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Clients, Friends, Associates:
As we prepare for a new year, we also reflect on an eventful 2019 year that included developments impacting both traditional hedge fund managers as well as those in the digital asset space. Regardless of all the changes in the investment management space, year-end administrative upkeep and 2020 planning are always particularly important, especially for general counsels, Chief Compliance Officers (“CCOs”), and key operations personnel. As we head into 2020, we have put together this checklist and update to help managers stay on top of the business and regulatory landscape for the coming year.
This update includes the following
California Consumer Privacy Act
There has been much discussion about the California Consumer Privacy Act (“CCPA”) passed earlier this year and effective January 1, 2020.Please be aware that most private fund managers will not be affected by the new law. We have provided a detailed overview of the CCPA here, but below are the main items applicable to private fund managers:
Given the above, what should managers do if they are potentially subject to the CCPA? We believe managers should start thinking about the following steps:
Annual Compliance and & Other Items
Annual Compliance Review. On an annual basis, the CCO of an RIA must conduct a review of the adviser’s compliance policies and procedures. This annual compliance review should be in writing and presented to senior management, We recommend that firms discuss the annual review with their outside counsel or compliance firm, who can provide guidance about the review process as well as a template for the assessment and documentation. Conversations regarding the annual review may raise sensitive matters, and advisers should ensure that these discussions are protected by attorney-client privilege. CCOs may also want to consider additions to the compliance program. Advisers that are not registered may still wish to review their procedures and/or implement a a compliance program as a best practice.
Form ADV Annual amendment. RIAs or managers filing as exempt reporting advisers (“ERAs”) with the SEC or a state securities authority must file an annual amendment to Form ADV within 90 days of the end of their fiscal year. For most managers, the Form ADV amendment would be due on March 31, 2020. RIAs must provide a copy of the updated Form ADV Part 2A brochure and Part 2B brochure supplement (Or a summary of changes with an offer to provide the complete brochure) to each “client”. Note that for SEC-registered advisers to private investment vehicles, a “client” for purposes of this rule means the vehicle(s) managed by the adviser and not the underlying investors. State-registered advisers need to examine their state’s rules to determine who constitutes a “client”.
Switching to/from SEC Regulation.
SEC Registration. Managers who no longer qualify for SEC registration as of the time of filing the annual Form ADV amendment must withdraw from SEC registration within 180 days after the end of of their fiscal year (June 29, 2020, for most managers), by filing a Form ADV-W. Such managers should consult with legal counsel to determine whether they are required to register in the states in which they conduct business. Managers who are required to register with the SEC as of the date of their annual amendment must register with the SEC within 90 days of filing the annual amendment (June 29, 2020, for most managers, assuming the annual amendment is filed on March 31, 2020).
Exempt reporting advisers. Managers who no longer meet the definition of an ERA will need to submit a final report as an ERA and apply for registration with the EC or relevant state securities authority, if necessary, generally within 90 days after the filing of the annual amendment.
Custody Rule Annual Audit
SEC RIAs. SEC-registered investment advisers (“SEC RIAs”) must comply with certain custody procedures, including (i) maintaining client funds and securities with a qualified custodian; (ii) having a reasonable basis to believe that the qualified custodian sends an account statement to each advisory client at least quarterly; and (iii) undergoing an annual surprise examination conducted by an independent public accountant.
SEC RIAs to pooled investment vehicles may avoid both the quarterly statement and surprise examination requirements by having audited financial statements prepared for each pooled investment vehicle in accordance with generally accepted accounting principles by an independent public accountant registered with the Public Company Accounting Oversight Board (“PCAOB”). Statements must be sent to investors in the fund within 120 days after the fund’s fiscal year end. Managers should review their custody procedures to ensure compliance with the rules.
California RIAs. California-registered investment advisers (“CA RIAs”) that manage pooled investment vehicles and are deemed to have custody of client assets are also subject to independent party and surprise examinations. However, CA RIAs can avoid these additional requirements by engaging an auditor (that is an independent public accountant registered with the PCAOB) to prepare and distribute audited financial statement to all investors ( or other beneficial owners_ of the pooled investment vehicle, and to the Commissioner of the California Department of Business Oversight (“DBO”). Those CA RIA s that do not engage an auditor must, among other things, (i) provide notice of such custody on the Form ADV; (ii) maintain client assets with a qualified custodian; (iii) engage an independent party to act in the best interest of investors to review fees, expenses, and withdrawals; and (iv) retain an independent certified public accountant to conduct surprise examinations of assets.
