Category Archives: Investment Advisor

Investment Adviser Representative Registration Requirement

Employees of Registered IAs Must Generally be Registered

State-registered investment advisory firms need to make sure that their employees who are deemed to be “investment advisory representatives” are appropriately registered. This means that any employee (or owner) of the IA firm who provides investment advice or who has supervisory authority will generally need to be registered with the state as a representative of the firm. In order to register, the applicant will need to have certain qualifications and generally the series 65 will be sufficient for these purposes.

There are consequences for not properly registering employees as investment advisor representatives. In an earlier article on whether IA firms can have silent owners, we discussed the fact that many state administrators have the power to censure or fine IA firms if they do not follow the registration rules. I recently stumbled across an example of a state taking such an action.

In the attached [intentionally removed], the Texas State Securities Board (“Board”) concluded that the “unregistered employee” of the registered investment advisory firm provided investment advice to IA clients for compensation and that the IA firm failed to maintain a supervisory system reasonably designed to ensure compliance with the Texas Securities Act and Board Rules. The Board reprimanded the IA firm and also ordered an administrative fine of $5,000. The firm was required to comply with the Act and Board Rules moving forward.

The two important take-aways from this order are:

Always make sure employees are registered or clearly exempt from registration, and
Always ensure that you have an up-to-date compliance program that helps to ensure that the firm will operate within all applicable laws and regulations.

We always recommend that registered IA firms discuss any registration and compliance related matters with an experienced investment management attorney with detailed knowledge of the laws of the state where the firm is registered.

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IARD Fee Waiver for 2010

Proposed Hedge Fund Registration Bill Now Excludes VC Funds

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Venture Capital Funds May Not Have to Register with Hedge Funds

While hedge funds have reluctantly resigned to the likely fate of SEC registration (see MFA Supports Registration), the venture capital community has been fighting hard to remain unregistered. On this front, the VC community enjoyed a victory last week as Congressman Paul E. Kanjorski (D-PA) proposed an amendment to the Obama administration’s Private Fund Investment Advisers Registration Act of 2009 (“PFIARA”). The new proposed bill provides an exemption from registration for certain managers to “venture capital funds” as that term will be defined by the SEC. The following section provides the full wording of the new exemption and I end this posts with some of my thoughts on this exemption.

Venture Capital Fund Registration Exemption

The following section has replaced the previous section 6 (which now becomes section 7). Besides this change the PFIARA remains the same.

SEC. 6. EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.

Section 203 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3) is amended by adding at the end the following new subsection:

‘‘(l) EXEMPTION OF AND REPORTING BY VENTURE CAPITAL FUND ADVISERS.—The Commission shall identify and define the term ‘venture capital fund’ and shall provide an adviser to such a fund an exemption from the registration requirements under this section. The Commission shall require such advisers to maintain such records and provide to the Commission such annual or other reports as the Commission determines necessary or appropriate in the public interest or for the protection of investors.’’.

Discussion of the Exemption

From a political perspective, I am actually pretty surprised that this was added to the bill. First, I find it interesting that a bill named the “Private Fund” registration act (not “Hedge Fund” registration act) would then exempt certain private funds. Second, it is curious that the drafter left it to the SEC to create a definition of “venture capital fund” – it will be interesting to see how the SEC interprets this Congressional mandate. Finally, it is also curious that VC funds are specifically exempted and potentially not private equity funds. Generally VC funds are regarded as a type of private equity fund – presumably the SEC could fix this by creating a very broad definition for “venture capital funds” which would also include private equity. Unfortunately this puts the SEC in a difficult position as they will now have to deal with the politics of creating definitions.

We will keep you up to date on this and other bills. Please also remember that this current version of the bill is subject to future change.

For the full proposed bill, please see: Hedge Fund Registration Bill – No VC Registration

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10/1/09: Kanjorski Releases Financial Reform Drafts on Investor Protection, Private Advisor Registration

Capital Markets Chairman Addresses Key Pieces of Financial Regulatory Reform Through Comprehensive Bills and Administration Input

WASHINGTON – Congressman Paul E. Kanjorski (D-PA), Chairman of the House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises, today released discussion drafts of three pieces of legislation aimed at tackling key parts of reforming the regulatory structure of the U.S. financial services industry. The draft bills include the Investor Protection Act, the Private Fund Investment Advisers Registration Act, and the Federal Insurance Office Act.

Chairman Kanjorski introduced bipartisan legislation earlier this year and in the last Congress to create a federal insurance office, which was backed by the Obama Administration and included in its proposals for financial services regulatory reform. Congresswoman Judy Biggert (R-IL), Ranking Member of the House Financial Services Subcommittee on Oversight and Investigations, joined as an original co-sponsor of the 2009 bill when it was first introduced. Chairman Kanjorski also worked to revise and significantly enhance the Investor Protection Act and the Private Fund Investment Advisers Registration Act proposed by the Obama Administration this summer.

“Today, we take another step forward in overhauling the regulatory structure of the financial services industry,” said Chairman Kanjorski. “With these three bills we will address many of the shortcomings and loopholes laid bare by the current financial crisis. The Investor Protection Act will better protect investors and increase the funding and enforcement powers of the U.S. Securities and Exchange Commission. We must ensure that investor confidence continues to increase for the betterment of our financial system.

