Author Archives: Hedge Fund Lawyer

Dodd-Frank Establishes New Laws Regarding Spot Commodities and Spot Forex

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) has changed a number of laws in all of the securities acts including the Commodity Exchange Act. Two specific changes deal with certain transactions in commodities on the spot market. Specifically, Section 742 of the Act deals with retail commodity transactions. In this section, the text of the Commodity Exchange Act is amended to include new Section 2(c)(2)(D) (dealing with retail commodity transactions) and new Section 2(c)(2)(E) (prohibiting trading in spot forex with retail investors unless the trader is subject to regulations by a Federal regulatory agency, i.e. CFTC, SEC, etc.). According to a congressional rulemaking spreadsheet, these are effective 180 days from the date of enactment.

We provide an overview of the new sections and have reprinted them in full below.

New CEA Section 2(c)(2)(D) – Concerning Spot Commodities (Metals)

The central import of new CEA Section 2(c)(2)(D) is to broaden the CFTC’s power with respect to retail commodity transactions. Essentially any spot commodities transaction (i.e. spot metals) will be subject to CFTC jurisdiction and rulemaking authority. There is an exemption for commodities which are actually delivered within 28 days. While the CFTC wanted an exemption in which commodities would need to be delivered within 2 days, various coin collectors were able to lobby congress for a longer delivery period (see here).

It is likely we will see the CFTC propose regulations under this new section and we will keep you updated on any regulatory pronouncements with respect to this new section.

New CEA Section 2(c)(2)(E) – Concerning Spot Forex

The central import of new CEA Section 2(c)(2)(E) is to regulate the spot forex markets. While the section requires the CFTC to finalize regulations with respect to spot forex (which were proposed earlier in January), it also, interestingly, provides oversight of the markets to other federal regulatory agencies such as the CFTC. This means that in the future, different market participants may be subject to different regulatory regimes with respect to trading in same underlying instruments. A Wall Street Journal article discusses the impact of this with respect to firms which engage in other activities in addition to retail forex transactions. The CFTC’s proposed rules establish certain compliance parameters for retail forex transactions, requires registration of retail forex managers and requires such managers to pass a new regulatory exam called the Series 34 exam. We do not yet know whether the other regulatory agencies will adopt rules similar to the CFTC or if they will write rules from scratch.

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CEA Section 2(c)(2)(D)

‘‘(D) RETAIL COMMODITY TRANSACTIONS.—

‘‘(i) APPLICABILITY.—Except as provided in clause (ii), this subparagraph shall apply to any agreement, contract, or transaction in any commodity that is—

‘‘(I) entered into with, or offered to (even if not entered into with), a person that is not an eligible contract participant or eligible commercial entity; and

‘‘(II) entered into, or offered (even if not entered into), on a leveraged or margined basis, or financed by the offeror, the counterparty, or a person acting in concert with the offeror or counterparty on a similar basis.

‘‘(ii) EXCEPTIONS.—This subparagraph shall not apply to—

‘‘(I) an agreement, contract, or transaction described in paragraph (1) or subparagraphs (A), (B), or (C), including any agreement, contract, or transaction specifically excluded from subparagraph (A), (B), or (C);

‘‘(II) any security;

‘‘(III) a contract of sale that—

‘‘(aa) results in actual delivery within 28 days or such other longer period as the Commission may determine by rule or regulation based upon the typical commercial practice in cash or spot markets for the commodity involved; or

‘‘(bb) creates an enforceable obligation to deliver between a seller and a buyer that have the ability to deliver and accept delivery, respectively, in connection with the line of business of the seller and buyer; or

‘‘(IV) an agreement, contract, or transaction that is listed on a national securities exchange registered under section 6(a) of the Securities Exchange Act of 1934 (15 U.S.C. 78f(a)); or

‘‘(V) an identified banking product, as defined in section 402(b) of the Legal Certainty for Bank Products Act of 2000 (7 U.S.C.27(b)).

‘‘(iii) ENFORCEMENT.—Sections 4(a), 4(b), and 4b apply to any agreement, contract, or transaction described in clause (i), as if the agreement, contract, or transaction was a contract of sale of a commodity for future delivery.

‘‘(iv) ELIGIBLE COMMERCIAL ENTITY.—For purposes of this subparagraph, an agricultural producer, packer, or handler shall be considered to be an eligible commercial entity for any agreement, contract, or transaction for a commodity in connection with the line of business of the agricultural producer, packer, or handler.’’.