Other State RIAs. Advisers registered in other states consult with legal counsel about those states’ specific custody requirements.
California Minimum Net Worth Requirement and Financial Reports.
RIAs with Custody. Every CA RIA that has custody of client funds or securities must maintain at all times a minimum net worth of $35,000, however the minimum net worth is $10,000.00 for a CA RIA (i) deemed to have custody for another type of pooled investment vehicle and (ii) that otherwise complies with the California custody rule described above (such advisers, “GP RIAs”).
RIAs with discretion. Every CA RIA that has discretionary authority over client funds or securities, whether or not they have custody, must maintain at all times a net worth of at least $10,000, and preferably $12,000.00 to avoid certain reporting requirements.
Financial Reports. Every CA RIA that either has custody of, or discretionary authority over, client funds or securities must file an annual financial report with the DBO within 90 days after the adviser’s fiscal year end. The annual financial report must contain a balance sheet, income statement, supporting schedule, and a verification form. These financial statements must be audited by an independent certified public accountant or independent public accountant if the adviser has custody and is not a GP RIA.
Annual Re-Certification of CFTC Exemptions. Commodity pool operators (“CPOs”) and commodity trading advisers (“CTAs” currently relying onc ertain exemptions from registration with the Commodity Futures Trading Commission (“CFTC”) are required to re-certify their eligibility within 60 days of the calendar year end. CPOs and CTAs currently relying on relevant exemptions will need to reevaluate whether they remain eligible to rely on such exemptions.
CPO and CTA Annual Updates. Registered CPOs and CTAs must prepare and file Annual Questionnaires and Annual Registration Updates with the National Futures Association (“NFA”), as well as submit payment for annual maintenance fees and NFA membership dues. Registered CPOs must also prepare and file their fourth quarter report for each commodity pool on Form CPO-PQR, while CTAs must file their fourth quarter report on Form CTA-PR. or more infomration on Form CPO-PQR, please see our earlier post. Unless eligibel to claim relief under Regulation 4.7, registered CPOs and CTAs must update their disclosure documents periodically, as they may not use any that are materially inaccurate or incomplete and must be corrected promptly, and the corrected version must be distributed promptly to pool participants.
Trade Errors. Managers should make sure that all trade errors are properly addressed pursuant to the manager’s trade errors policies by the end of the year. Documentation of trade errors should be finalized, and if the manager is required to reimburse any of its funds or other clients. it should do so by year-end.
Soft Dollars. Managers that participate in soft dollar programs should make sure that they have addressed any commission balances from the previous year.
Schedule 13G/D and Section 16 Filings. Managers who excercise investment discretion over accounts (including funds and separately managed accounts (“SMAs”) that are beneficial owners of 5% or more of a registered voting equity security must report these position on Schedule 13D or 13G. Passive investors are generally eligible to file the short form Schedule 13G, which is updated annually within 45 days of the end of the year. Schedule 13D is required when a manager is ineligible to file Schedule 13G and is due 10 days after the acquisition of more than 5% beneficial ownership of a registered voting equity security. For managers who are also making Section 16 filings, this is an opportune time to review your filings to confirm compliance and anticipate needs for the first quarter.
Section 16 filings are required for “corporate insiders” (including beneficial owners of 10% or more of a registered voting equity security). An initial Form 3 is due within 10 days after becoming an “insider”; Form 4 reports ownership changes and is due by the end of the second business day after an ownership change; and Form 5 reports any transactions that should have been reported earlier on a Form 4 or were eligible for deferred reporting and is due within 45 days after the end of each fiscal year.
Form 13F. A manager must file a Form 13F if it exercises investment discretion with respect to $100 million or more in certain “Section 13F securities” within 45 days after the end of of the year in which the manager reaches the $100 million threshold. The SEC lists the securities subject to 13F reporting on its website.
