Author Archives: Hedge Fund Lawyer

Form ADV Part 2 Questions & Answers

SEC Provides Guidance on ADV Part 2

Many SEC and state registered investment advisers have completed the new Form ADV 2 as part of the annual updating amendment.*  The SEC recently published guidance with respect to certain aspects of the new form.  The question and answer style guidance deals with such topics as: IARD submission deadlines, delivery of the brochure, and the Part 2B brochure supplement (for certain “supervised persons” with client contact).  For hedge fund managers, the most important points include:

  • Fund managers do not need to provide investors in the fund with copies of Form ADV Part 2.
  • In Part 2A, hedge fund managers are required to only briefly discuss the major risks of the fund’s investment strategy and then may direct investors to the fund’s offering documents for more detailed information on the risks of the program.
  • Offshore hedge fund managers who only provide advice to offshore funds do not have to file or prepare an ADV Part 2.
  • Part 2B Brochure Supplements (for “supervised persons”) do not need to be delivered until later this year.

Below we have reprinted some of the more applicable portions of the guidance.  The full set of questions and answers can be found here.

For additional information on preparation and delivery of the new form, please also see Form ADV Instructions for Part 2A.

* Note: most state registered advisers were required to complete the new Part 2 by March 31 as required by the state securities administrator.  Some states, such as Colorado, do not require the new Part 2 until later this year.  If you are a state or SEC registered adviser who has not submitted the new Part 2, please feel free to contact us and we can help you with this process.

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Updated as of March 18, 2011

Staff Responses to Questions About Part 2 of Form ADV

The staff of the Division of Investment Management has prepared the following responses to questions about Part 2 of Form ADV, under the Investment Advisers Act of 1940 and expects to update from time to time our responses to additional questions. These responses represent the views of the staff of the Division of Investment Management. They are not a rule, regulation, or statement of the Securities and Exchange Commission, and the Commission has neither approved nor disapproved this information. The adopting release for the most recent Amendments to Form ADV (dated July 28, 2010, the “Adopting Release”) can be found at: http://www.sec.gov/rules/final/2010/ia-3060.pdf.

Compliance Dates

Question I. 1

Q: The Commission has extended the compliance dates for certain advisers to deliver Part 2B, the brochure supplement. What are the new compliance dates?

A: On December 28, 2010, the Commission extended the compliance dates for delivery of Part 2B for certain investment advisers. (See IA-3129 athttp://www.sec.gov/rules/final/2010/ia-3129.pdf)

  • All advisers registered with the Commission as of December 31, 2010, and having a fiscal year ending on December 31, 2010 through April 30, 2011, have until July 31, 2011, to prepare and begin delivering brochure supplements to new and prospective clients and have until September 30, 2011 to deliver brochure supplements to existing clients. The compliance dates for delivering brochure supplements for all other advisers registered with the Commission as of December 31, 2010 remain unchanged. Upon filing their new brochures through the IARD, they must start to provide to their new clients a brochure supplement for a supervised person before or at the time that supervised person begins to provide advisory services to the client. In addition, they must deliver brochure supplements to their existing clients within 60 days of when they are required to file their new brochures with the Commission.
  • All newly registered advisers filing their applications for registration from January 1, 2011 through April 30, 2011, have until May 1, 2011 to prepare and begin delivering brochure supplements to new and prospective clients and have until July 1, 2011 to deliver brochure supplements to existing clients. The compliance dates for delivering brochure supplements for newly registered advisers filing applications for registration after April 30, 2011 remain unchanged. (Posted March 18, 2011)

Question I. 2

Q: Has the Commission also extended the compliance dates for filing and delivering Part 2A, the brochure (“new brochure”)?

A: No. The compliance dates for delivering new brochures remain unchanged for both newly registered advisers and existing advisers.

  • Each adviser currently registered with the Commission whose fiscal year ends on or after December 31,

    2010 must include in its next annual updating amendment to its Form ADV a new brochure. (Rule 204-1(c)) Upon filing its new brochure with the Commission, an adviser must (i) begin to deliver the new brochure to new clients and prospective clients in lieu of its old brochure in accordance with its obligations under rule 204-3, and (ii) deliver to its existing clients within 60 days of when an adviser is required to file it. (Rule 204-3(g)).

  • Each adviser applying for registration with the Commission after January 1, 2011 must file a brochure or brochures that meet the requirements of amended Part 2A as part of the application for registration on Form ADV. (Rule 203-1(b)). Such an adviser must, upon registering, begin to deliver to its clients and prospective clients the new brochure or brochures in accordance with rule 204-3(a). (Posted March 18, 2011)

Preparing Brochures

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Question II. 4

Q: Item 8.B of Part 2A requires an adviser to explain the material risks for each significant investment strategy or method of analysis the adviser uses. Does Item 8.B require an adviser that uses pooled investment vehicles as a significant investment strategy or method of analysis to duplicate the risk disclosures contained in a prospectus or other offering document for the pooled investment vehicle?

A: An adviser may satisfy the requirement of Item 8.B by providing a brief explanation of the material risks for each strategy and referring clients to the prospectus, offering memoranda, or other documents that a client participating in the pool will or has received that set out a more detailed discussion of risks. (Posted March 18, 2011)

Question II. 5

Q: Item 8.B of Part 2A requires an adviser to explain the material risks for each significant investment strategy or method of analysis the adviser uses. Does Item 8.B require an adviser that uses multiple investment strategies or methods of analysis to explain the material risks for each significant investment strategy or method of analysis in the brochure?

A: Yes, an investment adviser using multiple significant investment strategies or methods of analysis must explain the risks for each significant investment strategy or method of analysis it uses. An adviser using multiple strategies or methods of analysis may satisfy the requirements of Item 8.B by summarizing the strategies and methods and their material risks and referring clients and prospective clients to a separate disclosure document that the client has or will receive that sets out a more detailed explanation of the material risks of investment strategies or methods of analysis that are or will be used to manage the client’s account. (Posted March 18, 2011)

Question II. 6

Q: The staff has previously stated its view that an offshore adviser to an offshore private fund does not have an obligation to deliver a brochure under rule 204-3 to the offshore fund or to any investors in an offshore private fund it advises. ABA Subcommittee on Private Investment Entities, SEC Staff Letter (Aug. 10, 2006). The note to rule 203-1 states that an adviser that does not have to deliver a brochure to any clients does not have to prepare or file a brochure with the Commission. Does the 2006 staff response and the note work together such that an offshore adviser whose only clients are offshore funds would not have to prepare or file a brochure as part of its Form ADV?

A: Yes. (Posted March 18, 2011)

Filing and Delivering Brochures

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Question III. 2

Q: Rule 204-3 requires an adviser to deliver a brochure and one or more brochure supplements to each client or prospective client. Does rule 204-3 require an adviser to a hedge or other private fund to deliver a brochure and supplement(s) to investors in the private fund?

A: Rule 204-3 requires only that brochures be delivered to “clients.” A federal court has stated that a “client” of an investment adviser managing a hedge fund is the hedge fund itself, not an investor in the hedge fund. (Goldstein v. Securities and Exchange Commission, 451 F.3d 873 (D.C. Cir. 2006)). An adviser could meet its delivery obligation to a hedge fund client by delivering its brochure to a legal representative of the fund, such as the fund’s general partner, manager or person serving in a similar capacity. (Posted March 18, 2011)

Question III. 3

Q: Must an adviser to a hedge fund or other private fund file as part of its Form ADV the brochure it is required to deliver to the hedge fund or other private fund?

