Author Archives: Hedge Fund Lawyer

Alternative Mutual Funds Overview

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Hedge Fund Strategies Employed by Mutual Funds

Since the financial crisis of 2008, a growing number of retail investors have sought access to more sophisticated investment strategies to protect against downside risk.  Most retail investors are not eligible to invest directly in hedge funds so they have turned to mutual funds that employ alternative investment strategies to achieve greater diversification.  This increasing demand for alternative mutual funds is also fueled by hedge fund investors seeking greater transparency and liquidity, as well as more conservative investment strategies that are typically utilized by mutual funds.  Additionally, the Dodd-Frank Act restricts certain individuals and institutions from investing in hedge funds, which will likely force these investors to seek out “hedge-like” investment vehicles in which to invest the money formerly invested in hedge funds.  To accommodate these new investors and the converging demands of retail and hedge fund investors, investment managers have developed mutual funds designed to mimic hedge fund investment strategies to the extent permitted under federal securities laws.

What is an Alternative Mutual Fund?

An alternative mutual fund is a professionally managed, pooled investment vehicle, designed to provide individual investors with access to investment strategies that offer non-correlated returns and diversification benefits. Generally, the goal of alternative mutual funds is to minimize portfolio volatility and preserve return objectives. Strategies utilized by alternative mutual funds include traditional hedge fund investment strategies such as long-short, market neutral, arbitrage and merger/arbitrage strategies.

Starting an Alternative Mutual Fund – Legal Considerations

Some of the operational and legal steps for launching a mutual fund are similar to starting a hedge fund, but there are some important differences. The high-level legal steps to launch an alternative mutual fund include:

  1. Register the fund manager as an investment adviser with the SEC.
  2. Form a corporation or a business trust (or leveraging an existing business trust) – a mutual fund will typically be established as a Delaware statutory trust or Massachusetts business trust.
  3. Prepare and file Form N-1A with the SEC to simultaneously register the fund as an investment company under the Investment Company Act of 1940 (’40 Act) and register fund shares under the Securities Act of 1933. This filing includes the fund’s prospectus, which discloses the fund’s investment objective, investment strategies and principal investment risks, as well as other material information regarding the fund manager and the fund.
  4. Seed the fund (or fund family) with at least $100,000 as required by the ’40 Act.
  5. Choose a board of directors (or trustees). While board sizes vary, the ’40 Act requires that at least 40% of the directors on a board be independent. Typically, independent directors hold a majority (75%) of board seats in nearly 90% of fund complexes.
  6. Negotiate agreements with fund service providers, including a custodian, prime broker (for fund derivative transactions), transfer agent, fund accountant, independent auditor, administrator, financial printer, and distributor. [Note: some hedge fund service providers also provide services to mutual funds, but in general the service providers are likely to be different.]
  7. Draft fund compliance policies and procedures reasonably designed to detect, prevent, and resolve violations of federal securities laws.
  8. Make requisite blue sky filings (or notice filings) in states where fund shares will be sold.

Other Considerations

The ‘40 Act also imposes leverage and other investment restrictions on mutual funds. While some of these restrictions can be addressed by investing in ETFs and other investments, it is imperative that investment managers consult a ’40 Act attorney prior to launching an alternative mutual fund to fully understand the implications of regulatory restrictions on portfolio management.

Conclusion

Investor preference and regulatory developments are driving the convergence of mutual funds and hedge funds and resulting in a rapidly growing demand for mutual funds that employ hedge fund strategies. This demand is being met by the emergence of alternative mutual funds. The process of launching an alternative mutual fund varies depending on the complexity of the fund, however, these steps along with others can typically be completed in six months with the assistance of a seasoned ’40 Act attorney and other fund service providers.  For more information on registering a mutual fund and the regulations governing mutual funds, please see the SEC’s Investment Company Registration and Regulation Package or contact us.

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Cole-Frieman & Mallon LLP is a boutique investment management law firm with an alternative mutual funds law practice. Aisha Hunt, a Partner and the head of the ’40 Act practice at Cole-Frieman & Mallon LLP, can be reached directly at 415-762-2854.

 

California’s Hedge Fund "Pay to Play" Laws Updated

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New Lobbyist Requirements Apply to Hedge Fund Placement Agents

With the enactment of AB 1743 (effective January 1, 2011) and SB 398 (effective October 9, 2011), California has imposed new requirements on persons who market investment managers and their funds to California pension plans – that is, California Public Employees’ Retirement System (CalPERS) and the California State Teachers’ Retirement System (CalSTRS). The laws, similar to the recently passed SEC pay to play rules, are designed to prevent “pay-to-play” activities to increase transparency and accountability by prohibiting a person from acting as a “placement agent” in connection with any potential investment by CalPERS or CalSTRS.