“Additionally, we need to ensure that everyone who swims in our capital markets has an annual pool pass. The Private Fund Investment Advisers Registration Act will force many more financial providers to register with the SEC. Many financial firms skirt government oversight and get away like bandits, but now the advisers to hedge funds, private equity firms, and other private pools of capital would become subject to more scrutiny by the SEC.

“Finally, bipartisan legislation which I first introduced in the last Congress to create a federal insurance office to fill a gap in the federal government’s knowledge base on financial activities. For several years, including in this Congress, I have worked to advance bipartisan legislation to address this issue, and I am pleased that the Administration also understands the need for this office and welcome the refinements they suggested to my bill.”

Summaries of the three legislative discussion drafts follow:

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Private Fund Investment Advisers Registration Act

Everyone Registers. Sunlight is the best disinfectant. By mandating the registration of private advisers to hedge funds and other private pools of capital, regulators will better understand exactly how those entities operate and whether their actions pose a threat to the financial system as a whole.

Better Regulatory Information. New recordkeeping and disclosure requirements for private advisers will give regulators the information needed to evaluate both individual firms and entire market segments that have until this time largely escaped any meaningful regulation, without posing undue burdens on those industries.

Level the Playing Field. The advisers to hedge funds, private equity firms, single-family offices, and other private pools of capital will have to obey some basic ground rules in order to continue to play in our capital markets. Regulators will have authority to examine the records of these previously secretive investment advisers.

http://kanjorski.house.gov/index.php?option=com_content&task=view&id=1627&Itemid=1

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THE NATIONAL VENTURE CAPITAL ASSOCIATION APPLAUDS VENTURE CAPITAL EXEMPTION LANGUAGE IN DRAFT OF PRIVATE FUND INVESTMENT ADVISERS REGISTRATION ACT

Washington D.C., October 1, 2009 —

The following statement is attributed to Mark G. Heesen, president of the National Venture Capital Association:

“The National Venture Capital Association (NVCA) applauds the Private Fund Investment Advisers Registration Act proposal announced today by Representative Paul Kanjorski (DPA), Chairman of the House Financial Services Capital Markets Subcommittee. We are extremely appreciative of the work done in drafting this legislation by the Subcommittee and Members of the full Committee under the leadership of Chairman Barney Frank (DMA). This proposal recognizes that venture capital firms do not pose systemic financial risk and that requiring them to register under the Advisers Act would place an undue burden on the venture industry and the entrepreneurial community. The venture capital industry supports a level of transparency which gives policy makers ongoing comfort in assessing risk. The NVCA is committed to working with Congress, the SEC and the Administration on the most effective implementation of this proposal.

We look forward to sharing specific thoughts with Members of the Committee on Tuesday, October 6 when NVCA Chairman Terry McGuire is scheduled to testify at the hearing, “Capital Markets Regulatory Reform: Strengthening Investor Protection, Enhancing Oversight of Private Pools of Capital, and Creating a National Insurance Office.” The National Venture Capital Association (NVCA) represents more than 400 venture capital firms in the United States. NVCA’s mission is to foster greater understanding of the importance of venture capital to the U.S. economy and support entrepreneurial activity and innovation. According to a 2009 Global Insight study, venture-backed companies accounted for 12.1 million jobs and $2.9 trillion in revenue in the United States in 2006.

The NVCA represents the public policy interests of the venture capital community, strives to maintain high professional standards, provides reliable industry data, sponsors professional development, and facilitates interaction among its members. For more information about the NVCA, please visit www.nvca.org.

http://www.house.gov/apps/list/press/financialsvcs_dem/discussion_draft_of_the_private_fund_investment_advisors_registration_act.pdf

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Cole-Frieman & Mallon LLP helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510. Other related hedge fund law articles include:

Investment Adviser Registration Filing Tips

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How to get an IA application approved quickly

Occasionally we find the opportunity to comment on other blog posts from other legal professions within and outside of the investment management industry. A legal blogger who I regularly follow is David Feldman from the Reverse Mergers & SPAC Blog. David is the expert in the reverse mergers field and has authored the authoritative text Reverse Mergers: Taking a Company Public Without an IPO (Bloomberg Press). In his post yesterday, Speeding a Self-Filing, he discusses some tips that are designed to help self-filers get through the registration process as quickly as possible. The points are well-received and I would like to take the opportunity to discuss a couple of the points as they relate to the investment adviser registration process with the various state securities commissions. [Note: unlike other types of regulatory filings with the SEC, a SEC investment advisor registration is fairly quick and relatively straightforward. Managers should be aware, however, that the SEC is likely to do a quick examination within the first couple of months after a hedge fund manager registers with the SEC. Usually this is to make sure the advisor is broadly aware of the compliance issues involved with being registered with the SEC.]

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Tip 1

Respond quickly to comments: Management is busy, so are the lawyers and accountants. Nevertheless, one part of the process in your control is how fast you get back to the SEC when they have comments. If you care about getting the self-filing done quickly, drop everything and get the response done as soon as possible.

HFLB thoughts: it is the rare case when a state investment advisor registration gets approved without some sort of comment or inquiry from the securities commission. Depending on the state, the inquiry can be more or less detailed and probing. In most cases, however, once an inquiry is provided to the applicant, registration is likely to be right around the corner. Accordingly, once an inquiry is provided to the manager, the manager and the lawyer should work to get a response drafted immediately.