A: Yes. (Posted March 18, 2011)

Covered Persons for Brochure Supplements

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Preparing Brochure Supplements

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Delivery of Brochure Supplements

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Cole-Frieman & Mallon LLP is a boutique hedge fund law firm.  We provide investment adviser registration and compliance services to SEC and state registered hedge fund managers.  Bart Mallon can be reached directly at 415-868-5345.

California Requests Input on IA Exemption Changes

Seeks to Raise IA Exemption Threshold to $100MM AUM

In an Invitation for Comments released today, California officially seeks comments to change its rules with respect to hedge fund managers and a certain exemption from investment adviser registration.  California currently exempts from registration those investment advisers with a place of business in California and more than $25MM of AUM (please see our post on the California IA exemption).  California may, however, increase the asset threshold for the exemption because of the changes under the Dodd-Frank Act.

Prior to Dodd-Frank, hedge fund managers could not register with the SEC unless they had $25MM of AUM.  Now, the threshold will be $100MM of AUM.  Accordingly, some states are proposing to amend current laws so they reflect the changes at the federal level.  The invitation for comments seems to be based on a recent NASAA proposed hedge fund model rule which would require all non-SEC registered hedge fund managers (to Section 3(c)(1) funds) to register with the state securities commission.   The proposed model rule was a natural step for NASAA to take considering that the Dodd-Frank Act did, with respect to some states, leave a regulatory gap.  Connecticut is another state which has an exemption for managers with more than $25MM of AUM (please see our post on the Connecticut IA exemption).

California Invitation

California provided the following as a reason for the invitation:

As a result of Dodd-Frank, on July  21, 2011, Section  260.204.9 will no longer provide an exemption from California licensing requirements.  In anticipation of these changes, the California Corporations Commissioner will be amending Section 260.204.9 to reflect the changes in the corresponding federal rules.  The Commissioner seeks input on the issue of how best to regulate advisers to alternative investment vehicles, while balancing the regulatory burden on such advisers, with any corresponding investor protections issues.

The following are the items which California asks interested parties to discuss:

1.  To avoid the “retailization” of private alternative investment funds, should the exemption apply exclusively to advisers to Section 3(c)(7) funds (i.e., not to Section 3(c)(1) funds)?
2.  Should all persons investing in a Section 3(c)(1) fund be required to be qualified clients? If so, should the Department issue an order that “grandfathers” Section 3(c)(1) funds organized prior to July 21, 2010?
3. Should the proposed statutory disqualification provisions be expanded to include additional factors?
4.  Should the proposed asset under management threshold (AUM) be a different amount than that set forth in the proposed rule (i.e. $100 million)?  If so, what is the basis for a different threshold?
5.  Are there criteria other than AUM that the Commissioner should consider to determine whether an adviser should be exempt (e.g., the fund is subject to an annual audit)?
6.  Should the Department’s definition of venture capital company/fund conform to the proposed SEC definition?
7.  Should the Department adopt the North American Securities Administrators Association (NASAA) proposed model rule for an exemption for Private Fund Advisers?

What this means

Right now this does not mean anything.  The division will take comments into consideration when they begin to draft the proposed amendment to the current hedge fund registration exemption.  After the proposed amendment is drafted, there will be a public comment period prior to any new regulation being officially adopted.  This means that interested parties will have the ability to have their comments heard now and after a proposed rule has been announced.  Comments on this particular release are due by March 28, 2011.

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Bart Mallon is an attorney who works with both state and SEC registered fund managers.  His firm, Cole-Frieman & Mallon LLP, routinely provides regulatory and compliance services to registered investment advisers.  He can be reached directly at 415-868-5345.

Form CPO-PQR

Proposed Form CPO-PQR Released

For your review, we have published the proposed Form CPO-PQR which can be found here: Form CPO-PQR

As recently proposed by the CFTC, registered commodity pool operators will be required to file proposed From CPO-PQR on either a quarterly or annual basis depending on assets under management and scope of business activities.  There are special rules for those managers who are also registered as an investment adviser with the SEC and who file Form PF.

This post will provide an overview of the major aspects of the Form COP-PQR as it is currently proposed.

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Who is required to file Form CPO-PQR?

All CPOs are required to file at least parts of Form CPO-PQR.

When do managers need to file Form CPO-PQR?

Most managers will need to file some parts of Form CPO-PQR on a quarterly basis.  Some managers, depending on assets under management, will need to file additional sections of the form on either an annual or quarterly basis.

The sections of the form will need to be filed within 15 days of the end of the quarter; however, for some managers, some sections will not need to be completed until 90 days after

the end of the quarter.

What are the sections of Form CPO-PQR?

Form CPO-PQR has 3 major sections.  F

  • Schedule A – must be filed by all CPOs which operate at least one pool during the quarter within 15 days of the end of the quarter.
  • Schedule B – must be filed by Mid-Sized CPOs annually within 90 days of the end of the year and Large CPOs quarterly within 15 days of the end of the quarter.
  • Schedule C – must be filed by Large CPOs quarterly within 15 days of the end of the quarter.

A Mid-Sized CPO is a CPO that had at least $150 million in pool AUM as of the close of business on any day during a quarter.

A Large CPO is a CPO that had at least $1 billion in pool AUM as of the close of business on any day during a quarter.

Note: Schedule B and Schedule C may not have to be filed with the CFTC if the CPO has completed certain sections of Form PF and meet other certain requirements.

Details of the Schedules

Schedule A

Part 1 – includes information with respect to the firm such as name, NFA ID #, contact person, chief compliance officer, # of employees, # of owners, # of pools

Part 2 – includes information on each pool which was operated during the quarter.  For each commodity pool this information includes:

  • Identifying information: mame of pool, NFA ID#, jurisdiction of organization, fiscal year end, structure
  • Outside Administrator: name, contact info, NFA ID#, start of relationship, services provided, % of pool assets valued by outside administrator
  • Broker – name, NFA ID #, contact info
  • Other service providers – carrying broker, trading manager, custodian, auditor, marketer
  • Information regarding assets over quarte
    • Beginning AUM & NAV
    • Ending AUM & NAV
    • Income over quarter
    • Additions, withdrawals and redemptions over quarter
  • Monthly ROR calculated in accordance with CFTC regulations
  • Schedule of investments – there is a drill down on cash, equities, alternatives, fixed income, derivatives, options, investment funds, longs/shorts, positive/negative OTE, long/short option value, pool positions exceeding 5% of NAV
  • Subscriptions & redemption information

Schedule B

Schedule B applies to both Mid-Sized and Large CPOs.  The information is essentially the same information as required in Sections 1.b and 1.c of Form PF.  The following information is required for each pool which is managed by the CPO:

  • Pool Information – name, NFA ID#, strategy,  % of assets traded using algorythim, investor information
  • Borrowings & types of creditors – total borrowings, listing of creditors
  • Counterparty credit exposure – aggregate counterparty exposure, listing of counterparties
  • Trading & clearing – for derivatives, securities and repos
  • Value of aggregate derivative positions

Schedule C

Schedule C is only completed by Large CPOs.  Schedule C will not need to be completed if the Large CPO has completed certain parts of Form PF.

