Author Archives: Hedge Fund Lawyer

NFA Guidance on CPO / CTA Yearly Exemption Affirmations

Yesterday the NFA issued a notice to persons that are currently relying on exemptions or exclusions from registration as a Commodity Pool Operator or Commodity Trading Advisor. The notice explains that certain exemptions and exclusions must be “affirmed” on an annual basis via the NFA’s online Exemption System. The first annual affirmation is due within the first 60 days after December 31, 2012. Exemptions that are not affirmed within this period will be automatically withdrawn. The NFA notice also contains a number of FAQs.

We have reprinted the notice below.

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Notice to Members I-12-30

December 3, 2012

Guidance on the Annual Affirmation Requirement for those Entities that are currently operating under an exemption or exclusion from CPO or CTA registration

In February 2012, the CFTC issued final rules that now require any person that claims an exemption or exclusion from CPO registration under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or an exemption from CTA registration under 4.14(a)(8) to annually affirm the applicable notice of exemption or exclusion within 60 days of the calendar year end. The first notice affirming these exemptions is due for the calendar year ending December 31, 2012 and annually thereafter. Failure to affirm any of the above exemptions or exclusions will be deemed as a request to withdraw the exemption or exclusion and therefore, result in the automatic withdrawal of the exemption or exclusion once the 60 day period has elapsed.

How to complete the affirmation process

Starting on December 3, 2012, any person or entity that claims an exemption or exclusion under CFTC Regulation 4.5, 4.13(a)(1), 4.13(a)(2), 4.13(a)(3), 4.13(a)(5) or 4.14(a)(8) will be able to complete the affirmation process by accessing NFA’s Exemption System at http://www.nfa.futures.org/NFA-electronic-filings/exemptions.HTML.

Once logged into the system, you will be directed to the Exemption Index, which lists all Firm Level (at the top) and Pool Level (at the bottom) exemptions on file with NFA. Exemptions requiring affirmation will be identified with an icon in the ‘Affirm’ column. After clicking

on the icon, a pop-up box will appear requesting affirmation that the exemption continues to be effective. By clicking ‘OK’, the current date will replace the ‘Affirm’ icon and effectively complete the affirmation requirement for the given exemption for the year. The same process must be completed for each and every exemption on file that requires affirmation.

Failure to affirm an active exemption or exclusion from CPO or CTA registration will result in the exemption/exclusion being withdrawn after the 60 day period has ended. For registered CPOs or CTAs, withdrawal of the exemption/exclusion will result in the firm being subject to Part 4 Requirements for that pool regardless of whether the firm otherwise remains eligible for the exemption/exclusion. For non-registrants, the withdrawal of the exemption may subject you to enforcement action by the CFTC.

Frequently Asked Questions for Exemptions

How often will I need to affirm my exemptions?

You will need to affirm each applicable exemption on an annual basis, within 60 days after December 31. NFA will provide an annual email reminder of the affirmation process. The email reminder will be sent to the email contact on file in NFA’s Exemption System. In order to ensure that your firm receives NFA’s annual reminder, you must ensure a current email address has been provided in NFA’s Exemption System. If the contact information changes during the year, firms are urged to promptly update this information.

What if NFA records reflect an exemption for a pool that is no longer active?

A registered CPO can update NFA’s records with the applicable information. The CPO must first withdraw the exemption by accessing NFA’s Electronic Exemption System at http://www.nfa.futures.org/NFA-electronic-filings/exemptions.HTML. At the time you withdraw the exemption, you will be directed to the Annual Questionnaire to delete or cease the pool.

A non-registered entity must notify NFA with specific information about the pool by sending written notification to [email protected]. The written notification should include the full name of the entity and the pool.

If I can no longer qualify for an exemption or exclusion from CPO or CTA registration, what should I do?

If you do not affirm the applicable exemption or exclusion within the 60 day period, it will be automatically withdrawn. As a result, in order to continue to operate the pool, you may be required to be registered as a CPO and/or CTA and be an NFA Member. You can apply for registration and NFA membership in NFA’s Online Registration System (ORS), which is available on NFA’s website. For assistance in the process, NFA has a number of video tutorials available at http://www.nfa.futures.org/NFA-registration/videos/index.HTML.

I currently operate pools exempt under 4.13(a)(3), but I will no longer meet the requirements of this exemption as of January 1, 2013. I understand that NFA currently offers certain entities the ability to pre-register as a CPO, which allows a firm to defer registration until that date. Is this available to entities that operate pools exempt under 4.13(a)(3)?

No, the pre-registration option is not available to entities operating 4.13(a)(3) pools. It is only available to entities operating pools that are exempt under 4.13(a)(4), 4.5, CPO 12-03 No-Action, or 4.13 No Action.

How will firms that I do business with know that I have completed the Affirmation Process?

Once an entity affirms the applicable exemptions, NFA’s BASIC System will reflect the affirmation date for each exemption held. Further, BASIC will also reflect a withdrawal date if the exemption is not affirmed in the required 60-day period.

If I currently conduct business with an exempt CPO or CTA, how do I ensure that these entities have properly affirmed their exemptions in order to satisfy my Bylaw 1101 requirements?