Tip 2

Don’t argue on comments you will probably give in on later: Often a company or accountant will say, well, we think they will very likely not give us any room on our response, but let’s try and see what happens. If you care about the speed of the process, it is usually not worth challenging comments if your advisers believe there is virtually no chance of success.

HFLB thoughts: we would also like to add that if the regulators are asking for something that does not materially affect the investment program or the manner in which the management company will operate, the manager might be better off acquiescing instead of fighting. I have had groups fight with regulators on principles only to later abandon the fight for practicality. There is definitely an element of picking your battles wisely.

Tip 3

Always be respectful: The SEC is an important and powerful government agency. Almost everyone I have worked with there are highly intelligent and well-meaning folks. But their focus sometimes jibes with that of companies they are seeking to regulate for the protection of investors. Make sure you are always respectful and responsive to the SEC. Not only do they deserve it, but belligerence is just as likely to lead to more ire from them than positive results.

HFLB thoughts: this is an extremely important point. Regulators are charged with a tough and important job and it does not help anyone to be anything less than absolutely respectful.

Many of the above comments apply equally as well for those groups who are registering with other regulatory bodies such as the CFTC (as a CPO or a CTA) and who need to go through the NFA disclosure document review process.

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Please contact us if you have any questions about investment advisor registration or if you would like information on starting a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice, Cole-Frieman & Mallon LLP, is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Mallon P.C. Comments on Proposed Investment Adviser Custody Rule

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In May we reported that the SEC was requesting comments on the new Proposed Investment Adviser Custody Rules. The SEC’s comment period ended this past week with a flurry of activity before the submission deadline. As we reported previously, there has been a general industry backlash against the rule because it does not provide any substantive protection for investors and creates significant additional costs for investment advisory firms – including the requirement of a surprise audit for those adviser which directly debit advisory fees from the client’s brokerage account.

Mallon P.C. participated in this discussion by submitting the following Comment on Proposed Investment Adviser Custody Rule. Specifically we found that there would be no good reason to institute the rule as written and believe that it would harm small investment advisory firms disproportionately. Additionally, we urged the SEC to consider alternatives to the proposed rule which would have more effective investor protections with less impact on the business aspects of the investment advisers who would be subject to the rule.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. If you are a hedge fund manager who is looking to start a hedge fund, or if you have questions about investment adviser registration with the SEC or state securities commission, please call Mr. Mallon directly at 415-296-8510.

Private Fund Investment Advisers Registration Act of 2009

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Bart Mallon, Esq.
http://www.hedgefundlawblog.com

****UPDATE 10/27/2009****

The House Financial Services Committee voted on October 27, 2009 to pass the Private Fund Investment Advisers Registration Act of 2009 as H.R. 3818 (full text of bill as passed – please note that it is different from the earlier version of the bill reprinted below). The bill as passed by the committee required private equity fund managers to register but specifically excludes managers of venture capital funds from the registration requirements. The House Committee released a press release discussing the bipartisan vote.

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Text of Private Fund Investment Advisers Registration Act of 2009

Today the Obama Administration released its proposed legislation which would require hedge fund managers to register with the SEC (as well as private equity fund and venture capital fund managers). The full text of the Private Fund Investment Advisers Registration Act of 2009 has been copied below.

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TITLE IV—REGISTRATON OF ADVISERS TO PRIVATE FUNDS

SEC. 401. SHORT TITLE.

This Act may be cited as the “Private Fund Investment Advisers Registration Act of 2009”.

SEC. 402. DEFINITIONS.

Section 202(a) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-2(a)) is amended by adding at the end the following:

“(29) The term ‘private fund’ means an investment fund that—

“(A) would be an investment company (as defined in section 3 of the Investment Company Act of 1940 (15 U.S.C. 80a-3)), but for section 3(c)(1) or 3(c)(7) of the Investment Company Act of 1940 (15 U.S.C. 80a-3(c)(1) or 80a-3(c)(7)); and

“(B) either—

“(i) is organized or otherwise created under the laws of the United States or of a State; or

“(ii) has 10 percent or more of its outstanding securities owned by U.S. persons.

“(30) The term ‘foreign private adviser’ means any investment adviser who—

“(A) has no place of business in the United States;

“(B) during the preceding 12 months has had—

“(i) fewer than 15 clients in the United States; and

“(ii) assets under management attributable to clients in the United States of less than $25,000,000, or such higher amount as the Commission may, by rule, deem appropriate in accordance with the purposes of this title; and

“(C) neither holds itself out generally to the public in the United States as an investment adviser, nor acts as an investment adviser to any investment company registered under the Investment Company Act of 1940, or a company which has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a-53), and has not withdrawn its election.”.

SEC. 403. ELIMINATION OF PRIVATE ADVISER EXEMPTION; LIMITED EXEMPTION FOR FOREIGN PRIVATE ADVISERS; LIMITED INTRASTATE EXEMPTION.

Section 203(b) of the Investment Advisers Act of 1940 (15 U.S.C. 80b-3(b)) is amended—

(a) in paragraph (1), by inserting “, except an investment adviser who acts as an investment adviser to any private fund,” after “investment adviser” the first time it appears;

(b) by amending paragraph (3) to read as follows:

“(3) any investment adviser that is a foreign private adviser;”; and

(1) in subparagraph (A), by striking “or”;

(2) in subparagraph (B), by striking the period at the end and adding “; or”; and

(3) by adding at the end the following new subparagraph:

“(C) a private fund.”

