Category Archives: Laws

SEC Expands Definition of Accredited Investor

New definition to be effective before end of year

On August 26, 2020, the SEC Commissioners voted to adopt amendments to expand the definition of “accredited investor” and “qualified institutional buyer”. Historically the test for accredited investor status was only based on a person’s income or net worth but has now been expanded in a limited fashion to include persons with certain financial designations. The amendments will become effective 60 days after publication in the Federal Register, which is expected within 1-2 weeks. Below we have highlighted the applicable updates and we will continue to provide information on this topic as it develops.

For more information, please also see the SEC Press Release and Fact Sheet.

Accredited Investor Definition Update

Individuals

With respect to individuals, the following will now also be accredited investors:

(1) individuals with certain qualifying professional certifications, designations and other credentials (currently includes Series 7, Series 65, and Series 82 licensed individuals); and

(2) individuals who are “knowledgeable employees” (which expands the definition from only certain directors, executive officers, etc).

For individuals, the amendments also clarify that natural persons may include the income from “spousal equivalents” for the purposes of calculating joint income and net worth. “Spousal equivalent” is generally defined as a cohabitant occupying a relationship generally equivalent to that of a spouse.

Entities

With respect to entities, the following will now also qualify as accredited investors:

(1) SEC and state-registered investment advisers;

(2) rural business investment companies;

(3) limited liability companies with total assets in excess of $5 million and not formed for the specific purpose of acquiring the securities offered;

(4) entities owning “investments,” as defined in Rule 2a51-1(b) of the Act, in excess of $5 million [note: the intent of this category (4) entities meeting an investments-owned test is to include Native American tribes and other federal, state, territorial, and local government bodies within the accredited investor definition]; and

(5) family offices with at least $5 million in assets under management and their family clients.

Qualified Institutional Buyer Definition Update

Along with the accredited investor update, the definition of “qualified institutional buyer” in Rule 144A will be updated to include entities and any institutional investors that meet the $100 million in securities owned and invested threshold. The scope of the new amendments include Native American tribes, governmental bodies, and bank-maintained collective investment trusts.

Conclusion

While these changes are incremental rather than radical, they are a step in the right direction and hopefully portend further expansion of the definition to allow greater access to the private capital markets. Those parties (investment managers and private placement sponsors) who want to take advantage of the expanded definition will need to speak with legal counsel about updating applicable subscription documents. We will be providing further updates on timing and other matters as they develop.

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Bart Mallon is a founding partner of Cole-Frieman & Mallon LLP. Cole-Frieman & Mallon is a boutique law firm focused on providing institutional quality legal services to the investment management industry. For more information on this topic, please contact Mr. Mallon directly at 415-868-5345.

Independent Directors for Failed Offshore Hedge Fund Found Personally Liable

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Weavering Case Overview

An August 26, 2011 judgment of the Grand Court of the Cayman Islands, Financial Services Division, held two independent directors personally liable for “wilful neglect or default” in exercising their supervisory responsibilities as directors of the Weavering Macro Fixed Income Fund Limited (the “Fund”). The two independent directors were ordered to pay US $111 million plus costs.

The judgment is notable because it gives guidance for directors of Cayman Islands companies in discharging their “duty to exercise independent judgment, to exercise reasonable care, skill and diligence and to act in the interests of the [Fund].” The guidance is likely to impact the manner in which offshore directors supervise functions that are delegated to professional service providers, including investment managers and administrators. The court indicated that the exercise of the power of delegation “does not absolve [independent directors] from the duty to supervise the delegated functions.” “They are not entitled to assume the posture of automatons . . . without making enquiry . . . on the assumption that the other service providers have all performed their respective roles . . . .”

The following points made by the court in the opinion provide useful guidance for independent directors as well as the professional service providers in coordinating with and responding to the supervision of independent directors.

Supervision During Fund Establishment Phase

Directors should satisfy themselves that the overall structure of a fund is consistent with Cayman Island industry standards and that the terms in the service providers’ contracts are reasonable.
Directors should understand the nature and scope of work of each of the professional service providers and determine that the division or responsibilities between the service providers is appropriate.
Directors should satisfy themselves that the hedge fund offering documents comply with the requirements of Cayman Islands law (in particular section 4(6) of the Mutual Funds Law). The court suggests that this may be done by making inquiry of the lawyers who have coordinated the work of developing the offering documents.

Supervision During Ongoing Operations

Directors should convene board meetings to discuss matters of substance and not simply to rubber stamp routine matters raised by the investment manager. Generally, an agenda should be prepared in advance of the meeting and the substance of discussions should be maintained in the minutes at least to the extent that it is necessary to understand the basis upon which any decisions were made and any resolutions passed.
Directors should review a fund’s balance sheet and other financial reports so that they can understand the fund’s general financial/NAV position and satisfy themselves that a fund is trading in accordance with any investment restrictions.
If directors accept a responsibility for a fund’s financial statements, they must exercise independent judgment in satisfying themselves that the financial statement do present fairly the fund’s financial condition.
Directors must be cognizant of issues that are likely to arise from side letters and determine whether there could be an adverse impact on a fund before approving or signing the letters.

Conclusion

We have talked previously about some of the offshore hedge fund structural considerations and we have discussed the issues involved with establishing a Cayman hedge fund, but we have not specifically written a post about the obligations of directors of offshore hedge funds. Independent directors of offshore funds will need to be more cognizant about their duties going forward and the position needs to be taken seriously. As with other high profile hedge funds that have failed, certain service providers and directors are being taken to task for not properly doing what they were supposed to do. As more lawsuits go through the courts we are likely to see more lawsuits similar to this lawsuit.

The case can be found here: Weavering Judgement – Grand Court of the Cayman Islands

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Cole-Frieman & Mallon LLP provides legal services to domestic and offshore hedge funds. Bart Mallon can be reached directly at 415-868-5345. Karl Cole-Frieman can be reached at 415-352-2300.

New Accredited Investor Definition

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Fund Managers Should Amend Subscription Documents

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

Revising Subscription Documents

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

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

SEC. 413. ADJUSTING THE ACCREDITED INVESTOR STANDARD.

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

(b) REVIEW AND ADJUSTMENT.—

(1) INITIAL REVIEW AND ADJUSTMENT.—

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

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

(2) SUBSEQUENT REVIEWS AND ADJUSTMENT.—

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

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

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

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

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SEC Discussion on New Net Worth Rules

Section 179. Rule 215 – Accredited Investor

Question 179.01

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

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

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

Obama Signs Historic Wall Street Reform Bill

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

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

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

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

Other interesting changes:

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

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

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Other related hedge fund law articles:

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

Hedge Fund Court Case | SCERS v. Epsilon Global

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www.hedgefundlawblog.com

Recently, the U.S. District Court for the Western District of Washington came down with a ruling primarily addressing two issues for hedge fund managers: (1) providing investors with timely annual reports and financial statements and (2) delayed redemptions that could bar the management company from charging management fees (see Seattle City Employees’ Retirement System v. Epsilon Global Active Value Fund II, L.P. ). Although the decision is not binding authority in any jurisdiction, it sheds light on how the redemption provisions in a fund’s offering documents fund’s offering documents can affect the management company’s right to continue charging those fees when a redemption is suspended or delayed.

Case Background & Remedy Sought

On March 15, 2010, Seattle City Employees’ Retirement System (“SCERS”), an investor of Epsilon Global Active Value Fund II, L.P. (“Epsilon”), filed suit against the Epsilon, the general partner, the investment manager, and officers of the fund for failing to provide a 2008 annual report and audited financial statement to its investors. When SCERS inquired about the required disclosures and did not receive a satisfactory response from the fund, it decided to request a redemption of its investment on January 28, 2010. About a week later, on February 4, 2010, an Epsilon officer temporarily suspended the redemption of shares in a letter issued to the investors. The letter stated that the funds had not received their audited financial statement for 2008 because an SEC investigation of one of the funds was pending.