Placement Agents Deemed to be Lobbyists

Placement agents—generally persons that are compensated to act for an external investment manager in connection with securing an investment by CalPERS and CalSTRS—are considered lobbyists under the new laws. SB 398 clarifies that placement agents include those that market interests in any type of private investment fund (not just marketing investment management services), including private equity funds, hedge funds, venture capital funds, and real-estate funds. There are two exclusions from being considered a placement agent under the laws:

“(1) an employee, officer, director, equityholder, partner, member, or trustee of an external manager who spends one-third of his or her annual time managing the assets held by the external manager; and

(2) any employee, officer, director or affiliate of an external manager, if that external manager is: (a) registered with the SEC or a comparable state securities regulator; (b) selected for investment through a statutorily defined competitive bidding process; and (c) willing to be subject to the fiduciary standard of care applied to the retirement fund board.”

Placement Agent Registration Requirements

Placement agents must register under the Political Reform Act of 1974 (PLR) prior to acting as a placement agent. Additionally, among other things, placement agents:

  • Must not make gifts to a person totaling more than $10 in any calendar month if that person works for CalPERS or CalSTRS;
  • May not make a political contribution to any elected state officer or candidate for elected office if the agent is registered to lobby the governmental agency for which the candidate is seeking election (e.g. CalPERS Board Member, CalSTRS Board Member, Supt. of Public Instruction, State Treasurer, or the State Controller; and
  • May not receive fees that are contingent on the outcome of any proposed legislative action or administrative action, including investment decisions.

Local Lobbyist Regulations

The new laws also subject placement agents to “applicable” local lobbyist regulation if the agents market to local government plans. Before marketing to any California city or county retirement system, investment managers should evaluate the relevant local lobbyist ordinances to determine which, if any, local requirements may apply.

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Cole-Frieman & Mallon LLP is an investment management boutique law firm.  The firm’s clients include hedge fund managers, hedge fund investors and other groups within the investment management industry.  Bart Mallon can be reached directly at 415-868-5345.

FINRA Cannot Sue to Collect Unpaid Fines

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2nd Circuit Holds that FINRA Lacks Statutory Authority and FINRA Rule was Invalid

The Securities Exchange Act of 1934 (the “Exchange Act”) authorizes the Financial Industry Regulatory Authority (“FINRA”) and other SROs to regulate within the securities industry. FINRA’s role includes registering and educating industry participants, examining firms, implementing rules, and enforcing them alongside the federal securities laws. FINRA’s enforcement tools include imposing fines for violations. Last week, in Firero v. FINRA, the United States Court of Appeal for the Second Circuit found that FINRA lacked the power to sue for unpaid fines.

Summary of Facts and Judgment

Fiero Brothers (the “Firm”) was a FINRA member and registered broker-dealer. John J. Fiero (“Mr. Fiero,” and together with the Firm, “Fiero”) was the Firm’s only registered representative. In 1998, FINRA brought an enforcement action against Fiero for engaging in illegal short-selling, among other violations. FINRA permanently barred and fined them $1 million, plus costs. For the next ten years, FINRA attempted unsuccessfully to collect the fine from Fiero. In 2003, FINRA filed suit in New York state court to recover the fine and costs. The lower courts found in FINRA’s favor; however, the New York Court of Appeals reversed, holding that the FINRA complaint fell under the exclusive jurisdiction of the federal courts.

Fiero then sought a declaratory judgement in federal district court, that FINRA lacked authority to collect fines through judicial proceedings. FINRA filed a counterclaim seeking to enforce its fine, and both parties moved to dismiss each other’s claims. The District Court entered judgment in FINRA’s favor, dismissing Fiero’s complaint. The Second Circuit reversed, holding that:

(1) the Exchange Act did not authorize FINRA to sue for fines, stating that the specificity of the statute, and omission of the power to sue indicated Congress’ intent to withhold this power from SROs. The court noted that FINRA’s longstanding practice did not include filing suits, and that the Fiero case was the first it had brought; and

(2) FINRA’s 1990 rule permitting it to sue for fines was improperly promulgated under the Exchange Act, specifically that it was not a “housekeeping rule” that is approved upon receipt of the SEC (as submitted by FINRA), but was instead a substantive rule, subject to notice and a comment period.

Implications of the Court’s Decision

Following the decision, FINRA’s general counsel reportedly stated that FINRA would “continue to review the ruling and weigh our options.”

Those options include seeking review by the United States Supreme Court, or asking Congress to provide SROs with the right to seek enforcement of their fines in court. In the meantime, FINRA may, and will, pursue collection of fines short of litigation, and suspend or bar violators from the industry. FINRA may seek the SEC’s assistance in obtaining court orders that include payment of fines. However, the decision hampers FINRA to the extent that fear of litigation inspired violators to pay their fines.

But some commentators have noted that FINRA seldom pursued barred individuals for unpaid fines, and rarely sued (one put the total number of lawsuits at five, including Fiero). Furthermore, violators who are not barred have an incentive to pay their fines if they wish to keep their licenses. Reactions were positive from those who believed that FINRA had been exceeding its statutory power for years, and abusing the rule-making process.