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CEA Section 2(c)(2)(E)

‘‘(E) PROHIBITION.—

‘‘(i) DEFINITION OF FEDERAL REGULATORY AGENCY.—In this subparagraph, the term ‘Federal regulatory agency’ means—

‘‘(I) the Commission;

‘‘(II) the Securities and Exchange Commission;

‘‘(III) an appropriate Federal banking agency;

‘‘(IV) the National Credit Union Association; and

‘‘(V) the Farm Credit Administration.

‘‘(ii) PROHIBITION.—

‘‘(I) IN GENERAL.—Except as provided in subclause (II), a person described in subparagraph (B)(i)(II) for which there is a Federal regulatory agency shall not offer to, or enter into with, a person that is not an eligible contract participant, any agreement, contract, or transaction in foreign currency described in subparagraph (B)(i)(I) except pursuant to a rule or regulation of a Federal regulatory agency allowing the agreement, contract, or transaction under such terms and conditions as the Federal regulatory agency shall prescribe.

‘‘(II) EFFECTIVE DATE.—With regard to persons described in subparagraph (B)(i)(II) for which a Federal regulatory agency has issued a proposed rule concerning agreements, contracts, or transactions in foreign currency described in subparagraph (B)(i)(I) prior to the date of enactment of this subclause, subclause (I) shall take effect 90 days after the date of enactment of this subclause.

‘‘(iii) REQUIREMENTS OF RULES AND REGULATIONS.—

‘‘(I) IN GENERAL.—The rules and regulations described in clause (ii) shall prescribe appropriate requirements with respect to—

‘‘(aa) disclosure;

‘‘(bb) recordkeeping;

‘‘(cc) capital and margin;

‘‘(dd) reporting;

‘‘(ee) business conduct;

‘‘(ff) documentation; and

‘‘(gg) such other standards or requirements as the Federal regulatory agency shall determine to be necessary.

‘‘(II) TREATMENT.—The rules or regulations described in clause (ii) shall treat all agreements, contracts, and transactions in foreign currency described in subparagraph (B)(i)(I), and all agreements, contracts, and transactions in foreign currency that are functionally or economically similar to agreements, contracts, or transactions described in subparagraph (B)(i)(I), similarly.’’.

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Cole-Frieman & Mallon LLP provides legal support and forex registration services to forex managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

New Accredited Investor Definition

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Fund Managers Should Amend Subscription Documents

The Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) immediately changed the definition of accredited investor. Prior to the enactment of the Act, an accredited investor could use the value of their primary residence to compute the $1,000,000 net worth requirement. Now, investors may not use the value of their primary residence to determine their net worth. The mortgage or indebtedness on the primary residence, also, does not count against net worth except to the extent that the indebtedness exceeds the fair market value of the residence (see SEC discussion below).

Revising Subscription Documents

Some managers have subscription documents which describe the prior manner of calculating net worth for accredited investors. Such managers should immediately revise their subscription documents. Additionally, if a manager accepts investments from previous individual investors who have declared they are “accredited investors,” the manager should have such investors verify they meet the new net worth requirement. Generally the manager can accomplish this through a fairly simple verification or confirmation form. For those managers who have administration firms process subscription documents, the administration firm should be providing these verification forms to the subscribing investors. With respect to individual investors who are not making additional subscriptions, there is no current requirement to verify their net worth under the new rules.

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Below are the Dodd-Frank laws dealing with the new accredited investor standard.

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

(a) IN GENERAL.—The Commission shall adjust any net worth standard for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, so that the individual net worth of any natural person, or joint net worth with the spouse of that person, at the time of purchase, is more than $1,000,000 (as such amount is adjusted periodically by rule of the Commission), excluding the value of the primary residence of such natural person, except that during the 4-year period that begins on the date of enactment of this Act, any net worth standard shall be $1,000,000, excluding the value of the primary residence of such natural person.