Part 1 – the following information is required for each CPO:

  • Geographical breakdown of pools investments
  • Turnover rate of aggregate portfolio of pools
  • Duration of pools’ fixed income investments

Part 2 – the following information is required for each Large Pool:

  • Basic information – name, NFA ID#, unencumbered cash at end of month, monthly open positions
  • Liquidity of portfolio
  • Pool counterparty credit exposure
  • Pool risk metrics
  • Pool borrowing information
  • Pool derivative positions and posted collateral
  • Pool financing liquidity
  • Information on pool investors
  • Duration of fixed income assets

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Cole-Frieman & Mallon LLP provides comprehensive legal services for CPOs including completing Form CPO-PQR.  Bart Mallon can be reached directly at 415-868-5345.

CFTC Notice to CPOs re: Annual Reporting Requirement

As we discussed in our post on NFA annual compliance obligations, commodity pool operators will need to submit annual audited reports to the NFA by March 31 of this year.  This requirement applies generally to all CPOs unless the CPO requests exemptive relief from the annual audit requirement.

The CFTC has provided the following notice to remind CPOs about this annual requirement and to also provide some resources to managers regarding the technical aspects of the audit requirement.  The CFTC is recommending that managers provide their audit firms with the notice below so the firm can appropriate prepare the audited finacial statements.

The full notice is reprinted in full below.

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U.S. Commodity Futures Trading Commission
Three Lafayette Centre
1155 21st Street, NW, Washington, DC 20581
Telephone: (202) 418-5430
Facsimile: (202) 418-5536

February 2, 2011

To: All Commodity Pool Operators
Attention: Chief Financial Officer
Subject: Annual Reporting for Commodity Pools

The Division of Clearing and Intermediary Oversight (“DCIO” or “Division”) of the Commodity Futures Trading Commission (“CFTC” or “Commission”) is issuing this letter to assist commodity pool operators (“CPOs”) with the preparation and filing of commodity pool annual financial reports required under the Commodity Exchange Act (“Act”) and Commission regulations.1  This letter highlights current regulatory changes affecting CPOs with respect to financial filings and provides reminders of regulatory requirements in response to common deficiencies observed in prior years’ annual reports.  CPOs, including those that operate in non-U.S. jurisdictions, are encouraged to provide this letter to their public accountants and others assisting in the preparation of commodity pool annual financial statements.

The Division has issued similar guidance letters in prior years, which are available at the Commission’s website.2  Those letters should be consulted as they contain information relevant for many commodity pools, including the following topics:

In addition, CFTC interpretations and other staff letters that provide written guidance concerning the Act and the Commission’s regulations are available on the Commission’s website.  In particular, an illustrative example regarding Regulation 4.22(e)(2) is available in CFTC Interpretative Letter 94-3 (http://www.cftc.gov/tm/tm94-03.htm), Special Allocations of Investment Partnership Equity.

I. Recent Regulatory Activity

The CFTC issued final forex rules, which became effective on October 18, 2010.   Any firm acting as a counterparty to certain off-exchange forex transactions involving retail persons is required to register as a Retail Foreign Exchange Dealer. In addition, any individual acting as a forex solicitor, account manager and/or pool operator is required to register with the Commission as an Introducing Broker, Commodity Trading Advisor (CTA) or CPO, as appropriate, and to become a member of the National Futures Association (NFA).

NFA also adopted compliance rules applicable to CPOs as follows:

  • Rule 2-45 prohibits a CPO from permitting a commodity pool to use any means to make a direct or indirect loan or advance of pool assets to the CPO or any person or entity affiliated with the CPO.
  • Rule 2-46 requires each CPO that is a member of NFA to file, on a quarterly basis, with NFA, the following information for each pool the CPO operates that is subject to a reporting requirement under Regulation 4.22 (which includes exempt pools under Commission Regulation 4.7):
    • the identity of the pool’s administrator, carry broker(s), trading manager(s) and custodian(s);
    • a statement of changes in net asset value for the quarterly reporting period;
    • monthly performance for the three months comprising the quarterly reporting period; and
    • a schedule of investments identifying any investment that exceeds 10% of the pool’s net asset value at the end of the quarterly reporting period.

Such information must be filed with NFA within 45 days of the end of the quarterly reporting period, and must be filed using NFA Easyfile electronic filing system.

NFA also updated the Self Examination Checklist for CPOs and CTAs as of September 2010. NFA Compliance Rule 2-9 (Supervision) requires members to review their operations on a yearly basis using the NFA self-examination checklist

II. Filing Deadlines and Procedures for Commodity Pool Annual Reports

Commission regulations establish the dates by which commodity pool annual reports must be provided to pool participants and received by the NFA.

Specifically, Commission regulations provide that:

  • Commodity pool annual reports must be distributed to pool participants and filed with NFA within 90 calendar days of the pool’s fiscal year end.  The filing date for annual reports with a year end of December 31, 2010 is March 31, 2011.  Copies of the annual reports must be filed with the NFA.  A CPO should not file copies of the annual reports with the Commission.
  • CPOs must submit annual reports to NFA electronically in accordance with NFA’s EasyFile electronic filing system (http://www.nfa.futures.org/NFA-electronic-filings/easyFile-Pool-filers.HTML) and procedures.
  • An annual report may be distributed in hardcopy or electronically to pool participants.  The CPO, however, must obtain a participant’s prior consent to distribute an annual report in electronic format.
  • Applications for an extension of time to file an annual report must be submitted to NFA prior to the annual report due date and must include the information required by Regulation 4.22(f)(1).  Any request for an extension of time that exceeds 90 days from the original due date must be submitted to the Commission, and a copy filed with NFA.  The Commission generally does not grant extensions that would exceed 90 days from the original due date.
  • CPOs of commodity pools that invest in other collective investment vehicles may obtain an “automatic” 90-day extension of the distribution and filing due date by submitting the information specified by Regulation 4.22(f)(2) to NFA prior to the original due date.  In subsequent years, the CPO will be presumed to operate the pool as a fund of funds and continue to qualify for the automatic extension.  However, the CPO is obligated to inform the NFA if those circumstances change and to begin filing within the standard 90-day time frame.  In addition, this extension of time has been made available to Regulation 4.7 exempt pools, even if the report is not audited by a certified public accountant.
  • Draft financial statements.  Some CPOs have filed incomplete, or “draft,” unaudited financial statements for pools exempt under Regulation 4.7 to meet the due dates for such filings.  CPOs are reminded that although Regulation 4.7 provides exemption from certain requirements, including the requirement that financial statements be subject to an audit by a certified public accountant, annual reports filed with NFA and distributed to pool participants must include all required information and be in accordance with U.S. Generally Accepted Accounting Principles (“GAAP”) or, in some instances, International Financial Reporting Standards (“IFRS”) to be considered timely filed.  Draft unaudited financial statements do not satisfy the filing requirements.