Form 13H. Managers who meet the SEC’s large trader thresholds (in general, managers whose transactions in exchange-listed securities equal or exceed two million shares or $20 million during any calendar day, or 20 million shares or $200 million during any calendar month) are required to file an initial Form 13H with the SEC within 10 days of crossing the threshold. Large traders also need to amend Form 13H annually within 45 days of the end of the year. In addition, changes to the information on the Form 13H will require interim amendments following the calendar quarter in which the change occurred.
Form PF. Managers to private funds that are either registered with the SEC or required to be registered with the SEC and who have at least $150 million in regulatory assets under management (“RAUM”) must file Form PF. Smaller private advisers (fund managers with less than $1.5 billion in RAUM or more in RAUM) must file Form PF within 50 days of the end of each fiscal quarter.
Form MA. Investment advisors that provide advice on municipal financial products are considered “municipal advisors” by the SEC, and must file a Form MA annually, within 90 days of their fiscal year end.
SEC Form D. Form D filings for most funds need to be amended on an annual basis, on or before the anniversary of the most recently filed Form D. Copies of Form D are publicly available on SEC’s EDGAR website.
Blue sky filings. On an annual basis, a manager should its blue sky filings for each state to make sure it has met any initial and renewal filings requirements. Several states impose late fees or reject late filings altogether. Accordingly, it is critical to stay on top of filings deadlines for both new investors and renewals. We also recommend that managers review blue sky filings submission requirements. Many states now permit blue sky filings to be filed electronically through the Electronic Filings Depository (“EFD”) system, and certain states will now only accept filings through EFD.
IARD Annual Fees. Preliminary annual renewal fees for state-registered and SEC-registered investment advisers are due on December 16, 2019. If you have not already done so, you should submit full payment into your Renewal Account by E-Bill, check or wire as soon as possible.
Pay-to-Play and Lobbyist Rules. SEC Rules disqualify investment advisers, their key personnel and placement agents acting on their behalf, from seeking to become engaged by a governmental client if they have made certain political contributions. State and local governments have similar rules, including California, which requires internal sales professionals who meet the definition or “placement agents” (people who act for compensation as finders, solicitors, marketers, consultants, brokers, or other intermediaries in connection with offerings or selling investment advisory services to a state or public retirement system in California) to register with the state as lobbyists and comply with California lobbyist reporting and regulatory requirements. Note that managers offering or selling investment advisory services to local government entities must register as lobbyists in the applicable cities and counties. State laws on Lobbyist registration differ widely, so managers should carefully review reporting requirements in the states in which they operate to make sure they are in compliance with the relevant rules.
Annual Fund Matters
New Issue Status. On an annual basis, managers need to confirm or reconfirm the eligibility of investors that participate in initial public offerings or new issues, pursuant to both Financial Industry Regulatory Authority, Inc. (“FINRA”) Rules 5130 and 5131. Most managers reconfirm investor eligibility via negative consent (i.e. are informed of their status on file with the manager and are asked to inform the manager of any changes), whereby a failure to respond by any investor operates as consent to the current status.
ERISA Status. Given the significant problems that can occur from not properly tracking ERISA investors in private funds, we recommend that managers confirm or reconfirm on an annual basis the ERISA status of their investors. This is particularly important for managers that track the underlying percentage of ERISA funds for each investor, with respect to each class of interests in a pooled investment vehicle.
Wash Sales. Managers should carefully manage wash sales for year-end. Failure to do so could result in book/tax differences for investors. Certain dealers can provide managers with swap strategies to manage wash sales, including Basket Total Return Swaps and Split Strike Forward Conversion. These strategies should be considered carefully to make sure they are consistent with the investment objectives of the fund.
Redemption Management. Managers with significant redemptions at the end of the year should carefully manage unwinding positions so as to minimize transaction costs in the current year (that could impact performance) and prevent transaction costs from impacting remaining investors in the next year. When closing funds or managed accounts, managers should pay careful attention to the liquidation procedures in the fund constituent documents and the managed account agreement.
NAV Triggers and Wavers. Managers should promptly seek waivers of any applicable termination events set forth in a fund’s ISDA or other counterparty agreement that may be triggered by redemptions, performance, or a combination of both at the end of the year. (NAV declines are common counterparty agreement termination events).