Rule-making is likely the area most impacted by the ruling. The court’s criticism that FINRA bypassed the notice and comment procedure may cause SROs and the SEC to scrutinize proposed rules, or second-guess existing “housekeeping” rules, to ensure that they are not substantive, and subject to a lengthy approval process. Moreover, future litigants may be encouraged to seek judicial review of SRO rules that were approved in the more streamlined process for “housekeeping” rules.

New York is home to many financial firms, and the courts there have expertise in interpreting the federal securities laws. Though not binding on other courts, the Second Circuit’s decision will be influential among the other federal circuits. State courts may follow the New York Court of Appeals, and decide that they do not have subject matter jurisdiction over collections cases involving federally-authorized SROs.

A remaining question is whether the decision will impact the proposed SRO for investment advisers, and FINRA as the candidate for that role. At this point, the particulars of that legislation and the SRO’s powers in collecting fines, is unknown. The decision is not expected to affect FINRA’s status as the frontrunner to fill this role.

Conclusion

Recent years have seen expanded regulation of the financial industry. Thus, it is surprising that the Second Circuit determined that FINRA lacked a particular enforcement tool. However, it is this climate of expanding regulation that may give FINRA the leverage to seek greater enforcement powers and options from Congress. In the meantime, and perhaps despite a FINRA spokeswoman’s comment that “the decision will not…restrict our ability to enforce FINRA rules and securities laws….,” at least some violators who receive significant fines, but have the means to leave the industry may walk away as an alternative to paying fines.

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Cole-Frieman & Mallon LLP provides legal advice and support to all types of investment managers.  If you have a question regarding any industry SRO, please feel fre to contact us directly.  Bart Mallon can be reached directly at 415-868-5345.

NASAA Examination of IA Compliance Deficiencies

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Examination Reveals Compliance Focus Areas

NASAA, the lobbying body of the various state securities divisions, recently released a set of examination findings which describe the common compliance deficiency areas for IA firms registered with the state securities commissions.  The exams, which were completed by state administrators, showcase a number of compliance issues for both registered investment advisers and fund managers.  According to the NASAA press release:

Examinations of 825 investment advisers conducted between January 1, 2011 and June 30, 2011 uncovered 3,543 deficiencies in 13 compliance areas, compared to 1,887 deficiencies in 13 compliance areas identified in a similar 2009 coordinated examination of 458 investment advisers.

Below we have summarized the findings released in the NASAA 2011 Examinations Findings (.ppt).

Deficiency Categories

Below are the categories which were covered, along with the percentages of advisers with at least one deficiency in such category:

  • Registration (59.9%)
  • Books and Records (45%)
  • Unethical Business Practices (36.8%)
  • Supervisory/Compliance (30.2%)
  • Advertising (21.6%)
  • Privacy (21.2%)
  • Financials (19.8%)
  • Fees (19.4%)
  • Custody (12.6%)
  • Investment Activities (3.9%)
  • Solicitors
  • Pooled Investment Vehicles (Hedge Fund)
  • Performance Reporting

Discussion of Deficiencies

There are a number of slides devoted to providing more granular information on the various deficiencies.  Below are some of my thoughts when I read through these deficiencies:

  • Properly completing ADV, including proper descriptions (AUM, fees, business overview, disclosures) and making sure there are no inconsistencies; unregistered IAs were not a large part of the deficiencies.
  • Investment adviser books and records are what you would expect – a number of different items were not properly kept as required by regulations. Surprisingly, it seems that many IAs do not keep the suitability information on their clients as required.
  • Under unethical practices, it seems that many of the deficiencies were likely caused by careless drafting of contract documents. Non-contract unethical business practices revolved around advertising and conflicts of the IA.
  • One interesting note for Supervisory/Compliance is that a large number of IAs did not follow their own internal procedures. This might be worse than having inadequate procedures – if your compliance manual says you will do something, you should make sure it is being done.
  • Financials might be what you would expect – issues with respect to net worth of the IA, bond issues and inaccurate financials.
  • Advertising deficiencies focused on website issues. I would expect this to increase in the future as more IAs establish websites in the future. Additionally, social media deficiencies are likely to increase in the future as more firms use these tools to advertise their business. [Note: while the managed futures industry has different regulations, the concepts of social media regulation for the futures industry can be applied to securities compliance.]
  • Custody is probably the single most misunderstood concept for IA firms. Most people view custody to be having physical possession of a client’s cash or securities.  However, if you directly deduct a fee from a client account (even if this is done by the custodian, i.e. Schwab) then in most states the IA is deemed to have “custody” of the account and must adhere to the custody requirements of the state.
  • It is interesting to note that with respect to investment activities the following were some common deficiencies: preferential treatment (I assume, without disclosure), aggregate trades, and soft dollars.
  • Solicitors have become a more prevalent issue over the last few months as more fund managers (who are RIAs) offer separately managed account programs. [Note: we will have more articles forthcoming on this issue shortly.] For solicitor issues the big items were undisclosed solicitors and issues with disclosure. Also, the agreement between the IA and the solicitor was a common deficiency.
  • Hedge fund managers with no separately managed account business had many more deficiencies than IA only firms. Deficiencies with respect to hedge funds related to valuation, cross-trading and preferential treatment (again, we assume, without disclosure).

