Monthly Archives: January 2020

Aspect Advisors & CFM 2020 IA/BD Compliance Update

A while ago we mentioned that we were hosting a compliance update for investment advisers and broker-dealers. The below is our summary of that event.

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We wanted to take this opportunity to thank everyone who attended and participated in our 2020 compliance update with Justin Schleifer (Aspect Advisors) and Bart Mallon (Cole-Frieman & Mallon). We understand that compliance sometimes feels like an obligation. Still, we think that our discussion last week touched on many important items for financial industry professions to keep top of mind in this new year and new decade.

We have attached a copy of the presentation to this email. Please feel free to forward along to anyone who might be interested. Some high points included:

High level trends influence how the modern investment manager interacts with compliance. Trends include the ongoing bull market, the movement of investment dollars from public investments (via IPO) to private markets, and the emergence of technology/ fintech. While these are distinct trends that need to be acknowledged, traditional compliance concepts still apply to managers although the concepts may be deployed or utilized in a different way than before.

Regulation Best Interest (“Reg BI”) will have an impact on the investment management industry in 2020. Broker-dealer and IA firms will scurry to meet the Reg BI implementation deadline. The effects will be felt more keenly by broker-dealers as they revise their practices to account for the updated fiduciary standards. Asset managers will need to address the regulation through a new Form CRS (sometimes referred to as ADV Part 3).

Privacy is paramount. There is general momentum toward consumers craving privacy. Governments and regulators are taking baby steps but are expected to do more in the future – we see that things such as the California Consumer Privacy Act and GDPR have already begun to influence the operations of many investment management companies. While managers should always maintain fundamental compliance records, there will be changes in the way that investor and customer data is ultimately accessed and available. It is therefore important for managers to stay up to date with those advances and any accompanying compliance processes.

Technological innovation (in both traditional and digital asset markets) is stretching the regulators’ ability to keep up. Regulators have trouble attracting talent to head new divisions to deal with technological innovation. Accordingly, money managers and entrepreneurs utilizing new technologies will need to understand the necessity of being able to explain the use of technology to regulators.

Access to new capital? The industry is always looking for ways to get new investors involved. A new accredited investor standard has been proposed but is not likely to significantly expand the pool of potential accredited investors and thus capital available for investment. Similar initiatives to broaden the distribution of investment products or management to a broader base of end investors (such as Regulation CF, Regulation A+, and 506(c) general solicitation) have seen generally middling to poor results for various reasons.

Information Security/Cybersecurity will continue to be a big regulatory focus and focus on this area is a business best practice. Larger firms will outsource to high tech IT firms or bring IT talent in-house. Smaller firms have many basic tools at their disposal and should focus on vendor management and selection, employee training, access to information, and other pivotal ways to increase security (2FA, using non-public wifi, port blockers, screen protectors, etc).

Taking humans out of investment management. Many investment management companies are creating organizations to bring services to the masses; these companies scale to limit human involvement. Questions on how to deal with compliance on a larger scale naturally emerge. The integration of technology (including with outside compliance vendors) becomes a key focus and commensurately decreases the reliance on human capital.

Other smaller trends have emerged. The focus on private markets is expected to heat up, not decrease (WeWork notwithstanding). Firms will continue to expand with sophisticated financial services, tools, investment strategies, different products, and new market participants, especially as millennials begin investing and saving more. As technology improves lower-fee products proliferate; many firms charge very low management fees and rely more on performance fees.

We look forward to seeing you again at a panel event in the future and wish you the best during this first quarter.

Regards,

Bart Mallon & Justin Schleifer

Aspect Advisors LLC

Aspect Advisors LLC is modern regulatory consultant providing customized compliance solutions to entrepreneurs. The firm has a focus on fintech companies, broker-dealers, and investment managers (hedge fund, VC, PE, RIA, etc). We provide compliance and back-office solutions engineered to decrease worry and save time and resources. Among other items, the firm helps clients with regulatory registration, drafting compliance policies and procedures, conducting annual reviews, and other bespoke items.

Cole-Frieman & Mallon LLP

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 services both start-up investment managers, as well as multi-billion-dollar firms. The firm provides a full suite of legal services to the investment management community, including hedge fund, private equity fund, venture capital fund, mutual fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog, which focuses on legal issues that impact the hedge fund community. For more information, please visit us at colefrieman.com.