(b) REVIEW AND ADJUSTMENT.—

(1) INITIAL REVIEW AND ADJUSTMENT.—

(A) INITIAL REVIEW.—The Commission may undertake a review of the definition of the term ‘‘accredited investor’’, as such term applies to natural persons, to determine whether the requirements of the definition, excluding the requirement relating to the net worth standard described in subsection (a), should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIFICATION.—Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ‘‘accredited investor’’, excluding adjusting or modifying the requirement relating to the net worth standard described in subsection (a), as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

(2) SUBSEQUENT REVIEWS AND ADJUSTMENT.—

(A) SUBSEQUENT REVIEWS.—Not earlier than 4 years after the date of enactment of this Act, and not less frequently than once every 4 years thereafter, the Commission shall undertake a review of the definition, in its entirety, of the term ‘‘accredited investor’’, as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, to determine whether the requirements of the definition should be adjusted or modified for the protection of investors, in the public interest, and in light of the economy.

(B) ADJUSTMENT OR MODIFICATION.—Upon completion of a review under subparagraph (A), the Commission may, by notice and comment rulemaking, make such adjustments to the definition of the term ‘‘accredited investor’’, as defined in section 230.215 of title 17, Code of Federal Regulations, or any successor thereto, as such term applies to natural persons, as the Commission may deem appropriate for the protection of investors, in the public interest, and in light of the economy.

SEC. 415. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

The Comptroller General of the United States shall conduct a study on the appropriate criteria for determining the financial thresholds or other criteria needed to qualify for accredited investor status and eligibility to invest in private funds, and shall submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study not later than 3 years after the date of enactment of this Act.

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SEC Discussion on New Net Worth Rules

Section 179. Rule 215 – Accredited Investor

Question 179.01

Question: Under Section 413(a) of the Dodd-Frank Act, the net worth standard for an accredited investor, as set forth in Securities Act Rules 215 and 501(a)(5), is adjusted to delete from the calculation of net worth the “value of the primary residence” of the investor. How should the “value of the primary residence” be determined for purposes of calculating an investor’s net worth?

Answer: Section 413(a) of the Dodd-Frank Act does not define the term “value,” nor does it address the treatment of mortgage and other indebtedness secured by the residence for purposes of the net worth calculation. As required by Section 413(a) of the Dodd-Frank Act, the Commission will issue amendments to its rules to conform them to the adjustment to the accredited investor net worth standard made by the Act. However, Section 413(a) provides that the adjustment is effective upon enactment of the Act. When determining net worth for purposes of Securities Act Rules 215 and 501(a)(5), the value of the person’s primary residence must be excluded. Pending implementation of the changes to the Commission’s rules required by the Act, the related amount of indebtedness secured by the primary residence up to its fair market value may also be excluded. Indebtedness secured by the residence in excess of the value of the home should be considered a liability and deducted from the investor’s net worth. [July 23, 2010]

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides legal support and hedge fund registration services to all types of investment managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

New Form ADV Part 2 Format Released

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SEC Announces New Format for ADV Part 2

Advisors registered with the SEC should have received a notification from the SEC about the new Part 2 format. We have posted that release below and the communication we received from the SEC. We have also posted the new release as well as the instructions for the new ADV Part 2. We will be providing an overview and our thoughts on these changes in the coming days.

Complete Release – New Form ADV Part 2

New Form ADV Part 2 Instructions

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Form ADV Part 2: New Format and Brochure Supplements Required

The SEC recently adopted amendments to Part 2 of Form ADV and related rules that require investment advisers to prepare plain English narrative brochures and brochure supplements. You may view the adopting release and amended form at http://www.sec.gov/rules/final/2010/ia-3060.pdf . The revised form and rules require you to file a narrative brochure(s) electronically in a text searchable PDF format on IARD and to deliver the brochure to clients. You must also prepare, and deliver to clients, brochure supplements for certain employees and maintain them in your files. If your fiscal year ends on December 31, you are required to file a narrative brochure(s) with your annual amendment filing that is due by March 31, 2011. If your fiscal year end is other than December 31, you are required to file a narrative brochure(s) with your annual amendment filing for your 2011 year end. Please review the final release, amended rules, and amended Part 2 of Form ADV for additional information on when and how you are required to comply with these amendments. You cannot reply to this email. If you have questions, please email [email protected].

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides legal support and hedge fund compliance services to all types of investment managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Obama Signs Historic Wall Street Reform Bill

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Requires Hedge Fund and Private Equity Fund Managers to Register with SEC

As expected President Obama signed the Dodd-Frank Wall Street Reform and Consumer Protection Act (“Act”) on Wednesday July 24, 2010. The Act was designed to address many of the issues that led to the financial crisis of 2008 and is being hailed as the largest financial regulatory bill since the various securities acts of the 1930s.