IA Compliance Best Practices

As a result of the report, the NASAA identified the following as best practices for IAs:

  • Review and revise Form ADV and disclosure brochure annually to reflect current and accurate information.
  • Review and update all contracts.
  • Prepare and maintain all required records, including financial records.
  • Back-up electronic data and protect records.
  • Document all forwarded checks.
  • Prepare and maintain client profiles.
  • Prepare a written compliance and supervisory procedures manual relevant to the type of business to include business continuity plan.
  • Prepare and distribute a privacy policy initially and annually.
  • Keep accurate financials. File timely with the jurisdiction.
  • Maintain surety bond if required.
  • Calculate and document fees correctly in accordance with contracts and ADV.
  • Review all advertisements, including website and performance advertising, for accuracy.
  • Implement appropriate custody safeguards, if applicable.
  • Review solicitor agreements, disclosure, and delivery procedures.

Conclusion

It is clear that NASAA is trying to be more of an influence on how the state administrators conduct examinations and the focus areas of those examinations.  While it is helpful for NASAA to release investment adviser compliance best practices, it would be more useful if they released more robust compliance materials such as sample compliance manuals/ policies and clearer guidance on state interpretations of regulations.  As Congress and the SEC determine whether to establish an investment adviser SRO, we are likely to see NASAA take a larger thought leadership role.  In any event, investment advisers and hedge fund managers should begin to start thinking about registration and implementing robust compliance policies and procedures which address all parts of state or SEC IA registration regulations.

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Cole-Frieman & Mallon LLP provides legal advice to hedge fund start ups and well as established fund complexes.  Bart Mallon can be reached directly at 415-868-5345.

Connecticut Issues Orders Regarding Investment Adviser Registration

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Three Orders Focused on New Hedge Fund Regulations

On June 11, 2011, Connecticut Department of Banking issued three orders relating to Connecticut investment adviser registration requirements in response to the SEC issuing final hedge fund registration regulations required by the Dodd-Frank Act.  The orders (1) create a registration transition period for previously exempt advisers, (2) provide several new exemptions from state registration and (3) define the term “client” for the purposes of Connecticut’s de minimus exemption.

First Order – State Registration Timeline

The first order establishes a state registration timeline for Connecticut advisers affected by the Dodd-Frank Act.  Under this order the following timelines will be in effect:

Investment advisers currently registered with the SEC with assets under management of less than $90 million as of March 30, 2012, will have until June 28, 2012 to withdraw from registration with the SEC and register as an investment adviser in CT.

Investment advisers who had relied on the repealed “private adviser” exemption under Rule 203(b)(3) will have until March 30, 2012 to either register with Connecticut or to register with the SEC and make a notice filing with Connecticut.

Investment advisers who are not eligible for SEC registration or for either of the above deferrals and new advisers starting their advisory business after July 21, 2011 must continue to comply with applicable Connecticut registration and notice filing requirements.

This first order can be found here.

Second Order – Exemptions from Connecticut IA Registration

Previously, Connecticut provided an exemption from investment adviser registration for those hedge fund managers who were located in Connecticut and had more than $25M in assets under management and managed less than 15 hedge funds. The new order repeals this previous exemption and adopts the same exemptions from Connecticut state registration as have been adopted by the SEC.

Accordingly, the following investment advisers are exempt from registration in Connecticut:

  • Foreign private advisers
  • Investment advisers that are registered with the CFTC
  • Investment advisers to small business investment companies
  • Investment advisers to venture capital funds
  • Investment advisers solely to private funds with assets under management of less than $150 million.

Some of these exempted advisers will still be subject to various reporting and recordkeeping requirements by the SEC and may need to make notice filings and/or reports available to Connecticut.

It is important for managers to understand that the above extensions don’t apply to investment advisers and fund managers commencing business on or after July 21, 2011. Those investment advisers and others that don’t fall into the described exemptions remain subject to applicable registration and notice filing requirements in Connecticut.

The second order can be found here.