NFA’s BASIC System will reflect whether an exemption held by a particular CPO or CTA has been successfully affirmed by including an affirmation date. A withdrawal date will be reflected for any exemption that was not affirmed for a given CPO or CTA. NFA has also provided Members with access to a spreadsheet that includes a list of all entities that have exemptions on file with NFA that must be affirmed on an annual basis. This spreadsheet can be found in the Member’s Annual Questionnaire at http://www.nfa.futures.org/NFA-electronic-filings/annual-questionnaire.HTML. Once logged in, you will see a link to a spreadsheet which is updated nightly. The spreadsheet will include all entities with an exemption(s) that requires affirmation, as well as the affirmation date, if applicable. If the spreadsheet does not reflect an affirmation date, the exemption has not been affirmed.

Any questions regarding these processes should be directed to:

Susan Koprowski, Manager, Compliance ([email protected] or 312-781-1288) or

Michael Mason, Manager, Compliance ([email protected] or 312-781-1447).

You are receiving this message because you are either a Member of National Futures Association (NFA) or you subscribed to the email subscription list on NFA’s Website. Additionally, you may be receiving this message because NFA records indicate you previously filed notice of exemption from CPO or CTA registration. To cancel or change your subscription at any time, visit the Email Subscriptions page on our Website at http://www.nfa.futures.org/news/subscribe.asp.

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Cole-Frieman & Mallon LLP provides legal services to CFTC registered firms and NFA member firms. Bart Mallon can be reached directly at 415-868-5345.

Hedge Fund Seed Deals Overview

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Seed Capital Arrangements for Hedge Fund Managers

We receive numerous inquiries from new managers seeking capital sources in today’s challenging financial climate. Recent regulatory changes have increased legal and compliance costs associated with launching a hedge fund and many smaller investors are wary to invest with first time managers, despite their potential to generate alpha. One way emerging managers can secure the much needed capital is via a “seed deal” whereby a seed capital provider (the “Seeder”) makes a significant capital investment (the “Investment’) in the manager’s fund (the “Fund”) in exchange for a share of the management fees and/or incentive fees. In addition to providing the manager with start-up operating and investment capital, the manager gets additional credibility with prospective investors. This article will summarize some of the basic terms involved in seed deals, as well as a number of issues a manager should consider. Please note that each seed deal is unique and a manager should work with experienced counsel to negotiate the appropriate terms.

Seed Deal Basics

Investment.

The amount of Investment can range greatly, the initial funding can be as much as $150 million

or as little as $1 million depending on a variety of factors.

Lock-Up Period.

Depending on the size of the Investment and other negotiated terms, the Seeder will generally commit keep the Investment in the Fund for a period 2 to 4 years, subject to certain early withdrawal rights, including but not limited to:

Violation of proscribed investment guidelines;
Decline of Investment by a certain percentage;
Misconduct by the manager or its principals;
Key man provisions or change of control; and
Reaching a certain AUM threshold.

Share of Revenues.

In exchange for the Investment, the Seeder receives a percentage of the manager’s revenues (including management fees and/or incentive fees) lasting in perpetuity or for a specified term. This arrangement is usually accomplished in one of two ways:

1. Equity Interest: The Seeder receives a direct equity interest in the management entity and typically receives revenues “net” of expenses. In this type of deal, the Seeder will generally require limitations or consent for expenses.

2. Fee Sharing Agreement: The Seeder enters into a profit/fee sharing agreement with the manager whereby the Seeder will be entitled to a portion of the management and/or incentive fees received by the manager. Fee sharing agreements have been more common as they offer greater freedom for the manager to operate its business. In this type of arrangement, the fees will generally be calculated on a gross basis. The actual sharing percentage varies depending on the amount of the Investment; however, amounts from 15 to 30% are common.

Seeder Rights and Obligations

Depending on the size of the Investment, the Seeder may obtain certain special rights, including but not limited to:

Access to Fund records and accounts, including “side letters” with other investors;
Portfolio transparency;
Most Favored Nation treatment;
Capacity rights
Right of first refusal on launch of subsequent funds, service providers or corporate events;
Management and oversight rights, including budget approval, fund terms, investment guidelines and restrictions;
Special liquidity terms;
Notification of significant matters and periodic meetings with principals of the manager.

The Seeder may agree to serve on an advisory committee for the manager, assist in the marketing of the Fund, and/or provide office space or other specified services to the manager.

Fund Manager Obligations

Depending on the size of the Investment, the manager may agree to additional obligations, including but not limited to:

Principal Investment

Principals of the manager agree to make and maintain a certain investment in the Fund, and may be required to re-invest a portion of received inventive allocation.

Revenue Share of All Fees

The fee sharing agreement will include all fees the manager receives from its investment management related activities (including other funds or managed accounts managed by the manager).

Non-Compete/Non-Solicitation

Principals of the manager will be prohibited from forming other management companies or funds for a period of time and may agree to a specific time commitment. In addition, the principals will agree to not solicit other employees of the manger or the Seeder for a period of time after they leave.

Representations, Warranties and Covenants

The manager will be required to make certain representations, warranties and covenants relating to regulatory and compliance issues.

Indemnification

The Seeder will usually be fully indemnified by the manager against losses arising out of the seed agreement or the investment in the Fund or any Fund document.