Fund Expenses. Managers should wrap up all fund expenses for 2019 if they have not already done so. In particular, managers should contact their outside legal counsel to obtain accurate and up to date information about legal expenses for inclusion int he NAV for year-end performance.
Electronic Schedule K-1s. The Internal Revenue Service (“IRS”) authorizes partnerships and limited liability companies to issue Schedule K-1s to investors solely by electronic means, provided the partnership has received the investor’s affirmative consent. States may have different rules regarding electronic K-1s and partnerships should check with their counsel whether they may still be required to send state K-1s on paper. Partnerships must also provide each investor with specific disclosures that include a description of the hardware and software necessary to access the electronic K-1s, how long the consent is effective, and the procedures for withdrawing the consent. If you would like to send K-1s to your investors electronically, you should discuss your options with your service providers.
“Bad Actor” Recertification Requirement. A security offering cannot rely on the Rule 506 safe harbor from SEC registration if the issuer or its “covered persons” are “bad actors.” Fund managers must determine whether they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 506. The SEC has advised that an issuer may reasonably rely on a covered person’s agreement to provide notice of a potential or actual bad actor triggering event pursuant to contractual covenants, bylaw requirements, or undertakings in a questionnaire or certification. If an offering is continuous, delayed, or long-lived, however, issuers must update their factual inquiry periodically through bring-down representations, questionnaires, and certifications, negative consent letters, periodic re-checking of public databases, and other steps., depending on the circumstances. Fund managers should consult with counsel to determine how frequently such an update is required. As a matter of practice, most fund managers should perform such an update at least annually.
U.S. FATCA. Funds should monitor their compliance with the U.S> Foreign Account Tax Compliance Act (“FATCA”). U.S. FATCA reports are due to the IRS on March 31, 2020 or September 30, 2020, depending on where the fund is domiciled. Reports may be required by an earlier date for jurisdictions that are parties to intergovernmental agreements (“IGAs”) with the U.S. Additionally, the U.S> may require that reports be submitted through the appropriate local tax authority in the applicable IGA jurisdiction, rather than the IRS. Given the varying U.S. FATCA reporting requirements applicable to different jurisdictions, managers should review and confirm the specific U.S. FATCA reporting requirements that may apply. AS a reminder, we strongly encourage managers to file required reports and notifications, even if they already missed previous deadlines. Applicable jurisdictions may be increasing enforcement and monitoring of FATCA reporting and imposing penalties for each day late.
CRS. Funds should also monitor their compliance with the Organisation for Economic Cooperation and Development’s Common Reporting Standard (“CRS”). All “Financial Institutions” in the Cayman Islands and the British Virgin Islands are required to register with the respective jurisdiction’s Tax Information Authority and submit returns to the applicable CRS reporting system by May 31 2020. Managers to funds domiciled in other jurisdictions should also confirm whether any CRS reporting will be required in such jurisdictions. CRS reporting must be completed with the CRS XML v1.0 or a manual entry form on the Automatic Exchange of Information portal. We recommend managers contract their tax advisors to stay on top of the U.S. FATCA and CRS requirements and avoid potential penalties.
Annual Management Company Matters
Management Company Expenses. Managers who distribute profits on an annual basis should attempt to address management company expenses in the year they are incurred. If ownership or profit percentages or adjusted at the end of the year, a failure to manage expenses could significantly impact the economics of the partnership or the management company.
Employee Reviews. An effective annual review process is important to reduce the risk of employee litigation and protect the management company in the event of such litigation. Moreover, it is an opportunity to provide context for bonuses, compensation adjustments, employee goals and other employee-facing matters at the firm. It is not too late to put an annual review process in place.
Compensation Planning. In the fund industry, and the financial services industry in general, the end of the year is the appropriate time to make adjustments to compensation programs. Since much of a manager’s revenue is tied to annual income from incentive fees, any changes to the management structure, affiliated partnerships, or any shadow equity programs should be effective on the first of the year. Make sure that partnership agreements and operating agreements are appropriately updated to reflect such changes.
Insurance. If a manager carries D&O or other liability insurance, the policy should be reviewed on an annual basis to ensure that the manager has provided notice to the carrier of all claims and all potential claims. Newly launched funds should also be added to the policy as appropriate.