Third Order – Definition of “Client” for Connecticut’s De Minimus Exemption

To further conform its regulations to the new SEC rules, Connecticut has adopted the definition of “client” in accordance with the Investment Advisers Act Rule 202(a)(30)-1 for Connecticut’s de minimus exemption. The de minimus exemption allows an investment adviser to not register with the state if the investment adviser:

  1. does not have a place of business in Connecticut AND
  2. during the preceding 12 month period had fewer than 6 “clients” who are residents of Connecticut

Under the new Connecticut rule, a single “client” generally means:

  1. a natural person, family members of the same household and accounts for such persons OR
  2. an entity (such as a hedge fund) to which the investment adviser provides investment advice based on the entity’s investment objectives (two entities with exactly the same ownership can, together, be counted as a single client)
The third order can be found here.

Conclusion

The new SEC rules implementing investment adviser regulation amendments under the Dodd-Frank Act have created new compliance and regulatory issues for investment advisers. States will need to amend their rules to coordinate their regulatory regime with the new changes. We expect to see similar releases from other states in the coming weeks, and will be providing updates as appropriate.

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Cole-Frieman & Mallon LLP provide advice with respect to hedge fund formation as well as investment adviser registration and compliance.  Bart Mallon can be reached directly at 415-868-5345.

Karl Cole-Frieman Speaking at San Francisco Hedge Fund Event

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Dodd-Frank Implementation Considerations for Private Equity and Hedge Funds

On October 18th Grant Thornton LLP and Financial Women’s Association of San Francisco will be hosting a panel discussion and reception focused on regulatory issues for hedge funds and private equity funds.  Karl Cole-Frieman, a partner with Cole-Frieman & Mallon LLP, will be the attorney on the panel and will be discussing both the legal and business aspects of compliance with the various Dodd-Frank regulations.

Information on the event is posted below and you can register for the event by clicking here.

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Grant Thornton LLP and the Financial Women’s Association of San Francisco invite you to join our upcoming panel discussion, focusing on implementation considerations for Private Equity and Hedge Funds under the Dodd-Frank Act. At this informative event, professionals from the industry will discuss various hot topics including:

  • Registration requirements
  • Restructuring considerations
  • Implementation and best practices
  • Focus areas of SEC examinations
  • Cost effective ways to comply with Dodd-Frank

Featured Panelists

Winston Wilson – National Financial Services Sector Leader, Grant Thornton LLP

Mark Catalano – Director, Deutsche Bank, Alternative Fund Services

Chris Lombardy – Member, Regulatory compliance, Kinetic Partners

Karl Cole-Frieman – Partner, Cole-Frieman & Mallon LLP

Moderated by Ann Oglanian, President & CEO, ReGroup LLC

Agenda

4:00 – 4;30 p.m. Registration*

4:30 – 6:00 p.m. Panel / Q&A

6:00 – 7:00 p.m. Cocktail reception

Location

Omni Hotel

500 California Street

2nd Floor

San Francisco, CA 94104

* This event is by invitation only. Spots are limited so register early!

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Cole-Frieman & Mallon LLP provides a variety of services including: hedge fund formation, advisor registration and counterparty documentation, CFTC and NFA matters, seed deals, internal investigations, operational compliance, regulatory risk management, hedge fund due diligence, marketing and investor relations, employment and compensation matters, and routine business matters. For more information please visit us at: http://www.colefrieman.com/.

Hedge Fund Soft Dollar Disclosure Practices

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 Disclosure Under Greater Scrutiny

Both registered investment advisers and unregistered managers are generally required to make complete and accurate disclosures with respect to their investment programs.  The obvious purpose of this requirement is to provide potential investors and clients with accurate information so the investors can make informed decision about the merits of a particular investment or investment program.  Disclosures regarding a manager’s soft dollar practices are especially important.  In general managers will need to provide accurate disclosure of their soft dollar practices in Form ADV, the hedge fund offering documents, the investment advisory contracts, and marketing materials.

Note: The Hedge Fund Law Blog discussed the Section 28(e) safe harbor for research and brokerage services in a previous post.

ADV Part 2 Required Soft Dollar Disclosures

The SEC’s most recent guidance regarding required soft dollar disclosures is provided by the instructions for Item 12 (“Brokerage Practices”) of the new Form ADV Part 2. The “Research and Other Soft Dollar Benefits” section of Item 12, requires disclosure of “all soft dollar benefits you receive, including, in the case of research, both proprietary research (created or developed by the broker-dealer) and research created or developed by a third party.”

The following specific items from the instructions provide additional guidance as to the details that must be included in the disclosures:

a. Explain that when you use client brokerage commissions (or markups or markdowns) to obtain research or other products or services, you receive a benefit because you do not have to produce or pay for the research, products or services.

b. Disclose that you may have an incentive to select or recommend a broker-dealer based on your interest in receiving the research or other products or services, rather than on your clients’ interest in receiving most favorable execution.

c.  If you may cause clients to pay commissions (or markups or markdowns) higher than those charged by other broker-dealers in return for soft dollar benefits (known as paying-up), disclose this fact.

d. Disclose whether you use soft dollar benefits to service all of your clients’ accounts or only those that paid for the benefits. Disclose whether you seek to allocate soft dollar benefits to client accounts proportionately to the soft dollar credits the accounts generate.

e. Describe the types of products and services you or any of your related persons acquired with client brokerage commissions (or markups or markdowns) within your last fiscal year.