For most hedge fund and private equity fund managers, the major concern is the requirement that managers register with the SEC by July 24, 2011. Registration, of course, means that firms are going to be required to appoint a chief compliance office, comply with certain advertising restrictions and implement robust recordkeeping procedures. Along with the increased compliance and reporting requirements, managers should be aware that firms will also be subject to surprise or routine SEC audits.

Fund managers who run section 3(c)(1) funds should also be aware of the fact that the definition of both qualified client and accredited investor are affected. The definition of a qualified client will be required to be initially adjusted by the SEC and then will be adjusted every 5 years thereafter. The definition of an accredited investor now does not include the value of an investor’s primary residence. This definition will be subject to adjustment every 4 years.

Other interesting changes:

Venture Capital Funds – VC funds will not be required to register as investment advisers with the SEC, but the SEC may promulgate rules requiring such managers to keep certain records and make reports to the SEC.
Registered CPOs not subject to IA registration – a commodity pool operator which provides advice to a private fund which invests in securities will not also need to be registered as an investment adviser unless the CPO’s business becomes predominantly securities-related.
Recordkeeping – although hedge fund and private equity fund managers will be subject to reporting requirements, there is the possibility for enhanced confidentiality measures for some groups. [This is an issue we will likely hear much more about in the future.]
Short sale reporting – managers generally with $100M in AUM will be required to report their short positions to the SEC.
SIPC protection for futures – the Act extends SIPC protection for futures and options on futures in portfolio margining accounts.
Futures position limits – in the next 6 months the CFTC will be required to impose aggregate position limits on energy products and metals. In the next 9 months the CFTC will be required to impose aggregate position limits on agricultural commodities.
OTC Derivatives – formerly unregulated derivative transactions will now be regulated by the CFTC, SEC or both. These transactions will generally need to be cleared through central clearinghouses.

Many pundits have noted that most of the “real” change will take place through the agency rule-making process which is expected to commence shortly and last at least 12 months. Both the SEC and CFTC will be releasing rule proposals for comments and we will be reporting on these as they occur.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides legal support and hedge fund compliance services to all types of investment managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Bay Area Hedge Fund Event | July 28, 2010

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YOU’RE INVITED!

The Bay Area Hedge Fund Roundtable presents:

Due Diligence and Fraud – The Reality of Headline Risk

FEATURING:

Scott Adams – American Federation of State, County and Municipal Employees

Shaun Dalton – Formerly with Bernard L. Madoff Investment Securities and Stanford Financial Group

Olivia Robinson – Background Intelligence, Inc.

MODERATED BY JAY GOULD, PILLSBURY WINTHROP SHAW PITTMAN LLP

JULY 28, 2010 SAN FRANCISCO, CA

CHECK IN – 3 PM

PRESENTATION – 3:30 PM

Sens Restaurant @

Four Embarcadero Promenade Level

Admission is $25 – Cash only please, receipts will be provided.

Cocktail Reception to Follow

Please RSVP to [email protected].

The Bay Area Hedge Fund Roundtable (“BAHR”) is an informal (and not for profit) organization of members of the Bay Area hedge fund community that was established in 2001. BAHR strives to provide intelligent, fresh perspectives from industry leaders on current developments and offer an open, casual environment where members can exchange information and expertise and further develop their relationships within the industry.

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Hedge Fund Law Blog is sponsored by Cole-Frieman & Mallon LLP which provides legal and hedge fund registration services to fund managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Financial Reform Bill Passes Senate

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As has been widely reported, the Senate passed the Financial Reform Bill setting the stage for President Obama to sign the bill within the next week. With respect to investment advisors, one of the central items is the private equity and hedge fund registration requirement. We will be reporting further on the bill in the coming days and weeks.