SEC. 404. COLLECTION OF SYSTEMIC RISK DATA; REPORTS; EXAMINATIONS; DISCLOSURES.

Section 204 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-4) is amended—

(a) by redesignating subsections (b) and (c) as subsections (c) and (d); and

(b) by inserting after subsection (a) the following new subsection (b):

“(b) RECORDS AND REPORTS OF PRIVATE FUNDS.—

“(1) IN GENERAL.—The Commission is authorized to require any investment adviser registered under this Act to maintain such records of and submit to the Commission such reports regarding private funds advised by the investment adviser as are necessary or appropriate in the public interest and for the assessment of systemic risk by the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council, and to provide or make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council those reports or records or the information contained therein. The records and reports of any private fund would be an investment company, to which any such investment adviser provides investment advice, maintained or filed by an investment adviser registered under this Act shall be deemed to be the records and reports of the investment adviser.

“(2) REQUIRED INFORMATION.—The records and reports required to be filed with the Commission under this subsection shall include but shall not be limited to the following information for each private fund advised by the investment adviser:

“(A) amount of assets under management, use of leverage (including off-balance sheet leverage), counterparty credit risk exposures, trading and

investment positions, and trading practices; and

“(B) such other information as the Commission, in consultation with the Board of Governors of the Federal Reserve System, determines necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(3) MAINTENANCE OF RECORDS.—An investment adviser registered under this Act is required to maintain and keep such records of private funds advised by the investment adviser for such period or periods as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(4) EXAMINATION OF RECORDS.—

“(A) PERIODIC AND SPECIAL EXAMINATIONS.—All records of a private fund maintained by an investment adviser registered under this Act shall be subject at any time and from time to time to such periodic, special, and other examinations by the Commission, or any member or representative thereof, as the Commission may prescribe.

“(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this Act shall make available to the Commission or its representatives any copies or extracts from such records as may be prepared without undue effort, expense or delay as the Commission or its representatives may reasonably request.

“(5) INFORMATION SHARING.— The Commission shall make available to the Board of Governors of the Federal Reserve System and the Financial Services Oversight Council copies of all reports, documents, records and information filed with or provided

to the Commission by an investment adviser under section 204(b) as the Board or the Council may consider necessary for the purpose of assessing the systemic risk of a private fund or assessing whether a private fund should be designated a Tier 1 financial holding company. All such reports, documents, records and information obtained by the Board or the Council from the Commission under this subsection shall be kept confidential.

“(6) DISCLOSURES BY PRIVATE FUND.—An investment adviser registered under this Act shall provide such reports, records and other documents to investors, prospective investors, counterparties, and creditors, of any private fund advised by the investment adviser as the Commission, by rules and regulations, may prescribe as necessary or appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

“(7) CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission shall not be compelled to disclose any supervisory report or information contained therein required to be filed with the Commission under subsection (b). Nothing in this subsection shall authorize the Commission to withhold information from Congress or prevent the Commission from complying with a request for information from any other Federal department or agency or any self-regulatory organization requesting the report or information for purposes within the scope of its jurisdiction, or complying with an order of a court of the United States in an action brought by the United States or the Commission. For purposes of section 552 of title 5, United States Code, this subsection shall be considered a statute described in subsection (b)(3)(B) of such section 552.”.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-10) is amended by striking subsection (c).

SEC. 406. CLARIFICATION OF RULEMAKING AUTHORITY.

Section 211 of the Investment Advisers Act of 1940 (15 U.S.C. 80b-11) is amended—

(1) in subsection (a)—

(A) by striking the second sentence; and

(B) by striking the period at the end of the first sentence and inserting the following:

“, including rules and regulations defining technical, trade, and other terms used in this title. For the purposes of its rules and regulations, the Commission may—

“(1) classify persons and matters within its jurisdiction and prescribe different requirements for different classes of persons or matters; and

“(2) ascribe different meanings to terms (including the term ‘client’) used in different sections of this title as the Commission determines necessary to effect the purposes of this title.”; and

(2) by adding at the end the following new subsection:

“(e) The Commission and the Commodity Futures Trading Commission shall, after consultation with the Board of Governors of the Federal Reserve System, within 6 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2009, jointly promulgate rules to establish the form and content of the reports required to be filed with the Commission under subsection 204(b) and with the Commodity Futures Trading Commission by investment advisers that are registered both under the Investment Advisers Act of 1940 (15 U.S.C. 80b et seq.) and the Commodity Exchange Act (7 U.S.C. 1a et seq.).”.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510. Other related hedge fund law articles include:

Obama Moves Forward with Hedge Fund Registration Legislation

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Bart Mallon, Esq.
http://www.hedgefundlawblog.com

Treasury Announces New “Private Fund Investment Advisers Registration Act of 2009”

After much discussion in the press over the last 8 to 10 months abut the possibility for hedge fund registration, the Treasury today announced the Obama Administration’s bill which requires managers to “private funds” to register with the SEC. This registration requirement would apply to managers of all funds relying on the Section 3(c)(1) or Section 3(c)(7) which includes managers to private equity and venture capital funds. Additionally, all registered managers would need to provide the SEC with certain reports on the funds which they manage.