Ultimately, SCERS sought a preliminary injunction to:

to disclose the name/address of undisclosed investors, to disclose the name/address of Epsilon’s directors and officers, and
to present documents showing investments into the master fund and the specific fund pending SEC investigation,and
bar Epsilon from collecting management fees,

Court Findings

Disclosures

The court found that although SCERS would likely succeed on the merits of its claim–that Epsilon breached its agreement to produce an annual report and audited financial statement–the court had no power to cure that breach because Epsilon’s auditors had not completed the report and the court could not compel the production of a non-existent report. In addition, SCERS was not entitled to the disclosures that it requested. Neither the offering documents nor the governing substantive law gives SCERS the right to those documents.

Management Fees

With respect to the management fees, the court found that SCERS was unlikely to succeed on the merits. The court reviewed the redemption provisions in the fund’s offering documents. The offering documents grant Epsilon two separate authorities–the power to suspend redemptions and the power to delay redemptions (two very common provisions). The documents provided that the fund shall not charge management fees when the fund delays redemptions, but the documents did not provide that the fund would not charge fees if there was a suspension of redemptions. The court found that the language Epsilon used in its February 4, 2010 letter to the investors indicated a suspension of redemptions, not a delay. Therefore, the court could not bar Epsilon from charging management fees.

Other

The court concluded by indicating that SCERS failed to meet the remaining elements required for a preliminary injunction. In terms of the requested disclosures, SCERS failed to describe what harm would result if it did not receive them. The court denied SCERS’ motion for a preliminary injunction and with no remaining causes of action, the suit was resolved.

Manager Take-Aways

First, manager should always be aware of the possibility of litigation when redemptions are delayed or suspended and should plan accordingly. Although the facts we have about this case are limited to what was included in the opinion, it seems like there may have also been ways that the fund managers could have communicated with the investors to avoid litigation. Another important aspect to this case is drafting of the offering documents – managers should address the issue of management fees on delayed or suspended redemptions. In this case, the documents were drafted (perhaps unintentionally) in a way that favored the manager.

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

Massachusetts Hedge Fund Exemption

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Exclusion From Definition of Investment Adviser

Generally Massachusetts will require hedge fund managers with a place of business in Massachusetts to register as an investment adviser with the Massachusetts Securities Division. However, there is an exemption from registration for some hedge fund managers located in Massachusetts. [Note: to be more accurate, the “exemption” really is an exclusion from the definition of investment adviser under the Massachusetts Securities Act.]

Definition of Investment Adviser

Under Section 401(m) of the Massachusetts Securities Act, the term investment adviser means:

any person who, for compensation, engages in the business of advising others, either directly or through publications or writings, as to value of securities or as to the advisability of investing in, purchasing, or selling securities, or who, for compensation and as a part of a regular business, issues or promulgates analyses or reports concerning securities. …“Investment adviser” shall not include: … a person whose only clients in this state are federal covered advisers, other investment advisers, broker-dealers, banks, savings institutions, trust companies, insurance companies, investment companies as defined in the Investment Company Act of 1940, employee benefit plans with assets of not less than $5,000,000, governmental agencies or instrumentalities, or other financial institutions or institutional buyers, whether acting for themselves or as trustees with investment control; (emphasis added)

This definition is similar for most states and is based on the Uniform Securities Act which was designed to help standardize state securities laws. Normally the definition of “other financial institutions or institutional buyers” is not defined under state law or division regulations and will normally be understood to mean large institutions.

Massachusetts has specifically defined “Institutional Buyer”.

Definition of “Institutional Buyer” for Section 401(m)

Under Massachusetts regulations,

Institutional Buyer shall include any of the following:

a. An organization described in Section 501(c)(3) of the Internal Revenue Code with a securities portfolio of more than $ 25 million.

b. An investing entity whose only investors are accredited investors as defined in Rule 501(a) under the Securities Act of 1933 (17 CFR 230.501(a)) each of whom has invested a minimum of $ 50,000.

c. An entity whose only investors are financial institutions and institutional buyers as set forth in M.G.L. c. 110A, § 401(m) and 950 CMR 12.205(1)(a)6.a. and b.

See 950 CMR Section 12.205(1)(a)(6)

For hedge fund managers, section (b) above is important. A hedge fund would be considered to be an “institutional buyer” if (i) the fund only accepts accredited investors and if (ii) each investor has contributed at least $50,000 to the fund. If the fund does not meet both parts of the test, the fund will not be an “institutional buyer” and the fund manager would not be excluded from the definition of investment adviser and would need to register as such with the Massachussetts Securities Division.

Consequences for Not Registering

If a fund manager does not meet the two tests above, the manager will need to be registered or face certain consequences. These consequences may include:

An order to cease and desist conducting business
A requirement to register with the division
Administrative fines
Offer of rescission of fund interests to investors
Further division scrutiny

Some managers may be tempted to not register but as we can see from a previous Massachussetts Securities Division Complaint against an unregistered hedge fund manager, the consequences and the time/money/effort spent with a formal division complaint will be far more cumbersome than simply registering with the division in the first place.

Conclusion

Many states have intricate laws with respect to hedge fund manager registration. These laws will become even more important to understand if/when the Wall Street Reform bill passes in which case many SEC registered advisers will need to switch to state registration.

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Other related hedge fund law articles:

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

Wall Street Reform and Consumer Protection Act

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Financial Reform Bill Overview & Hedge Fund Registration Requirement

Well over a year after Lehman and Madoff, Congress has finally drafted a single financial reform bill which will be voted on by the House and Senate before being signed by President Obama. Below we have reprinted an overview of the major provisions of the act. As has been regularly discussed over the last few months, hedge funds (and private equity funds) with assets of $100 million will be required to register with the SEC. Additionally, investment advisers who were previously subject to SEC jurisdiction (i.e. mangers with AUM of $30 million to $100 million) will now become subject to state regulation (for more on this terrible idea, please see my article on overburdened state securities divisions).

In addition to hedge fund registration, other major provisions of the bill which will likely have an impact on hedge funds and the investment management industry include:

New Consumer Financial Protection Bureau with a Consumer Hotline
New Financial Stability Oversight Council (could potentially require funds to be subject to supervision by Federal Reserve)
Volcker Rule (limiting bank prop trading and sponsorship of hedge funds)
Increased Transparency into OTC Derivatives (including foreign exchange swaps)
Potential Fiduciary Duty for Brokers furnishing investment advice
Increased SEC funding

The following press release from the House Committee on Financial Services can be found here.

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Dodd-Frank Wall Street Reform and Consumer Protection Act

Create a Sound Economic Foundation to Grow Jobs, Protect Consumers,Rein in Wall Street, End Too Big to Fail, Prevent Another Financial Crisis

Washington, DC – Americans have faced the worst financial crisis since the Great Depression. Millions have lost their jobs, businesses have failed, housing prices have dropped, and savings were wiped out.

The failures that led to this crisis require bold action. We must restore responsibility and accountability in our financial system to give Americans confidence that there is a system in place that works for and protects them. We must create a sound foundation to grow the economy and create jobs.

HIGHLIGHTS OF THE LEGISLATION

Consumer Protections with Authority and Independence: Creates a new independent watchdog, housed at the Federal Reserve, with the authority to ensure American consumers get the clear, accurate information they need to shop for mortgages, credit cards, and other financial products, and protect them from hidden fees, abusive terms, and deceptive practices.

Ends Too Big to Fail Bailouts: Ends the possibility that taxpayers will be asked to write a check to bail out financial firms that threaten the economy by: creating a safe way to liquidate failed financial firms; imposing tough new capital and leverage requirements that make it undesirable to get too big; updating the Fed’s authority to allow system-wide support but no longer prop up individual firms; and establishing rigorous standards and supervision to protect the economy and American consumers, investors and businesses.

Advance Warning System: Creates a council to identify and address systemic risks posed by large, complex companies, products, and activities before they threaten the stability of the economy.