Forex Registration Workshop Announced

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NFA to Discuss Forex Registration in Vegas

The NFA announced a workshop to inform forex managers about the various registration and compliance matters that managers will need to be especially aware of during the registration process. While we do not yet know what the final rules will look like, we do know a few things and believe that managers will need to focus on the following issues:

Series 34 exam – this is an exam specifically for forex managers. In addition to the Series 34, the managers will most likely need to have passed the Series 3 exam as well.
Forex Compliance – all NFA registrants will need to make sure they are compliant with all CFTC laws and regulations in addition to NFA rules.
Forex Disclosure Documents – all forex CTAs and CPOs will need disclosure documents. While these disclosure documents will be similar to traditional futures/commodities disclosure documents, there are some specific forex disclosures managers will also need to include in the documents. As always, managers should remember that the disclosure documents and the managed account agreement are legal documents and should be drafted by an attorney.

The full NFA announcement is reprinted below.

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NFA’s Registration/Compliance Workshops for Currently Unregistered Forex IBs, CPOs and CTAs in Conjunction with the Upcoming Futures and Forex Expo

Caesars Palace in Las Vegas
Saturday, September 25, 2010

In early 2010, the Commodity Futures Trading Commission (CFTC) published its proposed rules regarding the regulation of retail off-exchange foreign currency (forex) products. One component of the proposed rules requires all forex introducing brokers, account managers and pool operators to register with the CFTC as forex IBs, CTAs and CPOs and to become Members of National Futures Association (NFA).

In anticipation of the publication of the CFTC’s final rules, NFA will be offering registration/compliance workshops in conjunction with the upcoming Futures and Forex Expo to be held on September 23-25 at Caesars Palace in Las Vegas. These workshops will outline the registration process and discuss regulatory requirements for each registration category.

The schedule for the workshops is as follows:

8:30 – 10:30 a.m. Registration workshop for all registration categories. This session will cover who has to register and will present a walkthrough of the registration process.
10:30 a.m. – 12:00 p.m. General compliance workshop for all registration categories. This session will include discussion of NFA rules regarding promotional material/sales practices, supervisory procedures (including ethics training requirements, supervision of branch offices and disaster recovery/business continuity planning) and anti-money laundering requirements.
1:30 – 3:00 p.m. Disclosure documents/financial requirements workshop for CPOs and CTAs, including performance reporting.
3:00 – 5:00 p.m. NFA staff available for one-on-one consultations.

All workshops will be held in the Tribune Room in the Convention Center at Caesar’s Palace.

Although there is no fee to attend the workshops, advanced registration is recommended.

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Hedge Fund Compliance Guide

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After the passage of the Dodd-Frank financial reform bill, managers and service providers will be preparing to go through the registration process. Managers should note that while the registration process is fairly straightforward, the ongoing compliance requirements under the Investment Advisers Act are perhaps more important. In this guide we will be providing an overview and links to the important compliance considerations.

Specifically, we will be discussing the practical application of the following rules to both hedge fund managers and private equity fund managers:

Rule 204-2 — Books and Records to Be Maintained by Investment Advisers
Rule 204-3 — Written Disclosure Statements
Rule 204A-1 — Investment Adviser Codes of Ethics
Rule 205-3 — Exemption from the Compensation Prohibition of Section 205(a)(1) for Investment Advisers
Rule 206(3)-2 — Agency Cross Transactions for Advisory Clients
Rule 206(4)-1 — Advertisements by Investment Advisers
Rule 206(4)-2 — Custody or Possession of Funds or Securities of Clients
Rule 206(4)-3 — Cash Payments for Client Solicitations
Rule 206(4)-4 — Financial and Disciplinary Information that Investment Advisers Must Disclose to Clients
Rule 206(4)-6 — Proxy Voting
Rule 206(4)-7 — Compliance Procedures and Practices

Business Continuity Plans

Rule 206(4)-8 — Pooled Investment Vehicles

This guide will complement the hedge fund registration guide we have developed as well.

Survey of State Securities Divisions

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Are States Equipped to Handle Increased IA Registrations?

Under the new financial reform bill, expected to be signed into law sometime in July 2010, the state securities divisions will play a larger role in the oversight of investment managers. Under the current system, investment advisers (who generally provide financial planning services or investment advice to individuals) with $30 million of AUM are required to register with the SEC. Under the new laws to take effect under the reform bill, investment advisers with up to $100 million of AUM will be required to register with the state of their principal place of business. This means that thousands of managers who are currently subject to SEC jurisdiction and oversight will become subject to state jurisdiction and oversight. We do not believe that the states have the desire, expertise or, most importantly, the budget to handle an increase in the jurisdiction and oversight. Because we think the states securities divisions are cash strapped, we conducted our own mini-survey to find out the answer. [Note: we also recommend the article The New Sheriffs in Town about this same issue.]