Note: This description must be specific enough for your clients to understand the types of products or services that you are acquiring and to permit them to evaluate possible conflicts of interest. Your description must be more detailed for products or services that do not qualify for the safe harbor in section 28(e) of the Securities Exchange Act of 1934, such as those services that do not aid in investment decision-making or trade execution. Merely disclosing that you obtain various research reports and products is not specific enough.

f. Explain the procedures you used during your last fiscal year to direct client transactions to a particular broker-dealer in return for soft dollar benefits you received.

Hedge fund managers should note that the disclosures must be detailed and specific and include a description of the procedures used to direct trades in exchange for soft dollar benefits. Hedge fund offering documents should contain similar soft dollar disclosures. The only case where disclosure is not required is when an investment adviser is not using any soft dollars at all.

Importance of Complete and Accurate Soft Dollar Disclosures

Under general fiduciary principles, an investment adviser has a duty to seek best execution for discretionary client trades. The receipt of soft-dollar benefits in exchange for trade execution represents a conflict of interest with the fiduciary duty of best execution because the client is generally paying for more than mere execution. Accurate and complete disclosure of the adviser’s conflicts of interest is fundamental to an adviser’s fiduciary duty and typically deemed necessary in order to avoid violating the anti-fraud provisions of the Investment Advisers Act of 1940 (see Sections 206(1), (2) and (4)). Additionally, Section 207 of the Advisers Act provides that it is unlawful for any person willfully to make any untrue statement of material fact in any registration application filed with the SEC or willfully to omit to state in any such application any material fact required to be stated therein. Accordingly, many of the SEC enforcement actions involving soft dollars contain allegations of violations of Section 206 and/or Section 207 of the Advisers Act.

Examples of Improper Disclosure

The SEC takes disclosure practices seriously.  Below are two cases involving deficiencies in soft dollar disclosure practices:

In Schultze Asset Management LLC, et al., Investment Advisers Act Release No. 2633 (Aug. 15, 2007), the SEC sanctioned Schultze Asset Management (“SAM”) for violations of Section 206(1) and 206(2) because SAM’s disclosures to an advisory client indicated that SAM was using “client commissions generated by the account only for expenses covered by the safe harbor provided by Section 28(e),” when, in fact, SAM used the soft-dollars generated by the client trades to pay for expenses outside the 28(e) safe harbor, including the salary of the principal. In resolution of the action, SAM returned approximately $350,000 to its clients, representing all soft dollar payments SAM received. Additionally, the SEC censured SAM, its principal, and fined SAM and the principal $100,000 and $50,000 respectively.

In In re Dawson-Samberg Capital Mgmt, Inc. Investment Adviser Act Release No. 1889 (Aug. 3, 2000), the SEC sanctioned Dawson-Samberg for violations of Section 206(2) and Section 207 of the Advisers Act because of its failure to appropriately disclose soft dollar practices that included use of soft dollars to pay for “research-related travel expenses.” Dawson-Samberg and one of its principals were censured and fined $100,000 and $20,000 respectively.

Conclusion

Manager need to take soft dollar disclosure seriously.  If you have questions about whether current disclosure is sufficient, you should discuss with your legal counsel.

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Cole-Frieman & Mallon LLP provides legal advice to hedge fund managers.  The firm also has a focus on investment adviser registration and compliance matters.  Bart Mallon can be reached directly at 415-868-5345.  Karl Cole-Frieman can be reached at 415-352-2300.

FINRA Rule 5131 Effective September 26, 2011

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FINRA “Anti-Spinning” Rule 5131

The anti-spinning provisions of FINRA Rule 5131, which addresses certain conflicts of interest in allocation of New Issues, will go into effect September 26, 2011. Although Rule 5131 only applies to FINRA members (broker-dealers), hedge funds that invest in initial public offerings will be required to provide certain representations to their broker-dealer before they will be allowed to participate in New Issues. The definition of “New Issues” for purposes of Rule 5131 is the same as for FINRA Rule 5130, and includes most initial public offerings of equity securities.

Please note: Rule 5131 does not replace Rule 5130 and it creates additional requirements with respect to New Issues.

Spinning Prohibition

The purpose of the anti-spinning provision of FINRA Rule 5131 is to prohibit the practice of broker-dealers from allocating New Issues to executive officers and directors of current or potential clients in exchange for investment banking business (the practice commonly known as “spinning”).

Rule 5131 generally prohibits a broker-dealer from allocating New Issues to any account (including an account maintained by a hedge fund) in which beneficial interests are held by the following persons, if the broker-dealer currently has or has the expectation of a relationship with that company:

  • an executive officer or director of a public company or a covered non-public company, or
  • a person materially supported by such executive officer or director.