Transparency & Accountability for Exotic Instruments: Eliminates loopholes that allow risky and abusive practices to go on unnoticed and unregulated — including loopholes for over-the-counter derivatives, asset-backed securities, hedge funds, mortgage brokers and payday lenders.

Executive Compensation and Corporate Governance: Provides shareholders with a say on pay and corporate affairs with a non-binding vote on executive compensation and golden parachutes.

Protects Investors: Provides tough new rules for transparency and accountability for credit rating agencies to protect investors and businesses.

Enforces Regulations on the Books: Strengthens oversight and empowers regulators to aggressively pursue financial fraud, conflicts of interest and manipulation of the system that benefits special interests at the expense of American families and businesses.

STRONG CONSUMER FINANCIAL PROTECTION WATCHDOG

The Consumer Financial Protection Bureau

Independent Head: Led by an independent director appointed by the President and confirmed by the Senate.
Independent Budget: Dedicated budget paid by the Federal Reserve system.
Independent Rule Writing: Able to autonomously write rules for consumer protections governing all financial institutions – banks and non-banks – offering consumer financial services or products.
Examination and Enforcement: Authority to examine and enforce regulations for banks and credit unions with assets of over $10 billion and all mortgage-related businesses (lenders, servicers, mortgage brokers, and foreclosure scam operators), payday lenders, and student lenders as well as other non-bank financial companies that are large, such as debt collectors and consumer reporting agencies. Banks and Credit Unions with assets of $10 billion or less will be examined for consumer complaints by the appropriate regulator.
Consumer Protections: Consolidates and strengthens consumer protection responsibilities currently handled by the Office of the Comptroller of the Currency, Office of Thrift Supervision, Federal Deposit Insurance Corporation, Federal Reserve, National Credit Union Administration, the Department of Housing and Urban Development, and Federal Trade Commission. Will also oversee the enforcement of federal laws intended to ensure the fair, equitable and nondiscriminatory access to credit for individuals and communities.
Able to Act Fast: With this Bureau on the lookout for bad deals and schemes, consumers won’t have to wait for Congress to pass a law to be protected from bad business practices.
Educates: Creates a new Office of Financial Literacy.
Consumer Hotline: Creates a national consumer complaint hotline so consumers will have, for the first time, a single toll-free number to report problems with financial products and services.
Accountability: Makes one office accountable for consumer protections. With many agencies sharing responsibility, it’s hard to know who is responsible for what, and easy for emerging problems that haven’t historically fallen under anyone’s purview, to fall through the cracks.
Works with Bank Regulators: Coordinates with other regulators when examining banks to prevent undue regulatory burden. Consults with regulators before a proposal is issued and regulators could appeal regulations they believe would put the safety and soundness of the banking system or the stability of the financial system at risk.
Clearly Defined Oversight: Protects small business from unintentionally being regulated by the CFPB, excluding businesses that meet certain standards.

LOOKING OUT FOR THE NEXT BIG PROBLEM: ADDRESSING SYSTEMIC RISKS

The Financial Stability Oversight Council

Expert Members: Made up of 10 federal financial regulators and an independent member and 5 nonvoting members, the Financial Stability Oversight Council will be charged with identifying and responding to emerging risks throughout the financial system. The Council will be chaired by the Treasury Secretary and include the Federal Reserve Board, SEC, CFTC, OCC, FDIC, FHFA, NCUA and the new Consumer Financial Protection Bureau. The 5 nonvoting members include OFR, FIO, and state banking, insurance, and securities regulators.
Tough to Get Too Big: Makes recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.
Regulates Nonbank Financial Companies: Authorized to require, with a 2/3 vote, that a nonbank financial company be regulated by the Federal Reserve if the council believe there would be negative effects on the financial system if the company failed or its activities would pose a risk to the financial stability of the US.
Break Up Large, Complex Companies: Able to approve, with a 2/3 vote, a Federal Reserve decision to require a large, complex company, to divest some of its holdings if it poses a grave threat to the financial stability of the United States – but only as a last resort.
Technical Expertise: Creates a new Office of Financial Research within Treasury to be staffed with a highly sophisticated staff of economists, accountants, lawyers, former supervisors, and other specialists to support the council’s work by collecting financial data and conducting economic analysis.
Make Risks Transparent: Through the Office of Financial Research and member agencies the council will collect and analyze data to identify and monitor emerging risks to the economy and make this information public in periodic reports and testimony to Congress every year.
No Evasion: Large bank holding companies that have received TARP funds will not be able to avoid Federal Reserve supervision by simply dropping their banks. (the “Hotel California” provision)
Capital Standards: Establishes a floor for capital that cannot be lower than the standards in effect today.

ENDING TOO BIG TO FAIL BAILOUTS

Limiting Large, Complex Financial Companies and Preventing Future Bailouts

No Taxpayer Funded Bailouts: Clearly states taxpayers will not be on the hook to save a failing financial company or to cover the cost of its liquidation.
Discourage Excessive Growth & Complexity: The Financial Stability Oversight Council will monitor systemic risk and make recommendations to the Federal Reserve for increasingly strict rules for capital, leverage, liquidity, risk management and other requirements as companies grow in size and complexity, with significant requirements on companies that pose risks to the financial system.
Volcker Rule: Requires regulators implement regulations for banks, their affiliates and holding companies, to prohibit proprietary trading, investment in and sponsorship of hedge funds and private equity funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial institutions supervised by the Fed will also have restrictions on proprietary trading and hedge fund and private equity investments. The Council will study and make recommendations on implementation to aid regulators.
Extends Regulation: The Council will have the ability to require nonbank financial companies that pose a risk to the financial stability of the United States to submit to supervision by the Federal Reserve.
Payment, clearing, and settlement regulation. Provides a specific framework for promoting uniform risk-management standards for systemically important financial market utilities and systemically important payment, clearing, and settlement activities conducted by financial institutions.
Funeral Plans: Requires large, complex financial companies to periodically submit plans for their rapid and orderly shutdown should the company go under. Companies will be hit with higher capital requirements and restrictions on growth and activity, as well as divestment, if they fail to submit acceptable plans. Plans will help regulators understand the structure of the companies they oversee and serve as a roadmap for shutting them down if the company fails. Significant costs for failing to produce a credible plan create incentives for firms to rationalize structures or operations that cannot be unwound easily.
Liquidation: Creates an orderly liquidation mechanism for FDIC to unwind failing systemically significant financial companies. Shareholders and unsecured creditors bear losses and management and culpable directors will be removed.
Liquidation Procedure: Requires that Treasury, FDIC and the Federal Reserve all agree to put a company into the orderly liquidation process because its failure or resolution in bankruptcy would have adverse effects on financial stability, with an up front judicial review.
Costs to Financial Firms, Not Taxpayers: Taxpayers will bear no cost for liquidating large, interconnected financial companies. FDIC can borrow only the amount of funds to liquidate a company that it expects to be repaid from the assets of the company being liquidated. The government will be first in line for repayment. Funds not repaid from the sale of the company’s assets will be repaid first through the claw back of any payments to creditors that exceeded liquidation value and then assessments on large financial companies, with the riskiest paying more based on considerations included in a risk matrix
Federal Reserve Emergency Lending: Significantly alters the Federal Reserve’s 13(3) emergency lending authority to prohibit bailing out an individual company. Secretary of the Treasury must approve any lending program, and such programs must be broad based and not aid a failing financial company. Collateral must be sufficient to protect taxpayers from losses.
Bankruptcy: Most large financial companies that fail are expected to be resolved through the bankruptcy process.
Limits on Debt Guarantees: To prevent bank runs, the FDIC can guarantee debt of solvent insured banks, but only after meeting serious requirements: 2/3 majority of the Board and the FDIC board must determine there is a threat to financial stability; the Treasury Secretary approves terms and conditions and sets a cap on overall guarantee amounts; the President activates an expedited process for Congressional approval.