Additional Considerations

When contemplating entering into a seed deal arrangement, the manager should also consider the following:

Buyout Rights

The manager may request the right to buyout (in whole or in part) the Seeder’s interest in the Fund, after a specified number of years or upon receiving a certain amount of fees. The buyout price can be determined ahead of time and is generally determined by a formula based on Investor receiving a certain amount of fees or a certain rate of return on the Investment.

Put Rights

Similar to the above, the Seeder may also request the right to sell its interest back to the manager.

Tag Along Rights

In the event of a sale of the manager, the Seeder may request a provision that would require the purchaser to also buy out the Seeder’s interest in the manger on a pro rata basis.

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Cole-Frieman & Mallon LLP is an investment management law firm focused on established and emerging hedge fund managers. If you have questions about hedge fund seed deals, please contact us.

Business Development Company (BDC) Overview and Formation

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What is a Business Development Company?

Business Development Companies (“BDCs”) are a type of publicly-traded closed-end fund that are registered under the Investment Company Act of 1940 (the “1940 Act”). BDCs are designed to facilitate the raising of capital by small, developing, and financially troubled companies that historically lacked access to the public capital markets. A BDC is required to make available “significant managerial assistance” to the companies in which it invests including management and operational assistance. As such, BDCs are not intended to be passive investment vehicles. BDCs make investments in the form of long-term debt or equity capital with the goal of generating capital appreciation and/or current income. In recent years, a number of private equity managers have also launched BDCs as a means of accessing public capital.

BDC Advantages

BDCs are preferable to other investment funds for a number of reasons:

Unlike mutual funds and other open-end funds, BDCs provide the same liquidity to investors as other publicly traded investments.
BDC investors are not limited to “qualified purchasers” and investors need not meet income and net worth requirements.
BDC managers have access to permanent capital that is not subject to shareholder redemption.
Unlike other registered fund managers, BDC managers may charge performance fees (e.g. “2 and 20” incentive fees).

BDC Limitations

BDCs are subject to a number of restrictions and limitations including the following:

BDCs must maintain low leverage – total debt may not exceed total equity.
BDCs are restricted in their ability to enter into transactions with affiliates.
BDCs must adopt and implement policies and procedures designed to prevent violations of the federal securities laws and must appoint a chief compliance officer to administer these policies and procedures.
No single BDC investment can account for more than 25% of total holdings and 70% of all assets must be invested within a limited number of categories.
BDCs must distribute at least 90% of their taxable earnings quarterly.

Permissible Investments

Section 55 of the 1940 Act requires that a BDC invest at least 70% of its total assets in the following:

Privately issued securities purchased from issuers that are “eligible portfolio companies;”
Securities of eligible portfolio companies that are controlled by a BDC and of which an affiliated person of the BDC is a director;
Privately issued securities of companies subject to a bankruptcy proceeding, reorganization, insolvency or similar proceeding or otherwise unable to meet their obligations without material assistance;
Cash, cash items, government securities or high quality debt securities maturing in one year or less; and
Office furniture and equipment, interests in real estate and other similar non-investment assets incidental to the BDC’s operations.

Tax Treatment

BDCs are typically organized as limited partnerships or Subchapter M regulated investment companies in order to obtain pass-through tax treatment. Distributions to shareholders are taxable as either ordinary income or capital gains in the same manner as distributions from mutual funds.

BDC Formation

To become a BDC, a company must file Form N-6 with the SEC (intent to file a notification of election). Then, a company must file a notice on Form N-54A indicating that it elects to be regulated as a BDC under the 1940 Act. In order to elect to be regulated as a BDC, a company must register its equity securities under Section 12 of Securities Exchange Act of 1934. This registration requires BDCs to periodically file Form 10-K, 10-Q and 8-K as well as proxy statements with the SEC. A BDC must also register its securities under the Securities Act of 1933 by preparing and filing a Form N-2 registration statement which describes essential information about the BDC to help investors make informed investment decisions. The registration statement must disclose (i) the terms of the offering including number of shares and price, (ii) the intended use of the proceeds, (iii) investment objectives and strategies, (iv) risks associated with the investment, and (v) a description of the BDC’s management.

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Cole-Frieman & Mallon LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart Mallon can be reached directly at 415-868-5345.

Cole-Frieman & Mallon LLP 4th Quarter Newsletter

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Below is our quarterly newsletter which was sent to our clients and friends last week. If you would like to receive this news letter, please contact us.

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Clients and Friends:

There have been a number of new regulatory developments over the past three plus months of concern to investment managers, namely:

California Private Fund Adviser Exemption
CFTC Regulatory Changes
Foreign Account Tax Compliance Act (“FATCA”)
JOBS Act

Below we detail these developments, provide some of our thoughts on the current regulatory environment and outline some items that managers should be aware of as this year comes to a close. Please feel free to contact us with any thoughts or questions on these matters.