25% De Minimus Exemption

In addition to specific exemptions for certain types of accounts, the prohibition does not apply to an account where the interests of executive officers or directors of a public company or a covered non-public company, or persons materially supported by them, are less than 25% of such account. This means that if two investors in a hedge fund are both directors of the same public company but their combined interest in the fund is 20% of the fund, the broker-dealer will not be prohibited from allocating New Issues to that hedge fund.

Broker-Dealer Compliance with Rule 5131

Before allocating New Issues to any account, a broker-dealer will need to confirm the following:

  • whether the underlying investors in the account are executive officers or directors of a public company or a covered non-public company, or persons materially supported by them;
  • if yes, what company that investor is associated with, and
  • whether the interests of any one company are more than 25% of the account.

Correspondingly, investment managers will need to obtain this information from the underlying investors in their fund.

Implications for Investment Managers

If you currently manage a fund that invests in New Issues, you will likely be asked to complete a Rule 5131 certification by your broker-dealer. You will need to contact your existing investors and obtain written representations regarding their status, which may be done in the form of a questionnaire. You will also need to revise your hedge fund subscription documents to include similar representations for each new investor. Investor representations will need to be updated annually, which may be done through the use of a negative consent letter.

Even if more than 25% of the fund is owned by executive officers or directors (or persons materially supported by them) of one company, the fund may still participate in New Issues by implementing “carve-out” procedures to reduce the beneficial interests of those persons below 25%. Managers wishing to make use of such carve-outs should make sure the operating documents of their fund allow such procedures.

Please contact us if you need assistance in preparing questionnaires, revising offering documents or if you have questions regarding your ability to participate in New Issues under Rule 5131.

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Cole-Frieman & Mallon LLP is a firm with a practice focused on investment management law.  Bart Mallon is a hedge fund attorney and can be reached directly at 415-868-5345.

FINRA Rule 5131 – New Issue Allocations and Distributions

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Full Text of FINRA Rule 5131

The following is the full version of FINRA Rule 5131 effective as of September 26, 2011.  This rule, in conjunction with FINRA Rule 5130, governs the manner in which investors may participate in New Issues.  Specifically, Rule 5131 prevents “spinning” which is the practice of allocating new issues to executive officers and directors of current or potential clients in exchange for investment banking business.

The following rule can also be found on the FINRA website here.

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5131. New Issue Allocations and Distributions

(a) Quid Pro Quo Allocations

No member or person associated with a member may offer or threaten to withhold shares it allocates of a new issue as consideration or inducement for the receipt of compensation that is excessive in relation to the services provided by the member.

(b) Spinning

(1) No member or person associated with a member may allocate shares of a new issue to any account in which an executive officer or director of a public company or a covered non-public company, or a person materially supported by such executive officer or director, has a beneficial interest:

(A) if the company is currently an investment banking services client of the member or the member has received compensation from the company for investment banking services in the past 12 months;

(B) if the person responsible for making the allocation decision knows or has reason to know that the member intends to provide, or expects to be retained by the company for, investment banking services within the next 3 months; or

(C) on the express or implied condition that such executive officer or director, on behalf of the company, will retain the member for the performance of future investment banking services.

(2) The prohibitions in this paragraph shall not apply to allocations of shares of a new issue to any account described in Rule 5130(c)(1) through (3) and (5) through (10), or to any other account in which the beneficial interests of executive officers and directors of the company and persons materially supported by such executive officers and directors in the aggregate do not exceed 25% of such account.

(c) Policies Concerning Flipping

(1) No member or person associated with a member may directly or indirectly recoup, or attempt to recoup, any portion of a commission or credit paid or awarded to an associated person for selling shares of a new issue that are subsequently flipped by a customer, unless the managing underwriter has assessed a penalty bid on the entire syndicate.

(2) In addition to any obligation to maintain records relating to penalty bids under SEA Rule 17a-2(c)(1), a member shall promptly record and maintain information regarding any penalties or disincentives assessed on its associated persons in connection with a penalty bid.

(d) New Issue Pricing and Trading Practices

In a new issue:

(1) Reports of Indications of Interest and Final Allocations. The book-running lead manager must provide to the issuer’s pricing committee (or, if the issuer has no pricing committee, its board of directors):

(A) a regular report of indications of interest, including the names of interested institutional investors and the number of shares indicated by each, as reflected in the book-running lead manager’s book of potential institutional orders, and a report of aggregate demand from retail investors;

(B) after the settlement date of the new issue, a report of the final allocation of shares to institutional investors as reflected in the books and records of the book-running lead manager including the names of purchasers and the number of shares purchased by each, and aggregate sales to retail investors;

(2) Lock-Up Agreements. Any lock-up agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer entered into in connection with a new issue shall provide that:

(A) Any lock-up agreement or other restriction on the transfer of the issuer’s shares by officers and directors of the issuer shall provide that such restrictions will apply to their issuer-directed shares; and