III. Master/Feeder and Fund of Funds

Master/Feeder Structures. FASB ASC 946-205-45-6 permits nonpublic feeder pools either to follow the disclosure and reporting provisions of FASB ASC 946-210, or to present a complete set of master financial statements with each feeder financial statement.

Fund of Funds. Year end  pool financial statements must disclose specific income and fee information for investee pools as specified in Regulation 4.22(c)(5).  CPOs must disclose amounts of income and fees associated with investments in investment partnerships that exceed five percent of the commodity pool’s net assets.  Illustrative disclosures are in Attachment B to this letter.

If a commodity pool’s annual financial statements are found deficient with respect to compliance with GAAP, the CPO may be required to revise the commodity pool’s financial statements, distribute the revised statements to participants, and re-file the statements with NFA.

IV. Requests for Limited Relief from U.S. GAAP Compliance for Certain Offshore Commodity Pools

Regulation 4.22(d)(2), applicable to year end  annual reports,  permits CPOs that operate commodity pools organized under the laws of a non-U.S. jurisdiction to prepare financial statements for such pools using IFRS, provided that:

  • The use of IFRS does not conflict with any representations made in the pool’s offering memorandum or other operative document;
  • The IFRS financial statements contain a condensed schedule of investments as required by U.S. GAAP (FASB ASC 946-210-50), or, if required, a full schedule of investments;
  • The IFRS financial statements report any special allocations of partnership equity in accordance with Commission Regulation 4.22(e)(2); and
  • If IFRS would require that the pool consolidate its financial statements with another entity, such as a feeder fund consolidating with its master fund, all applicable disclosures required by U.S. GAAP for the feeder fund must be presented with the reporting pool’s consolidated financial statements.

To claim the relief to use IFRS accounting standards, the CPO must file a notice with NFA within 90 days after the end of the pool’s fiscal year.  Furthermore, Regulations 4.22(a)(5) and 4.7(b)(2) permit a CPO to present a pool’s periodic account statements and other disclosure documents on the same basis as that of its annual report.

In addition, Division staff has, on a case-by-case basis, provided limited relief to CPOs that operate offshore pools by allowing such commodity pools to prepare and to present their financial statements in accordance with another comprehensive basis of accounting other than IFRS, such as United Kingdom or Irish accounting standards, instead of U.S. GAAP.  In each case, the Division’s relief to use accounting standards other than U.S. GAAP was conditioned upon the offshore pool following the additional elements now required by Regulation 4.22(d)(2)(i).

CPOs seeking to prepare and present their offshore pools’ financial statements on another comprehensive basis of accounting other than IFRS may request relief from the U.S. GAAP requirement by submitting their requests, enumerating compliance with each of the elements specified in Regulation 4.22(d)(2), to the undersigned at the address shown on this letterhead.  If you have any further questions, contact Ronald Carletta, Branch Chief, or Al Goll, Auditor, at the phone numbers or addresses listed in Attachment A.

V. Reports of Liquidating Pools

Commission Regulation 4.22(c)(7) provides for the filing and distribution of a final annual report within 90 days of a pool’s permanent cessation of trading.  Alternatively, the CPO of a liquidating pool may provide the following information within 90 days of the permanent cessation of trading in lieu of an otherwise required final annual report:

  • Statements of Operations and Changes in Net Assets for the relevant period as contained in the regulation; and,
  • An explanation of the winding down of the pool’s operations with written disclosure that all interests in, and assets of, the pool have been redeemed, distributed, or transferred on behalf of participants; or
  • In the event that all interests in, and assets of, the pool have not been distributed, redeemed, or transferred to participants by the time the final report is issued, the CPO must disclose the value of assets remaining to be distributed and an approximate timeframe for when the CPO expects distribution to occur.  If the CPO is unable to complete distribution within the estimated timeframe, the CPO must update the above detailed information to both NFA and the pool’s participants in writing.

If the CPO is not able to liquidate the pool’s assets within time to prepare, file, and distribute the final annual report as prescribed by the regulation, Commission Regulation 4.22(c)(7) requires the CPO to provide written notice to each participant and NFA, disclosing the following:

  • The value of assets remaining to be liquidated, the timeframe within which liquidation is expected to occur, any impediments to liquidation and any fees or expenses that will be charged to the pool prior to final distribution;
  • Which financial reports the CPO will continue to provide to participants from the time of the cessation of trading until the final annual report is distributed, and the frequency of such reports, pursuant to the pool’s constitutive documents; and
  • The timing of the final annual report.

Additionally, a CPO who is availing itself of the alternative filing in lieu of a final annual report may file unaudited information provided that the CPO obtains waivers from all participants and certifies the same to NFA when the final report is filed.

This relief also is applicable for pools that have claimed an exemption under Regulations 4.7 or 4.12.

VI. Accounting Resources

A. FASB Accounting Standards Codification

On July 1, 2009 the Financial Accounting Standards Board (FASB) launched the FASB Accounting Standards Codification (the Codification) as the single source of authoritative nongovernmental U.S. GAAP.  Although the FASB does not provide guidance in how specific requirements of GAAP are referred to in footnotes of financial statements, it notes that prior to the issuance of the Codification it was not unusual for footnotes to refer to specific standard numbers (for example, “as required by Statement 133”). Because these references are no longer the source of GAAP, such references will change. The FASB encourages the use of plain English to describe broad Topic references in the future. For example, to refer to the requirements of the Derivatives and Hedging Topic, they suggest a reference similar to “as required by the Derivatives and Hedging Topic of the FASB Accounting Standards Codification” and not use the specific numeric reference.

B. AICPA Commodities Audit Practice Aid

The AICPA Audit Practice Aid, Audits of Futures Commission Merchants, Introducing Brokers, and Commodity Pools Second Edition (product number 006639), is a useful tool for auditors and accountants of commodity entities.  It can be purchased at the AICPA website: http://www.CPA2biz.com.  CPOs and public accountants should also ensure that they monitor the Commission for recent developments which may not be reflected in the Audit Practice Aid.

C. AICPA Audit Risk Alert

The AICPA 2010 Audit Risk Alert (“ARA”) Financial Institutions Industry Developments, Including Depository and Lending Institutions and Brokers and Dealers in Securities contains sections on the commodities industry.  The ARA can be purchased at the AICPA website: http://www.CPA2biz.com.

D. FASB ASC Topic 820 (Formerly FAS 157, Fair Value Measurements)

Resources that may be helpful in understanding and applying FASB ASC Topic 820 are:

  • Measurements of Fair Value in Illiquid (or Less Liquid) Markets, issued by the AICPA Center for Audit Quality available at http://www.thecaq.org/resources/pdfs/MeasurementsIlliquidMarkets.pdf.
  • ASC 275-10-50, Risks and Uncertainties (AICPA Statement of Position 94-6, Disclosure of Certain Significant Risks and Uncertainties, when auditing financial statements that contain complex fair value measurements);
  • ASC 820-10, Fair Value Measurements and Disclosure: Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) –  (guidance that generally the net asset value reported by investee investment companies will continue to be an acceptable fair value indicator, with certain exceptions.)