Other Tax Considerations. Fund managers should assess their overall tax position and consider several steps to optimize tax liability. Managers should also be aware of self-employment taxes, which can potentially be minimized by structuring the investment manager as a limited partnership. Managers can take several steps to optimize their tax liability. including (i) changing the incentive fee to an incentive allocation; (ii) use of stock-settled stock appreciation rights; (iii) if appropriate terminating swaps and realizing net losses; (iv) making a Section 481(a) election under the Internal Revenue Code of 1986, as amended (the “Code”); (v) making a Section 475 election under the Code; and (vi) making charitable contribution. Managers should consult legal and tax professionals to evaluate these options.
Regulatory & Other Items from 2019
SEC Annual Enforcement Report. On November 6, 2019, the SEC Division of Enforcement published its Annual Report, which highlighted enforcement efforts protecting “main street investors” through the SEC Retail Strategy Task Force, Share Class Selection Disclosure Initiative, misleading risk factor disclosures by public companies, and enforcement efforts regarding ICOs and Digital Assets. The 2019 fiscal year also saw the SEC file its first charges for unlawful promotion of an ICO. Enforcement was also brought against an ICO research and rating service for failing it disclose it was compensated by issuers whose offerings it rated. During teh 2019 fiscal year, the SEC brought a total of 862 enforcement actions and obtained monetary judgments worth 4.3 billion dollars, both of which were increases from 2018 figures.
SEC Enforcement for Failure to Disclose Conflicts Arising from Revenue Sharing. On August 1, 2019, the SEC filed a complain against an SEC Registered Investment Adviser (“RIA”) for its failure to disclose conflicts of interest which arose from a revenue sharing agreement with a broker used by most of the adviser’s clients. The revenue sharing agreement in question provided that, if the adviser invested client assets in certain classes of mutual funds which paid the broker to be listed on its platform, the adviser would receive a portion of such revenue. Between July 2014 and December 2019, the adviser received over $100 million from the broker through this revenue sharing agreement. Through this time, the adviser never disclosed to its clients that there were other mutual fund investments less expensive than the investments subject to the revenue split agreement. Considering such omissions to be material, the SEC determined the adviser’s clients did not make these investments with full knowledge of the adviser’s incentives. Lesson to be learned: fund managers should always ensure all pertinent conflicts of interest, including those related to revenue sharing from third parties, are adequately disclosed to their clients.
SEC Bars Chief Compliance Officer from the Securities Industry. On July 17, 2019, the SEC settled charges of fraud against Colorado investment advisers Salus, LP and S.A.I.C. Limited, and their owners Brandon Copeland and Gregory Prusa, who was also the CCO, for making materially false, statements to prospective investors. The SEC alleged that Mr. Prusa in particular made false or misleading statements in the Form ADV filing for Salus, LP., claiming to have up to $178 million in assets under management and 20 high net worth individual clients. Salus, LP also promoted itself as an SEC RIA. None of this information in the Form ADV was true and Salus, LP never had any assets under management or individual clients.
CFTC And NFA Updates.
CFTC Public Enforcement Manual. For the first time ever, the CFTC’s Division of Enforcement published its Enforcement Manual aiming to provide clarity on the CFTC’s investigations and enforcement of violations. Managers may find the manual useful to evaluate the predictability of CFTC enforcement actions. The manual also highlights the CFTC’s intention to incentivize self-reporting and cooperation with the CFTC as the manual notes such cooperation will be considered in deciding the enforcement outcome, including the possibility of a non-prosecution agreement or deferred prosecution agreement.
Digital Asset Updates.
SEC Emphasis on ICOs. Much like the prior year, throughout 2019, the SEC focused much of its regulatory and enforcement efforts on ICOs. Notable developments included:
SEC Releases a Framework for “Investment Contract” Analysis of Digital Assets. On April 3, 2019, in response to the regulatory and enforcement efforts focused on ICOs, the SEC released guidance on response to the regulatory and enforcement efforts focused on ICOs, the SEC released guidance on ICOs and how to comply with U.S. federal securities law. A key tale-away from the SEC’s guidance and framework is that the SEC is willing to exempt certain digital assets from being treated as securities. While a concrete regulatory scheme has not been crafted to deal specifically with ICOs, the SEC’s framework helps potential digital asset developers understand whether their digital asset is offered or sold as an “investment contract” and therefore subject to U.S. federal securities laws.