The Treasury release is below and can be found here. We will post the text of the new act shortly. [Update: we have just published the text of the Private Fund Investment Advisers Registration Act of 2009.]

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Fact Sheet: Administration’s Regulatory Reform Agenda Moves Forward: Legislation for the Registration of Hedge Funds Delivered to Capitol Hill

Continuing its push to establish new rules of the road and make the financial system more fair across the board, the Administration today delivered proposed legislation to Capitol Hill to require all advisers to hedge funds and other private pools of capital, including private equity and venture capital funds, to register with the Securities and Exchange Commission (SEC). In recent years, the United States has seen explosive growth in a variety of privately-owned investment funds, including hedge funds, private equity funds, and venture capital funds. At various points in the financial crisis, de-leveraging by such funds contributed to the strain on financial markets. Because these funds were not required to register with regulators, the government lacked the reliable, comprehensive data necessary to monitor funds’ activity and assess potential risks in the market. The Administration’s legislation would help protect investors from fraud and abuse, provide increased transparency, and provide the information necessary to assess whether risks in the aggregate or risks in any particular fund pose a threat to our overall financial stability.

Protect Investors From Fraud And Abuse

Require Advisers To Private Investment Funds to Register With The SEC. Although some advisers to hedge funds and other private investment funds are required to register with the Commodity Futures Trading Commission (CFTC), and some register voluntarily with the SEC, current law generally does not require private fund advisers to register with any federal financial regulator. The Administration’s legislation would, for the first time, require that all investment advisers with more than $30 million of assets under management to register with the SEC. Once registered with the SEC, investment advisers to private funds will be subject to important requirements such as:

Substantial regulatory reporting requirements with respect to the assets, leverage, and off-balance sheet exposure of their advised private funds
Disclosure requirements to investors, creditors, and counterparties of their advised private funds
Strong conflict-of-interest and anti-fraud prohibitions
Robust SEC examination and enforcement authority and recordkeeping requirements
Requirements to establish a comprehensive compliance program

Require Increased Disclosure Requirements. The Administration’s legislation would require that all investment funds advised by an SEC-registered investment adviser be subject to recordkeeping requirements; requirements with respect to disclosures to investors, creditors, and counterparties; and regulatory reporting requirements.

Protect Financial System From Systemic Risk

Monitor Hedge Funds For Potential Systemic Risk. Under the Administration’s legislation, the regulatory requirements mentioned above would include confidential reporting of amount of assets under management, borrowings, off-balance sheet exposures, counterparty credit risk exposures, trading and investment positions, and other important information relevant to determining potential systemic risk and potential threats to our overall financial stability. The legislation would require the SEC to conduct regular examinations of such funds to monitor compliance with these requirements and assess potential risk. In addition, the SEC would share the disclosure reports received from funds with the Federal Reserve and the Financial Services Oversight Council. This information would help determine whether systemic risk is building up among hedge funds and other private pools of capital, and could be used if any of the funds or fund families are so large, highly leveraged, and interconnected that they pose a threat to our overall financial stability and should therefore be supervised and regulated as Tier 1 Financial Holding Companies.

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Bart Mallon, Esq. runs hedge fund law blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Mallon P.C. helps hedge fund managers to register as investment advisors with the SEC or the state securities divisions. If you are a hedge fund manager who is looking to start a hedge fund or register as an investment advisor, please contact us or call Mr. Mallon directly at 415-296-8510. Other related hedge fund law articles include:

Net Capital Requirement for State Registered Hedge Fund Managers

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Overview of Net Capital Requirement and Bond Alternative

Hedge fund managers who need to register as investment advisors in their state of residence often have to deal with the net capital requirement issue. Usually there will be two separate net capital requirements for the investment advisor (meaning the fund’s management company) depending on the nature of the advisor’s business:

Advisors with Discretionary Authority – $10,000
Advisors with Custody – $35,000

[Note: these requirements do not usually apply to forex hedge fund managers unless such managers are also registered as investment advisors.]

Generally all state-registered hedge fund managers will have discretionary authority of the hedge fund’s investments so most advisors will need to maintain the $10,000 requirement. Also, most hedge fund managers will also be deemed to have “custody” of the fund assets because they will either have direct access to the hedge fund’s bank account or because they will directly deposit their management fees from the fund’s brokerage account. Accordingly, most state-registered hedge fund managers will need to maintain the more burdensome $35,000 net capital requirement. There is no requirement to combine the $10,000 with the $35,000 for managers with both discretionary authority and custody – in these situations the manager will only need to maintain the $35,000.

Investment Advisor Bond

As an alternative to maintaining a firm net capital according to the rules above, some states will allow hedge fund managers to post a bond in the required amount instead. Not all states will allow a manager to post a bond instead, so you should be sure to talk with your hedge fund attorney or compliance professional before you begin the process of securing a bond.

Securing the Bond

There are a number of groups out there that can underwrite these sorts of bonds for the money managers. The fees for such bonds will be anywhere from $250 to $1,000, depending on a number of factors including the credit history of the managing member of the fund management company. It will generally take anywhere from a few days to a couple of weeks to secure the bond and from there, the manager will likely need to show proof to the state securities division that the bond has been secured in the appropriate amount.