REFORMING THE FEDERAL RESERVE

Federal Reserve Emergency Lending: Limits the Federal Reserve’s 13(3) emergency lending authority by prohibiting emergency lending to an individual entity. Secretary of the Treasury must approve any lending program, programs must be broad based, and loans cannot be made to insolvent firms. Collateral must be sufficient to protect taxpayers from losses.
Audit of the Federal Reserve: GAO will conduct a one-time audit of all Federal Reserve 13(3) emergency lending that took place during the financial crisis. Details on all lending will be published on the Federal Reserve website by December 1, 2010. In the future GAO will have authority to audit 13(3) and discount window lending, and open market transactions.
Transparency – Disclosure: Requires the Federal Reserve to disclose counterparties and information about amounts, terms and conditions of 13(3) and discount window lending, and open market transactions on an on-going basis, with specified time delays.
Supervisory Accountability: Creates a Vice Chairman for Supervision, a member of the Board of Governors of the Federal Reserve designated by the President, who will develop policy recommendations regarding supervision and regulation for the Board, and will report to Congress semi-annually on Board supervision and regulation efforts.
Federal Reserve Bank Governance: GAO will conduct a study of the current system for appointing Federal Reserve Bank directors, to examine whether the current system effectively represents the public, and whether there are actual or potential conflicts of interest. It will also examine the establishment and operation of emergency lending facilities during the crisis and the Federal Reserve banks involved therein. The GAO will identify measures that would improve reserve bank governance.
Election of Federal Reserve Bank Presidents: Presidents of the Federal Reserve Banks will be elected by class B directors – elected by district member banks to represent the public – and class C directors – appointed by the Board of Governors to represent the public. Class A directors – elected by member banks to represent member banks – will no longer vote for presidents of the Federal Reserve Banks.
Limits on Debt Guarantees: To prevent bank runs, the FDIC can guarantee debt of solvent insured banks, but only after meeting serious requirements: 2/3 majority of the Federal Reserve Board and the FDIC board determine there is a threat to financial stability; the Treasury Secretary approves terms and conditions and sets a cap on overall guarantee amounts; the President initiates an expedited process for Congressional approval.

CREATING TRANSPARENCY AND ACCOUNTABILITY FOR DERIVATIVES

Bringing Transparency and Accountability to the Derivatives Market

Closes Regulatory Gaps: Provides the SEC and CFTC with authority to regulate over-the-counter derivatives so that irresponsible practices and excessive risk-taking can no longer escape regulatory oversight.
Central Clearing and Exchange Trading: Requires central clearing and exchange trading for derivatives that can be cleared and provides a role for both regulators and clearing houses to determine which contracts should be cleared. Requires the SEC and the CFTC to pre-approve contracts before clearing houses can clear them.
Market Transparency: Requires data collection and publication through clearing houses or swap repositories to improve market transparency and provide regulators important tools for monitoring and responding to risks.
Regulates Foreign Exchange Transactions: Foreign exchange swaps will be regulated like all other Wall Street contracts. At $60 trillion, this is the second largest component of the swaps market and must be regulated.
Increases Enforcement Authority to Punish Bad Behavior: Regulators will be given broad enforcement authority to punish bad actors that knowingly help clients defraud third parties or the public such as when Wall Street helped Greece use swaps to hide the true state of the country’s finances and doubles penalties for evading the clearing requirement.
Higher standard of conduct: Establishes a code of conduct for all registered swap dealers and major swap participants when advising a swap entity. When acting as counterparties to a pension fund, endowment fund, or state or local government, dealers are to have a reasonable basis to believe that the fund or governmental entity has an independent representative advising them.

NEW OFFICES OF MINORITY AND WOMEN INCLUSION

At federal banking and securities regulatory agencies, the bill establishes an Office of Minority and Women Inclusion that will, among other things, address employment and contracting diversity matters. The offices will coordinate technical assistance to minority-owned and women-owned businesses and seek diversity in the workforce of the regulators.

MORTGAGE REFORM

Require Lenders Ensure a Borrower’s Ability to Repay: Establishes a simple federal standard for all home loans: institutions must ensure that borrowers can repay the loans they are sold.
Prohibit Unfair Lending Practices: Prohibits the financial incentives for subprime loans that encourage lenders to steer borrowers into more costly loans, including the bonuses known as “yield spread premiums” that lenders pay to brokers to inflate the cost of loans. Prohibits pre-payment penalties that trapped so many borrowers into unaffordable loans.
Establishes Penalties for Irresponsible Lending: Lenders and mortgage brokers who don’t comply with new standards will be held accountable by consumers for as high as three-years of interest payments and damages plus attorney’s fees (if any). Protects borrowers against foreclosure for violations of these standards.
Expands Consumer Protections for High-Cost Mortgages: Expands the protections available under federal rules on high-cost loans — lowering the interest rate and the points and fee triggers that define high cost loans.
Requires Additional Disclosures for Consumers on Mortgages: Lenders must disclose the maximum a consumer could pay on a variable rate mortgage, with a warning that payments will vary based on interest rate changes.
Housing Counseling: Establishes an Office of Housing Counseling within HUD to boost homeownership and rental housing counseling.

HEDGE FUNDS

Raising Standards and Regulating Hedge Funds

Fills Regulatory Gaps: Ends the “shadow” financial system by requiring hedge funds and private equity advisors to register with the SEC as investment advisers and provide information about their trades and portfolios necessary to assess systemic risk. This data will be shared with the systemic risk regulator and the SEC will report to Congress annually on how it uses this data to protect investors and market integrity.
Greater State Supervision: Raises the assets threshold for federal regulation of investment advisers from $30 million to $100 million, a move expected to significantly increase the number of advisors under state supervision. States have proven to be strong regulators in this area and subjecting more entities to state supervision will allow the SEC to focus its resources on newly registered hedge funds.

CREDIT RATING AGENCIES

New Requirements and Oversight of Credit Rating Agencies

New Office, New Focus at SEC: Creates an Office of Credit Ratings at the SEC with expertise and its own compliance staff and the authority to fine agencies. The SEC is required to examine Nationally Recognized Statistical Ratings Organizations at least once a year and make key findings public.
Disclosure: Requires Nationally Recognized Statistical Ratings Organizations to disclose their methodologies, their use of third parties for due diligence efforts, and their ratings track record.
Independent Information: Requires agencies to consider information in their ratings that comes to their attention from a source other than the organizations being rated if they find it credible.
Conflicts of Interest: Prohibits compliance officers from working on ratings, methodologies, or sales; installs a new requirement for NRSROs to conduct a one-year look-back review when an NRSRO employee goes to work for an obligor or underwriter of a security or money market instrument subject to a rating by that NRSRO; and mandates that a report to the SEC when certain employees of the NRSRO go to work for an entity that the NRSRO has rated in the previous twelve months.
Liability: Investors can bring private rights of action against ratings agencies for a knowing or reckless failure to conduct a reasonable investigation of the facts or to obtain analysis from an independent source. NRSROs will now be subject to “expert liability” with the nullification of Rule 436(g) which provides an exemption for credit ratings provided by NRSROs from being considered a part of the registration statement.
Right to Deregister: Gives the SEC the authority to deregister an agency for providing bad ratings over time.
Education: Requires ratings analysts to pass qualifying exams and have continuing education.
Eliminates Many Statutory and Regulatory Requirements to Use NRSRO Ratings: Reduces over-reliance on ratings and encourages investors to conduct their own analysis.
Independent Boards: Requires at least half the members of NRSRO boards to be independent, with no financial stake in credit ratings.
Ends Shopping for Ratings: The SEC shall create a new mechanism to prevent issuers of asset backed-securities from picking the agency they think will give the highest rating, after conducting a study and after submission of the report to Congress.