California Private Fund Adviser Exemption

On August 27, 2012 the California Office of Administrative Law approved the long awaited private fund adviser exemption (“Private Fund Adviser Exemption”). The immediately effective exemption is only available to advisers who provide advice solely to “qualifying private funds,” which include venture capital funds, Section 3(c)(1) funds and Section 3(c)(7) funds. The Private Fund Adviser Exemption is not available to advisers who also manage separate accounts. Advisers to qualifying private funds who qualify for the Private Fund Adviser Exemption and manage less than $100,000,000 can file as “exempt reporting advisers” and thereby avoid the registration and compliance requirements in California. Specific requirements for advisers seeking to rely on the Private Fund Adviser Exemption can be found here.

CFTC Expanded Jurisdiction Over Certain Swaps

With the issuance of new rules from the CFTC affecting swaps, investment managers that trade swaps will need to determine whether the swaps they trade will subject the manager to CFTC regulation; and if so, whether CFTC registration is required or an exemption from registration is available. As of October 12, 2012 an investment manager that trades swaps covered by the new rules may find itself subject to regulation by the CFTC, even if the adviser does not trade futures or commodity interests. Similarly, an adviser to a commodity pool that trades swaps and is currently relying on Regulation 4.13(a)(3) – the “de minimis” exemption from CFTC regulation for advisers who trade only minimal futures, commodity interests and swaps – will need to reassess whether it can still fit within this exemption after taking into account its swaps trading.

CFTC Regulatory Changes

Recent regulatory changes, which become effective on December 31, 2012, require advisers to private funds or accounts using commodity futures, commodity options and other CFTC regulated derivatives to register with the CFTC or rely on an exemption from such registration. These changes include:

CFTC Regulation 4.13(a)(4) Exemption Rescinded: Managers to funds offered only to “qualified eligible persons” have previously relied on this exemption from CPO registration. This exemption will no longer be available as of December 31, 2012.
CFTC Regulation 4.13(a)(3) De Minimus Exemption: Managers to commodity pools with a limited use of commodity interests can rely on this exemption from registration as a CPO. However, with the CFTC’s extended jurisdiction over swaps, many pools may no longer qualify and must register as a CPO with the CFTC.
Annual Re-Certification: CPOs and CTAs relying on exemptions from registration will be required to re-certify their qualifications annually on a calendar-year basis, beginning on December 31, 2012.
New Reporting Requirements: Registered CPOs and CTAs must file certain new reports and include standardized risk disclosure to describe risks of swap transactions in the disclosure documents.

FATCA

Enacted by Congress as part of the HIRE Act of 2010 with the goal to combat tax evasion, FATCA will go into effect on January 1, 2013. The new regulations will require financial institutions to identify and disclose direct and indirect U.S. investors and withhold U.S. income tax on nonresident aliens and foreign corporations, or be subject to a 30% FATCA tax. Foreign financial institutions, which include hedge funds, funds of funds, commodity pools and other offshore investment vehicles, will be required to enter into an agreement with the IRS by June 30, 2013 to avoid being subject to the FATCA tax. Domestic funds will also need to determine the FATCA status of each of their investors and will be subject to new withholding and reporting requirements for any recalcitrant investors. Final regulations have not been promulgated, however, managers should discuss compliance methods with their administrators and other third party service providers.

Jumpstart Our Business Startups Act (“JOBS Act”)

The JOBS Act, signed into law in April 2012, has two big implications for the hedge fund industry:

The first, which was effective immediately, raised the maximum number of investors permitted in a 3(c)(7) fund from 499 to 1,999. Private funds relying on the 3(c)(1) exemption are still limited to 99 investors.
The second, which is still awaiting final rules by the SEC, lifts the ban on general solicitation and advertising under Rule 506 of Regulation D. The proposed amendments would allow issuers to use general solicitation and general advertising to offer securities, provided that the issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.

Managers should remember that while general solicitations may be allowable in the future, these rules are not yet final. In addition, all registered investment advisers will still be subject to applicable advertising regulations under the Investment Advisers Act. CFTC registered managers are still subject to certain CFTC regulations that prohibit marketing to the public, and managers that intend to rely on the 4.13(a)(3) “de minimus” exemption (discussed above) are also prohibited from marketing to the public.

Form PF

Managers to private funds who are registered (or required to be registered) as investment advisers with the SEC and have at least $150 million under management, will need to file Form PF with the SEC. The filings must be made either on a quarterly or annual basis, depending on the type of private fund and regulatory assets under management. For managers to hedge funds, the filings and compliance dates are as follows:

Greater than $5 billion regulatory AUM – The filing must be made on a quarterly basis, within 60 days of the end of each fiscal quarter, beginning on June 15, 2012.
At least $1.5 billion (but less than $5 billion) in regulatory AUM – The filing must be made on a quarterly basis, within 60 days of the end of each fiscal quarter, beginning on December 15, 2012.
At least $150 million (but less than $1.5 billion) in regulatory AUM – The filing must be made on an annual basis, within 120 days of the end of each fiscal year, beginning on December 15, 2012.