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Please contact us if you have any questions or would like to start a hedge fund. Other related hedge fund law articles include:

Bart Mallon, Esq. runs Hedge Fund Law Blog and has written most all of the articles which appear on this website. Mr. Mallon’s legal practice is devoted to helping emerging and start up hedge fund managers successfully launch a hedge fund. Cole-Frieman & Mallon LLP will also help state based Investment Advisors to register with their state securities division. If you are a hedge fund manager who is looking to start a hedge fund or an investment advisor looking to register, please call Mr. Mallon directly at 415-296-8510.

Form U4 and Form U5 Amendments

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NASAA Requests Comments on Proposed Changes

Form U4 is the form used by Investment Advisory firms to register investment advisor representatives with their firm. It is also used by broker-dealers to register reps with their firms. Form U5 is used by both IA and BD firms to terminate a representative’s employment with such firm. While I have not reviewed the changes to the forms in depth, the summary discussion (reprinted below) sounds reasonable. We may be submitting comments on these proposals in the future as we discuss with other industry participant – please let us know if you have strong thoughts one way or another on the proposed changes.

The press release and discussion are both reprinted below. For more information, please visit the NASAA site here. Please also review our recommended articles at the very bottom of this page.

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Notice for Request for Comment on Amendments to Forms U4 and U5 and Proposed Guidance for Filings by Investment Adviser Representatives

The proposed changes have been published by both FINRA and the SEC for public comment. On May 13, 2009, the SEC approved the proposed changes. NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this notice includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

The comment period begins June 9, 2009, and will remain open for 14 days. Accordingly, all comments should be submitted on or before June 23, 2009.

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NOTICE FOR REQUEST FOR COMMENT ON AMENDMENTS TO THE UNIFORM APPLICATION FOR SECURITIES INDUSTRY REGISTRATION OR TRANSFER (FORM U4), THE UNIFORM TERMINATION NOTICE FOR SECURITIES INDUSTRY REGISTRATION (FORM U5), AND PROPOSED GUIDANCE FOR FILINGS BY INVESTMENT ADVISER REPRESENTATIVES.

The NASAA CRD/IARD Steering Committee and the CRD/IARD Forms and Process Committee have worked with FINRA, regulators, and representatives of the financial services industry in developing amendments to the Form U4 and Form U5. The proposed changes have been published by both FINRA and the SEC for public comment. On May 13, 2009, the SEC approved the proposed changes. NASAA is now publishing the amended forms for further review and comment by its members and other interested parties in anticipation of adoption of the revised forms by the NASAA membership.

In addition, this memo includes suggested guidance for states in responding to inquiries regarding the impact of the revisions on filings by investment adviser representatives.

Questions or comments regarding the revised forms should be directed to the following individuals:
Melanie Lubin
Office of the Attorney General
Division of Securities
200 Saint Paul Place
Baltimore, Maryland 21202-2020
(410) 576-6360
[email protected]

Pam Epting
Office of Financial Regulation
200 East Gaines Street
Tallahassee, Florida 32399-0372
(850) 410-9819
[email protected]

Joseph Brady
NASAA
750 First Street, NE
Suite 1140
Washington, DC 20002
202-737-0900
[email protected]

The comment period begins June 9, 2009, and will remain open for fourteen (14) days. Accordingly, all comments should be submitted to the individuals noted above on or before June 23, 2009.

Summary of Proposed Changes to Registration Forms

The SEC recently approved amendments for Forms U4 and U5 (“the Forms”). These changes fall into the following categories.

Willful Violations. Additional questions have been added to Form U4 in order to enable regulators to identify more readily individuals and firms subject to a particular category of statutory disqualification pursuant to Section 15(b)(4)(D) of the Exchange Act.
Revision to Arbitration and Civil Litigation Question. Changes were made to the text of the question on the Form U4 regarding disclosure of arbitrations or civil litigation to elicit reporting of allegations of sales practice violations made against a registered person in arbitration or litigation in which that person was not named as a party to the arbitration or litigation.
Revision to Monetary Threshold. The monetary threshold for reporting settlements of customer complaints, arbitrations or civil litigation on the Forms has been raised from $10,000 to $15,000.
Date and Reason for Termination. The definition of “Date of Termination” in the Form U5 has been revised in order to enable firms to amend the “Date of Termination” and the “Reason for Termination” subject to certain conditions.
Technical Amendments. Certain technical and clarifying changes were made to the Forms.

The SEC approved these amendments effective May 18, 2009, except the new disclosure questions regarding willful violations, which become effective 180 days later on November 14, 2009. Firms will be required to amend Form U4 to respond to the new disclosure questions the first time they file Form U4 amendments for registered persons after May 18, 2009, at which time they may provide provisional “no” answers. However, firms must provide final answers to the questions no later than November 14, 2009.

Revisions Regarding Willful Violations.

The amendments modify the Forms to enable regulators to query the CRD system to identify persons who are subject to disqualification as a result of a finding of a willful violation. Specifically, the amendments add additional questions to existing Questions 14C and 14E on Form U4. Question 14C, which inquires about SEC and Commodity Futures Trading Commission (CFTC) regulatory actions, adds three new questions regarding willful violations. Similarly, Question 14E, which concerns findings by a self-regulatory organization, adds three identical questions. The Form U4 Regulatory Action Disclosure Reporting Page (DRP) will continue to elicit specific information regarding the status of the events reported in response to these questions.