EXECUTIVE COMPENSATION AND CORPORATE GOVERNANCE

Gives Shareholders a Say on Pay and Creating Greater Accountability

Vote on Executive Pay and Golden Parachutes: Gives shareholders a say on pay with the right to a non-binding vote on executive pay and golden parachutes. This gives shareholders a powerful opportunity to hold accountable executives of the companies they own, and a chance to disapprove where they see the kind of misguided incentive schemes that threatened individual companies and in turn the broader economy.
Nominating Directors: Gives the SEC authority to grant shareholders proxy access to nominate directors. Also requires directors to win by a majority vote in uncontested elections. These requirements can help shift management’s focus from short-term profits to long-term growth and stability.
Independent Compensation Committees: Standards for listing on an exchange will require that compensation committees include only independent directors and have authority to hire compensation consultants in order to strengthen their independence from the executives they are rewarding or punishing.
No Compensation for Lies: Requires that public companies set policies to take back executive compensation if it was based on inaccurate financial statements that don’t comply with accounting standards.
SEC Review: Directs the SEC to clarify disclosures relating to compensation, including requiring companies to provide charts that compare their executive compensation with stock performance over a five-year period.
Enhanced Compensation Oversight for Financial Industry: Requires Federal financial regulators to issue and enforce joint compensation rules specifically applicable to financial institutions with a Federal regulator.

IMPROVEMENTS TO BANK AND THRIFT REGULATIONS

Volcker Rule: Implements a strengthened version of the Volcker rule by not allowing a study of the issue to undermine the prohibition on proprietary trading and investing a banking entity’s own money in hedge funds, with a de minimis exception for funds where the investors require some “skin in the game” by the investment advisor–up to 3% of tier 1 capital in the aggregate
Abolishes the Office of Thrift Supervision: Shuts down this dysfunctional regulator and transfers authorities mainly to the Office of the Comptroller of the Currency, but preserves the thrift charter.
Stronger lending limits: Adds credit exposure from derivative transactions to banks’ lending limits.
Improves supervision of holding company subsidiaries: Requires the Federal Reserve to examine non-bank subsidiaries that are engaged in activities that the subsidiary bank can do (e.g. mortgage lending) on the same schedule and in the same manner as bank exams, Providesthe primary federal bank regulator backup authority if that does not occur.
Intermediate Holding Companies: Allows use of intermediate holding companies by commercial firms that control grandfathered unitary thrift holding companies to better regulate the financial activities, but not the commercial activities.
Interest on business checking: Repeals the prohibition on banks paying interest on demand deposits.
Charter Conversions: Removes a regulatory arbitrage opportunity by prohibiting a bank from converting its charter (unless both the old regulator and new regulator do not object) in order to get out from under an enforcement action.
Establishes New Offices of Minority and Women Inclusion at the federal financial agencies

INSURANCE

Federal Insurance Office: Creates the first ever office in the Federal government focused on insurance. The Office, as established in the Treasury, will gather information about the insurance industry, including access to affordable insurance products by minorities, low- and moderate- income persons and underserved communities. The Office will also monitor the insurance industry for systemic risk purposes.
International Presence: The Office will serve as a uniform, national voice on insurance matters for the United States on the international stage.
Streamlines regulation of surplus lines insurance and reinsurance through state-based reforms.

INTERCHANGE FEES

Protects Small Businesses from Unreasonable Fees: Requires Federal Reserve to issue rules to ensure that fees charged to merchants by credit card companies for credit or debit card transactions are reasonable and proportional to the cost of processing those transactions.

CREDIT SCORE PROTECTION

Monitor Personal Financial Rating: Allows consumers free access to their credit score if their score negatively affects them in a financial transaction or a hiring decision. Gives consumers access to credit score disclosures as part of an adverse action and risk-based pricing notice.

SEC AND IMPROVING INVESTOR PROTECTIONS

SEC and Improving Investor Protections

Fiduciary Duty: Gives SEC the authority to impose a fiduciary duty on brokers who give investment advice –the advice must be in the best interest of their customers.
Encouraging Whistleblowers: Creates a program within the SEC to encourage people to report securities violations, creating rewards of up to 30% of funds recovered for information provided.
SEC Management Reform: Mandates a comprehensive outside consultant study of the SEC, an annual assessment of the SEC’s internal supervisory controls and GAO review of SEC management.
New Advocates for Investors: Creates the Investment Advisory Committee, a committee of investors to advise the SEC on its regulatory priorities and practices; the Office of Investor Advocate in the SEC, to identify areas where investors have significant problems dealing with the SEC and provide them assistance; and an ombudsman to handle investor complaints.
SEC Funding: Provides more resources to the chronically underfunded agency to carry out its new duties.

SECURITIZATION

Reducing Risks Posed by Securities

Skin in the Game: Requires companies that sell products like mortgage-backed securities to retain at least 5% of the credit risk, unless the underlying loans meet standards that reduce riskiness. That way if the investment doesn’t pan out, the company that packaged and sold the investment would lose out right along with the people they sold it to.
Better Disclosure: Requires issuers to disclose more information about the underlying assets and to analyze the quality of the underlying assets.

MUNICIPAL SECURITIES

Better Oversight of Municipal Securities Industry

Registers Municipal Advisors: Requires registration of municipal advisors and subjects them rules written by the MSRB and enforced by the SEC.
Puts Investors First on the MSRB Board: Ensures that at all times, the MSRB must have a majority of independent members, to ensure that the public interest is better protected in the regulation of municipal securities.
Fiduciary Duty: Imposes a fiduciary duty on advisors to ensure that they adhere to the highest standard of care when advising municipal issuers.

TACKLING THE EFFECTS OF THE MORTGAGE CRISIS

Neighborhood Stabilization Program: Provides $1 billion to States and localities to combat the ugly impact on neighborhood of the foreclosure crisis — such as falling property values and increased crime – by rehabilitating, redeveloping, and reusing abandoned and foreclosed properties.
Emergency Mortgage Relief: Building on a successful Pennsylvania program, provides $1 billion for bridge loans to qualified unemployed homeowners with reasonable prospects for reemployment to help cover mortgage payments until they are reemployed.
Foreclosure Legal Assistance. Authorizes a HUD administered program for making grants to provide foreclosure legal assistance to low- and moderate-income homeowners and tenants related to home ownership preservation, home foreclosure prevention, and tenancy associated with home foreclosure.

TRANSPARENCY FOR EXTRACTION INDUSTRY

For Investors

Public Disclosure: Requires public disclosure to the SEC payments made to the U.S. government relating to the commercial development of oil, natural gas, and minerals on federal land.
SEC Filing Disclosure: The SEC must require those engaged in the commercial development of oil, natural gas, or minerals to include information about payments they or their subsidiaries, partners or affiliates have made to a foreign government for such development in their annual reports and post this information online.

Congo Conflict Minerals:

Manufacturers Disclosure: Requires those who file with the SEC and use minerals originating in the Democratic Republic of Congo in manufacturing to disclose measures taken to exercise due diligence on the source and chain of custody of the materials and the products manufactured.
Illicit Minerals Trade Strategy: Requires the State Department to submit a strategy to address the illicit minerals trade in the region and a map to address links between conflict minerals and armed groups and establish a baseline against which to judge effectiveness.
Deposit Insurance Reforms: Permanent increase in deposit insurance for banks, thrifts and credit unions to $250,000, retroactive to January 1, 2008.
Restricts US Funds for Foreign Governments: Requires the Administration to evaluate proposed loans by institutions such as the IMF or World Bank to a middle-income country if that country’s public debt exceeds its annual Gross Domestic Product, and oppose loans unlikely to be repaid.

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Other related hedge fund law articles:

Cole-Frieman & Mallon LLP provides comprehensive formation and regulatory support for hedge fund managers. Cole-Frieman & Mallon LLP also provides private equity registration support. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Private Fund Investment Advisers Registration Act of 2010

2 Replies

Full Text of PFIARA of 2010 (requiring Hedge Fund Registration)

The following is the full text of the Private Fund Investment Advisers Registration Act of 2010 which was part of the recently passed Senate financial regulation bill. The central part of this act eliminates the Section 203(b)(3) exemption for registration for hedge fund managers (see Section 403). The act also requires hedge fund managers to provide the SEC with certain information about their trading program and investment positions (see Section 404).