4th Quarter Items

January 1, 2013 Fund Launches – Managers seeking to launch a fund on the first of the year should begin the fund formation process as soon as possible in order to give themselves and service providers ample time to prepare during the busy season.
CFTC Regulatory Matters:
- Managers should review the recently expanded list of CFTC regulated products to determine whether they will be subject to CFTC regulation. CPOs currently relying on CFTC Regulation 4.14(a)(4) will need to assess whether the commodity pool is eligible for the “de minimis” exemption or register with the CFTC as a CPO by December 31, 2012. CPOs currently relying on CFTC Regulation 4.13(a)(3) will need to evaluate whether the commodity pool is still eligible for the exemption.
- CPOs and CTAs that have exemptive relief under CFTC Regulations will need to reconfirm their qualifications by December 31, 2012.
IARD Renewal – FINRA will be sending out notice reminders to facilitate the annual renewal of investment adviser registration. Preliminary Renewal Statements will be made available on IARD on November 12, 2012.
Form PF – As discussed above, managers to private funds with less than $5 billion regulatory AUM will need to make Form PF filings with the SEC beginning on December 15, 2012, on either a quarterly or annual basis, depending on the types of private funds managed and regulatory AUM.

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Cole-Frieman & Mallon LLP is a premier boutique investment management law firm, providing top-tier, responsive and cost-effective legal solutions for financial services matters. Headquartered in San Francisco, Cole-Frieman & Mallon LLP has an international practice that services both start-up investment managers as well as multi-billion dollar firms. The firm provides a full suite of legal services to the investment management community, including: hedge fund, private equity fund, and venture capital fund formation, adviser registration, counterparty documentation, SEC, CFTC, NFA and FINRA matters, seed deals, hedge fund due diligence, employment and compensation matters, and routine business matters. The firm also publishes the prominent Hedge Fund Law Blog (www.hedgefundlawblog.com) which focuses on legal issues that impact the hedge fund community. For more information please visit us at: www.colefrieman.com.

This newsletter is published as a source of information only for clients and friends of the firm and should not be construed as legal advice or opinion on any specific facts or circumstances. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. Circular 230 Disclosure: Pursuant to regulations governing practice before the Internal Revenue Service, any tax advice contained herein is not intended or written to be used and cannot be used by a taxpayer for the purpose of avoiding tax penalties that may be imposed on the taxpayer. Cole-Frieman & Mallon LLP is a California limited liability partnership and this publication may be considered attorney advertising in some jurisdictions.

Hedge Fund Compliance & Due Diligence Webinar

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Bart Mallon Speaker at Hedge Fund Compliance and Due Diligence Webinar

Due diligence continues to be a hot topic for fund managers; compliance has been a central issue for managers ever since SEC registration was required for those managers with more than $150M of AUM. Below is a release for webinar which will be taking place later this month. Bart Mallon will be speaking about the legal issues involved with compliance and due diligence.

Registration is free and sign up is here.

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Corgentum Consulting Hosts Hedge Fund Operational Due Diligence Webinar on Compliance and Legal Risk

Corgentum Consulting will host a complimentary Webinar titled, ‘Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence’ on October 23, 2012, at 10:30am EDT

NEW YORK – Oct. 1, 2012 – Corgentum Consulting, the leading provider of the industry’s most comprehensive hedge fund operational due diligence reviews, will host a complimentary Webinar titled, “Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence” on October 23, 2012, at 10:30am EDT. Join the speakers as they examine the effective techniques for evaluating a fund’s legal and compliance risks.

The global hedge fund regulatory landscape has undergone a number of recent significant changes. New SEC registration requirements and Form PF filings in the US continue to challenge hedge funds. Internationally, increased calls for Asian hedge fund regulation in countries such as Singapore and Australia, as well as discussions surrounding MiFID II and the EU passport directive in Europe, continue to complicate the web of legal and regulatory rules.

DATE: October 23, 2012

TIME: 10:30am to 11:30am EDT

SPEAKERS:

• Jason Scharfman, Managing Partner, Corgentum Consulting

• Paul Brook, Principal, Compliance Solutions Associates

• Bart Mallon, Partner, Cole-Frieman Mallon & Hunt LLP

Some of the topics that will be covered during the Webinar include:

• Techniques for evaluating fund compliance programs

• Evaluating legal documentation risk

• Understanding the effects of recent hedge fund case law

• Monitoring ongoing fund adherence to regulatory requirements

If you are interested in joining the “Techniques for Analyzing Hedge Fund Compliance and Legal Risks During Operational Due Diligence” Webinar, please visit https://www1.gotomeeting.com/register/389516416 or contact [email protected].

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About Corgentum Consulting

Corgentum Consulting is a specialist consulting firm which performs operational due diligence reviews of fund managers. The firm works with investors including fund of funds, pensions, endowments, banks and family offices to conduct the industry’s most comprehensive operational due diligence reviews. Corgentum’s work covers all fund strategies globally including hedge funds, private equity, real estate funds, and traditional funds. The firm’s sole focus on operational due diligence, veteran experience, innovative original research and fundamental bottom up approach to due diligence allows Corgentum to ensure that the firm’s clients avoid unnecessary operational risks. Corgentum is headquartered at 26 Journal Square, Suite 1005 in Jersey City, New Jersey, 07306. Phone 201-360-2430. The Web site is www.corgentum.com.

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Cole-Frieman & Mallon LLP provides hedge fund compliance and legal services to investment management community. Bart Mallon can be reached directly at 415-868-5345.