Adding new disclosure questions to Form U4 requires firms to amend such forms for all their registered persons. To ensure that firms have appropriate time to populate the forms accurately, the SEC delayed the effective date for the new regulatory action disclosure questions for 180 days until November 14, 2009. This schedule will provide firms with up to 180 days from the release date to answer the regulatory action disclosure questions. Additionally firms, at their discretion, can file provisional “no” answers to the six new regulatory action questions during the 180-day period between the release date and the effective date. During this time, the regulatory action disclosure questions will appear in the CRD system in a manner designed to indicate that such questions are not effective until 180 days from the release date and that any answers provided in response to such questions are provisional until such time as those questions become effective. Any “no” answers filed in response to the new regulatory action disclosure questions during such 180-day period that are not amended before November 14, 2009, will become final, and the firm and subject registered person will be deemed to have represented that the person has not been the subject of any finding addressed by the question(s). If a firm determines that a registered person must answer “yes” to any part of Form U4 Questions 14C or 14E, the amendment filings must include completed DRP(s) covering the proceedings or action reported.

With respect to Form U5, the amendments did not alter Question 7D (Regulatory Action Disclosure), but added new Question 12C to the Form U5 Regulatory Action DRP. As of May 18, 2009, firms that answer “yes” to Question 7D on Form U5 will be required to provide more detailed information about the regulatory action in Question 12C of the DRP. For regulatory actions in which the SEC, CFTC or an SRO is the regulator involved, Question 12C requires firms to answer questions eliciting whether the action involves a willful violation. These questions correspond to the questions added to the Form U4. A firm will not be required to amend Form U5 to answer Question 12C on the DRP and/or add information to a Form U5 Regulatory Action DRP that was filed previously unless it is updating a regulatory action that it reported as pending on the current DRP.

Revisions to the Arbitration and Civil Litigation Disclosure Question.

The Forms have been revised to require the reporting of allegations of sales practices violations made against registered persons in a civil lawsuit or arbitration in which the registered person is not a named party. Specifically, Question 14I on Form U4 and Question 7E on Form U5 were amended to require the reporting of alleged sales practice violations made by a customer against persons identified in the body of a civil litigation complaint or an arbitration claim, even when those persons are not named as parties. The new questions apply only to arbitration claims or civil litigation filed on or after May 18, 2009. A firm is required to report a “yes” answer only after it has made a good-faith determination after a reasonable investigation that the alleged sales practice violation(s) involved the registered person.

Revisions to the Monetary Threshold.

The current monetary threshold for settlements of customer complaints, arbitrations or litigation was set in 1998 and has not been adjusted since that time. The changes to the Forms include raising the existing reporting threshold from $10,000 to $15,000 to reflect more accurately the business criteria (including the cost of litigation) firms consider when deciding to settle claims. This change is reflected in Question 14I on Form U4 and Question 7E on Form U5.

Revisions Regarding “Date of Termination” and “Reason for Termination.”

Revisions to Form U5 provide that the date to be provided by a firm in the “Date of Termination” field is the “date that the firm terminated the individual’s association with the firm in a capacity for which registration is required.” The amendments further clarify that, in the case of full terminations, the “Date of Termination” provided by the firm will continue to be used by regulators to determine whether an individual is required to requalify by examination or obtain an appropriate waiver upon reassociating with a firm. Revisions to Form U5 also clarify that the relevant SRO or jurisdiction determines the effective date of termination of registration. The rule change also permits a firm, as of May 18, 2009, to amend the “Date of Termination” and “Reason for Termination” fields in a Form U5 it previously submitted, but in such cases it requires the firm to provide a reason for each amendment. To monitor such amendments, including those reporting terminations for cause, FINRA will notify other regulators and the broker-dealer with which the registered person is currently associated (if the person is associated with another firm) when a date of termination or reason for termination has been amended. The original date of termination or reason for termination will remain in the CRD system in form filing history.

Technical Revisions.

The Forms were amended to make various clarifying, technical and conforming changes generally intended to clarify the information elicited by regulators and to facilitate reporting by firms and regulators. For example, the amendments eliminated as unnecessary certain cross-references in the Forms. Additionally, certain “free text” fields were converted to discrete fields. The amendments also add to Section 7 of Form U5 (Disclosure Questions) an optional “Disclosure Certification Checkbox” that will enable firms to affirmatively represent that all required disclosure for a terminated person has been reported and the record is current at the time of termination. Checking this box will allow the firm to bypass the process of re-reviewing a person’s entire disclosure history for purposes of filing Form U5 in situations in which disclosure is up to date at the time of the person’s termination. The amendments make additional technical changes to the Forms. For example, they incorporate the definition of “found” from the Form U4 Instructions into the Form U5 instructions; provide more detailed instructions regarding the reporting of an internal review (conducted by the firm); and clarify how an individual may file comments to an Internal Review DRP.

Guidance Regarding U4 Filings for Investment Adviser Representatives.

As explained above, the questions added to items 14C and 14E have been approved by the SEC but the effectiveness of the questions has been delayed until November 14, 2009. The questions currently appear on the form in a manner designed to indicate that they are not currently effective. Further, the answers to the questions currently default to “no” and will continue to do so until they become effective later this year unless a filer manually selects a “yes” answer. The delayed effective date coupled with the default “no” answer is a temporary accommodation in order to give filers an opportunity to determine the appropriate answers to the new questions.