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TITLE IV—REGULATION OF ADVISERS TO HEDGE FUNDS AND OTHERS

SEC. 401. SHORT TITLE.

This title may be cited as the ‘‘Private Fund Investment Advisers Registration Act of 2010’’.

SEC. 402. DEFINITIONS.

(a) INVESTMENT ADVISERS ACT OF 1940 DEFINITIONS.—Section 202(a) of the Investment Advisers Act of1940 (15 U.S.C. 80b–2(a)) is amended by adding at the end the following:

‘‘(29) The term ‘private fund’ means an issuer that 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 that Act.

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

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

‘‘(B) has, in total, fewer than 15 clients who are domiciled in or residents of the United States; on DSKH9S0YB1PROD with BILLS

‘‘(C) has aggregate assets under management attributable to clients in the United States and investors in the United States in private funds advised by the investment adviser 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

‘‘(D) neither—

‘‘(i) holds itself out generally to the public in the United States as an investment adviser; nor

‘‘(ii) acts as—

‘‘(I) an investment adviser to any investment company registered under the Investment Company Act of 1940; or

‘‘(II) a company that 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.’’.

(b) OTHER DEFINITIONS.—As used in this title, the terms ‘‘investment adviser’’ and ‘‘private fund’’ have the same meanings as in section 202 of the Investment Advisers Act of 1940, as amended by this title.

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—

(1) in paragraph (1), by inserting ‘‘, other than an investment adviser who acts as an investment adviser to any private fund,’’ before ‘‘all of whose’’;

(2) by striking paragraph (3) and inserting the following:

‘‘(3) any investment adviser that is a foreign private adviser;’’; and

(3) in paragraph (5), by striking ‘‘or’’ at the end; (4) in paragraph (6), by striking the period at the end and inserting ‘‘; or’’; and (5) by adding at the end the following: ‘‘(7) any investment adviser, other than any entity that has elected to be regulated or is regulated as a business development company pursuant to section 54 of the Investment Company Act of 1940 (15 U.S.C. 80a–54), who solely advises— ‘‘(A) small business investment companies that are licensees under the Small Business Investment Act of 1958; ‘‘(B) entities that have received from the Small Business Administration notice to proceed to qualify for a license as a small business investment company under the Small Business Investment Act of 1958, which notice or license has not been revoked; or ‘‘(C) applicants that are affiliated with 1 or more licensed small business investment companies described in subparagraph (A) and that have applied for another license under the Small Business Investment Act of 1958, which application remains pending.’’.

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—

(1) by redesignating subsections (b) and (c) as subsections (c) and (d), respectively; and

(2) by inserting after subsection (a) the following:

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

‘‘(1) IN GENERAL.—The Commission may require any investment adviser registered under this title—

‘‘(A) to maintain such records of, and file with the Commission such reports regarding, private funds advised by the investment adviser, as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk by the Financial Stability Oversight Council (in this subsection referred to as the ‘Council’); and

‘‘(B) to provide or make available to the Council those reports or records or the information contained therein.

‘‘(2) TREATMENT OF RECORDS.—The records and reports of any private fund to which an investment adviser registered under this title provides investment advice shall be deemed to be the records and reports of the investment adviser.

‘‘(3) REQUIRED INFORMATION.—The records and reports required to be maintained by a private fund and subject to inspection by the Commission under this subsection shall include, for each private fund advised by the investment adviser, a description of—

‘‘(A) the amount of assets under management and use of leverage;

‘‘(B) counterparty credit risk exposure;

‘‘(C) trading and investment positions;

‘‘(D) valuation policies and practices of the fund;

‘‘(E) types of assets held;

‘‘(F) side arrangements or side letters, whereby certain investors in a fund obtain more favorable rights or entitlements than other investors;

‘‘(G) trading practices; and

‘‘(H) such other information as the Commission, in consultation with the Council, determines is necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk, which may include the establishment of different reporting requirements for different classes of fund advisers, based on the type or size of private fund being advised.

‘‘(4) MAINTENANCE OF RECORDS.—An investment adviser registered under this title shall maintain such records of private funds advised by the investment adviser for such period or periods as the Commission, by rule, may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(5) FILING OF RECORDS.—The Commission shall issue rules requiring each investment adviser to a private fund to file reports containing such information as the Commission deems necessary and appropriate in the public interest and for the protection of investors or for the assessment of systemic risk.

‘‘(6) EXAMINATION OF RECORDS.—

‘‘(A) PERIODIC AND SPECIAL EXAMINATIONS.—The Commission—

‘‘(i) shall conduct periodic inspections of all records of private funds maintained by an investment adviser registered under this title in accordance with a schedule established by the Commission; and

‘‘(ii) may conduct at any time and from time to time such additional, special, and other examinations as the Commission may prescribe as necessary and appropriate in the public interest and for the protection of investors, or for the assessment of systemic risk.

‘‘(B) AVAILABILITY OF RECORDS.—An investment adviser registered under this title shall make available to the Commission 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.

‘‘(7) INFORMATION SHARING.—

‘‘(A) IN GENERAL.—The Commission shall make available to the Council copies of all reports, documents, records, and information filed with or provided to the Commission by an investment adviser under this subsection as the Council may consider necessary for the purpose of assessing the systemic risk posed by a private fund.

‘‘(B) CONFIDENTIALITY.—The Council shall maintain the confidentiality of information received under this paragraph in all such reports, documents, records, and information, in a manner consistent with the level of confidentiality established by the Commission pursuant to paragraph (8). The Council shall be exempt from section 552 of title 5, United States Code, with respect to any information in any report, document, record, or information made available, to the Council under this subsection.’’.

‘‘(8) COMMISSION CONFIDENTIALITY OF REPORTS.—Notwithstanding any other provision of law, the Commission may not be compelled to disclose any report or information contained therein required to be filed with the Commission under this subsection, except that nothing in this subsection authorizes the Commission—

‘‘(A) to withhold information from Congress, upon an agreement of confidentiality; or

‘‘(B) prevent the Commission from complying with—

‘‘(i) 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

‘‘(ii) an order of a court of the United States in an action brought by the United States or the Commission.

‘‘(9) OTHER RECIPIENTS CONFIDENTIALITY.— Any department, agency, or self-regulatory organization that receives reports or information from the Commission under this subsection shall maintain the confidentiality of such reports, documents, records, and information in a manner consistent with the level of confidentiality established for the Commission under paragraph (8).

‘‘(10) PUBLIC INFORMATION EXCEPTION.—‘‘(A) IN GENERAL.—The Commission, the Council, and any other department, agency, or self-regulatory organization that receives information, reports, documents, records, or information from the Commission under this subsection, shall be exempt from the provisions of section 552 of title 5, United States Code, with respect to any such report, document, record, or information. Any proprietary information of an investment adviser ascertained by the Commission from any report required to be filed with the Commission pursuant to this subsection shall be subject to the same limitations on public disclosure as any facts ascertained during an examination, as provided by section 210(b) of this title.

‘‘(B) PROPRIETARY INFORMATION.—For purposes of this paragraph, proprietary information includes—

‘‘(i) sensitive, non-public information regarding the investment or trading strategies of the investment adviser;

‘‘(ii) analytical or research methodologies;

‘‘(iii) trading data;

‘‘(iv) computer hardware or software containing intellectual property; and

‘‘(v) any additional information that the Commission determines to be proprietary.

‘‘(11) ANNUAL REPORT TO CONGRESS.—The Commission shall report annually to Congress on how the Commission has used the data collected pursuant to this subsection to monitor the markets for the protection of investors and the integrity of the markets.’’.