Survey of State Securities Divisions

Over the past couple of weeks, we called each state securities division and tried to speak with a person familiar with each division’s financial situation and other aspects of their operations. While we were not always able to speak with the appropriate person, we were at times able to divine interesting information from our discussion. For many states we have sent in record requests under the Freedom of Information Act and while our reports below are not complete, they do show us that a number of securities divisions are in fact having financial difficulties. These questions focus on the issues we think are important. [Please note: most of the answers below are not official but were instead taken from our informal phone conversations with people in the various divisions.]

Question: Is the securities division facing budget cuts?

Arizona – yes, there have been budget cuts over the last couple of years.
Delaware – no, but statewide salaries have been cut 2.5%
Kansas – there is a constrained budget
New Mexico – yes
Oregon – yes
Pennsylvania – budget restraints
Utah – yes
Vermont – yes, as of 2009
Washington – yes
Other: A number of divisions either stated no or that they could not provide that information.

Question: has the securities divisions faced staff reductions?

Utah – yes
Washington – operating under a hiring freeze
Other: A number of states said there were vacant positions (Alaska, Arizona, Delaware, Kansas, New Mexico (3))

Question: are division staff forced to take furlough days?

California – yes, either 1 or 2 Fridays a month
Colorado – yes, 1 days per month instituted in Fall of 2009
Connecticut – yes, instituted in 2008
Delaware – yes, instituted in 2009
Hawaii – yes
Maine – yes
Michigan – yes
Minnesota – yes
Nevada – yes
New Mexico – in 2009 (5 days) but not in 2010
Oregon – yes
Vermont – yes – instituted in 2009
Virginia – yes
Washington – yes
Wisconsin – yes

[Note: we expect this number to rise as soon as we receive information back from our Freedom of Information Act requests.]

Question: how many staff members does the division employ?

Arkansas – 38
Delaware – 13 (2 examiners)
Indiana – 18-20 (1 examiner)
Louisiana – 11 (2 examiners)
Montana – 5 (2 examiners)
Nebraska – 10 (1 examiner)
New Hampshire – 10 (2 examiners)
New Mexico – 22 (1 examiner)
North Dakota – 9 (3 examiners)
Utah – 19 (5 examiners)
Washington – 38 (8 examiners)
West Virginia – 11 (5 examiners)
Wisconsin – 16 (10 examiners)

Question: how often does the division audit registrants?

Indiana – 3-4 year cycle
Louisiana – 2 year cycle
Montana – 3 year cycle
Nebraska – every 2-3 years
New Hampshire – risk-based cycle
New Mexico – 3 year cycle
Utah – 5 audits per month (3 routine, 2 for cause; mostly broker-dealer issues)
Virginia – 3.5 year cycle
Washington – high-risk firms audited 1-2 years; lower risk firms audited every several years
Wisconsin – 3 year cycle

We will periodically update this information as we receive it from the divisions.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides legal support and hedge fund compliance services. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Wall Street Reform Bill Issues – Performance of State Securities Regulators

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As we move closer to the signing of the Dodd-Frank Wall Street Reform and Consumer Protection Act, more groups are highlighting the fact that state securities divisions are going to be affected by the act. After pressure from NASAA, the association of state securities regulators, Congress has provided that state regulators will be required to provide oversight of investment advisers with up to $100 million of AUM – a significant increase from the current level of $30 million of AUM. Of course this will increase the number of advisers that the states oversee and will make the job of the securities divisions much more difficult. We have consistently stated that we do not think the states, collectively, are going to be capable to provide proper oversight with the increase in responsibility – mostly because of budget issues. We have been surveying the states to see which divisions have budget issues and will be reporting on that shortly. Until then we will examine one securities division which has faced scrutiny from members of the investment community and the state legislature.

Overview of Utah Division of Securities Audit

Over the years there has been a number of complaints about the manner in which the Utah Division of Securities conducts business – a simple Google search will reveal a number of interesting stories. After repeated complaints the state legislature decided to audit the division and released a report in July of 2008 entitled A Performance Audit of the Division of Securities.

The results are nothing less than shocking.