Internal Revenue Services Publishes Guidance for Calculating Taxes on Cryptocurrency. On October 9, 2019 the U.S. Internal Revenue service (the “IRS”) published its first guidance in five years relating to taxes owed on cryptocurrency holdings. Most notable in this guidance are the liabilities created by cryptocurrency forks. The IRS guidance states that tax liabilities will only apply to the new cryptocurrencies when they are recorded on the blockchain and if the taxpayer can actually control and spend the coins.
Bakkt Cleared to Launch Bitcoin Futures. Bakkt, a bitcoin futures exchange and digital assets platform founded by the Intercontinental Exchange (“ICE”) was given approval by the CFTC for Bakkt’s futures contracts. Bakkt’s bitcoin futures would be exchanged-traded on ICE Futures U.S. and cleared on IC Clear US, both of whom are regulated by the CFTC. Bakkt also announced it had acquired a New York state trust charter through the New York Department of Financial Services to create the Bakkt Trust Company, a qualified custodian, allowing Bakkt Warehouse – part of the Bakkt Trust Company – to provide bitcoin custodial services for physically delivered futures. September 23, 2019 was the launch date of Bakkt’s custody and physically-settled bitcoin futures contracts products which aims to address issues that have slowed institutional participation in this market in the past.
SEC Approves First-Ever Reg A+ Token Offering. Blockstack became the first company in history to receive SEC approval for a public securities offering where investors would receive tokens. These securities, called “Stacks”, raised a total of $23 million from more than 4,500 investors. In the United States alone $15.5 million was raised through a Reg A+ sale while the other $7.6 million was raised through a Reg S offering in Asia. This approval, although new, has potentially created a regulatory roadmap for public token offerings.
IRS Guidance on Qualified Opportunity Fund. On April 17, 2019, the IRS issued additional guidance for the deferral of capital gains through investment in qualified opportunity funds. Most notable the IRS clarified the “substantially all” requirement for the holdings period and use of tangible business property. Under these new regulations, certain properties are able to qualified as a “qualified opportunity zone business property” if substantially all of the use of such property is in a qualified opportunity zone for substantially all of the qualified opportunity fund’s holding period of such property. This “substantially all” threshold, the IRS clarified, is (i) 70% with respect to the use of the property; and (ii) 90% with respect to the qualified opportunity fund’s holding period of such property.
Cayman Islands Data Protection Law. Effective from September 30, 2019, the Cayman Islands Data Protection Law (the “DPL” and passed in 2017) came into force. The DPL applies to all investment advisers providing investment advise to Cayman Islands funds. Under the DPL, Cayman investment funds are considered “data controllers” even if they are not registered with the Cayman Islands Monetary Authority. Investment advisers to such funds are considered “data processors”. The DPL requires data controllers to update their Cayman fund’s subscription agreements to incorporate DPL compliant language and otherwise provide investors with an updated DPL compliant privacy notice. Fund administrators are also subject to the DPL and must ensure that they are compliant. Updates to a fund’s administration agreement may be required.
New York SHIELD Act. New York State passed the Stop Hacks and Improve Electronic Data Security Act (the “SHIELD Act”) on July 25, 2019 amending the State;s data breach notification law. Designed to take effect in March 2020, the SHIELD Act requires certain businesses and/or individuals to implement safeguards to protect the security, confidentiality, and integrity of information. The SHIELD Act Broadens “private information” to include credit card numbers, debit card numbers, usernames and passwords (including security questions and answers) relating to individual’s online account and biometric information (line fingerprints). The SHIELD Act also expands the definition of “beach” to include unauthorized access to private information (instead of just unauthorized acquisition). The scope of the breach notification was broadened to include persons or businesses that own or license private information of New York resident. This expansion also means the law is no longer limited to those conducting business in New York but also managers who, for example, only store a New York investor’s private information. Managers who own private information of a New York resident should review these updated security measures and implement security programs as specifically discussed in the SHIELD act.
Compliance Calendar. As you plan your regulatory compliance timeline for the coming months, please keep the following dates in mind:
Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Mr. Mallon can be reached directly at 415-868-5345.