SEC. 405. DISCLOSURE PROVISION ELIMINATED.

Section 210(c) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–10(c)) is amended by inserting before the period at the end the following: ‘‘or for purposes of assessment of potential systemic risk’’.

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), by inserting before the period at the end of the first sentence the following:

‘‘, including rules and regulations defining technical, trade, and other terms used in this title, except that the Commission may not define the term ‘client’ for purposes of paragraphs (1) and (2) of section 206 to include an investor in a private fund managed by an investment adviser, if such private fund has entered into an advisory contract with such adviser’’; and

(2) by adding at the end the following:

‘‘(e) DISCLOSURE RULES ON PRIVATE FUNDS.—The Commission and the Commodity Futures Trading Commission shall, after consultation with the Council but not later than 12 months after the date of enactment of the Private Fund Investment Advisers Registration Act of 2010, 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 this title and the Commodity Exchange Act (7 U.S.C. 1a et seq.).’’.

SEC. 407. EXEMPTION OF 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:

‘‘(l) EXEMPTION OF VENTURE CAPITAL FUND ADVISERS.—No investment adviser shall be subject to the registration requirements of this title with respect to the provision of investment advice relating to a venture capital fund. Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules to define the term ‘venture capital fund’ for purposes of this subsection.’’.

SEC. 408. EXEMPTION OF AND RECORD KEEPING BY PRIVATE EQUITY 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:

‘‘(m) EXEMPTION OF AND REPORTING BY PRIVATE EQUITY FUND ADVISERS.—

‘‘(1) IN GENERAL.—Except as provided in this subsection, no investment adviser shall be subject to the registration or reporting requirements of this title with respect to the provision of investment advice relating to a private equity fund or funds.

‘‘(2) MAINTENANCE OF RECORDS AND ACCESS BY COMMISSION.—Not later than 6 months after the date of enactment of this subsection, the Commission shall issue final rules—

‘‘(A) to require investment advisers described in paragraph (1) to maintain such records and provide to the Commission such annual or other reports as the Commission taking into account fund size, governance, investment strategy, risk, and other factors, as the Commission determines necessary and appropriate in the public interest and for the protection of investors; and

‘‘(B) to define the term ‘private equity fund’ for purposes of this subsection.’’.

SEC. 409. FAMILY OFFICES.

(a) IN GENERAL.—Section 202(a)(11) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–2(a)(11)) is amended by striking ‘‘or (G)’’ and inserting the following:

‘‘; (G) any family office, as defined by rule, regulation, or order of the Commission, in accordance with the purposes of this title; or (H)’’.

(b) RULEMAKING.—The rules, regulations, or orders issued by the Commission pursuant to section 202(a)(11)(G) of the Investment Advisers Act of 1940, as added by this section, regarding the definition of the term ‘‘family office’’ shall provide for an exemption that—

(1) is consistent with the previous exemptive policy of the Commission, as reflected in exemptive orders for family offices in effect on the date of enactment of this Act; and

(2) recognizes the range of organizational, management, and employment structures and arrangements employed by family offices.

SEC. 410. STATE AND FEDERAL RESPONSIBILITIES; ASSET THRESHOLD FOR FEDERAL REGISTRATION OF INVESTMENT ADVISERS.

Section 203A(a)(1) of the Investment Advisers Act of 1940 (15 U.S.C. 80b–3a(a)(1)) is amended —

(1) in subparagraph (A)—

(A) by striking ‘‘$25,000,000’’ and inserting ‘‘$100,000,000’’; and

(B) by striking ‘‘or’’ at the end;

(2) in subparagraph (B), by striking the period at the end and inserting ‘‘; or’’; and

(3) by adding at the end the following:

‘‘(C) is an adviser to a company that has elected to be a business development company pursuant to section 54 of the Investment Company Act of 1940, and has not withdrawn its election.’’.

SEC. 411. CUSTODY OF CLIENT ASSETS.

The Investment Advisers Act of 1940 (15 U.S.C. 80b–1 et seq.) is amended by adding at the end the following new section:

‘‘SEC. 223. CUSTODY OF CLIENT ACCOUNTS.

‘‘An investment adviser registered under this title shall take such steps to safeguard client assets over which such adviser has custody, including, without limitation, verification of such assets by an independent public accountant, as the Commission may, by rule, prescribe.’’.

SEC. 412. ADJUSTING THE ACCREDITED INVESTOR STANDARD FOR INFLATION.

The Commission shall, by rule—

(1) increase the financial threshold for an accredited investor, as set forth in the rules of the Commission under the Securities Act of 1933, by calculating an amount that is greater than the amount in effect on the date of enactment of this Act of $200,000 income for a natural person (or $300,000 for a couple) and $1,000,000 in assets, as the Commission determines is appropriate and in the public interest, in light of price inflation since those figures were determined; and

(2) adjust that threshold not less frequently than once every 5 years, to reflect the percentage increase in the cost of living.

SEC. 413. GAO STUDY AND REPORT ON ACCREDITED INVESTORS.

SEC. 414. GAO STUDY ON SELF-REGULATORY ORGANIZATION FOR PRIVATE FUNDS.

The Comptroller General of the United States shall—

(1) conduct a study of the feasibility of forming a self-regulatory organization to oversee private funds; and

(2) submit a report to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of such study, not later than 1 year after the date of enactment of this Act.

SEC. 415. COMMISSION STUDY AND REPORT ON SHORT SELLING.

(a) STUDY.—The Division of Risk, Strategy, and Financial Innovation of the Commission shall conduct a study, taking into account current scholarship, on the state of short selling on national securities exchanges and in the over-the-counter markets, with particular attention to the impact of recent rule changes and the incidence of—

(1) the failure to deliver shares sold short; or

(2) delivery of shares on the fourth day following the short sale transaction.

(b) REPORT.—The Division of Risk, Strategy, and Financial Innovation shall submit a report, together with any recommendations for market improvements, including consideration of real time reporting of short sale positions, to the Committee on Banking, Housing, and Urban Affairs of the Senate and the Committee on Financial Services of the House of Representatives on the results of the study conducted under subsection (a), not later than 2 years after the date of enactment of this Act.

SEC. 416. TRANSITION PERIOD.

Except as otherwise provided in this title, this title and the amendments made by this title shall become effecttive 1 year after the date of enactment of this Act, except 5 that any investment adviser may, at the discretion of the investment adviser, register with the Commission under the Investment Advisers Act of 1940 during that 1-year period, subject to the rules of the Commission.

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Cole-Frieman & Mallon LLP is a hedge fund law firm which provides comprehensive formation and regulatory support for hedge fund managers. Bart Mallon, Esq. can be reached directly at 415-868-5345.

Qualified Eligible Person (QEP) Definition

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The securities laws can be written obtusely and the definition of a qualified eligible person (QEP) may be one of the best examples of this. There is no quick and easy definition of a what a QEP is so we are trying to make it as easy as possible to understand. This post discusses the importance of the classification, provides the overview of the definition and then provides a link to the actual statutory language.

Why QEP Definition is Important for CPOs

The definition of QEP is important for commodity pool operators (CPOs) in a couple of situations. The first is the 4.13(a)(4) exemption from the registration provisions for a CPO that provides advice to a commodity pool with only QEPs. The second situation where a CPO will need to make sure the investors are QEPs is if they want to take advantage of the Rule 4.7 exemption. The Rule 4.7 exemption allows CPOs to follow less-strict reporting requirements with regard to the commodity pool they manage. These two exemptions essentially provide for reduced regulatory oversight of a CPO who provides advisory services to these class of investors.

Definition of QEP

A qualified eligible person is an investor who fits into one of two distinct groups: (1) investors who do not need to meet the portfolio requirement and (2) investors who need to meet the portfolio requirement.