E. AICPA Technical Guidance

Beginning at paragraph 8.23, the AICPA Audit and Accounting Guide, Investment Companies (May 1, 2010 edition) discusses organization and offering costs.  The AICPA issued technical guidance regarding accounting treatment of offering costs incurred by investment partnerships.3  This guidance:

  • Provides that investment partnerships that continually offer interests should defer offering costs incurred prior to commencement of operations and then amortize such costs, generally on straight-line basis, over the time period that it continually offers interests, up to a maximum of 12 months; and
  • Defines the phrase “continually offer interests.”

Registrants are reminded that organization costs are not affected by this guidance and must be charged to expense as incurred as required by FASB Codification Section 720-15-25-1 (AICPA SOP No. 98-5,

Reporting on the Costs of Start-up Activities.)  However, if appropriately disclosed to investors and potential investors, net asset value used to compute investment entrance and exit values, may be adjusted to amortize such costs differently, but generally not to exceed a period of 60 months.

IX. DCIO and NFA Contact Information

If a CPO, a public accountant, or other member of the public has any questions on the foregoing, please feel free to contact the DCIO staff or NFA staff listed in Attachment A to this letter.

Very truly yours,

Thomas J. Smith
Director and
Chief Accountant

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1 The Act is codified at 7 U.S.C. paragraph 1 et seq.  The Commission’s regulations are found in Title 17 of the Code of Federal Regulations.  The Commission’s internet website, www.cftc.gov, provides links to both the Act and Commission regulations.

2 Prior letters from 1998 forward are available at the Commission’s website at http://www.cftc.gov/industryoversight/intermediaries/guidancecporeports.html.

3 See paragraph 8.33 of the AICPA Audit and Accounting Guide, Investment Companies (May 1, 2010 edition).

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ATTACHMENT A
CFTC DIVISION OF CLEARING AND INTERMEDIARY OVERSIGHT CONTACT INFORMATION

Regional Office Locations
Eastern Region
140 Broadway, 19th Floor
New York, NY 10005-1146

Contacts
Ronald A. Carletta
Phone: (646)-746-9726
E-Mail: [email protected]

Al Goll
Phone: (646)-746-9723
E-Mail: [email protected]

Fax: (646)-746-9937

Location of CPO’s Principal Office
All states east of the Mississippi River, except Illinois, Indiana, Michigan, Ohio, and Wisconsin. Any location outside of the United States

Regional Office Locations
Central Region
525 West Monroe Street
Suite 1100
Chicago, IL 60661

Contacts
Lisa M. Marlow
Phone: 312-596-0566
Fax: 312-596-0711
E-Mail: [email protected]

Location of CPO’s Principal Office
Illinois, Indiana, Michigan, Ohio, and Wisconsin

Regional Office Locations
Southwestern Region
Two Emanuel Cleaver II Boulevard, Suite 300
Kansas City, MO 64112

Contacts
Kurt Harms
Phone: 816-960-7711
Fax: 816-960-7750
E-Mail: [email protected]

Location of CPO’s Principal Office
All states west of the Mississippi River

National Futures Association Contact Information

National Futures Association
300 South Riverside Plaza,
Suite 1800
Chicago, IL 60606

Tracy Hunt, Senior Manager, Compliance
Phone: 312-781-1284
Fax: 312-559-3453

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Cole-Frieman & Mallon LLP provides comprehensive compliance and regulatory support for CTAs and CPOs.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

NFA 2011 Annual Regulatory Reminder

Earlier this year we provided a general overview of the annual compliance requirements for CPOs and CTAs.  The NFA has just released their annual reminder for all CFTC registratants (including IBs, FCMs and RFEDs).  The NFA notice, reprinted below in full, provides a good overview of what CFTC registered firms need to be focusing on during the next month or so.

CFTC registered firms are reminded that now is a good time to review and revise their compliance manuals and complete the NFA self-examination process.

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Notice I-11-06
February 03, 2011

Annual Regulatory Reminder

National Futures Association has always been committed to providing our Members with the resources they need to meet their regulatory obligations as efficiently as possible. Therefore, we are providing you with an annual reminder regarding certain requirements that are not part of your day-to-day operations. This list does not capture all of your responsibilities for the upcoming year, but it should help remind you of certain non-routine requirements.

Within the next 12 months you will be required to:

  1. Complete the Annual Update process on the anniversary date of your firm’s registration. This process includes (1) completing the electronic Annual Registration Update; (2) electronically submitting the firm’s Annual Questionnaire on NFA’s website and (3) paying your annual registration fees and NFA dues.  Failure to satisfy all of the requirements in the annual update process within 30 days of your anniversary date will result in the withdrawal of your firm’s NFA registration and/or Membership. NFA’s BASIC system displays information reflecting whether or not firms are actively engaged in futures-related business activity or retail off-exchange foreign currency activities. If you commence operations, you should update your Questionnaire in order to change how your status is displayed in BASIC.
  2. Complete NFA’s Self-Examination Checklist located on NFA’s website at http://www.nfa.futures.org/NFA-compliance/publication-library/self-exam-checklist.HTML.
  3. Send your firm’s Privacy Policy to every current customer, client and pool participant (in addition to sending it to every new customer when the customer opens an account, enters into an advisory agreement, or purchases a subscription). For guidance in preparing your policy, please consult NFA’s Privacy Policy questionnaire (Appendix D of the Self-Exam Checklist).
  4. Test your Disaster Recovery Plan and make any necessary adjustments. For guidance in preparing your plan, please consult NFA’s Business Continuity and Disaster Recovery Plan questionnaire (Appendix B of the Self-Exam Checklist).
  5. Provide Ethics Training as outlined in your firm’s written Ethics Training Procedures. For guidance in developing your procedure, please consult NFA’s Ethics Training Policy questionnaire (Appendix C of the Self-Exam Checklist).
  6. Supervise the operations of any Branch Offices, including conducting an annual onsite inspection of every Branch Office.

If you are a registered Commodity Trading Advisor, you will also be required to:

  1. File any new exemption notices electronically through NFA’s Exemption System.
  2. If soliciting new clients, distribute a Disclosure Document that is no more than 9 months old and that has been reviewed and accepted by NFA. Ensure that the document includes a complete business background and discloses all potentialconflicts of interest in accordance with NFA’s recent guidance. Disclosure Documents should be filed electronically throughNFA’s Disclosure Document System.
  3. If placing bunched orders, analyze each trading program at least quarterly to ensure that the order allocation method has been fair and equitable and document this analysis.
  4. The FCM that carries your client accounts will be contacting your clients to verify that the information obtained under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the client with an opportunity to correct and complete the information. If the FCM notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the client based on the changed information.