Faith in government agencies is based on the belief that they will act fairly and effectively. The report shows capricious behavior and essentially a belief that members of the investment management community are ‘guilty’ until proven ‘innocent’. Special attention should be paid to the fact that the state securities divisions do have power to make life miserable for a business owner, even if that business owner has not acted wrongly. Redress is difficult and “the Division Always Wins” (see below). It is in with this understanding that we question whether the states will be in the best position to oversee the investment management industry.

Below are a number of direct quotes from the audit – many should make any ready angry and sick. [Please note that we are not saying that all securities divisions have these problems. Additionally, we have not conducted any follow up with Utah so we do not express any opinion on the current state of the division.]

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Reason for audit:

The credibility of the Division of Securities has been challenged by those investigated by the division. Their concerns are with procedural errors, an alleged overzealous pursuit of securities violations, and the perception that those investigated do not receive fair treatment.

While the division protects securities investors, it is alleged the division has abused its power and damaged reputations. The division has significant authority but its credibility depends on using that authority judiciously.

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Ad Hoc Manner of Conducting Investigations:

There does not appear to be a consistent relationship between the number of complaints, number of cases opened, and the number of actions filed. This is because cases can be opened without a resulting action, there can be multiple actions on one case, or the action may not be filed until the following year. In addition, our evaluation leads us to believe the information is not reliable.

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Reason for Division Audit

Legislators requested this audit based on concerns about how the division managed three cases. We reviewed the division’s administrative process followed in these cases and a number of others brought to our attention. We did not address the legal issues of any of the cases. Our work has been complicated by the desire of many interviewees to keep their names confidential. They fear reprisal for criticizing the division’s actions.

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Lack of Policies & Procedures Equals Inconsistent Decisions

The division has not been operating under set, written policies and procedures. As a result, division decisions for actions against the regulated industry and the treatment of its employees rest solely with department and division management. Frequent management changes have brought changes in management philosophy and an increased likelihood for inconsistent decisions.

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Years of No Policies & Procedures

During the course of this audit, we were told that the division did have policies and procedures a number of years ago. However, there have been no written policies and procedures in place, or operational procedures followed, for at least the last four years under the direction of three division directors. Shortly before this audit’s completion, division staff found a discarded copy of a 1993 policies and procedures manual. It is disconcerting that the division has faced procedural control difficulties for a number of years, yet no one in either departmental or divisional leadership noted the lack of policies and procedures.

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HUGE ISSUE FOR STATE REGISTERED MANAGERS

Complaints surfaced that those charged with securities violations could not get a fair hearing.

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Division Bias Ignored

In several cases, it was questionable if the former director had maintained an independent and unbiased perspective. For example, the former director did not recuse himself from serving as the presiding officer after helping to draft the pleadings for the case. It was apparent he was no longer impartial. Even the perception that the presiding officer is biased is concerning as it can give the appearance of unfair treatment.

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Intimidation…and…the Division always wins…

Those accused of securities violations told us they felt intimidated into settling, given that the division’s former director would likely serve as the presiding officer. One business owner perceived the system as “a stacked deck” because the investigator, jury, and judge are all in the same office. He informed us that during an investigation, a division employee boasted that the division always wins.

Page 11

State Lawyer Effectively Pushed Out

poor communication between the former director and an attorney resulted in the exclusion of the attorney from a decision on how a case would be handled, even though the attorney had been involved in the case for a number of months. The attorney was frustrated and raised concerns when the former director drafted and sent out documents over the attorney’s name, thus implying the AG gave his approval, even though the attorney was not aware a decision had been made and had not reviewed the final document. He learned about the legal action when defendants contacted him because they assumed he represented the division. The former director contends that the attorney was familiar with the document.

Pages 12-13

Questionable Actions

During the audit, many individuals associated with various cases contacted us with complaints about the division. Our review of case files resulted in a number of questionable actions including: inappropriate publicity, emphasis on punishment rather than compliance, the use of intimidation tactics, violating terms of settlement agreements, failure to notify those being investigated, and inconsistent case management.

Page 15

Fear of Retaliation!!??

To evaluate these complaints, we reviewed case files, listened to tapes of hearings, and interviewed staff and attorneys involved with the cases. Many of those who talked with us requested confidentiality because they feared retaliatory action by the division if they were identified.

Page 15

Inconsistent Procedures…

questionable actions often can be attributed to the divisions lack of clearly defined procedures. A discarded policy manual states that “the manual will be reviewed and updated on a yearly basis to reflect current or additional practices.” Not complying with this requirement has resulted in division policies and procedures that are inconsistently applied.