1. Investors who do not need to meet the portfolio requirement:

The following are considered to be QEPs regardless of whether or not they meet the portfolio requirement:

registered futures commission merchants
registered broker or dealers
registered commodity pool operators (under certain conditions, see rule for more details)
registered commodity trading advisors (under certain conditions, see rule for more details)
state or SEC registered investment advisers (under certain conditions, see rule for more details)
qualified purchasers
knowledgeable employee of the CPOs
certain persons related to advisers to exempt from registration as a CPO or CTA
trusts (under certain conditions, see rule for more details)
501(c)(3) organizations (under certain conditions, see rule for more details)
non-United States persons
certain entities in which all of the owners/participants are QEPs

2. Investors who need to meet the portfolio requirement:

The following will be considered to be QEPs only if they meet the portfolio requirement described below:

investment companies registered under the Investment Company Act (i.e. mutual funds)
certain business development companies (defined under both the Investment Company Act and Investment Advisers Act)
banks, savings and loan associations, and other like institutions acting for their own accounts or for the account of a QEP
insurance companies acting for their own account or for the account of a qualified eligible person
plans established and maintained by various governments and related bodies for the benefit of their employees, if such plan has total assets in excess of $5,000,000
employee benefit plans within the meaning of the ERISA (under certain conditions, see rule for more details)
501(c)(3) organizations with total assets in excess of $5,000,000
corporations, business trusts, partnerships, LLCs or similar business ventures with total assets in excess of $5,000,000 and not formed for the specific purpose of participating in the exempt investment program
a natural person whose individual net worth, or joint net worth with that person’s spouse, at the time of either his purchase in the exempt pool or his opening of an exempt account exceeds $1,000,000 [HFLB note: this is one part of the accredited investor definition]
a natural person who had an individual income in excess of $200,000 in each of the two most recent years or joint income with that person’s spouse in excess of $300,000 in each of those years and has a reasonable expectation of reaching the same income level in the current year [HFLB note: this is one part of the accredited investor definition]
pools, trusts, insurance company separate accounts or bank collective trusts, with total assets in excess of $5,000,000 (under certain conditions, see below)
other entities authorized by law to engage in such transactions (under certain conditions, see rule for more details)

3. Portfolio Requirement

If an investor is one of the entities described in (2) above, it will also need to meet the portfolio requirement. The portfolio requirement can be met in one of three ways:

Owns securities and other investments with an aggregate market value of at least $2MM;
Has had on deposit with a FCM at least $200K in exchange-specified initial margin and option premiums for commodity interest transactions in the 6 months prior to the investment; or
Has a combination of the two above. For example, has $1MM in securities/investments and $100K in exchange-specified initial margin in the 6 months prior to the investment

The above definitions have been shortened for the purpose of providing a general overview. When determining whether an investor meets the qualified eligible person definition the CPO should take special care to make sure that the investor meets the full definition which can be found here. Generally the investor will make these representations in the subscription documents which are drafted by the hedge fund attorney.

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Bart Mallon, Esq. runs the Hedge Fund Law Blog. He can be reached directly at 415-868-5345.

CPO Reporting Requirements | Commodity Pool Operator Compliance

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CFTC Regulation 4.22 Overview

CFTC registered commodity pool operators have a number of regulatory and compliance issues to be aware of. In addition to a having a compliance program which addresses the business and regulatory issues applicable to the manager, one of the more important compliance requirements is found in CFTC Regulation 4.22 which provides the reporting framework with respect to (i) periodic reports to investors and (ii) annual reports to investors and the NFA. While many hedge fund administration firms provide a monthly or quarterly report/statement, generally those reports/statements do not provide the detailed information that is required for commodity pools. This article provides an overview of the information required to be included in the periodic and annual statements and will also discuss other aspects of the regulation.

Overview of the Statements

Generally CPOs are required to distribute, within 30 days of end of the required period (see below), an account statement to each investor the fund. The account statement must included an itemized “statement of operations” and “statement of changes in net assets” which is presented and computed in accordance with generally accepted accounting principles (“GAAP”).

The statement of operations must separately itemize the following:

Realized net gain/loss on commodity interest positions
Unrealized net gain/loss on commodity interest positions
Total net gain/loss on other transactions (including interest and dividends earned), unless the gain/loss from trading are part of a related trading strategy (see 4.22(e)(3))
Total management fees during period
Total advisory fees during period (including performance fees/allocations)
Total brokerage commissions during period
Total of other fees for investment transactions
Total of other expenses incurred or accrued by the fund during period

Note: most of the above items must be itemized according to 4.22(e)(1) and special allocations should be noted according to 4.22(e)(2).

The statement of changes in net assets must separately itemize the following:

Fund NAV at beginning of period
Fund NAV at end of period
Total contributions to fund during period
Total redemptions (voluntary or involuntary) during period
Total fund income/loss during period
Total value of investor’s interest in the fund at the end of the period

Monthly or Quarterly Commodity Pool Reporting

For funds which have more than $500,000 of assets, the account statements must be sent to investors on a monthly basis. The account statement is due to the investor within 30 days of the end of the month. For funds which have less than $500,000 of assets, the account statements must be sent to investors on (at least) a quarterly basis. The account statement is due to the investor within 30 days of the end of the quarter. In both cases, a final report for the year does not need to be sent to fund investors if the CPO’s annual report (described below) is sent to pool participants within 45 calendar days after the end of the fiscal year.

Annual Reporting Requirement

The CPO will need to provide, within 90 days after the end of the fund’s fiscal year (or within 90 days of the cessation of trading if the fund closes), an annual report to (i) each investor in the fund and (ii) the NFA. The annual report must be presented and computed in accordance with GAAP consistently applied and must be audited by an independent public accountant.*

Annual report must include:

Fund NAV for the preceding two fiscal years
Total value of investor’s interest in the fund at the end of the preceding two fiscal years
Statement of Financial Condition for the fund’s fiscal year and preceding fiscal year
“statement of operations” and “statement of changes in net assets”
Footnotes if required to make statements not misleading (including certain information on underlying funds if the fund invests in other commodity pools)
Certain information if there is more than onve ownership class or series.

In the event that the CPO will not be able to file the annual report with the NFA within the 90 day period, the CPO can file an extension under certain circumstances. It is very important that the CPO provides the annual report on time or files for the exemption. If a CPO cannot file the report within the time frame required and does not file for the exemption, the NFA will take action against the CPO see CFTC Fines CPOs For Late Annual Reports.

*Note: if the fund is organized offshore then the CPO may be able to prepare and calculate the annual report in accordance with International Financial Reporting Standards issued by the International Accounting Standards Board, please generally see 4.22(d)(2).

Statements Required to be Signed by Principals

Both the account statement and the annual report must contain a signed affirmation (usually provided by a principal or associated person of the CPO) that the information contained in the account statement is accurate and complete.

Such information shall include:

Name of individual signing
Capacity of individual signing
Name of the CPO
Name of the fund

Other Items

Regulation 4.22 is intricate and there are many specifics for certain fund managers. Specifically, if a commodity fund invests in other commodity funds there are certain rules which I have not covered in-depth in this overview.

With regard to the fiscal year, most commodity pools will elect to have their fiscal year be the calendar year. A fund can elect to have the fiscal year end on a different date under certain circumstances, see generally 4.22(g).

With regard to account statements and annual reports, these can be provided to fund investors electronically (either through email or through a password-protected website). In the event a fund manager wants to provide statements in this way, the manager will need to make sure the commodity pool’s offering documents specifically discusses this possibility. Additionally, the manager should make sure the fund’s subscription documents include a specific place for the investor to consent to the electronic delivery of the account statement or annual report.

Conclusion

Regulation 4.22 is detailed and, for some groups, complicated. The NFA has shown a willingness to send a message to firms which do not follow NFA rules or CFTC regulations. If you are a CPO and have questions with regard to your account statements or annual reports, please feel free to contact us.

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Bart Mallon, Esq. of Cole-Frieman & Mallon LLP runs the Hedge Fund Law Blog as well as the forex registration website. He can be reached directly at 415-868-5345.