If you are a registered Commodity Pool Operator, you will also be required to:

  1. File any new exemption notices electronically through NFA’s Exemption System.
  2. If soliciting new pool participants, distribute a Disclosure Document that is no more than 9 months old and that has been reviewed and accepted by NFA. Ensure that the document includes a complete business background and discloses all potential conflicts of interest in accordance with NFA’s recent guidance. Disclosure Documents should be filed electronically through NFA’s Disclosure Document System.
  3. Update your CPO Questionnaire on NFA’s website for any pools that have liquidated.
  4. Submit to NFA through NFA’s EasyFile system, and distribute to current participants, a certified Annual Report for each pool as of the close of the pool’s fiscal year. CFTC Regulations require Commodity Pool Operators to follow strict deadlines and filing requirements, and failing to meet those deadlines may result in a disciplinary action against a CPO. To learn more about EasyFile, go to NFA’s website and access the seminar at http://www.nfa.futures.org/NFA-compliance/NFA-education-training/webinars.HTML. Since NFA acts as the CFTC’s delegate when NFA receives and reviews Annual Reports, the reports are subject to requests under FOIA. CPOs may request confidential treatment of Annual Reports but must strictly follow the CFTC procedures contained in CFTC Regulation 145.9 for filing such requests. For information on how to request confidential treatment of Annual Reports filed with NFA, consult the information on NFA’s website at http://www.nfa.futures.org/NFA-compliance/NFA-commodity-pool-operators/cpo-confidential-treatment-requests.HTML.  When preparing pool Annual Reports, refer to the CFTC’s annual letter for useful tips.
  5. Within 45 days after the end of each quarter, submit to NFA through NFA’s EasyFile system, a Pool Quarterly Report for each pool that you operate. Information required to be filed includes: (a) the identity of the pool’s administrator, carrying broker(s), trading manager(s) and custodian(s); (b) a statement of changes in net asset value; (c) monthly performance for the three months comprising the quarterly reporting period; and (d) a schedule of investments identifying any investment that exceeds 10% of the pool’s net asset value at the end of the quarterly reporting period.

If you are a registered Introducing Broker, you will also be required to:

  1. Conduct Anti-Money Laundering (“AML”) training for relevant employees and complete an audit of your AML procedures and training. For guidance in developing your AML procedures, use NFA’s AML Procedures System.
  2. The FCM that carries your customer accounts will be contacting your customers to verify that the information obtained under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the customer with an opportunity to correct and complete the information. If the FCM notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the customer based on the changed information.
  3. If you are not operating pursuant to a guarantee agreement, submit a certified annual report within 90 days after the firm’s fiscal year end. IBs that are also registered as Broker/Dealers (“BDs”) must submit the report within 60 days after the firm’s fiscal year end. IBs that are not also registered as BDs must file this certified statement via NFA’s EasyFile system.
  4. If you are not operating pursuant to a guarantee agreement, submit semi-annual 1-FR-IB filings via EasyFile within 17 business days of the date of the statement (in addition to completing and maintaining monthly net capital computations). IBs also registered as BDs may file via WinJammer and must also file with NFA all statements required by FINRA. All financial statements should be prepared using the accrual basis of accounting as required by Generally Accepted Accounting Principles.

If you are a registered Futures Commission Merchant or Retail Foreign Exchange Dealer, you will also be required to:

  1. Conduct Anti-Money Laundering (“AML”) training for relevant employees and complete an audit of your AML procedures and training. For guidance in developing your AML procedures, use NFA’s AML Procedures System.
  2. Review your Point of Contact information for USA PATRIOT Act 314(a) information requests and notify NFA of any changes (FCMs only).
  3. Supervise the operations of any GIBs, including conducting an annual onsite inspection of every GIB.
  4. Contact active customers who are individuals, at least annually, to verify that the information obtained from that customer under NFA Compliance Rule 2-30(c) remains materially accurate, and provide the customer with an opportunity to correct and complete the information. If the customer notifies you of any material changes to the information, assess whether additional risk disclosure is required to be provided to the customer based on the changed information. However, if another FCM or IB introduces the customer’s account on a fully disclosed basis or a CTA directs trading in the account, then notify that Member of the changes to the customer’s information.
  5. Submit a certified annual report within 90 days after the firm’s fiscal year end, or if your firm is also registered as a Broker/Dealer, within 60 days after the fiscal year end (in addition to submitting the firm’s monthly Focus II/I-FR-FCM with NFA via WinJammer).
  6. For firms that offer off-exchange foreign currency futures and options contracts (FOREX) to retail customers, provide written information regarding NFA’s Background Affiliation Status Information Center (BASIC), including the website address to every current customer (in addition to sending it to every new customer when the customer opens an account).
  7. For firms that offer FOREX to retail customers, review the security, capacity, credit and risk-management controls, and records provided by your electronic trading systems and certify that the requirements outlined in NFA Interpretive Notice 2-36(e) have been met. Prepare a certification, signed by a principal who is also a registered AP, and provide a hardcopy to NFA with the submission of your annual audited financial statement.

If your firm or its clients trade security futures products (futures whose underlying instrument is either a single security or a narrow-based security index), consult NFA’s website for a comprehensive listing of your requirements athttp://www.nfa.futures.org/NFA-compliance/NFA-general-compliance-issues/security-futures-products.HTML.

We recommend that you keep this email as a reference guide to ensure that all requirements are completed on time throughout the year.

We also want to remind you again: Every firm that is required to be registered as an FCM, RFED, IB, CPO or CTA in connection with its FOREX activity must be approved by NFA as a FOREX firm. NFA Members are prohibited from engaging in retail Forex transactions with these firms unless the firm has received this designation. In addition, FOREX firms must have at least one principal who is registered as an Associated Person (AP) and is approved as a FOREX AP. All individuals who solicit retail FOREX business or who supervise that activity must have taken and passed two exams — the National Commodity Futures Examination (Series 3) and the Retail Off Exchange Forex Examination (Series 34), which is a new exam focusing exclusively on Forex-related questions. However, individuals who were registered as APs, sole proprietors or floor brokers on May 22, 2008, do not need to take the Series 34 exam unless there has been a

two year gap in their registration since that date.

As always, if you need assistance with these or any other NFA requirements, please contact NFA’s Information Center at (800) 621-3570.

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Cole-Frieman & Mallon LLP provides comprehensive compliance and regulatory support for CTAs and CPOs.  Bart Mallon, Esq. can be reached directly at 415-868-5345.

Form PF

Proposed Form PF Released

For your review, we have published the proposed Form PF which can be found here: Form PF.

According to an SEC proposal announcement last week, SEC registered managers will be required to file proposed Form PF with the SEC on either a quarterly or annual basis in the future.  Form PF is a multi-purpose form to be used by all types of SEC registered investment advisers – hedge fund managers, private equity fund managers, and liquidty fund managers. While the level of specificity changes with AUM (high AUM managers must disclose more information), Form PF requests much more information from fund managers than have previously been required to be provided to regulators.

This post will provide an overview of the major aspects of the Form PF as it is currently proposed.

[Please note that the form is highly dependant on precise definitions. The discussion below is general and I have not discussed some of the nuances. For example, when I discuss AUM, the discussion is necessarily general.]

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Who is required to file Form PF?

Mangers must file Form PF if they meet the following two tests:

  1. Registered or required to be registered with the SEC and
  2. Provide advice to a private fund (generally a 3(c)(1) or 3(c)(7) fund) *

* the term private fund is defined in Form PF.

When do managers need to file Form PF?

Managers will need to file Form PF either (i) on an annual basis if they have less than $1 billion of AUMor (ii) on a quarterly basis if they have more than $1 billion of AUM.

If the manager files on an annual basis, the filing will need to be completed within 90 days of the end of the manager’s fiscal year.

If the manager files on a quarterly basis, the filing will need to be completed within 15 days of the end of the calendar quarter.

