, and enforcement efforts regarding Initial Coin Offerings (“ICOs”) and digital assets. In 2018, the SEC brought a total of 821 enforcement actions and obtained monetary judgements totaling $3.95 billion, both of which were increases from 2017 figures.
CFTC and NFA Updates.
NFA Develops New Swaps Proficiency Program and Exam. On June 5, 2018, the NFA announced the creation of a new online proficiency and exam program for swaps. The online program and exam are expected to launch in early 2020, and any associated persons engaging in swaps activities will be required to pass the program and exam. Previously, training and examinations had only been required for associated persons engaging in futures or forex activities.
Digital Asset Updates.
SEC Settles Charges Against Digital Asset Hedge Fund Management Company. On December 7, 2018, the SEC settled charges against the management company of a digital asset hedge fund for alleged violations of the general solicitation rules. In the settlement agreement, the SEC alleged that the management company violated the general solicitation rules because they did not have substantive and pre-existing relationships with all investors in their fund, offered securities over a website that was accessible to the general public without a password, failed to take reasonable steps to verify accredited investor status, and engaged in general solicitation via online and in person events. In the settlement, the management company agreed to abide by a cease and desist order and to pay a $50,000 civil penalty
SEC Settles Charges Against Digital Asset Hedge Fund Manager. On September 11, 2018, the SEC announced the settlement of charges against a digital asset hedge fund and its manager. The charges included failing to register the hedge fund as an investment company, and offering and selling unregistered securities. Settlement terms included a cease and desist order against both the fund and fund manager, censure, and a $200,000 penalty. Notably, this is the first action the SEC has taken against a digital asset fund based on violations of the registration requirements of the Investment Company Act of 1940, as amended (the “Investment Company Act”).
SEC Emphasis on ICOs. Throughout 2018, the SEC focused much of its regulatory and enforcement efforts on ICOs. Notable developments included:
NFA Digital Asset Disclosure Rule. On July 20, 2018, the NFA released an Interpretive Notice creating new disclosure requirements for Futures Commission Merchants (FCMs), CPOs, and CTAs engaging in digital asset activities. For more information on this Interpretive Notice, please see our previous post.
New York Attorney General Releases Report on Digital Asset Exchanges. On September 18, 2018, the Office of the Attorney General of New York (the “OAG”) released a report summarizing a crypto exchange fact-finding initiative. Based on the digital asset exchanges examined, the OAG outlined three primary areas of concern: potential conflicts of interest, lack of anti-abuse controls, and limited customer fund protection.
SEC Settles Charges Against Founder of Digital Asset Exchange. On November 8, 2018, the SEC settled charges against the founder of a digital asset exchange. The SEC took the position that the digital asset exchange qualified as an “exchange” under the Securities Exchange Act of 1934, as amended, and therefore was required to register with the SEC, which it had not done. The founder agreed to settlement terms including $300,000 in disgorgement, $13,000 for pre-trial interest, and a $75,000 penalty.
Second Circuit Amends Insider Trading Ruling. On June 25, 2018, the U.S. Court of Appeals for the Second Circuit amended its decision in United States v. Martoma, clarifying tippee liability in insider trading cases. The Second Circuit held that a “meaningfully close personal relationship” is not required for tippee liability, and once again upheld a former portfolio manager’s 2014 conviction for insider trading. For further discussion of the original 2017 decision please see our previous 2017 Third Quarter Update.
Fifth Circuit Vacates DOL Fiduciary Rule. On March 15, 2018, the Fifth Circuit Court of Appeals issued a judgement vacating the Department of Labor (“DOL”) Fiduciary Rule in its entirety, finding that the DOL lacked the authority to enact the rule. The Fiduciary Rule would have expanded the definition of a “fiduciary” to include anyone making a securities or investment property “recommendation” to an employee benefit plan or retirement account. For further discussion please see our previous 2018 Second Quarter Update.
Section 3(c)(1) of the Investment Company Act Amended. President Trump authorized the Economic Growth, Regulatory Relief, and Consumer Protection Act (“Growth Act”) on May 24, 2018. A portion of the Growth Act amends Section 3(c)(1) of the Investment Company Act by increasing the number of investors allowed in a qualifying venture capital fund from 100 to 250 investors. The Growth Act defines a qualifying venture capital fund as one with less than $10 million in aggregate capital contributions and uncalled committed capital.
Qualified Opportunity Zones. The 2017 Tax Cuts and Jobs Act mandated that the IRS create “Qualified Opportunity Zones” (“QOZs”), which are designated low-income areas that will provide certain tax breaks and incentives. Qualified Opportunity Funds (QOFs) that make investments in QOZs may qualify for tax incentives including a tax deferral of capital gains that are re-invested into QOFs and a tax exclusion for capital gains that are reinvested into QOFs and held for ten years. On October 19, the IRS released proposed regulations and guidance notes that provide clarification on how QOFs can receive capital gain tax deferrals if they are located in QOZs.
The Cayman Islands Monetary Authority (“CIMA”) Provides Anti-Money Laundering (“AML”) Compliance Guidance and Delays the AML Officer Deadline. CIMA released a notice on April 6, 2018 providing guidance on the 2017 revisions to its AML Regulations. The notice discusses the requirement for private funds to appoint an Anti-Money Laundering Compliance Officer (“AMCLO”), Money Laundering Reporting Officer (“MLRO”) and Deputy Money Laundering Reporting Officer (“DMLRO”), and offer guidance on compliance obligations when these duties are outsourced or delegated. Under these new CIMA requirements, investment funds that conduct business in or from the Cayman Islands must appoint individuals to these new AML officer positions. CIMA has delayed certain deadlines for funds that launched prior to June 1, 2018:
Funds formed on or after June 1, 2018 must have appointed the officers (and confirmed such officers through REEFS for registered funds) at launch. If you have any questions, we recommend fund managers discuss AML compliance with offshore counsel and the fund’s administrator.
Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345.