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

Regulation D 506(c) Exemption

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Regulation D 506(c) Exemption

General Solicitation Allowed for Private Fund Managers Under 506(c)

Regulation D (“Reg. D”) offers issuers exemptions from registration of their securities under the Securities Act of 1933, as amended (the “Securities Act”). Most managers rely on Rule 506(b) which allows sale of securities to an unlimited number of accredited investors and up to 35 non-accredited investors, so long as there is no general solicitation. Rule 506(c) was enacted as part of the JOBS Act to permit general solicitation, so long as certain steps are followed. While originally many private fund managers eschewed the exemption because of the additional requirements, the exemption has gained popularity with private fund managers in the digital asset space. The main reason is that such managers can more broadly and generally solicit their fund – something that private fund managers in the traditional securities space would not do.

Background Requirements

Under Rule 506(c) of Reg. D, general solicitation is permitted without having to register the issuer’s securities under the Securities Act, so long as (1) all investors are accredited (as defined under Reg. D); (2) reasonable steps have been taken to verify that all investors are accredited, so long as the issuer does not have prior knowledge that the investor is non-accredited; and (3) certain integration, resale restrictions of securities, and bad actor disqualification rules are followed. If these requirements are met, an issuer can broadly solicit and advertise the offering of its securities and still be in compliance with Reg. D.

The second requirement above imposes an obligation for an issuer to proactively take steps in order to verify that an investor is in fact accredited. The list of verification methods recommended in the statute is non-exhaustive but a common method of verification includes, if confirming on the basis of income, reviewing W-2s or other similar tax forms for the previous two years, and obtaining a written representation from the investor that the investor has a reasonable expectation of qualifying as an accredited investor during the current year. Another method often used is having an investor engage certain parties such as a registered CPA or a licensed attorney to represent that the investor is an accredited investor.

A private fund relying on 506(c) must still follow all other applicable securities regulations, such as the 2,000 investor limit pursuant to Section 12(g) of the Securities Exchange Act of 1934, as amended (unless the investor is relying on a different exemption that limits investor count in the private fund). Additionally, the private fund must file a Form D electronically with the SEC, and reflect its 506(c) reliance in the fund offering documents. Each state also has specific securities requirements which typically are met by making a “blue sky filing” (i.e. filing a copy of the Form D) in the applicable state that the private fund is soliciting in.

Positive Aspects

Rule 506(c) offers managers avenues that were previously prohibited under Rule 506(b). This expands investor base and provides for a less restrictive discussion of the fund’s strategy and terms. Further, there is no limit on dollars that can be raised and no limit on dollars from particular investors.

Converting from 506(b) to 506(c)

Many investment managers in the digital asset space are seeking to convert their offering from 506(b) to 506(c). In order to convert a previous offering to a 506(c) offering, the private fund needs to (1) file a new Form D with the SEC, indicating its reliance on 506(c); (2) amend the private fund’s offering documents; and (3) follow the verification methods described above for all subsequent investors in the private fund. We confirmed the foregoing procedures with the SEC. The SEC further indicated in a Q&A that if a private fund that previously relied on Rule 506(b) followed all applicable requirements of Rule 506(b), the private fund would only need to take reasonable steps to verify the accredited investor status of subsequent investors, not existing investors. If existing investors make an additional investment in the fund, the verification methods will need to be taken. Thus, it is recommended as a best practice to verify that all existing investors in the fund are accredited.

Conclusion

We anticipate that many investment managers in the digital asset space will begin to increasingly rely on this exemption. Although general solicitation is permitted under this exemption, all applicable securities regulations still need to be followed (i.e. the anti-fraud provisions under the Investment Advisers Act of 1940, as amended). Counsel should be contacted to further discuss the applicable requirements if you are considering conducting an offering pursuant to Rule 506 (c).

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon LLP has been instrumental in structuring the launches of some of the first digital currency-focused hedge funds and works routinely on matters affecting the digital asset industry. Bart can be reached directly at 415-868-5345.

Aspect Advisors & CFM Compliance Update – January 23, 2020