Page 15

Emphasis on Punishment Rather than Compliance

The division appears to emphasize punishment of offenders rather than compliance with securities laws. A number of those involved in the division’s actions believe the division has overzealously pursued securities violations. They criticize that charges are brought one after another, cases are drawn out over long periods of time, and decisions on who to investigate can be arbitrary.

Page 17

Threats and Coercion

The division’s use of intimidation to obtain information has been cited by both those being investigated and others involved with the division. In one case, the accused stated that an investigator attempted to coerce cooperation by intimidating and threatening that the person would be arrested. In another case, investigators seized personal information by copying all information from the business owner’s computer without distinguishing business and personal information. The owner said that he complied with the investigator’s demands only because they threatened to immediately close him down if he refused.

Page 18-19

Does not Honor Settlement Agreements

The division has, at times, violated the terms of its settlement agreements. In one case, the division agreed to not publicize the action or commence further administrative actions and then violated both terms of the agreement. The person accused told us he felt compelled to plead guilty to a lesser criminal charge rather than place his business in jeopardy defending a greater charge. The division agreed to not seek additional charges but nevertheless pursued an administrative action. The respondent then signed the settlement agreement after the division agreed to not publicize it. However, the day the settlement was signed, the division publicized the information on its web page and also published the information in its newsletter the following month.

Page 19-20

Surprised Charges Filed…Harming Innocent Business

According to the business owner, he learned about the investigation only after it was completed and charges were filed. Before he had an opportunity to respond, the media called to ask about the division revoking his license and issuing fraud charges. The media release was damaging to the business and the resulting retraction and apology was damaging to the division.

Page 21

Fines Arbitrary!!??

The division has been criticized for not identifying how fines are set. Board minutes disclosed the former director explained that fines are set to “make it hurt,” which is troublesome to those in the securities industry. The former director explained to us that fines are set based on an evaluation of the seriousness, nature, circumstances, and persistence of the conduct which is consistent with the Financial Industry Regulatory Authority (FINRA) guidelines. However, because the division does not have written guidelines or procedures identifying the process used to set fines, they appear to be set arbitrarily, based solely at the discretion of the division.

Page 22

Staff Demoralized, Scared of Reprisal

Personnel conflicts within the Division of Securities (division) have resulted in management turnover and a demoralized staff. Both the department executive director and the division’s former director have been open about their beliefs that specific employees have seemed reluctant to accept change and may be subverting management authority. A number of division staff feel their jobs are threatened or other forms of management reprisal may occur should they offend management in some way. The escalating conflicts have resulted in reprimands, restructuring, and ultimately, the resignation of the director, and the threat of legal action by several employees.

Page 25

Division Blatantly Breaks Laws at Director’s Direction

After being hired in October 2005, a number of the former director’s actions have been questionable. He was reprimanded and received a one-day suspension without pay for instructing staff to hold fine payment checks without processing them within the three-day time period required by statute (Utah Code 51-4-1). Delaying the deposit would allow the division to retain funds in the division rather than transfer them to the state general fund. By statute, if a balance in the division’s education fund exceeds $100,000 at the close of a fiscal year, the excess must be transferred to the General Fund (Utah Code 61-1-18.7(6)).

Staff related other instances in which they feel the former director gave them inappropriate directions. For example, staff provided information showing the director:

directed staff to sign pleadings that the former director had either drafted or modified, possibly to prevent his name, as the presiding officer, from appearing on documents. Administrative rules state “the signature shall be deemed to be a certification that the signer has read the pleading and that, to the best of his knowledge and belief, there is good ground to support it.”

directed staff to provide protected information to an influential person which violates Utah securities law prohibiting employees from disclosing non-public information filed with or obtained by the division (Utah Code 61-1-18.3).

used coercive settlement tactics by instructing staff to keep unwarranted allegations in the pleadings to serve as a bargaining chip for the negotiations. The respondent agreed to the settlement after the allegations were removed.

Page 30-31

We hope that this provides another look at the issue of having the states responsible for investment advisers with a wide ranging practice which may involve investors from many states.

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Cole-Frieman & Mallon LLP provides comprehensive formation and hedge fund start up support. Bart Mallon, Esq. can be reached directly at 415-868-5345.