JOBS ACT – SEC Proposes New Changes to Rules 506 and 144A

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The JOBS Act, enacted earlier this year, directed the SEC to remove prohibitions on general solicitation and general advertising and revise rules on the resale of securities by large institutional investors. On August 29th, the SEC issued a proposed rule to modify Rules 506 and 144A of the Securities Act, which deal with general solicitation and advertising and resales of securities by large institutional investors, respectively.

Rule 506

Under the proposed rule, companies issuing securities would be permitted to use general solicitation and general advertising to offer securities if the following conditions have been met:

The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
All purchasers of securities are accredited investors, because either:
- They come within one of the categories of persons who are accredited investors under existing Rule 501.
- The issuer reasonable believes that the meet one of the categories at the time of the sale of the securities.

The proposed rule would use a set of factors to determine if an issuer has taken the necessary steps to verify a purchaser is an accredited investor. These factors include:

The issuer takes reasonable steps to verify that the purchasers of the securities are accredited investors.
The amount and type of information that the issuer has about the purchaser.
The nature of the offering, meaning:
- The manner in which the purchaser was solicited to participate in the offering.
- The terms of the offering, such as a minimum investment amount.

Form D

The proposed rule would also affect Form D, which issuers must file with the SEC when they sell securities under Regulation D. The revised form would contain a new separate box for issuers to check if they are claiming the new Rule 506 exemption that would permit general solicitation and general advertising.

Rule 144A and QIBs

The Rule 144A exemption is a safe harbor under Section 5 of the Securities Act of 1933 that essentially allows unlimited resales of certain unregistered securities of US and foreign issuers not listed on a US securities exchange or quoted on a US automated inter-dealer quotation system to “qualifying institutional buyers” (QIBs). A QIB is an entity acting for its own account or the accounts of other qualified institutional buyers that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers that are not affiliated with the entity. For hedge funds and private funds this means an unregistered fund or entity that owns or invests at least $100 million in securities of unaffiliated issuers and a registered fund manager acting for its own account or the accounts of other QIBs that in the aggregate owns and has discretions over at least $100 million in securities of unaffiliated issuers. Even if a manager is a QIB, each fund itself must have $100 million in securities to qualify as a QIB.

Under the proposed rule, offers of securities could be made to investors who are not QIBs as long as the securities are sold only to persons whom the seller and any person acting on behalf of the seller reasonably believe are QIBs.

Conclusion

The modification of Rule 506 would allow companies to advertise and solicit the sales of securities in ways that they had not been able to do so previously. The effect on Rule 144A would be to permit the offers of securities to investors who are not QIBs but persons whom the seller reasonably believes are QIBs.

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Cole-Frieman Mallon & Hunt LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart Mallon can be reached directly at 415-868-5345.

FATCA Implications for Hedge Funds

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Foreign Account Tax Compliance Act Overview

The Foreign Account Tax Compliance Act (“FATCA”) was enacted by Congress as part of the HIRE Act of 2010. FATCA will become effective on January 1, 2013 and some parts of the act will be applicable to investment managers. The primary objective behind FATCA is to combat tax evasion by making it difficult for U.S. persons to hide income and assets overseas. To accomplish this objective, the new regulations will require financial institutions to identify and disclose direct and indirect U.S. investors and withhold U.S. income tax on nonresident aliens and foreign corporations. Foreign financial institutions, and certain onshore entities, will be required to comply with the new disclosure and tax withholding requirements or be subject to a 30% FATCA tax. While proposed regulations and applicable forms have yet to be finalized, investment managers should be prepared for the new FATCA regime and compliance rules.

Application to Investment Funds

Non-U.S. Funds

Foreign financial institutions (each, an “FFI”), which include hedge funds, funds of funds, commodity pools and other offshore investment vehicles, will be required to enter into an agreement with the IRS (“FFI Agreement”) to avoid being subject to the FATCA tax. Each FFI will be required to:

obtain, verify and report information on its direct and indirect U.S. investors pursuant to specific due diligence procedures;
perform annual reporting;
deduct and withhold 30% from any payment made by the fund to U.S. investors refusing disclosure and non U.S. investors without proper FATCA documentation; and
comply with requests for additional information.

U.S. Funds

Domestic funds will need to determine the FATCA status of each of their investors and will be subject to new due diligence and reporting obligations for current and new investors. In addition, U.S. funds will be required to deduct and withhold a 30% FATCA tax from investors who do not provide the required documentation.

FATCA Timeline

The current timeline for FATCA compliance is as follows (however dates may change as regulations are finalized):

FFI Agreement – FFIs will be able to enter into an FFI Agreement through an IRS online system starting on January 1, 2013 (but no later than June 30, 2013).
Reporting Obligations – due diligence and reporting requirements under FATCA will be implemented in a staggered manner, based on an investor’s account balance, beginning on January 1, 2013. IRS plans to release new tax forms in the next few months.
Withholding Obligations – the 30% FATCA tax will be implemented in a staggered manner, beginning on January 1, 2014 and will eventually include interest, dividends and other FDAP (fixed, determinable, annual, periodic) income from U.S. sources, gross proceeds from sale of U.S. securities and foreign pass-through payments.