What are the sections of Form PF?

Form PF has 5 major sections. For managers filing on an annual basis, generally only Section 1 will need to be completed. For managers filing on a quarterly basis, Sections 2, 3 or 4 will need to be completed depending on the types of investment vehicles for which the manager provides investment advice.  The sections are:

  • Section 1 – All Filers
  • Section 2 – Hedge Fund Managers with at least $1B AUM
  • Section 3 – Liquidity Fund Managers with at least $1 B AUM
  • Section 4 – Private Equity Fund Managers with at least $1 B AUM
  • Section 5 – Managers Applying for Hardship Exemption

More Detail on Section 1 and Section 2

Section 1

Section 1 applies to all managers who are registered with the SEC.

Section 1a

Contains more general information on the manager and its business.

Section 1b

Managers must provide the following information on the “private funds” which they manage:

  • gross and net asset value
  • borrowing/creditor information
  • derivative positions
  • investor concentration
  • detailed performance information, including performance after performance fees

Section 1c

Managers must provide the following information on the “hedge funds” which they manage:

  • strategy
  • % of assets traded using algorithm
  • counterparties/exposure
  • % of equity, debt, ABS traded on and off exchange
  • % of equity, debt, ABS cleared by a central clearing counterparty (CCP) and not cleared by a CCP
  • % of derivatives traded on and off exchange
  • % of derivatives cleared by a CCP and not cleared by a CCP
  • % of repos and clearing information

Section 2

Section 2 of Form PF requires managers to provide the SEC with a surprising amount of detail with respect to the fund, the fund’s investment strategy, counterparties and investors. Below we have provided an overview of some of the different requirements.

Section 2a

Generally the following information for the manager as a whole:

  • drill down of positions – equity, corporate bonds, convertible bonds, sovereign and muni bonds, loans, repos, ABS/structured products, credit derivatvies, commodities, cash
  • turnover rate
  • geographic breakdown of instruments

Section 2b

For each fund, the following information for such fund:

  • drill down of investments
  • liquidity
  • positions representing 5% or more of fund’s NAV
  • counterparty information
  • CCP information
  • reporting VaR
  • how market factors effect fund’s portfolio
  • secured/unsecured borrowing
  • investor information – side pockets, whether manager has right to suspend withdrawals, whether there are gates, whether there is currently a suspension of withdrawals, whether the gate provision is currently enacted

Section 3 and Section 4

These sections include questions which are applicable to liqidty funds and private equity funds. They are structured similar to section 2 (a & b), but overall there is less information requested.

Other

Items to Note

Form PF instructions are very specific with respect to the information that should be completed in the certain sections. In addition, there are unique items that may not apply to all firms which need to be considered. Some of these items to note with respect to the form:

  • there will be issues with respect to related persons
  • there will be sub-adviser issues
  • managers must understand the difference between reporting for individual funds v. reporting for fund structures (i.e. master-feeder, mini-master, parallel)
  • there are many new definitions (135 defined terms in the glossary – 11 pages worth!)
  • special rules for managers making transitions (quarterly to annually) and final filings
  • private fund identification numbers are required and can only be obtained by filing Form ADV (original or amended filing)
  • filing Form PF is done electronically, signed by a managing member of the firm
  • there are likely to be confusions with definitions (likely to be worked out during and after the comment period)

Initial Thoughts

I am still fully developing my thoughts on the form and should have more detailed thoughts in later posts – in the meantime, my bullet point thoughts are as follows:

  • The form seems to be thoughtfully laid out.
  • The amount and detail of the questions is surprising.
  • Managers with many funds are going to face a large reporting burden.

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Bart Mallon provides investment adviser registration services through Cole-Frieman & Mallon LLP, a law firm focused on the investment management industry.  He can be reached directly at 415-868-5345.

Annual ADV Updating Amendment for IA Firms

Under SEC and state regulations, a registered investment advisory firm must file its annual amendment to Form ADV within 90 days of the end of its fiscal year.  For most firms this means that the Annual Updating Amendment is due by March 31.  In addition to the traditional updates which firms need to make on Form ADV, advisers will also need to be aware of the new regulations with respect to ADV Part 2 which may require the adviser to complete a new form ADV part 2 during the updating process.  We are making special note of the updating requirement earlier than usual because of the new ADV 2 requirement.

Overview of Major Items on ADV to Update

When a firm completes an annual update to Form ADV, the firm should go through each question and make sure disclosures are accurate and up to date.  In general the firm’s chief compliance officer will complete the update or work with an outside investment adviser compliance firm or law firm to complete the update.

Some of the key items of Form ADV which need to be updated include:

  • Employees (Items 5.A. and 5.B.)
  • Number of clients (Items 5.C. and 5.H.)
  • Number of accounts (Item 5.F.)
  • Assets under management (Item 5.G.)
  • Other material changes can also be disclosed on the Annual Updating Amendment, such as changes to reportable disciplinary and financial disclosures, contact information, custody, and ownership.   [Note: these items need to be updated on Form ADV within 30 days of when they take place.]

While Part 1 of Form ADV can be completed using the online form on the IARD system, the new ADV Part 2 must be filed electronically as a text-searchable PDF.  You will not be able to

submit a PDF file of a scanned copy Part 2 on the IARD system.

New Regulations Regarding ADV Part 2

IA firms applying for SEC registration as of January 1, 2011 and existing firms filing Annual Updating Amendments are now required to use the new Part 2A, the “firm brochure.”  In addition, the SEC has established the following compliance dates regarding Part 2B, the “brochure supplement:”

SEC Compliance Dates for Delivery of Brochure Supplements to Clients

SEC Compliance Dates Extensions*
New/Prospective Clients Existing Clients New/Prospective Clients Existing Clients
New IA registrants Applying as of 01/01/11, deliver upon registering Applying between 01/01/11 and 04/30/11, begin delivering by 05/01/11

Applying after 04/30/11, deliver upon registering

Applying between 01/01/11 and 04/30/11, deliver by 07/01/11.
Existing IAs Upon filing Annual Updating Amendment Within 60 days of filing Annual Updating Amendment Registered as of 12/31/10 with fiscal year ending 12/31/10 through 04/30/11, begin delivering by 07/31/11

Registered as of 12/31/10 with fiscal year ending after 04/30/11, deliver upon filing Annual Updating Amendment

Registered as of 12/31/10 with fiscal year ending 12/31/10 through 04/30/11, deliver by 09/30/11

Registered as of 12/31/10 with fiscal year ending after 04/30/11, deliver within 60 days of filing Annual Updating Amendment

*On December 28, 2010, the SEC extended the compliance dates by four months to provide certain IAs more time to deliver the brochure supplement.

Incorporating the New ADV Part 2 for State Registrations

Because not all states have adopted the new ADV Part 2, state-registered IAs should check their state rules to confirm whether they need to use the new form or if they can continue to use the old form.  In many states, the next amendment to Form ADV must include the new ADV Part 2, even if it is not the Annual Updating Amendment.  For example, as of January 1, 2011, states including Alaska, California, Connecticut, Indiana, Maine, Maryland, Massachusetts, Ohio, Oregon, and Tennessee are requiring that registered IAs use the new ADV Part 2 as part of any amendment, as well as the required Annual Updating Amendment.