(B) At least two business days before the release or waiver of any lock-up or other restriction on the transfer of the issuer’s shares, the book-running lead manager will notify the issuer of the impending release or waiver and announce the impending release or waiver through a major news service, except where the release or waiver is effected solely to permit a transfer of securities that is not for consideration and where the transferee has agreed in writing to be bound by the same lock-up agreement terms in place for the transferor;

(3) Agreement Among Underwriters. The agreement between the book-running lead manager and other syndicate members must require, to the extent not inconsistent with SEC Regulation M, that any shares trading at a premium to the public offering price that are returned by a purchaser to a syndicate member after secondary market trading commences:

(A) be used to offset the existing syndicate short position, or

(B) if no syndicate short position exists, the member must either:

(i) offer returned shares at the public offering price to unfilled customers’ orders pursuant to a random allocation methodology, or

(ii) sell returned shares on the secondary market and donate profits from the sale to an unaffiliated charitable organization with the condition that the donation be treated as an anonymous donation to avoid any reputational benefit to the member.

(4) Market Orders. No member may accept a market order for the purchase of shares of a new issue in the secondary market prior to the commencement of trading of such shares in the secondary market.

(e) Definitions

For purposes of this Rule, the following terms shall have the meanings stated below.

(1) A “public company” is any company that is registered under Section 12 of the Exchange Act or files periodic reports pursuant to Section 15(d) thereof.

(2) “Beneficial interest” shall have the same meaning as in FINRA Rule 5130(i)(1).

(3) “Covered non-public company” means any non-public company satisfying the following criteria: (i) income of at least $1 million in the last fiscal year or in two of the last three fiscal years and shareholders’ equity of at least $15 million; (ii) shareholders’ equity of at least $30 million and a two-year operating history; or (iii) total assets and total revenue of at least $75 million in the latest fiscal year or in two of the last three fiscal years.

(4) “Flipped” means the initial sale of new issue shares purchased in an offering within 30 days following the offering date of such offering.

(5) “Investment banking services” include, without limitation, acting as an underwriter, participating in a selling group in an offering for the issuer or otherwise acting in furtherance of a public offering of the issuer; acting as a financial adviser in a merger, acquisition or other corporate reorganization; providing venture capital, equity lines of credit, private investment, public equity transactions (PIPEs) or similar investments or otherwise acting in furtherance of a private offering of the issuer; or serving as placement agent for the issuer.

(6) “Material support” means directly or indirectly providing more than 25% of a person’s income in the prior calendar year. Persons living in the same household are deemed to be providing each other with material support.

(7) “New issue” shall have the same meaning as in Rule 5130(i)(9).

(8) “Penalty bid” means an arrangement that permits the managing underwriter to reclaim a selling concession from a syndicate member in connection with an offering when the securities originally sold by the syndicate member are purchased in syndicate covering transactions.

(9) “Unaffiliated charitable organization” is a tax-exempt entity organized under Section 501(c)(3) of the Internal Revenue Code that is not affiliated with the member and for which no executive officer or director of the member, or person materially supported by such executive officer or director, is an individual listed or required to be listed on Part VII of Internal Revenue Service Form 990 (i.e., officers, directors, trustees, key employees, highest compensated employees and certain independent contractors).

• • • Supplementary Material: ————–

.01 Issuer Directed Allocations. The prohibitions of paragraph (b) above shall not apply to allocations of securities that are directed in writing by the issuer, its affiliates, or selling shareholders, so long as the member has no involvement or influence, directly or indirectly, in the allocation decisions of the issuer, its affiliates, or selling shareholders with respect to such issuer-directed securities.

.02 Annual Representation. For the purposes of paragraph (b), a member may rely on a written representation obtained within the prior 12 months from the beneficial owner(s) of the account, or a person authorized to represent the beneficial owner(s) of the account, as to whether such beneficial owner(s) is an executive officer or director or person materially supported by an executive officer or director and if so, the company(ies) on whose behalf such executive officer or director serves. A member may not rely upon any representation that it believes, or has reason to believe, is inaccurate. A member shall maintain a copy of all records and information relating to whether an account is eligible to receive an allocation of the new issue under paragraph (b) in its files for at least three years following the member’s allocation to that account.

.03 Lock-up Announcements. For the purposes of this Rule, the requirement that the book-running lead manager announce the impending release or waiver of a lock-up or other restriction on the transfer of the issuer’s shares shall be deemed satisfied where such announcement is made by the book-running lead manager, another member or the issuer, so long as such announcement otherwise complies with the requirements of paragraph (d)(2) of this Rule.

Amended by SR-FINRA-2011-017 eff. Sept. 26, 2011.

Adopted by SR-NASD-2003-140 eff. May 27, 2011.

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Cole-Frieman & Mallon LLP is a hedge fund law firm.  Bart Mallon can be reached directly at 415-868-5345.