Next Steps

As we mentioned previously, final regulations have not been promulgated. However, when they are, managers will need to do the following:

Review and update fund offering documents and other investor agreements to disclose additional reporting obligations imposed by FATCA and risk of withholding for “recalcitrant investors” (those investors who choose not to disclose their name to the IRS).
Asses fund structure and identify entities that may be affected by new FATCA regime.
Work with third-party service providers to ensure proper registration and compliance once FATCA rules are finalized, including: (a) investor due diligence and documentation; (b) FFI Agreement; and (c) FATCA withholding.

If you have questions about the new FATCA requirements and how they impact your fund, please contact us directly.

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Cole-Frieman & Mallon LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart Mallon can be reached directly at 415-868-5345.

California Private Fund Adviser Exemption Approved

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California Hedge Fund Managers Relieved of IA Registration Requirement

On August 27, 2012 (“Effective Date”), the California Office of Administrative Law approved the long awaited private fund adviser exemption (“Private Fund Exemption”). The immediately effective exemption is only available to advisers who provide advice solely to “qualifying private funds,” which include venture capital funds, Section 3(c)(1), and Section 3(c)(7) funds. The Private Fund Exemption is not available to advisers who also manage separate accounts.

Currently, a California based adviser who manages less than $100,000,000 must either register as an investment adviser with the California Department of Corporations (“Department”), or rely on an exemption from registration. Under the new Private Fund Exemption advisers can file as “exempt reporting advisers” (“ERAs”) and thereby avoid the burdensome registration process.

Requirements Generally

To qualify for the Private Fund Exemption, the adviser must

have not violated any securities laws;
file and periodically update certain items on Part 1 of the Form ADV;
pay California’s investment adviser registration and renewal fees; and
fulfill any additional requirements when advising funds organized under Section 3(c)(1).

Additional Requirements for 3(c)(1) Fund Managers

The additional requirements for advisers advising 3(c)(1) funds include:

1. All investors in the fund must either (i) be accredited investors; (ii) be managers, directors, officers or employees of the adviser; or (ii) have received the fund interest via a transfer not involving a sale.

2. Advisers may only charge performance fees to qualified clients; and

3. Advisers shall provide each investor with annual audited financial statement of the fund within 120 days after the end of each fiscal year; provided, however, advisers who begin operations more than 180 days into a fiscal year may include the audit of the initial fiscal year in the fiscal year immediately succeeding the initial fiscal year.

Other Information

An adviser to 3(c)(1) funds that existed prior to Effective Date may take advantage of the Private Adviser Exemption if, as of the Effective Date, it complies with the requirements enumerated above. Any investors in funds existing prior to the Effective Date who do not meet the standards outlined in Item 1 above, will be allowed to remain in the funds provided that they do not make any additional capital contributions. Furthermore, as of the Effective Date, advisers must cease charging performance fees to any investors who do not meet the “qualified client” definition.

To take advantage of the Private Fund Exemption, an adviser must file a partial Form ADV with the Department via the IARD system no later than 60 days from the Effective Date. Advisers currently registered with the Department may choose to withdraw their registration and make a filing under the Private Fund Exemption.

For information on whether your firm may be able to claim an exemption from registration, please see the California Private Fund Adviser Exemption Chart.

If you would like help to utilize the California exemption, please contact us directly.

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart can be reached directly at 415-868-5345.

ERISA 408(b)(2) Disclosure Requirements

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Disclosures Required From Service Providers to Certain Plans

On February 3, 2012, the Department of Labor (“DOL”) issued the long awaited final regulation requiring certain pension plan service providers to disclose information ab

out their compensation and potential conflicts of interest (the “Final Regulation”). The Final Regulation was established under Section 408(b)(2) of the Employee Retirement Income Security Act of 1974 (“ERISA”). While ERISA generally prohibits the furnishing of goods, services, or facilities between a plan and a party in interest to the plan, Section 408(b)(2) provides relief from such prohibited transactions. It allows service contracts or arrangements if they are reasonable, the services are necessary for the establishment or operation of the plan, and no more than reasonable is paid for the services. The Final Regulation became effective on July 1, 2012.

Covered Service Providers and Covered Plans

The Final Regulation applies to the following covered service providers (“CSPs”) who expect to receive at least $1,000 in compensation for services to a covered plan:

• ERISA fiduciaries providing services directly to a covered plan (including fund managers).

• Federal or state law registered investment advisers.

• Record-keepers or brokers who make designated investment alternatives to the covered plan.

• Providers of one or more of the following services to the covered plan who also receive indirect compensation in connection with such services: accounting, auditing, actuarial, banking, consulting, custodial, insurance, investment advisory, legal, recordkeeping, securities brokerage, third party administration, or valuation services.

The Final Regulation applies to ERISA-covered defined benefit and defined contribution plan such as pension plans and 401(k) plans.

Final Regulation Disclosure Requirements

Covered service providers must provide responsible ERISA fiduciaries with the information they need to:

• Evaluate the reasonableness of total direct and indirect compensation received by the CSP, its affiliates, and/or subcontractors;

• Ascertain potential conflicts of interest; and

• Fulfill reporting and disclosure requirements under Title I of ERISA.

The required information must be furnished in writing reasonably in advance of the date any service contract or arrangement is entered into. Such writing must describe the provided services and all compensation to be received. CSPs who disclose indirect compensation must describe the arrangements between the payer and CSP pursuant to which such compensation is paid, identifying the sources of such compensation and the services to which it relates. Furthermore, CSPs must disclose whether they are providing recordkeeping services and the compensation attributable to such services.