The CRD/IARD Steering Committee has received inquiries regarding how investment adviser representatives should respond to these questions. It is the Steering Committee’s recommendation that state and territorial securities regulators handle the filings for investment adviser representatives in the same manner as broker-dealer agents who file on or after May 18, 2009. That is, investment adviser representatives should be allowed to file provisional responses to the questions contained in 14C and 14E on the Form U4 until such time as the questions become effective on November 14, 2009.

Forms.

Copies of the revisions as approved by the SEC are attached.

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Advisors Tell SEC to Rethink Proposed Custody Rule

2 Replies

Overwhelming Majority of Investment Advisors Disagree with Proposed Changes to Custody Rule

In an effort to deter fraudulent activity, the SEC has proposed to amend Rule 206(4)-2, also known as the ‘custody rule’, to require that all registered investment advisers with custody of client assets engage an independent public accountant to conduct an annual surprise examination of client assets. According to this proposal, there would be no exception to the annual surprise inspection requirement for advisors who possess custody of client funds solely because they withdraw funds from client accounts for payment of a client’s fees. Of the 20 responses submitted to the SEC by investment advisors and related industry professionals, 2 respondents supported the proposal and 18 respondents were opposed. Several of the respondents on both sides of the issue concede that, for those cases where a registered investment advisor does not use a qualified independent custodian, the proposed legislation offers a necessary higher level of scrutiny and oversight.

Respondent Rosamond R. Dewart, retired federal employee, states:

” I would support the proposed rule if […] it could accomplish the intent of the rule. Investment advisers certainly need more scrutiny. I have lost confidence in the entire financial sector.”

However, the majority of respondents argue that the surprise examination requirement will grossly and negatively impact small-to-medium advisers who fall who only possess ‘custody’ of client accounts as described above.

Carolyn Santo, a CFP from Hawaii, asserts in her response:

“The proposed changes to the SEC rules involving making investment advisors pay for surprise audits on themselves is a classic example of an unwieldy and clumsy attempt to protect the investing public from a super micro-minority in the world of white collar crime.”

Those opposed to the proposed changes argue that, due to a number of recent enforcement actions against investment advisors alleging fraudulent conduct , many regulators and politicians assume that the ability to withdraw fees from a client account gives investment advisors complete control of the cash inside the account. Many assert that this assumption is simply not true, and additionally point out that the costs assumed for the surprise audit may be unrealistic and unfair to small-to-medium advisors, forcing some advisors to pass these costs along to client investors.

Peter J. Chepucavage, General Counsel of Plexus Consluting LLC, states:

” We think the added cost is disproportionate to the added compensation, a fact often present in one size fits all regulation.”

Another respondent, John M. Smartt, Jr., CPA, adds:

” The additional proposed regulation, annual audit, is a significantly higher cost without significant benefits. An estimated $8,100 audit charge would cost me more than 10% of my current gross income (as a Tennessee RIA)”.

Some opposed to the new regulation have offered some constructive suggestions as to compliance alternatives that the SEC ought to consider:

Changing the definition of “custody” for accounts held at regulated third party custodians such as brokerage firms and/or trust companies
Increasing public knowledge by disseminating information about the entire industry
Increasing investigation of Red Flag situations (i.e. large withdrawals and lavish spending)
Establishing a substantial reward for information leading to the discovery of a financial scam
Requiring a higher level of disclosure of the independent custodian to the client when cumulative withdrawals are greater than an established percent of the account’s value for the prior quarter.

With regards to the suggestion for greater disclosure, Warren Mackensen, founder of Mackensen & Company, Inc., strongly encourages the SEC to implement the following additional four (4) client protection controls for advisers who debit fees from client accounts to avoid unnecessary an costly annual surprise examinations by a CPA firm:

Requiring custodians to limit fee deductions to, say, 2%, which would provide sufficient investor protection that the adviser is not absconding with client assets
Requiring at least quarterly statements directly from the qualified custodian (our clients receive monthly statements)
Requiring the custodians to send statements in any month in which a client fee was deducted (more immediate notice to the clients if statements are otherwise quarterly); and
Requiring the investment adviser to send an invoice showing the fee calculation directly to the client so that the client may compare the fee computation with his/her monthly statement showing the debited fee.

Others opposed to the proposed changes have noted the following additional points with regards to client protections already in place when an adviser uses a qualified custodian:

The third party custodian already acts as a gatekeeper to the advisors ability to pull funds from client accounts, making it virtually impossible for a an advisor using a major third party custodian, such as Charles Schwab, TD Ameritrade, Fidelity, etc.) to ‘drain the account’ through fees, as they will not process withdrawals that exceed a certain percentage per year.
Any advisor who is able to deduct fees from client accounts needs written authorization to make payments to anyone other than the client, adding an extra layer of protection for the client.

Overall, it appears that the overwhelming response to the proposed legislation indicates that the majority of investment advisors would prefer that the SEC adopt less costly and less time-consuming compliance alternatives to maximize investor protection. With regards to the anticipated effectiveness of the proposed legislation, Carolyn Santo writes,

” The wrongful taking of client assets is a criminal act, and increasing the regulatory burden on the entire industry is not going to lessen the fact that a small number of people are dishonest and will steal from clients.”

To view all comments submitted to the SEC regarding the proposed amendments to Rule 206(4)-2, including discussions from the above-cited respondents, please visit:
http://www.sec.gov/comments/s7-09-09/s70909.shtml