For more information on ADV Part 2, especially with respect to state adoptions, please see our update on new ADV Part 2.

For information on expected costs to prepare the new Form ADV 2, please see this post.

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Bart Mallon provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.

SEC Study on Uniform Fiduciary Duty for BDs

Recommendation for Uniform Fiduciary Duty

Under Section 913 of the Dodd-Frank Act, the SEC was required to condict a study of the effectiveness of the current legal and regulatory structure for broker-dealer firms and investment advisory firms with respect to the provision of personalized investment advice to retail customers and to comment on any gaps in the legal and regulatory structure.  Essentially Congress wants to know whether retail investors really understand the difference between BDs and IAs.  This issue has been one which many in the industry have strong opinions about, particularly from the investor side and the broker-dealer side.

The following is a brief overview of the SEC study which was recently released.

SEC Recommendations

In the study, the SEC spent considerable time providing a background and overview of the regulatory regimes of both investment advisers and broker-dealers.  The study also discussed retail investors and made many references to other studies which have been conducted on this and similar issues.  Ultimately, the SEC staff was trying to determine what standards should be in place with the understanding that retail investors may have limited understanding of the regulatory structure of IAs and BDs.

Overall, the SEC’s recommendations fall into two categories:

  • Uniform Fiduciary Standard – SEC staff recommended that the SEC should apply a uniform fiduciary duty with respect to both IAs and BDs when such firms provide personalized investment advice regarding securities to retail custodmers [note: the fiduciary standard does not apply to brokers when they are activng in the capcity of a broker with respect to a transaction.]
    • With respect to the uniform standard, the staff noted that the SEC should provide guidance in some form with respect to implementing this standard.  Such guidance should cover, at least, the following items: standards of conduct, duty of loyalth, principal trading, duty of care, personalized investment advice about securities, and investor education.
  • Harmonization of Regulations – in general the SEC staff believes that harmonization, when it adds meaningful investor protection, would be advantageous.  Specifically, the staff discussed the following issues which potentially should have substantially similar rules/regulations for both IAs and BDs:
    • Advertising and other communications
    • Use of finders and solicitors
    • Solicitation
    • Licensing and registration of firms
    • Licensing and continuing education for representatives of BD and IA firms
    • Books and records

[Because of the complexity of the issue, the above is only a gross overview.]

Our thoughts

It seems clear that if two firms are engaged in the exact same activity with respect to retail investors (providing personalized investment advice regarding securities), then such firms should be subject cialis super active to the same standards of care with respect to those activities.  However, it is also clear that implementing this change in regulatory framework will not be easy.Should be a bias toward harmonization when possible and practicle

What we found particularly interesting about the study  was the discussion about state registered investment advisers and the various rules they must adhere to – it seems funny that at the federal level we are trying to harmonize regulations, whereas the report makes clear that each states rules have completely different rules (see report starting at page 85).

Probably the most interesting thing is that the Staff recommended “that the Commission should consider requiring investment adviser representative to be subject to federal continuing education and licensing requirements.”  This means that the SEC  (or potentially a SRO) would be required to create and administer an exam (similar probably to the Series 65 exam for state registered investment adviser representatives) and continuing education (similar to the CE requirements for brokers).

The full report can be found here: Study on Investment Advisers and Broker Dealers.

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Bart Mallon provides legal advice to both investment advisers and broker-dealers through Cole-Frieman & Mallon LLP, an investment management law firm.  He can be reached directly at 415-868-5345.

SEC Study on Enhancing IA Examinations

Recommendations for Enhancing IA Exams

Under Section 914 of the Dodd-Frank Act, the SEC was required to conduct a study with respect to the need for enhanced examination and enforcement resources for investment advisers.  SEC staff recently released the study which is designed to provide Congress with recommendations with respect to the findings of the study.  In general, the study found that the SEC is not currently properly equipped to appropriately handle IA examinations because of capacity issues.  The study presents a number of statistics which show that IA registrations have greatly increased while the funding for the SEC’s Office of Compliance Inspections and Examinations (“OCIE”) has been subject to cutbacks in staff.

To strengthen the IA examination process, the SEC staff recommended that Congress take one of three different courses of action:

  1. Impose user fees on SEC-registered investment advisers
  2. Authorize one or more SROs to examine SEC-registered investment advisers
  3. Authorize FINRA to examine dual registrants (firms registered as both IAs and BDs)

SEC Recommendations

The Study provides three different options that Congress should consider with respect to the issue of instituting the most appropriate infrastructure for IA examinations.  These options and some of the positive and negative implications are discussed below.

1.  User Fees

Congress could authorize the SEC to implement user fees for registration.  These fees would go directly to the OCIE and pay for the IA examination program.

Discussion items:

  • would provide scalable resources (i.e. resources would increase or decrease in proportion to the number of registered investment advisor firms) – these resources would not be subject to the Congressional appropriations process
  • may be less expensive than instituting a new SRO regime and would utilize the existing OCIE staff expertise and knowledge
  • avoid all of the issues which would exist with establishing an SRO structure (inefficiencies, authority, membership, governance, and funding issues)
  • supported by some parts of the IA industry

2.  Delegation to SRO or SROs

Congress could authorize the SEC to delegate examination responsibilities to FINRA or another self regulatory organization(s).

Below are some of the points both for and against delegation to an SRO or multiple SROs:

  • scalable resources (i.e. funded by membership fees)
  • additional rulemaking – IA firms would be subject to laws (Investment Advisers Act of 1940), regulations (SEC Rules) and member (SRO) rules
  • SEC would need to oversee the SRO and subject the SRO to periodic audit/examination
  • an SRO would provide for more examination of IAs – for example, FINRA and NFA have examined more BDs and CPOs/CTAs than the SEC has examined IAs
  • many logistical issues involved with instituting any SRO and/or allowing FINRA to take over these responsibilities
  • multiple SROs (for different types of IAs) would likely create even more logistical issues
  • unclear how the SRO structure would work with state registered IAs
  • potential conflict of interest if the SRO (FINRA) was the same for the buy side and the sell side

3.  Authorize FINRA to examine dual IA-BD registrants

Congress could expand FINRA’s jurisdiction to oversee those firms which are registered as both an IA and as a BD.

  • only marginally helpful – only 5% of IAs are also registerd as BDs and many of these firms are the largest broker-dealer firms
  • gets rid of inefficiency by having two examinations – one from FINRA on the BD side and one from the OCIE on the IA side
  • risk of different interpretation of provisions of the Investment Advisers Act

Conclusion

This study simply states the obvious – the SEC does not have the resources it needs to adequately do its job.  It seems like the major conclusion has already been reached – IA firms are going to need to pay for their oversight because Congress will not pay for it.  The only question is whether managers will be making payments to the SEC (first option) or to FINRA or other SRO(s) (second two options).  Whatever Congress ultimately decides, it is likely that managers will be facing more fees in the future.

The full text can be found here: Study on Enhancing Investment Adviser Examinations

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Bart Mallon is an attorney focused on the investment management industry and provides investment adviser registration and compliance services through Cole-Frieman & Mallon LLP.  He can be reached directly at 415-868-5345.