Conclusion for Fund Managers

Fund managers with ERISA clients will need to begin drafting and providing these disclosures to such clients. This will be another requirement for start up fund managers to consider when deciding whether to take on ERISA clients. While ultimately the disclosures are not extremely onerous, they do add another to-do to a manager’s list.

Please contact us if you have questions or if you would like help drafting the disclosure required under 408(b)(2).

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm which provides legal services to the hedge fund industry. Bart can be reached directly at 415-868-5345.

CFTC Adopts New Segregated Funds Rules Post PFG

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In the wake of the failure of MF Global in 2011, regulators and self-regulatory organizations scrambled to assess the damage and to implement regulations to oversee how futures commission merchants (“FCMs”) manage and report segregated funds. Just as some of these rules were being implemented, the Peregrine Financial Group scandal hit, and the renewed calls for reform have likely triggered another wave of regulations.

Recent Activity on Segregated Funds

It has been a busy couple of months for rules affecting segregated funds:

• July 9: The NFA brought an emergency action against Peregrine Financial Group, Inc. (“Peregrine Financial”) and Peregrine Asset Management, Inc. for, among other things, failing to demonstrate that they could meet capital and segregated funds requirements. The NFA was Peregrine Financial’s designated self-regulatory organization.

• July 10: The NFA notified CPO Members holding assets at Peregrine Financial to notify the NFA of their exposure to Peregrine Financial.

• July 13: The CFTC adopted the new segregated funds rules for FCMs proposed by the NFA in late May.

• July 16: The NFA, following harsh criticism, announced an external review of its general audit practices and procedures, as well as its execution of those procedures with respect to the NFA’s review of Peregrine Financial’s segregated funds.

• Late July: The NFA and other regulatory and self-regulatory organizations publicly discussed proposals for new rules affecting segregated funds.

New Regulations Effective September 1, 2012

The CFTC announced on Friday, July 13 that it had adopted the segregated funds rules proposed by the NFA. These rules will become effective on September 1, 2012. Below is a summary; greater details can be found on the NFA’s website here.

• Policies and Procedures. All FCMs must have written policies and procedures regarding the maintenance of the firm’s residual interest in its customer segregated funds. These policies and procedures must target an amount (either by percentage or dollars) that the FCM seeks to maintain as its residual interest in those accounts and ensure that the FCM remains in compliance with the applicable segregation requirements.

• Pre-Approval and NFA Notice. No FCM may withdraw, transfer or otherwise disburse funds from any customer segregated funds account exceeding 25% of the FCM’s residual interest in customer segregated funds unless (a) the firm’s CEO, CFO or other defined principal pre-approves the transaction in writing, and (b) a notice is filed immediately with the NFA.

• Monthly or Semi-Monthly Reporting. All FCMs must provide NFA with certain financial and operational information on a monthly or semi-monthly basis. NFA will subsequently make some of the information publicly available on its website in the future.

Note: all of these new requirements

also apply to foreign futures and options customer secured amount funds accounts.

Proposed Rules and Procedures

Various regulators and self-regulatory organizations have put forth the following rules and procedures for discussion and possible adoption in the future:

• Web-Based Balance Confirmation. A committee of self-regulatory organizations have agreed to put into place a web-based process that FCMs can use to confirm their segregated account balances. [Note: this committee includes the CME Group, NFA, InterContinental Exchange, Kansas City Board of Trade and the Minneapolis Grain Exchange.]

• Direct e-Monitoring of Accounts. The CFTC, the NFA, and a number of self-regulatory organizations have expressed support for requiring FCMs to provide regulators with direct read-only access to the FCMs’ segregated accounts, to facilitate monitoring of account balances.

• Clearinghouses. CME Group expressed potential support for having segregated funds held at clearinghouses or other depositories, with the interest being returned to the FCMs.

Conclusion

FCMs should be aware of the new CFTC rules that will go into effect on September 1, 2012. FCMs should also prepare for the imposition of some or all of the rules proposed by various self-regulatory organizations.

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Special Reminder: CPOs Must Notify NFA of Exposure to Peregrine Financial

As mentioned above, the NFA is requiring CPO Members that hold assets at Peregrine Financial to report their exposure. Specifically, the NFA requires the following information within 48 hours of receiving the NFA notice:

• The name of each pool account held at Peregrine Financial and its NFA Pool ID number;

• The current dollar amount of pool assets held at Peregrine Financial for each pool account and the corresponding date;

• The most recent net asset value for each pool with funds at Peregrine Financial and the date of the valuation;

• Any withdrawal restrictions that the firm has implemented or plans to implement with respect to each pool.

In addition, please note that following the failure of MF Global, the NFA required CPOs to disclose the extent of their exposure in the CPO’s disclosure documents. The NFA may require a similar disclosure related to Peregrine Financial.

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Bart Mallon is a partner with Cole-Frieman Mallon & Hunt LLP, an investment management law firm with a focus on managed futures law and regulations which affect CTAs, CPOs, IBs and FCMs. Bart can be reached directly at 415-868-5345.